Beyond Riba: Reconstruction of Just Financial Order—II  Who should create money?

The first part of this series concluded with a question that goes deeper than the contractual forms employed by conventional or Islamic banks: who should possess the power to create money—society through its sovereign monetary authority, or commercial banks through the expansion of credit? It is impossible to reconstruct a financial order without answering this question.

Popular understanding of banking remains surprisingly detached from the way modern money actually comes into existence. The conventional explanation suggests that people first deposit their savings with banks and banks subsequently lend part of those deposits to borrowers. Banks thus appear principally as intermediaries between savers and investors. Modern banking does not operate quite like this.

The Bank of England, explaining the process in unusually clear terms, acknowledges that most money in a modern economy is created by commercial banks when they make loans. A bank granting financing normally credits the borrower’s account and simultaneously records a corresponding asset on its own balance sheet. 

The deposit is created through the act of lending rather than necessarily representing money previously deposited by another saver. When the loan principal is repaid, the corresponding bank-created money is extinguished. This requires an important correction to the familiar expression “fractional-reserve banking”. 

Banks are certainly required to maintain reserves, liquidity and regulatory capital, but contemporary money creation cannot accurately be understood as a mechanical process in which every rupee of reserves is successively multiplied into a predetermined number of rupees of loans. 

Lending is constrained by capital requirements, liquidity, creditworthiness, profitability, regulation, settlement requirements and ultimately monetary policy. It nevertheless remains true that deposit-taking commercial banks create a substantial part of the money used by society.

Pakistan is no exception. State Bank of Pakistan’s monetary data show that at end-June 2026 broad money was about Rs. 46.46 trillion. Currency in circulation was about Rs. 11.94 trillion, while deposits with banks were approximately Rs. 34.47 trillion. The greater part of what Pakistanis use as money does not consist of notes issued by the State Bank. It consists of claims recorded in the banking system. This distinction has profound consequences for our discussion of riba.

Commercial-bank creation of deposit money should not automatically be declared riba. The Quran does not prescribe a reserve ratio, a central-bank structure or a particular technique for creating currency. 

To equate fractional-reserve banking itself with riba would unnecessarily turn a question of monetary system into a theological declaration. The real objection is different.

A society must ask whether the privilege of creating generally accepted purchasing power should be exercised primarily through private debt contracts; who receives the initial benefit of newly created purchasing power; towards which activities the new credit is directed; who absorbs the losses when excessive credit creation produces instability; and whether private institutions can earn a predetermined return from money whose creation depends ultimately upon the sovereign monetary and payment system.

These are questions of political economy and distributive justice. Pakistan provides an especially revealing example. SBP’s provisional monetary aggregates at end-June 2026 recorded net government-sector borrowing of more than Rs. 37 trillion. 

Net borrowing from scheduled banks was overwhelmingly larger than direct borrowing from SBP, while credit to the private sector stood at around Rs. 11.4 trillion. The precise categories require care in interpretation, but the broad structural message is difficult to miss: the banking system has become deeply intertwined with financing the State itself.

Banks operate within an extraordinary circle. The State confers the banking licence, provides the settlement infrastructure, regulates deposits, maintains monetary stability and acts ultimately as guardian of systemic stability. Banks create deposit money through their financing operations and then deploy enormous resources in government securities carrying returns ultimately serviced through public revenues.

The citizen appears at both ends of the transaction by providing deposits to the banking system and later pays taxes from which sovereign financial obligations are serviced. The arrangement may be perfectly lawful under the existing system, but a project seeking elimination of riba cannot ignore its structural implications.

Conversion of conventional banks into Islamic banks does not, by itself, answer this problem. An Islamic deposit-taking institution can participate in the same process of deposit creation when it extends financing. If its balance sheet remains concentrated in sovereign instruments and if its returns remain indirectly anchored to the prevailing interest-rate structure, conversion of contractual terminology leaves the underlying monetary structure substantially intact.

This is one reason why the proposal recently advanced by Muhammad Munir Ahmad for an alternative riba-free system deserves serious consideration. It correctly asks whether money creation and commercial financing should be separated. Its criticism of the privileges inherent in the existing banking structure identifies a problem much larger than the replacement of an interest-bearing loan with murabaha or ijarah. The proposed solution, however, requires considerable refinement. One possibility is a system under which transaction money is fully backed by sovereign money. 

Current accounts used for salaries, business payments and ordinary transactions would represent money held for payment and safekeeping. Banks would not be permitted to use these balances to create additional financing.

