An Introduction to Islamic Finance: Theory and Practice

The Stability of the Islamic Financial System 141

economy. The central bank plays a role as the lender of last resort. It will
advance liquidity in the form of discounts to banks that are short of reserves
for settling their liabilities. Central banks that fear fi nancial instability may
charge punitive rates for such loans.
A second source of instability may result from depreciations in the
value of assets. Assume the loans and securities of Bank 1 depreciate to
$50 because of non - recoverable loans (credit risk), or a speculative fall in the
prices of bonds, mortgage securities, foreign exchange, and other assets,
(market risk), as illustrated in Table 7.1. Assume that a depositor at Bank 1
writes a check for $100 for a payee at Bank 3, and then Bank 1 will be
short by $90. Besides liquidating its assets at discount, Bank 1 will have to
borrow or inject new capital of $40 to be able to meet its debt obligations.
The banking system as a whole may face a general speculative deprecia-
tion of assets (stock market crashes, a fall in securities, bonds, or mortgage
asset prices, non - performing loans, etcetera). The bailing out by the central
bank will increase bank reserves and will lead to an expansion of the money
supply. Such bailouts are infl ationary and will impose a tax on money hold-
ers, creditors, wage earners and pensioners in favor of debtors. In other
words, the central bank makes the public bear the cost of asset price depre-
ciation, while asset price appreciation remains private and benefi ts specula-
tors or asset holders.

FINANCIAL STABILITY OF ISLAMIC FINANCE

As discussed in the previous chapter, theoretically, the Islamic fi nancial sys-
tem consists of a banking sector, a stock market, and a market for securi-
tized assets. It was also shown that the banking sector may have a sub - sector
which specializes in high - credit and short - maturity securities to fi nance trade
or commodities on the basis of murabahah (cost - plus sale) to support the
payment system. This would be analogous to the concept of narrow bank-
ing which has been suggested in the conventional system to promote stability
in the payment systems and in the fi nancial system.

TABLE 7.1 Impact of credit and market risks

Balance Sheet: Bank 1

Assets Liabilities

Reserves = $10

Loans and securities = $50

Borrowed reserves = $40

Losses = $40

Deposits = $100

Central Bank Advance = $40

Total = $140 Total = $140