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MIDDLE EAST POLICY, VOL. IX, NO. 1, MARCH 2002
PRINCIPLES OF ISLAMIC BANKING:
DEBT VERSUS EQUITY FINANCING
Mohammed Akacem and Lynde Gilliam
Dr. Akacem is a professor and Dr. Gilliam an associate professor, both in
the Department of Economics, Metropolitan State College of Denver.1
I
t is difficult to pinpoint the start of
Islamic banking, but the consensus is
that it took place in Egypt in the
1960s.2
The Egyptian experiment did
not last very long, and it was not until the
mid 1970s before Islamic banking started
to take hold in many Muslim countries.
The change can partly be explained by two
main factors. First, the 1970s saw two oil-
price shocks, which led to a massive
transfer of wealth from the oil-consuming
to the oil-producing countries. The accom-
panying increase in per capita income led
many to seek an alternative to traditional
banking that was consistent with Islamic
teaching. Second, the second oil shock
coincided with the Iranian revolution, which
brought about the Khomeini government
and the first Islamic republic. Thus began
an Islamic revival that spread to other
countries and paved the way for more
financial institutions of the Islamic type.
This paper looks at Islamic banking as
a model of equity finance. Debt financing
by conventional banks has experienced
crises both in the 1930s and more recently
in the 1980s with the savings-and-loan
(S & L) and banking crises in the United
States. Initially the U.S. answer was to
institute deposit insurance in order to
eliminate or at least minimize bank runs.
However, that has caused both banks and
S & Ls to assume more risk at the cost of
greater taxpayer exposure because they
lacked the incentive to be risk averse. The
current U.S. banking model of debt finance
together with an implicitly unlimited3
deposit insurance results in the socializing
of loss and the privatizing of gain.
While the U.S. banking system repre-
sents the debt-finance model, the Japanese
financial structure presents an interesting
combination of both this model and the
Islamic equity-finance structure. The
evidence shows that the growth of Japan’s
economy in the postwar period was greatly
enhanced by the willingness of its banks to
both lend money and assume equity stakes
in the country’s manufacturing and indus-
trial sector.
The objective of this paper is to
analyze the effectiveness of these three
models: pure equity finance as in Islamic
banking, pure debt finance and a combina-
tion of the two. The emphasis of the paper
will be on the contention that the Islamic
banking model is better able to handle
macroeconomic shocks because of its
reliance on equity rather than debt.
Finally, we examine the issue of debt
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AKACEM: PRINCIPLES OF ISLAMIC BANKING
equity swaps as one of the best alterna-
tives for surplus funds from Islamic banks.
We will also attempt to explain why Islamic
banks have not been active in this market.
THE PROHIBITION OF INTEREST
Western academics were interested in
Islamic banking because of the system’s
emphasis on the non-payment of interest.
The idea of a financial structure operating
without a rate of interest was odd to many
accustomed to a fractional-reserve banking
system. The non-existence of a “price” of
capital4
raises all sorts of questions. How
would capital, then, find its most productive
use? How can a whole financial system
perform without the use of prices? While
the non-payment of interest is an important
characteristic of the system, there are
other important policy implications that
affect the conduct of monetary policy and
economic growth and development. As
Khan and Mirakhor correctly point out,
While the abolition of interest-based
transactions is a central tenet of the
Islamic economic system, it is by no
means an adequate description of the
system as a whole5
An alternative capsule characterization
of the idea underlying Islamic banking is
that money should be based on equity
rather than debt. Theoretically, the policy
implications of such a financial structure
extend to the macroeconomic management
of an economy as well as to some aspects
of the problem of international debt.
At first, economists who are exposed
to Islamic banking often ask, how could a
financial system operate without its most
important variable? How does an Islamic
financial structure allocate funds? More
important, how do banks earn a return if
they do not charge customers for the use
of funds, and how do customers get paid if
no interest is used?
The answer is rather simple and
straightforward. Under Islamic banking,
the answer lies in the profit or loss system
(PLS). Instead of guaranteeing a fixed
rate of return (interest in the traditional
sense), an Islamic bank and the borrower
enter into an agreement that clearly spells
out the way in which profits or losses are
to be shared between the parties from the
venture to be financed. The usual relation-
ship between creditor and debtor that we
are accustomed to in the West is turned on
its head. Expected rates of return from
projects or investments are used6
instead
of interest rates.
In Islam, money is not capital per se
but merely potential capital. It requires the
services of someone else, like an entrepre-
neur, to translate it into productive use. In
the Muslim scholar’s view:
the lender has nothing to do with this
conversion of money into capital and
with using it productively.7
Thus, the idea of getting a return for
money deposited in a bank is unacceptable
in Islam. Money must be put to productive
use, and a risk must be undertaken to
justify a return. Furthermore, returns
should not be fixed regardless of profits.
Thus, guaranteed fixed interest rates,
irrespective of the profitability of the bank,
is an argument used by Muslim scholars to
explain, in part, the bank and S & L failures
in the United States.
Interest is forbidden by the Quran as
unjust. It is argued that the misfortunes of
a fellow human being should not be ex-
ploited for gain. Muslim scholars are not
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satisfied with the theory of interest, as
Iqbal and Mirakhor note:
The notion that interest is a reward for
saving does not in their [Muslim
scholars’] view constitute a moral
justification for interest, since such a
justification only arises if savings are
used for investment to create addi-
tional capital and wealth.8
In other words, a person who abstains
from consumption and saves should not be
rewarded for that act. Unless these
savings are turned into productive invest-
ment, such a reward is incompatible with
the teachings of Islam.
