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Unresovled Issue in Islamic Economics

Unresovled Issue in Islamic Economics

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Published by: naveed43944498 on Jan 15, 2009
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09/09/2011

 
271
CREDIT CREATION AND CONTROL:AN UNRESOLVED ISSUE IN ISLAMIC BANKING
Prof. Dr. Zubair Hasan
 Department of Economics,Faculty of Economics and Management Sciences International Islamic University, Malaysia (IIUM) zubair@iiu.edu.my 
Abstract
. This paper deals with a still unresolved issue - credit creation and control- in an interest free banking system. The available literature on the subject is scanty,controversial and inconclusive. The paper holds that credit creation per se is not un-Islamic; the essential point is how credit is generated and used. It argues that creditcreation cannot be banished; it is an imperative for frictionless adjustment of moneysupply to unavoidable fluctuations in its demand in modern economies. It seeks tocorrect the misunderstanding in the literature that banks create credit ex nihilo.Demand for money apart, fiscal policies and foreign exchange transaction erode thecredit controlling power of the central banks. The paper blames major difficultiesincluding those of credit creation and control on the evolution of Islamic banking onthe same pattern as its mainstream counterpart and suggests some structuralmodifications. Finally, it finds the conventional weapons of credit controlinefficacious for use in an interest free banking system and suggests the inclusion of a ratio of cash to bank advances among them. The paper has some importanttechnical and policy implications.
1. INTRODUCTION
Commercial banks are essentially dealers in credit. Interest is the price that guides themin making business decision. They were initially started as institutions for meeting theshort term credit requirements of trade industry and commerce and it remains theirprimary function even today
1
. In view of that requirement, the legal framework neverput restrictions on the credit creation power of these banks. However, legislation didrequire the central bank of each country to oversee and control that power so that it maynot be used to the detriment of social well-being.Islamic banks were conceived of to be organized on the same structural pattern asconventional banks. The use of interest alone was to be eliminated from their operations(Siddiqi, 1983). The choice unwittingly became source of much confusion at the
(1) It may well be argued that over time the structure and functions of conventional banks haveundergone radical changes. We are living in an era of 
universal banking
where banks now combinevarious sort of functions
 – 
deposit taking, investment, mortgage, leasing, units etc. under a unitarycontrol. Islamic banks can also follow suit. The argument is ill-conceived. Conventional banks took centuries to evolve from commercial into universal sort of banking. Most Islamic banks are yet intheir infancy. They in general lack experience, skills and expertise as well as resources to short circuitthe process. More than that, universal banking has not obliterated the issue of credit creation andcontrol. Rather, it has made the issue all the more complicated. Credit management still remains theprimary function of central banks, worrisome too.
 
272conceptual level and led the progress of these banks in some wrong directions (Hasan2005, 22). In Islamic banking the abolition of interest, the insistence on sharing businessrisks with the owners, the longer lock-in of investment funds and the socialresponsibilities the system is supposed to shoulder raise some ticklish issues that itsstructural constraints could rarely help resolve.The misdoing raises many puzzling questions relating to credit creation. CanIslamic banks in the first place create credit like the conventional banks to enhance theirearnings? If yes, what must replace interest as
 price
for the funds they would provide totheir customers? How would the central bank put, if need be, a tab on their creditcreation activities from a social viewpoint? Shall it be using the same weapons for thepurpose in their case also as it has been using in the case of conventional banks, or itwill have to modify them in some way? What amendments, if any, the currentregulations will require? The literature on Islamic banking does show awareness of suchsort of issues; in fact, they were amply debated during the 1980s. But the discussioncreated more confusion than light and remained agonizingly inconclusive. To ourknowledge, it has since seldom been reopened for discussion.We believe that Islamic economists must look at the issue of credit creation and controlafresh in a more definitive way and this paper is intended to set the ball rolling. Afterattending to some preliminaries, we shall look at the question of credit creation fromtwo angles that seem to have escaped the attention of the learned. First, we find thatthere has been an uncalled for alarm about the possible misuse by the banks of the creditcreation power they enjoy. True, this power of the system as a whole is vast, but onemust not ignore the constraints that put a tab on it in practice. The alarm has beenoverdone because the demand side of the credit market has almost completely beenignored in the discussions on the subject. Credit is not a free gift of nature; it has a cost,even in an interest free Islamic system. Cost apart, the legal environment for banking ina country also impacts the volume of credit the system can create (Hoshi 2006, 2). Itfollows that the power to create credit the banks carry does not imply that they coulduse that power to generate any amount of lending they wish unless there is acorresponding demand for the same. Given the rate of interest, conventional bankstogether
have
power to keep the supply of credit perfectly elastic, but what amount of itwould actually be generated depends on the demand side of the market as Figure 1shows.
SQ0 Q
1
Q
2
Volume of credit
 
