Islamic Banking and Economic Stability


IslamicBanking and Economic Stability

Islamicbanking describes a banking system that is based on the Sharia law.This system has become established as an emerging alternative tointerest-based banking and has experienced growth over the pasttwo-three decades both in Muslim as well as non-Muslim countries.Islamic banks have been in a position to record high growth rates innumber and size and have operations in more than 75 countries aroundthe globe. Bankers usually project that this form of banking may havecontrol over 50% of savings in the Islamic countries in the comingdecade (Rosly, 2005). The practices, as well as activities associatedwith the Islamic banks, reflect the environment in which they areusually based. In the secular societies of northern Africa, Islamicbanks usually compete on the basis of the quality of products thatthey provide rather than on the religious grounds. In Kuwait, Islamicbanking has focused on the petroleum sector and real estateinvestment while in the United Arab Emirates, Islamic banks haveemphasized on trade and finance. The concept of the Islamic economicsystem stresses on the worship of the creator, which entails theman’s duty in developing life on earth thus securing an excellentstandard of living for an individual. Islam emphasizes that man isthe primary agent for developing life on earth, which sees thedevelopment of man as a required condition in the development ofsociety. The economic ills such as economic instability, inflation,poverty, and economic injustice are in conflict with the Islamicvalue system (Hassan &amp Lewis, 2007). The purpose of this reportis to discuss Islamic banking and its notion of attaining economicstability.

Theprinciple objectives and functions of the Islamic banking systementail economic well-being with full employment as well as a maximumrate of economic growth, generation of adequate savings, and equaldistributions of income among other things. These functions andobjectives are exceedingly critical in ensuring economic stability.According to the World Bank, commercial banks prefer lending tolow-risk activities and are usually reluctant to finance high-riskprojects even if such projects may present better investmentopportunities. The commercial banks are also less willing to financesmall firms, which do not have adequate collateral. However, incontrast, Islamic banks have a primary objective of fostering seriouseconomic development since they seek to maximize social benefit(Hassan &amp Lewis, 2007). Therefore, Islamic banks work hard toovercome shortages and difficulties to assist the economy progress toa higher stage of self-sustained development, which result in afavorable impact on socio-economic harmony because of the equalincome distribution. Islamic banking is not focused only aroundcreditworthiness but on the worthiness and profitability of aproject. This makes Islamic banking promote economic stability.


Theglobal economic downturn started by the failure of the sub-mortgagesystem in the United States stimulated the process for Islamicbanking system in most secular countries. Muslim countries were theonly subscribers of Islamic banks in the initial stages of the 21stcentury however, the worst experience of crisis forced secularistcountries like the United Kingdom, Japan, and Singapore to adjusttheir banking laws for smooth operations of Islamic banks (Rosly,2005). Subsequently, most international banks and nonbankingfinancial institutions opened new windows for Sharia bank in theWestern countries. Islamic economists have argued that high-interestrates charged by banks have an impact of impoverishing the borrowers.As a result of high interests charged by the conventional banks,borrowers become pressured and burdened, which make it hard for themto repay loans. Failure of the borrowers to repay their loans resultsin a liquidity crunch in the economy. The liquidity crunch may causeinstability in the economy. Because of the negative impacts ofinterests on the society, Islamic banking does not support the ideaof charging interest. Most of the ideas of the Islamic banking systemsupport the economy and thus lead to economic stability. Islamicbanks have been considered to show financial stability, which isvital in supporting economic stability. The following literatureshows that Islamic banking systems have financial stability, whichtranslates to promoting economic stability.

Financialstability has been considered a significant tool for economic growthand stability because most transactions in the real economy are madeand achieved through the financial system. Realizing the role of thebanking sector in the overall economic development, the stability andgrowth of an economy depend on the stability of its banking sector.Therefore, in determining whether Islamic banking supports economicstability, it is important to establish whether the banks arefinancially stable (Mohamed &amp Iqbal, 2011). This is because theirfinancial stability is a clear indication that they support economicstability. It has emerged that Islamic banks are stable financially.