In Islam, the theory preceded the
practice of banking. The Quran and
Sharia9
essentially contained the param-
eters within which the practice of Islamic
banking can be undertaken. So, contrary
to the evolution of Western banking, where
the practice preceded the theory, Islamic
banking developed in the early 1970s
according to strict rules laid down in the
Quran and other writings.
Given the emphasis on equity rather
than debt, Iqbal and Mirakhor have argued
that an interest-free banking (IFB) model
would lead to :
more varied and numerous investment
projects for which financing is sought;
more cautious, selective and perhaps
more efficient project selection by the
suppliers of funds; and greater
involvement of the public in invest-
ment and entrepreneurial activities,
particularly as private equity markets
develop, than in the traditional fixed-
interest-based system.10
PRINCIPLES OF ISLAMIC
BANKING
There are major differences between
an interest-free banking model and the
traditional interest-based banking (IBB)
model. Under the latter, the level of
interest is fixed in advance,11
whereas in
the former, the benefits (as well as losses)
are shared between the creditor and the
borrower according to a formula that
reflects their respective levels of participa-
tion. Thus, the profit-sharing concept
implies an interest in the profitability of the
“joint venture” on the part of the creditor
(the bank). The emphasis is not on “pay-
ment on demand” at set time intervals – as
with an interest-based system – but, rather,
on the long-term success of the joint
venture.
This has considerable implications at
the macroeconomic level. First, working
capital would theoretically tend to be
greater. Second, an economy with an
Islamic banking system is less vulnerable to
business cycles.12
With such an arrange-
ment, the level of risk is spread between
the bank and the entrepreneur in accor-
dance with their respective participation.13
In an IBB model, the creditor (bank) is
usually “detached” from the act of invest-
ment by the entrepreneur. Should the
unfortunate investor experience a sudden
cash-flow problem, his operation will likely
cease to exist. Muslim scholars argue that
such a macroeconomic shock, when
repeated across the economy, would not
occur under an IFB model. Since banks
are part owners of the ventures they help
finance, they are not likely to “jump ship”
at the first sign of trouble. In other words,
an IFB model is better able to absorb
shocks than an IBB model. As we shall
see later, not everyone agrees.14
Under
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IFB, the emphasis is on the long run,
whereas in an interest-based banking
framework, the emphasis is on the short
term.
Under a Western-style banking system,
the rate of interest is an important variable.
It conveys the nature and state of supply
and demand; it embodies information
concerning the market overall. More
important, it helps reduce the search cost
for alternative financing schemes.
On the other hand, the profit-sharing
mode of finance does not readily provide
us with a systematic mechanism by which
these profit shares are arrived at. As a
result, the search for the most profitable
option under IFB will most likely take
longer and will probably be costly. Given
the limited number of players in different
countries, this will persist until the system is
generalized to cover a greater number of
participants.
Determining the exact mechanism by
which profit and loss should be determined
is one area where more work needs to be
done. Ultimately, with a great number of
players in the market, we can argue that in
the limit at least, the profit-sharing concept
may approach a market solution.
An added cost to the Islamic banks
that traditional banks do not have to bear is
their obligation to oversee projects in which
they are partners. This requires manage-
rial skills and expertise in overseeing
different investment projects.15
While John Maynard Keynes would
not have supported an IFB system, he did
make the case for a low level of interest
rates in the long run. Abolishing the rate of
interest would essentially diminish the role
of savings and investment, the driving force
of a Keynesian framework. Nevertheless,
it is possible to imagine Keynes supporting
IFB, provided the equity (as opposed to
interest) system leads to higher capital
accumulation and thus employment, which
is consistent with the tenets of Islamic
economics.
Some disagree. Pryor argues that an
IFB model will not stimulate enough
savings and investment and thus economic
growth. A banking system based on equity,
Pryor argued, would not be optimum in
terms of generating the needed savings for
economic growth.16
The evidence, how-
ever, shows that Islamic banks do not lack
deposits but rather the right financial
instrument to put these funds to work,
particularly in the short end of the mar-
ket.17
Theoretical work18
done in the
Islamic economic literature has shown that
an economy which uses an IFB system will
inherently be more stable. Finally, to those
skeptics who argue that the removal of
interest would deprive the economic
system of a major driving force, one could
argue that the expected rate of return
could play the same role.19
Nevertheless,
while this would work in a formal math-
ematical model, doubts still persist as to its
impact on capital accumulation. In any
case, some of the proposals made by an
Islamic banking model are not new. In
fact, they are similar to those made by
Kareken and Simon as well as Friedman.20
Recently, the U.S. treasury’s own banking
proposal has been moving in the same
direction. Finally, the Japanese banking
system also exhibits a striking similarity to
that of an IFB model, particularly in its
emphasis on “partial” equity finance.
STRUCTURE OF ISLAMIC
BANKING
Profits from trade and productive
investment are very much encouraged
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under Islam. As noted earlier, the main
objection in Islam is not against the pay-
ment of profits but against a fixed prede-
termined payment – interest or otherwise –
that is not a function of the profits and
losses incurred in a venture. The only
condition is that the entrepreneur faces an
uncertain rate of return or profit.
The system puts the emphasis on
partnership. An Islamic financial system
becomes an equity-based system with no
debt. Depositors become shareholders.
