AAOIFI Accounting Standards and a Theory of Interest-Free Banking

Based on the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) issued six new Financial Accounting Standards (FAS) in 2017, we derive the cost of financing formulas for various Islamic financing contracts. Later, we present a simple theoretical framework for interest-free Islamic banking based on the Basic Limited-Participation Model seminal approach developed by Lucas (Lucas, RE Jr. (1990). Liquidity and interest rates. Journal of Economic Theory, 50(2), 237–264.) and Fuerst’s (Fuerst, TS (1992). Liquidity, loanable funds, and real activity. Journal of Monetary Economics, 29(1), 3–24.), and later followed by Walsh (Walsh, C (1998). Money in the short run: Informational and portfolio rigidities. In Monetary Theory and Policy, pp. 211–223. Cambridge, Mass.: MIT Press.). We compare the competing theoretical models for conventional banks and for interest-free Islamic banks and formulate testable hypothesis. To complement our models, we provide empirical evidence by using a unique sample of 15 banks from Bangladesh that provide both conventional banking and Islamic banking services. Results suggest that Islamic bank profit rates and conventional bank interest rates are correlated in an economic environment where conventional and Islamic banks dwell under same regulatory framework.