Reviewof Literature

Differentliterature supports the idea that Islamic banking is financiallystable. A study conducted by Said (2012) concentrated on measuringthe efficiency of Islamic banking during the global financialmeltdown. The study made a conclusion that large Islamic banks hadrecorded efficiency during the 2006-2008 crises, but decreased in2009. The efficiency of Islamic banks was indicated to improveappreciably during the economic crises. In another study, Cihak andHesse (2008) studied the financial stability of Islamic andconventional banks. The study found that Islamic banks were morelikely to be sound and stable compared to the conventional banks. Thefindings indicated that small Islamic banks have a tendency to befinancially stronger compared to the conventional banks.

Intheir research, Beck et al. (2010) established that Islamic banks aremore cost-effective in different countries. Nevertheless, incountries where both Islamic and conventional banks exist,conventional banks are perceived to be more cost-effective comparedto the Islamic banks. This study indicated that some variation ofeffectiveness and stability of conventional banks across countriesthat have varied market shares of Islamic banks. The research showedthat in nations where the market share of Islamic banks is higher,conventional banks were considered to be more cost-effective but theywere less stable. In another study by Hussein (2010), financialstability in the banking sector became measured using threeindicators Tobin Q, ROAV, and bank liquidity. The research foundthat external factors to the banks such as macroeconomic and marketbehavior have a significant relationship with the liquidity of banks.

Farooket al. (2012) evaluated the variances in the financial strength ofIslamic banks in comparison to the conventional banks. The researchshowed that Islamic banks are not as financially stable like theconventional banks. Specifically, the research showed that smallIslamic banks were deemed to be more financially stable compared tothe conventional banks nonetheless, large Islamic banks wereindicated to be less stable. Likewise, Shahid and Abbas (2012)carried an investigation to establish the financial stability ofIslamic banking in Pakistan. Outcomes from the investigation depictedthat small Islamic banks are stronger than the small conventionalbanks as well as huge Islamic banks. Furthermore, large Islamic bankswere also proved to be stronger than the large conventional banks.s

Ali(2012) investigated the effect of the Islamic banks market structureon the general bank risk using the Z-index. The outcomes of theresearch showed high Islamic bank stability. The results of theZ-index helped in providing a conclusion that Islamic banks have ahigher franchise value and better stability. Ali (2012) provided thatIslamic banks are steady financially. Additionally, Mat Rahim andZakaria (2013) examined the relative strength between Islam andconventional banks in Malaysia. The result of the research showedthat Islamic banks are reasonably more stable compared toconventional banks.

Thereare different principles that Islamic banks use, which are criticalin promoting economic stability. The following paragraphs discussthese principles and how they promote economic stability.

Interest(Riba) Principle

Unlikein other commercial banks, interest is forbidden in Islamic banking.According to the Riba principle, all banking activities have to avoidinterest. Indeed, Riba is sometimes deemed to be a greater sin forMuslims compared to eating pork, committing adultery, or drinkingalcohol. Instead of interest, Islamic banks earn a profit or mark-upand fees on financing facilities they extend to customers (Kettell,2011). Besides, according to this principle, depositors do not earninterest but usually earn a share of the profits of the bank. InIslamic banking, the banks are not allowed to charge for the use ofmoney. Whereas conventional financial institutions buy money fromdepositors and sell money in the form of loans, Islamic financialinstitutions are required to trade in real assets or services. Also,this principle works under the philosophy that no individual issupposed to profit from another person’s loss. The entitlement ofthe return is supposed to lie in a person bearing the risk involvedin the creation of the return. Through this principle, the Islamicbanking system is likely to lead to economic stability. This isbecause inflation is likely to be kept stable or eliminated byremoving the element of interest rates. Also, by not chargingdepositors for the use of money, depositors are likely to be giventhe opportunity to accumulate resources, which can be used intransforming the economy. It is the economic transformations thatwould help in maintaining economic stability. Thus, this principle isexceedingly critical for economic stability.

