gif Islamic Finance
refers to the sale of goods at a price, which includes a profit margin agreed to by both parties. The purchase and selling price, other costs, and the profit margin must be clearly stated at the time of the sale agreement.
Islamic banks are very similar to their con- ventional competitors in terms of the legal formation procedures. Generally, banks are mainly structured as companies or corpora- tions, two terms that are used to describe organisations that are associated with the aim of carrying out business for gain.
The formation process of Islamic banking companies is similar to that of conventional banks, except that the shareholders of Is- lamic banks will demand that their banking company refrain from many transactions, such as those relating to trading in alcohol and tobacco production. In the case of Is- lamic banking companies, however, the ba- sis of the institution requires the presence of a special board: the Sharia Supervisory Board (SSB). This body has been defined as ‘the main vehicle to evaluate, approve contract documents and supervise all op- erations of the bank in conformity with its objectives and ultimately with principles of Islamic law’.
Accordingly, the board consists of schol- ars in Islamic laws who have a background in economics and finance. The role of this board is totally different from the role of the board of directors, although the two boards, in one way or another, collaborate to run the company. Members of the SSB ensure that the transactions carried out by the institu- tion comply with the principles of Islamic finance.
Relationships between depositors, inves- tors and bankers As has been noted, Islamic economic theory is highly driven by certain ethical issues. Most of the prohibitions stated in the main textual sources have a moral dimension, such as the prohibition of interest. The other injunctions offered by Islamic economic the- ory also rely on the ethical commitment of individuals: voluntary charitable giving, for example, is not imposed by any of the tex- tual sources of the Islamic law; rather, it is based on the individual’s own commitment to certain moral aims and objectives.
Further, the key principles of Islamic eco- nomic theory (justice, equality and fairness) are based on certain values such as consid- eration of the needs of other individuals, not taking advantage of those who are in diffi- culty, and selflessness. It must be noted that the individuals’ commitment to the ethical aspect of Islamic economic theory is based
66 Global Islamic Finance May 2012
on its religious genesis. The individuals’ beliefs in the rewards granted and punish- ments meted out in this world and the next, and in the pleasure or displeasure of God, have a key role in maintaining the individu- als’ commitment to these principles. All the involved parties in any financial transactions under the umbrella of the Islamic finance have no interest in exploiting one another. Cooperation is a key to the success because if the transaction fails, they all fail.
Yet, it is still important to maintain and guar- antee discipline and for that the Shariah su- pervisory board was created. Furthermore, Islamic intermediation is asset-based and centers on risk sharing. This eliminates and reduces the probability of defaults by bond issuers. In fact, concepts of asymmetric in- formation, moral hazard, and adverse selec- tion went a long way in explaining a large number of capital market phenomena as well as behaviour of capital market partici- pants. The main concepts related to asym- metric information are explained.
Adverse selection Adverse selection, anti-selection, or nega- tive selection is a term used in economics, insurance, statistics, and risk management. It refers to a market process in which “bad” results occur when buyers and sellers have asymmetric information (i.e. access to dif- ferent information): the “bad” products or customers are more likely to be selected. Adverse selection problems arise before the contract is signed because the bank has less information on the project than the cli- ent (borrower). Mishkin, adverse selection is an asymmetric information problem that transpires before the transaction occurs, when parties who are the most likely to pro- duce an undesirable (adverse) outcome for a financial contract are most likely to try to enter the contract and thus be selected.
Financial transactions do expose Islamic banks to principal-agent problem when the bank enters into the contract as rab al- mal (principal) and the user of funds is the agent. Adverse selection problems arise be- fore the contract is signed because the bank has less information on the project than the entrepreneur (information concerning the characteristics of a venture).
According to Ali, the bank would be exposed to adverse selection when it fails to choose the finance applicants who are most likely to perform. Obviously, adverse selection can be avoided by careful screening of finance seekers. When a bank provides equity and debt finance simultaneously, it will have more access to information than in a situ- ation when only debt finance is provided. It could, therefore, be concluded that screen-
ing would be more effective and adverse se- lection less probable with universal banking. In summary, banking theory indicates that Islamic banks should operate as universal banks, and when they do, they would be ex- posed to lower levels of moral hazard and adverse selection.
Adverse selection is one of asymmetric infor- mation problems arise in a situation where one party has extra information that oth- ers don’t. It creates the other party to have a failure judgment in making a decision. In the case of Shariah banks, adverse selec- tion is a situation where bad debtors have more information about their business pro- posal future condition. Although in the be- ginning of business proposal they already have loss calculation on the business, they still propose the business to Shariah banks, because the risk will be shared between the banks and the debtors.
For Morris and Shin, some participants in financial markets have either private in- formation or better expertise in evaluating new financial instruments and markets. This gives rise to adverse selection. In Akerlof and the classical adverse selection models that followed, there is market unravelling with equally informed traders on both sides of the market. We are concerned with situ- ations where, on both sides of the market,
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