Concept and Ideology
Investment Decisions And Banking Efficiency
Investment decision model
Islamic banking, for its profit-loss sharing
character, is conceived as more production-oriented and growth promoting
than its conventional counterpart. This is because the bank's earnings are
directly linked to the earnings generated from the venture financed by it.
Further, replacement of interest with the principle of profit-loss sharing
increases the horizon of investment opportunity in an economy. It also
promotes efficient allocation of financial resources, ensures equitable
distribution of income and promotes stability in the economy. Thus,
Islamic banking is efficient from most of the macroeconomic measures of
efficiency. The efficiency of the Islamic banking system can best be
illustrated when the investment decision-making procedures between the two
systems are analyzed. This necessitates an analysis of the investment
The investment decision model is based on the following assumptions:
This is an economy where both the conventional and Islamic banks operate side by side.
Customers are well aware of the functioning of the two systems of banking.
Religious considerations do not affect rational behavior of the borrowers and bankers.
Investment decisions in the money market are not affected by the operation of capital market.
There is no change in price level.
There is only one market rate of interest prevailing in the economy.
There is no shortage in supply of credit in the money market.
Question of moral hazard is absent.
Investment decision Model: General
The Conventional Investment Demand curve explains how investment decisions are made by firms or entrepreneurs in an economy. Rate of interest being one of the key factors in the investment decision model, Conventional banking appears to be an integral part in the investment decision-making process. Akkas keeps the structure of the investment decision model intact and extends it to meet the requirement of being a general one incorporating into it the investment decision process of Islamic banking. This is illustrated in the following figures. Fig-la represents the investment decision model under conventional banking system and Fig-1b represents the same under Islamic banking. The generalized banking decision-making process is modeled in Fig-2, which is derived by superimposing Fig-1b on Fig-la.
The horizontal axis of Fig-2 depicts the level of
investment, I, at different rates of interest (ri) for a
conventional bank and financier's rate of return (rf) for
Islamic bank, which are both shown vertically. The horizontal shape of the
ri curve indicates that although the rate of interest seems to
affect the level of investment inversely, it is neither related nor
influenced by the rates of return of the projects financed by the bank.
The downward sloping rf (rate of profit for an Islamic bank)
curve, on the other hand, is directly variable to changes in rate of
return, r. This is because both r and rf, maintaining
almost a proportional change, are downward sloping and they meet at
the zero rate of return, which is depicted at point N'.
A relation between r and rf can be
established if the ratio, l (the percentage share of r going to the borrowing entrepreneur), is
known. Thus, the rf can be measured in the following
rf = (I - l) r.
Investment Decision: conventional banking
The bank makes a loan at a fixed
rate, which includes a mark-up to cover its cost of capital. The
bank is not worried about the rate of return on the project. In other
words, in conventional banking, the rate of return to the bank is fixed
regardless of the success of the project, which is the opposite of what
happens in a PLS banking system.
Under the conventional banking framework, as
depicted in Fig-la, the bank charges a fixed rate of interest to finance
only those projects which have rates of return greater than or equal to
the rate of interest. Thus, the conventional banking system could be
termed a Fixed Return System and the investment decision could be
I = f(ri, r)...................(1)
with -- < 0; -- > 0
where, I represents level of investment,
ri the rate of interest and r the rate of return from the
Here --- < 0 indicates an inverse relation
between interest rate and investment demand,
Whereas -- > 0 shows a positive relation between
investment, I and rate of return, r.
Investment decision: Islamic banking
Under the profit-loss sharing system of investment financing, the bank receives a variable rate of return as it shares a percentage of profits earned by the borrower. Though there is a consensus as to sharing losses in proportion to capital participation, some of the Muslim economists think that the ratio may vary with the application of different types of modes of financing (Hasan 1988, p.47). Thus, the Profit-loss-sharing system of investment financing may be termed a Variable Return System.
Since the Islamic banking system does not charge interest on any financing agreements, the client neither receives nor pays fixed rate of return while financing his investment. Thus, the question arises as to what actually is the allocating device that ensures optimum allocation of scarce financial resources and establishes equilibrium in the money market? Furthermore, how does the financing decision of a bank relate to the investment decision of a firm?
