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| Volume IX, March 2002, Number 1 |
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| EXCERPT: Principles of Islamic Banking: Debt versus Equity Financing |
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| Mohammed Akacem and Lynde Gilliam |
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Dr. Akacem is a professor and Dr. Gilliam an associate professor, both in the Department of Economics, Metropolitan State College of Denver.1
It is difficult to pinpoint the start of
Islamic banking, but the consensus is
that it took place in Egypt in the
1960s.2 The Egyptian experiment did not last very long, and it was not until the mid 1970s before Islamic banking started to take hold in many Muslim countries. The change can partly be explained by two main factors. First, the 1970s saw two oil-price shocks, which led to a massive transfer of wealth from the oil-consuming to the oil-producing countries. The accompanying increase in per capita income led many to seek an alternative to traditional banking that was consistent with Islamic teaching. Second, the second oil shock coincided with the Iranian revolution, which brought about the Khomeini government and the first Islamic republic. Thus began an Islamic revival that spread to other countries and paved the way for more financial institutions of the Islamic type.
This paper looks at Islamic banking as a model of equity finance. Debt financing by conventional banks has experienced crises both in the 1930s and more recently in the 1980s with the savings-and-loan
(S & L) and banking crises in the United States. Initially the U.S. answer was to institute deposit insurance in order to eliminate or at least minimize bank runs. However, that has caused both banks and S & Ls to assume more risk at the cost of greater taxpayer exposure because they lacked the incentive to be risk averse. The current U.S. banking model of debt finance together with an implicitly unlimited3 deposit insurance results in the socializing of loss and the privatizing of gain.
While the U.S. banking system represents the debt-finance model, the Japanese financial structure presents an interesting combination of both this model and the Islamic equity-finance structure. The evidence shows that the growth of Japan's economy in the postwar period was greatly enhanced by the willingness of its banks to both lend money and assume equity stakes in the country's manufacturing and industrial sector.
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1 For an earlier treatment of this subject, see Mohamed Akacem, "Islamic Economics: Equity Banking as an Approach to Prosperity," Economic Direction, Summer 1993.
2 It was started by Ahmed El-Naggar, who is recognized as the father of Islamic Banking. El-Naggar's objective in introducing interest-free banking to Egypt was to link up the often forgotten rural areas with the rest of the economy by establishing financial institutions. This is still a problem in many developing economies. Thus, his overall concern was with rural economic development, as this sector housed the majority of the country's population. Islamic banks continue to be accused of departing from their primary mission, which is to fund projects consistent with the social and development needs of the country.
3 Because of the "too big to fail" theory. There are numerous examples in the United States where big banks were not allowed to fail because of their size and their ultimate impact on the financial structure and the economy. Thus, the $100,000 deposit insurance has become irrelevant. The current U.S. Treasury proposal is an attempt to address the open-ended exposure of the bank-insurance fund and ultimately, U.S. taxpayers.
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