Understanding Islamic Finance - Doha Academy of Tertiary Studies

The Philosophy and Features of Islamic Finance 93banks and the exogenous factors. The central bank would gear its monetary policy to thegeneration of growth in the money supply, which is neither “inadequate” nor “excessive”but just sufficient to exploit fully the capacity of the economy to supply goods and servicesfor broad-based welfare.Commercial banks’ deposits constitute a significant part of the overall money supply.These deposits may be “primary deposits”, which provide the banking system with the basemoney (cash-in-vault + deposits with the central bank) or “derivative deposits”, which, ina proportional reserve system, represent money created by commercial banks in the processof credit extension and constitute a source of monetary expansion. Since derivative depositsalso lead to an increase in money supply, the expansion in derivative deposits needs also tobe regulated if the desired monetary growth is to be achieved. This could be accomplished byregulating the availability of base money to the commercial banks and restricting the banksfrom making the “cash reserves” ineffective through their reserve-sweep programmes. 18Corrective measures would be needed to set aside the impact of exogenous factors asfar as possible. These measures would include the use of monetary tools, e.g. moppingup liquidity in case the money supply increases due to capital inflows and investing thefunds in commodity-producing avenues so that the increase in money supply is matched byan increase in the supply of goods and services with a proper gestation period and in thelong run.The whole discussion on the creation of money and credit in the available literature onIslamic finance is centred on the assumption that the Islamic finance model is based on atwo-tier Mudarabah or Shirkah system for the mobilization and use of funds. Although theIslamic banking system in vogue is not based on this model and Islamic banks are usingfixed-income modes, yet it is worthwhile to briefly discuss the stance of Islamic economistson this important area with far-reaching implications.The institution of credit and bank money has been an important key issue discussed byIslamic economists. Early writers on Islamic economics saw something morally wrong incredit money. Some doubted its need and ascribed its proliferation to the vested interestsof the banks that gain a lot out of thin air or of no air at all, create an artificial purchasingpower and take advantage of the demand for it. This demand is also illicitly created bythose who have managed to liquidate their assets and prefer to enjoy a guaranteed incomeagainst their withheld money. They advocate a 100 % reserve system. Such economists saythat if any extra money is needed for financing fresh transactions, it should be issued by thecentral bank.Those who favour credit creation have argued that in the Islamic system of banking,credit will be created only to the extent that genuine possibilities of creating additionalwealth through productive enterprise exist. Demand for profit-sharing accommodation willbe limited by the extent of the available resources and the banks’ ability to create credit willbe called into action only to the extent of this demand, subject to the constraint imposed byprofit expectations that satisfy the banks and their depositors. They say that credit shouldnot be ascribed in any way as being the child of interest, as banks’ ability to create credit isindependent of the terms and conditions on which it is created.All Islamic economists, however, realize that interest is the villain and if a measuredamount of credit and money is generated in the market without the involvement of interest,18 For the latest tactics of conventional banks in creating fictitious money and their impact, see Hatch, 2005.