Paper Title: Islamic Finance and Money Creation: Sharīʿah Issues and a Reform Proposal

Author:        Abdullah Al-Sulami and Ayman Saleh

Publisher:    Journal of King Abdul Aziz University: Islamic Economics, 39(3), 89-107.

This paper investigates a fundamental structural crisis within contemporary Islamic finance. The authors identify the persistent dominance of debt-based contracts in Islamic banking, specifically Murābaḥah and Tawarruq, over genuine partnership and equity-based modes such as Mushārakah and Muḍārabah.

This reality has attracted sustained theological and academic criticism, as early Islamic economic thought promised a profound departure from conventional debt intermediation toward risk-sharing and ethical socio-economic development. Rather than treating this divergence as a transient administrative defect, managerial opportunism, or a moral failure of Islamic bank boards, the authors advance the thesis that this debt bias is a structural inevitability. They argue that Islamic banks have chosen to operate within a fractional reserve banking framework and have consequently embedded themselves organically into modern commercial money creation mechanisms.

The study adopts a descriptive-analytical approach. The authors examine banking history from seventeenth-century English goldsmiths to contemporary central banking, evaluating the transition from physical coin custody to digital ledger entries. They contrast the traditional textbook fractional reserve money multiplier theory against the empirically grounded credit creation theory of banking.

The authors argue that the popular money multiplier model mischaracterizes banks as passive financial intermediaries that collect savings prior to lending out a fraction of reserves. Citing modern empirical literature, such as publications from the Bank of England and contemporary monetary economists, the study demonstrates that modern banks generate deposits endogenously.

In this framework, lending creates deposits ex nihilo through double-entry accounting rather than by mobilizing pre-existing client savings. The paper documents that bank-created credit money constitutes the overwhelming majority of broad money in modern economies. They cite empirical estimates showing that electronic deposit money represents approximately 97% of the circulating money supply in the United Kingdom. Similarly, they observe that commercial deposit money accounts for roughly 91% of broad money in the Kingdom of Saudi Arabia.

The core analytical argument posited by the authors is that generating deposit liabilities forces banks into strict risk-aversion. Because banks issue liabilities that depositors treat as demand-accessible cash equivalents, the bank cannot risk asset depreciation without facing insolvency.

If an Islamic bank utilizes genuine Mushārakah or Muḍārabah to fund entrepreneurial activities, it must assume legitimate commercial risk. Under Islamic jurisprudence, an equity financier cannot demand capital recovery if an entrepreneur incurs a legitimate loss without negligence or transgression. If the equity-financed business subsequently fails, the bank loses its asset, but remains fully liable for the customer deposits that were transferred across the banking system.

Because start-ups and business enterprises exhibit high failure rates in real-world markets, authentic equity partnerships would expose fractional reserve banks to severe capital depletion and runs.

Consequently, central banks impose stringent regulatory liquidity metrics and capital charges, such as Basel standards, that discourage unhedged equity holdings on bank balance sheets.

To protect institutional solvency, Islamic banks are forced to substitute authentic partnership models with fixed-income, collateral-backed debt contracts. Instruments like Murābaḥah and organized Tawarruq allow the bank to secure legal debtor obligations that remain enforceable regardless of underlying business profitability. The authors argue that this makes Islamic banking economically identical in substance to conventional interest-based banking, despite differences in formal legal attire.

Islamic banks routinely market their liability accounts as commingled Muḍārabah or investment agency (Wakālah) arrangements. The authors argue that this characterization is conceptually invalid when viewed through credit creation theory.

Because banks do not fund customer financings from depositor balances, but rather create new ledger balances upon extending facilities, investment deposits do not serve as direct investment capital. Instead, customer deposits function merely as liquidity buffers and regulatory cushions that enable the bank to meet reserve ratios and clearing obligations. Therefore, attributing profits from debt assets to depositors cannot be justified as an authentic return on deployed capital.

In real-world commercial activities, profits are irregular, lumpy, and often realized only at contract termination. Using arbitrary formulas to distribute yields introduces substantial ambiguity (gharar) and unfair economic disparities.

The authors extend their analysis to macroeconomic externalities, focusing on private seigniorage and the allocation of purchasing power. They cite classical jurists such as Ibn Mufliḥ and Imām al-Ghazālī, who affirmed that issuing money (al-sikkah) is an exclusive sovereign responsibility reserved for legitimate state authority to prevent fraud and maintain monetary stability. The authors argue that delegating credit creation to private, profit-maximizing banks constitutes an impermissible private monopoly (iḥtikār). This structure allows private corporations to capture seigniorage revenues that rightfully belong to the public.

The authors critique the inflationary consequences of private credit expansion. Adopting Milton Friedman’s perspective that inflation is always and everywhere a monetary phenomenon, they argue that private credit creation inflates nominal money balances beyond the growth rate of real goods and services.

