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Islamic Financial System
Describing the Islamic financial system
simply as "interest-free" does not provide a true
picture of the system as a whole. While prohibiting
the receipt and payment of interest is the nucleus of
the system, it is supported by other principles of Islamic
teachings advocating individuals' rights and duties, property
rights, equitable distribution of wealth, risk-sharing, fulfilment
of obligations and the sanctity of contracts. Similarly, the Islamic
financial system is not limited to banking but covers insurance,
capital formation, capital markets, and all types of financial
intermediation and suggests that moral and ethical aspects in the
regulatory framework are also necessary in addiiton to prudent
and sound controls.
 
 
The philosophical foundation of an Islamic financial system goes beyond the interaction of factors of production and economic behavior. The Islamic financial
system can be fully appreciated only in the context of Islam's teachings on the business ethic, wealth distribution, social and economic justice, and the role of the state. Whereas the conventional financial system focuses primarily on the economic and financial aspects of transactions, the Islamic system places equal emphasis on the ethical, moral, social, and religious dimensions, to enhance equality and fairness `the principles of Islamic law (Shari’ah) and its practical application through the development of Islamic economics. Practitioners and clients need not be Muslims, but they must accept the ethical restrictions underscored by Islamic values.
 
Islamic finance may be viewed as a form of ethical investing, or ethical lending, except that no loans are possible unless they are interest-free. The general objectives (maqsid) of Islamic finance transactions may be summarised as below:
  • To be true to the Shari’ah principles;
  • Should be free from unjust enrichment;
  • Must be based on true consent of all parties; must be an integral part of a real trade or economic activity such as a sale, lease, manufacture or partnership.

 

 
 
[ Extract from article on Islamic Financial System by Zamir Iqbal, World Bank publication

 
What is Islamic finance?
Islamic finance was practiced predominantly in the Muslim world throughout the
Middle Ages, fostering trade and business activities with the development of credit. In Spain and the Mediterranean and Baltic states, Islamic merchants became indispensable middlemen for trading activities. In fact, many concepts, techniques, and instruments of Islamic finance were later adopted by European financiers and businessmen.

In contrast, the term “Islamic financial system” is relatively new, appearing only in the mid-1980s. In fact, all the earlier references to commercial or mercantile activities conforming to Islamic principles were made under the umbrella of either “interest-free” or “Islamic” banking. However, describing the Islamic financial system simply as “interest-free” does not provide a true picture of the system as a whole. Undoubtedly, prohibiting the receipt and payment of interest is the nucleus of the system, but it is supported by other principles of Islamic doctrine advocating risk sharing, individuals' rights and duties, property rights, and the sanctity of contracts. Similarly, the Islamic financial system is not limited to banking but covers capital formation, capital markets, and all types of financial intermediation.

Interpreting the system as “interest free” tends to create confusion. The philosophical foundation of an Islamic financial system goes beyond the interaction of factors of production and economic behavior.

Whereas the conventional financial system focuses primarily on the economic and financial aspects of transactions, the Islamic system places equal emphasis on the ethical, moral, social, and religious dimensions, to enhance equality and fairness for the good of society as a whole. The system can be fully appreciated only in the context of Islam's teachings on the work ethic, wealth distribution, social and economic justice, and the role of the state.

The Islamic financial system is founded on the absolute prohibition of the payment or receipt of any predetermined, guaranteed rate of return. This closes the door to the concept of interest and precludes the use of debt-based instruments. The system encourages risk-sharing, promotes entrepreneurship, discourages speculative behavior, and emphasizes the sanctity of contracts.

An Islamic financial system can be expected to be stable owing to the elimination of debt-financing and enhanced allocation efficiency. A “two-windows” model for Islamic financial intermediaries has been suggested in which demand deposits are backed 100 percent by reserves, and investment deposits are accepted purely on an equity-sharing basis. Analytical models demonstrate that such a system will be stable since the term and structure of the liabilities and the assets are symmetrically matched through profit-sharing arrangements, no fixed interest cost accrues, and refinancing through debt is not possible.

Allocation efficiency occurs because investment alternatives are strictly selected based on their productivity and the expected rate of return. Finally, entrepreneurship is encouraged as entrepreneurs compete to become the agents for the suppliers of financial capital who, in turn, will closely scrutinize projects and management teams.

Basic instruments
Islamic markets offer different instruments to satisfy providers and users of funds in a variety of ways: sales, trade financing, and investment.

Basic instruments include cost-plus financing ( murabaha), profit-sharing mudaraba), leasing ( ijara), partnership ( musharaka), and forward sale ( bay' salam). These instruments serve as the basic building blocks for developing a wide array of more complex financial instruments, suggesting that there is great potential for financial innovation and expansion in Islamic financial markets.

Principles of an Islamic financial system
The basic framework for an Islamic financial system is a set of rules and laws, collectively referred to as shariah, governing economic, social, political, and cultural aspects of Islamic societies. Shariah originates from the rules dictated by the Quran and its practices, and explanations rendered (more commonly known as Sunnah) by the Prophet Muhammad. Further elaboration of the rules is provided by scholars in Islamic jurisprudence within the framework of the Quran and Sunnah.

The basic principles of an Islamic financial system can be summarized as follows:
 

Prohibition of interest. Prohibition of riba, a term literally meaning “an excess” and interpreted as “any unjustifiable increase of capital whether in loans or sales” is the central tenet of the system.

More precisely, any positive, fixed, predetermined rate tied to the maturity and the amount of principal (i.e., guaranteed regardless of the performance of the investment) is considered riba and is prohibited. The general consensus among Islamic scholars is that riba covers not only usury but also the charging of “interest” as widely practiced.

This prohibition is based on arguments of social justice, equality, and property rights. Islam encourages the earning of profits but forbids the charging of interest because profits, determined ex post, symbolize successful entrepreneurship and creation of additional wealth whereas interest, determined ex ante, is a cost that is accrued irrespective of the outcome of business operations and may not create wealth if there are business losses. Social justice demands that borrowers and lenders share rewards as well as losses in an equitable fashion and that the process of wealth accumulation and distribution in the economy be fair and representative of true productivity.

Risk sharing. Because interest is prohibited, suppliers of funds become investors instead of creditors. The provider of financial capital and the entrepreneur share business risks in return for shares of the profits.

Money as “potential” capital. Money is treated as “potential” capital—that is, it becomes actual capital only when it joins hands with other resources to undertake a productive activity. Islam recognizes the time value of money, but only when it acts as capital, not when it is “potential” capital.

Prohibition of speculative behavior. An Islamic financial system discourages hoarding and prohibits transactions featuring extreme uncertainties, gambling, and risks.

Sanctity of contracts. Islam upholds contractual obligations and the disclosure of information as a sacred duty. This feature is intended to reduce the risk of symmetric information and moral hazard.

Shariah-approved activities. Only those business activities that do not violate the rules of shariah qualify for investment. For example, any investment in businesses dealing with alcohol, gambling, and casinos would be prohibited.

Simple derivatives, such as forward contracts, are being examined because their basic elements are similar to those of the Islamic instrument of deferred sale. Project finance, which puts emphasis on equity participation, is another natural fit for Islamic finance.

Microfinance
Microfinance is another candidate for the application of Islamic finance. Islamic finance promotes entrepreneurship and risk sharing, and its expansion to the poor could be an effective development tool. The social benefits are obvious, since the poor currently are often exploited by lenders charging usurious rates.

Economic Development of Islamic countries
An Islamic financial system can play a vital role in the economic development of Islamic countries by mobilizing dormant savings that are being intentionally kept out of interest-based financial channels and by facilitating the development of capital markets. At the same time, the development of such systems would enable savers and borrowers to choose financial instruments compatible with their business needs, social values, and religious beliefs.
 
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‘The Global Financial Crisis: Can Islamic Finance Help?'
[Extract from article by Dr Umer Chapra in NEWHORIZON magazine published by the Institute of Islamic Banking and Insurance 01 January, 2009]
Greater Justice in Human Society
One of the most important objectives of Islam is to realise greater justice in human society. According to the Quran, a society where there is no justice will ultimately head towards decline and destruction (Quran, 57:25). Justice requires a set of rules or moral values, which everyone accepts and faithfully complies with. The financial system may be able to promote justice if, in addition to being strong and stable, it satisfies at least two conditions based on moral values. One of these is that the financier should also share in the risk so as not to shift the entire burden of losses to the entrepreneur, and the other is that an equitable share of financial resources mobilised by financial institutions should become available to the poor to help eliminate poverty, expand employment and self-employment opportunities and, thus, help reduce inequalities of income and wealth.
 
First Condition of Justice
To fulfill the first condition of justice, Islam requires both the financier and the entrepreneur to equitably share the profit as well as the loss. For this purpose, one of the basic principles of Islamic finance is ‘no risk, no gain'. This should help introduce greater discipline into the financial system by motivating financial institutions to assess the risks more carefully and to effectively monitor the use of funds by the borrowers. The double assessment of risks by both the financier and the entrepreneur should help inject greater discipline into the system, and go a long way in reducing excessive lending.

Islamic finance should, in its ideal form, help raise substantially the share of equity and Profit-Loss-Sharing (PLS) in businesses. Greater reliance on equity financing has supporters even in mainstream economics. Professor Kenneth Rogoff of Harvard University states that in an ideal world equity lending and direct investment would play a much bigger role.

Greater reliance on equity does not necessarily mean that debt financing is ruled out. This is because all the financial needs of individuals, firms, or governments cannot be made amenable to equity and PLS. Debt is, therefore, indispensable, but should not be promoted for nonessential and wasteful consumption and unproductive speculation.

For this purpose, the Islamic financial system does not allow the creation of debt through direct lending and borrowing. It rather requires the creation of debt through the sale or lease of real assets by means of its sales - and lease-based modes of financing ( murabaha, ijara, salam, istisna and sukuk). The purpose is to enable an individual or firm to buy now the urgently needed real goods and services in conformity with his/her ability to make the payment later. It has, however, laid down a number of conditions, some of which are:
  • The asset which is being sold or leased must be real, and not imaginary or notional.
  • The seller or lessor must own and possess the goods being sold or leased.
  • The transaction must be a genuine trade transaction with full intention of giving and taking delivery.
  • The debt cannot be sold and thus the risk associated with it must be borne by the lender himself.
The first condition will help eliminate a large number of derivatives transactions which involve nothing more than gambling by third parties who aspire to claim compensation for losses which have been actually suffered only by the principal party and not by them.
 
Second Condition of Justice
The second condition will help ensure that the seller (or lessor) also shares a part of the risk to be able to get a share in the return. Once the seller (financier) acquires ownership and possession of the goods for sale or lease, he/she bears the risk. This condition also puts a constraint on short sales, thereby removing the possibility of a steep decline in asset prices during a downtown. The Shari'ah has, however, made an exception to this rule in the case of salam and istisna where the goods are not already available in the market and need to be produced or manufactured before delivery. Financing extended through the Islamic modes can thus expand only in step with the rise of the real economy and thereby help curb excessive credit expansion.
 