Regarding the formed question, the rate of interest is replaced by the rate of return in the Islamic banking system. By this replacement there is no strong theoretical reason to support the often-made a priori assertion that investment levels would decline (Haque & Mirakhore 1986, p.iii). Though there is no difference of opinion in regard to the rate of return on equity financing as a tool of efficient allocation of resources in a Zero Interest Rate Economy (ZIRE), some disagreements still persist as to the interpretation of the equilibrium condition. According to Arif, capital will flow into those sectors that offer the highest rate of profits to investors until equilibrium is reached in the all sectors (Arif 1982, pp.1-23). Kahf, on the other hand, says the equilibrium level of investment can be determined at a point where its cost equals its return (Kahf 1982, pp.107-23). While Saqr is of the opinion that equilibrium will be reached at a point where the expected rate of profit is just equal to the normal rate of profit. Each industry has its own normal rate, and rates differ according to the size of investment, time maturity, degree of risk and other related factors (Sakr 1982, pp.63-65). Jarhi's views seem to be more operational and clear. He says, that there are two robust rules for static efficiency: First is that marginal rates of return on investment must be equal in all industries. The second rule requires the use of discounting to take proper care of the time dimension of costs and benefits. The process of discounting is entirely acceptable in Islam. This is a rate of return on an alternative real investment (Jahri 1982). Further, Uzair suggests the average rate of profit prevailing in the economy should be used as the measure of opportunity cost that guides project evaluation and resource allocation in the private sector (Uzair 1982, pp.69-70).
The problem still persists as to the definitions of profit and the method of its calculation. The following discussion concentrates upon resolving these issues. The term profit in the capitalist world refers to the reward for enterprise whereas in Islamic context it is a reward that has to be divided between capital and enterprise. In other words, profit in an Islamic system consists of return of capital to the investors and the sharing of the remaining profits from the business operations. But the problem arises with the r being gross rate of return accrued from project, which includes cost of borrowing and l and 1-l being the ratios going to the financier and the entrepreneur leading to confusion in making a comparison between the first rate and the next two ratios (see Fig-3).
Generalized Investment Decision Model of Conventional and Islamic Banking Systems
However, the dilemma is not insurmountable. Since we know the rate of return per unit of investment, we may arrive at total profit. The ratios may then be applied to the total profit for the purpose of determining shares of profit going to the financier and the entrepreneur. When we know the ratios and the shares of profits, their respective rate of return against their investment may easily be calculated. When we know the financier's rate of return at each level of investment, we can derive the financier's rate of return curve, i.e., r curve.
Under Islamic banking, the financial contract specifies the following returns to the financier (bank) and the investor (borrower), respectively:
r = total rate of return
rf = financier's rate of return i.e.,
lr = entrepreneur's rate of
Assuming linearity in the movement of
'l', the financing and investment decisions under
Islamic banking are shown in Fig-1b.
In this figure, the rf curve crosses the
horizontal axis at the point marked N' where r = 0, implying the
financier's interest to finance all those projects which have rates of
return greater than or equal to zero. This may not happen since financing
always involves some administrative cost. If so, minimum cost of borrowing
under Islamic banking will be somewhere (point M) and the zero rate of
return (point N'); say, at point M' as shown above.
find some additional features of the Fig-3. These are:
ri curve is a horizontal line parallel
rf curve is downward sloping and meets
with the r curve at its lower level compared to where ri
curve meets, and
The equilibrium under Islamic banking takes place
at a higher level of investment (ONV) than that of the
Conventional banking (ONF).
Banking efficiency can be tested by employing the following tests:
Allocation of resources
These are now discussed one by one as:
Islamic banking assists in the promotion of
productive activities in many dimensions. An Islamic bank, while
financing investment, confronts five types of productivity challenges
in terms of its ability to affectively provide financing to society.
First, how much its financing system is capable of utilizing
investment opportunities that exist in an economy. Second, how far
its financing system can help ensure effective performance of the projects
financed by it. Third, how much the system is capable of ensuring
maximum possible timely recovery of the loan financed. Fourth,
how profitable are the returns from its investments. Finally, how
much the system is elastic or responsive to providing financial services
for the entrepreneur seeking finance. Thus a financial system, to be
productive, faces five kinds of efficiency tests:
Investment opportunity utilization test
Project efficacy test
Loan recovery test
Profit maximization test and
Test of elasticity in financing.
Islamic banking is found to be sound in each of the efficiency test as explained below.
Investment opportunity utilization test
testing the investment opportunity utilization capacity of the investment
financing system of a bank, it is essential to know what is actually meant
by the term investment opportunity and how it can be quantified so as to
help to measure the bank's capacity to utilize it.
Investment opportunity means total number of
projects, calculated in money terms, in an economy, which are waiting to
be financed having their internal rates of return greater than or equal to
zero, i.e., IRR ³
0, assuming no cost of borrowing and non-existence of other alternative
opportunities for investment. For a clear understanding of the concept we
may refer to Fig-3. The vertical axis shows different rates of return of
bank-financed projects while the horizontal axis indicates amount of
investment that could be made at different rates of return. The downward
sloping rate of return curve, r, indicates that projects available in an
economy can be arranged in descending order in terms of their rate of
return and can be financed as long as the rate of return is greater than
zero. If so, according to Fig-3, ON' is the investment opportunity
Under the assumptions of zero borrowing cost and
fund availability, the investment opportunity utilization test can be used
to compare different types of banking systems. One useful
measurement is the Fund Utilization Rate, which is measured by the ratio
of employed funds as a percentage of Loanable funds and may be used as a
proxy for Investment Opportunity Utilization.
