113 CHAPTER 6 The Islamic Financial System T he primary role of a financial system is to create incentives for an efficient allocation of financial and real resources for competing aims and objec- tives across time and space. A well-functioning financial system promotes investment by identifying and funding good business opportunities, mobi- lizes savings, monitors the performance of managers, enables the trading, hedging and diversification of risks, and facilitates the exchange of goods and services. These functions ultimately lead to the efficient allocation of resources, rapid accumulation of physical and human capital and faster technological progress, which, in turn, feed economic growth. Within a financial system, financial markets and banks perform the vital functions of capital formation, monitoring, information gathering, and facilitation of risk sharing. An efficient financial system is expected to per- form several functions. First, the system should facilitate efficient financial intermediation to reduce information and allocation costs. Second, it must be based on a stable payment system. Third, with increasing globalization and demands for financial integration, it is essential that the financial system offers efficient and liquid money markets and capital markets. And, finally, it has to have a well-developed market for risk trading, where economic agents can buy and sell protection against event risks as well as financial risks. Research on financial intermediation and financial systems in the past two decades has enhanced our understanding of the significance of the financial system and the crucial role it plays in economic development. For example, studies have shown that countries with higher levels of financial develop- ment grow faster by about 0.7 percent a year. Between 1980 and 1995, 35 countries experienced financial crises. These were, essentially, periods during which the financial systems of these economies stopped functioning and, as a consequence, their real sectors were adversely affected, which led to reces- sions. Although strong evidence points to the existence of a relationship between economic development and a well-developed financial system pro- moting efficient financial intermediation through a reduction in information, transaction and monitoring costs, this linkage and the direction of causation An Introduction to Islamic Finance: Theory and Practice, Second Edition by Zamir Iqbal and Abbas Mirakhor Copyright © 2011 John Wiley & Sons (Asia) Pte. Ltd.