Third and Fourth Conditions of Justice
The third and the fourth conditions will not only motivate the creditor to be more cautious in evaluating the credit risk but also prevent an unnecessary explosion in the volume and value of transactions. This will prevent the debt from rising far above the size of the real economy and also release a substantial volume of financial resources for the real sector, thereby helping expand employment and self-employment opportunities and the production of need-fulfilling goods and services. The discipline that Islam wishes to introduce in the financial system may not, however, materialise unless governments reduce their borrowing from the central bank to a level that is in harmony with the goal of price and financial stability.

One may raise an objection here that all these conditions will perhaps end up shrinking the size of the economy by reducing the number and volume of transactions. This is not likely to happen because a number of the speculative and derivatives transactions are generally known to be zero-sum games and have rarely contributed positively to total real output. Hence a decline in them is also not likely to hurt the real economy.

While a restriction on such transactions will cut the commissions earned by the speculators during an artificially generated boom, it will help them avert losses and bankruptcy that become unavoidable during the decline and lead to a financial crisis.

The injection of a greater discipline into the financial system may tend to deprive the subprime borrowers from access to credit. Therefore, justice demands that some suitable innovation be introduced in the system to ensure that even small borrowers are also able to get adequate credit. Such borrowers are generally considered to be subprime and their inability to get credit will deprive them from realising their dream of owning their own homes and establishing their own microenterprises.

Microfinance
There is no doubt that a number of countries have established special institutions to grant credit to the poor and lower middle class entrepreneurs. Even though these have been extremely useful, there are two major problems that need to be resolved. One of these is the high cost of finance, ranging from 30 to 84 per cent in the interest-oriented microfinance system. This causes serious hardship to the borrowers in servicing their debt. No wonder the minister of finance for Bangladesh described microcredit interest rates in that country as extortionate in an address he delivered at a microcredit summit in Dhaka in 2004. It is, therefore, important that microcredit is provided to the very poor on a humane, interest-free basis (qard hasan). This may be possible if the microfinance system is integrated with zakat and waqf institutions. For those who can afford to bear the cost of microfinance, it would be better to popularise the Islamic modes of PLS and sales- and lease-based modes of finance, not only to avoid interest but also to prevent the misuse of credit for personal consumption.

Another problem faced by microfinance is that the resources at the disposal of microfinance institutions are inadequate. This problem may be difficult to solve unless the microfinance sector is scaled up by integrating it with the commercial banks. Commercial banks do not generally lend to small borrowers because of the higher risk and expense involved in such financing. It is, therefore, important to reduce their risk and expense. This may be done partly by a subsidy from zakat and waqf funds for those borrowers who are eligible for zakat.

Islamic Financial System capable of minimising the severity and frequency of financial crises
Thus we can see that the Islamic financial system is capable of minimising the severity and frequency of financial crises by getting rid of the major weaknesses of the conventional system. It introduces greater discipline into the financial system by requiring the financier to share in the risk. It links credit expansion to the growth of the real economy by allowing credit primarily for the purchase of real goods and services which the seller owns and possesses, and the buyer wishes to take delivery. It also requires the creditor to bear the risk of default by prohibiting the sale of debt, thereby ensuring that he evaluates the risk more carefully. In addition, Islamic finance can also reduce the problem of subprime borrowers by providing credit to them at affordable terms.
 
Reform of the Conventional Financial System
Since the current architecture of the conventional financial system has existed for a long time, it may perhaps be too much to expect the international community to undertake a radical structural reform of the kind that the Islamic financial system envisages. However, the adoption of some of the elements of the Islamic system, which are also a part of the western heritage, is indispensable for ensuring the health and stability of the global financial system.
 
These are:
  • The proportion of equity in total financing needs to be increased and that of debt reduced.
  • Credit needs to be confined primarily to transactions that are related to the real sector so as to ensure that credit expansion moves more or less in step with the growth of the real economy and does not promote destabilising speculation and gambling.
  • Leverage needs to be controlled to ensure that credit does not exceed beyond the ability of the borrower to repay.
  • If the debt instruments, and in particular CDOs, are to be sold, then there should be full transparency about their quality so that the purchaser knows exactly what he is getting into. It would also be desirable to have the right of recourse for the ultimate purchaser of the CDOs so as to ensure that the lender has incentive to underwrite the debt carefully.
  • While there may be no harm in the use of CDOs to provide protection to the lender against default, it needs to be ensured that the swaps do not be come instruments for wagering. Their protective role should be confined to the original lender only and should not cover the other purchasers of swaps who wish to wager on the debtor's default. For this purpose the derivatives market needs to be properly regulated to remove the element of gambling in it.
  • All financial institutions, and not just the commercial banks, need to be properly regulated and supervised so that they remain healthy and do not become a source of systemic risk.
  • Some arrangement needs to be made to make credit available to subprime borrowers at affordable terms to enable them to buy a home and to establish their own microenterprises. This will help save the financial system from crises resulting from widespread defaults by such borrowers.
   
Stability of the Islamic Financial System

“Resilience and Stability of the Islamic Financial System – An Overview” by Noureddine Kirchene and Abbas Mirakhor presented at the seminar held on 30 January 2009 on ‘Comparative Development of the Islamic Economic Model in context of current market conditions', organised by KPMG, London, UK.

Introduction: the Concept of Stability
The financial crisis, that broke out in August 2007, was considered to be the worst in the post war period. Representing the collapse of trillions of fictitious credit derivatives and the meltdown of uncontrolled credit growth, the scope of the crisis and its intensity only kept worsening and could reach unmanageable size [The size of the credit derivatives (ABSs, CDSs, etc.) is unknown, which makes the financial crisis complex. Most of the derivatives are over the counter (OTC). Contrary, to exchange transactions (futures contracts, options, stocks), there is no centralized clearing institutions for credit derivatives. Reform efforts will seek to establish clearing facility for credit derivatives in order to be able to quantify them]. It has crippled the financial system of many advanced countries, and has claimed long established banking institutions that were deemed too big too fail. Large bailouts by governments and massive liquidities injections by central banks have only fanned more the flames. Capital markets have frozen, leading in turn to unexpected crash in stock markets, wiping out trillions of dollars in share values and in retirement investment accounts. Economic uncertainty has never been as high. Has the crisis been correctly tackled or has it only been made worse? In view of incredibly high liquidity injection by major central banks, has money supply become out of control? How long the crisis will last? How many sectors and countries will it affect? What will be its impact on growth and employment? What will be its fiscal and inflationary cost? Will inflation finally run out of control? While precise answers are not possible, the present crisis has already slowed down economic growth in many industrial countries, triggered food riots and energy protests in many vulnerable countries, increased unemployment, and imposed extraordinary fiscal costs. Notwithstanding its far reaching and devastating consequences, the crisis has made the quest for financial stability a pressing and fundamental issue in economics and finance.

Financial instability has been a recurrent phenomena in contemporary economic history, affecting countries with varying intensity. The most enduring crisis was the Great Depression 1929-33. Eminent economists who lived through the Great Depression fought very hard to establish a banking system, based on some pillars of Islamic finance, capable of preserving long-term financial stability. Their proposals became known as the Chicago Reform Plan, as they were elaborated by economic professors at the University of Chicago [The Chicago Plan was elaborated by Henry Simons, Frank Knight, Aaron Director, Garfield Cox, Lloyd Mints, Henry Schultz, Paul Douglas, and A. G. Hart. Professor Irving Fisher from Yale University was a strong supporter of the Plan. His book, 100% Money, was an attempt to win support among academics and policy makers for the Plan]. The Chicago Plan basically divides the banking system into two components: a warehousing component with 100% reserve requirement and an investment component with no money contracts and interest payments, where deposits are considered as equity shares and are remunerated with dividends, and maturities are fully observed. What transpired from the Chicago Plan and subsequent literature was that only a financial system along Islamic principles is immune to financial instability.

Financial stability is a basic concept in finance. It applies to a household, firm, bank, government, or a country. It is an accounting concept conveying notions of solvency, or equilibrium. For a given entity, financial stability can be defined as regularly liquid treasury position, whereby the sources of funds exceed uses of funds. The sources of funds are diverse and include income streams (salaries, transfers, taxes, interest income, dividends, profits, etc.), borrowing or loan recovery, and sales of real and financial assets. The uses of funds include current expenditures (including interest payments), capital expenditures, purchase of assets, lending or debt amortization. Accounts are separated into income or current accounts, and balance sheet or capital accounts. Financial stability means that the consolidated account tends to be regularly in surplus [The consolidated account can be compared to the overall fiscal account of the government or to the balance of payments of a country. Each account is composed of two components: a current account component and a capital account component. The overall balance of the consolidated account should be sustainable for financial stability to be maintained over time].

Financial instability can be defined as the opposite of financial stability. It can be associated with notions of default, arrears, or insolvency. It manifests itself through a regularly deficient treasury position, whereby the sources of funds fall short of uses of funds or payments obligations. When financial instability persists, access to borrowing becomes unavailable. The entity facing financial instability may have to recapitalize, liquidate assets, restructure liabilities, seek a bailout, or may be subject to merger or liquidation.

In banking, stability means that assets and liabilities maturities are matched, assets preserve their values and do not depreciate, and the amount of IOUs is fully backed by gold or warehouse deposits that served for issuing these IOUs. Over issues of gold or warehouse certificates, bank notes, or scriptural money may cause instability in case of a run from domestic or international depositors [For instance, the United Kingdom suspended gold standard in September 1931 following a run on its gold reserves. Similarly, the US suspended gold standard in August 1971 when its gold reserves fell critically]. The amount of claims may exceed largely the stock of gold or merchandise; in these conditions, conversion may be suspended, bankruptcies may happen, or IOUs may be devalued. Under a fiat money system, the central bank may act as the last resort lender to preserve stability by printing new money which may lead to currency depreciation.

The paper reviews in Section II some examples of financial instability, both in distant and recent past and the ordeal that followed this instability. The general pattern was that each episode was preceded by a speculative boom and excessive price volatility in one or many types of assets, which could be common stocks, gold, commodities, land, housing, foreign currencies, or any other asset. The bursting of the boom caused in turn asset price deflation and banking failure. Each major financial crisis has wiped out real income gains setting real GDP and real per capita income at levels much lower than pre-crisis levels [For instance, US real GDP was reported to have fallen by over one third during 1929-1933 and was not able to return to 1929 level until 1939. In Japan, financial instability, caused by the collapse of stock and real estate prices following an asset boom during 1985-1989, was responsible for economic stagnation of 1990-2001].

