An economic theory of Islamic finance

Al-Jarhi, Mabid (2016): An economic theory of Islamic finance.

Abstract

We have demonstrated by using macroeconomic, banking and finance theories that Islamic finance, when applied according to our paradigm (Al-Jarhi, 1981) would have distinct advantages. In addition, it provides a justifiable prescription for reforming the contemporary market economy. The advantages of Islamic finance formulated above, although noteworthy, are not sufficient to induce Islamic bankers to be true to Islamic finance. The reason is that such advantages are mostly external and can only induce behavior after being internalized. An important policy implication is that such internalization is left to banking and finance regulators. Only when the license of Islamic banking is strictly enforced by the monetary authority that Islamic bankers would stop mimicking conventional finance. Our main policy implications are only one headline that requires more detailed explanation that is found somewhere else (Al-Jarhi, 2014). In addition, some Islamic finance contracts require special guidelines in order to reduce the amount of information asymmetry associated with them. In addition, certain modifications have to be introduced to the corporate governance of Islamic banks, especially in allowing investment account holders to be represented on their boards of directors.

• Item Type: MPRA Paper
• Language: English
• Keywords: Keywords: Islamic monetary economics, Islamic finance, information asymmetry, adverse selection, moral hazard, lemon problem, nominal transactions, real transactions, debt sustainability, monetary policy.
• Subjects: E - Macroeconomics and Monetary Economics > E0 - General > E03 - Behavioral Macroeconomics; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates; E - Macroeconomics and Monetary Economics > E4 - Money and Interest Rates > E42 - Monetary Systems ; Standards ; Regimes ; Government and the Monetary System ; Payment Systems; G - Financial Economics > G0 - General > G02 - Behavioral Finance: Underlying Principles; G - Financial Economics > G2 - Financial Institutions and Services > G20 - General

References

1. Al-Jarhi, Mabid Ali (1981), "A Monetary and Financial Structure for an Interest-Free Economy: Institutions, Mechanism and Policy''. Seminar on Monetary and Fiscal Economics of Islam Islamabad, available in Ahmad, Ziauddin, et al (eds.) Money and Banking in Islam, Islamabad, Institute of Policy Studies, 1983. pp. 69-87.

2. Al-Jarhi, Mabid Ali (2002), “Transactions in Conventional and Islamic Economies: A Comparison,” in Habib Ahmad, Ed., Theoretical Foundations of Islamic Economics, Book of Readings No. 3, International Institute of Islamic Thought (IIIT), Islamabad, Islamic Educational and Cultural Organization (ISESCO), Rabat, Islamic Research Institute, Islamabad, and Islamic Research and Training Institute, Jeddah, 2002.

3. Al-Jarhi, Mabid Ali (2003) “Islamic Banks & Universal Banks: Need for Leveled Playing Field,” A paper presented to the International Seminar on Islamic Banking: Risk Management, Regulation and Supervision, organized by The Ministry Finance Indonesia, the Central Bank Indonesia and the Islamic Research and Training Institute (Member of Islamic Development Bank Group), Jakarta, Indonesia, September 30 - October 2.

4. Al-Jarhi, Mabid Ali (2003) “Narrow Banking and Islamic Banking,” Islamic Economic Studies. 5. Al-Jarhi, Mabid Ali (2004), “Islamic Finance: An Efficient & Equitable Option”, Mimeo The Islamic Research and Training Institute, the Islamic Development Bank, placed by the World bank on the link: http://www.iefpedia.com/english/wp-content/uploads/2009/11/ISLAMIC-FINANCE-AN-EFFICIENT-EQUITABLE-OPTION.pdf

6. Al-Jarhi, Mabid Ali (2007), “The Philosophy of Islamic Banking and Finance, “Keynote address, Conference on Islamic Banking and Finance, January 5 – 7, 2004, Darussalam, Brunei, jointly organized by University of Brunei, Darussalam and Islamic Research and Training Institute, IDB. Published in Salman Syed Ali & Ausaf Ahmad, eds., Islamic Banking and Finance: Fundamentals and Contemporary Issues, Islamic Research & Training Institute, Islamic Development Bank.

7. Al-Jarhi, Mabid Ali (2014) “Towards an Economic Theory of Islamic Finance Regulation,” Journal of Islamic Banking and Finance, March, Vol. 2, No. 1, pp. 345-366

8. Al-Jarhi, Mabid Ali (2016), “Islamic finance at crossroads,” to be presented to the 11th International Conference of Islamic economics and Finance, Kuala Lumpur, October.