They are no longer guaranteed the face
value of their deposits. They essentially
gain or lose depending on the profits and/or
losses of the bank. Thus, on the liability
side, depositors are nothing more than
shareholders; on the asset side, the bank
has shares from the joint ventures it helps
finance.
A typical example is for an entrepre-
neur to approach a bank for the financing
of a given project. In such an arrangement,
the lender, in this case the bank, advances
the capital, and the entrepreneur brings his
expertise and time to the partnership. The
profits are split according to an agreed-
upon ratio. If the venture incurs a loss or
fails, the bank loses the capital spent on the
project and the entrepreneur his time and
effort. There can be other types of
arrangements in which the joint venture can
involve multiple partners and different
levels of capital investments. Nevertheless,
the principle remains the same.
The Sources of Funds
Before an analysis of the Islamic-bank
balance sheet is done and compared to that
of a traditional bank, we must first examine
the most important sources and uses of
funds for Islamic banks.21
There are two
kinds of deposits: transactions deposits and
investment deposits. Transactions deposits
are essentially similar to checking accounts
in the United States. In both, the Islamic
bank and the traditional bank,22
the face
value of deposits is guaranteed. Similarly,
there are no returns on this type of ac-
count, and a service charge may be levied.
However, the Islamic bank differs from the
traditional bank in the use of these ac-
counts. The money raised through the
transaction accounts cannot be used for
risky23
ventures. The traditional bank
guarantees the face value of deposits
through deposit insurance, and the Islamic
bank through the restriction imposed on the
use of the funds collected through the
transaction accounts. In essence, one
version of the model as presented in Iqbal
and Mirakhor is literally another version of
Simon’s proposal of 100-percent re-
serves.24
The idea is to have a financial
institution offer two windows. The win-
dow for demand deposits would be re-
quired to keep 100-percent reserves; the
window for investment deposits could be
invested in joint ventures. This version of
the model stipulates no reserve require-
ments for the investment window.
Nienhaus argues otherwise.25
Islamic
banking, he says, does not stipulate a
system of 100-percent reserves, as in the
Chicago school, but rather is a simple
fractional reserve system no different from
the Western model. He maintains that as
long as Islamic banking operates with a
reserve requirement of less than 100
percent, there will be money creation; as
such an IFB model is no different from an
IBB system. While it is true that money
creation will occur under the circum-
stances that Nienhaus outlines, the implica-
tions of an Islamic banking system never-
theless still hold.
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The second source of funds, invest-
ment accounts, is the most important for
Islamic banks. Investment accounts are
not similar to traditional savings accounts.
They do not earn a fixed and/or predeter-
mined rate of return (or interest). Rather,
investment accounts are nothing more than
shares or equity. Thus, their face value is
not guaranteed, unlike saving accounts in
the traditional banking system. Holders of
these accounts will share the profits and
losses with the bank according to the
performance of the different joint ventures.
The only guarantee that the holder of
an investment account receives is the
proportion of the profits and losses that are
to be divided between the investor and the
bank. This is known as the profit or loss
ratio. This ratio is agreed upon in advance
and cannot be changed during the life of
the contract.
Uses of Funds
In traditional banking, a good part of a
bank’s business is in making loans and
earning interest on them. However, instead
of making loans, an Islamic bank takes an
equity position through the credit that it
advances. There are two kinds of lending:
a one-party joint partnership known as
mudarabah and a multiparty joint partner-
ship known as musharaka. The principle
is the same under either venture.
The Islamic bank makes funds avail-
able for a productive investment to be
made by a joint venture between it and one
or more investors. But how to convince a
bank to part with its investors’ money
when the face value of its “loans” (in the
Western sense) is not guaranteed? The
answer has to do with a simple equity-
stake position that businesses and banks
take every day of the year in a multitude of
ventures. Where Islamic banking departs
from the traditional fractional-reserve
banking is its treatment of risk. Under
Islamic banking, risk is transferred to the
lender, forcing the latter to finance only
those ventures that are sound and to avoid
speculative ones.
There are other types of financing
such as consumption loans. These are
done according to a “hire purchase”
formula or a “mark up.” The bank simply
buys the product (car, house, etc.) and sells
it back to the customer at a profit. The
payments are made in installments.
Some have argued that such a system
could lead to financial repression. Since
the banks must carefully choose their
projects, they may disregard all of those
that do not guarantee a quick and safe rate
of return. The evidence appears to indicate
that Islamic banks may become risk averse
and more reluctant to engage in equity
finance.26
The asset side (uses of funds): the
balance sheet of a typical Islamic bank
would list the different investments or
equity stakes it has in the various projects
(loans for a traditional bank). The value of
this investment/equity will reflect the
general level of economic activity. On the
liabilities side (sources of funds), traditional
deposits (either demand or savings)
become shares and bear more resem-
blance to an equity position in a mutual
fund. Instead of being guaranteed the face
value of their deposits, these depositors are
essentially shareholders whose returns
vary with the profits and losses of the
bank. This is no different from an account
in a mutual fund whose value is not guar-
anteed but fluctuates with the market.
With such an arrangement, there is no
need for deposit insurance. There is less
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likelihood of financial panics or runs, since
both sides of a bank’s balance sheet would
tend to move together. Research in the
area of mutual-fund banking, or “non par”
banking as Cowen and Kroszner refer to it,
comes to the same conclusion.
