Discipline Under Risk-Sharing Liabilities: Runs, Disclosure, and Smoothing in Islamic Banking

Abstract

This paper examines when fragility disciplines Islamic banks and when it instead destroys value in profit-sharing investment accounts (PSIAs). The central question is whether performance-linked funding can preserve the disciplinary benefits of runnable claims while avoiding inefficient liquidation when retail investors interpret weak interim payouts as signals of distress. In PSIA settings this question is especially important: returns are contractually state-contingent, yet are behaviourally treated as deposit-like by monitoring-constrained investors. The paper develops a model of PSIA funding with two claimant classes: a monitoring-capable large depositor and a continuum of small depositors who coordinate on a salient public payout signal, and builds the analysis sequentially. A baseline liquidity framework first yields closed-form distress probabilities. Disclosure precision is then introduced as a policy instrument that simultaneously reduces the incidence of false alarms and raises the severity of withdrawals conditional on bad news. Return smoothing is added as a second instrument that dampens coordinated retail outflows but carries resource and governance costs. Finally, claimant heterogeneity is shown to generate a pooled-product externality under a single contract. Three results follow. First, disclosure has a non-monotonic effect on stability: higher precision lowers false alarms ex ante yet intensifies runs conditional on adverse news. Second, smoothing stabilises bad states by compressing the continuation wedge that otherwise deters long-run investment, although it may weaken the informational content of payouts. Third, when a single PSIA must serve both monitoring-capable and monitoring-constrained claimants, the optimal design is generically distorted; a segregated structure of restricted (information-sensitive) and unrestricted (stability-oriented) accounts therefore emerges as a second-best response. The main implication is that PSIA design involves a joint stability-governance trade-off. Product segregation can reduce inefficient liquidation, yet the stability-oriented pool may become the segment in which effective informativeness is weakest and governance risk is most concentrated. Fragility is therefore neither simply stabilising nor destabilising: it is contingently disciplinary, and the institutional responses used to suppress run risk can relocate that fragility into an informational and governance deficit borne by the least-informed claimants.

Date of Award	2026
Original language	American English
Awarding Institution	HBKU College of Islamic Studies