Optimal Islamic financial contracting in imperfect markets

Abstract

This study aims to determine the optimal contract for the principal and the agent when equities and debts are used in imperfect markets. Six contracts are considered namely, musharakah, mudarabah, venture capital, murabahah, ijarah and standard debt. This research puts stress on conflicts of interest between agents and the adverse selection issue, in imperfect markets in order to identify the optimal financing tool for the principal and the agent in case of equities and debts. Three approaches are adopted namely, the financial contracting enforceability approach, the adverse selection analysis and semi-structured interviews. The first approach attempts to determine the contract that maximizes the value of the firm and aligns agents’ interests among equities and debts in imperfect markets. Similarly, this approach allows us to assess the level of market frictions that the principal and the agent may bear if they want to maximize their profit for every contract. The second approach aims to identify the principal’s subjective perception of the risk of default when equities and debts are used. Furthermore, it allows us to determine the level of market frictions that agents may bear and the level of audit that they may consider to mitigate bankruptcy for each contract. The third approach consists of six semi-structured interviews conducted with experts and scholars in Islamic banking and finance to support the theoretical findings and enrich this study with additional insights. The findings reveal that equities are more vulnerable to moral hazard and information asymmetry, which induces the principal and the agent to request additional audit interventions to mitigate bankruptcy. Interestingly, it is found that the audit and monitoring are more effective for equities rather than debts for two raisons. Firstly, the flexibility of equity-based contracts allows agents to set-up a suitable auditing rule to avoid bankruptcy. Secondly, the audit sharing mechanism represents an incentive for both agents to disclose more information about the project and allows the principal and the agent to share the cost of the audit. Similarly, this study shows that Profit-and loss sharing contracts only dominate debt financings when the expected profit generated from the project is high. This evidence may encourage scholars and practitioners to re-think about equities with the aim to improve the entrepreneurial sector and fulfil shari’ah requirements. In addition, our findings shed some light on the need to create specific institutions such as private equity enterprises with more flexibility in terms of regulations and risk assessment because banks are meant to provide loans. Furthermore, this research proves that venture capital cannot substitute Islamic profit-and loss sharing arrangements from the principal-agent point of view. In addition, the semi-structured interviews’ findings reveal that venture capital and Islamic equity financing only work, if there are honest economic agents, wealthy investors and innovative ideas, which is hard to be achieve in Muslim countries. Concerning debt financing, it is revealed that murabahah slightly dominates ijarah financing from the principal-agent point of view. The gap between ijarah and murabahah from the principal-agent perspective is not relevant, implying that both contracts are achieving the same objective from the financial point of view. Although ijarah suits certain types of project, its role within the economy remains important in order to fulfil the need of economic agents looking for financing. Consequently, the findings of this study may motivate regulators and policy makers to re-think about ijarah financing in order to provide alternative solutions, regarding the legal issues encountering this type of contract.