MONETARY SYSTEM IN ISLAMIC (INTEREST-FREE) FRAMEWORK

Monetary system in Islamic (interest-free) framework

Monetary system in Islamic framework

The first modern experiment with Islamic banking can be traced to the establishment of the Mit Ghamr Savings Bank in Egypt in 1963. During the past four decades, however, Islamic banking has grown rapidly in terms of size and the number of players. Islamic banking is currently practiced in more than 50 countries worldwide.1 In Iran, Pakistan, and Sudan, only Islamic banking is allowed. In other countries, such as Bangladesh, Egypt, Indonesia, Jordan and Malaysia, Islamic banking co-exists with conventional banking. Islamic banking, moreover, is not limited to Islamic countries. In August 2004, the Islamic Bank of Britain became the first bank licensed by a non-Muslim country to engage in Islamic banking. The HSBC, University Bank in Ann Arbor and Devon Bank in Chicago offer Islamic banking products in the United States. Recent industry estimates show that Islamic banking, which managed around US$250 billion worth of assets worldwide as of 2004, is expected to grow at the rate of 15% per annum.

The rapid growth of Islamic banking raises a series of important questions: Is the growth in Islamic banking a result of the comparative advantages of the Islamic banking paradigm or is it largely attributable to the worldwide Islamic resurgence since the late 1960s? Should Islamic banks be regulated differently from their western counterparts? Thus, an important question in understanding the growth - as well as the regulation and supervision - of Islamic banking is how and to what extent it differs from conventional banking. To answer these questions, our study focuses on Malaysia, where a full-fledged Islamic banking system has developed alongside a conventional-banking system. The dual banking system in Malaysia, in particular, provides a unique setting for us to compare Islamic banking practices with those of conventional banking. In addition, Malaysia, which is reported to have the largest Islamic banking, capital, and insurance markets in the world (World Bank, 2006), is an ideal representative of Islamic banking practices in general.

From a theoretical perspective, Islamic banking is different from conventional banking because interest (riba) is prohibited in Islam, i.e., banks are not allowed to offer a fixed rate of return on deposits and are not allowed to charge interest on loans. A unique feature of Islamic banking is its profit-and-loss sharing (PLS) paradigm, which is predominantly based on the mudarabah (profit-sharing) and musyarakah (joint venture) concepts of Islamic contracting. Under the PLS paradigm, the assets and liabilities of Islamic banks are integrated in the sense that borrowers share profits and losses with the banks, which in turn share profits and losses with the depositors. Advocates of Islamic banking, thus, argue that Islamic banks are theoretically better poised than conventional banks to absorb external shocks because the banks' financing losses are partially absorbed by the depositors ([Khan and Mirakhor, 1989] and [Iqbal, 1997]). Similarly, the risk-sharing feature of the PLS paradigm, in theory, allows Islamic banks to lend on a longer-term basis to projects with higher risk-return ...