Islamic Banks and Investment Financing

Islamic Law prohibits charging interest. We study financial instruments used by Islamic banks and find that most are not based on profit-and-loss sharing (equity) but, instead, are very debt-like in nature. We see some bias against providing financing for agriculture and industry. Long-term financing is rarely offered to entrepreneurs. Our model shows that debt-like instruments are a rational response by Islamic banks to their contracting environments. As agency problems become more severe, debt becomes the dominant instrument of finance. We give conditions under which banning debt increases social welfare as well as conditions under which banning debt decreases social welfare.