Utilization of investment opportunity by
conventional banking system: In analyzing the investment
opportunity utilization capacity of conventional banking system, we may
again refer to Fig-3.
It can be seen that there exists ON' level
of investment opportunity. Assuming availability in the supply of
investible funds, the optimum level of investment under the conventional
banking framework will be determined at the point ONF,
where the rate of return, r, and rate of interest,
ri, intersect at point M.
With Ori rate of interest the level of
investment that a conventional bank is interested in financing is
ONF. Thus, projects beyond the point ONF, while
having positive rate of returns, are rejected for financing under the
conventional banking system since the rate of interest exceeds the rate of
return from those projects making them non-profitable for the
entrepreneurs and non-viable for bank financing. That means, under
conventional banking a portion of investment opportunity always remains
At this stage, it may be convenient to divide the
investment opportunity level, ON', into two zones: (i) the viable projects
zone, ONF, and (ii) the non-viable projects zone,
NFN'. The latter zone NFN' may increase or decrease
if the rate of interest changes. More specifically, the utilization
of investment opportunity level may be increased (or decreased) with the
decrease (or increase) in the rate of interest.
Theoretically, the viable projects zone
widens when the bank reduces the rate of interest in order to utilize
excess liquidity. The success of the policy depends on the stage of
cyclical fluctuations the economy confronts. It has been shown that the
conventional banking system has excess liquidity in the downswing phase of
cyclical fluctuations just after a boom (Chisti 1985, pp.3-11). At this
stage the spread between the payment commitment and cash flows reaches its
highest level creating a situation in which conventional banking finds
lending to be very risky. As a result, it becomes difficult for
conventional banking to expand the viable profit zone by reducing the rate
There might be another plausible reason why the
investment opportunity utilization range of the conventional bank reduces
even further. This may result in cases where the project has a net rate of
return (r - ri), which is very close to zero on the left of
point M. This is because of the fact that the marginal projects are
severely vulnerable to cyclical fluctuations and prone to losses. That is
why the rational entrepreneurs themselves avoid applying for bank
financing for those projects. That means, under the conventional banking
framework where entire risk is borne by the borrowers, entrepreneurs
submit only those projects for financing which have the highest
probability of generating a high minimum net rate of return not subject to
be offset by uncertainties. If this is true, the investment opportunity
utilization range o
Utilization of investment opportunity by Islamic
banking: An Islamic bank can finance up to the level
ONV of investment, thereby utilizing the extra potential
investment opportunity of NFNV. This is
possible for Islamic banking since it can remain at least at the level of
the average rate of return earned by the conventional bank by
counterbalancing the losses incurred in the low profit zone (right
of point P) by the excess profit earned in the high profit zone
(left of point P), thereby achieving the average rate of profit as that of
the conventional bank. Thus, the Islamic bank can utilize more of
the potential investment opportunity remaining untapped in the
economy. With a microeconomic analysis in a dynamic sense, Mukherji
(1984, pp.65-66) finds that compared to a capitalist firm, the
firm in a Zero Interest Rate Economy will have a high rate of growth at
low profit margin.
Project efficacy test
order for a banking system to be deemed project efficient, it must have a
system in place to monitor the projects that it has financed. This
is crucial because the economy has scarce resources and the banking system
needs to assure that those resources are being allocated to the most
Conventional banking and project
efficacy: In order to determine the project efficacy of the
conventional banking system, it is necessary to identify how close the
relationship the bank has with the entrepreneur to whom the loan was
made. In addition, it is important to determine what type of
monitoring the bank does of the ongoing project throughout the term of the
loan. There are four critical activities in which the financial
institution can engage in order to assure that a project has the best
opportunity for success: (a) the bank needs to perform a careful analysis
of the proposed project prior to making the loan; (b) the contract should
be written very clearly including all the details of the proposed project
and the terms and requirements of the loan; (c) the bank should verify the
status of the project with each advance, to ensure that the proceeds of
the loan are being used for the purpose intended and not being
misappropriated; and (d) the bank should monitor the performance of the
business to ensure their ability to properly service the indebtedness.