ProhibitedActivities / Commodities

Sharialaw prohibits the use or dealing with certain commodities oractivities. Islamic banking system is required to encourage anddevelop the application of Islamic principles and Sharia law tofinance transactions, banking, as well as business affairs. TheSharia law controls the engagement of investment entities inactivities, which are tolerable and consistent with the Sharia lawthis prevents the occurrence of activities that are forbidden byIslam. According to this principle, only halal activities arepermitted. Therefore, Islamic banking system will be inappropriate infinancing any enterprise engaged in any type of activities orcommodities that are unlawful in Islam, or that is deemed harmful tomankind. For instance, the Islamic bank does not finance liquormanufacturing, storage, transportation, or distribution companies.Scholars of Sharia screen the suitability of investments on anongoing basis and offer guidance on commodities to the bank’smanagement. This principle promotes economic stability since by thebank not engaging in activities that are likely to be harmful tomankind, it is in a position to support healthy living, whichtranslates to enhanced productivity (Mohamed &amp Iqbal, 2011). Itis the increased productivity of humans that help in encouragingeconomic stability. Furthermore, through this principle, the Islamicbanking system cannot engage in exploitative contracts. This impliesthat individuals are not going to be exploited, which implies thattheir resources would be used constructively in the economy a movethat would result in economic stability. In addition, under thisprinciple, economic activities that are not favorable to the economyare likely to be avoided a move that would encourage economicstability.


TheIslamic banking system is usually based on Sharia laws. Shariascholars ensure that the business framework of the Islamic bankingadheres to Islamic laws and offer guidance. While the conventionalbanking system relies on man-made laws, Islamic banking strictlyfollows religious laws (Kettell, 2011). Individuals who areconversant with the Islamic laws are given priority in providingguidance to the Islamic banking system in matters regardinginvestments and implementation of banking projects. This makes thissystem be in a position to avoid engaging in investments that mayhave adverse effects on the society, and thus work towards economicstability. Therefore, the business framework used by the Islamicbanking system supports economic stability due to the use ofreligious laws in the business.


TheIslamic banking system does not accept any contract that is based onan uncertain future event. For instance, the Islamic banking systemdoes not allow dealing in derivatives and hedging. Failure to acceptany contract that is based on an uncertain future event is criticalfor economic stability (Rosly, 2005). By avoiding uncertain futureevents, the Islamic banking system eliminates a scenario where theeconomy can be affected by future uncertain events. This is importantin promoting economic stability.

Participationand Risk Sharing

Partnershipand the sharing of risks entail an important principle in Islamicbanking. Islamic banking system offers investors or depositorsparticipation in risk sharing type packages instead of fixed intereston deposits. Any risk-bearing instrument that reflects a real assetand earns a variable rate of return attached to the performance ofthe asset is deemed to be consistent with the Islamic law. Islamicbanking condemns the notion of a risk-free reward or return. Instead,the Islamic banking system employs the notion of participation in theenterprise, using funds at risk on a profit and loss sharing basisand these encourage better resource management. The relationship thatthe Islamic banking system supports in relation to its depositors isvital in supporting economic stability. This is because through thisprinciple, the Islamic banking system will help its depositors tomanage their resources in a better way that would support economicundertakings, which would result in economic stability.

Focuson the Socioeconomic Goals of the Society

TheIslamic banking system has to contribute towards achievingsocio-economic goals of the society. Islamic banking emphasizes onthe ethical, social as well as moral dimensions of wealth generationthat boost equality and justice for the society as a whole. Islamicbanking institutions are responsible towards the poor and the needyin society and have to contribute to the efforts of povertyalleviation and empowerment of individuals. This is through creatingsocial funds for the needy and the poor as well as providingscholarships to students (Hassan &amp Lewis, 2007). The Islamicbanking system’s concern for the socio-economic status ofindividuals in the society is exceedingly important in ensuringeconomic stability. For instance, through the social funds that theIslamic banks provide for the poor and the needy, the economy iscapable of maintaining its processes thus remaining stable.


