Failure of Islamic Banking - Essay Example

Islamic Finance Reasons behind failure of Islamic banks in adopting Profit-Loss Sharing System Islamic banks have successfully adopted Profit-Loss Sharing (PLS) system, which is based on financial transactions. However, its success is questioned because, with time many issues were observed. Initially, the PLS system aims at helping the banks to compare its bad and mediocre transactions that indicated efficient resource management. The main benefit of the PLS system is that the profit is shared with the investors of the banks instead of interests.source?? Despite the advantages offered by the system, it has failed to change the operational structure efficiently because of many reason; the most important ones are agency costs and information asymmetry. Agency cost Agency cost is referred to internal cost of a company, which arises due to conflict of interest between the management and shareholders. The shareholders expect that the management should run the company in such a manner that it increases the shareholder’s value. However, it is observed that the management concentrates on maximizing the wealth of the company and does not take into consideration the interest of the shareholders. This creates a difference between the management and stakeholders. The same problem was observed in the Islamic banks; though the PLS system aimed at increasing the wealth of the investors but it failed to fulfil the expectation of the shareholders (Dar and Presley, 2000). The main rule of PLS system is that the banks provides part of its profit, obtained from investment, to the investor instead of interest. As a result, if the banks fail to earn any profit on the investments, the investors do not get any bonus (Dar and Presley, 2000). The same situation is observed when the company is small to afford high profit and even earn a considerable amount. If a new company invests in the bank, it has the right to earn the profit but the scheme had already dried up the earnings of the financial institutions. This indicates that the company as an investor is not at all profitable and the banks have failed to implement PLS appropriately. This has created misunderstanding between the management of the banks and the investors (small companies) as the payment under this scheme cannot be taken as granted (Abduh and Omah, 2012). When the banks failed to offer higher return on the scheme such as Murabaha financing despite good performance, it is subject to elements of uncertainty. These uncertainties are vague demand for goods and services, business environment that surrounds the world. Moreover, the banks are seen to suppress the profit as the management has the power and capability to manipulate accounts and avoid those payments to employees when the profit should be shared among the shareholders or investors (Dar and Presley, 2000). According to the principle of PLS system, the banks should follow the profit sharing plans but they neglected the interest of the shareholders instead they maximized their wealth.(reframe) Moreover, few Islamic banks provided the bonus or profit to the investors twice a year and it does not give the same benefits, which are provided by the incentive sharing scheme. Another important drawback of PLS system is that it does not consider hard work of employees, which demoralize the efficient workers to a great extent. These workers give their best in order to provide positive contribution towards the success of the financial institution. Hence, the Islamic banks have failed to implement the PLS system efficiently as they did not consider the interest of the shareholders, which is its main principle (Dar and Presley, 2000). It is observed that specialised Islamic banks such as Mudaraba Companies (MCo’s) in Pakistan, who compiles PLS system, had limited amounts of fund that can be invested in Musharaka and Mudaraba investment. According to International Association of Islamic Banks, the PLS have covered less than 20% of the investments that are made by the Islamic banks, existing globally (Dar and Presley, 2000). Hence, the problems experienced by the Islamic banks due to agency problems are crucial to the extent that the main rule of the PLS is not followed. The employees are devoid of their marginal contribution as the entrepreneurs do not put any effort to invest on the PLS basis. The entrepreneurs penalized the employees with the losses that are incurred during the production process. Hence, Islamic banks failed to execute PLS system as they did not follow the risk-free rule of the system (Dar and Presley, 2000). Information asymmetry Information asymmetry is another root cause for the decline of Musharaka and Mudaraba financing. This is the main reason why “fixed- interest financing dominates over the PLS system during a principle-agent contract” (Halkos and Salamouris, 2004). The agents and principle contracts experience the problem of information asymmetry, which becomes difficult for them to trust and select contracts. The banks should evaluate the imperfect information of the borrowers before the banks provide loans. The evaluation is done so as to examine whether the borrower has the capability to repay loan amount. The credibility of borrow also assists the banks to understand whether the payment will be default. Asymmetry in information may increase the cost of the banks. The information provided by the borrower may be adequate for the loan amount but lenders needs to check the consistency in information as they have to bear the risk of default payment. Information asymmetry results in adverse selection; this problem is encountered by both the Islamic and conventional banks; however, issue with the Islamic banks is quite new (Halkos and Salamouris, 2004). The main strength of PLS system is that it can minimize the risk by sharing the project returns that occurs between the users and capital suppliers (Mills and Presley, 1999). Despite the risk sharing benefits of the PLS system, it had experience the problem of adverse selection, when ascertaining the quality and capability of the loan applicants. This becomes difficult when the debt is available from certain competing sources. The borrowers, who are of the opinion that their projects will supply high non-monetary returns and low profits, choose PLS mode of financing. The reason behind this decision is identified as they are destined to get higher returns at a much lower cost of capital. However, the PLS system also attract the applicants, who have the knowledge of risky projects. This helps the banks to demarcate the capability of the borrowers. In order to determine that the projects undertaken by the borrowers are risk free, banks do extensive appraisal for providing the benefits on managerial and collateral shareholdings (Ika and Abdullah, 2011). The banks are exposed to adverse selection even after the loan is sanctioned to the borrowers. If the bank returns are associated with the declared profit, the borrowers are expected to receive higher incentives; hence, the banks experience risk of default