Investment would take place through an entirely different window. A person seeking a return would knowingly place funds in an investment account. Those funds could be employed in mudarabah, musharakah, leasing, trade finance and other genuine commercial arrangements. Return would arise from investment, ownership, enterprise or service rather than merely from allowing a bank to create a debt against a transaction deposit.

This idea is neither historically unprecedented nor uniquely associated with Islamic economics. During the Great Depression, economists associated with what became known as the Chicago Plan proposed 100 per cent reserve backing for transaction deposits, expressly separating the monetary function of banks from their credit function. Irving Fisher became one of its prominent advocates. 

Decades later, an International Monetary Fund (IMF) working paper by Jaromir Benes and Michael Kumhof revisited the proposal and modelled potential effects including greater control over credit cycles and reductions in private and public debt. The paper was research rather than IMF policy, but its importance for our discussion is obvious: separation of money creation from private lending is a serious monetary proposition capable of examination on economic rather than theological grounds.

This distinction is essential for any Quranic interpretation. We do not need to label every feature of modern banking religiously prohibited in order to question it. A system may be economically unstable, socially regressive or institutionally unjust without every component independently constituting riba as conventionally understood by theologists.

Sovereign money also requires careful definition. It cannot mean giving governments an unlimited printing press. If commercial banks can abuse the privilege of credit creation, governments can abuse monetary sovereignty even more destructively. 

History offers abundant examples of fiscal authorities financing persistent deficits through currency creation, eventually destroying purchasing power. Inflation then becomes an arbitrary levy, falling particularly heavily upon wage earners, pensioners and those holding monetary savings. Transferring money creation to the State therefore solves nothing unless the power is constitutionally and institutionally restrained.

Money should be sovereign in the sense that its creation is a public function exercised on behalf of society, not a fiscal facility belonging to the government of the day. The monetary authority must remain professionally independent in determining the quantity of money required by the economy, subject to transparent statutory objectives concerning price stability, productive capacity, employment and financial stability. Parliamentary accountability must accompany operational independence. The State should not create Rs. 100 merely because it wishes to spend Rs. 100.

New money represents a claim upon society’s existing and future production. Creating purchasing power without corresponding expansion of goods and services redistributes real resources through inflation. A just monetary order must subject public money creation to rules as strict as those imposed upon private credit creation.

A gradual transition is equally indispensable. Moving abruptly from the existing system to full-reserve transaction banking could contract credit, disrupt liquidity, impair bank balance sheets and destabilise government financing. Pakistan cannot announce monetary purification on one morning and discover a banking crisis by evening.

Existing deposits, government securities, financing portfolios and central-bank operations would have to be mapped first. Transaction deposits could then progressively be separated from investment funds. Sovereign money could replace bank-created transaction money over a defined period while investment institutions continued to finance productive activity from genuinely mobilised capital. The object is not to abolish banking. It is to restore banking to financial intermediation.

Banks possess valuable expertise in evaluating enterprises, administering payments, assessing risks and mobilising capital. These services deserve compensation. What requires reconsideration is whether the same institution should simultaneously create transaction money, determine where newly created purchasing power first enters the economy, earn from the resulting debt and remain protected by a public safety net when systemic failure threatens.

The issue becomes still more important in Pakistan because banking has increasingly gravitated towards sovereign financing. An alternative order must redirect financial skill and capital towards agriculture, manufacturing, housing, exports, technology, infrastructure and small enterprises instead of allowing government borrowing to remain the easiest route to banking profitability.

Elimination of riba, understood seriously and holistically within Quranic economic model, takes us beyond the rate charged upon a loan. It compels examination of the structure through which money itself enters circulation. The answer need not be dogmatic. Commercial-bank money creation is not automatically riba; sovereign money is not automatically just; and full-reserve banking is not ordained merely because it appears attractive as an alternative.

The test is institutional substance. Money is a social institution. The authority to create it carries enormous distributive power. That power must neither be privatized without accountability nor nationalised without restraint.

Once this principle is accepted, the next question follows naturally. If transaction money is to be protected and investment funds are to bear genuine commercial risk, can both continue to be treated simply as “deposits”?

The third part of this series will examine the distinction between money placed with a bank for safekeeping and payments, and money consciously placed at risk for investment. That distinction may prove more important to a genuinely riba-free banking system than many of the contractual innovations introduced during the last four decades.

[To be continued]

_______________________________________________________________________

Dr. Ikramul Haq, Advocate Supreme Court, Adjunct Faculty at Lahore University of Management Sciences (LUMS), member Advisory Board and Visiting Senior Fellow of Pakistan Institute of Development Economics (PIDE), holds an LLD in tax laws. He was full-time journalist from 1979 to 1984 with Viewpoint and Dawn. He also served Civil Services of Pakistan from 1984 to 1996.