Abstract
Most of the articles written about Islamic banking are concerned with the theoretical foundation of an interest-free banking system, and how the financial system works in that environment. But no one has attempted to explore whether an interest-free financial system is essential for Islamic countries if a high proportion of savers and investors in those countries do not participate in the interest-bases system, and consider the involvement in any interest-based transaction a sin. The consequences of less efficient financial system are critical. First, there is a high probability that productive projects are forgone. Second, accumulation of savings is inefficient. Third, the interest rate as monetary instrument will not function as policy makers intend.Using a sample of 1313 banks consist of all commercial banks operating in 40 countries drawn from a new database, I show that interest-based banking systems operating in Islamic countries are inefficient compared to their counterparts operating in non-Islamic countries.