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Working Paper
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The Financial Instability Hypothesis by Hyman P. Minsky
and
Islamic banking as a solution for modern debt problems
February 2014
Baku, Azerbaijan
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Prepared by:
Mr. Behnam Gurbanzada Director of Islamic Banking Department of the International bank of
Azerbaijan
Mr. Salman Alioglu, PhD, Economist and expert of Islamic Economy and business studies

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Economy based on debt financing works as long as the growth of income or assets
allows debtors to service debt, and as soon as the growth of revenue or assets stops, debtors
face problems in servicing their debts.
The separation of the interest rate on the profitability in the real sector is due to different
nature of interest and profits: if the business profit is the income of the owner of the real
assets, the interest rate is a charge for the provision of debt. Just the different nature of interest
and profits explains their diverse nature: during the crisis the interest rate is often not only
reduced, but rather increased. This phenomenon is associated with an increase in the
population of caution, which is reflected in the M1 (money on demand accounts and cash) and
M2 (deposits) ratio. If uncertainty persists or gets worse, people will increase the demand for
liquidity or "cash for a rainy day" hence the demand for liquidity grows faster than those for
deposits, the M1share in M2 increases. The growth of the demand for liquidity stimulates the
growth of interest rates.
A significant contribution to research the problem of discontinuity between the assets of
debtors and their obligations was made by Hyman Minsky, who put forward the Financial
Instability Hypothesis. The theoretical argument of the financial instability hypothesis starts
from the characterization of the economy as a capitalist economy with expensive capital
assets and a complex, sophisticated financial system. The economic problem is identified
following Keynes as the "capital development of the economy," rather than the Knightian
"allocation of given resources among alternative employments." The focus is on an
accumulating capitalist economy that moves through real calendar time.
Keynes stated:
“There is a multitude of real assets in the world which constitutes our capital wealth -
buildings, stocks of commodities, goods in the course of manufacture and of transport, and so
forth. The nominal owners of these assets, however, have not infrequently borrowed money
(Keynes' emphasis) in order to become possessed of them. To a corresponding extent the
actual owners of wealth have claims, not on real assets, but on money. A considerable part of
this financing takes place through the banking system, which interposes its guarantee between
its depositors who lend it money, and its borrowing customers to whom it loans money
wherewith to finance the purchase of real assets. The interposition of this veil of money
between the real asset and the wealth owner is an especially marked characteristic of the
modern world."
The capital development of a capitalist economy is accompanied by exchanges of
present money for future money. The present money pays for resources that go into the
production of investment output, whereas the future money is the "profits" which will accrue
to the capital asset owning firms (as the capital assets are used in production). As a result of
the process by which investment is financed, the control over items in the capital stock by
producing units is financed by liabilities – these are commitments to pay money at dates
specified or as conditions arise. For each economic unit, the liabilities on its balance sheet
determine a time series of prior payment commitments, even as the assets generate a time
series of conjectured cash receipts.
H. Minsky relates the debt crisis to the cyclical nature of economic development. So, in
the beginning stage of the business upward cycle firms finance their investment projects
mostly at their own expense with little loans. This is explained by the fact that at this stage the
growth of investment activity is still moderate, and the credit risks are far higher. The income
of companies allows them to pay interest on loans and the principal of the loan. As economic

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and favourable forecasts grow, firms actively begin to increase investments, and the credit
risks reduce. As a result, firms actively move to external capital financing. However, revenues
cannot grow continuously. After a while there comes a situation when the cash flows of many
companies are down, but their debts are not reduced. As a result, the ability of firms to service
their debts on loans decreases, and the number of defaults on loans begins to grow.
In order not to become bankrupt, the debtor company are forced to take out new loans to
repay old debts. That is, at this stage, the debts are repaid not by income, but through new
borrowing (Minsky called such funding mechanism as the Ponzi-financing). But sooner or
later the debtors applying this mode of financing debt find themselves unable to get new loans
due to raising the credit risks (causing decreased the desire of banks to lend). Thus, debtors
are unable to pay the financial sector, and it results in the debt crisis.
