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 decision model.

Key Assumptions
  1. The investment decision model is based on the following assumptions:

  2. This is an economy where both the conventional and Islamic banks operate side by side.

  3. Customers are well aware of the functioning of the two systems of banking.

  4. Religious considerations do not affect rational behavior of the borrowers and bankers.

  5. Investment decisions in the money market are not affected by the operation of capital market.

  6. There is no change in price level.

  7. There is only one market rate of interest prevailing in the economy.

  8. There is no shortage in supply of credit in the money market.

  9. 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 way:

                              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 stated as:

                              I = f(ri, r)...................(1)

                                       dI            dI

                              with -- < 0;       -- > 0 

                                       dri          dr

where, I represents level of investment, ri the rate of interest and r the rate of return from the project.


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., (1-l)r .......... (2)      

lr = entrepreneur's rate of return.    

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.


We find some additional features of the Fig-3. These are:

  1. ri curve is a horizontal line parallel to X-axis.

  2. rf curve is downward sloping and meets with the r curve at its lower level compared to where ri curve meets, and

  3. The equilibrium under Islamic banking takes place at a higher level of investment (ONV) than that of the Conventional banking (ONF).

Banking efficiency

Banking efficiency can be tested by employing the following tests:

  • Productivity

  • Allocation of resources

  • Distributive justice

  • Economic stability

These are now discussed one by one as:

Productivity tests

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:

  1. Investment opportunity utilization test

  2. Project efficacy test

  3. Loan recovery test

  4. Profit maximization test and

  5. 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

In 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 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 level.


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 unutilized.


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 of interest. 


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

In 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 profitable projects.


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 finances. 


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 system.

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 considered.


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 MN.


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 advanced.


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. Thus,


 E=  --             ....................................(3)    



where, Ef means elasticity of financing, df 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 productive.


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 length.


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 fee.

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, p.413).


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 satisfied.


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 ri curves.


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.

Distributive justice

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:

  1. Classifying deposits and advances in terms of account size or, if possible, in terms of income size;

  2. Interest-income or profit income ratios between the entrepreneurs and the bank, and that of the bank and the depositors; and

  3. Rural-urban 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 business venture.


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 the transaction.

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 wealthy.   


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.


From 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 factors.

Economic stabilitys

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 fluctuations.


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 ponzi. 


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 over.


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--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 cycle.


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 flows.


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 economy. 


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 magnitude.


The aforementioned 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 system.           


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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