The authors illustrate that modern Islamic banks frequently finance consumption through organized Tawarruq and credit cards, which expands purchasing power without generating new production. Furthermore, they construct an example showing that an Islamic bank can finance a factory to build furniture via Istiṣnāʿ, while simultaneously financing a retail consumer to purchase that same furniture piece. This process expands the money supply twice against a single physical output, demonstrating that asset-backed debt financing still contributes to aggregate price inflation.

The paper emphasizes that private credit creation worsens economic inequality. Banks allocate credit based on repayment capacity and collateral rather than economic productivity or social welfare. This institutional design favours affluent borrowers who possess real assets to pledge, while denying credit to impoverished individuals and under-capitalized innovators.

Wealthy borrowers use newly created bank purchasing power to purchase income-generating real estate and equity assets, driving asset price inflation. Lower-income households are locked out of asset ownership, and their real wages are eroded by general price increases.

Additionally, because bank-created money enters the system as debt that must be repaid with a financing markup, the volume of outstanding financial claims continually exceeds the supply of money in circulation. The economy is trapped in an unsustainable cycle where continuous new borrowing is required to avoid liquidity crises and structural bankruptcies.

To address these foundational issues, the authors argue that money creation must be separated from commercial financing, drawing on historical proposals like the 1930s Chicago Plan and modern Sovereign Money initiatives by Positive Money. The authors propose dividing the banking architecture into three separate components: The Central Monetary Authority, Payment Network Utilities, and Financing Institutions.

Despite the paper’s analytical contributions, a critical evaluation highlights several significant theoretical, empirical, methodological, and jurisprudential limitations.

Shariah compliant fixed-return instruments of finance serve a functional economic purpose by providing risk mitigation, predictable cash flows, and capital preservation across time.

Equity financing in two-tier Muḍārabah also has limitations, such as moral hazard, asymmetric information and adverse selection as discussed in this article.  

The authors attribute collateral requirements almost entirely to the pressures of money creation. However, corporate finance literature and financial intermediation theory show that debt contracts and collateral exist to address asymmetric information, moral hazard, and costly state verification.

Even in an institution that cannot create money, an equity partner must monitor the entrepreneur’s operational integrity and verify reported profits. Because verification and auditing are costly, debt contracts with collateral remain an efficient mechanism to minimize monitoring expenses, regardless of whether a firm creates money.  In replacing debt with equity financing, it is also important to revisit equity financing structures and add covenants for effective risk management against moral hazard.  

The paper suffers from an absence of quantitative and econometric evidence. The methodology is entirely descriptive and qualitative. The authors do not provide empirical balance-sheet analyses, panel regressions, or counterfactual simulations comparing Islamic banks with conventional counterparts. There is no country that has adopted 100% full reserve banking yet. While there are problems in the fractional reserve system, an abrupt transition to a full reserve banking system also needs careful deliberation, as discussed in this book review. 

In response to the referendum regarding sovereign monetary system, the consensus among Swiss economists, policymakers, and the central bank was that a 100% sovereign money system would introduce severe credit rigidity, raise borrowing costs for businesses, compromise central bank independence, and limit policy tools during macroeconomic downturns.

The authors argue that depositors possess an inherent aversion to risk that forces banks to avoid equity instruments. Yet their reform model confines risk-averse individuals to fee-charging, zero-yield payment accounts, while expecting investment funds to attract sufficient capital without balance-sheet protections.

By segregating transactional money from investment capital, the reform risks creating a credit crunch and driving up capital costs for productive enterprises. The authors’ political economy framework exhibits notable public choice deficiencies. They propose transferring credit creation and allocation authority to the state and the Ministry of Finance. This institutional design assumes that state bureaucracies will distribute debt-free money toward socially optimal projects without political interference.

Public choice theory and historical experience suggest that giving governments direct control over money creation frequently leads to fiscal dominance, political patronage, and high inflation. The paper offers few institutional safeguards to insulate sovereign money creation from political capture, addressing this risk in only a brief footnote.

Furthermore, modern commercial banks do not operate outside state authority; they are chartered, licensed, and regulated by central banks that represent sovereign authority.

On Islamic debt based financing, while synthetic transactions like organized Tawarruq warrant academic and theological scrutiny, categorizing all fixed-income debt contracts as disguised usury undermines the Sharīʿah distinction between valid sale transactions (bayʿ) and interest-based lending (ribā).

In conclusion, Al-Sulami and Saleh provide a provocative and structural critique of modern Islamic commercial banking. Their paper demonstrates that the persistence of debt contracts is closely tied to the operational constraints of the fractional reserve banking architecture. However, their proposed reform blueprint—rooted in the Chicago Plan and Sovereign Money concepts—carries challenges that require careful deliberation before an attempt to implement.