Thus, the excess of debtors' liabilities over assets of, or the debt crisis is caused by the
cyclical nature of economic development: if business profits is of cyclical nature and
decreases in the phase of economic recession, the level of the debtors' liabilities to downward
the phase of the economy doesn't reduce, furthermore, it increases due to interest rates. Thus,
the cause of the debt crisis is the rigidity of the obligations to the downside. And just the
interest rate, i.e. the requirement of payment of interest regardless of profits prevents
reduction of the liabilities in the economic downturn phase and the equalization of the
liabilities and assets, resulting in the debt crisis.
Also, it should be noted that the debt crisis and Ponzi-financing can also be caused by
the practice of financing long-term assets through short-term liabilities, resulting in a gap
between the maturities of assets and liabilities and assumes payment of obligations due to new
borrowing.
A striking example of Ponzi financing is asset securitization, one of the causes of the
financial crisis in 2007-2008, when the funds acquired structured securities (structured
investment vehicle - SIV) with certain cash flows and issued warranties for their short-term
commercial paper through several tranches, and whose income was formed as the difference
between the rate on long-term assets and short-term rate on borrowed funds. When it became
difficulty to involve new short-term debt investments, banks were unable to pay debts.
These financial pyramid schemes cause extremely adverse affection the development of
the financial market and the economy as a whole.
In particular, the Ponzi finance schemes worsen the credit risk assessment: the return of
credits due to new borrowing creates the appearance of normal maintenance obligations,
which does not assess adequately the risks of debtors. Apart from the fact that the debtors fall
into a debt trap, there is also the flow of capital from the most successful firms to the least
successful ones: the growth of financing of inefficient companies diverts financial resources
from more efficient allocation of resources. Moreover, the Ponzi finance schemes causing
“unhealthy" demand for credit often result in increase of the interest rates, which further
complicates the debt service and, moreover, causes the expansion of the Ponzi - financing
practice.
It is should be noted that Minsky suggests the following to prevent the financial
instability and Ponzi-financing problems:
• First, changes in the structure of aggregate demand and production technologies
are to be stimulated. Minsky believed that the share of consumption should
increase in aggregate demand, and technology have become more labour-
intensive, "... the economy focused on the production of consumer goods through
less capital intensive methods... will be less prone to financial instability and
inflation".

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• Second, the legislative restriction on short-term financing long-term investments
should be applied; however, it is difficult to apply such restriction in practice
In our opinion the Ponzi - financing solution is associated with revision of relations
between firms and banks. There is the fact that the problems of deviation from credits, Ponzi -
financing and financial instability caused by the excess of liabilities over assets of debtors are
an integral part of the economy based on debt relations. So, their solution under economic
terms with domination of debt relations based on interest rates is not possible. Such problems
may be solved only be by avoiding debt and transition to investment financing assuming
participation in the profit/loss. In Islamic financing it is called Musharakah.
Capitalist system which is based on the practice of lending on interest inevitably yield
various problems to the financial market, such as inflation, recurrent business cycles,
unemployment, increasing inequality and poverty amidst plenty (Siddiqi, 2006). Based on this
premise, the Islamic banking posits that an efficient financial system should be largely based
on profit sharing contract rather than lending, whereby it was arguably contributed to greater
stability in the economic system in general and financial markets in particular (Siddiqi, 2006).
The Musharakah financing mechanism operates on a capital contribution basis for a
defined existing or potential project or assets. The outstanding financing amount could
increase or decrease depending on the demands for funding during the financing period. At
any point in time, the outstanding capital contribution provides the basis for determining the
profit or loss sharing ratio. As a profit and loss sharing arrangement, Musharakah takes
various forms, depending on the parties’ capital contribution and their effort in managing the
venture. Musharakah is considered as the most flexible form of equity financial claim that can
be adopted for various economic sectors, including services, production and distribution.
