Performance of profit-loss sharing financing in Islamic banking: knowledge-based view v.s. incentive-based view

Abstract

Most studies in Islamic economics and its proponents propose Profit-Loss-Sharing (PLS) system as the basic concept of the Islamic banking operation, however, current practices witness non-PLS financing contracts to be overly dominant The most cited argument of the lacking of PLS Financing is the agency problems (i.e. adverse selection and moral hazard). Studies that put more focus on agency problem in the form of agent's negative behavior are known as the incentive-based view (IBV). This paper tries to criticize the weaknesses of this view, which considers as a more dominant approach, aiming at improving the financing performance of banking institution. One of the negative impacts of applying IBV is too much reliance on collaterals for the banks in approving the credit financing so they may overlook or less focus on profitability consideration of the project/business, known as lazy-bank hypothesis. This affects the degree of confidence of the Islamic bank managers .. to advance PLS financing. On the other hand, another approach emerges importantly to enhance the Islamic banks' capability based on knowledge to increase the quantity of PLS financing, known as knowledge-based view (KBV). This paper tries to compose a conceptual model combining both views.