The Theory Of Islamic Banking (5/5)

3. Socioeconomic Consequences of Islamic Banking

The possible socioeconomic consequences of Islamic banking have been the subject matter of extended discussion in recent literature. The discussion has proceeded mainly on the basis of the presumption that PLS based modes of financing will have a dominant role in the conduct of Islamic banking while the other modes would be used sparingly. The main focus of discussion has been on the possible impact of Islamic banking on savings, investment, rate and pattern of growth, allocative efficiency and the overall stability of the banking and the economic system.

(A) Effects on Savings and Investment

Concerns have been expressed that adoption of an interest free system may have an adverse effect on savings because of increased uncertainty regarding the rate of return[1]. Muslim economists have pointed out that standard economic analysis does not yield a definitive conclusion regarding the effect of increased uncertainty of rate of return on the quantum of savings. It has been agreed that the actual outcome would depend on a number of factors such as the form of the utility function and its risk properties, for example, the degree and the extent of risk aversion, the degree to which future is discounted, whether or not increased risk is compensated by higher return, and finally the income and substitution effects of increased uncertainty[2]. It has further been argued that the move to an Islamic interest free system, under certain conditions, could lead to increased rates of return on savings. Consequently, the increased level of uncertainty that could result from adoption of PLS based system could be compensated for by an increased rate of return on savings, leaving the overall level of savings unchanged or perhaps even leading to an increase in savings [3].

Muslim economists expect PLS based banking to exercise a favorable effect on the level of investment[4] . It has been pointed out that both the demand for investment funds and the supply of investment funds are likely to show an increase consequent on replacement of interest-based banking by PLS based banking. The demand for investment funds is likely to increase as a fixed cost of capital is no longer required to be met as a part of the firm's profit calculations. The marginal product of capital can, therefore, be taken up to the point where maximum profits are obtained without the constraint of meeting a fixed cost of capital. The supply of investment funds is likely to increase as PLS based banking is enabled to undertake the financing of a larger number of risky projects on account of an enhanced risk absorbing capacity [5].

 (B) Impact on the Rate and Pattern of Growth

The likely impact of the adoption of Islamic banking practices on the rate and pattern of growth has been discussed by several scholars[6]. It has been pointed out that the expected favorable effect of PLS based banking on the level of investment would impart a pronounced growth orientation to the economy. The increased availability of risk capital under the Islamic system would promote technological innovation and experimentation which would be another favourable factor for growth. Islamic banks are also expected to influence the pattern of growth through appropriate selectivity in their financial operations to ensure that the process of growth is broad based and an optimal use is made of bank resources for purposes which rank high in Islamic socioeconomic objectives. It is recognized that the central bank of the country will have to play a strong guiding role in this context.

 (C) Impact on Allocative Efficiency

Allocative efficiency of an interest free economy has been an area of major concern in the writings of many Muslim economists[7]. It has been stated that a financial system based on an Islamic framework of profit sharing would be more efficient in allocating resources as compared to the conventional interest based system. This position is defended on the basis of the general proposition that any financial development that causes investment alternatives to be compared to one another, strictly based on their productivity and rates of return, is bound to produce allocative improvements, and such a proposition is the cornerstone of the Islamic financial system.

Muslim economists do not deny that investment efficiency requires the use of discounting to take proper care of the time dimension of costs and benefits. They emphasize that non-existence of interest does not mean that discounting as a technique of computing the present value of future cash flows cannot be used in an interest free economy. It has further been pointed out that interest rate is not the proper discount factor under conditions of uncertainty even in interest based economies. Under conditions of uncertainty, the rate of return on equity is the proper discount rate. Since the real world is a world of uncertainty and since no real investment in any economy can be undertaken without facing risks, cash flows of such investment should be discounted not by a riskless interest rate but by the true opportunity cost of venture capital[8].

 (D) Consequences for the Stability of the Banking System

It has been argued in the literature on Islamic banking that a switch over from interest based banking to PLS based banking would impart greater stability to the banking system. The argument proceeds on the following lines. In the interest based system, the nominal value of deposit liabilities is fixed. However, there is no assurance on the assets side that all the loans and advances will be recovered. Shocks on the assets side, therefore, lead to divergence between assets and liabilities, and the banking system can suffer a loss of confidence in the process, leading to banking crises. In the PLS based system, the nominal value of investment deposits is not guaranteed, and shocks to the assets positions are promptly absorbed in the values of investment deposits. This minimizes the risk of bank failures and enhances the stability of the banking system[9]

 (E) Effects on the Stability of the Economic System

The literature on Islamic banking has taken note of apprehensions expressed in certain circles that replacement of interest by profit/loss sharing may make the whole economic system highly unstable as disturbances originating in one part of the economy will be transmitted to the rest of the economy [10].The general consensus holds such apprehensions to be lacking in substance and suggests, on the contrary, that elimination of interest, coupled with other institutional features of an Islamic economy, will tend to enhance stability. It has been pointed out that interest based debt financing is a major factor in causing economic instability in capitalist economies. It is easy to see, for example, how the interest based system intensifies business recession. As soon as banks find that business concerns are beginning to incur losses, they reduce assistance and call back loans, as a result of which some firms have to close down. This increases unemployment resulting in further reduction in demand, and the infection spreads.

Islamic banks, on the other hand, are prepared to share in losses which reduce the severity of business recession and enable the productive enterprises to tide over difficult periods without a shut down. Islamic banking has, therefore, to be regarded as a promoter of stability rather than a conduit of instability [11].