# What will happen to a poor country’s economy if it replaces its entire banking system with the Islamic banking system?

I don't know much about economics. So, I am just curious about the Islamic banking system.

What I understand is: I know that the USA is the dominant economy and the USD is the dominant currency in the world both as the reserve currency and the trading currency. So, each and every country on earth is dependent on the USA one way or the other. On the other hand, the banking system runs on interests that cause recession from time to time which affects poor countries.

So, I have the following question:

What will happen to a poor country’s economy if it replaces its entire banking system with the Islamic banking system only? Will it do better, or will it become bankrupt?

• Welcome! Please edit the question to limit it to a specific problem with enough detail to identify an adequate answer. Avoid asking multiple distinct questions at once. – emeryville Apr 1 '20 at 6:15

## 2 Answers

I see a lot of research on Islamic banking, but I don't see a lot of studies that speculate on the question framed here. You might be interested in this study where the author claims:

It would be better if Islamic banks had the opportunity to work as a sole system in an economy. That would provide Islamic banking system to fully utilize its potentials. Studies show that Islamic banks can not operate with its full efficiency level if it operates under a conventional banking framework, their efficiency goes down in a number of dimensions. The deterioration is not because of Islamic bank’s own mechanical deficiencies. Rather it is the efficiency-blunt operations of the conventional banking system that puts obstructions to efficient operation of Islamic banks.

However, it doesn't look like these assertions have been proven. For example here is a study that suggests that Islamic finance works best on a small scale as larger-scale Islamic banks seem to have unique instability issues.

Suppose you prohibit "usury", in the sense that the interest rate must be zero.

If the return on lending is zero, no one would lend in a capitalist system. You are deprived of the capital while someone else is using it, and afterwards, you get exactly the same amount of money (or, in less draconian systems, you'd get a "minimal" interest rate that made you indifferent between the safest asset available, like a treasury bond). So in the time you lent out your capital, you were deprived of using it for your own purposes, and someone else benefited.

So in such a system, what happens? Loans are no longer purely a financial instrument, but become non-pecuniary as well. I lent you money to start a business, so you have to, say, marry your beautiful daughter to my idiot son, etc. Financial markets vanish, but networks of overlapping obligations replace them. You destroy markets that create securities as commodities in favor of a primitive system of trading favors.

What happens then? Black markets for liquidity. Loan sharks, the mob, and so on. If I can't get a mortgage from a conventional bank, I go to the guy with cash who is willing to break the law. You force many people into financial dependence on systems outside government oversight, because they are doing something illegal.

Would this help a developing country? Definitely not. Many already struggle under this kind of system, and killing off markets for loans would be a disaster.

Accountability is at the heart of well-functioning markets. The problem with the western system is that large players --- say, airlines --- know that in a crisis, the government will step in and save them, so they take inappropriate risks and fail to plan for bad outcomes. This has nothing to do with charging interest.

• Where is the analysis wrong? Interest rates are prices. When you make a good or service illegal and get rid of the price signal, you destroy information and you get the consequences I listed. Using profit-sharing as a workaround does not fix any of that. – user26098 Apr 2 '20 at 13:00
• Interest rates are the prices of consumption at future dates denominated in today's dollars. That is all they are. Just because a particular group of people wants to pretend there is a difference between the lending service and the provision of capital doesn't mean anything. This is like the difference between the legal and economic incidence of a tax, or the debate over whether the individual mandate is a tax, or cap and trade, etc. You can fool some people by manipulating words, but that doesn't change incentives. – user26098 Apr 2 '20 at 14:05
• I go to a convention bank (Islamic Bank). The bank says they will give me a $\$$17.5k loan to buy a car (The IB says it will buy a \$$17.5k car and loan it to me). In 5 years I have to pay$\$$20k back (in 5 years I have to have paid \$$20k), or the bank will repo the car (the IB will reclaim its property). That means over the course of 5 years I pay each bank $\$\$2.5k. The interest rate is r=(20-17.5)/17.5=.14 if I pay it all right before the loan ends. "The grip of the West," what a laugh. – user26098 Apr 2 '20 at 14:32