Agency Problems in Islamic Finance

Where is the Adverse Selection and Moral Hazard Problem in Islamic Finance? By Anders K. Møller The College of Wooster May 2013 Supervisor: Prof. Amyaz Moledina Prepared in partial fulfillment of the requirements of ECON-299 – Alternative Financial Institutions Møller 1 1. Introduction Islamic finance has seen an enormous rise in popularity in recent years: Global Islamic financial transactions and contracts are worth an estimated $1.3 trillion, a number that is growing at a rate of between 15% and 20% per year (Pak, Islamic Finance Faces). As Haque and Mirakhor explain, it is very important to analyze the financial structures of Islamic banking and how the profit-sharing model overcomes financial market uncertainty, because some economists have expressed concerns that removal of interest-based debt financing will lower investment (Haque and Mirakhor 1986, pg. iii). However, Islamic Finance reduces the problems of adverse selection and moral hazard due to increased information sharing. This is because Islamic banks do not charge interest, but instead share risk with the entrepreneur. It is important to banish myths about market failures in Islamic finance if people are to understand its true potential. The purpose of this essay is to review the literature on how adverse selection and moral hazard occur in Islamic finance. It begins by describing how Islamic finance overcomes the adverse selection and moral hazard problems that might arise out of eliminating interest. It then goes on to show how profit/loss sharing (PLS) contracts can overcome the incentive incompatibilities, which is the main agency (principal-agency) problem faced by lenders in the Islamic finance system. This essay demonstrates that risk-sharing, formalized and dictated in PLS contracts, reduces or eliminates agency problems such as high monitoring costs and incentive incompatibility. 2. Overview of Riba, Adverse Selection, and Moral Hazard Islamic finance is based on Shari’ah law and its rules governing the exchanges in the market place. The prohibition of interest, or riba, is one of the most central principles in Islamic finance, mandated to guard against exploitation of those who do not possess financial capital (Iqbal and Mirakhor 2011, Pg. 41-2). Instead, Islam dictates a financial system based on mutual liability and risk sharing. The orro er s risk lies in the opportunity cost of investing their time and energy into the usi ess, hile the le der s risk is i the apital pro ided. This means that if a business venture is successful, both borrower and lender share the profits; if however the venture fails, the borrower loses their vested work and potentially their source of income, but only the lender is financially liable. Adverse selection and moral hazard are two types of agency problems in lending.1 Armendariz and Morduch explain adverse selection as the problem that arises when banks lack good information about potential borrowers, and thus are unable to discriminate against risky borrowers. Lenders charge high interest rates to compensate for the higher inherent risk in lending (Armendariz and Murdoch 2007, pg. 41-2). According to Ahmed (2002), adverse selection in Islamic finance arises before the contract is signed because the bank has less information on the project than the borrower (Ahmed 2002, pg. 42). 1 Agency problems include lack of collateral and asymmetric information. Asymmetric (or imperfect) information, which refers to the lack of information by one party compared to another in an economic transaction, is further sub-divided into adverse selection and moral hazard. Møller 2 Moral hazard refers to situatio s here the a k s risk is tied to u o ser a le hoi es ade the borrowers, a d i ludes issues su h as shirki g a d ithholdi g of i for atio (Armendariz and Murdoch 2007, pg. 48). Moral hazard can (generally) be categorized as either ex ante or ex post, which relates to borrower actions before and after the loan has been disbursed, respectively. Ex ante actions by the borrower affect the realization of returns by the lender, and typically relates to asymmetrical information (or in simple terms, imperfect information on behalf of the lender). Ex post moral hazard refers to diffi ulties that e erges to the le der after the loa has ee ade a d the orro er has i ested ; once project returns are realized, there is a risk of the borrower (agent) either running away from the loan, or does not fully disclose profitability (Armendariz and Murdoch 2007, pg. 50). This is also known as the enforcement problem. 