In Section III, the paper reviews the causes of financial instability and economic depression or recession it causes. Credit expansion and abundant liquidity, supported by cheap money policy and low interest rates, lead to speculative booms and asset price bubbles. Financial innovations, Ponzi finance, swindles, and fraud develop during a speculative boom. During a bubble, many illiquid credit instruments become monetized, for instance through securitization, and fuel further liquidity. Over indebtedness erodes creditworthiness and causes defaults. Sharp credit contraction, deflation of asset prices, and bankruptcies that follow thereafter explain economic recession or depression. The paper discusses Minsky's hypothesis that in a conventional system stability is unstable and that instability is endogenous to such a financial system which is apparently destined to experience periods of financial instability. However, Minsky's endogeneity analysis, while integrating Keynes' views regarding instability of expectations and Schumpeter's view on creative destruction adapted to financial innovations, is not fully supported by facts.

Subsequently, Section IV establishes that, in many episodes of financial instability, monetary policy contributed directly to speculative booms and to their severe deflationary or inflationary consequences. Contrary to Minsky's endogeneity hypothesis, financial instability could have been easily avoided had the central bank acted to pre-empt a speculative boom by precluding risky lending, or had it kept tight control on liquidity creation and credit expansion. By being entrusted with achieving full employment, central banks have relied on interest rate setting for achieving this objective to the neglect of close monitoring of monetary aggregates. Such mandate of the central bank, besides undermining long-term economic growth, has created an uncertain money framework and has become a source of serious financial instability [Henry Simons (1948) considered the central bank to be almost solely responsible for financial instability for allowing multiplication of money substitutes by banking institutions and for failing to strictly control monetary aggregates and credit. The same views were held by Allais (1999) who considered uncontrolled money expansion and destruction by the banking system to be a major cause of financial instability].

Section V analyzes the recent episode of international financial instability, and shows that it was caused by monetary expansion in reserve centers and beggar-thy-neighbor policies in pursuit of short-term economic growth gains, and recalls the notion of a common world currency as a remedy to international financial instability. Section VI analyzes the mechanics of the credit multiplier. It shows that banks do create money substitutes through issuing liabilities. Under securitization, the credit multiplier becomes theoretically infinite. If not controlled by the monetary authority, bank money creation can lead to excessive credit and money growth in the economy and become a source of instability.

Section VII discusses the main theme of the paper: the stability of the Islamic financial system [The paper discusses stability of Islamic banks at a theoretical level. Deviations from basic Islamic banking precepts could expose Islamic financial institutions to the same instability as conventional banking. In many instances, troubled Islamic banks were found to apply the same principles as conventional banking]. An Islamic financial system avoids interest and interest-based assets [Hassan and Lewis (2007) offered a comprehensive description of Islamic modes of financing which are based on profit and loss sharing investment, types of risks in Islamic banking, and financial innovations, including access to capital markets and securitization, introduced by Islamic banks], and thus restricts speculation [Speculation may create a disconnect between the market price of an asset (e.g., common stock, house, etc.) and its true economic value or fundamentals. For instance, if a stock market crash happens and shares drop by 20 percent, this does not mean that existing real capital has deteriorated by 20 percent. Similarly, if the stock price index increases by 50 percent over a year period, it does not imply that existing real capital has appreciated in real terms in the same proportion. In the same vein, the construction cost of a house may decrease, due to productivity gains; however, because of speculation, its market price may increase two, three, or fourfold]. Mirakhor (1988) showed that an Islamic financial system can be modeled as non-speculative equity ownership model that is intimately linked to the real sector and where demand for new shares is determined by real savings in the economy. All causes of financial instability analyzed in previous sections, namely money creation out of thin air, speculation, and interest-based financial assets are absent in Islamic finance. Banks own directly real assets and operate like an equity holding system. Savings is redeployed into productive investment with no ex-nihilo money creation. Mirakhor (1988) showed that the rate of return on equities is determined in a growth model by the marginal efficiency of capital and time preference and is significantly positive in a growing economy, implying that an Islamic banking is always profitable provided that real economic growth is positive. Mirakhor (1988) finding establishes a basic difference between Islamic banking where profitability is fully secured by real economic growth and conventional banking where profitability is not driven primarily by the real sector [Conventional banks may suffer large losses, as seen recently in many industrial countries, in spite of continuing real economic growth].
 
An Islamic banking system has two types of banking activity. A deposit banking for safekeeping and payment purposes. This system operates on 100 percent reserve requirement, and fees may be collected for this type of banking services. An investment banking system which operates on risk and profit sharing basis with an overall rate of return which is positive and determined by the economy growth rate. The paper shows that Islamic banks do not create and destroy money; consequently, the money multiplier, defined by the savings rate in the economy as suggested by Mirakhor (1988), is much lower in an Islamic system compared to a conventional system, providing thus a basis for strong financial stability, greater price stability, and a sustained economic growth [This inherent stability of Islamic banking has led famous economists (Irving Fisher (1936), Henry Simons (1948), Maurice Allais (1999), and many others) to formulate monetary reform proposals along Islamic banking principles. These proposals are known as the Chicago Plan; they call for dissociating banking into two independent activities: (i) 100 percent reserve deposit banks; and (ii) investment banks that redeploy savings into investment through selling securities].
 
In Section VIII, the paper discusses the types of finance that can be excluded from Islamic banking and safeguards and regulatory framework for the Islamic finance system [A penetrating treatment of regulatory and supervision challenges in Islamic banking can be found in Archer and Abdel Karim (2007)]. Section IX concludes. It focuses on the social cost of financial instability; namely, when the central bank tries to socialize losses from a speculative boom through large bailouts, it sets an inflationary process. Such an outcome penalizes the public for policy mismanagement, and causes large wealth redistribution from fixed income, wage earners, and creditors in favors of banks and debtors. Moreover, high inflation causes a deflation of real output and may degenerate into stagflation when inflationary expectations become fully embedded in the price and wage system. Last resort bailouts are tantamount to validating uncontrolled money creation by financial institutions. An Islamic system avoids such an outcome. By its absence, last resort lending in an Islamic system does not validate uncontrolled liquidity creation, and therefore it would rule out monetary-policy-based inflation. As recent financial crisis as well as previous financial instability episodes were essentially caused by overly expansionary monetary and credit policies in many industrial as well developing countries there is certainly a need for a Basle III agreement that would regulate regulators, i.e., central banks, and set guidelines for safe central banking aimed at financial stability and not at full employment. Absent such regulatory framework, existing Basle agreements I and II, even if fully observed, would not prevent severe financial instability [In October 2008, failing to force banks to resume lending to unqualified borrowers, major central banks have bypassed banks and decided to lend directly to these borrowers immense loans at negative real interest rates. Such desperate and disorderly conduct of central banks undermines every regulatory framework].
 
Financial instability: Recurrence and Severity
Financial instability has been a recurrent event that plagued economies both in distant and recent pasts and can render even the most advanced financial systems vulnerable. Its costs are unavoidable either in terms of widespread bankruptcies and deflation or in terms of runaway inflation that generates a wealth redistribution in favor of debtors at the expense of creditors, pensioners, and wage earners. It erupts when a speculative boom bursts. The object of speculation has varied from boom to boom. The list of assets and goods that may attract speculation could be endless, and may include all types of commodities futures, bonds, gold, agriculture land, buildings, housing, stocks, and foreign exchange. Often, financial instability has its roots in a previous instability episode and lays, in turn, the ground for another episode of financial instability. Hence, conventional banking system seems to be caught in cycles of instability. While financial instability has not been a rare occurrence, its severity and duration have varied. Instability may manifest itself though a temporary crisis of the banking system and limited spillover to the real economy. It may, however, evolve into a severe banking and economic crisis, as was the case in Argentina for example, resulting in large number of bankruptcies, deposits losses, deflation or inflation episodes, contraction in output and massive unemployment, collapse of exchange rates, paralysis of international trade and emergence of trade restrictions. Economic decline can persist for many years before recovery starts and activity returns to pre-crisis level.

The present financial crisis in the US and Europe, which finds its origin in the “Greenspan put” in the wake of the collapse of the stock market in late 1990s and the collapse of long-term capital management (LTCM) hedge funds, has manifested itself through a burst in housing bubble, collapse of credit derivatives and securitization, meltdown of sub-prime market loans, and massive bailout of financial institutions in the US and Europe. [The "Greenspan Put" refers to the monetary policy that Alan Greenspan, the former Chairman of the US Federal Reserve Board, fostered from the late 1980s to the middle of 2000. During this period, when a crisis arose, the Fed came to the rescue by significantly lowering the federal funds rate, often resulting in a negative real yield. In essence, the Fed pumped liquidity back into the market to avert further deterioration. The Fed did so after the 1987 stock market crash, the Gulf war, the Mexican crisis, the Asian crisis, the LTCM debacle, Y2K, and the internet bubble burst. The Fed set interest rates at record low levels during 2001-2004 causing a phenomenal credit expansion at about 12 percent per year. The Fed's pattern of providing ample liquidity resulted in the investor perception of put protection on asset prices. This created a moral hazard problem where investors increasingly believed that when there is a financial crisis, the Fed would step in and inject liquidity until the problem got better. Invariably, the Fed did so each time, and the expectation became firmly embedded in asset pricing in the form of higher valuation, narrower credit spreads, and excess risk taking. The end result has been moral hazard in risk taking and successive bubbles in equities, real estate, and commodities].

As writedowns have so far exceeded US$500 billion, old-established institutions have fallen (e.g., Lehman Brothers) and many financial giants are rescued through massive bailouts (including the recently rescued Fannie Mae, Freddie Mac, and AIG) the spread of the unfolding crisis attests to the severity of this episode of financial instability. Destabilizing financial and economic shocks are still intensifying in credit, commodities, and currency markets; as in the case of Japan during 1990-2001, they could foreshadow a prolonged contraction of output growth and employment. Although reminiscent of the 1970s stagflation, the present financial crisis has set off highest inflation in modern history in energy and food prices, triggering widespread food riots and protests, and has been reducing real incomes at a fast rate. The last-resort lending by central banks is eroding real savings, undermining capital accumulation, and long-term economic growth. As the crisis is still evolving, uncertainties are rising and economic recession could be longer and more severe than any other postwar recession.

Financial instability is not restricted to developed countries. It has played havoc with a number of major South East Asian economies, causing banking and corporation bankruptcies, severe contraction of output and employment (exceeding 10 percent in real terms), and loss of international reserves. Many highly indebted poor countries and middle income countries have experienced severe debt crisis which have disrupted their economic growth. In spite of major debt write-offs, many debt-burdened countries have not yet been able to experience sustained recovery or achieve debt sustainability.

History is replete with recurrent financial instability. Many episodes and their causes have been documented (e.g., Friedman and Schwartz, 1963, Galbraith, 1954, Kindleberger, 1977, Minsky, 1986). Severe financial turbulences occurred in1837,1873,1893, and 1907. In the wake of each episode, massive bankruptcies ensued, leading to millions of jobs lost and to economic decline. Certainly, the Great Depression of 1929-1933 was the worst episode of financial instability in modern history. It hit hard in the US and Europe, causing large scale bankruptcies, debt deflation, steep fall in output (by over one third in real terms) and prices, and massive unemployment and poverty. It was responsible for monetary chaos that prevailed in 1930s, leading to the human tragedy of the Second World War. Soon after the war, warring powers rushed to establish the Bretton-Woods system with the mandate to stabilize world economy, adopt fixed instead of highly volatile and flexible exchange rates, and take steps to mitigate the causes that led to monetary instability of the pre-war period.

