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Islamic Banking

Mervyn K. Lewis and Latifa M. Algaoud

The prohibition of interest is the feature of Islamic banking which most distinctly sets it apart from conventional banking. To Western eyes, this seems a strange restriction, but Christian countries themselves maintained such a ban for 1,400 years. Islamic Banking asks why Islam has been able to maintain its stand. The book explores the intricacies of Islamic law and the religious and ethical principles underpinning Islamic banking. It then considers the analytical basis of Islamic banking and financing in the light of modern theories of financial intermediation, and identifies the conceptual issues to be overcome.  
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Chapter 4: Islamic Banking and Financial Intermediation

Mervyn K. Lewis and Latifa M. Algaoud


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 small set of savers. 3. Providing liquidity: those providing funds may wish to lend...

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