3. Moral Hazard and Adverse Selection in Islamic Finance Moral hazard and adverse selection can theoretically arise out of the inability for an Islamic bank to charge riba. Banks utilize interest both as a compensation for higher risk as well as a screen for removing high-risk borrowers who know their own project to have a high risk level (in which case their business plan is more likely to fail, thus making them personally liable to the bank). Failure to screen applicants for those who are likely to perform successfully exposes the bank to adverse selection (AlJarhi 2002, pg. 10). However, this is relatively easy to overcome from effective screening, which is a natural component of Islamic banking (further discussed below). Other authors such as Ghannadian and Goswami (2004) theorize there is higher ex ante and ex post moral hazard in Islamic banking loans because debt contracts based on interest payments are more desirable for banks doing investment transactions. As they explain, ex post asymmetrical information would make the bank unable to accurately predict profits because there is no deterrent for the enterprise to understate returns. A thorough audit of the fir s realized profits by the bank ex post is very costly (Ahmed 2002, pg. 44). Because banks nonetheless can estimate the expected risk of projects ex ante, traditional banking systems view the most effective response to be debt contracting that establishes and enforces a return reflective of the perceived risk level (Ghannadian and Goswami 2004, pg. 744-45). Many authors have shown that the Islamic financial system mitigates or removes these market failures in financial transactions. Zamir Iqbal argues that the strict selection procedure that arises out of risk sharing between lender and borrower creates allocation efficiency. Because lenders cannot charge interest and are financially liable for the entire investment, projects are strictly chosen based on their productivity and expected rate of return (Iqbal 1997, pg. 42). Two of the central principles of an Islamic financial system are trust and the sanctity of contracts. According to Iqbal and Mirakhor (2011), Islam pla es a stro g e phasis o trust a d o siders trust orthi ess a o ligator perso alit trait; It makes clear that performing contractual obligations or promises is an important and mandatory characteristic of a true elie er. All tra sa tio s i the arketpla e ust e ased o trust, which fosters entrepreneurial honesty, and contractual obligations and full disclosure of information must be upheld as a sacred duty. Both of these principles are intended to reduce risks associated with lack of perfect information and moral hazard (Iqbal and Mirakhor 2011, pg. 42-45). Greater information seeking and trust in Islamic financial transactions greatly diminishes the adverse selection problem. Møller 3 Authors such as Al-Jarhi (2002) and Ahmad (2002) go further in describing how Islamic lending reduce both adverse selection and moral hazard because they are based on PLS contracts. Traditionally, monitoring must be implemented at ex ante, interim, and ex post transaction phases to be effective; however, the involvement of an Islamic lender under a PLS contract turns the lender into an investment partner which increases access to information, thus enabling them to greatly mitigate both adverse selection and moral hazard. As Al-Jarhi e plai s, Equity finance provides the bank with access to information necessary to practice monitoring at all intervals. (Al-Jarhi 2002, pg. 10-11). Habib Ahmad (2002) further points out that Islamic lenders may not be willing to finance projects if insufficient information is available, and only if the risk-adjusted rate of return is greater than the return on risk-free investments; since the bank act as an investment partner it will seek sufficient information to effectively assess the proje t s risk a d the appropriate profit-sharing ration, thus overcoming the adverse selection problem. Although critics Ghannadian and Goswami view debt contract financing by banks as the most effective system for developed nations, they suggest that a system based on equity contracts is the most effective tool in developing countries that do not have sufficient information to assess risk structures; risk sharing helps overcome adverse selection problem, which typically cause banks in developing countries to have untenably high interest rates (Ghannadian and Goswami 2004, pg. 751). Jouabar-Snoussi and Mehri (2012) in their arti le Agency Problems in Venture Capital Contracts: Islamic Profit Sharing Ratio as a Screening Device suggest that the pro le of ad erse selection is avoided simply by the existence of an optimal profit-sharing ratio (PSR) as part of the profit/loss sharing contract (Jouabar-Snoussi