12 AN INTRODUCTION TO ISLAMIC FINANCE
debtor carrying the greatest part of the risk, and with governments enforc-
ing the contract. Such a system had a built-in incentive structure that pro-
moted a moral hazard and asymmetric information and thus required close
monitoring. The costs could be managed if monitoring could be delegated
to an institution that could act on behalf of the collectivity of depositors/
investors; hence the existence of banking institutions.
In the late 1970s–early 1980s, Minsky and others demonstrated that such
a system was inherently prone to instability because there would always be a
maturity mismatch between liabilities (short-term deposits) and assets (long-
term investments). Because the nominal values of liabilities were guaranteed,
but the nominal values of assets were not, when the maturity mismatch became
a problem, banks would attempt to manage their liabilities by offering higher
interest rates to attract more deposits. There was always the possibility that
this process would not be sustainable, resulting in an erosion in confi dence
and runs on banks. Such a system, therefore, needed a lender of last resort and
bankruptcy procedures, restructuring processes, and debt-workout procedures
to mitigate the contagion.
During the 1950s–60s, Lloyd Metzler of the University of Chicago had
proposed an alternative system in which contracts were based on equity
rather than debt, and in which there was no guarantee of nominal values
of liabilities since these were tied to the nominal values of assets. Metzler
showed that such a system did not have the instability characteristic of the
conventional banking system. In his now-classic article, Mohsin Khan (1987)
showed the affi nity of Metzler’s model with Islamic fi nance. Using Metzler’s
basic model, Khan demonstrated that this system produces a saddle point
and is, therefore, more stable than the conventional system.
By the early 1990s, it was clear that an Islamic fi nancial system was not
only theoretically viable, but also had desirable characteristics that rendered
it superior to a debt-based conventional system. The phenomenal growth of
Islamic fi nance during the decade of the 1990s demonstrated the empirical
and practical viability of the system.
The crises we have been witnessing in the international fi nancial system
since 1997 have set the stage for Islamic fi nance to demonstrate its viabil-
ity as potentially a genuine alternative global fi nancial system. The present
international system is defi cient in many ways, of which the two most impor-
tant are:
■ (^) A debt-based system needs an effective lender of last resort, and the
present international fi nancial system does not have one and it is not
likely that one will emerge anytime soon; and
■ (^) A debt-based system needs bankruptcy proceedings, debt restructur-
ing, and workout mechanisms and processes that the present interna-
tional fi nancial system lacks. There are preliminary discussions under
way for an international sovereign-debt restructuring mechanism to be
established, but there are many complications. While such a mechanism,