In general, the conventional banking
system does engage in these four activities. Hoever, some doubt
exists as to how stringently they pursue these activities, as the
profitability of the bank is not tied directly to the profitability of the
individual project. It is argued relies too much upon collateral for safe
return of the principal and interest. Thus, it is neither committed to nor
serious in the effective operation of the projects that the bank
Islamic banking and the project
efficacy: The Islamic banking system, by its very nature, is a
partner in the projects that it finances. The bank's income under Islamic
banking has a direct functional relationship with the profit generated
from the project. In other words, bank's profit increases or decreases
with the rise or fall in returns from the projects that it finances.
Thus the Islamic banking system is very much concerned about the
performance of the project for which it provides financing. The concern is
exemplified in the following activities: (a) the bank carefully considers
every loan request and assesses the profitability of the each proposed
projects; (b) the bank keeps a careful eye on the installation phase of
the projects; and (c) the bank continues to oversee the project as long as
it is a partner to the project. These activities ensure effective
implementation of the projects and ultimately a better chance for success.
Thus, since in the Islamic banking system, the profitability of the bank
directly depends on the successful performance of the project, the bank
has a greater interest in seeing that the project is a success.
Therefore, Islamic banks tend to have a higher degree of project
efficiency than that of their counterparts in the conventional banking
Loan recovery test
This test measures the ability of a financial
system to take the steps necessary to recover loans, both in the ordinary
course of business and when a loan has gone into default. There are
various opportunities to ensure that the ultimate recovery of a loan will
be successful. Those opportunities exist in the selection process,
disbursement procedures, and proper monitoring of the business to which
the loan was made throughout the life of the loan. Financial systems
can differ on these various points, which will ultimately decide the
effectiveness of a particular system in recovering the loan. While
measuring comparative productivity of the two financing mechanisms in loan
recovery, the question of cost effectiveness should be duly
Conventional banking and loan
recovery: Loan recovery rate might be another criterion for
measuring productivity of a banking system. The higher the recovery rate,
the greater is the possibility of recycling scarce financial resources
leading to increase in the productive efficiency.
Conventional banking is not as
effective in this aspect of productive efficiency. Conventional banking
relies heavily on collateral used to secure the loan
Conventional banking systems become
complacent in the loan selection process, becoming too optimistic that the
collateral will assure ultimate recovery of the loan. By
looking at the collateral as the source of final repayment in lieu of
looking at the prosperity of the project, conventional banking systems
hinder productivity in two ways: i) productive capacity and resources need
to be spent in recovering loans instead of considering new projects for
investment, and ii) the cost of recovering the loan reduces the
profitability of the bank.
Islamic banking and loan recovery: On
the other hand, Islamic banking is more productive in terms of loan
recovery due to its built-in profit-loss-sharing mechanism. Failure of a
project not only reduces profit, but also it may lead to capital losses. A
delay in the receipt of profit and capital reduces ingestible funds
for further financing, which reduces the bank's productivity. Thus,
the Islamic PLS system fosters loan selection based on the profitability
of the project, which results in timely recovery of capital that can, in
turn, be loaned to another successful project.
Profit maximization test
Another way to determine the productive capacity of
a particular banking system is to measure how well it utilizes its limited
financial resources. In other words, is the banking system making
effective use of ingestible funds by investing the most profitable
projects? A productive bank will prioritize projects from most profitable
to least and will extend financing to the most lucrative projects first
until it runs out of capital. This will assure the bank the highest
profit. Referring to Fig-3, the most productive
financing system would be the one that finances projects starting from
point O and proceeds along the line ON'. Two financial ratios used to
measure profit maximization are (i) Profit-Employed Fund Ratio and (ii)
Profit-Loanable Fund Ratio.
Conventional banking and profit
maximization: Conventional bank's efficiency with profit
maximization may be tested in terms of the Fig-3. Assuming availability of
investible funds and no alternative opportunities for investment,
conventional banking can maximize its profit if it finances at point
indicated by ON', where r = 0. This is impossible for conventional banking
since it charges the same rate of interest irrespective of the
profitability of the different projects. Any attempt at
financing projects beyond ONF will lead to pulling down
the level of interest rate thus reducing total profits. With the lending
rate of interest being Ori, the profit maximizing investment
level for conventional banking is thus ONF. Therefore,
the total profit (return) it earns is Ori
Conventional banking may increase the
volume of its return if the lending rate rises. This takes place at a
lower level of investment. What this means is that conventional banking is
unable to capitalize on some projects (considered as non-viable due to
high lending rate), but may be able to offset those foregone opportunities
by charging the higher rate of interest on the remaining projects.
The above analysis clearly shows that conventional
bank's productive efficiency in terms of investment opportunity
utilization works opposite to its profit maximization efficiency
criterion. Furthermore it has already been illustrated above that the
investment opportunity utilization level as well as the profit
maximization is affected by the low rate of recovery of the loans
Islamic banking and profit
maximization: Profit maximizing equilibrium of Islamic banking
takes place at a higher level of investment than its conventional
counterpart. The economy in which Islamic banking operates is in
equilibrium, according to the Fig-3, at ONV level of
investment, at point M´ where the marginal rate of return on investment is
equal to its marginal cost for all banks. The equilibrium point M'
is preferable to M since the average profit at the former point is greater
than at the latter point.