The run-inducing incentive to with-
draw funds at par before the bank
renders its liabilities illiquid by closing
vanishes with the possibility of non-
par clearing. In effect, there would be a
continuous (or, say, daily) “marking to
market” of the assets and liabilities.27
Islamic banking, similar to mutual-fund
banking, would mark to market the assets
and liabilities, thus relieving banking
authorities from excessive regulatory
oversight. Unlike the savings-and-loan
crisis, where figures on the net worth of
these financial institutions proved to be
meaningless due to the historical cost-
approach, under Islamic banking (or
mutual-fund banking) this would not be the
case. Net-worth
values would con-
stantly give an
adequate read on the
health of the financial
institution.
A further implica-
tion of the profit-loss
system is the extent to
which Islamic banks
can get involved in the projects they
finance. Since the financing of any
economic or business activity turns into an
ownership stake, banks have an incentive
to make the joint venture work. They
become fully involved in overseeing the
project and make sure that the money is
spent wisely. Under these arrangements,
the whole system turns into an equity-
based system and away from the typical
debt finance to which traditional banks are
accustomed.
One way to grasp the difference
between the working of Islamic banks and
Western or traditional banks is to look at
both the asset side (use of funds) and the
liability side (source of funds) of both
institutions. On the asset side,28
the
Islamic bank would have a certain amount
of fixed assets in cash and reserves as well
as equity (instead of loans) in the various
projects it helped finance. On the liability
side of the balance sheet, the bank would
have investment accounts profit or loss
(PLS) deposits – which are essentially
shares. It is important to note that invest-
ment accounts are different from savings
accounts, since the face value of the
former is not guaranteed.
The usual concentration on the quality
of bank assets tends to diminish, since the
liabilities side of the balance sheet is
nothing more than claims on the assets.
Since under Islamic banking the face value
of the liabilities is only
guaranteed for
transaction accounts,
both sides of the
banks’ balance sheet
would fluctuate. With
competition, the bank
must, however,
ensure an adequate
rate of return (a
dividend) for its depositors if it does not
want to cause an outflow of deposits, as
noted in the example in Kuwait.
Under Islamic banking, risk is trans-
ferred partly to the lender. This forces the
lender to know where the money is spent
and how. The bank becomes an active
partner whenever it lends money.
Under Islamic banking,
risk is transferred partly to
the lender. This forces the
lender to know where the
money is spent and how.
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There are additional costs associated
with such a financial system. Since the
emphasis is put on the expected profitabil-
ity of the venture to be financed rather
than the credit worthiness of the business
partner, the lender must undertake costly
project appraisals, come up with profit-and-
loss ratio splits between it and the entre-
preneur, and audit ongoing projects all the
time. Whereas the traditional bank looks at
the credit worthiness and collateral of the
borrower, its Islamic counterpart faces a
lot more costly underwriting. All of this
could effectively lead to financial repres-
sion. In fact, what this has done is to skew
the distribution of financing by Islamic
banks toward short-term “quick kill” types
of transactions such as trade finance.
A country whose financial structure
exhibits “some” resemblance to an Islamic
banking system is Japan. However, the
similarity applies only to part of the asset
side of the balance sheet. As Kim notes:
banks as a rule provided joint debt-
equity financing. Moreover, holding
other things constant, the level of a
bank’s equity holding increased in pro-
portion to financing it supplied the firm
and to the riskiness of investment.29
What is interesting in the Japanese
banking model is that its structure combines
elements of both a traditional banking
system and an Islamic one. As noted
above, the asset side of the balance sheet
in a Japanese bank in part mimics that of
an Islamic bank with its equity financing of
companies. But it also engages in straight
debt financing consistent with the workings
of a traditional bank. By engaging in joint
debt-equity finance, the Japanese bank is
able to address the “agency problem of
informational asymmetry.”30
Since the
bank is now part owner, it has access to
more information on the firm and in turn
achieves “efficiency gains in monitoring.”31
Agency problems occur whenever
there is a conflict of interest between
owners of capital (principal) – the Islamic
bank in this case – and agents (or manag-
ers) as to the running of a company.
Barnea et al. argue,
Agency problems arise because,
under the behavioral assumption of
self interest, agents do not invest their
best efforts unless such investment is
consistent with maximizing their own
welfare.32
The joint debt-equity finance is a
significant departure from both traditional
and Islamic banking systems, combining
characteristics of both. The experience of
the Japanese economy in the postwar
period shows that such a structure can
indeed contribute to economic growth.33
Kim notes the following:
The rapid investment-led growth from
the 1950s to the early 1970s put a
formidable burden on Japan’s financial
system. By virtue of the pace of
growth, industries’ demand for
external funds was large relative to
their net worth or collateral, and hence
the potential agency costs in issuing
debt and equity were commensurately
high. In such a setting, the banks,
which were the primary conduit of
investable funds, were legally sanc-
tioned simultaneously to extend loans
and to hold shares of clients’ firms.
The predominant mode of financial
contracts during Japan’s rapid growth
period thus featured the major lenders
also as significant shareholders.
Judging from the performance of its
economy, such a system appears to
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have met admirably the task of
underwriting Japan’s growth.34
MONETARY POLICY IN AN
INTEREST-FREE BANKING
SYSTEM
Islamic banking is a fractional reserve
system. Nienhaus was essentially correct
when he stated that an IFB model is no
different from an IBB model in that
respect.35
Under an IFB model, the
central bank has the power to control high-
powered money through varying its own
level of deposits with commercial banks.
