Islamic Banking

Topics: Fractional-reserve banking, Money, Monetary policy Pages: 20 (7077 words) Published: December 19, 2011
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Credit creation and control: an unresolved issue in Islamic banking Zubair Hasan
Department of Economics, Faculty of Economics and Management Sciences, International Islamic University Malaysia, Selangor, Malaysia Abstract
Purpose – To reopen for discussion the issue of credit creation and control in the area of Islamic banking. Design/methodology/approach – In view of a rapid expansion of Islamic banking in recent decades, the answer to questions whether Islamic banks can create credit like mainstream banks and, if yes, what methods central banks could use to control it in their case is of paramount importance. An overview of the literature on the subject is provided and credit creation process is explained as background material for the discussion. Findings – The literature on the subject is scanty, controversial and inconclusive. One reason seems to be the mismatch between structural design of Islamic banks and the objectives they are supposed to meet. It is concluded that Islamic banks can create credit in the usual manner but central banks will have to design new tools for credit control applicable to Islamic banks. Research limitations/implications – It is not a rigorous analytical exercise as the main purpose of the paper is to reopen an important issue for discussion. It is an opinioned work and presents rather tentative answers to the questions raised. Practical implications – The findings of the paper may have serious implications for the current structure of Islamic banks and the legal framework for regulating their credit creation activities. Originality/value – The paper draws attention to a rather neglected issue in Islamic banking and offers guidelines to resolve it. Keywords Islam, Banking, Credit control, Fiscal policy Paper type Conceptual paper

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1. Introduction Commercial banks are essentially dealers in credit. Interest is the price that guides them in making business decision. They were initially started as institutions for meeting the short-term credit requirements of trade industry and commerce and it remains their primary function even today[1]. In view of that requirement, the legal framework never put restrictions on the credit creation power of these banks. However, legislation did require the central bank of each country to oversee and control that power so that it may not be used to the detriment of social well-being. Islamic banks were conceived of to be organized on the same structural pattern as conventional banks. The use of interest alone was to be eliminated from their operations (Siddiqi, 1983). The choice unwittingly became source of much confusion at the conceptual level and led the progress of these banks in some wrong directions The author is grateful to his Research Assistant Ms Sarabdeen Masahina, a post-graduate student in the faculty, for her valuable help in the writing of this paper.

International Journal of Islamic and Middle Eastern Finance and Management Vol. 1 No. 1, 2008 pp. 69-81 q Emerald Group Publishing Limited 1753-8394 DOI 10.1108/17538390810864269

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(Hasan, 2005, p. 22). In Islamic banking the abolition of interest, the insistence on sharing business risks with the owners, the longer lock-in of investment funds and the social responsibilities the system is supposed to shoulder raise some ticklish issues that its structural constraints could rarely help resolve. The misdoing raises many puzzling questions relating to credit creation. Can Islamic banks in the first place create credit like the conventional banks to enhance their earnings? If yes, what must replace interest as price for the funds they would provide to their customers? How would the central bank put, if need be, a tab on their credit creation activities from a social viewpoint? Shall it be using the same weapons for the purpose in...

References: Economic Research Council (1981), “Government debt and credit creation: a study of the creation of credit and its effect on the British economy”, Research Report No 10, Economic Research Council, London. Hasan, Z. (2002), “Mudarabah as a mode of financing in Islamic banking: theory, practice, and problems”, Middle East Business & Economic Review, Vol. 14 No. 2, pp. 41-53. Hasan, Z. (2005), “Islamic banking at the crossroads: theory versus practice”, in Iqbal, M. and Wilson, R. (Eds), Islamic Perspectives on Wealth Creation, Edinburgh University Press, Edinburgh, pp. 3-20. Hoshi, T. (2006), “Creditor rights and credit creation by banks in transition economies”, working paper, Graduate School of International Relations and Pacific Studies, University of California, San Diego, CA, NBER, and TCER. Siddiqi, M.N. (1983), Banking Without Interest, The Islamic Foundation, Leicester.
Further reading Ariff, M. (Ed.) (1982), Monetary and Fiscal Economics of Islam, International Centre for Research in Islamic Economics, King Abdulaziz University, Jeddah. Chapra, M.U. (1985), Towards a Just Monetary System, The Islamic Foundation, Leicester. Grffiths, A. and Wall, S. (Eds) (2004), Applied Economics, 10th ed., Prentice-Hall, Hemel Hempstead. Gupta, S.B. (1990), Monetary Economics: Institutions, Theory and Policy, S. Chand & Co., New Delhi.
Hasan, Z. (1991), “The financial system and monetary policy in an Islamic economy, by Mohsin Khan and Abbas Mirakhor: comments”, JKAU: Islamic Economics, Vol. 3, pp. 85-93. Levine, R. (1998), “The legal environment, banks and long-run economic growth”, Journal of Money Credit and Banking, Vol. 30, pp. 325-68. Wachtel, P. (2001), “Growth and finance: what do we know and how do we know it?”, International Finance, Vol. 4, pp. 335-62. About the author Zubair Hasan is an Indian Economist. Having worked in a number of educational institutions mainly the University of Delhi, he is presently with the Department of Economics, Faculty of Economics and Management Sciences, International Islamic University, Malaysia (IIUM). He has published several books, chapters in books and numerous articles in academic journals of repute on topics in economic theory and finance-mainstream and Islamic – his main areas of interest. He is a resource person with a couple of Islamic financial institutions including INCEIF of Bank Negara, Malaysia. Zubair Hasan can be contacted at: zubair@iiu.edu.my
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