Financial instability led to abandonment of the gold standard after the First War 1914-1918 and its replacement by the gold exchange standard and flexible exchange rates (1922 Genoa agreement). It was then replaced by the fixed exchange rates system, which was in turn abandoned and replaced by a return to floating exchange rates. The suspension of gold standard has made inflation a regular feature of the conventional monetary system leading to prolonged and destabilizing inflationary episodes.

Causes of financial instability
In view of its devastating effects, considerable research effort has been devoted to explaining the causes of financial instability and to prescribe remedies that would reduce the risk of instability and spare the economy dire and needless costs in terms of deep contraction in output, large scale unemployment, bankruptcies, dramatic fall in real incomes, and social hardship. Financial instability has often been caused by war or large fiscal deficits which were financed by printing money. However, financial instability could also be caused by ill-designed monetary policies, abundant liquidity and excessive and imprudent credit expansion, or by market forces endogenous to the financial system.

1. Over-indebtedness and Deflation

Irving Fisher (1933) reviewed many possible causes that may lead to financial instability. He argued that two dominant factors were responsible for each boom and depression: over-indebtedness in relation to equity, gold, or income which starts a boom, and deflation consisting of a fall in asset prices or a fall in the price level which starts a depression. He noted that over-investment and over-speculation are often important, but they would have far less serious results if they were not conducted with borrowed money. That is, over-indebtedness may reinforce overinvestment and over-speculation. Disturbance in these two factors: debt and the purchasing power of a monetary unit, will adversely impact all other economic variables. If debt and deflation are absent, other disturbances would be powerless to bring on crises comparable in severity to those of 1837, 1873, or 1929-1933.

Fisher found that easy money was the great cause of over-borrowing. When an investor thinks he can earn high returns by borrowing at low rates, he will be tempted to borrow and to invest or speculate with borrowed money [Henry Simons (1948) advanced similar analysis for financial instability. He wrote “It is no exaggeration to say that the major proximate factor in the present crisis (i.e., 1929-1933 Great Depression) is commercial banking. We have reached a situation where private-bank credit represents all but a small fraction of our total circulating medium.” Fast expansion of bank credit at the expense of creditworthiness was followed by sharp credit contraction as banks attempt to restore the quality of the assets and recover from their losses. The power of banks to create and destroy money on a large scale has caused large fluctuations in output and employment and became a source of considerable monetary uncertainties. In Simons (1948), financial instability is compounded by price and wage rigidities, with the brunt of adjustment born by decline in quantities (i.e., output and employment)]. He maintained that this was the prime cause leading to over-indebtedness of 1929. Low interest rate policy adopted by the US to help England to return to the gold standard in 1925 contributed to unchecked credit expansion. Brokers' loans, with very small margins and low interest rates, expanded very fast and fueled stock market speculation. Inventions and technological improvements created investment opportunities leading to large debts. Other causes were the left-over domestic and foreign war debts and the reconstruction loans to Europe.

The depression was triggered by debt liquidation which led to distress selling and to contraction of deposit currency as bank loans were paid off, and to a slowing down of velocity of circulation. The contraction of deposits caused a fall in the level of prices. There followed a greater fall in the net worth of businesses, precipitating bankruptcies, a fall in profits leading to a reduction in output, trade, and employment, which in turn led to hoarding and slowing down of the velocity of circulation.

Fisher's analysis showed that financial instability of the scale of the Great Depression was avoidable if over-indebtedness was precluded. He emphasized the important corollary of his debt-deflation theory that great depressions are curable through reflation and stabilization. He maintained that the government can reflate the price level through printing money to finance deficit needed to kick-start economic recovery. The central bank can also re-inflate through open market operations or lending as a last resort. Referring to Sweden where economic policy was able to maintain stability during 1929-33, he believed that price level was controllable through appropriate policy instruments.

Friedman and Schwartz (1963), and Friedman (1959, 1969, 1972) conceived of financial instability as a monetary phenomenon--described as faster money expansion due to unchecked credit expansion-- and significantly downplayed real factors. In each financial crisis, banks suspended conversion of deposits into currency, and a wave of bank failures ensued. The analysis of the causes of the Great Depression by Friedman and Schwartz (1963) sheds light on the causes that led to the present financial crisis characterized by meltdown of sub prime loans and the burst of the housing boom. They argued that fierce competition among banks and financial innovation evaded prudential regulations, contributed to over borrowing for speculation in housing and stock markets and a deterioration of the quality of loans. They noted that financial instability of the scale of the Great Depression did not happen prior to the creation of the Federal Reserve System (Fed) in 1913. The founders of the Fed were expecting that financial instability of the 19th and early 20th century would be thwarted or significantly reduced by the creation of a central bank. With regard to the Great Depression, Friedman and Schwartz held the view that the Fed was accountable for two policy errors: it was reluctant to prevent a speculative boom at an early stage and it was not able to move fast enough to avoid massive bank failures and deep depression. Based on a comprehensive study of the US monetary history, they observed that financial stability prevailed only when money supply was increasing at a stable and moderate rate of 2-3 percent. In line with Simons (1948), Friedman strongly rejected discretionary and unpredictable monetary policy and prescribed the rule of setting fixed targets for the growth of monetary aggregates in line with the expansion of economic activity [Maurice Allais (1999) was a strong supporter of fixed rule. In full agreement with Friedman, he proposed a fixed target for money supply, compatible with a long-term inflation at about 2 percent a year].

Galbraith (1954), Kindleberger (1977), and Soros (2008) found that speculative manias gather speed through expansion of money and credit. During a speculative euphoria, many credit instruments become ‘monetized”, fueling speculation. The Radcliffe Commission in Britain in 1959 claimed that in a developed economy there is a wide range of financial institutions and many highly liquid assets which are close substitutes for money, as good to hold, and only inferior when the actual moment for a payment arrives. Call money, more specifically brokers' loans, combined with small margins and low interest rates, financed stock market speculation in 1929. Credit instruments can be monetized during a speculative boom; these instruments include bills of exchange, negotiable CDs, installment credit, NOW accounts, credit cards, mortgages, and students loans. When a speculative boom bursts, these credit instruments become illiquid and there is a rush back to liquidity and safety.

2. Minsky: stability is unstable

Minsky (1986, 1992) considered financial instability to be endogenous to conventional financial system. His core model is known as Financial Instability Hypothesis (FIH), which simply declares stability is inherently unsustainable. A fundamental characteristic of a conventional financial system, according to Minsky, is that it swings between robustness and fragility and these swings are an integral part of the process that generates business cycles. His theory “stability is unstable” was influenced by Keynes's notion of the fundamental instability of market expectations, and by Schumpeter's notion that capitalism renews itself through competition and innovation – ‘creative destruction' that chucks out the bad and ushers in the good. But while Schumpeter focused on technology's role in driving capitalism, Minsky's focus was on banking and finance. Minsky contended that nowhere is evolution, change and Schumpeterian entrepreneurship more evident and the drive for profits more clearly a factor in making for change than in the conventional banking and finance. Financial innovation as a destabilizing influence becomes evident with the burst of a speculative boom.

Minsky looked at all participants in the economy -- households, companies and financial institutions -- in terms of their balance sheets and cash flows. Balance sheets are composed of assets and liabilities, while cash flows validate the liabilities. Minsky's economy comprises what he calls a "web of interlocking commitments" -- a vast and complex network of interconnected balance sheets and cash flows that is always changing and evolving. During periods of stability people feel more confident. According to Minsky, they respond by increasing their liabilities relative to income; the "margin of safety" declines.

Minsky classified borrowers, according to their balance sheet and ability to make interest and principal payments, in three distinct categories, which are labeled as hedge, speculative, and Ponzi finance. Hedge financing units are those which can fulfill all of their contractual payment obligations by their cash flows. According to Minsky's definition, the greater the weight of equity financing in the liability structure, the greater the likelihood that the unit is a hedge financing unit. Speculative finance units are units that can meet their commitments on interest payment, even as they cannot repay the principal out of income cash flows. Such units need to roll over their liabilities — issue new debt to meet commitments on maturing debt. For Ponzi units, the cash flows from operations are not sufficient to fill either the repayment of principal or the interest on outstanding debts. Such units can sell assets or borrow. Borrowing or selling assets to pay interest (and even dividends) on common stocks lowers the equity of a unit. The key feature of a Ponzi scheme is its need to attract ever greater sums of money. To survive, Ponzi units must refinance, either by selling assets or by raising more debt. For this to happen asset prices must continue to rise. Ponzi finance typically emerges during a speculative bubble, when the margin of safety has been undermined.

Minsky stated that if hedge financing dominates, then the economy may well be an equilibrium-seeking and containing system. In contrast, the greater the weight of speculative and Ponzi finance, the greater the likelihood that the economy is a deviation-amplifying system. The first theorem of the financial instability hypothesis is that the economy has financing regimes under which it is stable, and financing regimes in which it is unstable. The second theorem of the financial instability hypothesis is that over periods of prolonged prosperity, the economy transits from financial relations that make for a stable system to financial relations that make for an unstable system.

Minsky observed that financial institutions compete furiously, both when investing and when providing credit to others. Inspired by Schumpeter's notion of "creative destruction", he described the proliferation of financial innovations as means to attract more borrowers and to bypass existing regulations. The level of product innovation has run far in advance of the capacity to utilize these products and the ability to understand the characteristics of risks and long-term consequences. Recent instruments-- based on the idea of “originate and distribute”, instead of “originate and hold”, as well as securitization models--include mortgage backed securities (MBS), collateralized debt obligations (CDO), and CDO tranches, let alone CDO-squared (tranches from CDO tranches), CDO-cubed (tranches on top of CDO-squared) or the most abusive credit default swaps (CDS). The more the layers of derivatives on top of each other, the more sensitive they are to even small changes in the underlying variables and assumptions (No wonder that many AAA rated CDOs have only a 50% rate of recovery, and everything else including AAs and single As are pretty much wipe outs).

Banks are not the only financial institutions competing fiercely with one another for profits. Swindles, fraud, theft, embezzlement, and deceptive rating dominate as Ponzi financing units multiply. They make large gains in the process. When their liabilities become valueless, losses are born by banks, and massive bankruptcies erupt. Present day hedge funds, as contrasted with Minsky's notion of hedge unit, play an increasingly important role in the credit markets, providing liquidity to the housing market by buying mortgage-backed securities and fueling the growth of leveraged buyouts and structured finance. As hedge funds are not regulated, little is known about the true extent of their leverage or the positions they take.

However, their capacity to leverage is potentially enormous. By borrowing five times its assets and investing in the riskiest part of a structured security such as collateralized mortgage obligations, a credit hedge fund could in theory become lender of $850 million worth of residential securities by committing just $10 million of its own funds. Credit hedge funds rely on short-term financing to pursue leveraged strategies. A synchronous deleveraging of credit hedge funds could become a new risk element in the credit markets.

