Islamic Banking and wealth distribution : an application of agent-based computational model

Abstract

The motivation of this study is to examine the role of both profit and loss sharing (PLS)-based and markup-based financing in wealth distribution. Historically, the objective of Islamic banking is to eliminate interest from the financial system and to promote the application of profit and loss sharing (PLS) schemes as an alternative. Nevertheless, the small number of applications of the PLS-based system currently indicates that the practice of Islamic banking institutions is far from ideal. Moreover, many empirical studies show that conventional bank lending is also able to reduce the gap in wealth distribution. Therefore, it seems that both Islamic and conventional banking systems may promote wealth distribution. Considering this research gap, the primary objective of this study is to examine the role of Islamic bank financing in wealth distribution by applying ABM as a tool of analysis. The introduction of interest-based model is to compare the results with the conventional system. The simulation results show that PLS-based financing has better performance in promoting wealth distribution than the markup-based or interest-based ones. The outcome also shows that the economy experiences higher inequality in wealth distribution, regardless the rate of interest on credit and interest on deposit. This implies that the types of financing are a key factor in determining wealth distribution, rather than merely focusing on access to finance. This research further concludes that both markup-based and PLS-based may promote wealth distribution subject to minimum threshold level of profit shared on deposit, markup on credit and profit share paid by the firm. It is also observed that there are two fundamental requirements to promote wealth distribution. First, that there is wealth transfer generated inside the system, and second, that there is an increase in the wealth of the majority of households. This research can be used as a feasibility study, particularly regarding the application of full PLS and its impact on wealth distribution. Therefore, a number of policies are proposed to promote the role of the Islamic banking industry in minimizing inequality in wealth distribution. Keywords: Islamic banking system, Conventional banking system, PLS based, markup based, interest based, Wealth distribution, Agent based computational model (ABM).