and Mehri 2012, pg. 3-5, 25-26). The PSR can act as a screening device for banks: assuming that an entrepreneur knows their own riskiness, it is an indicator of high risk if he/she is willing to accept a loan above a critical ratio. Such a scenario would signal to the bank that there is a strong possibility of agency problems with the entrepreneur. Conversely, a low-risk entrepreneur will understand their own capacity for creating a successful enterprise and negotiate a low PSR which ensures maximum profits for themselves. This would signal a safer investment. According to the authors, this signaling system using the PSR can provide a tool for lenders ( hat the ter Isla i e ture apitalists ) to help ith the o ple task of s ree i g pote tial e trepre eurs. 4. Ex Post Moral hazard: Incentive Incompatibilities The most challenging source of moral hazard in an Islamic financial transaction occurs ex post of a bank lending capital to an entrepreneur or a corporation (borrower) due to conflicts of interest. If there is a conflict of interest between the management and some or all of the shareholders of a firm, moral hazard arises when the agent (management) omits from sharing certain information with the owners (principal) hi h ould ha e ee utilized to ser e the pri iple s est i terest. This is known as the incentive incompatibility (Haque and Mirakhor 1986, pg.4-5), and is commonly referred to as the principal-agent problem in investment banking (although principal-agent problem is a broad term which means the same as agency problem ). As mentioned above, Islamic equity financing of firms is based on profit-sharing contracts where risk is shared between lenders and borrowers i.e. Islamic banks, and entrepreneurs and firms respectively (Haque and Mirakhor 1986, pg. iii). When a principal (lender) enters into contract with an agent (entrepreneur), they may for example have different attitudes towards entrepreneurial risk and thus have conflicting incentives. Moreover, given an unequal Møller 4 distribution of information about profit and company activities, the principal cannot perfectly monitor the agent. Given that the optimal cost of monitoring constitutes a high cost to the principal, less monitoring will take place and the agent may be disposed towards hiding the true risk level of an action. This issue can be easier understood given a relatively simple example. If Islamic bank A (principal) lends X amount to an entrepreneur who is the CEO of a start-up (firm B), the profits of the venture will be a function of X; i.e. P = f(x). The principal receives a pre-determined portion of profits equal to Z, and the agent (CEO) retains the remainder P – Z. If, for example, the e trepre eur s retai ed profits are a relatively small component of their wealth, they might well be risk-prone and willing to e pa d fir B s operatio s i spite of so e set of i here t risks. Let us assu e that the a k is ore risk-averse than the agent, and would not go along with any high-risk investments by the firm. If the agent is party to information about the risks expansion and chooses to withhold it from bank A, then he/she is exposing the principal to moral hazard. This example illustrates how there might be conflicts of interest between the shareholders (in this case, bank A is a major stakeholder in firm B) and the management, which is a source of moral hazard in Islamic financing of corporations. This is also known as an agency cost to bank A. This scenario fails, however, to take into account the re-alignment of interests that occur in a PLS contract. Haque and Mirakhor show that this type of moral hazard can be disseminated by creating optimized individual contracts. As the poi t out, he age osts are redu ed, the e efits are shared by both the agent and the principal, therefore, [they] both have a common interest in defining a monitoring and incentive scheme that yields outcomes as close as possible to ones that would be produced if information monitoring were costless (Haque and Mirakhor 1986, pg. 6). Both the principal and the agent thus create a contract that details transparent rules governing investment and profit decisions by the firm. Haque and Mirakhor go on to explain that since the principal has a vested interest i the su ess of the age t s fir , the disti tio et een lender and entrepreneur diminishes. In effect, the profit-sharing system eli i ates the fi ed ost of apital fro the fir s profit al ulatio s, a d thus [ ]oth the o ers of the fir a d the le ders to a fir [ e o e] residual i o e ear ers. In other words, both principal and agent have converging interests in achieving success for the firm because they both profit