116 AN INTRODUCTION TO ISLAMIC FINANCE
infrastructure. This section discusses the theoretical design of the banking -
style fi nancial intermediation and the capital markets when operating under
the Shari’ah legal system. When compared to the conventional system, the
Islamic fi nancial system has two distinct features: fi rst, as we have seen,
the prohibition of riba results in the elimination of debt and, ultimately,
opportunities to create leverage in the system. Second, the fi nancial system
promotes risk sharing through modes of transactions designed to share risks
and rewards on more equitable grounds.
The Islamic fi nancial system proposes a sound banking system which
operates without debt and promotes fi nancing of the real economy. The risk -
sharing nature of the system means that stock markets play a vital role and
are expected to form a large segment of the system. Where the conventional
system is dominated by the debt market, followed by the banking sector and
the stock market, in an Islamic system there is no debt market. Researchers
have argued that the debt market has been replaced by an active and vibrant
market of securitized assets, bears some resemblance to the conventional
asset - based debt market but has its own distinct features that enable it to
behave and operate differently.
The Banking System
As discussed in the previous chapter, there are several contracts or instru-
ments which facilitate fi nancial intermediation and banking in the Islamic
fi nancial system. Although committed to carrying out their transactions in
accordance with the rules of the Shari’ah, Islamic banks perform the same
essential functions as banks in the conventional system. That is, they act
as the administrators of the economy’s payments system and as fi nancial
intermediaries. The need for them in the Islamic system arises precisely for
the same reason as that in the conventional system. That is, generally, their
raison d’etre is the exploitation of the imperfections in the fi nancial markets.
These imperfections include the imperfect divisibility of fi nancial claims,
transaction costs associated with the search, acquisition, and diversifi cation
for the surplus and defi cit units, and the lack of market expertise and econo-
mies of scale in monitoring transactions.
This brief review of the contracts available under the Islamic economic
system leads us to conclude that transactional and fi nancial contracts (as
discussed in Chapter 4), coupled with intermediation contracts, offer a com-
prehensive set of instruments with varying fi nancing purposes, maturities
and degrees of risk, to satisfy the needs of diverse groups of economic agents
in the economy. This set of instruments can be used to design a formal
model for an Islamic fi nancial intermediary (IFI) or an Islamic bank that can
perform the typical functions of resource mobilization and intermediation.
By utilizing this set of intermediation contracts, an IFI will be able to offer
a wide array of commercial - and investment - banking products and services.
Formally, three theoretical models have been suggested for the structure
of Islamic fi nancial intermediation and banking. The fi rst model is commonly