Asymmetric Information and Islamic Financial Contracts

Abstract

This research paper aims to examine the relevance of asymmetric information to the two main financial contracts used by Islamic banks or conventional banks with Islamic windows, mudaraba and musharaka. We use theoretical proofs to explain how asymmetric information affects mudaraba and musharaka contract in terms of bank cost and yield and how to account for the adverse selection and moral hazard costs when calculating bank net profit or loss. We also provide suggestions supported by key modern theories including signalling, comparative advantage and incentives to resolve asymmetric information problems in the Islamic financial contracts. The research paper shows that asymmetric information is relevant to both mudaraba and musharaka contracts and directly affects Islamic banks and conventional banks with Islamic windows cost and yield. The paper also reveals that signalling and incentives are effective tools to deal with asymmetric information in Islamic financial contracts. Finally, the paper shows that Islamic finance providers need to opt for more secure financing, particularly with small borrowers.

Competition, capital growth and risk-taking in emerging markets: Policy implications for banking sector stability during COVID-19 pandemic

“…Taking into the account the nature of financial contracts used by Islamic banks or conventional banks with Islamic windows, such as musharaka , one may expect that the information used in the screening process of clients to be largely soft, which raises both the risk and costs incurred by the bank when assessing their clients. Relationship banking is one possible approach to resolve this problem as it enables better monitoring and screening of borrower [ 60 ]. Besides, banks can use their comparative advantage when monitoring clients.…”

“…High banking reserves and capital provide more assurance to banks against asymmetric information, particularly for those who are placing their funds under less restricted financial contracts like mudaraba . Moreover [ 60 ], suggests that Islamic financial contracts are subject to different type of asymmetric information ( gharar ) -related problems at both the ex-ante and ex-post stages of the lending process. Therefore, taking into account the portfolio of Islamic banks and in order to minimize losses caused by the asymmetric information, Islamic banks need to use more secure financing, particularly with SMEs, which tend to be more financially vulnerable when the economy is in decline.…”

The Shariah Compliance of Islamic Peer-to-Peer (P2P) Lending Practices in Indonesia: Identification of Issues and the Way Forward

“…29 d. Tadlis is an act of hiding the defects of an object by a seller to trick a buyer. 30 e. Dharar is an action that can cause harm or loss to other parties. 31 In addition to these explanations given by the MUI DSN Fatwa, Biancone 32 has identified other specific illicit activities, such as producing or selling alcohol, producing goods related to pork, pornography, tobacco, weapons and defence, genetic engineering (e.g.…”