Askari & Krichene: Islamic finance – an alternative financial system for stability, equity, and growth

From the Introduction:

Today, a number of poor countries suffer from slow economic growth with unproductive industrial and manufacturing sectors. A principal explanation lies in their unsupportive financial sector – low investment, shallow and fragile capital markets, and banks focused on short-term loans to the few corporations that have marketable collateral. Moreover, many of these countries are heavily indebted and face recurrent debt crises. The conventional financial system has not served them well. The advanced countries have been plagued by recurring financial crises. Minsky (1986) maintained that conventional finance was inherently unstable in the developed world. Periods of prosperity alternated with periods of depression and massive unemployment (Siegfried, 1906) and inevitable vicious cycles of periodic debt crises that push the economy into a recession or depression and wipe out much of the real income gains achieved prior to the crisis. Significant wealth is redistributed to debtors who have defaulted on their loans. Moreover, it is inflationary and, therefore, again inequitable. Prominent politicians have been critical of conventional finance. Eminent economists during the 19th and 20th centuries, witnessing financial crises occurring during their lifetime, proposed reforms that establish 100% reserve commercial banking and an investment banking system that channels investments on a passthrough basis. Some reforms called for abolishing interest-based credit and its replacement with equity-based investment. 100% reserve deposit banking was painstakingly described in the Chicago Reform Plan of 1933 (Phillips, 1994). However, financial institutions see fractional reserve banking and leveraging as important factors for their profitability and are opposed to such reforms.

The basic principles of financial stability advocated by many of these authors happen to be similar to those of Islamic finance. Islamic finance draws its precepts from the Quran and Sunnah. Basically, Islamic finance has two pillars: (i) a 100% reserve banking system and equity-based investment banking, and (ii) prohibition of interest and interest-bearing debt. Thus the only significant difference between the recommendations of these authors and Islamic finance is that all interest bearing debt is prohibited in Islam. In the Islamic system, credit plays a negligible role; there are no borrowers or lenders; there is no conflict between borrowers and creditors. There are only equityholders. There is no creation of money out of thin air or through the credit multiplier. Money injection does not multiply through the banking system, as banks do not lend deposits. Investment banks cannot cause a financial crisis as they invest their clients’ money only on a pass-through basis and thus systemic risk is minimised. As a result, Islamic finance is inherently stable.

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