Monetary stability and interest-free banking revisited

This paper revisits the issue of the efficiency of the Islamic interest-free banking system. Recently, Yousefi et al. (1997) used a testing methodology proposed in Darrat (1988) and claimed that the evidence does not support interest-free banking in the case of Iran. However, by their own admission, the empirical results they report are consistent with the superiority of interest-free over interest-based banking system in Iran, in three out of the four operational criteria used. Only over one criterion, the monetary aggregate/price link, do Yousefi et al.'s results appear in conflict with the efficiency of the Islamic banking system. On this score too, it is shown that their 'evidence' is in doubt due to the possibility of significant specification errors. Once these errors are corrected, the results seem unanimous in their support of the efficiency of interest-free banking system in Iran.