FRACTIONAL RESERVE BANKING/CREDIT CREATION AND ITS INFLUENCES ON ISLAMIC BANKING SYSTEM

Abstract

FRB is the process through which money is created out of nothing by the banks worldwide. Banks create money through the fractional reserve system which increases the money supply in the economy thereby causing inflation. The system of FRB enables the creation of purchasing power to the hands of a few individuals or groups of individuals out of nothing. In the world economy, the system of credit creation (which is called ‘fractional reserve banking, in which only a fraction of bank deposits is backed by actual cash-on-hand) is very harmful to our economy and a great hindrance to adopting partnership based modes of financing (Shirkah and Modarabah) in Islamic Banking, especially in the countries where Islamic and Conventional banking systems are equally run by central banks. There are several violations of ‘Maqasid ul Shariah’(Goals of Shariah) in the present operations of Islamic banks operating under the FRB framework, such as rich are getting richer while the poor ones suffer; the sovereignty of individuals is lost; causing members of the society to bear some hidden taxes, etc. So, there is a great need to change the system of ‘fractional reserve banking. Credit creation must be according to goods and services created, and credit creation must be based on financing, not on debt, that is why new credit is generated due to Modaraba transactions also. In this article, it is discussed that how the system of ‘fractional reserves banking’ damages the Shari’ah goals (Maqasid Ul Shariah), economy, and implementation of partnership-based modes of financing in Islamic banking, and what could be the best solution for this problem.