An Economic Theory of Islamic Finance Regulation

We argue that regulation can improve the performance of conventional banks up to a limit, but cannot eliminate the deficiencies resulting from the use of the conventional loan contract. Islamic finance requires complicated and costly procedures compared to conventional finance. Yet, it has significant macroeconomic benefits, which cannot be internalized by individual banks. Therefore, Islamic bankers tend to mimic conventional finance in order to cut costs and maximize short-term profits. Regulation can modify bankers’ incentives in order to capture the benefits of Islamic finance. Based on Al-Jarhi’s macroeconomic model (1983), we construct an economic theory of Islamic banking regulation. Results point out to the potential of designing regulations that discourage mimicking conventional finance in order to benefit from the Islamic finance advantages.