Market segmentation and non-uniform Shariah standards in Islamic finance

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. (C) 2016 Elsevier B.V. All rights reserved.