Islamic banking: perspectives from the theory of financial intermediation

Islamic banking rejects the notion of fixed-interest debt contracts in favor of profit-and-loss-sharing partnerships. Islamic banks might be able to offset the disadvantage implied by the need for extra monitoring of these debt contracts by operating within a strong bank-based financial environment, where there is both a better flow of information and stronger commitment between borrower and lender. At this stage, however, that sort of environment does not appear to be at hand. Thus, Islamic banking is not now useful as a development strategy. Still, it is a viable concept (as illustrated by real banks now operating). The main difficulty in the Islamic banking system is created by the fact that debt contracts are often the best financial practice, but shari`a forbids interest.