Mathematical assessment on the robustness of PLS mechanism against adverse selection and moral hazard problems

Abstract

Most of conventional banks conduct their banking and financial systems under interest scheme, which is vulnerable to asymmetric information problems. This paper provides a mathematical assessment on the robustness of profit and loss sharing (PLS) based contract against asymmetric information problems. In particular we show that PLS scheme has an inherent mechanism to overcome adverse selection and moral hazard problems. Specifically, it will be shown that PLS contracts is relatively immune to the problems. This is due to the so called incentive compatible mechanism provided by PLS contracts. We also propose a risk-pooling mechanism to seize the risk exposure. Mathematics Subject Classification: 91B02, 91B28, 91B44