113CHAPTER
6The Islamic Financial System
T
he primary role of a fi nancial system is to create incentives for an effi cient
allocation of fi nancial and real resources for competing aims and objec-
tives across time and space. A well - functioning fi nancial system promotes
investment by identifying and funding good business opportunities, mobi-
lizes savings, monitors the performance of managers, enables the trading,
hedging and diversifi cation of risks, and facilitates the exchange of goods
and services. These functions ultimately lead to the effi cient allocation of
resources, rapid accumulation of physical and human capital and faster
technological progress, which, in turn, feed economic growth.
Within a fi nancial system, fi nancial markets and banks perform the
vital functions of capital formation, monitoring, information gathering, and
facilitation of risk sharing. An effi cient fi nancial system is expected to per-
form several functions. First, the system should facilitate effi cient fi nancial
intermediation to reduce information and allocation costs. Second, it must
be based on a stable payment system. Third, with increasing globalization
and demands for fi nancial integration, it is essential that the fi nancial system
offers effi cient and liquid money markets and capital markets. And, fi nally,
it has to have a well - developed market for risk trading, where economic
agents can buy and sell protection against event risks as well as fi nancial
risks.
Research on fi nancial intermediation and fi nancial systems in the past two
decades has enhanced our understanding of the signifi cance of the fi nancial
system and the crucial role it plays in economic development. For example,
studies have shown that countries with higher levels of fi nancial develop-
ment grow faster by about 0.7 percent a year. Between 1980 and 1995, 35
countries experienced fi nancial crises. These were, essentially, periods during
which the fi nancial systems of these economies stopped functioning and, as
a consequence, their real sectors were adversely affected, which led to reces-
sions. Although strong evidence points to the existence of a relationship
between economic development and a well - developed fi nancial system pro-
moting effi cient fi nancial intermediation through a reduction in information,
transaction and monitoring costs, this linkage and the direction of causation
An Introduction to Islamic Finance: Theory and Practice, Second Edition
by Zamir Iqbal and Abbas Mirakhor
Copyright © 2011 John Wiley & Sons (Asia) Pte. Ltd.