From Interest to Profit-and-Loss Sharing: Reformulating Financial Intermediation Theory in Islamic Banking

Abstract

Conventional theories of financial intermediation explain banks as institutions that reduce transaction costs, resolve information asymmetries through delegated monitoring, and transform liquidity and maturity, earning income from the spread between deposit and lending interest rates. Islamic banking challenges the foundation of these theories by prohibiting interest (ribā) and requiring that returns be linked to the outcomes of real economic activity through profit-and-loss sharing (PLS) contracts such as muḍārabah and mushārakah. This article examines how financial intermediation theory must be reformulated to explain Islamic banking and why Islamic banks in practice continue to rely predominantly on debt-like sale contracts such as murābaḥah. Using a qualitative conceptual and normative approach based on library research, the study analyses classical and contemporary intermediation theory, Islamic economic thought, DSN-MUI fatwas, Indonesian Islamic banking law, and empirical literature on Islamic bank behaviour. The findings show that Islamic banking transforms intermediation in three respects: the bank–customer relationship shifts from creditor–debtor to partnership on the asset side and to investment agency on the liability side; risk is shared rather than transferred; and finance is tied to identifiable real assets or ventures. However, the persistence of murābaḥah dominance reflects unresolved agency problems, information asymmetries, regulatory treatment, and depositor expectations that make PLS financing costly for banks. The article proposes a reformulated intermediation framework consisting of asset-linked intermediation, two-tier risk-sharing intermediation, and value-based intermediation, and identifies institutional conditions, including risk-sharing infrastructure, governance of investment accounts, and supportive regulation, under which the PLS ideal can be progressively realised.