Prohibition of Riba and Gharar: A signaling and screening explanation?

Abstract

The emergence of Islamic Banks (IBs) with Sharia boards that restrict the set of permissible products and enforce prohibition of riba and gharar raises basic questions of how IB clients benefit by choosing financial services from a restricted menu of possibly higher-cost cash flows. Norms that restrict choice sets or impose otherwise harsh requirements would seem to act as a potential barrier to religious identification by raising costs for IB clients. Contrary to this intuition, a theoretical model demonstrates that premium financing costs and substantial restrictions on the set of financing options considered to be Sharia-compliant provide signaling technology that benefit IB clients who are highly pious. By revealing what would otherwise remain private information about one's intensity of religious piety, the signaling technology then provides a screening service, enabling high-piety types to separate and concentrate their social and commercial interaction with others who are similarly pious. Iannaccone (1992) demonstrates a rationale for harsh norms as a mechanism for reducing free-riding in the supply of club goods. In contrast, the model in this paper shows that piety can be signaled by the act of choosing to become an IB client and bearing the costs of restricted choice sets and premium pricing for financial products. This provides a new rationalization for prohibition of riba and gharar as a stable institution. Signaling piety is especially valuable in environments where piety is uncertain and otherwise difficult for others to observe. The model predicts that IBs' Sharia-compliance criteria will tend to be stricter and IB premiums larger in places where the proportion of highly pious Muslims is small.