Deposit Erosion

Secondly, it may be argued that since the number of depositors may tend to be risk averters, they may be driven away from banks in a system where there is the prospect of erosion in their deposits through losses incurred by banks. This need not be the case because all deposits would not be sharing in the profit or loss. Islamic banks would, like their conventional counterparts, have different categories of deposits – demand deposits and different types and maturities of investment deposits. Demand deposit s will be guaranteed and will not hence share in the profit or loss. They will not thus be exposed to any risk. It would be desirable to insure them partly or fully by a deposit insurance scheme. Hence, there is no reason to assume that demand deposits may be driven away.

Investment deposits would, however, share in the profit or loss. But it may be possible for banks to minimize the possibility of loss by diversifying their assets portfolios, managing their risks effectively, building loss – offsetting reserves. It may also be possible for them to offer to their clients different types of investment opportunities, carrying varying degrees of risks, with the object of attracting deposits of even risk averters.

Nevertheless, the possibility of loss would still remain. If the risk of loss has not reduced investment in businesses and joint stock companies, there is no reason to assume that the risk of loss on investment deposits would reduce such deposits. To the extent that the risk of loss does have an impact, it may exert a healthy influence on banks. It would help introduce greater discipline in the banking business by making the banks more careful in financing their clients. A great deal of the loose financing undertaken by conventional banks on the basis of the false assurance that they will receive the principal with interest may thus get minimized. It would also remove a major source of inconsistency and instability in the conventional banking system arising from their assets being exposed to risk when the deposits corresponding to these assets do not share in the risk. It would also exert a healthy influence on depositors by motivating them to take a greater interest in the affairs of their banks. They would, therefore, demand greater transparency.