The basic idea behind Islamic banking is that equity participating contracts are more efficient than based on ex-ante fixed interest. In fact, there is ample evidence regarding this issue in the literature on the Equity Premium Puzzle. Western researchers, such as Mehra and Prescott (1985) and others, have been perplexed by the fact that stocks, inspite of their risk and adjustment for it, offer much higher returns than bonds. Abel (1991) summarizes the work of prominent economists and assails the inability of sophisticated techniques such as the Consumption Capital Asset Pricing Model (CCAPM) in an attempt to explain this puzzling phenomenon. He suggests overhauling the CCAPM and calls for a new strand of the real business cycle theory. Siegel (1992) concludes that "Equities, however, still appear to be the best route to long-term wealth accumulation.''1
In the light of the international debt crisis, the U.S. savings and loan crisis and the current problems confronting the U.S. banking industry,2 Khan (1986) and Akacem (1991) have advocated a banking-system based on similar grounds to that of the Islamic Profit-Loss-Sharing (PLS) arrangement. Even prominent western economists like Simon (1948) and Kindleberger (1985) proposed abandoning fixed interest rates from western banking practices in order to protect the banking industry from rampant failure. Moreover, Weitzman (1984) has also demonstrated the superiority of the profit-loss sharing scheme over the pre-determined wage rates as a solution to the stagflation problem.
Bishnoi's (1992) recent paper lacks any rigorous theoretical and/or empirical analysis to substantiate his bold claim that Islamic banking is highly risky and lacks merit. Insinuating causal observations from the experience of one country (Pakistan) and then generalizing it to the entire Islamic Banking System is simply erroneous. The problems of Islamic Banking in Pakistan are unique and are described in Mirakhor (1988) as follows:
(1) The government of Pakistan borrows from the public at a fixed rate of interest higher than that paid by Islamic banks in their PLS accounts. Since this loan is less risky than that of the PLS accounts, it results in attracting deposits away from Islamic banks in the country. It, thus, leads to disintermediation, threatening the proper functioning of these banks. Mirakhor argues that such government policy is harmful to the process of Islamization of the Pakistan's economy.
(2) The banking community allocates a high percentage of assets on short-term trade related modes of financing, i.e., Murabaha (mark-up) rather than on long-term project financing modes of Musharka and Mudaraba. This causes capital starvation for industrial projects, and
(3) The banking industry in Pakistan also feels that as long as the entire business community in the country does not adopt Islamic ethical norms, the monitoring, costs of profit-sharing projects will remain high as they are subject to higher moral hazard.
Bishnoi(1992) laments on the lack of empirical evidence demonstrating the success of Islamic banking and argues otherwise through a simple, perhaps naive, look at the data from India. Contrary to Bishnoi's claim, there exists some empirical (regression-based) evidence on the merit of Islamic banking reported, for example, in Darrat (1988), Bashir and Darrat (1992), and Bashir, Darrat and Suliman (1993), to name just a few. In particular, Darrat (1988) used time series data (1960-1984) from a Muslim country (Tunisia) and tested empirically the hypothesis that the financial (banking) system in the country may become more efficient if interest transactions were eliminated within the banking sector. Efficiency was defined in terms of four criteria: (i) the stability of the velocity of money (equal to the ratio of national income to money supply), (ii) the stability of the public demand for cash balance, (iii) policy controllability of alternative monetary aggregates, and (iv) the monetary aggregates/ultimate policy goal linkages. The empirical evidence was astounding. First, in contrast to the fixed interest based financial system, an interest-free financial system was found to exhibit a well-behaving and smoother velocity of money. Second, only the interest-free system has a structurally stable demand for money function Third, only the interest-free monetary aggregates can be usefully utilized by the monetary authorities as an appropriate intermediate policy target. This inference was based on the finding that only the interest-free monetary assets can be effectively under the control of policy-makers and that only such assets have a reliable link with the ultimate policy objectives.