Following the teaching of Irving Fisher, Minsky held that the crisis has a deflationary impact as people seek to pay off debts. His prescription was conventional: more government spending and lower interest rates from the central bank could prevent debt deflation. His view on the consequences of these actions was less conventional. Minsky contended that successful interventions during crises discouraged financial conservatism. If the boom is unwound with little trouble, it becomes quite easy for the economy to enter a new phase of instability. Financial institutions respond to the fact that the authorities are protecting them from financial catastrophe by plunging anew into risky activities; hence an enhancement of moral hazard risk.

The successful resolution of a crisis further strengthens moral hazard. Moreover, large government deficits combined with low interest rates and high inflation reduce dramatically real savings and erode capital accumulation, thus reducing economic growth or even bringing it to a halt [In the Harrod-Domar model, real economic growth rate is equal to the savings rate, i.e., ratio of savings in percent of GDP, divided by the incremental capital output rate. The lower the savings rate, the lower economic growth will be. In the United States, low interest rates have caused large external deficits during 2001-2008, about 6-7 percent of GDP, negative national savings, and full dependence on foreign financing of economic growth].

Fisher and Minsky's prescription for massive bailouts and large scale last resort lending could be debatable from social equity and economic point of views. Recent large bailouts by the Fed was extended to investment banks which did not pay insurance premium to the FDIC, and were not regulated; they were therefore not eligible for Fed's lending facilities. Moreover, bailouts validate uncontrolled credit expansion and socialize losses from speculative booms while the gains enjoyed by speculators remain private. High Inflation resulting from last resort lending erodes real incomes of pensioners and wage earners. While the Fed has prevented bank liquidations, it has set off liquidation of real savings and investment, agonizing economic slowdown, and loss of jobs and incomes.

Destabilizing Monetary Policy

Minsky's endogeneity hypothesis, while integrating Keynes view on instability of expectations and Schumpeter's view on destructive innovations, has yet to be supported empirically when confronted with actual role of central banks in major financial crisis. Notably, the present crisis was almost solely the work of central banks; it was caused by lowest interest rates in post war period set by the Fed following the bursting of the Internet bubble in late 2000. As a consequence, total credit expanded at an exceptionally high rate of 12 percent per year in the US during 2001-2008. This phenomenal credit growth was at the cost of creditworthiness and erosion of underwriting standards [[1]As liquidity became of little value, loans were extended to subprime markets. Examples of sub prime loans were NINJA loans (no income, no job, no asset borrowers) that were extended to NINJA borrowers and were rated AAA by reputed rating agencies]. Soros (2008) wrote “when money is free, the rational lender will keep on lending until there is no one else to lend to”. Monetarists have sharply criticized interest rate setting and unbacked money creation by central banks and considered them as the main factors responsible for financial instability and inflationary episodes [Maurice Allais (1999) wrote: in essence, the present creation of money, out of nothing by the banking system, is similar - I do not hesitate to say it in order to make people clearly realize what is at stake here - to the creation of money by counterfeiters, so rightly condemned by law].

1. Interest rate setting as a cause of financial instability

Interest rate setting by the Fed at low levels during 1926-1929 to help Britain restore gold standard at pre-1914 parity was found to have led to speculative booms in housing and stock markets and to high economic growth. Reluctance of the Fed to raise interest rates with a view to protect farmers, builders, and the rest of the economy, contributed to uncontrolled credit growth during 1927-1929, which ended with the Great Depression. Interest rate setting by central bank has been sharply criticized throughout contemporary economic history by famous economists such as Thornton (1802), Wicksell (1898), and Friedman (1968, 1972), who opposed discretionary policy which creates both excessive credit and market risks for financial institutions. Interest rate setting is a form of price control that causes considerable distortions and inefficiencies; beside creating monetary uncertainties, it leads to an excessive credit expansion, speculation, and therefore to assets and commodities price instability [The current commodities boom could be easily explained by distortionary effect of interest rate setting. Interest rate on government bonds was 3 percent per year in July 2008. Return on oil futures contracts exceeded 120 percent per year in July 2008. Fixing prices in one market leads to lucrative speculation in parallel markets. Moreover, very low interest rates during 2002-2005 were found to be main driving factor for securitization. To bolster their incomes in the context of reduced margins and gain from abundant liquidity, banks were led to expand their assets through funds from securitization and supplement their incomes through fees and commissions from larger number of loans].

By targeting interest rate, a central bank abandons monetary aggregates and reduce substantially its direct contacts with individual banks. For instance, in the United States the role of District Banks has been curtailed and liquidity operations have been concentrated in the New York Fed [Under the regime of controlling monetary aggregates, District Banks used to have direct control of member banks' portfolio and could detect problem banks at an early stage at the discount window level. Since mid-sixties, such direct contacts have become very limited]. The central bank wants only to control interest rates and stands ready to supply any amount of money required to maintain interest rate pegged at a fixed target rate, regardless of creditworthiness, and to support the price of government bonds and finance fiscal deficits, via essentially open market operations. Furthermore, as the general price level increases or asset prices rise, the central bank stands to accommodate higher money demand for transactions or for fueling credit expansion, which in turn increases liquidity [[1] As the German hyperinflation (1920-1923) showed, the central bank can indefinitely accommodate rising price levels and higher demand for transaction money in a hyperinflationary process. Actual policy actions of central banks undermine the stated objective of banking soundness and stability].

Thornton (1802), in his classic “The Paper Credit of Great Britain”, provided the first rigorous and systematic analysis of a two-way relation between interest rates and inflation. He distinguished between the market (loan) rate of interest rate and the interest rate (marginal rate of profit or natural rate) which equilibrates savings and investment. He expressed the doctrine that inflation results from a divergence between the two rates. Under fiat money, when the central bank pegs loan rate of interest below the marginal rate of profit, it sets in motion a cumulative expansion in the demand for and supply of loans, currency issue, and the price level. Inflation could continue without limit because, contrary to gold standard which precluded credit expansion that would drain gold reserves, there existed no automatically corrective mechanism under costless fiat money system to bring it to an end. Inflation, in turn, signals that real savings are rapidly falling, and therefore economic growth is slowing.

Thornton analyzed the reverse causation from inflation to loan interest rate and discussed the effect of inflationary expectations on loan interest rates. Even if the central bank increases the loan rate of interest in response to inflation, the real interest, if not negative, may remain indefinitely below the real marginal rate of profit inducing further demand for bank credit. Accordingly, Thornton argued that central bank should abandon interest rate pegging and regain control of money supply through ceilings on credit and monetary aggregates [In the same vein, Friedman (1968) strongly argued that central bank cannot control interest rate or unemployment rate. Its actions to do so can only destabilize the financial system. It can only control money supply and credit]. Control of credit has also been strongly recommended by Soros (2008).

In order to contain runaway inflation caused by low interest rates, the central bank might be compelled to apply practical quantity theory of money and force ceilings on money and credit, thus abandoning interest rates control. Under these conditions, interest rates will explode. Given the huge amount of outstanding debt and their low credit worthiness, such a rise in interest rates will set off a financial crisis and mass defaults. Given the large amount of public debt, sharp rise of interest rates will cause fiscal deficits to widen [The US Treasury may compel the Fed to maintain low interest rate. The 1951 Accord between the Fed and Treasury was meant to alleviate Treasury's pressure regarding the setting of interest rates at low levels].

2. Unbacked lending and the central bank's key role in financial instability

Financial instability erupts when there are not sufficient real savings to support lending. This occurs when a lender creates fictitious claims on final consumer goods and lends these claims out. The borrower who holds the empty money, so to speak, exchanges it for final consumer goods. He takes from the pool of real savings without any additional real savings having taken place, all other things being equal. The genuine wealth producers who have contributed to the pool of final consumer goods — the pool of real saving — discover that the money in their possession will get them fewer final goods [Rueff (1964) showed that excessive credit expansion creates a purchasing power that has no real goods counterpart; it can undermine real economic growth and even trigger starvation].

The reason is that the borrower has consumed some of the final goods. There is a diversion of real wealth (final consumer goods) from wealth-generating activities towards the holders of new money, created "out of thin air."

As the pace of unbacked credit expands, relative to the supply of real savings, less becomes available to genuine wealth generators, all other things being equal. Consequently, with less real savings, less real wealth can now be generated. Real savings are required to support the life and well-being of individuals who are engaged in the various stages of production. In the extreme case, if everybody were to just consume without making any contribution to the pool of real saving, then eventually no one would be able to consume.

By means of monetary policy, the central bank makes it possible for banks to engage in the expansion of unbacked credit. Thus if Bank A is short of $100, it can sell some of its assets to the central bank for cash. It can also secure the $100 by borrowing it from the central bank. Where does the central bank get the money? Under fiat money system, it just makes it "out of thin air." Obviously, Bank A could also attempt to borrow the money from other banks. However, this will push interest rates higher and will slow down the demand from borrowers, which will diminish the creation of credit "out of thin air".

The conventional banking system can be seen as one huge monopoly bank, which is guided and coordinated by the central bank. Banks in this framework can be regarded as branches of the central bank. Through ongoing monetary pumping, the central bank makes sure that all banks engage jointly in the expansion of credit "out of thin air." The joint expansion in turn guarantees that checks presented for redemption by banks to each other are netted out. In short, by means of monetary injections, the central bank makes sure that the banking system is "liquid enough" so that banks will not bankrupt each other.

It appears therefore that the role of the central bank makes the present conventional financial system unstable and vulnerable to financial turmoil. It is not the expansion of credit as such that leads to an economic bust but the expansion of credit "out of thin air," since it is through unbacked credit that real savings are diverted from productive activities to nonproductive activities, which in turn weakens the process of real wealth expansion. The deliberate role of central banks in financial instability makes Minsky's endogeneity hypothesis debatable.

As central banks in many industrial countries have been entrusted with the mandate of achieving full employment, financial stability has not been given the attention it deserves [Full employment is an important objective. However, it should not fall under the central bank prerogative. It should be under the government development planning. Progress toward full employment can be achieved through education, sectoral development (agriculture, industry, infrastructure, etc.), and fully competitive labor markets. In many countries, unions and labor laws can be an obstacle for full employment, since price and wage rigidities can become inimical to full employment in any economy and a source of exchange rate overvaluation]. Their pursuit of this mandate has been self-defeating. By insisting on long-term demand-led and inflationary growth, low interest rate policy has fueled asset bubbles in stock, real estate, and commodities markets, and has slowed growth and increased unemployment [Central banks do not seem to accept the notion that long-term growth depends on increasing savings and investment. Demand policies can only reduce savings and capital accumulation and will undermine long-term economic growth. Moreover, the bursting of asset bubbles can become a drag on long-term economic growth as in Japan in 1990-2001 or during the Great Depression 1929-33]. With the central banks forcing credit expansion in order to stimulate growth and employment, at the expense of creditworthiness, or to finance fiscal deficits through abundant liquidity, financial institutions will not be immune to financial instability, even if they comply fully with Basle I and II guidelines. Absent highly stable and predictable monetary framework, financial institutions will face recurrent financial instability with increased frequency [Henry Simons (1948) sharply criticized monetary uncertainty, which stems from unpredictable changes in credit and money and near-money aggregates, unpredictable changes in interest rates, and proliferation of money and credit instruments (i.e., financial innovations)]. Recent as well as past financial crises demonstrate the need for safe and predictable central banking. Promoting such safe central banking in the Basle framework, geared toward financial stability and not full employment objective, should be a top priority in the quest for financial stability.