payment. The borrowers intentionally reduce the earned profit in order to avoid the increased return on the investment (Hobson, 2006). Hence, the banks need to cross check the demand and the financial state of the borrower, as with the passage of time they have to bear cost of deafly payment. It can be monitored by encouraging the borrower to declare the real profit. This activity in Islamic banks has the ability to reduce trust on the borrowers. In this context, it can be sated that the Islamic banks have failed to adhere to the rules of PLS system. The Islamic banks are not only subject to default risk but also to the risk of profit under- reporting. Both the risks are expensive for the banks when they do not have enough asset bases. In this case the stake of banks in certain projects that are undertaken by the borrower is high (Halkos and Salamouris, 2004). As compared to conventional banks, Islamic banks does not bear the same magnitude of moral hazards, instead they encounter limited problems. The Muslims follows the rule that, honesty should be rewarded whereas dishonesty is punishable. Nevertheless, this concept provides non-material incentives to the people. Goldsmith (1969) had stated that Islamic banks have undertaken projects with new entrepreneurs and have transferred sole ownership, in case of Mudaraba and shared ownership in case of Musharaka. The redeemable process provides good incentives for reducing moral hazards of Islamic banks (Hobson, 2006). It is obvious that perfect information makes a market complete and the equity financing does not make huge adverse selection hazard. Hence, perfect information helps the Islamic bank to avoid adverse selection (Halkos and Salamouris, 2004). Mitigation of the problems by Islamic banks and conventional banks – a comparative view There is no doubt that information asymmetry raises cost for the banks; hence the cost linked with this problem is significant. This is the reason why it should be mitigated by adapting appropriate measures and methods. The following section highlights the measures that can be undertaken in order to manage information asymmetry and moral hazard in the Islamic banks. One of the most important measures for mitigating the problem is lending from conventional banks. Apart from that, there are other measures too such as incentive compatible profit –sharing contracts, maintenance of the long term relationship with the customers along with screening and monitoring (Halkos and Salamouris, 2004). Islamic banks Screening and monitoring Monitoring and screening method can be used as a measure to mitigate adverse selection and moral hazards like conventional banks. The Islamic banks should screen the information that is collected from the borrowers in order to reduce adverse selection. Moreover, the banks should also undertake random auditing so as to restrict profit under-reporting. Hence, an incentive structure can reduce the moral hazard problem by employing conditional and collateral methods of screening and monitoring (Siddiqi, 2006). Maintenance of long term relationship with the customer The improved relationship between the bank and borrower will increase the efficiency of the PLS system. The repetition of interaction between the banks and borrowers aims at reducing the monitoring cost. In this case, the banks have the knowledge regarding the auditing system of the borrowers and monitor the transactions over a long period of time. Hence, the banks have the ability to develop accurate statement regarding the performance of the borrower with respect to others, which are in the same circumstances (Siddiqi, 2006). Through the established relationship, the banks can evaluate the returns that can be expected from the borrowers; lower returns indicate the inefficiency of the borrower to a great extent. Effective supervision of the credit position of the borrower helps the bank to avoid information asymmetry. If the credit officers of the Islamic banks are in close vicinity with the borrowers, it enables the former to measure the reputation of the latter and also assess the operations closely and easily. This assists in minimising the information asymmetry problem (Siddiqi, 2006). Incentive- compatible profit-sharing contracts The contracts signed between the customers and banks should have proper terms and conditions so that it is incentive-compatible. This will assist in reducing the moral hazards and adverse selection to a great extent. The contracts should follow a definite format that is based on honesty and specific incentive mechanisms such as provide stake along with ownership, link the transfer of ownership through distribution of bonus shares on performance; it also build reserve schemes for inducing the company provisions and shares for the profit related payment that is linked with the declared profits (Ali, 2011). Conventional banks The strategies undertaken by the conventional banks to mitigate the moral hazard problems and information asymmetry are discussed below: Compensating and collateral balances The banks require collateral properties that are promised from the borrowers in case the payment of a loan is defaulted. Hence, the collateral property acts as compensation to the bank. Hence the collateral properties reduce the impact of adverse selection. It aims at reducing the loss of the lender if by chance the borrower fails to make the payment. It is noteworthy to mention that the collateral increases the cost of loan for the borrower. The banks are even allowed to monitor the account balance of the borrowers. Thus, the conventional banks have devised an appropriate strategy for reducing the problems occurring in the banking system (Saddy, 2009). Reference List Abduh, M. and Omah, M. A. 2012. Islamic banking and economic growth: the Indonesian experience. International Journal of Islamic and Middle Eastern Finance and Management, 5(1), pp. 35 – 47. Ali, S., 2011. Islamic Banking In The Mena Region. Financial Flagship. Dar, H. and Presley, J., 2000. Lack of Profit Loss Sharing in Islamic Banking: Management and Control Imbalances. Economic Research Paper, pp. 1-27. Goldsmith, R., 1969. Financial structure and economic growth in advanced countries. Princeton: University Press. Halkos, G. and Salamouris, D., 2004. Efficiency measurement of the Greek commercial banks with the use of financial ratios: A data envelopment analysis approach. Management Accounting Research, 15, pp. 201- 224. Hobson, S., 2006. Project financing – risks underlying sukuk structures. Islamic Finance News. 3 (44), p. 15. Ika, S. and Abdullah, N., 2011. A comparative study of financial performance of Islamic banks and conventional banks in Indonesia. International Journal of Business and Social Sciences, 2(15), pp. 199-207. Mills, P.S. and Presley, J.R., 1999. Islamic finance: Theory and practice. Basingstoke: Palgrave Macmillan. Saddy, F., 2009. Risky Business. Islamic Banking & Finance, 7(3), p. 50. Siddiqi, M., 2006. Islamic Banking And Finance In Theory And Practice: A Survey Of State Of The Art. Islamic Economic Studies, 13(2), pp. 1-48. Read More