PLS Modes of Finance in Islamic Financial Institutions

The internal causes that are attributed to an absence or lack thereof of PLS modes of finance are those factors that are within an Islamic financial institution. Whilst many reasons have been cited including a lack of human resources and management issues, it is evident that a recurring them of information asymmetry, would be identified as the optimal cause as to why Islamic banks refrain from using profit and loss sharing contracts as a means of finance. The information asymmetry concern arises when one party in a transaction is ignorant to vital information, which could result in the second party taking advantage of the former parties lack of knowledge. Thus, the presence of such asymmetry results in three usual negative factors, these are; adverse selection, moral hazards, and agency costs. These will be explained further below.

Adverse selection:

Just like any other financial institution, Islamic banks are compelled to take into account the issue of risk management. Thus, it is imperative to this debate to discuss the issue of agency or contract enforcement problem within Islamic finance; one of the most discussed risks faced by Islamic banks today. Due to an apparent ‘low level of transparency’, it is argued that PLS contracts are inherently vulnerable to agency problems such as entrepreneurs. This can primarily be attributed to the fact that Islamic banks as investors, fear borrowers will in some cases withhold crucial information. Due to a lack of exhaustive information on borrowers, banks are unable to discriminate against risky borrowers. This is commonly referred to information asymmetry. In conventional banking, lenders charge elevated interest rates to negate the higher inherent risk in lending. However, due to a lac...

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