By purchasing or selling bank shares from
commercial banks, the central bank can
mimic standard open-market operations. It
can also selectively alter the reserve-
requirement ratios on a variety of liabilities
for the purpose of achieving a given
monetary target. Finally, not having a
discount rate at its disposal, a central bank
in an IFB system may be able to control
profit-loss ratios and thus achieve the same
purpose as a change in the discount rate in
a conventional banking model.36
Just as the direct investment rule
enacted by the Federal Home Bank Loan
Board controls the amount of insured
deposits that an S & L could directly invest
in risky projects, Islamic central banks can
also set a limit on how much of the banks’
funds can be invested in the different types
of profit- and loss-sharing ventures. The
objective of the limit is simply to reduce
bank risk by reducing the exposure to a
given sector of the economy.
It has been argued that, in the end, an
IFB model is not too different from an IBB
model. Furthermore, an IFB system,
according to Khan,
may well prove to be better suited to
adjusting to shocks that result in
banking crises and disruption of the
payments mechanism of the country.
In an equity-based system that
excludes predetermined interest rates
and does not guarantee the nominal
value of deposits, shocks to asset
positions are immediately absorbed by
changes in the values of shares
(deposits) held by the public in the
bank. Therefore, the real values of
assets and liabilities of banks in such
a system would be equal at all points
in time.37
Under a traditional banking system,
such an automatic adjustment will not
occur, and therein lies the potential for
financial instability.Acase in point is the
U.S. savings-and-loan crisis. With a fixed-
liabilities contract, a shock to the asset side
of the saving and loan balance sheet led to
a massive failure of many of them.
Nienhaus disagrees:
The arguments in favor of the stabiliz-
ing qualities are not convincing. They
are based on the thesis that Islamic
banks could not create money as
interest banks do. . . . The conversion
to Islamic banking principles does not
automatically result in “100-percent
money” as suggested by the Chicago
economists [Henry Simon and Milton
Friedman].An Islamic banking system
is a fractional reserve system and in
that respect not different from the
traditional system.38
However, Nienhaus agrees that bank
failures can be avoided in the context of an
IFB model. Morevover, he argues that the
shock-absorbing qualities of an IFB model
are more “attractive” on a microeconomic
than a macroeconomic level. From a
purely microeconomic point of view, an
IFB system could result in the survival of a
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bank. However, from a macroeconomic
standpoint, the system can result in distri-
butional inequities.
Let us assume that a bank fails. Under
an IBB model in the United States, owners
would suffer the large share of the loss
while depositors would normally be cov-
ered by insurance. Under an IFB model,
the loss is borne by both owners of capital
and depositors since there is no deposit
insurance.39
Furthermore, one significant
inequity not alluded to in the literature in
the case of a bank failure under IFB is the
extent to which the burden falls on the
poor. This is particularly relevant in LDCs
and has recently occured in Egypt, when
an Islamic bank went bankrupt through
fraud.
It is true that in a traditional banking
system, the Central Bank can have a
significant influence on domestic rates of
interest through the discount window, open-
market operations as well as other tools at
its disposal. Since in an Islamic banking
model, interest rates are replaced by
expected rates of returns, these are then
determined by the overall economy.40
Mirakhor concurs:
Due to the fact that the return to
liabilities will be a direct function of
the return to asset portfolios and also
because assets are created in re-
sponse to investment opportunities in
the real sector, the return to financing
is removed from the cost side and
relegated to the profit side, thus
allowing the rate of return to financing
to be determined by productivity in
the real sector. Thus, in the Islamic
financial system, it will be the real
sector that determines the rate of
return to the financial sector rather
than the other way around.41
As long as a secondary market exists
for these shares (or investment certifi-
cates), the market for these instruments
would quickly establish a norm. Contrary
to the critics who argue that an IFB model
may entail a high information cost (due to a
lengthy search for the right investment),
supporters would argue that an established
market can get around that particular
constraint.
IMPLICATIONS FOR THE U.S.
BANKING CRISIS
There are some interesting implications
that flow from the study of Islamic banking
to the U.S. banking crisis.42
At a time
when the United States has gone through a
major S & L crisis as well as a banking
crisis, and when the U.S. treasury is
struggling to come up with a plausible
bank-reform package, it would help to
comment on what parts of Islamic banking
can be applicable to the United States.
We are not suggesting that the U.S.
banking system should suddenly abolish
interest rates and turn to an equity-based
financial structure overnight. Neverthe-
less, U.S. banks should be allowed to
venture outside their traditional banking
business. The emphasis is on the rewriting
of the liabilities contract. Once that is
allowed to proceed, there will be less
pressure on U.S. banks as well as on the
deposit insurance fund and finally on U.S.
taxpayers.
One approach would be to allow U.S.
banks to play a dual role as both banks and
mutual funds under one roof. With deposi-
tors fully informed, they would have the
choice of making standard deposits that are
federally insured up to a reasonable limit or
open a mutual-fund account which is not.
Allowing financial institutions to play this
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134
dual role would enlarge the access of
mutual-funds accounts to a larger group of
the population. It is also more likely for
this to occur in a climate of low interest
rates. It is much easier for a customer to
walk to their local bank and open a mutual-
fund account with someone they know
rather than part with money over the
telephone to a total stranger.43
Allowing the banks to play this dual
role would limit the exposure of the Federal
Deposit Insurance Corporation (FDIC) as
more depositors move to the mutual-fund
side of the bank. Clearly, the evidence is on
the side of mutual funds, which have
performed adequately and without deposit
insurance. Doing so would at least help
minimize the probability of future financial
crisis and alleviate the need for an expen-
sive taxpayer bailout.
