The Islamic Financial System 133
circumstances, the rate of return on an investment must, generally, be higher
than the rate of interest paid to depositors, replacing interest rates with a
rate of return should increase the reward on savings. Consequently, insofar
as saving is responsive to reward, incentives would be created for increas-
ing savings (it should be noted that an increase in return to depositors is
a function of the share parameter negotiated between the banks and their
depositors on the one hand, and that negotiated between the banks and
their customers — that is, agent - entrepreneurs — on the other).
Concerns have been expressed, however, that the adoption of an Islamic
fi nancial system may lead to a reduction in savings and the retardation
of fi nancial intermediation and development. This assertion is based on
three different arguments. One argument suggests that since, in an Islamic
system, the individual’s income is subject to ordained levies, their savings
will be lowered. The second argument asserts that since savings receive no
reward from interest rates, there is no incentive for individuals to save. The
third argument maintains that savings will decrease because of increased
uncertainly of future prospects for Islamic fi nancial systems. For the fi rst
argument to hold, it must be assumed that the ordained levies in the Islamic
system are, in fact, larger than the numerous taxes that income and wealth
are subjected to in other systems; this assumption ultimately requires empir-
ical validation, but prima facie it appears to be baseless. But even if such an
assumption were to be true, the next point to consider is the fact that these
levies are transfers from groups with a low marginal propensity to consume
to those with a higher marginal propensity. The question is whether or not,
as a result of this transfer, aggregate demand will get suffi cient impetus so as
to increase investment, employment and income, so that aggregate saving is
also enhanced, particularly in a demand - constrained economy.
The second argument stems from a misunderstanding about Islam’s
prohibition against interest. It is thought that this prohibition is tantamount
to an imposition of a zero rate of return on investment and capital. This
view clearly refl ects confusion between rate of return and rate of interest.
While the latter is forbidden in Islam, the former is not only permitted but
is, in fact, encouraged.
The third argument is based on the proposition that increased uncer-
tainty in the rate of return affects savings adversely. This view, however, is
neither unique to an Islamic system nor unknown in the conventional eco-
nomics literature. Alfred Marshall, for example, maintained, on the basis of
casual observation, that uncertainty tends to reduce savings. Only recently
has this question been subjected to rigorous theoretical analysis, with con-
fl icting results. The few studies that have analytically or otherwise consid-
ered this question within the context of the Islamic framework have tended
to neglect the risk–return tradeoff aspects of the question. That is, the effects
on savings of a fi xed and certain rate of return are compared with effects on
saving when only uncertainty is taken into account. The result shows a
reduction in savings. It should be obvious that if the expected value of return
is kept constant while its variance is increased — that is, when increased risk