Islamic banks with mutuality and neutrality: A balance-sheet-based theoretical framework

The sole purpose of this paper is to develop a simple balance-sheet-based theoretical model for Islamic banks by incorporation of mutuality and neutrality characteristics as evidenced in large credit unions. The theoretical results reveal that an optimum combination of investment in Sharia’h-compliant securities and permissible lending in response to relative changes in expected average return of securities, lending rate and deposit rate. Counter-intuitively, the Islamic banks do not tend to change the optimum combination of loans and securities due to increase in risk unless it is massive and persistent springing from deep negative economic shocks. The findings of this paper have potential policy implications for Islamic banks and other business entities. As for policy implications, they should i) maintain balanced portfolio with moderate risk exposure, as applicable; ii) keep buffer capital higher than the minimum required to withstand unforeseen financial turmoil; iii) carefully assess costs and benefits of each permissible project; iv) monitor customer profiles to assess individual situations; v) recognize common bond; vi) balance member benefits for neutrality; vii) be transparent and ethical in dealing with clients; and viii) operate according to financial capacities.