Supervisionof the Islamic banks is done by the Sharia Supervisory Board (SSB).This body allows the Islamic banks to conduct their financialtransactions according to Sharia. The SSB comprises of three or morescholars who are well-versed with the Islamic jurisprudence (Kettell,2011). The presence of this board ensures that Islamic banks runaccording to the Sharia precepts. Since the Sharia principles have agreat consideration for the welfare of the society, the banks areinvolved in activities that ensure the welfare of the society, andthis is crucial for the economic welfare of the society. Thus,through the supervision of the Islamic banks by the SSB, the banksensure the welfare of the society which results in economicstability.


Islamicbanking has become adopted in different countries internationally. Ithas become established as an emerging alternative to interest-basedbanking and has experienced growth over the past two to threedecades. Bankers usually project that Islamic banking may havecontrol over 50% of savings in the Islamic countries in the comingdecade. The practices, as well as activities associated with theIslamic banks, reflect the environment in which they are usuallybased. The concept of the Islamic economic system stresses on theworship of the creator, which entails the man’s duty in developinglife on earth thus securing an excellent standard of living for anindividual. Islam emphasizes that man is the primary agent fordeveloping life on earth, which sees man as important in thedevelopment of society. The economic ills such as economicinstability, inflation, poverty, and economic injustice are inconflict with the Islamic value system. Financial stability has beenconsidered a significant tool for economic growth and stabilitybecause most transactions in the real economy are made and achievedthrough the financial system. Realizing the role of the bankingsector in the overall economic development, the stability and growthof an economy depend on the stability of its banking sector.Different principles adopted by Islamic banking support economicstability. Sharia law prohibits the use or dealing with certaincommodities or activities. Islamic banking system is required toencourage and develop the application of Islamic principles andSharia law to finance transactions, banking, as well as businessaffairs. Interest is forbidden in Islamic banking. According to theRiba principle, all banking activities have to avoid interest.Islamic banking emphasizes on the ethical, social as well as moraldimensions of wealth generation that boost equality and justice forthe society as a whole. Any risk-bearing instrument that reflects areal asset and earns a variable rate of return joined to theperformance of the asset is deemed to be consistent with the Islamiclaw. Islamic banking condemns the notion of a risk-free reward orreturn.


Ali,A. (2012). Islamic Banking Structures: Implications for Risk andFinancial stability. IslamicResearch and Training InstituteVol. 20 (2).

Beck,T., Demirguc-Kunt, A. &amp Merrouche, O. (2010). Islamic vs.Conventional banking: Banking Model, Efficiency and Stability. WorldBank.

Cihak,M. &amp Hesse, H. (2008). Islamic Banks and Financial Stability: anEmpirical Analysis. IMFWorking Paper.

Farook,S. Hassan, K.M. &amp Clinch, G. (2012). Islamicbanks and Financial Stability: Further Evidence.

Hassan,K., &amp Lewis, M. (2007). Handbookof Islamic banking.Cheltenham, UK: Edward Elgar.

Hussein,K. (2010). Bank Level Stability Factors and Consumer Confidence – Acomparative Study of Islamic and Conventional Banks’ Product Mix.Journalof Financial Services Marketing,Vol. 15 (3) PP. 259-270.

Kettell,B. (2011). Introductionto Islamic banking and finance.Chichester, U.K: Wiley.

Mohamed,A., &amp Iqbal, M. (2011). Thefoundations of Islamic banking: Theory, practice and education.Cheltenham, UK: Edward Elgar.

Rosly,S. A. (2005). Criticalissues on Islamic banking and financial markets: Islamic economics,banking, and finance, investments, takaful, and financial planning.Bloomington, Ind: AuthorHouse.

Said,A. (2012). Efficiency in Islamic Banking during a Financial Crisis:An Empirical Analysis of Forty-Seven Banks. Journalof Applied Finance and Banking,Vol. 2 (3) PP. 163-197.

Shahid,M.A. &amp Abbas, Z. (2012). Financial Stability of Islamic Bankingin Pakistan: An Empirical Study. AfricanJournal of Business Management,Vol. 6 (10) PP. 3706-3714.