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Guarantees and Profit-Sharing Contracts in Project Financing

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An Erratum to this article was published on 03 July 2014

Abstract

This paper proposes a model to study the arrangement of Islamic project finance with the participation of the government as a provider of loan guarantees. The owner-shareholders (musharakah certificate holders) initiate a project and raise funds by issuing Islamic profit-loss sharing mudarabah certificates. The government intervenes in providing financial guarantees in order to enhance the creditworthiness and increase the mudarabah capital capacity of the project. Our work raises several policy implications related to the structuring of Islamic project finance and the participation of both government and multilateral public agencies such as the Islamic Development Bank. It provides a unifying framework for the improvement of access to funds for Islamic projects and gives a rationale for government intervention in the arrangement of these projects.

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Notes

  1. Shariah is an Arabic word. And Shariah law is the legislative framework that regulates all aspects of life, both private and public.

  2. In fiscal year 2005 (as of September 2005), Export–Import Bank the export credit agency of the United States supported by project finance US $ 405 million in Qatar Liquified Gas Co. II, US $ 230 million dollar US in Egypt Basic Industries Corp. (EBIC) and US $ 263 million in Q-Chem II. (See Export–Import Bank of the United States website: http://www.exim.gov/products/guarantee/pfauth.html). On September 13, 2005, the Multilateral Investment Guarantee Agency, MIGA, a private sector branch of the World Bank Group, said it issued $1.2 billion in investment guarantees (insurance) for 33 new projects (62 contracts) in developing countries during the fiscal year ending June 30, 2005. (See MIGA website: http://www.miga.org/).

  3. Here flexibility over the investment amount means that the entrepreneur can maximize his net wealth from the project and decide on the amount to invest. Obviously, this is not contrary to the basic economic concept of decreasing returns to scale, as the entrepreneur will do so as long as the marginal gain to him outweigh the marginal cost. In our framework, we impose a minimum investment level to be done in the project, in that sense, the project is divisible beyond the minimum investment threshold.

  4. http://ifsb.org/terminologies.php.

  5. It is a guarantee by the bank or a third party on behalf of its customer, ensuring that his liabilities will be met.

  6. Note that there is no risk-free rate in Islamic finance, but as argued by some Islamic scholars, money deposited in an account and not used for investment can receive compensation for the opportunity cost or the deterioration in purchasing power for the depositor (e.g. Omar et al. (2010)). There is no common agreement among Islamic scholars on what rate should be applied as compensation. For instance, Aziz and Rahman (1999), among many other scholars, propose to use the zakat requirement (2.5 %) as a proxy for the risk-free rate in designing an Islamic version of the security market line. Jobst (2007) used a risk-free rate of 5 % to value securities under Islamic laws. Although, the author did not discuss the risk-free rate per se, one may suspect the risk-free rate to be equivalent to the inflation rate or opportunity cost. One may therefore legitimately take the inflation rate as an opportunity cost for the depositor. To be fair, it would be appropriate to provide the inflation rate to any money deposit in a bank account and not used for any specific project. This is a kind of risk sharing as well. As we have witnessed recently, real interest rate in the economy can be negative, which will imply negative returns for depositors and thus supporting the business cycle risk.

  7. See Hull (2008) for a general discussion on the use of risk neutral valuation in valuing real options and the estimation of λ. Schwartz and Moon (2000) propose a risk neutral pricing model of internet companies. Moreover, without loss of generally, we can assume the existence of a risk premium, μ−λσ, equals to any other rate than the inflation rate, π, and that won’t affect the main message of the paper.

  8. In our framework, we assume no intermediate payments before the maturity T of the project. However, if the intermediate cash flows have to be shared, this will require a modification to the option price as in Lai and Soumaré (2010) and the use of numerical methods to solve the problem. In addition, we do not address the issue of optimal capital structure for the project as done in Lai and Soumaré (2010), since it is not the main focus of our paper. Even with this simplified framework, our results raise important policy issues on the structuring of Islamic project finance with government intervention.

  9. From Eq. (5b), we can put together the expressions with D on the left hand side as follows: \( D - e^{ - \pi T} DN(y - \sigma \sqrt T ) = V_{0} (I)e^{(\mu - \lambda \sigma - \pi )T} \left[ {q(1 - \tau_{c} )N(x) + N( - y)} \right] - q(1 - \tau_{c} )e^{ - \pi T} IN(x - \sigma \sqrt T ) \), and next we divide the expressions on the left and right sides by \( (1 - e^{ - \pi T} N(y - \sigma \sqrt T )) \), which yields Eq. 6.

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Acknowledgments

Issouf Soumaré gratefully acknowledges financial support from the Institut de Finance Mathématique of Montréal, the Fonds Québecois de la Recherche sur la Société et la Culture (FQRSC) and the Social Sciences and Humanities Research Council of Canada (SSHRC). We thank seminar participants at Laval University, the 2006 Asian FA/FMA annual meeting, 2006 Academy of Financial Services annual conference and 2008 Financial Management Association Meetings, and National University of Malaysia, 2012 for their helpful comments and suggestions. The usual disclaimer applies.

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Authors and Affiliations

  1. Department of Economics and Finance, University of New Orleans, New Orleans, LA, 70148, USA

    M. Kabir Hassan

  2. Department of Finance & Insurance, Faculty of Business Administration, Laval University, Quebec, QC, G1K 7P4, Canada

    Issouf Soumaré

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  1. M. Kabir Hassan
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Correspondence to M. Kabir Hassan.

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Kabir Hassan, M., Soumaré, I. Guarantees and Profit-Sharing Contracts in Project Financing. J Bus Ethics 130, 231–249 (2015). https://doi.org/10.1007/s10551-014-2201-0

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