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 about how IB clients benefit when choosing 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 barrier to religious identification by raising costs for IB clients. Contrary to this intuition, our model demonstrates that premium costs associated with restrictions on the set of financing options considered to be Sharia-compliant provide a signaling and screening technology that benefits IB clients who are highly pious. By revealing what would otherwise remain private information about the intensity of religious piety, this signaling technology simultaneously provides a screening service that enables high-piety types to separate themselves and concentrate both social and commercial interactions 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, our model shows that piety can be signaled by the act of choosing to become an IB client and bearing the costs of its restricted choice set and premium pricing for otherwise identical cash flows. Signaling and screening provide 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.