Paper Title: Theoretical and Analytical Approach of Financial Stability: Islamic Perspective

Author:        Hassan Belkacem Ghassan and Noureddine Krichene

Publisher:    Turkish Journal of Islamic Economics, 12(1), 140 – 175.

Traditional banking systems, based on interest-based debt, have led to financial instability and crises throughout history. The 2007-2008 financial crisis highlighted the need for alternative systems.

Authors explain that Islamic finance offers a risk-sharing approach, prohibits interest-based contracts and promotes real economic investments. This system attracts savings and fosters stability, as asset value fluctuations are directly reflected in liability changes, reducing instability risks.

Financial stability’s definition varies across economic paradigms. Instability can arise from asset bubbles, banking deviations, and market fluctuations.

Researchers argue that credit creation and asset price inflation exacerbate instability. Western economics uses interest rate manipulation to mitigate crises, whereas Islamic economics emphasizes interest prohibition and Profit-Loss Sharing (PLS) systems, highlighting the impact of interest rates and exchange-rate risk on global financial instability.

Financial crises are often linked to unsustainable booms in financial and business cycles. Research shows that credit and house price cycles are closely tied to output cycles. From an Islamic perspective, synchronizing financial and business cycles can promote stability. A Shari’ah-compliant system without interest rates can align the financial cycle with the real economy, bolstering stability.

Western economists now suggest that traditional theories relying on the risk-shifting model are insufficient, prompting the need for new frameworks to tackle modern economic and financial challenges. In the stochastic return (SR) model with PLS contracts, investors share risks with financiers, promoting risk-taking in investment projects, unlike the fixed return (FR) model where investors bear all the risk.

Di Giorgio and Rotondi (2011) argued that the crisis stems from ineffective regulation and propose monetary policy be guided by either a ‘backward’ or ‘forward’ rule for interest rate smoothing. Their model highlights ongoing indeterminacy in the economy’s equilibrium state, cautioning that excessive focus on financial stability might trigger macroeconomic instability.

Authors note that most theoretical explorations suggest facing financial instability through the interest rate mechanism, often advocating the augmented Taylor rule.

However, the fundamental issue lies within the interest rate system itself. Consequently, Western strategies to combat financial instability may prove futile as long as they depend on banking interest and credit multiplier systems. Hence, it becomes evident that Islamic economic principles can achieve an optimal harmony between economic and financial stability. We must embrace Islamic finance, implementing 100% reserve banking and replacing interest-based debt with risk-sharing investment banking.

Exploring further avenues in developing the theoretical framework of Islamic finance requires adopting an integrated approach that encompasses individual, sectoral, and macro levels. Achieving financial stability necessitates dynamic, coordinated synergy among these three layers which are interconnected and mutually supporting within the Islamic paradigm. Such an approach to conceptualizing financial stability facilitates a deeper comprehension of the mechanisms underpinning the connections between financing and real economic activities.

The challenge ahead involves further theorizing on the individual and sectoral aspects within the Islamic conceptual framework while integrating the core principles and regulations delineated in the Qur’an and the Sunnah as most widely interpreted and accepted by the  scholars.

Expanding the theoretical modelling approach of Islamic financial risk-sharing to the sectoral level could provide valuable insights into why the stochastic return model of a specific real sector might outperform the fixed return model within that sector.

Similarly, further theoretical inquiries are imperative to delineate an equitable definition of money suitable for the financial sector and to devise a just integrated financial intermediation system aimed at curbing speculative behaviours across both the real and financial sectors of the economy.

Authors urge that the scholars of Islamic finance and monetary issues must define a unified money of exchange, particularly in Islamic nations, eliminating disparities in their current currency values, similar to standardizing meters and weights.