Test of elasticity in financing
Investment financing can surely be described as a
service industry. The service is provided to the entrepreneurs and
ultimately to society as a whole. Entrepreneurs' borrowing needs can
vary from short to long term. In addition, there may be a need for
temporary credit including consumption and working capital requirements.
Thus for a financing system, to be productive, it should have the
capability to respond to and fulfil all of the financing needs of the
entrepreneur. The elasticity of investment financing may be defined as a
ratio of change in short term financing to change in total investment.
where, Ef means elasticity of financing,
f means change in short-term financing,
and dI means change in total investment.
Thus, that banking system with the highest value of
elasticity measure, Ef, is considered to be more
Demand for short-term credit arises out of the need
for working capital, business transactions and consumer goods. These
financing needs are short term in nature and require quick response. Given
the nature of these financing needs, they are not placed into separate
projects categories. As a result, the profitability of these financing
needs is difficult to estimate in advance. Even where it is possible, it
may not be economical to do so in view of their cost.
It is from the above perspective that the
efficiency of both the conventional banking and Islamic banking in
short-term financing may be studied. Conventional banking, in this case,
enjoys advantages over Islamic banking in that the conventional banking
system allows for the calculation of interest for periods of any
For Islamic banking, short-term loan financing is
still a problem. It lacks specific financing arrangements necessary
to meet the working capital needs of entrepreneurs. In order
to handle this situation, Islamic banks simply add the working capital
needs to the request for Musharaka and Mudaraba,
which do not really meet the needs of the entrepreneur. Thus, working
capital financing under Islamic banking is relatively inflexible. Uzair
does not share this view. Rather, he is optimistic about the possibility
of applying profit-loss-sharing concepts to shorter-term financial needs.
He feels that this can be done through the introduction of proper
accounting methods that may help calculate profits generated from the use
of working capital on a quarterly, monthly, or on weekly basis, which
could be derived from past annual or quarterly averages (Uzair 1982). That
means according to him, if properly executed, Mudaraba and
Musharaka may also conveniently be used for financing even the
short-term working capital needs of the entrepreneurs. However, several
studies reveal that the use of these financing arrangements to provide for
the spontaneous short-term financing needs of entrepreneurs is actually a
very small percentage of total financing made under Islamic banking at
present. Of course, it is argued that most of the PLS-banks are operating
in a legal environment that does not adequately support the expansion and
smooth operation of these types of financing arrangements.
As far as the business transaction (particularly
trade financing) is concerned, the Murabaha contract is applied as
an alternative to its conventional counterpart using the bills purchased
and discounted method of financing. However, proponents of Islamic
banking prefers limiting the extensive use of Murabaha for these
short-term financing needs as they do not conform to the profit-loss
sharing characteristics of the Islamic banking system.
Islamic banking has not yet been able to devise
any alternative to consumption loan financing of its conventional
counterpart. The latest development of literature on the issue suggests
that banks under Islamic banking may separate a portion of its investible
funds for providing interest-free loans to consumers. In these
circumstances, the bank would charge the borrower a service
Allocation of resources
The Islamic banking system is very efficient in
allocating the resources of the economy. Allocating efficiency is
concerned with the best possible utilization of the community's scarce
financial resources so as to attain the maximum benefit to society. There
are two broad ways to promote economic welfare in a world of scarcity: (a)
prioritize the projects from most beneficial to least and allocate the
resources accordingly until the resources are exhausted, and (b) meet each
obligation with the least possible amount of resources (Sametz 1982,
Allocating efficiency is not only limited to
prioritizing projects in order of decreasing desirability and employing
resources according to that order, but also putting them to their best use
since all alternatives can not be satisfied simultaneously. A
question arises as to how one can be sure of the best use of funds without
having a criterion of fund allocation among projects, even if he is
provided with the prioritized order.
An optimum allocation of invest able funds may be
achieved if (a) each project in the prioritized list is given a
particular percentage weight and the funds are separated accordingly; and
(b) funds intended for a particular project should be allocated in term of
its profitability, assuming that all other conditions have been
Thus in order for an investment financing system to
be efficient, one must follow two criteria as far as allocating efficiency
is concerned: (a) projects should be prioritized in terms of decreasing
desirability, and (b) projects should be prioritized in terms of their
profitability (in descending order). Thus, one must use these two
criteria in order to measurer the efficiency of the conventional and
Islamic banking systems.
