The problems with fractional reserve banking and proposing a shariah-compliant full reserve banking model

Abstract

Fractional reserve banking, which constitutes the backbone of the conventional, pre-eminent economic system, is being questioned more than ever due to its serious problems in terms of sustainability, market discipline, resilience against crises, and Islamic economics. Although some supportive elements such as central banking, deposit insurance, and Basel regulations have emerged over time to sustain this naturally fragile system, none of them proved a permanent solution. This study aims to identify the economic consequences of the money creation process in the fractional reserve banking system, reveal its problems with Islamic economics, and examine the viability of alternative models based on full reserve banking. Following a brief discussion on essential theories and practices about the banking, credit, and money triangle and identifying the controversies, we will utilize a simulation method as an attempt to provide an original, tangible answer as to how a shariah-compliant and sustainable system can be achieved. Though we benefit from the earlier models such as that of Monett and Barrientos, Chan-Lau, Mallett, and Wilensky, our model will be unique, as we adopt more realistic assumptions and Islamic considerations.