9. Al-Jarhi, Mabid Ali and Munawar Iqbal (2001) Islamic Banking: Answers to Some Frequently Asked Questions, Occasional Paper No. 4, Islamic Research and Training Institute, Jeddah.

10. Aoki, Masahiko (2013), "The Contingent Governance of Teams: Analysis of Institutional Complementarity," in: Comparative Institutional Analysis, chapter 14, pages 230-249 Edward Elgar Publishing.

11. Calomiris, Charles W. (2000), U.S. Bank Deregulation in Historical Perspective, New York: Cambridge University Press. 12. Chachi, Abdelkader (2005), “Origin and Development of Commercial and Islamic Banking Operations,” J. KAU: Islamic Econ., Vol. 18, No. 2, pp. 3-25 (1426 A. H.)

13. Cole, Harold L. and Narayana Kocherlakota (1998), “Zero Nominal Interest Rates: Why they’re good and how to get them,” Federal Reserve Bank of Minneapolis Quarterly Review, 22 (Spring 1998): 2-10.

14. Contessi, Silvio, Li Li, and Katheryn Russ (2013), “Bank vs. Bond Financing Over the Business Cycle,” Economic Synopses, Federal Reserve Bank of St. Louis, Number 31.

15. Correia, Isabel and Pedro Teles (1997) The Optimal Inflation Tax, Discussion Paper 123, Institute for Empirical Macroeconomics, Federal Reserve Bank of Minneapolis, Minneapolis, Minnesota, August.

16. Dewenter, Kathryn L. and Alan C. Hess (1997), “Risks and Returns in Relationship and Transactional Banks: Evidence from Banks' Returns in Germany, Japan, the U.K., and the U.S.,” Wharton Financial Institutions Center, Working Paper 97-23, May. http://fic.wharton.upenn.edu/fic/papers/97/hess.pdf

17. Goodfriend, Marvin (2000), “Overcoming The Zero Bound On Interest Rate Policy, “Journal of Money, Credit, and Banking, (November, Part 2).

18. Greenwood, Jeremy and Bruce Smith (1997), “Financial Markets in Development, and the Development of Financial Markets,” J. Econ. Dynamics and Control, Jan. 1997, 21(1), pp. 145–81.

19. Ireland, Peter N. (2000), Implementing the Friedman Rule, NBER, June.

20. Kalemli-Ozcan, Sebnem, Bent, E. Sorensen and Oved Yosha (1999), “Risk Sharing and Industrial Specialization: Regional and International Evidence”, 1999 North American Winter Meetings of the Econometric Society.

21. Levine, Ross (1997), “Financial Development and Economic Growth: Views and Agenda,” Journal of Economic Literature Vol. XXXV (June), pp. 688–726.

22. Lucas, Robert E., Jr. (1994), "On the welfare cost of inflation," Working Papers in Applied Economic Theory 94-07, Federal Reserve Bank of San Francisco.

23. Miwa, Yoshiro and J Mark Ramseyer (2000), “Corporate Governance in Transitional Economies: Lessons from the Prewar Japanese Cotton Textile Industry,” Journal of Legal Studies, Vol 21, No. 1.

24. Mohsin S. Khan, (1986). "Islamic Interest-Free Banking: A Theoretical Analysis," IMF Staff Papers, Palgrave Macmillan, vol. 33(1), pages 1-27, March.

25. Nyankomo, Marwa & Zhanje Stephen (2015), “A Review Of Finance–Growth Nexus Theories: How Does Development Finance Fit In?” Studies in Business and Economics, Vol 10 No. 1, April.

26. Razin, Assaf, Efraim Sadka, and Chi-Wa Yuen (1998), “Capital Flows with Debt- and Equity-Financed Investment: Equilibrium Structure and Efficiency Implications,” IMF Working Paper, WP/98/159, November.

27. Samuelson, Paul A. (1958), “An Exact Consumption-Loan Model of Interest with or Without the Social Contrivance of Money,” The Journal of Political Economy, Volume LXVI, No. 6, December.

28. Uhlig, Harald, (2000) “Should We be Afraid of Friedman’s Rule, ” Humboldt University, Berlin, 58, June.

29. Vaona, Andrea (2005), “Regional Evidence on the Finance-Growth Nexus,” University of Verona, Department of Economics, Working Paper 30/2005.

30. Wilson, Charles (1979), “An infinite horizon model with money,” In General equilibrium, growth, and trade, ed. Jerry R. Green and José Alexandre Scheinkman, pp. 81–104. New York: Academic Press.

31. Wolman, Alexander L. (1997), “Zero Inflation and the Friedman Rule: A Welfare Comparison,” Federal Reserve Bank of Richmond Economic Quarterly Volume 83/4 Fall.