Prof. Turalay Kenc

Professor, INCEIF, Malaysia

The question of whether financial systems should rely on fixed-return debt or risk-sharing arrangements has been central to both conventional and Islamic finance debates. Waqar Masood Khan’s seminal paper “Towards an Interest-Free Islamic Economic System” (1989) (https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3141088) provides a rigorous theoretical foundation for the superiority of risk-sharing contracts under certain conditions.

Using a contract-theoretic model, Khan compares two financial arrangements: the Fixed Return Scheme (FRS), which mirrors conventional debt, and the Variable Return Scheme (VRS), which represents profit-and-loss sharing (PLS) contracts such as Mudarabah or Musharakah.

His analysis assumes a single lender allocating a fixed pool of funds across many independent projects, with symmetric information and costless observability.

Under these conditions, the lender can set the fixed payment D (FRS) or the profit share a (VRS) so that his expected payoff is identical under both schemes. At that point, the borrower’s expected payoff is also equal across the two contracts. The difference lies in the risk profile: under FRS, the borrower faces a discontinuous payoff with a positive probability of zero income if returns fall below D, whereas under VRS, the payoff is proportional to project returns, resulting in a smoother distribution.

For a risk-averse borrower, this lower variance translates into higher expected utility. Khan concludes that for every FRS, there exists a VRS that improves everyone’s welfare—a striking result that challenges the dominance of debt in modern finance.

However, when information asymmetry and monitoring costs are introduced, the advantage of VRS diminishes because debt contracts minimize information requirements, explaining their real-world prevalence.

This theoretical insight contrasts sharply with the perspective advanced by Gary Gorton and co-authors, such as Dang and Holmström (https://www.columbia.edu/~td2332/Paper_Ignorance.pdf, https://www.bis.org/publ/work479.pdf). Their research argues that debt contracts are not an accident of history but an optimal response to information frictions in financial markets.

Debt is “information-insensitive,” allowing “no-questions-asked” trading and supporting deep, liquid markets. Unlike equity or profit-sharing contracts, which require continuous valuation and monitoring, debt instruments trade at a fixed price and avoid costly information production.

This property makes debt socially valuable for liquidity provision, even though it introduces fragility when collateral values become uncertain. Gorton’s policy prescription is to regulate short-term debt markets and ensure collateral quality rather than replace debt with risk-sharing instruments. In essence, while Khan prioritizes allocative efficiency and fairness through risk-sharing, Gorton emphasizes transactional efficiency and liquidity under asymmetric information.

Recent contributions extend this debate in new directions. Lauzier, Lin, and Wang (2025) generalize the theory of Pareto-optimal risk-sharing to agents whose preferences are based on variability measures such as Gini deviation and inter-quantile differences. Their findings confirm that proportional sharing remains optimal under a wide range of conditions, reinforcing the welfare logic behind VRS beyond the expected-utility framework.

Similarly, Song and Jiang (2025) explore revenue-share financing (RSF) in a supply chain context and show that RSF can dominate debt when borrowing costs are high or demand uncertainty is significant.

These studies suggest that risk-sharing contracts retain strong theoretical appeal and practical relevance in environments characterized by uncertainty and risk aversion, provided that governance and monitoring challenges can be managed effectively.

Against this backdrop, asset-backed Ijara Sukuk structures offer a pragmatic solution that blends elements of both paradigms. Properly structured Ijara Sukuk involve a true sale of tangible assets to a bankruptcy-remote special purpose vehicle (SPV), with Sukukholders owning undivided shares in the asset or its usufruct and having recourse to the asset and its lease cash flows. This design creates a Shariah-compliant instrument that is anchored in real assets while generating predictable, contractible lease rentals.

From a Gorton-style liquidity perspective, such instruments approximate the “information-insensitive” qualities of safe assets: they reduce the need for continuous valuation, support secondary-market trading, and can qualify as High-Quality Liquid Assets (HQLA) under Basel III when properly standardized. For Islamic banks, Ijara Sukuk help address the chronic shortage of Shariah-compliant liquidity instruments, enabling compliance with liquidity coverage ratios and facilitating participation in central bank operations.

From Khan’s perspective, Ijara Sukuk do not deliver the full welfare benefits of pure profit-and-loss sharing, but they reduce the monitoring burden relative to equity-like contracts by anchoring claims in observable lease agreements and tangible collateral. This lowers agency costs while preserving a link to the real economy, mitigating some of the systemic fragility associated with unsecured debt.

Moreover, Ijara Sukuk can mobilize long-term capital for infrastructure and public-asset financing by securitizing stable cash flows into tradable securities, thereby deepening Islamic capital markets without compromising Shariah principles.

In short, asset-backed Ijara Sukuk provide a middle path: they offer the stability and liquidity benefits of debt-like instruments while retaining real-asset linkage and bankruptcy remoteness, features that enhance resilience and investor confidence. By doing so, they bridge the gap between the theoretical ideal of risk-sharing and the practical necessity of liquidity, making them a cornerstone for modern Islamic financial architecture.