M. Umer Chapra
Research Adviser
IRTI/IDB
Jeddah (Saudi Arabia)

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Why a new system of financial intermediation? Is there anything wrong with the prevailing interest-based system ?
Evaluation of a system on the basis of its contribution to :
 Efficiency
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Ease and promptness in the transfer of funds from the surplus to the deficit sectors
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Economy in transactions costs
Stability
 Equity
(Socio-economic justice)

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Interest-based system was never considered to be superior on the criterion of equity. Its superiority claimed on the criterion of efficiency, why?
Confidence in the Efficiency of the system has been shaken by its persistent instability over the last four decades .

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Call for a “New Architecture”
 Sound Macro-economic policies
 Sustainable exchange rates
 Proper regulation and supervision
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Adequate capital, proper risk management, effective corporate governance, greater transparency
 Why is market discipline unable to ensure the faithful observance of these principles?

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Reasons for the ineffectiveness of market discipline in the interest-based banking system:
 As a result of the absence of risk-sharing:
 Deposits are guaranteed - therefore depositors become complacent and do not monitor the banks carefully - do not demand transparency
 Banks rely on the crutches of collateral, which ensures the repayment of their loans - they do not evaluate the risks carefully - tend to extend credit excessively. This promotes:
 Public sector deficits
 Private sector living beyond means
 Highly leveraged short-term debt
 Rapid movement of funds
 Volatility
The greater the reliance on debt and the higher the leverage, the more severe the crises

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Some Examples:
 East Asia Crisis
 Long-term Capital Management (LTCM)
 Foreign Exchange Markets
 Remedy lies in injecting greater discipline in the financial system – How?
 Introduce risk sharing to make market discipline more effective
 More effective discipline will complement the role of regulators and supervisors and help make the financial system healthier and more stable

 Interest-free finance is intended to inject the needed discipline into the financial system through risk-sharing:
 Risk-sharing by banks ?
 The bank shares in the risk with the entrepreneur
 Risk-sharing by depositors ?
 Demand deposits
(These do not share in the risks and do not therefore get any return –must be guaranteed)
 Investment deposits
(These must share in the risks – just like shareholders)

 What about credit ?
 There is credit and the rate of return is fixed in advance – Is this interest ?
 There is no borrowing and lending – Rather there is purchase and sale of goods and services.
 The financier bears some risk in the sales-based modes of financing : murabahah, ijarah, salam and istisna ‘
 Wouldn’t this bring instability: NO
 Credit expands in step with the growth of the real sector
 Speculation minimized as a result of risk-sharing

 This shows that even though
Islamic finance is more difficult it can be more efficient.

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 Living beyond means
 Need fulfillment
 Full employment
 Equitable distribution?