accordingly (Haque and Mirakhor 1986, pg. 18). This improves cooperation between the shareholders and thus increases effort, reducing the risk of the enterprise. Moreover, if the firm faces financial difficulties the principal may well inject more equity to keep it afloat. They will do so as long as the marginal investment costs are lower than the rate of return (Moledina, lecture on 4-22-2013). This is yet another way in which a PLS reduces the risk of a firm. Abalkhail and Presley (2002) similarly discuss how a comprehensive contract can reduce asymmetric information between the agent and the principle to overcome the principal-agent problem. They explain that contracts a e for ulated to i flue e the age t s eha ior through either influencing the management, which is a monitoring approach where the investor becomes more involved, and/or provide incentives and involve the entrepreneur s capital which is an outcome-based approach (Abalkhail and Presley 2002, pg. 121-23). Such approaches will streamline the interests of the principal and the agent, which maximizes the efficiency of the firm. They therefore both stand to gain Møller 5 from overcoming the moral hazard problem and write a contract that stipulates full information and incentive compatibility (Abalkhail and Presley 2002, pg. 12). 5. Concluding Remarks It can be seen from the arguments highlighted above that the PLS contracts in Islamic banking allows the principal (the bank) to overcome both adverse selection and moral hazard problems. The latter includes ex ante moral hazard (asymmetrical information) in addition to ex post (principal-agent problem). Baldwin et. al. provide an excellent overview of the benefits of a PLS contract in relation to agency problems (Baldwin et. al. 2002). A PLS agreement creates a partnership between the principal (bank) and the agent (loaner) that is the equivalent of a venture capital partnership in conventional banking: this reduces asymmetrical information between agent and principal, which gives a stronger vetting process for loan granting that in return reduces the risk of each venture. It moreover aligns the effort incentives, so that the principal-agent problem is overcome (which furthermore reduces risk). Lastly, in some cases the principal may use their venture capital status as a shareholder in the firm to hire new management with valuable expertise in the market; this, yet again, reduces the probability that the enterprise will fail. Although a well-designed PLS contract can solve the main agency problem facing lending by Islamic banks as shown by authors such as Haque and Mirakhor (1986) and Abalkhail and Presley (2002), only general lessons about the specific design of such the contract have been drawn. More research is needed into how PLS contract will be designed, and how it fits into the wider picture of Islamic finance in general as well as conventional banking. Such studies might well enhance the global interest in Islamic financial institutions. Møller 6 Bibliography Abalkhail, M., & Presley, J. R. (2002). How informal risk capital investors manage asymmetric information in profit/loss-sharing contracts. Islamic Banking and Finance, New Perspectives On ProfitSharing And Risk. Ahmed, H. (2002). Incentive-compatible Profit-sharing Contracts: A Theoretical Treatment, published in Iqbal and Llyewellyn, 40-56. Al-Jarhi, M. A. (2002). Islamic finance: an efficient and equitable option. Islamic research and training institute, Islamic development Bank. Armendáriz, Beatriz, and Jonathan Morduch. The economics of microfinance. MIT press, 2007. Baldwin, K., Dar, H. A., & Presley, J. R. (2002). On determining moral hazard and adverse selection in the Islamic firm. Theoretical Foundations of Islamic Economics, 145. Ghannadian, F. F., & Goswami, G. (2004). Developing economy banking: the case of Islamic banks. International Journal of Social Economics, 31(8), 740-752. Iqbal, Z. (1997). Islamic financial systems. Finance and Development, 34, 42-45. Iqbal, Z., & Mirakhor, A. (2011). An introduction to Islamic finance: theory and practice (Vol. 687). Wiley. Jouaber-Snoussi, K., & Mehri, M. (2012, April). A Theory of Profit Sharing Ratio Under Adverse Selection: The Case of Islamic Venture Capital. In 29th International Conference of the French Finance Association (AFFI). Moledina, Amyaz (2013). Alternative Financial Institutions, 4/22/2013. The College of Wooster. Pak, Jennifer. "Islamic Finance Faces Growth Challenges." BBC News. BBC, 12 May 2012. Web. 30 Apr. 2013. <http://www.bbc.co.uk/news/business-20405292>. Ul Haque, N., & Mirakhor, A. (1986). Optimal Profit-sharing Contracts and Investment in an interest-free Islamic Economy.