The Stability of the Islamic Financial System 139
With the advent of the banking and credit system, the literature had
noted during the eighteenth and nineteenth centuries that the amount of
credit was a multiple of the quantity of gold in circulation. The development
of bank deposits and checks as means of payment was considered by clas-
sical economists as an innovation that economized on the use of gold and
expanded payments transactions without expanding the quantity of cur-
rency.^5 In a pure credit system, where all payments are carried out through
debiting and crediting bank accounts, the economy could dispense with the
use of currency altogether. Currency is issued by the state in the form of
metallic money or notes. Bank notes and deposits are the money created
by banks. The relationship between currency and bank deposits or credit is
known as “the credit multiplier.”
Each bank can issue money, in the form of bank credit. Normally, banks
issue credit against deposits. However, banks often issue a credit against
insuffi cient deposits. Where there is a shortfall in liquidity, a bank borrows
from other banks, issues papers, or borrows from the central bank. In a
high - risk environment, banks may refuse to issue loans and prefer to accu-
mulate excess reserves. The credit they issue depends on factors that act on
the supply side (the banks) and the demand side (the borrowers). It also
depends on the degree of development of the banking system. In countries
where the banking system is not developed, credit plays a more limited role
in the economy. In countries where the banking system is highly developed
and the number of banks is large, credit tends to be a large component of
the payments system.
In the money supply of any country, broad money, defi ned as currency
in circulation plus demand and time deposits, is many times larger than
high - powered money, or the monetary base. The money - creation process
explains how depository banks create money (Tobin 1965). The creation of
money is not a mechanical procedure; it depends on the bank’s willingness
to lend and the willingness of a borrower to borrow. If banks compete for
loans, lower interest rates, and push credit to sub - prime borrowers, and
borrowers are willing to accumulate debt, then credit may increase rapidly.
By contrast, if the banks turn prudent and raise interest rates or borrow-
ers face recession and falling profi ts, then money creation may contract. In
conditions of prudent banking, banks accumulate excess reserves, and issue
loans only to prime customers.
The mechanics of the credit multiplier are simple. Assume that the cen-
tral bank buys a government bond worth $100 by printing new money. The
seller of the bond, be it government or a private holder, deposits the pro-
ceeds with Bank 1, thus increasing the bank’s reserves by $100 as shown in
Figure 7.1. Assume that the reserve - requirement ratio is equal to 10 percent
of deposits. The bank keeps $10 dollars in reserves at the central bank, and
places $90 into income - earning assets such as loans or securities. The bor-
rower of $90 is paying interest. He will not keep this money idle at Bank 1.
He will most likely use it to fi nance investment or purchase a car, or con-
sumer goods. Therefore, the money will quickly leave Bank 1 and end up