Q: How Islamic Banking system is efficient allocation of resource?

Answer: At the macroeconomic level Islamic finance avoids the use of interest based lending.
The rate of interest is replaced by the rate of profit on equity and profit sharing finance, by
markups on credit purchase finance by rental rates on leasing finance. While time value of
money is maintained, there is no need to handle the complicated question of how to bring the rate
of interest down to zero in order to reach the optimal allocation of resource.

Conventional finance allocates financial resources with paramount regards for borrower ability
to repay loan principal and interest. In modes of Islamic finance that are based on equity and
profit sharing, focus would be on the profitability and rate of return of the concerned investment.
This type of finance has the potential of directing financial resources to the most productive
investment. This would increases the efficiency of the financing process and reinforce efficiency
in the real sectors.

Q: Why we can say Islamic Banking system maintain economic stability in an economy?

Answer: A conventional bank has on the one hand liabilities that include demand, time and
savings deposit which bank guarantee. On the other hand it has assets that are mostly composed
of debt instrument each of which has a quality that depends on the ability of the corresponding
debtor repay. Default of this assets side if it happens in significant proportion would imply
inability to meet the banks obligations on the liabilities side. Such default can be expected at
times of crisis, be it of macro-economic nature or caused by circumstances specific to the bank.
A bank operating according to Islamic rules of finance has liabilities of different nature. Only
demand deposits are guaranteed. Meanwhile investment deposit are placed on profit and loss
sharing basis. When such banks faces macroeconomic or specific crisis, investment depositor
automatically share the risk. The bank is less likely to fall and a bank run is less probable. It can
therefore be said that an Islamic banking system relatively more stable when compared to
conventional banking.

In conventional finance present money is traded in an integrated debt market against future
money which takes the shape of commitments to pay specific amount at specific future date or
bonds. Bonds are supposed to be easily traded financial instruments many of which are listed in
international financial market. Hundreds of billion dollar of debt traded daily in those market.
Bonds markets provide an easy and automatic mechanism through which short term funds flow
at will one country to another. Much of those follows factor that are only nebulously related to
economic fundamental. They bring an important element of instability that might start in one
single debt market in a fashion that economist come to call contagion.

The integrated debt market has grown immense in size as well as in scale of integration that now
encompasses the whole world economy. Many experience as lately manifested in the southeast
Asian economies have shown that integrated debt market are sources of both domestic financial
instabilities and contagion. Some economists have come forward with proposal to place
restriction on capital movement in contrary with what has been considered in economics as
received doctrine.

In contrast debt is created in Islamic finance through selling goods and services on credit.
Resulting debt instrument are not readily tradeable. We can visualize the existence of a credit
market for each commodity and service in a which the demand and supply to buy it on credit
determine a mark-up rate. Such credit markets would be fully segmented, while debt instrument
themselves traded only for nominal rate at maturity. There is no room for sudden and mass
movements of funds. Possibility of instability and contagion through debt market would
therefore be remote and the justification to choke capital movements with restrictions become
unnecessary.

Examinations of daily records of trading in financial market vividly shows that institutional
participants carry out huge speculative transaction. More often than not such transaction are
sources of instability. In contrast Islamic financial institution are automatically prevented from
carrying out such gambling activities, destabilizing speculation would be significantly curtailed
in financial market.

We have noted that Islamic finance never provides present money in return for future money. All
Islamic modes of finance involve money on the one end and goods and services on the other.
Monetary flows through Islamic financial modes would have to be tied directly with commodity
flows. In other words Islamic finance removes the dichotomy between financial and real
activities. Obviously this leaves little for excessive credit expansion as the finance extended I
automatically embarked for specific uses.

Speculative activities related to interest rate expectations would become out of place. Changes in
spending would automatically be reflected on change in demand and supplies of goods and
services, causing quantity of output produced to respond more quickly to market forces. In other
words markets are more likely to operate efficiently and smoothly. It is therefore interesting to
note that Islamic finance, though non-conventional, support market forces and mechanisms more
than does conventional finance.

Q: Why we can say Islamic Banking system is distributive justice?

Answer: One of the most important objective of Islam is to realized greater justice in human
society. According to the Quran a society where there are no justice will ultimately head towards
decline and destruction. Justice requires a set of rules or moral values which everyone accepts
and faithfully complies with.

First condition of justice

To fulfill the first condition of justice slam Islam requires both the financier and the entrepreneur
to equitably share the profit as well as the loss. For this purpose one of the basic principles of
Islamic finance is no risk no gain. This should help introduce greater discipline into the financial
system by motivating financial institution to assess the risk carefully and to effective monitor the
use of funds by the borrower. The double assessment of risk both financier and the entrepreneur
should help inject greater disciplined into the system and go a long way in reducing excessive
lending.

In Islamic finance should in its ideal form help raise substantially the share of equity and profit
loss sharing in business. Greater reliance on equity financing has supporters even in mainstream
economic.

Greater reliance on equity does not mean that debt financing ruled out. This is because all the
financial needs of individual, firms, or government cannot be made amenable to equity and PLS.
Debt is therefore indispensable but should not be promoted for non-essential and wasteful
consumption and unproductive speculation.

For this purpose the Islamic financial system doesn’t allow the creation of debt through direct
lending and borrowing. It rather requires the creation of debt through the sale or lease of real
asset by means of its sale and lease based modes of financing. The purposes is to enable an
individual or firm to buy now the urgently needed real goods and services in conformity with his
ability to make the payment later. It has however laid down a number of condition some of
which are:

 The assets which is being sold or leased must be real and not imaginary.
 The seller or lessor must own and posses the goods being sold or leased
 The transaction must be a genuine trade transaction with full of intention of giving and
taking delivery
 The debt cannot be sold and thus the risk associated with it must be borne by the lender
himself

The first condition will help eliminate a large number of derivatives transaction which involve
nothing more than gambling by third parties who aspire to claim compensation for losses which
have been actually suffered only by the principles party and not by them.

Second condition of Justice

The second condition will help ensure that the seller also shares a part of the risk to be able to get
a share in the return. Once the seller acquires ownership and possession of the goods for sale or
lease he bears the risk. This condition also puts a constraint on short sale thereby removing the
possibility of a steep decline at assets prices during a downtown. The Shariah has however made
an exception to this rule in the case of salam and istisna where the goods are not already
available in the market and need to be produced or manufactured before delivery. Financing
extended through Islamic modes can thus expand only in step with the rise of the real economy
and thereby help curb excessive credit expansion.
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