The Islamic Financial System 119
murabahah, ijarah, istisna’, mudarabah and musharakah investments on
their assets side.
The banks in the Islamic fi nancial system can reasonably be expected
to exploit economies of scale as their counterparts do in the conventional
system. Through their ability to take advantage of these imperfections, they
alter the yield relationships between the surplus and defi cit fi nancial units and
thus provide lower costs to the defi cit units and higher returns to the surplus
units than would be possible with direct fi nance. Just as in the conventional
fi nancial system, the Islamic depository enables fi nancial intermediaries to
transform the liabilities of business into a variety of obligations to suit the
preferences and circumstances of the surplus units. Their liabilities consist
of investments/deposits and their assets consist mainly of instruments of
varying risk/return profi le. These banks are concerned with decisions relat-
ing to such issues as the nature of their objective functions, portfolio choice
among risky assets, liability and capital management, reserve management,
the interaction between the assets and liabilities sides of their balance sheets
and the management of off - balance - sheet items — such as revolving lines of
credit, standby and commercial letters of credit and bankers’ acceptances.
Moreover, as asset transformers, these institutions become risk evalu-
ators and serve as fi lters to evaluate signals in a fi nancial environment with
limited information. Their deposit liabilities serve as a medium of exchange
and they have the ability to minimize the cost of transactions that convert
current income into an optimal consumption bundle. One major difference
between the two systems is that, given the prohibition against taking interest
and the fact that they have to rely primarily on profi t sharing, the Islamic
banks have to offer their asset portfolios of primary securities in the form of
risky open - ended “mutual fund” - type packages for sale to investors/deposi-
tors. In contradistinction to the Islamic system, banks in the conventional
system keep title to the portfolios they initiate. These assets are funded by
the banks through issuing deposit contracts, a practice that results in sol-
vency and liquidity risks, since their asset portfolios and loans entail risky
payoffs and/or costs of liquidation prior to maturity, while their deposit
contracts are liabilities that are often payable instantly at par. In contrast,
Islamic banks act as agents of investors/depositors and therefore create a
pass - through intermediation between savers and entrepreneurs.
In short, Islamic fi nancial intermediaries are envisioned to intermediate
on a “pass - through” basis such that the returns (positive or negative) on the
assets are passed to the investors/depositors. The intermediary will apply
fi nancial engineering to design assets with a wide range of risk–return pro-
fi les to suit the demands of the investors on the liabilities side.
Capital Markets
Conventional capital markets can be broadly divided into three categories;
(i) debt markets, (ii) equities or stock markets; and (iii) markets for structured
securities which are hybrids of either equity or debt securities. Debt markets