Paper Title: Does PLS in Islamic banking limit excessive money creation?

Author:        Khoutem Ben Jedidia, Hichem Hamza

Publisher:    Journal of Islamic Accounting and Business Research, 15(3), 422 – 442.

In this paper, authors argue that bank lending is the major source of monetary expansion. They agree that bank-led money creation is a key issue in both conventional and Islamic financial systems. Authors investigate the involvement of profit and loss sharing (PLS) in money creation and especially how can PLS limits money creation “out of nothing.”

Authors argue that Islamic banks create money differently compared to conventional ones. Especially, by avoiding a purely financial intermediary, money creation under the PLS principle sustains a strong relationship with the real economy and leads to a lower money multiplier. Therefore, PLS mechanisms allow financing through real assets and not credit assets “out of nothing.” This could prevent excessive money creation from causing harmful effects on indebtedness and financial instability.

Authors thinks that PLS offers a valuable resolution for banking system money creation through the optimization of Islamic bank financing by facilitating the separation of the monetary function from the credit one. This reform thought reinforces the stability value of money allowing it to fully perform its functions with reference to the directives of Sharia. This especially allows the integrity and purchasing power of money, the reduction of the gap between the evolution of both real and financial economies and, consequently, the indebtedness and crisis. Authors recommend to promote PLS financing by reforming institutional and regulatory constraints.

Nonetheless, the issue needs to be looked at more deeply. In practice, close link with the real economy has to go beyond just involving asset as a showpiece. Pricing and returns have to be directly linked with ex-post actual productivity of the particular asset in particular project.

Using conventional interbank rates to determine rentals and deferred price in advance with prior unilateral undertaking mimics the conventional structure. It does not bring any meaningful egalitarian system.

Even with the use of PLS nomenclature, Islamic banks follow the same BASEL rules and fractional banking system. Where Islamic banking solutions have shortcomings, central banks have the dual banking system to keep the system going as is. With the use asset light structures, Bai Inah and Tawarruq, even the nominal and structural differences become less distinct.

Therefore, there is a need to ensure proper PLS system. The issues of moral hazard, adverse selection and perverse incentives need to be handled to promote PLS.

Plain vanilla PLS may not work. But, by adding covenants, multi-tier profit sharing ratio, innovative expense sharing arrangements and bringing liquidity in the secondary market, PLS can work. After all, equity markets work and they have huge investor and capital base.

The right covenants need to be in place and Islamic banks have to think more in terms of VC and investment banks if they want their claim of having close link with real economy realize in true letter and spirit.