Enhancing the Structure of Islamic Banking by Lessening the Asymmetric Information Pertaining to Profit-and-Loss Sharing Instruments

The structure of Islamic banking is built upon two basic pillars; the abolition of interest and the use of profit and loss sharing mechanism. Today, Islamic banks put effort to keep the first pillar strong whereas the second pillar is abandoned to its fate. Our hypothesis is that one of the basic reasons of the poor performance regarding to profit and loss sharing mechanism is asymmetric information problem. In that regard, the aim of this paper is to develop problem solving approaches lessening the asymmetric information pertaining to profit and loss sharing instruments. Out of the two problem solving approaches developed in the paper, the first one is based on a negative incentive scheme and the second one is to check the validity of dividend signalling hypothesis for Islamic banking. A detailed literature review and quantitative analysis accompanied to the aim of this paper.