D
1
D
2
Rate of interest R
0
Figure 1: At a given rate of interest R
O
, credit supply S bythe banking system is perfectly elastic but its volume isconstrained by the demand variations as Q
1
and Q
2
.
 
 
273The opinion by default seems be that the Islamic banks can also create credit in thesame manner as conventional banks. Thus, it is pertinent to ask 
 – 
and this is our secondpoint -- what instruments the central banks could use for controlling credit creation inthe case of Islamic banks. The objectives, credit creation modes, nature of advances;and security cover demands in Islamic banking would all be much different from thoseof conventional banks. The matter becomes all the more serious if countries allow, as inMalaysia, the opening of Islamic windows in conventional banks. How would a centralbank apportion total credit created between the Islamic and non-Islamic operations inthis sort of mixed banking? Can there be a blanket application of rules or they mustdiffer?
2
The paper is divided into six Sections including the introduction. In Section 2 weshall attend to some preliminaries concerning credit forms and its various sources.Section 3 presents an overview of the literature for evaluating the current position of credit creation issues In fact; it has been a bewildering experience. Concepts have beenvague, definitions infirm and arguments rarely convincing. Any theoretical edifice wasrarely raised; empirical evidence seldom presented. To save time and space, we shalldiscuss broad positions taken rather than comment on individual contributions. InSection 4, we shall explain briefly the theory and process of credit creation withreference to its domestic and foreign bases of expansion. Section 5 discusses if Islamicbanks could create credit and if yes what credit control measures the central bank canuse in their case. Here we may propose some structural reforms for Islamic banking andargue for a dualistic credit control mechanism Section 6 summarizes the argument of the paper and contains some residual remarks.
2. CREDIT: DEFINITION SIGNIFICANCE AND SOURCES
We may define the term credit in a broad or narrow sense. In broad terms, credit isfinance made available by one party
 – 
lender, seller, or shareholder / owner
 – 
to anotherparty
 – 
borrower, buyer, or a business firm. The former could be a pure lender
 – 
afinancial institution or a private money lender, a seller / supplier of goods on thepromise of the buyer to make payment in future, or a shareholder / owner of a firmmaking funds available to the firm recognized as a separate entity.More commonly, the term credit is used in a narrow sense that is only for debtfinance. Credit is simply the opposite of debt; both are created instantly by the
same
contract. It is a special sort of exchange transaction involving future payments, interestadded to debt as its time value. It is this view of credit that lies at the heart of moderncommercial banking. The abolition of interest must make such transactions non-existentin an Islamic financial system. Amazingly, the abolition of interest and the remainingfeatures of commercial banking were assumed to harmonize!
(2) No such distinction is being presently made in Malaysia, and Bank Negara applies the same rulesuniformly to credit creation by all banks, Islamic or non-Islamic. Presumably, this is so becausecredit generated by the Islamic banks is still a drop in the ocean. Central banks will surely face achallenge as and when the share of Islamic banks in the pie assumes significance. Will it not beadvisable to foresee the inevitable and prepare for pre-empting the oncoming challenge?

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