ÁREA 6, 6A, 6B: COMEDOR Y COCINA, SALA DE JUEGOS

The lack of PLS financing in Islamic banks can be appreciated through an

understanding of the higher transaction costs involved in this mode of financing relative to the non-PLS modes which mimic the standard debt-contract. Building on Coase’s (1960) definition, Dahlman (1979) specifies three types of transaction costs which arise due to imperfect information. These are “search and information costs, bargaining and decision costs, [and] policing and enforcement costs” (p.148). Using Dahlman’s

categorisation, the following discussion illustrates why PLS is considered to be the more expensive and therefore the less preferred choice for Islamic banks relative to non-PLS (debt) financing.

Consider first, the case of search and information costs. In order to provide PLS

financing, Islamic banks must first seek out reliable investment partners with profitable projects. The ‘quality’ of the investment partner and the project to be financed however, cannot be fully verified ex-ante due to informational asymmetry (the

entrepreneurs/managers seeking finance have better information about the risks of the project than Islamic banks). Islamic banks therefore face an adverse selection problem. The terms of PLS contracts exacerbate this issue. To maximise their gain, entrepreneurs seeking to finance projects with high expected profits are likely to opt for non-PLS financing, which leaves them as the residual claimant. Entrepreneurs seeking to finance projects with low expected profits, however, would be keen to finance on PLS terms to minimise their losses in case of failure (recall that losses are shared in a musharakah or borne solely by Islamic banks in a mudarabah arrangement) (Iqbal and Lewis, 2009). In a world of imperfect information with potentially dishonest agents, entrepreneurs with low-quality projects (i.e. with high probability of failure) have an incentive to misrepresent the quality of their proposed project through unrealistic and inflated expected profits. Islamic banks therefore need to expend resources to verify the quality claims. This involves not only checking the past credit history of the potential

investment partners, but also the process of project evaluation including a profitability and feasibility analysis (Johnes et al., 2014). Such investigations inevitably raise costs compared to non-PLS financing, where a credit history check of the borrowing party suffices77. Making the correct selection also requires that Islamic banks have sufficient information to judge between high and low quality investment partners and projects. However, given poor quality and quantity of informational flows, especially in developing countries where the majority of Islamic banks operate (El Hawary et al., 2007; Khan, 2010), the risks and costs associated with adverse selection are likely to be high. Thus, to economise on search and information costs, Islamic banks facing acute adverse selection problems, especially when competing directly with conventional banks, are likely to prefer non-PLS over PLS financing (Iqbal and Lewis, 2009).

77 _{Even if entrepreneurs with high quality projects are actively seeking PLS financing and Islamic banks}

are willing to provide such options, the presence of ‘dishonest’ entrepreneurs tends to drive ‘honest and potentially profitable’ entrepreneurs out the market. The cost of dishonesty therefore is not limited to search and information costs incurred by Islamic banks but also includes the loss incurred from driving genuine PLS financing out of existence (see Akerlof, 1970).

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Next, consider the bargaining and decision costs which relate to the process of setting mutually agreeable contractual terms. PLS financing contracts are unstandardized. These client-specific contracts are designed to take into account the characteristics of the individual investment partners and the project under consideration. Accordingly, these contracts incur significant costs during the bargaining process as bank-client consultations are set up to determine contractual terms. Furthermore, to ensure

compliance with sharia, all new contracts require approval from the banks’ SSB (Johnes et al., 2014). PLS contracts therefore also incur additional administration costs related to the sharia approval process. This makes PLS contracts costlier and more time- consuming compared to the non-PLS alternatives for which pre-approved standardised contracts exist (ibid).

Finally, policing and enforcement costs are incurred because Islamic banks cannot determine if entrepreneurs will violate the terms of the contract or misappropriate funds ex-post. If such information was available ex-ante, Islamic banks would select only trustworthy entrepreneurs or include stringent contractual terms to limit the scope of contract violation and misappropriation of funds (Dahlman, 1979). However, this is not possible due to informational asymmetry. The entrepreneur has more knowledge of his intentions, capabilities to manage the work and the likelihood of success or failure of the project, relative to the Islamic bank. Additionally, as PLS contracts are better suited to long term projects due to the time diversification effect of equity (Dar et al., 1999), inherent uncertainty regarding the future presents additional problems for writing complete contracts. At the outset, the contracting parties can neither anticipate all future contingencies nor identify suitable adaptations, and therefore are subject to bounded rationality (Simon, 1957, 1972). The best outcome achievable is an incomplete contract. Gaps in incomplete contracts, however, provide scope for opportunistic behaviour i.e.

