146 AN INTRODUCTION TO ISLAMIC FINANCE
stable and the rate of return to the fi nancial sector will be fully aligned with
the profi t rate in the real sector of the economy.
It is clear that if demand deposits are backed by a 100 - percent reserve
requirement, the run - associated features of fractional-reserve banking would
be eliminated. By not imposing any reserve requirements for investment
deposits and replacing the par conversion privilege with a net asset liquida-
tion rule (for example, the rule that depositors bear the asset value risks on
a pro rata basis), the incentive for runs on investment deposits would also be
removed. The doctrinal justifi cation for a 100 - percent reserve requirement
based on the property - rights argument was advanced in earlier chapters;
the stability argument proposed is a further support for this view. Not all
Muslim scholars, however, are convinced of the necessity of a 100 - percent
reserve requirement. The proponents of the two - tier mudarabah model
argue that a fractional-reserve system fully guaranteed by a debt - issuance
scheme coupled with careful project selection is suffi cient to head off any
potential run on the banks.
CONCLUSION
Classical economists recognized in their writings that banks create money.
They also noted that business corporations, through issuing credit instru-
ments such as bills of exchange, commercial papers and promissory notes,
may contribute to an increase in quasi - money, when these instruments
become monetized in the form of bank discounts or through endorsement.
They identifi ed the relationship between all forms of private credit instru-
ments and circulating gold as the credit multiplier. The credit multiplier
depends on the defi nition of money and quasi - money, on the degree of
development of the credit system, and factors that motivate lenders to lend
and borrowers to borrow. Cognizant of the money-creation power of bank-
ing and fi nancial institutions, every country has adopted banking legisla-
tion and prudential regulation for limiting the use of this power beyond
the norms of safety. The credit multiplier is inversely related to the reserve-
requirement ratio in a fractional-reserve system. Under securitization and
an asset - backed securities system, the credit multiplier is larger than under
a reserve-requirement system and is theoretically unbounded. However, in
practice, the abnormally inverted credit pyramid is bound to collapse when
its underlying bubbles burst.
The credit multiplier was shown to be irrelevant for Islamic fi nance. The
corresponding notion is a savings multiplier, which is directly proportional
to the savings - to - income ratio. Islamic fi nance is theoretically immune from
credit multiplication and the business fl uctuations caused by credit booms
and busts. The growth of fi nancing activity will, therefore, be stable and
determined by the real growth of the economy, and not by unstable specu-
lative fi nance or money creation by fi nancial institutions. Accordingly, an
Islamic system would not be expected to experience deep boom and bust