Unfortunately, these criteria do not apply to the
conventional banking system. While conventional banks take into
account the profitability of the project, the collateral position, and the
personal integrity of the borrowers, ultimately profits of a conventional
bank are not derived from the projects that are financed. Therefore,
profitability does not work ultimately as a principal criterion for fund
allocation. Chapra refers to the contention of Ralph Turvey that, under
Conventional banking, the rate of interest is irrelevant to investment
decisions and hence should be replaced by the price of existing equipment
or share prices (Chapra 1985). In Fig-3 we do not find any strong
correlation between the downward slopping r and the horizontal
On the other hand, these criteria for asset
allocation fit quite comfortably into the Islamic banking system. In
addition, it is also in conformity with the Islamic welfare
conditions developed by Mannan (1982, pp.43-47). This is true
because the very basis of Islamic banking is profit loss sharing where
profitability stands first in order among the deciding factors in
selecting a project for financing. While the first criterion narrates the
distributional aspect of resource allocation, the second allocates
resources for their most productive utilization.
The rationale behind allowing banks to use public
money to finance capital investment is obviously the contribution it makes
to economic development of a country. Today, economic development is
not merely meant for increased production or growth in the production of
goods and services. Rather it means, according to the latest evolution of
the concept, growth plus equitable distribution.
A banking system may influence distribution in two
stages. First, it influences distribution through the deployment of
financial resources among different sectors, regions and different income
groups. Secondly, it affects distribution through the incomes generated by
the financing process among the participating parties (the
depositors, the bank, and the entrepreneurs). Hence, in order for a
banking system to be an efficient one, it should ensure equitable
distribution of invest able funds among different sectors, regions and
different income groups as well as distribution of risks and returns among
the participating parties.
The criteria that might be used here for
identifying relative distributive efficiency of the two systems of banking
are as follows:
deposits and advances in terms of account size or, if possible, in terms
of income size;
or profit income ratios between the entrepreneurs and the bank, and that
of the bank and the depositors; and
classification of deposits and advances.
The institution of interest gives rise to two types
of distributional problems. The first one relates to the distribution of
income between the bankers and the depositors. The second problem relates
to income distribution among various groups of people. The first category
of inequality arises under conventional banking systems because the
bankers appropriate the benefits derived from the lending activity. The
second type of distributional problems created by the institution of
'Riba' results from its dampening effects on investment and
employment (Rushdi 1988, pp.222-3).
It can be seen from Fig-3 that conventional banking
maintains a flat rate of interest regardless of the profitability of the
projects financed by it. In other words, a bank's income under the
conventional banking system is, by no means, related to profit accrued
from the projects that it has financed. Therefore, the bank
only receives the fixed interest rate as its profit or income. The
entrepreneur is the only party that will benefit from the profits of the
With regard to the risks surrounding a financing
arrangement in the conventional banking system, the entrepreneur is
entirely responsible for any losses that are incurred. This is
consistent with the fact that conventional banks place greater emphasis on
maintaining sound collateral on each loan. In this way, the
bank protects return of both principal and interest on the loan as the
collateral can be sold to satisfy the outstanding debt, regardless of
whether or not the borrower files bankruptcy.
The conventional banks pay a fixed rate of interest
to their depositors. Thus, by charging a fixed rate of interest to its
borrowers, the bank can assure that it makes enough interest income to pay
its depositors, meet its own operational costs and also earn a profit.
This system of fixed interest rates is somewhat biased against the
borrower and in favor of the bank and depositor, because the borrower's
rate is determined in a way that assures profits to the other parties in
It is important to specify the impacts of the
above distribution on other efficiency considerations pertaining to
conventional banking. We have illustrated earlier that marginal projects
(with net rate of return closer to zero) will never be approved for
financing since the entrepreneurs prefer minimizing risks. This limits
investment opportunity utilization capacity of the conventional bank
thereby reducing productive efficiency of conventional banking.
The income distribution scheme under conventional
banking works against the goal of optimum allocation of scarce financial
resources. This is because of the fact that conventional banking, instead
of financing in terms of profitability of projects, diverts funds to
projects with sound collateral. This results in loans being made to higher
income borrowers that can meet the collateral requirements and, thus,
skews the distribution of scarce resources in society to the
Since profits are shared between the entrepreneur,
the bank and depositors in the Islamic banking system, there is no bias
towards any income sector. In fact, the bank welcomes profitable
business ventures from all income sectors. Thus, we find a strong
correlation between the incomes of these three parties. This is true
whether the issue is seen either from micro or from macro viewpoint.
a micro point of view, Islamic banks share a proportion of the profits
accrued from a project implying an equitable distribution. It is because
of the fact that the distribution remains unaffected by the volume of
profit generated from the project and the share proportion being
determined by market forces, i.e., by the demand for and supply of invest
able funds (Siddiqi 1983, pp.163-64).