“self-interest seeking with guile” (Williamson, 1975, 1979, 1985) on part of the entrepreneur.

Islamic banks providing PLS financing are therefore exposed to large counterparty risk, especially in the case of mudarabah (El-Hawary et al., 2007) where Islamic banks and entrepreneurs form a principal/agent relationship78. The separation between ownership 78 _{The principal/agent framework can also be used to compare PLS and non-PLS financing. In a}

principal/agent relationship as in the case of mudarabah, agency problems arise specifically because

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and control i.e. Islamic banks are the residual risk bearers whilst entrepreneurs are the decision- makers, gives rise to conflict of interest (Jensen and Meckling, 1976). Three features of the mudarabah contract extenuate this problem. Firstly, extreme linearity i.e. returns for each party are a linear function of the profits generated from the financed project and therefore are fully dependent on the entrepreneurs (agents) effort and skill level. Since effort levels are unobservable, all benefits of shirking are enjoyed solely by the entrepreneurs. Secondly, discretionary power i.e. entrepreneurs have full control over investment decisions and may prioritise self-interest by misappropriating funds for personal use and/or make sub-optimal investment decisions. The incentive to do this is extremely high when an entrepreneur has secured funding for a low quality project since the full financial loss is borne by the bank. Finally, idiosyncratic uncertainty (risk) i.e. Islamic banks returns are contingent on the entrepreneurs’ claimed profits which may be misreported (Khalil et al., 2002). The entrepreneurs have an incentive to underreport profits not only from the desire to keep a bigger share but also due to discriminatory tax treatments since profits are taxed but interest is exempted as a cost item. The impact of the tax regime can be considerable, as evident from the case of mudarabah companies in Pakistan, which grew considerably before the withdrawal of their tax-exempt status in 1992 (Dar et al., 1999). In developing countries where tax avoidance/evasion is a much more serious problem, Islamic banks face the problem of receiving a share of profit, calculated using the entrepreneurs’ official financial

accounts which are created for tax purposes. Without access to the entrepreneur’s true accounts, concerns over potential losses due to dishonesty make non-PLS contracts more desirable (Kuran, 1995; Visser, 2009).

To minimise such agency problems, Islamic banks need to establish suitable incentives and expend resources to monitor the actions of entrepreneurs and enforce contract terms (Jensen and Meckling, 1976). While it is difficult to differentiate more from less

contracts cannot be written or enforced costlessly (Fama and Jensen, 1983). The higher agency costs associated with PLS include monitoring costs incurred by the principal, bonding costs incurred by agent (entrepreneur) to signal compliance with contractual terms or to compensate the principal in case of contract violation, and residual loss, which refers to the welfare reduction faced by the principal as agent’s decision diverges from the decision which maximise the principal’s welfare (Jensen and

Meckling, 1976). In this work, transaction costs framework is used as opposed to limiting the discussion to agency costs because, Islamic banks, strictly speaking, are in a partnership under a musharakah contract, not a principal/agent relationship. Under musharakah, Islamic banks can hold a management role, and have an impact on the decision making process, therefore the separation of ownership and control does not exist as it does in the mudarabah case.

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opportunistic entrepreneurs ex-ante (Williamson, 1979), it is also difficult to design contract terms that minimise opportunistic behaviour. The source of moral hazard therefore lies in the inability of contracting parties to write a complete contract which preserves incentives (Marshall, 1976) and aligns the interest of the entrepreneur with that of the Islamic bank. Allocating a share of the profit to the entrepreneur is one inherent incentive in PLS financing contracts. However, it may not be sufficient in the case of mudarabah as the entrepreneur does not face financial loss or when an

entrepreneur knowingly finances a low quality project. Banks may therefore need to set up in-person and on site monitoring systems to verify declared profits from PLS

projects which increases costs relative to non-PLS financing (Visser, 2009). Furthermore, in the case of a disputed mudarabah contract, negligence of the

