Abstract
•Screening mechanism provides new explanation for market segmentation in Islamic finance (IF).•Heterogeneous choices of stringency in Shariah-compliance can be rationalized.•Market segmentation achieves near-perfect informational efficiency.•Market segmentation may improve social welfare even though it is costly.•Separating equilibrium exists, which rationalizes heterogeneous Shariah-compliance policies.
This paper proposes a new answer to a controversial paradox in Islamic finance described by El-Gamal (2002): “despite the long development of uniform standards for Islamic finance, the market remains largely segmented.” We explain market segmentation as a separating equilibrium in which finance premiums serve as a socially beneficial (although costly) signaling mechanism. Market segmentation under a uniform standard of Shariah-compliance occurs when the Shariah Boards of two Islamic Finance Institutions (IFIs) use different degrees of stringency even though they agree on a common set of minimum requirements to comply with Shariah Law. Heterogeneous degrees of stringency chosen by different IFI Shariah Boards translate into different premiums paid by different customers. One IFI targets the moderately pious consumer segment while the other targets the highly pious segment. The IFI that targets highly pious consumers voluntarily offers a more limited set of investments and financing products. By allowing for multiple Muslim communities with distinct group identities and correspondingly variable willingness-to-pay to signal piety types, the model provides an explanation for market segmentation.