The Stability of the Islamic Financial System 147
cycles. Moderate and brief expansions and recession may be generated by
good or bad crops, productivity and technical change, or by real shocks and
not by the fi nancial system itself. The general price level is stable and cannot
be subjected to infl ationary pressure. The rate of economic growth is stable
and much higher than in a corresponding conventional fi nance system as
Islamic investment banks fi nance only highly productive investment projects
and not consumption, and are immune to the credit crises that characterize
conventional fi nance.
Conventional banks fail to meet inherent stability conditions even in the
presence of prudential regulations. First, credit losses from debt default or
the depreciation of assets may create a large divergence in relation to liabili-
ties that remain fi xed in nominal value. Second, bank credit has no fi xed
relation to real capital in the economy and bears no direct relation to the
real rate of return. Un - backed credit expansion through the credit multiplier
and further leveraging is a fundamental feature of conventional banks. Cash
fl ow could fall short of expectations and force large income losses on banks,
especially when the cost of funds is fi xed through a predetermined interest
rate. Third, banks caught in a credit freeze, with a drying up of liquidity,
may default on their payments. Fourth, banks are fully interconnected with
each other through a complex debt structure; in particular, the assets of one
bank instantaneously become liabilities of another, leading to fast credit
multiplication. A credit crash causes a dramatic contagion and a domino
effect that may impair even the soundest of banks.
Credit can be issued to fi nance consumption, and hence may rapidly
deplete savings and investment. The depletion of savings could be signifi -
cant if credit fi nances large fi scal defi cits. Hence, credit is no longer directly
related to the productive base, as it is in the equity - based system, and the
income stream from credit is no longer secured by real output as shown for
the equity system. Credit can expand through leverage to an unsustainable
multiple of real national income, increasing the risk of default. Credit expan-
sion through the credit multiplier is determined by the reserve-requirement
system, whereas equity in the equity - based system cannot expand more than
real savings. In the case of securitization, credit can, in theory, expand to an
infi nite degree.
In an economy governed by the principles of Islamic fi nance, the rate
of return on equities is determined by the marginal effi ciency of capital and
time preference, and is positive in a growing economy. This implies that
Islamic banks are always profi table provided that real economic growth is
positive. This establishes a basic difference between Islamic banking, where
profi tability is fully secured by real economic growth, and conventional
banking, where profi tability is not driven primarily by the real sector and
where banks may suffer losses even in the face of positive real growth. As
we have seen, the Islamic banking system has two types of banking activity:
deposit banking for safe keeping; and banking for payment purposes. This
system operates on a 100 - percent reserve requirement, and fees may be col-
lected for this type of service. In this system, investment banking operates