Participation in profit/loss, firstly, prevents excess of the liabilities over assets, reduces
the risk of the debtors' bankruptcy. Secondly, request of profit interest payments will prevent
the practice of debt repayment by involvement of new debts, which is typical for financing
long-term investments at the expense of short-term liabilities.
It is also to be noted that unlike debt relationship where payment of interest doesn't
depend on corporate income, participation in profit/loss allows more evenly distribute income,
risks and losses and, thereby, prevents the concentration of risks, making the financial system
more stable.
Transition to investment financing is also advantageous for the banks as deposits placed
with the banks will also be not debt, but investments, and it will prevent exceeding the bank's
liabilities over its assets. For such purpose, the bank deposits should be divided into savings
(Qard Hasan) and investment (Mudaraba) one. So, if someone wants just to save the money
for the future, the individual may make non-interest bearing deposit, which is a debt
obligation, if the asset holder wants to multiply its wealth it can take advantage of savings
investment deposit representing profit sharing.

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Islamic banking as a key for modern debt problems
Summary
The problem of a liquidity trap is caused by credit crisis due to the excess of liabilities of
companies over their assets, and the solution to this problem is to participate in the assets,
allowing companies to overcome the crisis of their balances. Furthermore, the transition to
participation in the assets avoiding the risks of insolvency debtors will boost the demand for
credit and, thus, the growth of credit activity and the exit from the liquidity trap.
The gap between the debtor's assets and liabilities is also associated with the problem
of debt deflation.
Debt deflation is a situation when the amount of total expenditure falls due to the fact
that the debt of the public and companies too big: a big debt forces them to exercise caution in
spending and further borrowing and to prefer the debt reduction.
Debt deflation theory was developed by Fisher, according to which the Great
Depression of the 1930s was caused by the heavily indebtedness of economic agents, when
the repayment of debt caused a reduction in aggregate demand and deflation that has become
topical again during current global crisis:
• repayment of debt results in a decline in sales due to reduction of costs
• repayment of loans causes a reduction in deposits, decreases the turnover velocity of
money
• a decline in sales, deposits and money velocity results in deflation
• reducing the level of prices results in bankruptcy of firms
• reduces the output, trade and employment
• crisis causes the increased pessimism and loss of confidence, which in turn
results in hoarding and further reduction of the velocity of money
• despite the reduction of the nominal interest rate, the real interest rate rises
Thus, the requirement of payment of interest, regardless of profits during the crisis
results in overflow of assets from debtors to creditors, which increases the concentration of
income. Same concentration of the growth is accompanied by a decrease in both consumption
and investment, which increases the crisis:
• the growth of income concentration increases the degree of liquidity preference, as the
individual with larger incomes stores more money balances relative to income ;
• the growth of cash balances causes reduction of consumption, which in turn results in
a decrease of investments.
According to Fisher, the solution to the problem of debt deflation is to stimulate
inflation. However, the growth of inflation in the presence of debt problems and reduction of
aggregate demand is an elusive goal. An example is, in particular, the example of Japan and
the United States, where it is not possible to stimulate lending activity and to overcome the
threat of deflation despite of large-scale infusion of money into the banking system.
In our opinion, a debt deflation can be avoided by means of participation in the assets.
Only under conditions of excess liabilities of debtors of their assets the debt service reduces
aggregate demand and causes deflation processes. Under the conditions of participation in the
assets the decline in assets will also decrease the obligations and interest payments. Decrease

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in debt and interest payments will allow prevents the growth of concentration of income and
reduction of consumption and investments.
Transition from the debt financing model to the investment one involving participation
in the assets and interest payments of profits will also reduce the problem of information
asymmetry and adverse selection. In the traditional banking system, interest rates are often
higher than the profitability of the real sector, and the higher interest rate compared to the real
sector:
1) the higher the number of persons employed in riskier areas, forcing banks to be more
cautious in lending.
2) the larger banks prefer to lend not to the most efficient enterprises and companies
with deposits, but those less effective, which results in the transfer of capital from more
efficient to less efficient companies.
