Credit creation and control: an unresolved issue in Islamic banking

Abstract. This paper deals with a still unresolved issue - credit creation and control- in an interest free banking system. The available literature on the subject is scanty, controversial and inconclusive. The paper holds that credit creation per se is not un-Islamic; the essential point is how credit is generated and used. It argues that credit creation cannot be banished; it is an imperative for frictionless adjustment of money supply to unavoidable fluctuations in its demand in modern economies. It seeks to correct the misunderstanding in the literature that banks create credit ex nihilo.Demand for money apart, fiscal policies and foreign exchange transaction erode the credit controlling power of the central banks. The paper blames major difficulties including those of credit creation and control on the evolution of Islamic banking on the same pattern as its mainstream counterpart and suggests some structural modifications. Finally, it finds the conventional weapons of credit control inefficacious for use in an interest free banking system and suggests the inclusion of a ratio of cash to bank advances among them. The paper has some important technical and policy implications.