In 1991, the U.S. Treasury floated its
own proposal.44
In essence, the proposal
stressed the need to start a two-window
approach. A typical bank would offer the
customer two choices. The first is a
“safe” window, where he/she would open
an insured account with little or no return.
The second is a “risky” window, where he/
she can open an account that would fetch
a higher return but is not insured by the
federal government.
Regardless of which banking proposals
one looks at, the objective of all of them is
to reduce the exposure of the FDIC’s
insurance fund. The money lent through
the “safe” window would be earmarked
for those with an excellent credit risk,
while through the other window would be
lent money for all sorts of potentially risky
but also more lucrative business.
IMPLICATION FOR THE
THIRD-WORLD DEBT
In the early 1980s banks began to sell
the debt of Less Developed Countries
(LDCs) in the secondary market since they
were increasingly unable to service their
debt obligations. Moreover, the cost of
rescheduling or carrying these debts on the
banks’ books was increasing. Very soon, a
new way was created to alleviate the debt
problem, at least marginally. This was
done through debt/equity swaps.
Interested banks, multinationals and
investors in general can buy an LDC’s debt
in the secondary market at a discount and
convert it into equity in the debtor’s
country.45
Doing so helps to lessen the
debt-servicing burden for the LDC and
would help the institution that engages in
such a transaction – particularly if it also
has a stake in that country’s economy.
More important, such a transaction is
consistent with the goals and objectives of
Islamic banking, which calls for an empha-
sis on the social and developmental bene-
fits of Islamic modes of finance.
Moreover, a case can be made that,
had third-world debt been financed partly
through an Islamic mode, the present debt
crisis would not be as severe. There is a
simple reason for this. A good many
“loans” would never have been made in
the first place. And for those that would
have been made, it is clear that an equity-
finance approach such as Islamic banking
would have stayed away from marginal
projects. This would have lessened the
burden on LDCs, but, more important,
prevented these countries from even
considering marginal projects. It would also
have directed more investments toward
export and market-oriented industries
instead of the public sector, which bank
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135
debt has tended to finance, especially when
it came with a government guarantee. A
number of Muslim countries could benefit
from a debt-equity swap program engi-
neered and facilitated by the leading
Islamic banks. These economies suffer
from the classical economic ills affecting
most LDCs: an overvalued exchange rate,
a bloated public sector, a reliance on import
substitution as a trade strategy, and a
struggling private sector.
The argument behind the approach is
the time given to the economies of devel-
oping countries to allow them to reform
and grow. Also, the LDCs that use equity
rather than debt will not have to succumb
to the “strict IMF mentality,” where severe
adjustment has to take place before a
balance-of-payment support program can
be agreed upon.
Another secondary benefit relates to a
diminished reliance on a country’s level of
international reserves. Since most non-oil
LDCs rely on hard-currency earnings from
the export of a single commodity, their
economies become subject to external
shocks whenever their term of trade turns
against them. In such cases, the LDC has
no recourse but to resort to commercial
borrowing, which further adds to its debt
burden with additional claims on its future
output. The ability of Islamic banks to
willingly become partners in some of these
LDCs diminishes the debt burden – or tax,
as some have referred to it – since the
LDC shares the profits from a venture, the
level of which varies with the LDCs
economy. The LDC is not forced to pay an
interest and principal, regardless of the
performance of its economy.
The concept of profit sharing or
Mudharabah has the potential to make
some contribution towards the alleviation of
international debt. Lending more money to
the developing countries only serves to
further increase their debt burden. In order
for Islamic banks to conform to their
guiding philosophy, they should take the
lead and start to seriously consider taking
equity in various projects in the developing
world. Debt-equity swaps is an ideal
investment for Islamic banks, since it
conforms to the Islamic banking philoso-
phy.46
But it has yet to be embraced.47
To facilitate the task and reduce the risk, a
number of them – with perhaps the Islamic
Development Bank (IDB)48
taking the lead
– could undertake this investment in a
syndicated fashion.
Being involved in the supervision or
management of a particular investment
project could increase the overall cost to
banks. However, given the present debt
crisis and the deep discounts that prevail in
the secondary market, equity finance could
reduce the overall risk and help guarantee
the success of the joint venture.
Convincing banks in general to join in a
profit-sharing scheme will not be an easy
task. Risk is often advanced as the prime
reason. Furthermore, the prevailing
attitude seems to discourage further
lending to countries that already cannot
repay existing loans. This is precisely the
argument in support of a push towards
more equity financing of deserving
projects. Rescheduling or simply refinanc-
ing old debt only serves to delay the
inevitable.
Moving away from the classical
refinancing of debt into equity participation
in new projects would no doubt help to
alleviate the debt problem. However,
before any success can be registered in
this area, Islamic banks need to first
address the distribution of investment of
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136
financing schemes within each of the
countries in which they operate. For
example, in Sudan one Islamic bank spends
only 5 to 10 percent of its financing on
profit-sharing ventures, while 50 to 70
percent is spent on trade finance. The rest
appears to be invested in multi-party
partnerships.
To be consistent with their own
philosophy, Islamic banks need to stress the
kinds of investments in manufacturing and
industry that add to the value of the sector.
