International Journal of Economics and Finance; Vol. 11, No. 1; 2019 ISSN 1916-971X E-ISSN 1916-9728 Published by Canadian Center of Science and Education 96 Asymmetric Information and Islamic Financial Contracts Abdelhafid Benamraoui 1 & Yousef Alwardat 2 1 Westminster Business School, Westminster University, UK 2 Faculty of Economy & Administration, King Abdulaziz University, KSA Correspondence: Yousef Alwardat, Faculty of Economy & Administration, King Abdulaziz University, KSA. E-mail: wardat61@yahoo.co.uk Received: November 11, 2018 Accepted: December 7, 2018 Online Published: December 18, 2018 doi:10.5539/ijef.v11n1p96 URL: https://doi.org/10.5539/ijef.v11n1p96 Abstract This research paper aims to examine the relevance of asymmetric information to the two main financial contracts used by Islamic banks or conventional banks with Islamic windows, mudaraba and musharaka. We use theoretical proofs to explain how asymmetric information affects mudaraba and musharaka contract in terms of bank cost and yield and how to account for the adverse selection and moral hazard costs when calculating bank net profit or loss. We also provide suggestions supported by key modern theories including signalling, comparative advantage and incentives to resolve asymmetric information problems in the Islamic financial contracts. The research paper shows that asymmetric information is relevant to both mudaraba and musharaka contracts and directly affects Islamic banks and conventional banks with Islamic windows cost and yield. The paper also reveals that signalling and incentives are effective tools to deal with asymmetric information in Islamic financial contracts. Finally, the paper shows that Islamic finance providers need to opt for more secure financing, particularly with small borrowers. Keywords: asymmetric information, Islamic financial contracts, signalling, comparative advantage, incentive theory 1. Introduction Since the work of Stiglitz and Weiss (1981) a number of research articles were devoted to the analysis of the relationship between asymmetric information and firm financing and investment decisions (Berger et al., 2011; Greenwald & Stiglitz, 1990; De Wet, 2004; Pike et al., 2005; Nyoni, 2018). These studies used mainly conventional financial markets and companies’ data and facts in their investigation of the relevance of asymmetric information to modern financial contracts with limited attention being paid to Islamic financial products. The consensus among the scholars is that asymmetric information can take place either before or after the financial contract is issued (Liu, Margiritis, & Tourani-Rad, 2011; Miskin; 1999; Morellec & Schürhoff, 2011). The first type of asymmetric information is the result of holding information that is unknown to at least one party involved in the contract and makes the individual or organisation who hold the information have an advantage or receive any form of benefits, which would have not been received if the information was known to all parties involved in the contract. This type of asymmetric information leads to adverse selection of products or services offered by the firms (Knutsen, 2001). Fund raisers and investors are likely to suffer from this problem in a situation where information asymmetry left unmanaged (Abosede & Oseni, 2011). The second type of asymmetric information is the result of taking an advantage of holding specific information after the contract has been agreed or exercised. Both types of asymmetric information are said to lead to inefficient allocation of capital, adverse selection of investments and to problems of moral hazard (see for example De Wet, 2004). Islamic finance and its main principles have been subject to extensive research both theoretically and empirically (see for instance: Chong, 2009; Berg, El-Komi, & Kim, 2016). The scholars accepted definition of Islamic finance is a form of finance, which follows the values set by the Sharia or the Islamic law (Gheeraert, 2014). The tenets of the Sharia include principally the prohibition of accepting interest rate ( riba), investing in certain sectors or products, such as alcohol, tobacco, pork and weapons, and engaging in speculative or gambling activities. The other fundamentals of Islamic finance are applying profit and loss sharing and avoiding excessive uncertainty or gharar (Medhioub & Cahffai, 2018). The application of these principles necessitates the fair