152 AN INTRODUCTION TO ISLAMIC FINANCE
which have changed the function of traditional fi nancial intermediation.
However, the complexity of markets in the wake of the fi nancial crisis of
2007–09 has reignited the debate on the need for more intermediation.
Financial intermediation in Islamic history has an established histori-
cal record and has made signifi cant contributions to economic development
over time. Financiers in the early days of Islam were known as sarrafs and
undertook many of the traditional and basic functions of a conventional
fi nancial institution such as intermediation between borrowers and lend-
ers, operating a secure and reliable domestic and cross - border payment
system and offering services such as the issuance of promissory notes and
letters of credit. Commercial historians have equated the function of sar-
rafs with a bank. Historians like Udovitch considered them as “bankers
without banks.” Sarrafs operated through an organized network and well -
functioning markets, which established them as sophisticated intermediar-
ies, given the tools and technology of their time. It is claimed that fi nancial
intermediaries in the early Islamic period instituted mutual - help arrange-
ments to help one another overcome liquidity shortages. There is evidence
that some of the concepts, contracts, practices, and institutions developed in
the Islamic legal sources of the late eighth century provided the foundations
for similar instruments in Europe several centuries later.^1
In all the models for Islamic fi nancial intermediation and banking
described earlier, the core principle is that the Islamic bank operates as an
agent of the investor (depositor) and both agree to share the profi ts and
losses of investments made by the bank. Any losses incurred as a result of
the bank’s investment activities are refl ected in the depreciation of the value
of the depositor’s wealth. All models see the probability of losses minimized
through a diversifi cation of the banks’ investment portfolios and careful
project selection, monitoring, and control.
Financial intermediation can take several forms in Islamic fi nancial mar-
kets. For the purposes of this chapter, we focus on fi nancial intermediation
either through deposit - taking Islamic banks or through “Islamic windows.”
FINANCIAL INTERMEDIATION BY ISLAMIC BANKS
An Islamic bank is typically a hybrid between a conventional commercial
bank and an investment bank, and thus resembles a universal bank. Table 8.1
constructs a conceptual balance sheet of an Islamic bank based on different
functions and services to give us an overview of its structure, operations and
capabilities of intermediation.
Liabilities
On its liabilities side, an Islamic bank offers current, savings, investment,
and special investment accounts to its depositors. Unlike conventional
commercial banks, which accept deposits with the promise to return the