Trade finance, which Islamic banks
currently prefer, imposes the same burden
on developing economies as straight debt
finance, since it involves immediate repay-
ment and does not add to the productive
capacity of the economy.49
CONCLUSION
Implementing the proposal outlined in
this paper will not be an easy matter.
Nevertheless, with some innovative
financing techniques, the equity participa-
tion idea may, some day, see the light. The
impact on global international debt will not
be significant, but it is hoped that the
technique of equity finance may gain
enough acceptance to be practiced by a
greater number of banks, Islamic and non-
Islamic. The savings and loans crisis as
well as the banking crisis have all given
fresh impetus to finding new ways to
minimize financial crises. It is noteworthy
that the proposals advanced so far are not
too different, in their objective, from the
principles of Islamic banking.
1
For an earlier treatment of this subject, see Mohamed Akacem, “Islamic Economics: Equity Banking as an
Approach to Prosperity,” Economic Direction, Summer 1993.
2
It was started by Ahmed El-Naggar, who is recognized as the father of Islamic Banking. El-Naggar’s
objective in introducing interest-free banking to Egypt was to link up the often forgotten rural areas with the
rest of the economy by establishing financial institutions. This is still a problem in many developing
economies. Thus, his overall concern was with rural economic development, as this sector housed the
majority of the country’s population. Islamic banks continue to be accused of departing from their primary
mission, which is to fund projects consistent with the social and development needs of the country.
3
Because of the “too big to fail” theory. There are numerous examples in the United States where big banks
were not allowed to fail because of their size and their ultimate impact on the financial structure and the
economy. Thus, the $100,000 deposit insurance has become irrelevant. The current U.S. Treasury proposal
is an attempt to address the open-ended exposure of the bank-insurance fund and ultimately, U.S. taxpayers.
4
Baqir Al-Hasani and Abbas Mirakhor, Essays on Iqtisad: The Islamic Approach to Economic Problems
(Silver Spring, MD: NUR, 1989), p. 170. Muslim scholars reject the notion that interest is the price of
capital, and argue that interest has nothing to do with the productivity of capital. They further maintain that
“interest is paid on money, not capital.” But, most important, the interest must be paid “irrespective of
capital productivity.” Thus, they conclude that “it is an error of modern theory to treat interest as the price
of, or return for, capital.”
5
Mohsin S. Khan and Mirakhor, eds., “The Financial System and Monetary Policy” Theoretical Studies in
Islamic Banking and Finance (Houston, TX: IRIS Books, 1986), p. 32.
6
For an elaborate and rigorous theoretical exposition of an Islamic banking model that uses expected rates of
return instead of interest rates, see Khan, “Islamic Interest Free Banking,” IMF Staff Papers, Vol. 33, No. 1,
March 1986. For a discussion of the general principles and an excellent description of an Islamic structure, see
Zubair Iqbal and Mirakhor “Islamic Banking,” IMF Occasional Paper, No. 49, 1987.
7
Iqbal and Mirakhor, ibid., p. 2.
8
Ibid., p. 1.
9
The religious law as found in the Quran and the traditions of the Prophet Muhammad.
10
Iqbal and Mirakhor, op. cit., p. 3.
11
Assuming a fixed rate of interest contract.
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137
12
Khan, op. cit.
13
Some would argue that all risk is transferred to the lender.
14
Volker Nienhaus, “The Impact of Islamic Economics on Banking, Finance and Modern Policy,” paper
presented at an international conference on Islamic banking in Geneva Switzerland, 1986.
15
As we shall see later, Japanese banks that engage in joint debt-equity finance have managed to perform
adequately, despite this added cost.
16
Khan, op. cit.
17
Many have argued that the lack of an interbank market is one of the most serious deficiencies of an Islamic
banking model. Money cannot be lent overnight, for example, for it is difficult to come up with a profit share
for such a short time period. Muhammad Uzair, “Some Conceptual and Practical Aspects of Interest-Free
Banking,” Studies in Islamic Economics, ed. Khurshid Ahmad (Leicester, U.K.: The Islamic Foundation, 1981)
argues otherwise. He claims that “the average annual rate of profitability for the borrowing firm” can be used
to estimate a quarterly – or even shorter – rate of profit. Theoretically, it seems, an interbank market under an
Islamic banking model is not an impossibility. Although practically it could very well prove to be costly to
establish and force banks to carry idle balances at times.
18
Khan and Mirakhor, Theoretical Studies in Islam Banking and Finance (Houston, TX: IRIS Books, 1987).
19
Khan, op. cit.
20
John H. Kareken, “Ensuring Financial Stability,” The Search for Financial Stability (Federal Reserve Bank
of San Francisco, 1985); Henry Simon, Economic Policy for a Free Society (University of Chicago Press,
1948); Milton Friedman, A Program for Monetary Stability (NY: Fordham University Press, 1959).
21
Akacem, “Islam and the U.S. Banking Crisis,” Wall Street Journal, May 9, 1991.
22
Throughout the paper, the term traditional bank refers to a non-Islamic bank, one in which interest is
featured.
23
Where the probability of incurring a loss is greater than zero.
24
Iqbal and Mirakhor, op. cit., footnote 9. This version has been presented by Mohsin Khan. See also
Simon, op. cit.
25
Nienhaus, op. cit.