Seen from a macro viewpoint, the distribution
remains unaltered since the Islamic bank receives a share of total profits
that are simply the addition of individual profits accrued from different
projects financed by the bank.
As to the distribution of income between the bank
and depositors, a standard proportion (in percentage terms) is always
maintained. Thus under the Islamic banking system, there is a strong
correlation among the incomes of the three participating
Stability efficiency is measured by the capacity of
a banking system to minimize cyclical fluctuations in an economy. The
economy, by nature, is subject to cyclical fluctuations. The intensity of
the fluctuations may differ from system to system. In other words,
differences in the operational system of different banking systems may
produce cyclical fluctuations of different scale. Here the hypothesis is
that an investment financing system that produces minimum fluctuations in
an economy may be considered more efficient.
In measuring stability efficiency of the two
systems of banking under discussion, the model developed in line with
Chisti (1985, pp.3-11) may be used. Chisti reviewed the
Miller-Modigliani theorem and Kalecki's theory of investment and also went
deeply into Minsky's interpretation of cyclical fluctuations. Finally he
firmed up Minsky's approach to analyzing the process of cyclical
According to Minsky (1982), the
fragility of the financial system depends on the relation between
contractual commitments (which are essentially interest and the principal
on debts), and the cash flows from regular operations (which are
essentially profits). With respect to this relationship he classifies
business firms into three groups, namely hedge, speculative, and
For hedge units, cash flows are expected to
exceed payment commitments on outstanding debts in every period. For
speculative units, cash commitment on debts exceeds cash flows from
regular operations only for some periods. For ponzi units, cash
payment exceeds cash flows for almost all near term periods.
During a prolonged period of tranquillity, prices
of capital assets tend to rise, and portfolio preference shifts towards
more speculative and ponzi financing. This makes the economy
very sensitive to interest rate variations. Thus, the cost of short-term
debt in the financial structure increases and the weight of cash in the
economy declines. Falling profits and rising interest costs turn some
hedge units into speculative units, and some
speculative units into ponzi ones.
When many speculative and ponzi units
find it difficult to meet payment commitments with cash flows they issue
more debts. Where it becomes increasingly difficult to meet payment
commitments by emitting more debts, ponzi/speculative units start
selling out their assets. However, when many businesses resort to generate
cash by selling out their assets, it causes a fall in asset prices. If the
asset prices fall to the level of the cost of production or even below,
new investment virtually stops. This very low level of investment exerts
pressure on profits to rise and this merry-go-round starts all
The above interpretation of the creation of
cyclical fluctuations consolidated in Minsky's own work (Minsky 1982)
is retained in the Chisti model. What Chisti has added is the
interpretation of the fixed financing condition, vis-à-vis the uncertainty
of profits to be mainly responsible for the gap between cash flows and
payment commitments. While interpreting the fixed financing condition,
Chisti agrees with the opinion that oscillations in the system are not
generated by exogenous shocks; rather they are inherently produced by the
system itself (Andronov, Vih and Khaikin, 1966; Minorsky, 1962).
The interaction between the stimulating effect of investment and the
retarding effect of the worsening financing conditions is the main force
that generates the cycles. He has explained the situation by using a Phase
Diagram (as in Fig-4).
Phase Diagram -- Cyclical Fluctuations in Investment
In region-I, both the levels of investment and
payment commitments are low. Internal funds, at this low level of
investment, may be sufficient to its financing and the excess of cash
flows over investment expenditures may be used to retire some existing
debts. At this low level of investment, prospective returns are high which
accelerates investment. This indicates the upswing of the business
In Region-II, general optimism
regarding investment continues. People forecast, in this situation, high
returns and high capitalization rates. As a result, prices of existing and
new capital goods tend to rise with the rise in investment. Under these
optimistic conditions, banks will be willing to provide more financing to
meet new investment plans. The situation is such that general long-term
assets are acquired by emitting relatively short-term liabilities. That
means a faster rise in debt payment commitments than cash
A boom in the economy characterizes region-III. At
this stage, the investment level is so high that it dampens optimism
regarding yields. High level of cash commitments tends to
lower the capitalization factor. As a result, the prices of existing
capital as well as new investment starts falling, which leads to a fall in
profits, i.e., cash flows. The payment commitments, at this stage, remain
at the same level as before. For many operating units it becomes difficult
to meet their cash commitment with their cash flows. The gap between the
two widens as businesses borrow additional funds to cover existing
obligations. At this stage, banks find lending to be very risky,
which makes refinancing more difficult. Therefore, given no other option,
the entrepreneurs are compelled to sell their assets to generate cash to
meet their payment commitments. When many adopt the same procedure, asset
prices fall and the sellers have to accept capital losses. Foreclosure,
bankruptcies and liquidating subsidiary companies increase during this
stage. With the significant fall in asset prices, new investment virtually
stops. This corresponds to Region-IV. Once the economy reaches this region
the process starts again from the bottom.
