Islamic Finance gif
monitored because of high information cost by the provider of capital (the principal). But the point is that such information costs will become too high in a profit-only system to insure against risk (as the premium will be too high). Ways and means must, therefore, be found to minimise such costs. Adverse selection problems arise before the contract is signed because the bank has less infor- mation on the project than the entrepreneur (information concerning the characteristics of a venture).
The moral hazard problem occurs at post- investment stage because of the ‘hidden’ action motivated by self-interest of the en- trepreneurs which is unknown to the bank- ers (information concerning the true char- acteristics of an individual entrepreneur are concealed from the bankers).
Performance of Islamic Banks vs. Conven- tional Banks The financial liberalisation and deregula- tion have created new challenges and new realities for IBs; the globalisation effect has also put these institutions in cutthroat competition with traditional financial institu- tions in well developed financial markets. On the other hand, the recent global crisis has renewed the focus on the relationship be- tween both Islamic and conventional banks and financial stability.
some traders are informed and some are not informed. This then translates into a coordination problem among uninformed traders. The coordination problem among uninformed traders plays an explicit or im- plicit role in a wide variety of finance mod- els. For Al-Jarhi, 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 applicants.
When a bank provides equity and debt finance simultaneously, it will have more access to information than when only debt finance is provided. We can therefore conclude that screening would be more effective and ad- verse selection less probable with universal banking. Banking theory would indicate that banks would be relatively more exposed to adverse selection during economic upturns and to moral hazard during downturns.
By allowing entrepreneurs to choose be- tween interest and profit and loss sharing, conventional banks create an adverse se- lection problem for the Islamic banks: entre- preneurs with below-average profit expecta- tions prefer profit and loss sharing in order to minimise their losses in the likely event of failure, while those with above-average expectations prefer interest in order to max-
imise their gains in the likely event of suc- cess. The upshot is that the Islamic banks receive a disproportionately large share of the bad risks”.
Moral Hazard Abdul Rahman distinguished between ex ante and ex post moral hazard problems. Ex ante moral hazard problems arise from the fact that financial institution cannot ef- fectively monitor borrowers and therefore cannot write a credible contract that enforc- es prudent behavior. Ex post Moral hazard problems arise as it is assumed that the financial institution cannot observe such re- turns and thus borrowers have incentives to pretend that their returns are low or default on their debt obligations.
Akerlof and Romer further elaborate on the moral hazard, arguing that banks may use fraudulent lending practices (such as insider lending) to “loot” banks. In this case bank managers extract value out of the banks even if this leads to insolvency.
The moral hazard phenomenon, noted in the text, is by no means specific to Islamic bank- ing; it exists in all situations, quite common in a capitalist system, where de centralised decision-making is the rule, and where there are incentives for economic agents (the agency), whose activities cannot be perfectly
As Islamic banking has become a phenom- enon, economists have started to study the benefit of financial transactions that are free of interest. The idea of prohibiting interest now has a new, economic dimension, as a result of which, religion is no longer the only reason for eliminating interest from busi- ness transactions. In theory, many economic advantages to interest-free banks have been suggested. In 1995, the International As- sociation of Islamic Banks (IAIB) described three profound advantages, as follows.
• The involvement of the bank in busi- ness will improve the efficiency of capi- tal allocation. The bank will be more concerned about the productivity of a project in which it shares losses and profits. A better allocation of the availa- ble funds can be achieved. In contrast, in the case of interest-based banks, the banks earn a fixed rate of interest; there is therefore no incentive to give priority to those ventures that have the highest profit potential.
• The socio-economic aspect of Islamic banking can help to create more job op- portunities, because the feasibility and productivity of a project are the only cri- teria on which an Islamic bank will base its financing decision. Consequently,
2012 May Global Islamic Finance 67
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