How Islamic banks create money

The way that money is created in a modern economy is not well understood by most people. I have never forgotten how informative I found having it explained in an economics textbook when I was 18.

Many proponents of Islamic finance assert, incorrectly, that Islamic banks do not create money. Accordingly I devoted my October column in the magazine "Islamic Finance News" to explaining in very simple terms how Islamic banks create money.

Islamic banks also create money

There are many valid reasons for supporting the growth of Islamic banking. There are also invalid reasons sometimes cited, the most egregious being those which are simply incorrect.

I hear from time to time at Islamic finance conferences that “unlike conventional banks, Islamic banks do not create money since all transactions have to involve real assets.” This sounds plausible but is incorrect. Like conventional banks, Islamic ones also create money.

The economy, and the aggregate banking sector, are complicated, and not easy to think about. Accordingly, I have adapted a simple explanation of money creation that I first encountered in a conventional economics textbook over 40 years ago.

Imagine a remote town, for example on a small island. Due to the size of the town, there is only one (Islamic) bank, so everyone who has a bank account does so with this bank. (In real life one considers the aggregate of all banks together, but it is simpler to illustrate with just one bank.)

One of the bank’s customers wants to buy a car with murabaha financing from the bank. Accordingly, the bank purchases a car from the local car dealer for $30,000 and sells it to the customer for, say, $35,000 payable in equal monthly instalments over three years.

The car dealer having received $30,000 from the bank of course deposits that money in his bank account. Indeed, the bank probably paid him by simply crediting $30,000 to his account.

In accordance with accounting standards for murabaha transactions, the bank must spread the $5,000 profit on selling the car over the 36-month period of the murabaha transaction in an appropriate way. Of course, on the day of the transaction no part of the 36 months has elapsed.

Accordingly, immediately after the above murabaha transaction, the bank’s balance sheet is as follows:

Prior to the murabaha transaction, people living on the island had $800,000 of spendable money being the customer deposits.

In other words, they could write cheques on their bank accounts or make electronic transfers in order to make purchases from vendors on this island, up to a total of $800,000. Of course, in practice they would be unlikely to spend all of the money immediately. However, even if it was all spent immediately, as long as it was only spent on this island, it would all be redeposited back in the bank.

After the murabaha transaction, the total amount of money on the island that can be spent is $830,000. Accordingly, the bank has created $30,000 of money.

The above is neither an argument for, nor against, Islamic banking. The important need when promoting Islamic banking is to understand where it differs from conventional banking, and where it does not.

Assets
Deposit with national central bank	$100,000
Other assets, mainly customer financings	$900,000
Total assets	$1,000,000

Liabilities
Customer deposits	$800,000
Shareholders’ equity	$200,000
Total	$1,000,000

Assets
Deposit with national central bank	$100,000
Other assets, mainly customer financings	$900,000
Murabaha financing of car	$30,000
Total assets	$1,030,000

Liabilities
Customer deposits	$800,000
Deposit made by car dealer	$30,000
Shareholders’ equity	$200,000
Total	$1,030,000