entrepreneur needs to be proven, most likely through a lengthy and costly legal process, so that the burden of full loss does not fall solely on the Islamic bank. PLS financing therefore presents significant moral hazard problems and requires intensive monitoring, which inevitably increases costs (Kuran, 1995; Khalil et al., 2002; Visser, 2009). To summarise, note that agency problems are particularly acute for PLS financing especially in the absence of control rights and state-contingent returns. Mitigating these problems increases costs. The presence of asymmetric information and costly state verification, makes non-PLS (debt) superior to PLS (equity) financing79 (Townsend, 1979; Williamson, 1987) with the preference for the former increasing as agency problems become more severe (Aggarwal and Yousef, 2000). Thus, the over-reliance on non-PLS financing exhibited by Islamic banks is simply a rational response to the informational asymmetry problems and the higher transaction costs associated with PLS financing (Dar et al., 1999; Aggarwal and Yousef, 2000; Kuran, 1995, 2004; El-Gamal, 2007; Visser, 2009; Khan, 2010).

3.6.2 A Broader Perspective on Transaction Costs: Importance of the Institutional Environment

Imperfect information and opportunism alone, although important, cannot be deemed sufficient to explain the lack of PLS financing in Islamic banks. Opportunism and 79

Although costly-state verification is argued to make “complete risk-sharing [i.e. PLS financing]

suboptimal” (Townsend 1979, p.267), it must be appreciated however, that Townsend’s model fails to explain the existence of outside equity (ibid) and that the optimality of debt disappears if dynamic considerations and/or ex-post renegotiations are introduced in the model (Aghion and Bolton, 1992).

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bounded rationality are innate characteristics of human nature and affect all complex financial transactions. These are neither new problems nor limited to PLS financing. Furthermore, Islamic economists have argued in favour of PLS financing precisely because of its the long established history in Islamic traditions, as is evident from detailed accounts in classical Islamic jurisprudence and religious texts (Kuran, 2005; Harris, 2009). Mudarabah and its variants were indeed the prevalent modes of financing in early Islamic societies (as highlighted earlier in section 3.2) . These were used widely by merchants operating trading caravans throughout the Mediterranean region not only by Muslims in the Middle East but also Jews and Christians. Trading caravans

constituted of two parties, the capital investor (principal) who provided goods to be sold, and the travelling party (agent), who travelled to other regions/countries for trade. Informational asymmetry and agency problems existed at the time as well, however these did not hinder the success and dominance of PLS modes (Udovitch, 1970 in Chapra, 2007).

So what can explain the prevalence of PLS modes in early Islamic societies? As

Williamson (1985) notes, it is extremely important to locate transaction costs within the larger social context in which they are embedded as culture, customs and norms have a bearing on the size of transaction costs and therefore need to be accounted for.

Financing of the trading caravans on a PLS basis was embedded in the early Islamic society as the norm. As Harris (2009) explains, mudarabah80 did not exist simply as a single financing contract but referred to a complex institution, a nexus of contracts which determined several relationships including agency, investment, risk and profit allocation between parties as well as the “creation of a separate pool of assets” (p.610). This also applied to musharakah which was recognised as a variant of the general mudarabah contract, where the travelling party also contributed capital. Several other variants of mudarabah also existed which formed a “complex multilateral system”

including, bilateral mudarabah, where the travelling partner in an initial mudarabah became the investing partner in the second; multilateral mudarabah where several capital providers invested in a single mudarabah to benefit from economies of scale, and even the case of a single investor spreading his investments across several

80 _{Harris (2009) uses the term commenda which is the European variant for the mudarabah.}

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travelling trade partners to lower his risk through diversification (see Harris, 2009, p.610-11 and references within).

Moreover, PLS financing did not operate in insolation. There existed a complex network of supportive institutions enabling PLS to work effectively. A strong independent legal system existed to enforce contract obligations, which provided

efficient resolution of disputes through the mechanism of qadi (judge) offices supported by the religious scholars. The merchant code of conduct represented an additional independent third-party enforcement mechanism. Travelling partners were required to comply with the merchant code, violation of which was treated as a breach of the mudarabah arrangement. A strong network of learned jurists helped convert this general code of conduct into operating rules and regulation, specifying detailed rules for

acceptable behaviour and judgements upon disputed cases. Furthermore, traders belonged to fraternities and guilds, which provided an informal credit rating system as well as an informal mechanism for contract enforcement. If any trader cheated, business relations with him were severed. Continual business provided scope for building up reputational capital, and encouraging more favourable terms of trade for the individual. A well-connected business community network created the environment where trust and cooperation was a recognised commercial practice (Udovitch, 1970 in Chapra, 2007; Harris, 2009).

