134 AN INTRODUCTION TO ISLAMIC FINANCE
is not compensated by higher returns — savings will be adversely affected.
This conclusion is, however, far from obvious when both risk and return are
allowed to vary. The theoretical conclusion of an analysis in which risk and
return variability have both been taken into account depends on assump-
tions regarding the form of the utility function and its risk properties, such
as the degree and the extent of risk aversion, the present future discount
and the degree to which the future is discounted, whether or not increased
risk is compensated by higher return and, fi nally, the income and substitu-
tion effects of increased uncertainty. It has been shown, for example, that
when future non - capital income is subjected to risk, decreasing temporal
risk aversion is a suffi cient condition for increased uncertainty about future
income to decrease consumption and increase savings. With respect to
capital income, the combined substitution and income effects of increased
uncertainty are indeterminable. Other studies have shown that under rea-
sonable assumptions, in face of uncertainty, there does exist a precautionary
demand for savings. The theoretical analysis has not, thus far, provided a
clear - cut hypothesis in this regard and it becomes an empirical question
whether savings will increase or decrease in an Islamic system. It can, how-
ever, be reasonably expected that a rational planner may make more provi-
sion for the future when the future becomes more uncertain; an expectation
which, prima facie, cannot be contradicted by any of the features underlying
an Islamic economic system.
It has already been indicated that incentives exist in an Islamic sys-
tem for effi cient intermediation, and system characteristics, most impor-
tantly the prohibition against interest, create an important opportunity
for the integration of fi nancial markets. Since legislative action would
make the charging of interest illegal and society’s value - orientation
would create a stigma for those charging interest, unorganized markets
could not operate on the basis of interest. They would have to allocate
their resources on the basis of profi t sharing and it would be their relative
ability and effi ciency in exploiting market imperfections, vis - à - vis that of
organized markets, that would determine how much of fi nancial activi-
ties would be carried out by the unorganized markets.
The productivity of small - scale investment, the extent of the familiarity
with agent - entrepreneurs and their ability to closely monitor projects, may still
allow unorganized fi nancial markets to exist, but it can be reasonably
expected that the spread between the rates of return in an organized and an
unorganized market would not be as wide as that which exists in the two
markets in an interest - based developing economy where the organized fi nan-
cial sector is regulated and interest rates are kept artifi cially low.
It can be stated, however, that the other problems plaguing the fi nancial
development of most developing countries, such as discrimination against
small and indigenous entrepreneurs, the shallowness of fi nancial markets
and the limited availability of asset choices for savers will not be automati-
cally eliminated by the introduction of an Islamic fi nancial system. In fact,
the introduction of an attractive and varied menu of asset choices will,