Islamic Banking's Role in Controlling Inflation

Topics: Fractional-reserve banking, Interest rate, Islamic banking Pages: 10 (2780 words) Published: August 31, 2010


Inflation has become a fact of life in nearly all countries, but it is a very serious problem in the developing countries. As far as commercial banking is concerned, it erodes the value of the depositor's savings as well as that of the bank's loans. Yet the banking system does not seem to specifically address this problem. This paper makes an attempt at finding a way of compensating for the loss suffered by capital due to inflation. Identifies the transactions in the commercial banking businesses that are affected by inflation, considers several possible ways of counteracting the adverse effects, and then presents one approach as most suitable for implementation. The method presented here is a general one, universally applicable to all lending-borrowing operations, to neutralize the effect of inflation on such transactions. It is simple and straight forward, but requires the Central Bank to play a pivotal role in its implementation. The method has special relevance to Islamic banking. For whereas in a conventional system the interest paid to the depositor may fully or partially compensate for the loss, and the bank may include it in the interest they charge the borrowers, in an Islamic system the depositor will have to bear the full loss. Therefore a method of compensation for the loss becomes even more urgent.


The dual banking system in Malaysia has enabled banks to offer two forms of financing method, the conventional loan and Islamic financing. In recent years, over a period of more than a decade, financial institutions have offered a wide variety of financing facilities from which consumers could choose. It is well known that the main difference between Islamic banks and conventional banks is interest rates (Haron and Shanmugam, 2000). In Islamic banks, interest rates are forbidden and unlawful to be practiced. Therefore, a new solution has to be created in order to ensure Islamic banks do not appear to be similar to the interest-based conventional banking system. The solutions are twofold; first, Islamic banks employ hibah rate or profit sharing ratio when providing profit to depositors of the banks. Second, Islamic banks employ profit rate when charging the customers on Islamic financing. No interest rates will be given. The hibah rate is given based on Islamic banks’ performance. It is not a guarantee by the bank. However, interest rate is a guarantee by conventional banks, regardless of whether the banks gain profit or not. This is a burden in the case of conventional banks. If they incur loss in their banking operation, the loss will be borne by them alone. However, in the case of Islamic banks, the loss will be shared by both parties; the depositor and the banks.

Shaharuddin and Safian (2005) undertook a study on Islamic variable rate financing which is acceptable from Islamic perspective. This study has revealed an innovation of Islamic financing. However, in this present study, a focus is only for flat rate rather than Islamic variable rate financing.

In this paper, the main objective is to argue Islamic financing’s performance in relation to the economic situation such as in inflation and deflation. A comparison between the Islamic financing and conventional loan is inevitable in the effort to analyze its performance. Shariah has allowed Islamic banks to apply the flat rate which is a free-market rate in order to provide a different feature of Islamic banking system as compared to conventional banking system. Islamic Banking is superior to conventional banking because Islamic Banking has a fixed rate of payment regardless of the economic condition and any risk is shared between the bank and the customer.

ARGUMENT 1: Economic situation and its effect on Islamic home financing

Economic instability can have a great impact on the interest rate but with Islamic banking, the rate of payment is...

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Haron. S, & Shanmugam, B. (2000). Islamic banking system. Kelana Jaya: Pelanduk Publications.
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