Find Events Find People Find Jobs Find Sites Find Help Index


October 28, 2002

Kia offers primer on Islamic interest-free banking

By Victor Rogers

Doing business globally often requires a deep understanding of the cultural and religious traditions—and political environments—that affect financial situations abroad. Many financial transactions in Islamic nations, for example, remain based on religious doctrine, and as such require banks to avoid charging interest to the borrower. (Islamic law prohibits “riba,” or interest in financial transactions.)

Many large U.S. corporations have understood the need to address their Islamic business partners and clients; Citibank, for instance, established its subsidiary Citi Islamic Investment Bank in 1996 in Bahrain to bring the Islamic banking style to investors and fund takers. Islamic banking extends back to America, as banks such as HSBC Bank USA offer interest-free loans to its U.S.-based Muslim customers.

While the application and interpretation of an interest-free banking system differs throughout the Muslim world—Indonesia and Malaysia, for example, have interest-free banks, but the majority remain interest bearing—Iran represents one of the more strict interpretations of the principle. Essentially, in interest-free banking, the bank and borrower share in profits in more of a risk-sharing approach.

According to Amir Kia, professor of economics, an interest-free banking system can provide market stability, as the rate of interest remains “an important factor in the demand-for-money determination.”

“In the U.S. system, we have recognized that because of the interest part of the money demand, we will continue to have an unstable system,” Kia said. “The system has two parts: demand and supply. The U.S. central bank is doing the best job it can do, but the main problem is the volatility of the interest rates. I would suggest that the interest rates should be fixed to zero.”

While Kia’s notion of interest-free banking may come as a strange concept to many Americans, Nobel Prize-winning economist Milton Friedman endorsed a monetary policy that encouraged a zero interest rate, suggesting it as a more efficient way to allocate resources.

Exploring this issue led Kia to complete the paper titled “Interest-Free and Interest-Bearing Money Demand: Policy Invariance and Stability,” in which he specifically studies the impact of Iran’s interest-free banking system on the country’s money demand. Prior research into interest-free banking systems concentrated on short-term demand, so Kia’s paper offers more conclusive results by taking a longer-range look at the subject.

While Kia admits that his research is mostly policy oriented, he noted the results show “a more stable banking system.” While the U.S. trade embargo remains in place against Iran, Kia’s research still manages to provide a useful look at a system used in some shape or form throughout many other Muslim nations.

Kia used previously accepted financial measurements to test the stability of short- and long-term money demand in Iran, as well as the impact of monetary policy on the stability of long-term money demand in the country. Using quarterly Iranian financial data from 1966–98 taken from the International Monetary Fund, he compared interest-free and interest-bearing instruments.

In 1984, the Iranian government banned interest payment on most lending and borrowing; Kia’s analysis specifically uses data from the pre-interest-free environment against the interest-free system post-1984.

Kia said he expected regime shifts in Iran to create more instability for interest-free money demand than interest-bearing demand. “I did not expect to have such a strong result in a country with the variety of social upheavals experienced there,” he said.

But short- and long-run demand for interest-free money remained stable, despite shifts in policy and leadership in Iran. Kia notes that Iran experienced “a wider range of real and monetary shocks over the sample period,” making his study of particular interest to monetary economists. From 1995–98, for example, the country’s Central Bank set credit ceilings for banking facilities, in order to curb inflation.

Essentially, Kia’s research showed that since the demand for interest-bearing money is not stable, the Central Bank does not lose a powerful tool of monetary policy (i.e., interest rate) in the absence of an interest-bearing money supply. This would appear to lend credence to his financial theory that suggests a need to alter the money supply to cap inflation, rather than a rejuggling of the interest rate.

While Kia noted that actual and expected interest rates in the United States play a large role in determining monetary policy and ultimately the demand for money, the limited data from Iran show a similar pattern in that country’s interest-bearing financial instruments.
“It was also found that agents in demanding interest-bearing assets are forward-looking, and their expectations are formed rationally in Iranian financial markets,” he said.