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.
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 lack of collateral as well as the prohibition of interest collection, PLS contracts in Islamic finance run the risk of shirking and withholding of information (Armendariz, Murdoch, 2007). This, in turn leaves Islamic banks susceptible to potential borrowers who under normal circumstances may be viewed as potentially ‘high risk’. Thus, rather than facing potential loss in light of this problem, Islamic banks choose instead to shy away from profit and loss sharing financing.
Whilst the lack of information on potential borrowers represents part of the problem, it is imperative to discuss the issue Islamic banks face with moral hazards. In short, Islamic banks face an issue of agency problems that relate to borrower actions before and after a loan has been expended. For example, research suggests that borrowers are not innocent of deceiving banks in order to gain their financial support. Thus, borrowers may appeal for financial support on the basis of entrepreneurship, yet their true intentions may be to use the money for other projects. Consequently, banks are vulnerable to shouldering the responsibility of loss due to deception on the borrowers (agency) part. (Nabi, 2013).
In addition to deceitful...