Pundits in the financial press have been asking an intriguing question: if too much debt and insufficient equity was partly responsible for the financial crisis, might Islamic banking be part of the solution? After all, Islamic principles require that financial transactions cannot include interest rate payments on debt, but rather have to rely on profit-loss risk-sharing arrangements (as in equity). For example, demand deposits that do not pay interest are fine, but savings deposits generally participate in the profits of the bank since these cannot accrue interest. Lending also generally follows a partnership model where the bank provides the resources and the client provides effort and expertise, and profits are shared at some agreed ratio. So can the heightened risk-sharing required by Sharia curb excess risk-taking by banks?
In practice Islamic scholars have also developed products that resemble those offered by conventional banks, replacing interest rate payments and discounting with fees and contingent payment structures. Nevertheless, Islamic banking still retains a strong element of equity participation. How does this affect bank risk-taking? Conceptually, the answer is not immediately clear. On the one hand, the equity-like nature of savings instruments may increase depositors’ incentives to monitor and discipline banks. On the other hand, if deposit instruments are equity-like, banks’ incentives to monitor and discipline borrowers may also be reduced since banks no longer face the threat of immediate withdrawal. Similarly, the equity-like nature of partnership loans can reduce the important discipline imposed on entrepreneurs by debt contracts.