Exploring Moral Hazard and Adverse Selection in Profit Sharing Contract
DOI:
https://doi.org/10.26668/businessreview/2023.v8i3.955Keywords:
Moral Hazard, Adverse Selection, Islamic Bank, Profit Sharing ContractAbstract
Purpose: The aim of this study is to review relevant articles on the problem of adverse selection and moral hazard in profit-sharing contracts in Islamic Banks. Adverse selection and moral hazard problems are problems that occur in profit-sharing contracts, so they impact the low porti on of this contract financing compared to margin-based and fee-based contracts.
Theoretical framework: The profit sharing contract in an Islamic bank has two potential problems, namely adverse selection and moral hazard that arise due to asymmetric information. Asymmetric information can occur due to limited information owned by Islamic banks as owners of funds (shahibul maal) regarding the business to be run by customers (mudharib). This asymmetric information mainly causes the agency problem. If an agent is negligent in making decisions with negative consequences and does not want to take responsibility for his actions, this can be classified as a moral hazard. Moral hazard can be in the form of self-interest, side effects, fraud, opportunism, and the behaviour of agents who commit willful mistakes, negligence and breach of contract. Meanwhile, adverse selection arises when the principal cannot observe the agent's characteristics because of asymmetric information before the contract is signed.
Design/methodology/approach: The study uses a qualitative approach by reviewing previous articles relevant to the discussion. The study is aligned with the practices that occur in profit-sharing contracts. Furthermore, discussions are deepened through forum group discussions with experts and practitioners in Islamic banks.
Findings: The results show that the conflicts in profit-sharing contracts include principal-agent conflicts and principal-principal conflicts due to adverse selection and moral hazards. The study results reveal that signalling and screening measures can be applied to overcome adverse selection problems while monitoring actions and switching to debt contracts can overcome moral hazard problems.
Research, Practical & Social implication: The study has implications for Islamic banks to draw up a clear and complete profit-sharing contract with the mudharib to reduce the moral hazard committed by the mudharib. In this case, Islamic banks can also ask the mudharib to submit comprehensive financial reports regarding their financial performance. Islamic banks must also pay attention to signalling and screening efforts to prevent adverse selection.
Originality/value: The value of the study provides a new literacy regarding the potential for agency conflict in the form of moral hazard and adverse selection that will be faced by Islamic banks when applying profit-sharing contracts with other parties as managers (mudharib).
Downloads
References
Abdul Razak, D., & Abdul-Wahab, A.-H. (2018). Promoting a Sharing Economy in the Islamic Finance Industry: a Study of Selected Oic Countries. Indonesian Journal of Nursing Practices, 1(1). https://doi.org/10.18196/ijief.114
Aggarwal, R., & Yousef, T. (2000). Islamic Banks and Investment Financing. Journal of Money, Credit and Banking, 32(1), 93–120. https://doi.org/https://doi.org/10.2307/2601094
Akerlof, G. A. (1970). The market for “lemons”: Quality uncertainty and the market mechanism. Quarterly Journal of Economics, 84(3), 488–500. https://doi.org/10.2307/1879431
Alam, M. K., Rahman, M. M., Runy, M. K., Adedeji, B. S., & Hassan, M. F. (2021). The influences of Shariah governance mechanisms on Islamic banks performance and Shariah compliance quality. Asian Journal of Accounting Research, ahead-of-p(ahead-of-print). https://doi.org/10.1108/ajar-11-2020-0112
Aljifri, K., & Khandelwal, S. K. (2013). Financial Contracts in Conventional and Islamic Financial Institutions: an Agency Theory Perspective. Review of Business and Finance Studies, 4(2), 79–89. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2263337
Altameemi, A. F., & Al-Slehat, Z. A. F. (2022). Islamic Investment Financing and Commercial Banks Facilities: Mediation Effect of the Islamic Bank Size. International Journal of Professional Business Review, 7(4), 1–21. https://doi.org/10.26668/businessreview/2022.v7i4.e458
Banchit, A., Boulanouar, Z., Wellalage, N. H., & Abidin, S. Z. (2013). Relationship Principal-Agent or Principal-Principal Conflicts and Islamic Banks ‟ Performance S. Business & Management Quarterly Review, 4(3), 8–16. https://ir.uitm.edu.my/id/eprint/8738