Causes of International Financial Instability.

Because financial instability in one major reserve currency center could spread to the rest of the world, causes of financial instability were also analyzed at the international level by Keynes (1943), Triffin (1959), Mundell (2005), Rueff (1964), and many others. There is general consensus that contagious financial instability is caused by unsustainable fiscal and money policies and by beggar-thy-neighbor trade policies at the level of reserve currency centers. Inflating reserve currency countries are unwilling to tighten monetary policy and undergo a temporary contraction needed for stability. The resulting large fluctuations in exchange rates expose banks to foreign exchange risks. One solution advocated by all authors mentioned is the creation of a common central bank and a common currency which is to be issued under strict quantitative guidelines, not exceeding a growth of 2-5 percent per year. A proposed common central bank would be independent of any government, and therefore of any fiscal or full employment pressure. Hence, it would be able to provide a stable currency.

In an insightful analysis Rueff (1964) strongly argued that collapse of gold standard has created more instability and brought the world economy to the age of inflation. He pointed out that the balance of payments deficits of reserve currencies provide a basis for creation of new credit and therefore to more speculation. He showed that a reserve center can run an indefinite balance of payments deficit without losing real resources as these deficits are financed through issuing currency. Indeed, external deficits of the US have caused substantial capital inflows in the US banks that contributed, to a large extent, to recent housing bubble. Central banks and foreign financial institutions ex-patriate or place their dollar holdings in interest earning assets in US banks. These deposits provide a basis for US banks to increase credit. According to Rueff, there was large monetary expansion in relation to world stock of gold in the post-war period. He proposed a devaluation of currencies to reflect new price of gold, restoration of gold standard, and actual transfer of gold from deficit to a surplus country. Rueff's analysis remains pertinent. Reserve currencies (such as dollar, euro, or yen) governments pursue national priorities at the expense of the rest of the world. They maintain monetary expansion in order to preserve full employment at home and prevent currency revaluation in order to maintain export competitiveness. This monetary expansion has created a hotbed of generation of financial instability. It has been inflationary and costly in terms of world economic growth, trade, and social stability.

Recourse to gold as reserve money has recently been gaining larger support in view of the fast depreciation of reserve currencies and mounting inflationary pressure in all reserve currencies centers. Monetary expansion has translated into rapid increase in foreign reserves of central banks, which rose by more than six fold during 2000-2007. In view of large currencies depreciation in relation to commodities and real purchasing power, these reserves will lose their real value rapidly. Use of gold as a reserve money will allow hedging foreign reserves against inflation.

Monetary Expansion and the Credit Multiplier

1. The credit multiplier in a credit system without securitization

By examining the monetary survey of any country, it can easily be observed that money in circulation is many folds the high powered money, or the base money. This is explained by the money creation process. Deposit banks do create money (Tobin 1965). Assume that the central bank buys a government bond worth $100 by printing new money. The seller of the bond, be it government or private holder, deposits the proceeds at Bank 1, therefore the reserves of this bank are increased by $100 (Exhibit 1). Assume that reserve requirement is equal to10 percent of deposits. The bank keeps $10 dollars in reserves, and places $90 in income earning assets in form of loans or securities.

The borrower of $90 is paying interest. He will not keep this money idle at Bank 1. He will most likely use it to finance investment or purchase a car, or consumer goods. Therefore, the money will leave quickly Bank1 and ends up as deposits in Bank 2. The process of money creation through credit multiplier continues until the initial amount of $100 would have been multiplied by 10 to become $1000.

Exhibit 1: The Money Multiplier Process
 
Balance Sheet: Bank 1
Assets Liabilities

Reserves = 10

Loans and securities=90
Deposits =100
Total =100 Total =100
 
Balance Sheet: Bank 2
Assets Liabilities

Reserves = 10

Loans and securities=90
Deposits =100
Total =100 Total =100
 
Balance Sheet: Bank 3
Assets Liabilities

Reserves = 10

Loans and securities=90
Deposits =100
Total =100 Total =100
 
Balance Sheet: Bank System
Assets Liabilities

Reserves = 10

Loans and securities=90
Deposits =100
Total =100 Total =100
 
Two traditional sources of instability can be observed. First, assume depositor at Bank 1 writes a check for $100 to a beneficiary whose bank is Bank 3, then Bank 1 will be in difficulty of payment, and will be caught. If depositors at Bank 1 and 2 exercise at the same time their drawing rights and write checks to a beneficiary at Bank 3, for amount of $100 and $90, respectively, both Bank 1 and 2 will be “caught”. Deposit banks money creation leads therefore to an unbacked expansion of credit, which exceeds real savings in the economy. The central bank plays a role of the lender of last resort.
 
A second source of instability is a depreciation of the value of assets. Assume the loans and securities of Bank 1 depreciate to $50 because of non recoverable loans (credit risk), or speculative fall in the prices of bonds, mortgage securities, foreign exchange, and other assets (market risk) (Exhibit 2). Assume that depositor at Bank 1 writes a check for $100 for a payee at Bank 3, then Bank 1 will be short of $90. Besides liquidating its assets at discount, Bank 1 will have to borrow or inject new capital of $40 to be able to meet its debt obligations. The banking system as a whole may face a general speculative depreciation of assets (stock market crash, fall in securities, bonds, or mortgage assets prices, non performing loans, etc.). The bailing out by central bank will increase bank reserves and will lead to an expansion of the money supply. Such bailout is inflationary and will impose a tax on money holders, creditors, wage earners and pensioners in favor of debtors. In other words, the central bank makes the public bear the cost of asset price depreciation.
Exhibit 2: Impact of Credit and Market Risks
 
Balance Sheet: Bank 1
Assets Liabilities

Reserves = 10

Loans and securities=50

Borrowed reserves = 40

Losses = 40

Deposits =100

Central Bank Advance = 40

Total =140 Total =140
 
 
2. The credit multiplier in a credit system with securitization
Securitization of assets exerts a powerful multiplication of credit, and makes credit expansion enormously greater than in a credit system without securitization. As illustrated in Exhibit 3, securitization can make credit expansion theoretically unbounded. Assume Bank1 emits a home loan. Assume also that Bank1 is the only bank that engages in securitization of assets; because of credit abundance, let home prices increase at a speculative rate of 10 percent at each new loan. Let the reserve requirement ratio be 10 percent, the initial home loan issued by Bank1 will work through the system and entails a cumulative credit expansion equal to 1000. Bank1 does not keep the loan in its book. It sells it through securitization, called securitization round 1, and issues a home loan equal to 110, reflecting higher home prices. The new loan will expand to a total of 1100. Bank1 sells the loan for 110, called securitization round 2, and issues a new home loan equal to 121, because of higher home prices. The new loan will expand to 1210. The process of securitization can be replicated indefinitely. It is supported by credit derivatives such as credit default swaps (CDSs) that spread credit risks among investors, both locally and internationally. At each step, credit multiplication is inflated by the increase in the price of houses. Securitization is financed from many sources that include central bank liquidity injection and lending, the banking system own money creation and interbank lending, money market funds, hedge funds, or foreign deposits (e.g., sovereign wealth funds, foreign central banks, etc.). If other banks engage in asset securitization, then credit expansion will increase without theoretical limit.
 
Exhibit 3: Credit Multiplication Under Securitization
 
Credit multiplication
Securitization Bank 1 Bank 2 Bank 3 Bank 4 Total
Initial home loan 100 90 81 72.9 1000
Home loan from Securitization 1 100*1.1 99 89.1 80.19 1100

Home loan from Securitization 2

100*1.12 108.9 98.1 88.21 1210
Home loan from Securitization 3 100*1.13 119.8 107.8 97.0 1331
Home loan from Securitization
100*1.1k        
 
 
The reverse credit multiplier

The credit multiplier may work in reverse and can lead to sharp contraction of credit and circulating media. Many instances will lead to credit contraction. These instances include increase in reserve requirement, withdrawal of deposits, denial of short-term financing by investors, payments of loans by borrowers, de-leveraging, depreciation of assets, or defaults. Under a simple reserve requirement system, credit contraction was responsible for a sharp decline in the circulating medium during the Great Depression 1929-33. Under securitization, and in view of the large magnitude of the credit multiplier, credit contraction could be far bigger than under a system without securitization, and may degenerate in massive defaults and bankruptcies. The financial crisis that broke out in August 2007 illustrates the magnitude of credit contraction and large scale bankruptcies that take place under a system of asset securitization.

Stability of the Islamic Financial System

Section III -IV have analyzed the causes of instability in a conventional financial system from a historical perspective and attributed these causes to the credit system, abundance of liquidity, speculation, and interest rate setting by the central bank. This section will attempt to demonstrate that these causes are, by and large, absent in an Islamic financial system, thus ensuring the stability of this system.

In Quran and Sunnah, Islamic finance has always been conceived as the finance activity of an Islamic economy where social equity is enhanced through mandatory zakat. In Quran, the verses that deal with interest (riba) have always been preceded or followed by verses that prescribe zakat. Hence, when social equity is secured through zakat, motives on the side of lenders to practice interest and dire needs of the poor to accept interest will disappear. In such an economy, Islamic finance will be essentially guided toward investment and wealth creation and much less toward consumption.

The basic tenets of Islamic finance are clearly stated by Allah SWT in the following two verses:

Quran, Chapter 2, verse 275: Those who devour usury will not stand except as stands one whom the Evil One by his touch hath driven to madness. That is because they say “Trade is like usury, but Allah hath permitted trade and forbidden usury. Those who after receiving direction from their Lord desist, shall be pardoned for the past; their case is for Allah (to judge); but those who repeat the offense are companions of the Fire: they will abide therein (for ever).

Quran, Chapter 2, verse 276: Allah will deprive usury of all blessing, but will give increase for deeds of charity; for He loveth not creatures ungrateful and wicked.

Two fundamental principles arise from these verses: the first is that an Islamic financial system is driven by trade and production and not by interest, since interest is forbidden; the second is that an Islamic system based on trade will be immune to instability, and that a system based on interest is inherently unstable and prone to repeated crisis and losses.

