Islamic Banks and Investment Financing

By Aggarwal, Rajesh K.; Yousef, Tarik | Journal of Money, Credit & Banking, February 2000 | Go to article overview

Islamic Banks and Investment Financing


Aggarwal, Rajesh K., Yousef, Tarik, Journal of Money, Credit & Banking


IN THE LAST TWO DECADES, Islamic banks have grown in size and number around the world. In this paper, we examine the types of financial contracts offered by Islamic banks. We try to understand any departures from traditional Islamic principles in the types of contracts offered. We suggest an economic rationale for the constraints imposed on Islamic banks and try to determine if these constraints are likely to be social welfare improving. We also examine the types of projects in which Islamic banks invest. In this process we hope to shed some light on the efficiency of Islamic banks and Islamic economies.

Islamic banks operate in over sixty countries, most of them in the Middle East and Asia. In three countries, Iran, Pakistan, and Sudan, the entire banking system has been converted to Islamic banking. In the other countries, the banking systems are still dominated by conventional banking institutions operating alongside Islamic banks. Even so, Islamic banking is the fastest growing segment of the credit market in Muslim countries that have Islamic banks: their market share has risen from 2 percent in the late 1970s to about 15 percent today, as measured by assets in the banking system (Babai 1995). Even conventional commercial banks have started to offer Islamic financial contracts. Unlike other commercial banks in the Middle East that were either created by or received extensive support from governments during the oil booms of the 1970s and 1980s, Islamic banks are generally the product of private initiative and have appeared predominantly in non-oil-exporting countries.

Islamic banks are supposed to offer instruments consistent with the religious beliefs and cultural characteristics of Muslim societies. According to prevailing interpretations of Islamic Law, financial instruments should emphasize profit-and-loss sharing (equity). Interest is prohibited, which seems to exclude debt contracts. This is in marked contrast with Western financial institutions. Banks in the United States, for example, primarily offer debt contracts to firms seeking capital (regulations prohibit banks from taking more than a 5 percent equity position in firms). Banks in Germany and Japan make equity investments in firms, but also use debt contracts. Non-Islamic banks operating in Muslim countries are able to offer debt contracts to firms. Even governments of Muslim countries, such as Saudi Arabia, borrow on the international capital markets. That Saudi Arabia does so is fascinating given that the Saudi monarchy derives its legitimacy from upholding Islamic Law and is a major promoter of Islamic economics. Nonetheless, Islamic Law prohibits Islamic banks from either receiving or paying interest.

We consider two issues. First, do Islamic banks operate according to the principle of profit-and-loss sharing? If not, why not? Second, is it social welfare improving to have a strict ban on debt? Who benefits and who loses from such a ban? On the first issue, our evidence indicates that most of the financing provided by Islamic banks does not conform to the principle of profit-and-loss sharing. Instead, much of the financing provided by Islamic banks takes the form of debt-like instruments.

On the second issue, proponents of Islamic banking argue that profit-sharing contracts (equity) are superior financial instruments to debt for a variety of reasons including the risk-sharing properties of equity (Ebrahim and Safadi 1995). We discuss some of these arguments in section 2. In addition, advocates of Islamic banking such as Chapra (1992) and Siddiqi (1983) have argued that Islamic banks will promote growth in Islamic countries by providing long-term financing to growth-oriented sectors of the economy.

Contrary to the expectations of Islamic banking's advocates, we find that Islamic banks rarely offer long-term financing to entrepreneurs seeking capital. In addition, the majority of Islamic banks' financial transactions at least initially were directed away from agriculture and industry and toward retail or trade financing. …

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