148 AN INTRODUCTION TO ISLAMIC FINANCE
on a risk/profi t - sharing basis, with an overall rate of return which is positive
and determined by the real economic growth rate. Islamic banks do not
create and destroy money; consequently, the money multiplier, defi ned by
the savings rate in the economy, is much lower in the Islamic system than
in the conventional system, providing a basis for strong fi nancial stability,
greater price stability, and sustained economic growth.
Conventional banks issue debt and earn interest. Debt accommodation
by banks has often been unlimited and has been checked only by crashes.
We have shown that credit expansion may have no relation to the real capi-
tal base and no direct relation to the real cash fl ow in the economy that
may be required for servicing debt. If fi nancing were to be extended to con-
sumption, then credit could erode the capital base and economic growth.
The equilibrium interest rate that clears the money market may have no
direct relation with the real rate of return in the economy. Such a deviation
was acknowledged by the classical economists and was seen to be a cause
of booms and busts, and excessive speculation in commodities and assets.
Banks are obliged to pay the face value of their liabilities. In the case of
credit loss, banks have to fully absorb these losses from their capital reserves
or through recapitalization. Governments may be compelled to extend large
and costly bailouts to rescue impaired banks and prevent a total collapse of
the fi nancial system.
The conventional system is vulnerable to many sources of instability.
Besides the inability to reach full - employment output, the system can suf-
fer from interest - rate distortions in relation to a natural interest rate and
can suffer from the absence of a direct link to a real capital base that gen-
erates cash fl ow for servicing debt. Minsky (1986) described the conven-
tional system as endogenously unstable, evolving from temporary stability
to periods of crisis. Credit losses play havoc with the real economy and
cause unemployment. The drying - up of credit during credit crashes makes
the Modigliani - Miller theorem untenable. In such circumstances, leveraged
fi rms will face higher fi nancing costs for their investments or fl uctuations
in their operations. The issue of instability in conventional fi nance is not
limited to the role of commercial and investment banks. In conventional
fi nance, the central bank plays the critical role of lender of last resort. If it
didn’t do so, conventional banks — which are interrelated through loans —
would risk simultaneous failure. Banks are exposed to credit and interest -
rate risk and may run out of liquidity. In order to maintain their payments,
the rediscount and borrowing from the central bank become pillars for the
smooth functioning of conventional fi nance. In Islamic fi nance, banks do
not have or cause any liquidity mismatch and are thus not dependent on
central bank fi nance to maintain their liquidity.
Finally, we should note that the social and human costs of fi nancial
instability and fi nancial crises, though impossible to quantify, might dwarf
even the economic costs. The human cost of prolonged unemployment — its
impact on the individual psyche and on families — cannot be overestimated.
The impacts on individual regions are much more extreme than the average