Islamic Banking and Western Financial Theories

Since in conformity with Islamic precepts they must observe the prohibition of the receipt and payment of interest in all their operations, Islamic banks mobilise funds primarily using profit sharing instruments that differ from those of conventional (non-Islamic) commercial banks. In this paper, we argue that the concept of financial risk, on which modern capital structure theories are based, is not relevant to Islamic banks. Given the contractual obligation binding the Islamic bank`s shareholders and investment account holders to share profits from investments, we propose a theoretical model in which, under certain assumptions, an increase in investment accounts financing enables the Islamic bank to increase both its market value and its shareholders` rates of return at no extra financial risk to the bank. We theoretically demonstrate that such a process leads to an increase in the Islamic bank`s market value but does not reduce its weighted average cost of capital. The evidence obtained from estimating and testing the model on annual accounts drawn from a sample of 12 Islamic banks lends support to our theoretical predictions, as do the results from counterfactual simulations and sensitivity experiments. We conclude that, in the context of Islamic banks both our theoretical and empirical results effectively dislodge the hitherto well-entrenched Modigliani and Miller (MM) propositions. Hence, viewed against the main competing tenets of the traditional school and the MM standpoint, our results provide an encompassing paradigm on the theory of capital structure