26
In interview conducted by the author in June of 1987 with the General Manager of the Kuwait Finance
House – one of the largest Islamic financial institution in the Middle East – it was found that most of the
bank’s activity was in short-term trade finance. When asked why the bank did not commit a larger share of its
funds toward projects, the manager argued that he first had to make sure that his depositors-shareholders
received adequate dividends every year or else he would lose them.
27
Tyler Cowen and Randall Kroszner, “Mutual Fund Banking: A Market Approach,” The Cato Journal, Vol.
10, No. 1, 1990, p. 227.
28
This is not meant to be a comprehensive list of all the items on the balance sheets of both types of
institutions. Rather, we limit ourselves to the most important items that differentiate them.
29
Sun Bae Kim, “The Use of Equity Positions by Banks: The Japanese Evidence,” The Economic Review,
Federal Reserve Bank of San Francisco, Fall 1991, p. 41.
30
Amir Barnea, Robert A. Haugen and Lemma W. Senbet, Agency Problems and Financial Contracting
(Prentice Hall, 1985), p. 38.
31
Kim, op. cit., p. 43.
32
For an elaborate discussion of agency problems, see Barnea et al., op. cit., p. 26. The authors distinguish
between the economic theory and the financial theory of agency. The economic theory of agency looks at the
relationship between a single provider of capital – the principal – and an agent (manager) who runs the firm/
business. This is notable in that it is this kind of arrangement that is emphasized under an Islamic banking
structure where the bank is the sole provider of capital while an entrepreneur invests his time and expertise in
the venture. The financial theory of agency looks at the relationship between different providers of capital –
equity and bond holders – and the benefit and costs to these groups depending on the type of financing would
not occur, so it is limited to equity finance. However, there is the possibility of an Islamic bank being only
one of many investors who acquire an equity position in a given venture.
33
Muslim scholars have always argued that an Islamic banking structure is conducive to growth because of its
emphasis on project financing through equity. The Japanese model incorporates only part of that, and has
shown some positive results. It is too early to conclude that an Islamic banking system that engages in 100-
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percent equity finance would be as successful because of the limited empirical evidence. Theoretically, at
least, the model has been shown to be superior to a traditional banking model.
34
Kim, op. cit., pp. 41-42. Whereas Japanese banks were legally required to engage in joint debt-equity
financing, Islamic banks are required to engage in equity (no debt) finance of projects. U.S. banks, on the
other hand, are currently limited to hold a maximum of 5 percent of stocks in any one firm. The U.S. banking
model appears to represent close to 100-percent debt finance – with all of the noted failures of the 1980s –
while the Islamic banking model represents 100-percent equity finance, with the Japanese model combining
characteristics of both.
35
Nienhaus, op. cit.
36
It is not quite clear whether the central banking authorities can do this or that it is consistent with Islamic
law. Some have argued that it is possible for contracts between banks and depositors not yet signed, but a
change in the profit-loss ratio cannot be applied retroactively.
37
Khan, op. cit., p. 19.
38
Nienhaus, op. cit., pp. 12-13.
39
Ibid., argues that “none of the Islamic banking models assume the existence of deposit insurance.” Techni-
cally, they should not. As long as depositors are fully aware of the risks of opening investment accounts with
an Islamic bank, their account is no different from a mutual-fund account or a privately held portfolio of
stocks. These do not and of course should not carry deposit insurance.
40
The Central Bank can, of course, influence to some extent the level and growth of economic activity and
thus the expected rates of return from the different ventures/investments (shares).
41
Al-Hasani and Mirakhor, op. cit., p. 176.
42
Akacem, “Islam and the U.S. Banking Crisis.”
43
Not that this has lessened the appeal of owning shares in mutual funds, but enlarging the access through
banks would help the smaller and less sophisticated investors who perhaps needs the higher returns to
compensate for the lower returns from regular saving accounts and Certificates of Deposit.
44
The U.S. Treasury “Modernizing the Financial System: Recommendations for Safer, More Competitive
Banks,” Washington, DC, February 1991.
45
This is usually done at a favorable exchange rate, thus giving the bank/investor a significant profit from the
transaction. The size of the profit depends on two things: the size of the discount in the secondary market
and the “premium” gained when the conversion is done at a “preferred” exchange rate (close to market) and
not the official one (usually overvalued).
46
Akacem, “Islamic Banking and International Debt,” paper presented at the Islamic Banking Conference,
Madison Hotel, Wahington, DC, September 25-26, 1986; and Sherif Omar Hassan “Islamic Banks and
International Development Agencies: Experience, Framework for Enhanced Cooperation,” paper presented at
the Islamic Banking Conference, Madison Hotel, Washington, DC, September 25-26, 1986.
47
In order for Islamic banks to succeed in swapping debt for equity in some of the LDCs, these should have a
debt-equity swap program in place. Our discussion assumes that most LDCs either do have a program or will
not hesitate to start one should the opportunity arise. In any case, the success of such a program could be
limited by two factors: First, Islamic banks could refuse to take on additional risk by venturing outside their
domestic market and thus continue to behave like a risk averse investor. Second, LDCs may not welcome
foreign investment through a debt-equity swap program since it automatically translates into a decrease in the
public sector and could engender very high social costs in the short run.
48
The Islamic Development Bank (IDB) is a regional development institution based in Jeddah, Saudi Arabia.
Most of the Muslim countries are members of the IDB, with Saudi Arabia holding the majority of capital. The
IDB engages in Islamic types of finance and some projects, but a significant amount of activity is also in
short-term trade finance.
49
Particularly when it is consumption oriented.
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