Can Interest-Free Finance Limit the Frequency of Crises and the Volatility of the Business Cycle?
Abstract
In light of the recent, global financial crisis, countries have discussed regulating firm leverage. Many firms and households were overleveraged during the crisis and such leverage has been blamed for exacerbating a debt-deflation crisis. By limiting the amount of debt that financial firms can carry, regulators hope to prevent future debt-deflation crises. Restricting the financing of firms, however, may have negative effects. According to financial accelerator theory, investment is tied to net worth. If firms are prohibited from taking on debt, the relationship between investment and equity prices is stronger, as firms must issue equity to raise capital. Thus, when economic conditions are poor, investment drops precipitously. As a result, limiting leverage may deepen recessions, exacerbating the volatility of the business cycle. The development of an interest-free financial system under Islamic finance offers insight into the effects of a leverage constraint. To comply with Islamic financing constraints, Islamic firms have developed financial products with characteristics of both equity and debt, altering their optimal capital structure. This paper attempts to measure the impact of Islamic finance on financial crises and the volatility of the business cycle via capital structure. The results show that Islamic, interest-free finance decreases crises by decreasing the total amount of external debt liabilities. Meanwhile, the models show no significant impact of Islamic finance upon the volatility of the business cycle. Thus, regulations limiting leverage and decreasing the tax advantage of debt may limit financial crises with little adverse effect upon business cycles.
Document Details
- Document Type
- Technical Report
- Publication Date
- May 14, 2011
- Accession Number
- ADA554676
Entities
People
- Jacob M. Stevens-haas
Organizations
- United States Naval Academy