From the March 2011 Civil-Military Fusion Centre paper, “The Increasing Role & Potential of Islamic Finance in Afghanistan” (behind the firewall at www.cimicweb.org):
Islamic finance is also guided by Sharia‟s banning of “usury”, which is the charging interest or high fees for the use of money. More broadly, Islamic principles suggest that money should not be self-generating (i.e., that it has no time-value and should not grow without work and/or risk-taking).
While Islam forbids interest-bearing loans, this restriction does not mean that the finance industry is forced to operate with limited profits. Rather, Islamic law forbids financial products which are based on debt rather than on real assets and actual economic activity. In other words, an investor should not profit without producing something or accepting a degree of risk (as in an investment). As such, an Islamic “loan” may be provided insofar that it is not seen as creating debt for the recipient (or an expectation of interest on the part of the loan provider), according to the Islamic Finance Council of the United Kingdom.
The loan-provider, under Islam, is understood more appropriately as an investor or financier who gives funds, for instance, to an entrepreneur and who will benefit to the extent that the entrepreneur is successful. Therefore, the financier will profit if the recipient profits and will lose money if the recipient‟s enterprise is unsuccessful. Hence, loans may only be taken to finance profitable undertakings, and, as stated in an article from the INSEAD business school, Islamic finance would disallow the provision of loans to purchase luxury items for the wealthy – as occurred in the case of the recent Kabul Bank crisis – or basic needs for the poor (which, under Islam, should be addressed through charity (or zakat) rather than loans).
So basically: no consumer credit, no demand deposits.
I’ve heard elements of this system advocated by American commentators. Steve Sailer has advocated limiting consumer credit through interest rate caps, and I think Ron Paul has criticized the mismatch between borrowing long and lending short.
Since the financial crisis, I’ve been much more open to alternatives in the banking system. But the alternatives are not without a downside:
Recent research by the International Monetary Fund (IMF) suggests that Islamic banks fared better than conventional banks during the global economic crisis which began in 2008. Islamic banks’ aversion to securities which are not based on real economic activity shielded them from the sorts of debt-based investments and instruments which led to the initial phase of the economic crisis in many Western countries. Islamic banks, hence, have also been increasingly trusted by depositors, and their asset levels have continued climbing throughout the economic crisis. In many respects, Islamic banks out-performed their conventional peers.
Yet, once the “banking crisis” began to affect the broader economy – slowing consumption, construction and production on a global level – Islamic banks were more vulnerable than conventional banks as a result of their investments in a narrow range of sectors (e.g., energy and construction) and their relatively permissive approaches to risk management. By 2009, however, conventional banks‟ profitability was down only 15% relative to 2007; for Islamic banks, which were then facing the full effect of the crisis for the first time, profitability was down nearly 50%.
The IMF ultimately does not take any position on the relative appropriateness of either Islamic or conventional banking but does highlight the relative benefits of each and the importance of reforms which can mitigate their respective risks.
And this is in addition to the dangers Megan has warned about: drying up consumer credit in the banking sector will drive many poor people to loan sharks, payday loans, and the like, plus substantially lower aggregate consumption and thus production.