Mirakhor (1988) defined an Islamic financial system as one in which there are no risk-free assets and where all financial arrangements are based on risk and profit and loss sharing. Hence all financial assets are contingent claims and there are no debt instruments with fixed or floating interest rates. Modeling the financial system as non speculative equity shares, he showed that the rate of return to financial assets is primarily determined by the return to real sector, and therefore in a growing economy, Islamic banks will always experience net positive returns [Henry Simons' views set forth in his Economic Policy for a Free Society and influenced by the depression of the 1930s were closest to an Islamic banking system. His policy recommendations, known as the Chicago Plan, called for a separation of the banking system into warehousing with a 100 percent currency reserve against bank deposit and investment banks whose liabilities will be in form of equity shares. His reform plan aimed at a vigorous effort to stamp out elasticity of credit in the financial system. This would involve restrictions on open-book credit and installment loans, as well as limitation of government debt to non-interest-bearing money and to very long-term debt (consol). He advocated a system in which all financial wealth would be held in equity form, with no fixed money contracts, so that no institution that was not a bank could create money substitutes].

Financial intermediation in Islam is different from that in a conventional system. Moreover, commercial banking under an Islamic system is generically different from conventional commercial banking. Banks do not contract interest bearing loans and do not create and destroy money. They participate directly in production and trade operations on a profit-loss sharing basis [Typical Islamic products are Mudarabah, Musharaka, Murabaha, Istisnaa, and Ijara (See Hassan and Lewis 2007 for detailed definitions)]. Banks do not act as simple lenders; they have to be directly involved in trade and investment operations, and assume direct ownership of real assets. Deposits at an Islamic financial institution could be seen as shares or equities and, unless insured, are subject to risks [Risks facing Islamic banks are credit risk, market risk, foreign exchange risk, displaced commercial risk, operational risks, and governance risk (See Archer and Abdel Karim 2007 for detailed analysis)]. They can earn a profit and face losses (Iqbal and Mirakhor, 2007).

There is no credit creation out of thin air. Under conventional banking, deposits at one bank can be instantaneously loaned out or used to purchase a financial asset and become reserves and a basis for a new loan at a second bank, thus contributing to purchasing power creation and inflation of prices of goods and assets; such step does not exist in Islamic banking. Deposits have to be re-invested directly by the bank in trade and production activities and create new flows of goods and services. New money flows arise from the proceeds of sales of goods and services. Money is not issued by the stroke of the pen, independently of the production of goods and services. Investment is equal to savings, and aggregate supply of goods and services is always equal to aggregate demand (implying that Say's law applies in the case of Islamic finance). There can be no bank run or speculation, as the source of credit for speculation, which is credit multiplication, does not exist. The liabilities of the financial institution are covered by tangible real assets that are owned directly by the institution. They are not covered by financial assets. Risks for Islamic financial institutions are mitigated as they relate essentially to returns from investment operations and not to the capital of these institutions (Khan, 1987).

In such system, the central bank has the sole monopoly for creating money. Interest rate cannot be used as a policy instrument. The central bank does not refinance banks as in conventional banking. It does not buy or sell financial assets to banks. The central bank has to apply quantitative ceiling on money aggregates. Such policy has been effective in maintaining financial stability and precluding speculative booms and inflation even in the conventional system. Money injection occurs through central bank buying foreign exchange, gold, or non-interest bearing government debt, possibly indexed on gold, a commodities basket, or a portfolio of real assets created by the government (See Choudhry and Mirakhor (1997) and Haque and Mirakhor (1999)).

1. Nature of Islamic Banking

Conceivably, an Islamic banking system may have two types of banking activities [Simons (1948) and Allais (1999) proposed a similar system composed of two types of banking]: a 100 percent reserve system for safekeeping, and an investment banking system.: safekeeping and payments activity as in pre-Islam and early Islam period and also as in goldsmith houses. This type of activity is similar to 100 percent reserve system, with deposits remaining highly liquid and checking services fully available. This system has to be a fee-based system to cover the cost of safekeeping and transfers and payments services.

The second activity is an investment activity whereby deposits are considered as longer-term savings and banks engage directly in risk taking in trade, leasing, and productive investment in agriculture, industry, and services. Most important characteristic of this activity is that it is immune to un-backed expansion of credit. An Islamic bank is assumed to match deposits maturities with investment maturities. Short-term deposits may finance short-term trade operations, with the bank purchasing merchandise or raw materials and selling to other companies; liquidity is replenished as proceeds from sales operations are generated. For longer-term investment, longer-term deposits are used. Liquidity is replenished as amortization funds become available. In all these investments, an Islamic bank is a direct owner of the investment process which is awarded through a due diligence process. In such a system, a financial institution therefore participates directly in the evaluation, management and monitoring of the investment process [Criticism was made that operational cost is higher than in conventional banking because of close monitoring and involvement in the investment process. This criticism has not been substantiated with data. Moreover, gains from stability and minimization of credit and market risks can largely offset presumed higher operation costs. Think of the cost of large bailouts and bank failures caused by recent financial crisis; these costs can be compounded by other economic and financial costs arising from inflation and economic slowdown]. Returns to invested funds arise ex-post from the profits or losses of the operation, and distributed to depositors as if they were shareholders of equity capital.

2. Balance sheet of an Islamic bank, investment activity

Let a deposit of $100 be made at an Islamic bank. This deposit is by definition savings; it is subject to certain maturity condition and cannot be drawn on sight. As mentioned above, safekeeping and payments functions of banks can be easily conceived; however, fees may have to be paid for this banking service. Upon deposits, the balance sheet looks as follows (Exhibit 4):

Exhibit 4: Simple Illustration of Islamic banking
 
Balance Sheet of an Islamic Bank, investment activity: step 1: deposit
Assets Liabilities

Reserves = 100

Deposits (saving) =100

Total =100 Total =100

Balance Sheet of an Islamic Bank, investment activity: step 2: investment
Assets Liabilities
Merchandise (gold, wheat,
 
oil, fertilizers, etc) and

working capital = 100

Deposits (saving) =100
 
 
 
 
Total =100 Total =100

Balance Sheet of an Islamic Bank, investment activity: step 3: closing of the operation 
Assets Liabilities
Reserves = 110
 
 
Deposits (saving) =100
 
Profits = 10
Total =110 Total =110
 
Contrary to conventional banking, an Islamic bank is prohibited from making a loan at fixed or floating interest rate. It has to engage in real trade or production activities. The Islamic bank may engage in short-term operations. It may, for instance, undertake trade operations, or it may finance crop transactions. It may buy goods, on the behalf of a trader, for resale at profit. The possession of goods takes place in physical terms, and not in form of financial or speculative contracts. For example, when it finances a crop transaction, the bank cannot act as a pure financier who accepts risk in financing activities. It has to be a full partner; it buys fertilizers on behalf of farmers and makes available financing for operating costs; it participates in the marketing activity of crops. The bank is involved directly in all phases of the transaction on a profit-loss sharing basis; it faces directly the risk of price and exchange rate fluctuations. It may lose part of the loan if sales proceeds from crops fall short of the amount of loan. It may also incur operating losses. The invested capital is repaid from the proceeds of crop sales. Net profits are distributed according to an agreed formula.

Upon investment in trade or any other productive activity, the balance sheet changes as indicated by step 2 in Exhibit 4. After the sale of merchandise, or the closure of the crop transaction, and assuming that the initial investment has been fully recovered and profits have been realized, the balance sheet is shown by step 3 in Exhibit 4.

An Islamic bank may engage in Mudarabah, Musharaka, Murabaha, Istisnaa, leasing, and installment sales operations. During the execution phase, the balance sheet appears as shown in Exhibit 5 (investment step). When the operation is fully closed, and assuming that the initial capital has been fully recovered and profits have been gained from the investment operation, the balance sheet looks as shown in Exhibit 5 (closing step).

Exhibit 5: Islamic modes of financing
 
Balance Sheet of an Islamic Bank, investment activity: investment step
Assets Liabilities

Mudarabah, Musharaka, Murabaha,

Installment sale, Istisnaa,

Leasing = 100
Deposits (saving) =100
 
 
 
 
Total =100 Total =100

Balance Sheet of an Islamic Bank, investment activity: closing step
Assets Liabilities
Reserves = 110
 
 

Deposits (savings) =100

Profits = 10
Total =110 Total =110

Depositors may withdraw or renew their deposits at maturity. An Islamic bank is basically different specie from a conventional bank. It is not a pure financial intermediary as in the conventional system. It has to finance real activities in production of goods and services. It does not lend money to a borrower at fixed or floating interest rate. It does not acquire financial assets. An Islamic bank identifies investment opportunities and evaluates them to minimize risks; participates directly in the management, monitoring and execution of trade and investment operations; and releases funds for purchases of goods and services as required for the completion of these operations. There is no credit creation which is not backed by real savings, the amount of deposits in the investment branch will be determined by real savings and savings to income ratio (Mirakhor, 1988), and not by credit multiplier as in conventional banking. New cash flows to an Islamic investment bank originate from new savings, and not from the proceeds of loans transferred from one bank to the other. There is therefore a wealth creating activity that generates new cash flows and not money creation by the stroke of the pen as in the case of conventional system. The growth of financing activity will therefore be stable and determined by real growth in the economy (Mirakhor, 1988), and not by unstable speculative finance or money creation by financial institutions. Accordingly, an Islamic system would not be expected to experience deep boom and busts cycles. Moderate and brief booms and recession may be generated by good crops, productivity, technical change, or by adverse shocks. They cannot be generated by the financial system itself as experience showed for conventional system. As shown in Mirakhor (1988), equilibrium in an Islamic economy thus structured will be stable and the rate of return to the financial sector will be fully aligned with the profit rate in the real sector of the economy.

Exhibit 6 compares the process of deposit creation under Islamic and conventional systems assuming a saving ratio of 20 percent of real GDP and reserve requirement ratio of 10 percent of deposits, respectively. It can be observed that total money expansion is $125 with a money multiplier equal to 1.25, and $1000 with money multiplier equal to 10 in Islamic and conventional system, respectively [[1] If the savings rate is 10 percent of GDP, and reserve requirement is 5 percent of deposits, then total deposits become $111 and $2,000 under an Islamic and conventional banking system, respectively. Theoretically, while an Islamic system faces no risk of a run or credit freeze, conventional system may face a risk of a run and credit freeze. In the event of a run or credit freeze, experience showed that conventional banks had to suspend conversion into currency, go bankrupt, or require large amounts of new liquidities from the central bank]. Invoking quantity theory which postulates MV=PY, where M is money stock, V is velocity of money circulation, P is the price level, and Y is real income, and assuming fixed Y and V, the price level would tend to rise at much slower pace under an Islamic as compared to the conventional system. Furthermore, as an Islamic system is immune to large economic fluctuations caused by financial instability, its rate of real economic growth, because it is supply and not demand determined, would be stable at a higher level than in conventional system. Under conventional banking system, economic growth preceding financial instability could be virtually wiped out during ensuing recession or depression phases.