In addition, there have been developments in Japan and in the U.S.A. which also point towards the growth of financial system/instruments based on the concept of equity participation. Japanese authorities have recently enacted certain reforms in their banking sector and expanded its participation nature.3 Even in the United States, there has been an explosion of financial instruments involving some form of equity participation. The growth of the mutual fund industry (half of which comprises equity funds) attests to this fact.4 The emergence of participating mortgages or shared 1 appreciation mortgages in the area of real estate financing also bears witness to this phenomenon. Finally, the recent innovation of a Stock Index Certificate of Deposit by some financial institutions in the U.S. is yet I another observation supporting, at least indirectly, the merit of the Islamic PLS principle.
The preceding analysis clearly suggests that Islamic banking is a rational meritorious economic scheme, both from the theoretical and empirical standpoints. Further support for the rationality and effectiveness of Islamic banking comes from real world experience among several Muslim as well as many non-Muslim countries, and backed by an increasing body of empirical evidence. Serious financial analysts are invited to study closely the Islamic banking scheme and subject its rather short experience to a fair I and objective assessment.
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REFERENCES
Abdcl, A. ''The equity Premium Puzzle," Federal Reserve Bank of Philadelphia Business Review. (Sept.-Oct 1991). pp. 3-13.
Akacem, M., "Islam and the U.S. Banking Crisis," Wall Street Journal (May 9, 1991).
Bashir, A.H.M., and Darrat, A.F., "Equity Participation Contracts and Investment", American Journal of Islamic Social Science, 9 (1992), pp. 219-232.
Bashir, A.H.M., Darrat, A.F., and Suliman M.O., "Equity Capital, Profit-Sbaring Contracts, and Investment: Theory and Evidence," Journal of Business Finance and Accounting (1993, forthcoming).
Bernstein P., "Who Needs Bonds?" Forbes (February 1, 1993). p. 113.
Bishoni T.R.,''Islamic Banking: Some Unsettled Issues of Stability and Growth", Journal of Objective Studies, (July 1992), p..l42-151.
Darrat A.F., "The Islamic Interest-Free Banking System: Some Empirical Evidence", Applied Economics, 20 (1988), p. 417-425.
Japan Economic Institute Report (Washington, D.C., January 29, 1993).
Khan, M.S., "Islamic Interest-Free Banking: A Theoretical Analysis", International Monetary Fund-Staff Papers, 33 (March 1986), pp. 1-27.
Kindleberger, C.P., "Bank Failures: The 1930s and the 1980s", Paper presented at the Conference on The Search for Financial Stability: The Past 50 Years (San Francisco, 1985).
Lynch, P., Beating the Street, New York, Simon and Schuster, (1993).
Mehra, R., and Prescott, E.G., "The Equity Premium: A Puzzle," Journal of Monetary Economics, (15 March 1985), p. 145-161.
Mirakhor, A., "The Progress of Islamic Banking: The Case of Iran and Pakistan," in Chibli Mallat, ed., Islamic Law and Finance, Boston:Graham & Trotman, 1988, pp.91-115.
Siegel, J., "The Equity Premium: Stock and Bond Return Since 1802" Financial Analyst Journal, (January-February 1992), pp. 28-46.
Simon, H.C., Economic Policy for a Free Society, Chicago: The University of Chicago Press, (1948).
Weitzman, M., The Share Economy Cambridge: Harvard University Press, (1984).
KEYNOTES
1. Practitioners like Bernstein(1993), and the legendary mutual manager Lynch (1993) also hold a similar view.
2. According to the Federal Deposit Insurance Corporation's Annual Report(l991), (Table 122), no less than 2,031 banks failed in the United States due to financial difficulties in the period 1934-1991. Two thirds of that number, i.e., 1,329 closed during the period 1980-87, and 209 banks collapsed in 1989 alone.
3. See, for example, Japan Economic Institute Report (1993).
4. There are, for instance, more mutual funds in the U.S. than stocks on the New York Stock Exchange.
