The Stability of the Islamic Financial System 145
the “two - windows” model discussed earlier. In the model, the banks accept
deposits on the basis of profi t and losses as if they were equity where the
nominal value of shares is not guaranteed and the rate of return on which is
variable. The model is shown to have stability in response to certain types
of shocks. A major policy recommendation emanating from this study is
that such a system, in which demand deposits have a 100 - percent reserve
requirement and investment deposits carry no guarantees, has desirable and
inherent safety benefi ts.
Conceptually, Islamic fi nance is a two - tier system: (i) a 100-percent
money system, and (ii) and an investment banking system, modeled as an
equity shareholding system.^6 Obviously, there is no money creation in a sys-
tem with 100 - percent reserve banking. Hence the credit multiplier is, by def-
inition, zero for such a system. The investment banking accepts savings in
the form of deposits and invests them in the purchase of equity shares. There
is, therefore, no creation of money through credit, and investment is fully
backed by savings. The amount of deposits in the investment branch will be
determined by real savings and the savings-to-income ratio and not by the
credit multiplier as in conventional banking. New cash fl ows to an Islamic
investment bank originate from new savings, and not from the proceeds of
loans transferred from one bank to the other. There is, therefore, a wealth -
creating activity that generates new cash fl ows, and not money creation by
the stroke of the pen as is the case in a conventional system. The process
of savings and income generation can be described as follows: assume an
Islamic investment bank accepts deposited savings in an amount of $100.
The bank invests this in the form of equity shares. Producing fi rms use this
capital to buy machinery and raw materials, and to expand their production
capacity. The recipients of the $100, as a result of sales of their goods and
services, are assumed to save, on average, a percentage of their income. For
our purposes, we’ll say 20 percent. Hence, they deposit new savings of $20
at the Islamic investment bank. The latter purchases equity shares for $20.
Recipient fi rms invest the new capital. The recipients of the $20, as proceeds
of sales of their goods and services, will save, on average, 20 percent of their
income, equivalent to $4. It can be easily shown that the process of income
and savings generation increases the initial $100 of savings into $125. If
we assume an average savings ratio, s, then the savings multiplier is expressed
as 1/(1 − s), and is directly proportional to the average savings ratio. The
higher the savings ratio, the higher will be the accumulated savings.
The growth of fi nancing activity will, therefore, be stable and deter-
mined by real growth in the economy, and not by unstable speculative
fi nance or money creation by fi nancial institutions. Accordingly, an Islamic
system would not be expected to experience deep boom and bust cycles.
Moderate and brief booms or recession may be generated by favorable cli-
matic conditions or natural disasters, by productivity and technical change,
or by real shocks. They cannot be generated by the fi nancial system itself, as
experienced and demonstrated under the conventional system. As shown in
Mirakhor (1988), equilibrium in an Islamic economy thus structured will be