State contingent banking and asset price bubbles: The case of Islamic banking industry

Saad Azmat, M. Kabir Hassan, Hamza Ghaffar and A.S.M. Sohel Azad

Global Finance Journal, 2021, vol. 50, issue C

Abstract: This paper examines how state contingent banking can help neutralize challenges like debt overhang and lack of optimal risk takings, problems associated with conventional banking that can eventually manifest in the creation of asset price bubbles and a financial crisis. Our analysis also contributes to the literature on Islamic banking which considers state contingent contracts as ideal from a religious perspective. We develop a model of banking with state contingent contracts on the liability and asset sides. Our model shows that in state contingent banking, the returns for the depositors, bank and the borrowers are more aligned with the real economy, which reduces the incentive for excessive borrowing, lending and investing. Our model also shows that with the state contingent banking on the liability side, during periods of heightened macroeconomic risk, depositors' payoff would be more volatile reducing the liquidity influx from the real economy to the banking sector. This neutralizes the pressure on state contingent banks to excessively lend on the asset side. Our model further demonstrates that state contingent contracts on the asset side can help avoid too much (or too little) lending by reducing the managerial discretion in charging low (or high) interest rates. With returns linked to the prices of the underlying assets, state contingent contracts may prevent lack of optimal risk taking.

Keywords: State contingent banking; Asset price bubble; Financial crisis; Risk sharing (search for similar items in EconPapers)
JEL-codes: G21 G24 G33 (search for similar items in EconPapers)
Date: 2021
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:glofin:v:50:y:2021:i:c:s1044028319303473

DOI: 10.1016/j.gfj.2020.100531

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