Social Norms and Economic Performance: An Example of Business Loans by Islamic Banks

In this paper we consider how social norms affect economic performance, using example of an Islamic bank providing a business loan to an entrepreneur. We show that the ability to rely on social norms mitigates the moral hazard problem, but introduces rigidities that prevent optimal response to adverse economic consequences, thereby improving performance during the booms, but handicapping it during the recessions. In the case of an Islamic bank, another consequence of this rigidity is a greater reluctance to invest in daring new ideas, which may be highly profitable but include a significant risk of failure. Although we use Islamic banks as our main example, the conclusions have broader validity and are not limited to religious social norms.