108 AN INTRODUCTION TO ISLAMIC FINANCE
contingencies. What is missing here is the element of mutuality. Each poli-
cyholder deals directly with the insurance company without the need to
know any other policyholder. For instance, if plant catches fi re in a factory,
the owner does not have to bear the full cost of rebuilding the plant. The
insurance company can cover this because it pools the resources of a large
number of such policyholders. Since fi res do not occur simultaneously in all
insured fi rms, an insurance company is expected to be in a position fi nan-
cially to replace one or a number of destroyed plants.
Stability of the Financial System
While, in our opinion, Islamic fi nance would be inherently stable (see
Chapter 7) because it is structured on a foundation of equity fi nancing and
risk sharing, conventional fi nance, a debt - and - interest - based system, has
proven to be unstable. Minsky has dubbed the instability of conventional
fi nance as “endogenous instability” because conventional fi nance experi-
ences a three - phased cycle: relative calm, speculation and fi ctitious expan-
sion, and then crisis and bankruptcy. Bankruptcy in conventional fi nance is
not limited to the private sector as governments can also face bankruptcy.
Again, recent historical analysis has demonstrated that all fi nancial, bank-
ing and currency crises are, at their core, a crisis arising from debt.^4 In the
recent past, the widespread bankruptcies of many developing countries have
entailed debt cancellation or forgiveness. This is often because governments
that borrowed at what were considered reasonable debt levels (normally
as measured by debt: GDP) later found themselves in an unsustainable
debt spiral as a result of increased debt service obligations. Some countries
even found themselves with debt levels many times larger than the original
amount of borrowed principal.
These developments have helped the perpetuation of a system that a
number of renowned economists, including Keynes, have deemed detrimen-
tal to growth, development and to equitable income and wealth distribution.
More recently, a growing literature and proposed reforms have argued
that the stability of a fi nancial system can only be assured by limiting
credit expansion and leveraging; this in turn requires the elimination of
subsidies that fuel moral hazard, such as subsidized deposit insurance
schemes and guarantees that support “too large to fail” institutions,
and restrictions to limit the creation of money through the fractional-
reserve conventional banking system. Islamic fi nance, based on risk sharing
and limiting fractional - reserve banking, has been shown to be inherently
stable and socially more equitable. In such a system, there is a one - to - one
mapping between the growth of fi nancial and real sector activities, mean-
ing that credit cannot expand or contract independently of the real sector
as in the conventional system. In other words, the real and the fi nancial
sectors are closely connected and cannot be decoupled as in conventional
fi nance.