Businesses also reduce the demand for loans due to the risk of insolvency when income
and assets in the future may not be sufficient to meet obligations, and choose other, less
efficient sources of investment financing; in particular they are forced to maintain a higher
price margin for products.
Thus, the transition from the debt financing model to investment one involving the
payment of interest of profits will prevent the excess interest rate of business profitability, and
reduce information asymmetry and adverse selection problems.
The interest rate gap from the real sector and the demand for interest and obligations
regardless of profits, as well as information asymmetry and adverse selection problem also
cause the so-called investment myopia. On the one hand, firms fearing are insolvent before
the banks reduce the demand for large long-term loans and prefer to finance long-term
investments at the expense of short-term loans. On the other hand, banks also make limits for
the issuance of long-term loans due to the presence of information asymmetries and the high
degree of uncertainty.
However, banks' limits for long-term loans to finance force firms to long-term
investments at the expense of short-term loans, which, as shown above, involve the payment
of loans due to new borrowing, i.e. spread in the economy of Ponzi -financing schemes.
Moreover, under the conversion of investment myopia in the habit it is not possible to
stimulate long-term investments only through monetary policy. Investment myopia may be
overcome only through a change in the formal and informal rules of the game, giving up the
idea of quick beneficiation at any cost.
Myopia investment of banks and firms and their reluctance to make long-term
investments can be overcome by linking the interest payments as profits. This measure, on the
one hand, will eliminate fears of firms to face problems in paying the loan, i.e. fear of being
financially insolvent, and thus it will increase the demand for long-term loans, on the other
hand, reduce information asymmetry and credit risks that will favour the growth of large long-
term loans from banks.
Opponents of interest payments from profits argue that investments are assets not
secured by mortgage, which in turn, increases the vulnerability of banks with inefficient
investment. However, it can be argued that the vulnerability of banks increased because of the
presence of collateral. First, the dependence of the collateral value of the interest rate makes
it fluctuating that increases the vulnerability of banks.
Secondly, when collateral loans exist, banks tend to issue riskier loans because banks
believe that the credit default losses may be offset by collateral. In particular, the issuance of
risky loans is one of the causes of the recent credit crisis in the U.S. For example, mortgage

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loans were often initially risky, as they were issued to people with low credit ability and
taking into account the expected growth in real estate prices, which resulted in the volume of
loans, exceeded the value of mortgaged real estate. When the house price growth slowed and
even decreased, the volume of bad loans increased. Thus, the presence of collateral increases
the likelihood of issuing risky loans
Third, the requirement of collateral increases the information asymmetry in the banking
sector, since the collateral credit recipients are often not efficient enterprises, and those who
provided bail.
Thus, the presence of collateral may not reduce, but rather increase the vulnerability of
banks and contribute to the banking crisis.
The problem of debt deflation, Ponzi financing and liquidity trap, information
asymmetry, investment myopia is the reverse of the debt financing model. Solving these
problems is only possible through the revision of the relationship between firms and banks
and the refusal of the debt and the transition to investment finance.
References
• Fisher, Irving. 1922 “The Debt Deflation Theory of Great Depressions.” Econometrica
1: 337-57
• Keynes, John Maynard, 1936. The General Theory of Employment, Interest, and
Money. New York: Hartcourt Brace
• Minsky, Hyman P. 1986. Stabilizing An Unstable Economy. Yale University Press
• Minsky, Hyman P. 1992. The Financial Instability Hypothesis. The Jerome Levy
Economics Institute of Bard College. Working paper No74.
• I.V. Rozmarinsky and K.A. Kholodilin. 1998. “Theory of endogenous money supply”.
• Mohammad Khairi Saat, Razli Ramli, Haryani Aminuddin. 2011. “Islamic Banking
Practices”. Kuala Lumpur .
• Islamic Finance and Money Markets. 2011. Chartered Institute of Management
Accounts. Second edition 2011
• Siddiqi, Muhammed Nejatullah. (February 2006). “Islamic Banking and Finance in
Theory and Practice: A Survey of State of Art”. Islamic Economic Studies,13(2).