The Islamic financial institutions have seen mushroom growth during the last decade owing to fact that there is a large demographic of untapped consumers around the globe have waited for a long time to have such products. Such an immeasurable success has compelled conventional financial institutions to launch products for this segment of consumers so that they are not left behind in the race. However, this has created serious doubts in the minds of the consumers about the products which are offered by Islamic Financial Institutions [hereinafter referred to as “IFI”] and Conventional Financial Institutions [hereinafter referred to as “CFI”] alike. Hence, this is high time that a rating agency of IFI needs to be launched which would set a benchmark for IFI and would also serve the purpose of removing the doubts in the mindset of consumers whose major motive is to seek Allah’s pleasure. For this very purpose we need to look at the brief history of IFI’s.
It was portrayed that such a system was inherently prone to instability because there would always be maturity mismatch between liabilities being short-term deposits and assets being long term investment. Owing to the fact that the nominal values of liabilities were guaranteed, but not the nominal value of assets, when the maturity mismatch became a problem, the banks would go into a liability management mode by offering higher interest rates to attract more deposits. There was always the possibility that this process could not be sustained resulting in erosion in confidence and bank runs. Such a system, therefore, needed a lender of last resort and bankruptcy procedures, restructuring processes, and debt workout procedures to mitigate contagion.
As we know that, in the absence of an analytic framework recognizable by modern economic and financial theory, most western observers and commentators termed to Islamic banking and financial system as a “zero-interest” system, by which they meant “no return to capital”. The challenge faced by Iran, Pakistan. and Sudan in mid 80’s when they started a joint effort to adopt a system-wide Islamic banking and finance to show that such a system was first theoretically and analytically a viable financial system; second, it had to be shown that such a system was empirically workable as a whole and financially viable for each of its parts, meaning Islamic banks and financial institutions although the Dubai Islamic Bank has already come into existence by that time but it was in its infancy. However, the folly of adopting such a system can be summarized in six propositions:
- Zero interest would mean infinite demand for funds but with zero supply
- System’s capability of equilibrating demand for and supply of funds?
- Zero interest rate may lead to no savings at all
- No saving would lead to no investment and no growth
- in this system, there could be no monetary policy since no instruments of liquidity management could exist without a fixed predetermined rate of interest; and, finally,
- This all meant that in countries adopting such a system there would be one way capital flight.
However, in the late 80’s, challenge been met when research, using modern analytic financial and economic theory, showed that:
- A modern financial system can be designed without the need for an ex ante determined positive nominal fixed interest rate and this study has also proved by western researchers that there was no satisfactory theory that could explain the existence of a positive nominal ex ante interest rate
- In furtherance, it was shown that by not assuming a nominal fixed ex ante positive interest rate, i.e., no debt contract, did not necessarily mean that there would have to be zero return to capital
- The basic proposition of Islamic finance : return to capital would be determined ex post and that the magnitude of return to capital was determined on the basis of the return to the economic activity in which the funds were employed
- Expected return determines investment
- Expected rate of return and income determines savings
- Positive growth
- Monetary policy of this system would function as in the conventional system, however, its efficiency depends upon the availability of instruments which could be designed to manage liquidity
- Finally, it was shown that, in an open-economy macroeconomic model without an ex ante fixed interest, but with returns to investment determined ex post, there was no justification to assume that there would be a one-way capital flight.
Hence, it was effectively concluded that the system which prohibited a fixed ex ante interest rate and allowed the rate of return to capital to be determined ex post, based on the returns to the economic activity in which the funds were employed, was theoretically viable