CHAPTER 4 23/05/2001 12:00 pm Page 1 4. Islamic banking and financial intermediation FINANCIAL MARKETS AND INTERMEDIARIES In the previous chapter we examined the principles of Islamic banking and showed how the institutions collect deposit funds from investors, both by means of mudaraba investment accounts and other deposit accounts, on one side of the balance sheet, and then invest these funds in a variety of Islamically-acceptable forms, on the other side. That is, we considered how they operate as financial intermediaries in financial markets. Nevertheless, they conduct financial intermediation in ways quite different from conventional banks since profit-andloss modes of finance and investment in trade and commodities feature extensively in their activities. There is a large literature in banking theory and finance that examines the optimality of the interest-based instruments used by conventional banks. In order to explore the differences that may result from substituting the Islamic financing instruments for the conventional techniques of banking, we need to review the theories of financial intermediation. Financial markets are a means whereby the resources arising from acts of savings are made available to investors. The functions performed can be summarised as follows: 1. Indirect financing: transferring resources (funds) from those who have them (savers) to those who can make use of them (borrowers or investors). There is never a perfect coincidence between those who have funds and those who can make use of those funds. 2. Accumulating capital: many projects require more capital than that of any one saver or any...
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