Abstract

There has been a revival of fundamental Islamic values in several countries throughout the world. The basic characteristic of an Islamic banking system is the prohibition of the payment or receipt of a predetermined interest rate which is considered usury. The Islamic system substitutes predetermined interest rate with the principle of profit-loss sharing, which transforms banks into equity-based firms. The principle of profit-loss sharing seems to be the cure for instability. The traditional banking practice of paying depositors a fixed (predetermined) interest, regardless of whether or not the bank is doing well, prevents banks from instantaneously adjusting to potential asset shocks. Such rigidity can lead to possible financial instability. The Islamic interest-free banking system can provide immunity against bank failure and financial instability, because this system redistributes the consequences of uncertainty over all parties to a business. By spreading the same risk over more heads, the Islamic interest-free system would promote stability.

Key words: Islamic banking system, traditional banking, financial instability, business,profit-loss sharing, depositors.