Exhibit 6: Contrasting Islamic and Conventional Banking
 

Contrast of two financial systems

Conventional finance

Islamic finance

  • Interest and interest-based transactions.
  • Deposits and loans.
  • Banks create and destroy money.
  • Asset-liability mismatch, illiquid.
  • Money multiplier depends on reserve ratio, very high; infinite with securitisation.
  • Speculation, a casino, debt trading.
  • Interest rate not related to real economy, high price distortion.
  • Highly cyclical: booms and busts, uncertainties, unpredictable growth.
  • Massive bankruptcies, contagion, bailouts
  • No interest and interest-based transactions.
  • Equity shares and ownership of real assets in investment projects.
  • Banks do not create or destroy money.
  • No asset-liability mismatch, liquid.
  • Money multiplier depends on the savings ratio, very low.
  • No speculation, no debt trading.
  • Profit rate determined by real economy, no price distortion.
  • Stable economic growth, predictable.
  • No systemic bankruptcies, no bailouts.   

3. Islamic banks face individual and not systemic risks

Risks facing Islamic financial institutions have been thoroughly discussed in Archer and Abdel Karim (2007) and Hassan and Lewis (2007).These risks were defined as credit risk, market risk, displaced commercial risk, operational risk, and governance risk. These risks, while facing individual banks, cannot be systemic and cannot have impact on the overall stability of an Islamic financial system, as this system is immune from speculative mania, liquidity expansion, and instability of returns. Unlike conventional banks, assets of Islamic banks are not collateralized by assets (e.g., stocks and mortgages) that can vary considerably in value. Losses from an investment operation cannot endanger the overall profitability of an individual bank or erode its capital base, as losses in one operation can be fully offset by gains in the rest of operations. There would be no mismatches between assets and liabilities. As Khan (1987) has shown, banks in an Islamic system would not need to engage in liabilities management mode resulting from maturity mismatch, a systemic characteristic of the conventional banking system. Moreover, in view of ownership of real capital, the rate of recovery of assets is very high in a failed operation. Most important, there is no contagious effect among assets within a bank or among banks [Usually, troubled Islamic banks were found to be essentially practicing conventional banking under an Islamic guise, or to have fallen under fraudulent schemes]. As in conventional banking, failure of a single bank in an Islamic system cannot affect stability of the overall financial system. However, abundance of liquidity, speculation, and uncontrolled credit and money creation and destruction can make even most advanced financial system very vulnerable and economic and financial consequences of instability far reaching as demonstrated by Japanese experience (1990-2001), the Asian crisis, or recent sub prime market meltdown.

Exclusions, Safeguards, and Regulation

Many types of financial transactions and instruments are excluded from Islamic finance, particularly interest rate-based bonds, securities, finance based on securitization of fictitious assets, speculative finance, hedge funds, and consumer finance that is not backed by real assets. In all of this type of finance, either the acquired assets are financial papers, or loans that have no real backing, and do not contribute to generate real activity and income. In particular, the conventional financing of consumer loans, besides being expensive for consumers, have high default risk, and do not generate new wealth. Financial innovations such as securitization, originate and distribute models, and many instruments that lead to speculation or to fictitious assets cannot exist in an Islamic system [Soros (2008) has urged the banning of many credit instruments that were used in recent speculative boom and caused a severe financial crisis that could be among the costliest in terms of economic growth and social stability]. Attempts by banks to issue their own money and liabilities would be strictly controlled [[1] Financial institutions can issue own money. For example, goldsmith houses used to issue gold certifications, far in excess of warehoused gold. Banks used to issue bank notes that circulated as a circulating medium].

The regulatory framework for an Islamic system has been thoroughly discussed in Archer and Abdel Karim (2007). Recognition of the need for strict and comprehensive regulation and supervision has led to guidelines for safe banking issued by the Islamic Financial Services Board in 2004. Islamic finance system has to obey a regulatory and supervision framework. Although the system is fully immune to speculative euphoria and to out-of-thin-air credit creation, strict guidelines regarding licensing, capital adequacy, risk management, investment in housing, real estate, and production activities, and maturities have to be in place. The central bank has to exert its authority over Islamic financial institutions and insure that their operations are immune to fraudulent practices and high risk exposure.

Conclusions

History is replete with episodes of instability of conventional banking system; examples of severe financial crisis are numerous both in recent and distant past. Such instability and its inflationary or deflationary impacts can be traced to interest-based financial practices and policies. As demand for loans could be interest inelastic, competition among conventional banks leads them to fuel a rapid expansion of credit which is not backed by real savings; asset prices go through bubbles and bursts generating tremendous wealth redistribution and bankruptcies, and economic activity experiences booms followed by crashes. Such instability has often led to prolonged economic decline that wiped out real income gains of the pre-crisis period. The role of the central bank as last resort lender has increased moral hazard and has reinforced financial instability. In particular, last resort lending validates uncontrolled money creation by banks and imposes a formidable tax on the economy. Central banks become entrenched in a vicious circle of financial instability, followed by bailout operations, cheap money policy, leading to a new round of financial instability. Last resort lending is debatable from social equity and economic point of views. Recent experience showed that massive liquidity injections by the Fed, European Central Bank, Bank of England, Bank of Japan, and other major central banks to bail out banks and hedge funds contributed to the emergence of high inflation in energy and food prices, food riots, protests, large declines in real incomes, and economic slowdown. Massive bailouts socialize losses, while they protect private gains from speculation. They impose huge costs on present and future generation of taxpayers to protect the wealth of bankers and high salaries of bank and hedge funds managers. They amount to an adverse wealth redistribution with negative impact on social justice.

Prominent monetarists, based on their analysis of the Great Depression, strongly argued that the conventional banking system is inherently unstable and brings more severe financial crisis. They considered interest rate setting by central banks to be a cause of large fluctuations in asset prices, a source of financial instability and cumulative inflation, and detrimental to long-term economic growth. Accordingly, they strongly suggested strict rules for imposing ceilings on credit and money supply to mitigate monetary instability and inflation. They called on the central bank to take full control of liquidity management and not to focus on achieving full employment. Advocates of the Chicago Plan called for fundamental reforms of the banking system. They called for a separation of warehousing and investment banking and reducing the proliferation of near money instruments and financial innovations [Maurice Allais (1999) recommended abolition of hedge funds, regulation of stock markets, and restoration of fixed exchange rates]. In the international field, reforms have suggested restoration of gold standard to eliminate basis for rapid expansion of credit at domestic and international levels; or alternatively, establish a world single currency to rein in credit expansion and financial and exchange rates instability.

In an Islamic system, banks-in accordance with Allah's command-have to prohibit interest and speculation and engage directly in trade and investment operations. In an Islamic system, unbacked expansion of credit is preempted, and banks cannot initiate and accentuate a speculative process. Credit is based on real savings. No excess purchasing power can be created by the stroke of the pen. Money flows arise from sales of goods and services and transit through the banking system for payments or investment purposes. They do not arise within the banking system and then transmitted to real activity. Islamic banks do not compete to issue loans to borrowers for liability management purposes arising from mismatched maturities between assets and liabilities; they compete only for real investment opportunities; their resources are reinvested in real activities. Given the stability of its financial system and resilience to monetary shocks symptomatic of the conventional system, an Islamic economic system would experience sustained economic growth and avoid detrimental impacts on social justice since inflation cannot be used to tax creditors and wage earners in favor of debtors and speculators. Although reforms along an Islamic system were strongly advocated in the 1930s, intensity of recent financial instability clearly shows a reform of the conventional system along Islamic principles may be the only path in the quest for stability.

References

Allais, Maurice, 1999, La Crise Mondiale D'Aujourd'hui, Clément Juglar.

Archer, S. and Abdel Karim, R. A., 2007, Islamic Finance: The Regulatory Challenge, John Wiley & Sons (Asia) Pte Ltd.

Choudhry, Nurun Nabi and Abbas Mirakhor, 1997, Indirect Instruments of Monetary Control in an Islamic Financial System, Islamic Economic Studies, Vol. 4, no. 2, pp. 27-65.

Fisher, Irving, 1933, The Debt-Deflation Theory of Great Depressions, Econometrica, Vol.1 No. 4, pp.337-357.

Fisher, Irving, 1936, 100% Money, Adelphi Company, New York.

Friedman, M., 1972, An Economist's Protest, Thomas Horton and Company, New Jersey.

Friedman, M., 1969, The Optimum Quantity of Money and Other Essays, Aldine Publishing Company, Chicago.

Friedman, M., 1968, The Role of Monetary Policy, The American Economic Review, Vol. 58, No. 1, pp. 1-17.

Friedman, M., 1959, A Program for Monetary Stability, Fordham University Press, New York City.

Friedman, Milton, and Anna J. Schwartz, 1963, A Monetary History of the United States, 1863-1960, A Study by the National Bureau of Economic Research, New York, Princeton University Press, Princeton, N.J.

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Hassan, K., and Lewis, M. K., 2007, Handbook of Islamic Banking, Edward Elgar Publishing Limited.

Haque, Nadeem Ul and Abbas Mirakhor, 1999, The Design of Instruments for Government Finance in an Islamic Economy, Islamic Economic Studies, Vol. 6, no. 2, pp. 27-43.

Iqbal, Z. and A. Mirakhor, 2007, An Introduction to Islamic Finance, John Wiley, Singapore.

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The table below contrasts some of the distinctive features of conventional and Islamic finance.
 

Contrast of two financial systems

Conventional banking

Reserve ratio=10 percent of deposits

Conventional finance

Islamic finance

Bank 2 Deposit = $20 Bank 2 Deposit = $90
Bank 3 Deposit = $4 Bank 3 Deposit = $81

Etc.

Etc.

Total deposits = $125 Total deposits = $1,000
 
 

"Banks have done more injury to the religion, morality, tranquillity, prosperity,
and even wealth of the nation than they can have done or ever will do good."
John Adams
 
"The issue which has swept down the centuries and which will have to be fought sooner or later is the people versus the banks."
Lord Acton - First Baron Acton of Aldenham
 
"When you or I write a check there must be sufficient funds in our account to cover that check, but when the Federal Reserve writes a check, it is creating money."
Boston Federal Reserve Bank
 
"It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning."
Henry Ford
 
"Most Americans have no real understanding of the operation of the international money lenders. The accounts of the Federal Reserve System have never been audited. It operates outside of the control of Congress and manipulates the credit of the United States."
Barry Goldwater
 
"We have stricken the shackles from 4,000,000 human beings and brought all labourers to a common level, but not so much by the elevation of former slaves as by reducing the whole working population, white and black, to a condition of serfdom. While boasting of our noble deeds, we are careful to conceal the ugly fact that by our iniquitous money system we have manipulated a system of oppression which, though more refined, is no less cruel than the old system of chattel slavery."
Horace Greeley
 
"Gentlemen, I have had men watching you (bankers) for a long time and I am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the bank."
Andrew Jackson
 
"The system of banking [is] a blot left in all our Constitutions, which, if not covered, will end in their destruction...I sincerely believe that banking institutions are more dangerous than standing armies; and that the principle of spending money to be paid by posterity... is but swindling futurity on a large scale."
Thomas Jefferson

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