Islamic banks and investment financing

Islamic Law prohibits charging interest. We study financial instruments use d by Islamic banks and find that most are not based on profit-and-loss shar ing (equity) but, instead, are very debtlike in nature. We see some bias ag ainst providing financing for agriculture and industry. Long-term financing is rarely offered to entrepreneurs. Our model shows that debtlike instrume nts are a rational response by Islamic banks to their contracting environme nts. As agency problems become more severe, debt becomes the dominant instr ument of finance. We give conditions under which banning debt increases soc ial welfare as well as conditions under which banning debt decreases social welfare.