142 AN INTRODUCTION TO ISLAMIC FINANCE
Proponents of the Islamic system claim that a fi nancial system based on
the Islamic framework of risk sharing would be more effi cient in allocat-
ing resources than a conventional interest - based system. This claim can be
defended on the basis of the general proposition that any fi nancial develop-
ment that causes investment alternatives to be compared to one another
based strictly on their productivity and rates of return is bound to produce
improved allocations. Such a proposition is the cornerstone of the Islamic
fi nancial system. But would such a system also improve stability?
The general argument underlying the proposition that the Islamic fi nan-
cial system is more stable than the conventional system is based on three
notions: (i) the avoidance of leverage and debt refi nancing due to the prohibi-
tion of debt; (ii) the matching of assets and liabilities; and (iii) the elimination
of the multiplier effect.
Absence of Leverage and Debt Refi nancing
Leverage is absent from the Islamic fi nancial system because of the con-
strained debt - carrying power of economic units in the system and on the
argument that the inability to refi nance positions in assets by creating addi-
tional debt, along with the non - existence of interest rates, renders the sys-
tem more stable.
In a conventional interest - based system, the fi nancing of investments
and the ownership of capital assets, as well as of consumer spending, is car-
ried out primarily through borrowing and lending, whereby a structure of
expected money receipts embodies the various commitments to make pay-
ments on existing debt. The liabilities on the books of an economic unit at
any time are the result of past fi nancing positions that are taken on the basis
of various margins of safety, one of which is an excess of anticipated receipts
over payment commitments. Based on this relationship, an economic unit in
such a system can assume one of three fi nancial postures.
First, a given economic unit in every period of its operation will have
cash fl ows from its participation in income generation, which are expected
to exceed contractual payments on outstanding debt. Another posture may
place an economic unit in a position in which, in the short term, payment
commitments exceed their corresponding cash fl ows, even though the total
expected cash fl ows (totaled over the foreseeable future) exceed the total pay-
ments on outstanding debt and the net income position of the short - term cash
fl ows exceeds the short - term interest payments on debts.
Finally, a situation may arise in which not only do the short - term pay-
ment commitments exceed the expected cash fl ows, but the short - term inter-
est payments on outstanding debt also exceed the income components of
the short - term cash fl ows. It has been argued that, in such an interest - based
system, there is a tendency on the part of the economic units (consumers,
fi rms, banks and governments) to increasingly assume the last two types of
fi nancial postures, in which economic units can fulfi ll their payment commit-
ments on debt only by the borrowing or selling of assets. Since the appreciation