The Implications of Agency Theory on Mudarabah and Musharakah Agreements: A Comparison with Conventional Debt

Sammanfattning: This is a theoretical study analysing the Islamic profit-sharing agreements mudarabah and musharakah. In the analysis mudarabah and musharakah agreements are compared to conventional debt agreements. By using a framework with verifiable payoff structure structural characteristics that have been omitted in previous research are addressed. It is found that, despite underreporting being stated as the main problem of these instruments, there are also other types of moral hazard problems inherent to the structure of mudarabah and musharakah contracts. The analysis illustrates that debt serves as a better incentive device to induce high effort. It is found that under mudarabah and musharakah, capital structure problems can arise only when the entity does not have sufficient retained earnings, when covenants limit the entrepreneur's mandate to seek outside financing or if a bonus strategy gives incentive to take on risky projects. The presence of information asymmetries are more harmful to profit-sharing agreements compared to debt agreements, leading to higher risk of market-breakdown. It is concluded that in contrast to debt, profit-sharing agreements are unlikely to function in the absence of mechanisms sending signals regarding the type of the project.