Islamic Banking Principles and Quantitative Balancing: Implications for Money Creation

Islamic Banking Principles and Their Implications for Money Creation

Islamic banking, rooted in Sharia principles , offers a distinct approach to finance that rejects interest (riba ) and emphasizes ethical, asset-backed transactions. The Profit and Loss Sharing (PLS) principle, central to Islamic finance, has significant implications for money creation and financial stability. Below is an analysis of these principles, supported by recent studies and their alignment with critiques of conventional banking:

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1. Islamic Banking and the Prohibition of Riba

Islamic banking prohibits riba (usury/interest), requiring that financial activities be tied to real economic transactions . This contrasts with conventional banking, where money is created "out of nothing" through fractional reserve lending, generating interest-based profits.

• PLS Mechanisms :
  • Mudarabah (profit-sharing): Banks provide capital to entrepreneurs, sharing profits and losses.
  • Musharakah (joint venture): Banks co-invest in projects, assuming shared risk.
    These models ensure that money creation is linked to productive investments, reducing speculative lending.

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2. PLS and Money Creation: A Structural Shift

According to Jedidia (2023) , the PLS principle limits the creation of money "out of thin air" ( ex nihilo ):

• Asset-Backed Financing : Every loan must be linked to real assets (e.g. infrastructure projects, manufacturing activities), preventing the creation of money without tangible collateral .
• Reduction of Speculation : Risk sharing discourages banks from over-expanding credit for speculative activities, as happens in the traditional banking system .

However, some studies highlight that Islamic banks also operate in a fractional reserve system , creating money through alternative mechanisms (e.g. sukuk or Murabaha contracts ). Therefore, the PLS does not completely eliminate money creation, but makes it more transparent and linked to the real economy .

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3. Implications for Financial Stability

• Lower Systemic Risk : PLS reduces exposure to speculative bubbles, as funding is tied to concrete projects. This aligns Islamic banking with Augusto Graziani 's vision of anchoring money to production.
• Economic Fairness : Profit and loss sharing promotes a fairer distribution of risk between banks and customers, mitigating the inequalities generated by the traditional system .
• Integrity of Money : According to Firano (2024) , the prohibition of interest and the focus on real activities preserve the purchasing power of money, reducing inflation caused by excessive liquidity creation .

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4. Parallel with Quantitative Balancing (QB)

Marco Saba's Quantitative Balancing (QB) and the PLS share objectives of transparency and stability, but differ in their methods:

• QB :
  • Reclassifies deposits as liabilities to the State Treasury, making seigniorage explicit and segregating customer funds.
  • Eliminate the accounting illusion of money creation by ensuring that balance sheets reflect economic reality .
• PLS :
  • It limits the creation of money through the connection with real assets, but does not change the accounting structure of banks.
  • It requires ethical governance to avoid deviations, such as the use of “simulated” Murabaha to circumvent the interest ban .

Complementarity :

A system that integrates PLS and QB could combine:

• QB accounting transparency.
• Ethics and the focus on reality of the PLS.
  
  
• This would reduce both opaque money creation and systemic risks .

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5. Criticalities and Limitations of the PLS

Despite the advantages, PLS presents challenges:

1. Practical Application : Many Islamic banks resort to hybrid instruments (e.g. fixed rate Murabaha ), which simulate interest, compromising adherence to Sharia principles .
2. Liquidity : Reliance on real assets may limit banks' ability to provide liquidity in times of crisis.
3. Regulation : More stringent international standards are needed to prevent PLS from becoming a mere gimmick to justify similar-traditional practices .

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6. Conclusion

The PLS is a step towards a more equitable and stable financial system, but it does not completely solve the problem of money creation "out of thin air". For a structural change, the PLS should be complemented with reforms such as the QB, which redefines the role of the State in managing seigniorage and segregation of deposits.

In a world where finance is often dissociated from the real economy, PLS and QB offer two complementary paths to a more just and resilient monetary system .

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Sources:

[1] Jedidia, K. T. (2023). Profit-Loss Sharing in Islamic Finance.

[2] Firano, Z. (2024). Islamic Banking and Financial Stability.

[3] Omerbegović Arapović, A. (2024). Full Reserve Banking and Monetary Separation .

[4] Graziani, A. (2003). The Monetary Theory of Production .

[5] Saba, M. (2025). Quantitative Balancing: Financial Statements .

[6] Bossone, B. (2021). Bank Money Creation and the Payments System.

[7] Bezemer, D. J. (2016). Towards an ‘accounting view’ of money.

[8] Schemmann, M. (2023). Bank Money in Crisis .

[9] Della Luna, M. (2017). Scriptural currency.

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This analysis shows how PLS, while not a complete solution, is an ethical model that can mitigate the risks of money creation. Integrated with QB, it could represent a transformative reform of the global financial system.