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Asymmetric information, credit risk and instrument characteristics in islamic finance

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posted on 17.02.2017, 01:41 by Azmat, Saad
This thesis investigates whether traditional finance theories can explain the different characteristics of Islamic financial instruments. The work is divided into three sections. The first develops new theoretical models based on asymmetric information and risk averse bank customers to explain the dominance of debt in Islamic banks, even though many consider Islamic joint venture (IJV) funding to be the ideal Islamic mode of financing. The second section focuses on Islamic bonds and examines whether conventional structural credit risk models, such as the Finger et al. (2002) CreditGrades model, truly capture Islamic bonds’ underlying risk. The structural models’ various extensions have been adjusted for the Islamic bonds’ unique characteristics and are tested through simulations to identify if they favour some Islamic bond structures over others. Data from 52 Malaysian Islamic bond issuers is also tested with these models. The third section analyses the determinants of Islamic bond credit ratings using data for 458 Malaysian Islamic bonds and the issuer’s choice of Islamic bond type using data for 456 Malaysian Islamic bonds. Here, the impact of firm specific variables, specific events (such as the 2008 AAOIFI recommendations) and specific Islamic instrument characteristics (such as Shariah advisor effect) are analysed using ordered and multinomial probit models. The findings for the first section suggest that asymmetric information models, when augmented with the risk averse bank customer behaviour, can help explain the lack of IJV Islamic banks. For the second section, the simulation results suggest that conventional structural models and their Islamic extensions have a bias against IJV bonds. Conventional models, however, can be used to capture the risk of secured against real asset bonds (SARA). The third section shows that firm specific variables (such as leverage and profitability ratios), specific events (2008 AAOIFI recommendation) and Islamic instrument specific characteristics (such as the Shariah-advisor effect) are all significant determinants of Islamic bond ratings as well as the issuer’s choice of Islamic bond type. This work offers several contributions to the literature. It is the first to augment asymmetric information models with risk averse utility function of bank customers to offer a comprehensive explanation of the negligible use of IJV by Islamic banks. Secondly, it is the first to develop Islamic extensions of conventional structural models and analyse how these models favour some Islamic bond structures over others. Thirdly, it is the first to examine the impact of firm variables, specific events and Islamic instrument specific determinants of Islamic bond ratings and the issuer’s choice of Islamic bonds. These findings have several implications for policy makers/regulators, Islamic banks, credit rating agencies and Islamic bond issuers. For policy makers/regulators and Islamic banks, this study may help implement more IJV mode of financing. For credit rating agencies, it should enable them to refine their Islamic bond credit rating models by identifying those variables that have the most impact on the bonds’ underlying risk. For corporate issuers, it should help achieve higher credit ratings and better decision making when issuing Islamic bonds.


Campus location


Principal supervisor

Michael Skully

Additional supervisor 1

Kym Brown

Year of Award


Department, School or Centre

Accounting and Finance


Doctor of Philosophy

Degree Type



Faculty of Business and Economics