by James Wilcox

More than a dozen countries have both sizable conventional banks and Islamic banks. Instead of paying fixed deposit interest rates, which are prohibited by sharia law, Islamic banks offer profit and loss sharing (PLS) accounts. Payments to PLS accounts should vary with banks’ earnings. To the extent that they do, PLS accounts may be more equity-like than deposits at conventional banks. However, widespread consensus holds that Islamic banks’ payments to depositors are nearly indistinguishable from the interest rates paid by conventional banks. We estimate how much Islamic banks pass through their PLS-related earnings to PLS-related accounts and how much their responses to various factors differ from those of conventional banks. We also analyze how much Islamic banks’ profit and loss sharing has been obscured by previous data difficulties and by their smoothing over time the payments to PLS accounts. The results may shed light on the prospects for PLS loans and deposits as a source of more-equity-like financing from banks for smaller businesses, which often obtain few conventional loans from banks.