Chapter 5: Islamic banks
In this chapter we analyse how banks have tried to apply Islamic principles. It is shown that these principles may lead to serious moral hazard and information problems and we examine how the banks deal with those problems. We start with a survey of the financial instruments offered by the banks, that is, the liabilities side of the bank’s balance sheet. Next we discuss the specific problems thrown up by some of these liabilities. Then we turn to the problems associated with typically Islamic bank assets. Agency problems figure prominently. A few observations on the practice of Islamic banking follow before the chapter ends with a couple of conclusions. In Chapter 4 the various Islamic financial instruments were discussed. Islamic banks use these instruments to provide their clients with funds. We now turn to the other side of the balance sheet. How do the banks fund themselves, what are their sources of funds. Basically, they use a subset of the available Islamic financial instruments. Islamic banks thus are free to issue shares but not, for instance, conventional bonds. The peculiar character of the banking business warrants a separate analysis of the banks’ liabilities.
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