Dar, H. a, & Presley, J. R. (2000). Lack of Profit Loss Sharing in Islamic Banking : Management and Control Imbalances. International Journal of Islamic Financial Services, 2(00), 9–12. http://www.iefpedia.com/english/wp-content/uploads/2009/09/Lack-of-Profit-Loss-Sharing-in-Islamic-Banking-Management-and-Control-Imbalances.pdf
Eisenhardt, K. M. (1989). Agency Theory: An Assessment and Review. The Academy of Management Review, 14(1), 57–74. https://doi.org/10.2307/258191
Fayed, M., & Ezzat, A. (2017). Do Principal-Agent Conflicts Impact Performance And Risk-Taking Behavior of Islamic Banks ? Topics in Middle Eastern and African Economies, Proceedings of Middle East Economics Association, 19(2), 1–30. http://www.luc.edu/orgs/meea/
Ismail, A. G. (2011). The Theory of Islamic Banking : Look Back to Original Idea. Journal of Islamic Economics, Banking and Finance, 7(3), 9–22. https://ibtra.com/pdf/journal/v7_n3_article1.pdf
Jensen, M. C., & Meckling, W. H. (1976). Theory of the firm: Managerial behavior, agency costs and ownership structure. Journal of Financial Economics, 3(4), 305–360. https://doi.org/https://doi.org/10.1016/0304-405X(76)90026-X
Mills, P. S., & Presley, J. R. (1999). Islamic Finance: Theory and Practice (1st ed.). Palgrave Macmillan, London. https://doi.org/https://doi.org/10.1057/9780230288478
Nicholson, W., & Snyder, C. (2012). Microeconomic Theory: Basic Principles and Extentions (J. W. Calhoun (ed.); Eleventh E). South-Western, Cengage Learning.
Pryor, F. L. (1985). The Islamic Economic System. Journal Of Comparative Economics, 9(2), 197–223. https://doi.org/10.1016/0147-5967(85)90039-3
Salman, K. R. (2017). Sharia PSAK Based Sharia Banking Accounting (Edisi 2). Penerbit Indeks.
Salman, K. R. (2020). Sharia Accounting Approach Akad and Wa’d (Edisi 1). Penerbit Rajagrafindo Persada.
Salman, K. R. (2021). Islamic Banking Accounting Concepts and Practices: Complete with Cases and Solution (1st ed.). Mitra Wacana Media.
Sarker, A. A. (2001). Islamic Business Contracts , Agency Problem and the Theory of the Islamic Firm. International Journal of Islamic Financial Services, 1(2), 01–15. https://doi.org/10.1093/jis/12.3.329
Varian, H. R. (1992). Microeconomic Analysis (Third Edit). Norton & Company, Inc.
Yuliana, R. (2013). Muhasabah of Islamic Banks in the Application of Profit Sharing Principles. IMANENSI: Jurnal Ekonomi, Manajemen Dan Akuntansi Islam, 1(1), 51–61. https://doi.org/10.34202/imanensi.1.1.2013.51-61
Zulpahmi, Nugroho, A. W., Sumardi, & Wibowo, B. P. (2022). Evaluation of Awareness and Perception of Islamic Microfinance Institutions and Higher Education Institutions in Indonesia Towards the Implementation of Sharia Governance: Dyad’S Perspective. International Journal of Professional Business Review, 7(4), 1–21. https://doi.org/10.26668/businessreview/2022.v7i4.743
Downloads
Published
How to Cite
Issue
Section
License
Copyright (c) 2023 Kautsar Riza Salman
This work is licensed under a Creative Commons Attribution-NoDerivatives 4.0 International License.
Authors who publish in this journal agree to the following terms: the author(s) authorize(s) the publication of the text in the journal;
The author(s) ensure(s) that the contribution is original and unpublished and that it is not in the process of evaluation by another journal;
The journal is not responsible for the views, ideas and concepts presented in articles, and these are the sole responsibility of the author(s);
The publishers reserve the right to make textual adjustments and adapt texts to meet with publication standards.
Authors retain copyright and grant the journal the right to first publication, with the work simultaneously licensed under the Creative Commons Atribuição NãoComercial 4.0 (http://creativecommons.org/licenses/by-nc/4.0/), which allows the work to be shared with recognized authorship and initial publication in this journal.
Authors are allowed to assume additional contracts separately, for non-exclusive distribution of the version of the work published in this journal (e.g. publish in institutional repository or as a book chapter), with recognition of authorship and initial publication in this journal.
Authors are allowed and are encouraged to publish and distribute their work online (e.g. in institutional repositories or on a personal web page) at any point before or during the editorial process, as this can generate positive effects, as well as increase the impact and citations of the published work (see the effect of Free Access) at http://opcit.eprints.org/oacitation-biblio.html
