This article was published in Arab Times on July 26th 2011.

Following their earlier article on Islamic Finance, Usman Hayat CFA, Director of Islamic finance & Environmental, Social, and Governance (ESG) factors in investing at CFA Institute and Raghu Madagolathur, President of CFA Kuwait, discuss limited purpose banking in the region as an alternative financial system that suits Islamic banking.

The global financial crisis has stirred a search for an alternative financial system. Whilst the Middle East has not been affected as much as some of the Western economies, it has by no means completely recovered. A number of high profile failures as well as continuous provisioning have prevented many banks from a robust recovery and global debate on alternative financial system is also relevant for the Middle East.

Islamic banks in the Middle East are also not immune from problems facing the global banking sector. For instance, they are exposed to speculative financing of real estate. It is worthwhile reviewing some of the issues that follow from our previous article on Islamic finance in the context of alternative financial systems.

The ongoing debate suggests that there are two major expectations from any alternative financial system. First, it should be free of bailouts of private institutions from public money, and second, it should focus on serving the real economy.

One potential alternative that might meet these expectations is limited purpose banking. It is proposed by Laurence Kotlikoff, a prominent economist and a professor at Boston University, who explains it at length in his book “Jimmy Stewart Is Dead” (2011).

As implied by its name, limited purpose banking limits the role of banks. In an audio podcast (2011) that we recorded with him, Kotlikoff explains that “limited purpose banking moves us from trust-me banking to show-me banking”. Simply put, banks will not extend credit themselves but operate like asset management companies offering mutual funds.

These mutual funds that do not borrow to invest will only buy the assets specified in their charters, be they mortgages or corporate bonds. The payment system would function through cash-only mutual funds. Banks will not be able to expand the money supply and the government would have full control of the money supply (M1).

There will be no opaque leveraged speculation through banking and no reason for a contagious run on the bank. Therefore, there will be no need for any bailout, deposit insurance, lender of last resort, and so on.

Unlimited liability will apply to those financial institutions, such as hedge funds, that cannot work as mutual funds. That is, the personal wealth of those who want to speculate on borrowed money will no longer be safe from their actions, cutting the appetite for speculation.

A single financial regulator will take the lead in ensuring safe custody of mutual fund securities and transparency in underlying transactions. This should help prevent fraud as exemplified by Bernie Madoff, “liar loans” and “toxic assets”.

This, in short, is how limited purpose banking seeks to eliminate bailouts and give finance compelling reasons to focus on the real economy.

Does it sound radical? “It’s not radical. What is radical is maintaining the current financial system”, argues Kotlikoff in his video on YouTube (2010). Limited purpose banking is not without its supporters.

Those who have praised “Jimmy Stewart Is Dead” include five Nobel laureates in economics and some known policymakers like George Shultz, former U.S. secretary of the Treasury. Mervyn King, the Governor of the Bank of England, has also talked about Kotlikoff’s “much wider vision of how the financial system can ultimately end”. Kotlikoff’s alternative may not appeal to high street bankers, but it may find appreciation in some unexpected quarters: Islamic finance. Islam, it is widely held, prohibits lending money on interest. Literature on Islamic finance tends to discourage the sale of risk and debt financing.

Similarly, it encourages profit and risk sharing, it sees as suitable for economic justice. However, observers often note that the Islamic finance industry, usually estimated at around $1 trillion in assets, does not always match this description. Take, for instance, “Islamic Law and Finance: Religion, Risk, and Return” (1998) by Frank E. Vogel and Samuel L. Hayes III, two professors from Harvard University. In the concluding chapter of this book, they termed it a “legal and financial embarrassment” that Islamic banks “mimic conventional banks” instead of being the profit-and-loss investment intermediaries that Islamic economic theory demands. They went on to suggest that genuine profit sharing through pooled funds could be the solution. Islamic finance, however, continues to be largely commercial banking within conventional fractional reserve banking.

According to the IFSL research report (2010) on Islamic finance, 74 percent of the assets of the industry are in commercial banking and only 5 percent are in funds. Fractional reserve banking is often criticized in Islamic finance. One of its foremost critics is Tarek El Diwani, a London-based Islamic finance adviser. In his book, “The Problem with Interest” (1997), Diwani makes a detailed economic case against the proliferation of debt and resulting injustice that he sees inherent in fractional reserve banking. It will soon be four decades since the establishment of the first Islamic commercial bank in 1975.

There are many challenges facing the industry but there is a growing realization among reformists that the current financial system is one of the biggest. At the very least, it favors interest-bearing loans and leveraged speculation, making Islamic finance swim against the current. But does limited purpose banking suit Islamic finance better? Dr. Volker Nienhaus, an economist from Germany, thinks it does. In a video podcast (2011) that we recorded with him, he suggests that ending financing via banking and routing financing through mutual funds will lead to genuine and transparent risk sharing between contracting parties.

According to Nienhaus, this structure will make finance serve the real economy and it “puts into practice what is promised” in Islamic finance. Nienhaus is of the view that Islamic financial sector should adopt this structure even if global banking reform does not mandate it. In the past, a similar proposal, but with a limited scope, was narrow banking. This was part of the Chicago Plan of 1930s. Interestingly, the Chicago Plan predates modern Islamic finance but some see it as a fit. In a research paper (2004), Valeriano García, Vicente Fretes Cibils, and Rodolfo Maino suggested that narrow banking and equity financing are “what Chicago and Islam have in common”. Some practitioners in Islamic finance—such as Iqbal Khan, the founding CEO of HSBC Amanah—have also spoken in favor of a mix of narrow banking and asset management for Islamic finance.

The Chicago Plan was never implemented despite the support of leading economists. Time will tell if limited purpose banking enjoys better luck. But it would probably enjoy support among reformists in both conventional and Islamic finance by meeting their expectations from an alternative financial system.