Thursday, December 16, 2010

Islamic Banks, Money Creation and "The Law of One Price"

In many nations, including Malaysia banks are operating presumably o­n Islamic Shari’ah principles. The banks claim they do not indulge in interest or riba that is strongly prohibited in Islam, and also design their financial products and instruments based o­n the Shari’ah principles. The banks should be commended for coming up with such products and instruments that strive to provide Muslims with an alternative banking and finance which are in line with the teachings of Islam. However, it should be noted that in a dual system where the Islamic bank operates in a fiat money and interest based financial system, the banks would also be creating money! Thus, instead of being a solution to the problem, the Islamic bank becomes a cause of the problem too, just like the conventional bank.

In the dual system where the Islamic bank is linked to the conventional banking system through fiat money, fractional reserve requirements and interest rates, the bank cannot operate independently from the conventional banking system according to its own principles. This is because arbitrage opportunities would set in if there are any “price” differentials between the Islamic and conventional systems. Profiteering such arbitrage opportunities would move the pricing in these two systems to converge, a force in economics called the "Law of o­ne Price" [18]. Therefore, in the present system, the Islamic bank cannot be independent from even the interest rates in the economy, the very thing it tries to avoid in the first place![19]

In fact it is o­nly a matter of time even the Islamic Banks would be gobbled up by the foreign giants in this era of globalization. Therefore, for an Islamic bank to truly operate o­n Islamic principles, it is imperative to redefine money and eliminate interest rates.

References :

[18] Sherman, Eugene J., Gold Investment, Prentice Hall, 1986.
[19] Vadillo, Umar I., The Return of the Gold Dinar:A Study of Money in Islamic Law, Madinah Press, 1996.

Credit to my respected brothers, Umar Ibrahim Vadillo, Ahamed Kameel Mydin Meera & Hassanuddeen Abdul Aziz

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