Religiosity, neglected risk and asset returns: Theory and evidence from Islamic finance industry

This paper studies the sociological influence of religion on risk and return in financial markets with particular focus on Islamic finance. The paper builds a theoretical model to show how intermediaries serve their customers’ religious needs by creating innovative Islamic finance instruments. The customers’ emphasis on religiosity expose the industry to theological risk, which can increase the financial fragility of the system. In our model, the theological risk emerges as a neglected component, which can be realized in the event of bad news challenging the religious legitimacy of (Islamic) finance structures. Using stock price data for 104 Islamic bond (Sukuk) issuers, our analysis shows that Islamic bond issuers experience a significant decline in their stock prices, following multiple formal and informal announcements in 2008, which challenges the religious legitimacy of the Islamic bond structures. We complement our analysis using 1361 new Sukuk issues in Malaysia from 2005 to 2016 to investigate the impact of a regulatory change (introduced by Bank Negara in 2015) that limited the supply of sovereign Sukuk to serve only the Islamic banking industry.