Islamic Banks and Investment Financing

Abstract

We study the set of instruments used by Islamic banks to finance projects in Muslim countries given that Islamic Law prohibits the charging of interest. Our evidence indicates that the bulk of the financing operations of Islamic banks do not conform to the principle of profit-and-loss sharing (e.g., equity contracts). Instead, most of the financing is based on the markup principle, and is very debt-like in nature. The majority of financial transactions are directed away from agriculture and industry and long-term financing is rarely offered to entrepreneurs seeking funds. We construct a model which provides insight into these stylized facts. The main implications of our analysis are that economies characterized by adverse selection and mora hazard will be biased towards debt financing. As these problems become more severe, debt will become the dominant instrument of finance. Thus, the use of debt-like instruments is a rational response on the part of Islamic banks to informational asymmetries in the environments in which they operate. We are able to explain the patterns and composition of financing that have emerged in Muslim countries in which Islamic banks operate.

JEL Classification: G32, P43, A13