Document Type : Science - Research (Islamic Risk Management Tools)

Authors

• Mohammad Hadi Andalib ¹
• Ahmad Shabani ²

¹ PhD Student in Islamic Economics, Faculty of Islamic Studies and Economics, Imam Sadiq University, Tehran, Iran

² Associate Professor, Department of Financial Economics, Faculty of Islamic Studies and Economics, Imam Sadiq University, Tehran, Iran

Abstract

1. Introduction and Objective
Information asymmetry has long been recognized as a critical challenge within financial markets, where unequal access to information between contracting parties can lead to inefficient outcomes. In the context of Islamic finance, this issue manifests most prominently through adverse selection and moral hazard, both of which are substantially intensified in profit-and-loss sharing arrangements. Participatory contracts such as Mushārakah and Muḍārabah rely on mutual trust, transparency, and aligned incentives. However, empirical evidence from Islamic banking practice—particularly in Iran—shows that actual utilization of these contracts remains limited. Banks frequently avoid participatory financing and shift toward fixed-return modes (such as Murābaḥah), mainly due to the heightened risk of borrower default arising from information asymmetry, insufficient visibility into business operations, and difficulties in monitoring managerial behavior.
      Within this environment, adverse selection emerges before contract formation when the bank cannot accurately distinguish between high-quality and low-quality project proposals or entrepreneurs. This may result in the unintended approval of risky proposals, thereby elevating the likelihood of non-performing financing. The problem is further accentuated by limitations in credit assessment processes, inadequate transparency in project data, and disparity in profit expectations and execution approaches between banks and entrepreneurs.
      Recent advances in decentralized technologies—particularly Web3 architectures incorporating blockchain, decentralized identity frameworks, distributed ledgers, and programmable smart contracts—provide new opportunities to address these long-standing informational and contractual challenges. Web3 offers a structural shift from centralized information control to transparent and verifiable records shared within a network of stakeholders. Such transparency can diminish information asymmetry, reduce opportunities for misrepresentation, automate contract enforcement, and improve the reliability of credit histories.
      The primary objective of this research is to assess the feasibility of reducing default risk caused by adverse selection in Islamic participatory contracts through the application of Web3 technology. The study aims to:
      (1) Identify the core factors that generate adverse selection in participatory financing,
      (2) Evaluate the strength and direction of their influence on default risk, and
      (3) Analyze how Web3 mechanisms can mitigate these factors and enhance the practical viability of participatory contracts in Islamic banking systems.

2. Methods and Materials
This research adopts a mixed-methods exploratory–confirmatory design. Owing to the complexity and conceptual novelty of integrating Web3 systems with Islamic financial contracts, the study began with a qualitative phase followed by quantitative model testing.
 
Qualitative Phase: Delphi Method
The qualitative stage employed a three-round Delphi process to identify and validate the principal determinants of adverse selection in participatory financing. The expert panel comprised university scholars in Islamic economics, senior managers of credit and risk departments in Iranian banks, and professional consultants in Islamic financial technology. The first round used open-ended questionnaires to collect diverse expert insights, resulting in an initial list of thirteen candidate factors. In the second round, a structured Likert-scale survey assessed the significance of the proposed factors. Consensus criteria were set at mean ≥ 3.5 and standard deviation ≤ 1, consistent with established Delphi methodology. In the final round, experts confirmed the final factor set, which consolidated into three primary constructs:
      (1) Lack of transparency in customer information,
      (2) Insufficient evaluation of the entrepreneur’s technical competence, and
      (3) Misalignment of objectives between financing partners.
 
      These validated constructs provided the basis for the structural model.

Quantitative Phase: PLS-SEM Analysis
In the second phase, a structured questionnaire was administered to 289 participants representing the same expert categories. Data were analyzed using Partial Least Squares Structural Equation Modeling (PLS-SEM) via SmartPLS software. PLS-SEM was chosen due to:
- The predictive and exploratory nature of the research,
- The inclusion of higher-order and formative construct, and
- Potential non-normality in expert response distributions.
 
      Model evaluation followed established metrics, including reliability (Cronbach’s alpha and composite reliability), convergent validity (AVE), discriminant validity, and structural path significance (t-statistics and p-values). Multi-collinearity was assessed using VIF values, all of which were below the acceptable threshold. Confidence levels were set at 95% with corresponding significance thresholds of p < 0.05.

3. Research Findings
The results of the structural model confirm that adverse selection exerts a direct and significant positive effect on default risk in participatory contracts (β = 0.299, p < 0.01). The components of adverse selection are strongly driven by:
- Lack of transparency in customer information (β = 0.932, p < 0.001),
- Misalignment of objectives between partners (β = 0.887, p < 0.001), and
- Insufficient assessment of entrepreneurial competence (β = 0.885, p < 0.001).
 
      This highlights that default risk in participatory financing is not merely a result of financial capacity constraints, but is deeply rooted in information imbalances and strategic behavior at the contract initiation stage.
      The model further demonstrates that Web3 technologies have a significant mitigating influence. The path coefficient for Web3’s direct effect on reducing default risk is negative and statistically meaningful (β = −0.214, p < 0.01). Additionally, Web3 reduces the negative effects of adverse selection and information asymmetry, as shown by reversed and weakened path effects in the Web3-enhanced environment.
      Key Web3 mechanisms enabling this outcome include:
- Real-time transparency and immutable information records,
- Smart contracts that automate profit-sharing and enforce commitments,
- Decentralized digital identity (DID) systems that support reliable, tamper-proof credit histories,
- Tokenization of collateral and tangible/ intangible assets, enabling verifiable and liquid security guarantees,
- Reduced monitoring and enforcement costs due to auditability of on-chain transactions.
 
4. Discussion and Conclusion
The findings of this research indicate that the primary barrier to effective participatory financing in Islamic banking is not merely structural or regulatory, but fundamentally informational. Adverse selection emerges where transparency, competence assessment, and goal alignment are weak. Conventional mechanisms—such as collateralization and post-contract supervisory audits—provide only partial and reactive mitigation. In contrast, Web3 offers a proactive and systemic solution by embedding transparency, verifiability, and automated compliance directly into the contract infrastructure.
      By shifting the reliance from personal trust to systemic trust, Web3 supports the original normative philosophy of Islamic finance: equitable profit-and-loss sharing, partnership-based financing, and ethical allocation of capital. From a policy perspective, adopting Web3 frameworks may substantially increase the feasibility and attractiveness of participatory financing modes for Islamic banks that currently avoid them due to high default exposure.
      This study contributes to the academic discourse on risk management in Islamic finance by demonstrating a structural linkage between information theory, contract design, and emerging decentralized technological capabilities. Practically, the research proposes a hybrid risk-management strategy, integrating traditional credit evaluation frameworks with Web3-based transparency, identity assurance, and automated enforcement.
      Future work should examine regulatory, Shariah governance, cybersecurity considerations, and interoperability standards needed to implement Web3-based participatory financing systems at scale. Nonetheless, the present results indicate that intelligent and compliant adoption of Web3 can significantly reduce default risk and enable the revival of participatory financing models in Islamic banking.

Keywords

• Adverse selection
• Default risk
• Participatory contracts
• Web 3 technology
• Structural equation modeling (SEM)

Main Subjects

• Islamic Risk Management Tools