Salman Syed Ali^
Introduction
Banking crises are particularly harmful for the economy and detrimental
for the health of financial sector. The cost of any banking crisis is not the
fiscal burden on government because it is simply a redistribution within the
economy—though, this redistribution can have second order welfare effects
in terms of envy and dissatisfaction etc. But the real cost of a banking crisis is
(i) the deadweight loss and (ii) the consequence of any diversion in
macroeconomic policy forced by the crisis. In context of Islamic banking the
cost also is the reputation damage to the nascent industry; a slowdown in new
developments towards interest free alternatives for the people; and
consequently a drag on realization of potential benefits for the society from
Islamic finance.
However, a milder crisis has its advantages too. That it may help avert a
more serious crisis. It may improve the efficiency of the banking sector by
shaking out the inefficient banks. It may force practitioners and researchers
to think hard for better approaches to run the financial system. Thus,
theoretically speaking, a few and small crisis are better than no crisis at all
because they keep the system on guard such that the long run benefits may
outweigh their costs.
The literature on banking crisis identify that the banking structure by its
nature is unstable and therefore itself contributes to the occurrence of crisis.
Being a deposit taking institution the liabilities of a bank are fixed and a fixed
interest is promised on them, while its assets in the form of loans are subject
(^) Economist, Islamic Research and Training Institute, Islamic Development Bank.