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Remedy for Banking Crises: What Chicago and Islam Have In Common: A Comment

Al-Jarhi, Mabid (2004): Remedy for Banking Crises: What Chicago and Islam Have In Common: A Comment. Published in: Islamic Economic Studies , Vol. 11, No. 2 (2004): pp. 23-42.

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Stability is a basic requirement for the proper functioning of the banking system and a key to its contribution to growth and development. Repeated failure of banks led some economists to believe that the banking and financial system may be suffering from structural problems and is in need of fundamental reform (Spong, 1993]. The Islamic monetary system is known to consider demand and investment deposits as two distinct contracts. Demand deposits are merely loans that are fully guaranteed by banks and must be returned on demand. Investment deposits are given to banks on a profit-and-loss sharing basis. They are clearly associated with risk-taking and have specific maturities which, in principle, are not revocable. That is why some economists insisted on the total separation between demand and investment deposits through subjecting the former to 100 percent required reserves (Al-Jarhi 1981, 1983). Compared to conventional finance, this sounds like narrow banking. Kenneth Spong [1993) argues that narrow banking would improve the competitiveness of banks and makes them more market responsive. With regard to the latter point, he suggests that narrow banking would make deposit insurance unnecessary. Garcia, Marino and Cibils (2000) find similarities between narrow banking and Islamic banking. As narrow banking seems to be an uncommon concept among specialists in Islamic economics, this comment is rather expanded to explain the what and why of narrow banking, how it relates to banking theory, its relationship with the long series of proposals for monetary reform, its pros and cons, and finally how it relates to Islamic banking. The paper concludes that narrow banking has merits that become especially obvious when other opportunities of investment outside the banking sector are recognized. It bears similarities with Islamic banking, to the extent that demand deposits are guaranteed both theoretically and practically. Under narrow banking, the role of investment banks would carry features similar to Islamic banking when the relationship between savers and banks are considered. However, when it comes to financing investment, Islamic banks avoid trading future for present money, while conventional investment banks stick to the interest-based modes of finance.

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