In summary, it is the difference between uncertain
cash flows and fixed payment commitments that is a major source of
instability in the economy. The magnitude of this difference depends
on the particular type of investment financing system available in the
Since the concepts of cash flows and payment
commitments have their different connotations in conventional and Islamic
banking due to differences in their operational structure, acceleration of
cyclical fluctuations in the two systems certainly differs in
model can conveniently be applied to measure roles of the two banking
systems in aggravating/reducing cyclical fluctuations in the economy and
thereby tracing their relative stability efficiency.
Conventional banking and stability
efficiency: The cyclical fluctuation process as depicted in the
Efficiency Model clearly identifies the widening gap between the payment
commitments and the cash flows as the main internal source of instability
in investment. The magnitude of the instability, however, depends on the
degree of responsiveness of cash flows to payment commitments. Since the
payment mechanism of conventional bank (conventional banking) emphasizes
maintaining of fixed rate and time of payments, the instability in
investment will be higher. The conventional banking system, by nature of
the fixed rate of interest structure, establishes an inflexible payment
schedule. Thus, the real cause of cyclical fluctuations in an economy
characterized by a conventional banking system is the fixed payment
commitments with uncertain cash flows. Henry Simmons and Joan Robinson
also support this view as referred to by Chapra (1985). Thus conventional
banking has a built-in destabilizing element (i.e., rate of interest),
which aggravates cyclical fluctuations once created in an economy.
Stability efficiency and Islamic
banking: Islamic banking has a different cash flow and payment
commitment arrangement with the entrepreneurs. Cash flows under Islamic
banking are defined as yields generated from regular operation of projects
(which essentially mean profits for entrepreneurs). Payment commitments,
on the other hand, are promises made to the bank by the entrepreneurs to
pay a certain percentage of profits generated by the project along with
repayment of principal. In other words, entrepreneurs commit to pay a
certain percentage of profits, not a fixed percentage of the loaned
amount. Thus, entrepreneurs pay less when profit is lower, and they pay
more when it is higher. Moreover, if profit is zero, they pay nothing to
the bank and if there is loss entrepreneurs are not obliged to pay any
profit, rather the bank shares the loss in proportion to its capital
participation. This system of payment, by its very nature, results in the
reduction of the spread between profits or cash flow and payment
commitments. Now let us show how the payment commitment arrangement under
Islamic banking helps reduce cyclical
fluctuations. Let us
recall the phase-diagram (Fig-4). Suppose we are in the Region I. At this
stage, both the cash commitments (C) and investment (I) is low. Thus, f
> 0; g < 0. The low level of investment can be financed by internal
funds. Prospective yields being high, stimulates further investment.
Region II is characterized by a continuous rise in
investment. Here, entrepreneurs go on expecting still higher prospective
returns. This leads them to increase investment by turning to external
financing. In addition they are further encouraged by the financing
arrangement that part of the risk will be borne by the financier. On the
other hand, financiers will be cautious in financing since they are aware
that if there is any loss they will be obligated to share in proportion to
their capital contribution.
In region III, the economy enters into the late
stage of the boom. High levels of investment, at this stage, dampen
forecasts of prospective and actual yields. However, unlike the fixed
interest rate case, where cash payments remain the same, payment
commitments under the Islamic banking system are adjusted to the decline
in cash flows. Therefore, there is not as large a need to refinance
existing debts or to take on additional debt in order to meet current
payment obligations, like in the conventional banking system. Moreover,
the terms of refinancing may not be as stringent as the situation that
arises when a borrower is unable to meet his current obligations.
Therefore, one can expect that level of investment will not fall as
drastically as it does in the conventional banking
In Region IV, the final phase of the cycle, there
is a drastic reshuffling of portfolios to generate additional cash to meet
the payment commitments. This results in a sharp drop in the price of
capital assets, which results in chaos in the financing industry. The main
reason for this chaos is the 'spread' between cash flows and payment
commitment. In the Islamic banking system, however, the difference between
cash flows and payment commitments is not as drastic as in the
conventional banking system. Therefore, there are not as many
foreclosures, bankruptcy cases and liquidations of business assets,
resulting in a more stable economy during this stage. The flexibility and
the built-in stabilizing capacity of the Islamic banking system
automatically adjusts the spread and keeps the capital markets and
financing under control. Thus, given this natural stabilizing attribute of
the Islamic banking system, it can be stated that it has higher stability
efficiency than its counterpart.
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