Principles of Islamic banking and finance/PIBF202/Key differences/Moral hazard-and adverse-selection in Islamic banking

Moral hazard and adverse selection are major issues in business transactions. "Adverse selection occurs when there's a lack of symmetric information prior to a deal between a buyer and a seller, whereas moral hazard occurs when there is asymmetric information between two parties and change in behavior of one party after a deal is struck. Moral hazard and adverse selection are two terms used in economics, risk management and insurance to describe situations where one party is at a disadvantage."

Moral hazard and adverse selection in conventional finance
In conventional banking adverse selection can occur when more risky borrowers approach banks for taking loans at higher interest rates while banks lack enough information about them. Similarly, those who have high health risks may like to buy certain health insurance without revealing their true condition. Moral hazard occurs after the deal is struck. For example, after having a fire insurance for your house you become less careful to avoid fire. Similarly, after getting a business loan from a bank you may not work prudently to pay back the loan and try to seek refuge under the bankruptcy laws. The banks themselves can lend recklessly if they think they will be eventually bailed out by the government. The sub prime loan crisis started in 2008 is the best example of such behavior.

Conventional banks use several methods that they have learnt through long experiences to minimize the two problems. The requirement of collateral against loans is an effective tool to ward off the twin problems. The use of credit history is another mechanism for estimating creditworthiness of borrowers. To defend against the twin problems, health insurance companies charge higher premiums based on age and health screening, and can ask the policy holders to pay a fixed percentage of medical costs incurred a or a lump sum amount.

The twin problems in Islamic banking
Islamic banking with PLS faces much more severe problems of adverse selection and moral hazard. The situation is further complicated when they operate in a dual banking system, competing with conventional banks. The PLS structure of mudarabah and musharakah provides ample opportunities to behave dishonestly. Mudarabah is particularly attractive for dishonest persons or risk lovers as all the losses has to be borne by the financiers. Although the financiers or Rabb-ul-Mal can make mudarib liable for losses in case he is proven to be negligent or dishonest, in the absence of collateral and the difficulty to prove someone guilty of misconduct in a trial court is difficult as well as costly.

Competent and risk averse funds users with not much religious concern about interest, will naturally prefer to take a loan from conventional banks rather than sharing their profits. They may go Islamic banks only if they cannot provide acceptable collateral. Others would find Islamic banks who do banking with PLS modes pretty attractive.

Islamic economists and financial experts have discussed this issue and provided insights, not only to tackle the problems of adverse selection and moral hazard problems, but to achieve relatively higher allocative efficiency and financial stability in the economy. , ,

First of all Islamic banks can minimize the adverse selection problem by screening applicants for funds by examining their personal background, business acumen and competency. Furthermore, without evaluating the economic and financial feasibility of their business undertakings no will invest as it must share the profits and losses. It has also been pointed out that banks, in many cases, may have better knowledge of possible outcome of a business because they deal with many funds users in a particular industry thus avoiding over investment that is often the beginning of a financial crisis.

For controlling moral hazard problems that occurs after a contract or deal has been signed between two business entities, banks should monitor the mudaribs to keep them on track. Unlike conventional banks, Islamic banks can also be empowered to check financial accounts of mudaribs. This might be a deviation from traditional mudarabah contracts but completely permissible, rather desirable, from shariah perspective.

To discourage moral hazard problems, it has also been suggested that the central bank or some other government agency should establish special speedy courts to settle any issue arising between banks (rabb-ul-maal) and funds users (mudaribS).

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