High levels of trust and cooperation between the principal and agent reduces the need for monitoring, and therefore lowers transaction costs, while legal support reduces enforcement costs (Williamson, 1985). Additionally, as the rules and regulations surrounding the contracts were well-understood by society at large at the time, costs incurred in the contract creation (bargaining stage) were also reduced81. Thus, the existence of supportive institutions reduced transactions costs associated with adverse selection, contract creation, monitoring and enforcement of PLS arrangements. In contrast, Islamic banks suffered from a lack of such supportive institutions in the early decades and this issue largely continues to the present-day in most Muslim countries (see Iqbal et al., 1998 and Chapra, 2007 for discussion on the institutional

81 _{A standard mudarabah template contract existed providing a number of default rules, as well as scope}

for adaptations to the individual needs of the contracting parties e.g. profit shares (Harris, 2009).

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needs of Islamic banking). Institutions which meet the specific needs of Islamic banks such as sharia courts to resolve disputes or external credit rating agencies for banks’ investment partners were at the start of Islamic banking missing (Chapra, 2007). This is a direct consequence of historical events. Although the western colonial period lasted less than a century (Nasr,1999), it left a lasting legacy by transporting the institutional framework of conventional interest-based banking to Muslim countries. Thus, the central banking system and the regulatory environment were designed in accordance with conventional banking needs. This broader operating environment was not altered (and still is only partially altered) to accommodate the emergence of Islamic banks, which at least theoretically, were aimed at using PLS financing modes (Chapra, 2007). As El-Gamal (2006) notes, when Islamic banking emerged, its products had to be functionally the same as its conventional counterparts to ensure acceptance from

regulators. For example, from a conventional supervisory perspective, banks are limited in the amount of risk they can accept on their financing and investment portfolio and that which they can pass onto their depositors (Kuran, 1995). Furthermore, by the time many of the industry-specific supportive institutions were developed in the early 2000s, the practice of form-over-substance had taken root along with the first mover advantage given to practitioners which shaped the methodology of developing sharia compliant financial products for future generations. For many, murabahah has been a well-known and accepted mode of Islamic finance for decades. This norm made it difficult for the entire industry to change course once supportive infrastructure institutions were established (El-Gamal, 2006).

Moreover, in most developing and emerging economies where Islamic banks operate, the level of institutional development generally is not as advanced as in the developed western world. Rapid urbanisation in Muslim countries has occurred “against the backdrop of inefficient legal systems” (Kuran, 1995, p.168). Property rights are poorly defined and protected, the risk of expropriation or intervention from governments is high, corruption is a significant feature of the economy and political stability is often challenged creating an environment of mistrust (Dar et al., 1999; Yousef, 2004; Khan, 2010). Weak legal systems not only make enforcement of contractual terms difficult but also expensive, raising the transaction costs associated with PLS financing.

As Harris (2009) notes, mudarabah was not a single contract that could be adopted in any environment, instead, to work it required a “supportive legal system” (p.616), which cannot be created by Islamic banks themselves. The government’s role in establishing supportive institutions is therefore paramount. Consequently, in recent years, several Muslim countries have moved towards adopting policies which encourage Islamic banking, including the elimination of discriminatory tax regimes which favour debt over equity (Kuran, 1995), and establishment of institutions to support the judicial system for Islamic finance, including Sharia courts, establishment of accounting and auditing standards (e.g. AAOIFI) to enable standardisation of reporting, as well as investment in education and training institutes for development of Islamic banking specific human capital (Iqbal and Molyneux, 2005; Baba, 2007; Iqbal, 2007).

Nevertheless, even where institutions specific to the needs of Islamic banking exist, their role in enabling PLS financing has largely been marginalised as one crucial point, the complementarity of institutions has been unexploited in most countries.

Complementarity refers to the extent to which one institution “enhances the usefulness of another” (Kuran, 2009, p.601-2). Institutional complementarity is essential for reforms to have the desired impact (Kuran, 2009). Adoption or transplantation of a single institution in a country does not instantly equalise the enabling contribution that institution makes in another country where it is supported by a strong network of complementing institutions. For example, creation of the Federal Shariah Court in