Shariah Compliance, Positive Assortative Matching and the Performance of IFI’s

Recently, Derigs and Marzban (2009) considered the effects of different strategies for constructing a shariah-compatible financial portfolio. They argued that shariah-compliant strategies result in a much lower portfolio performance than conventional strategies, because such compliance limits the set of admissible investments. Shariah finance does indeed prohibit investment in certain assets and industries, such as conventional bonds, derivatives, armaments, sex, tobacco and the gambling industries. However, the effects of these prohibitions are not exclusively negative. For example, a firm that is run in the interest of shareholders, protected by limited liability, is prone to excessive risk taking. If excessively risky projects are more likely to occur in these industries, the commitment of Islamic banks not to invest, enforced by shariah advisory boards, may result in an improvement of financial performance and attract more debt financing. Debt financing may also prove to be more beneficial than equity financing from the point of view of providing better incentives to management. This means that the effects of limiting the set of admissible investments by shariah law is ambiguous and invites us to seek for an alternative explanation of the low performance of Islamic banks. Let us briefly consider the costs and benefits of asset restriction.