Role of Financial Institutions in Reducing Inflation in Developing Countries


The impact of enterprises and financial institutions is the best solution for developing economies that considerably contributes to generating jobs, and raising incomes. The soundness of banking systems in developing countries and economies in transitions are usually more important than in industrialized countries since banks tend to dominate the financial sector in developing countries and economies in transition. In a study by Havrylyshyn & Rooden (2000), it was found that the banking system, made up of the central bank and specialized banks controlled by the central bank, constitutes the entire financial system in recently planned economies.

Background Information

Because economies in transitions have been always controlled by western developed countries financial and economic situation leaves much to be desired. In a study by Nelson & Sampat (2001), it was found that concentrated markets, a high proportion of non-performing loans, and very high operating costs are common weaknesses in their banking systems. This often causes wide spreads between lending rates and deposit rates that is the difference between the rate of interest charged by banks on loans or credit advanced to customers, and the rate of interest paid by banks to customers on funds deposited with them by their customers. Finally, in a study by Hainz (2003), it was found that borrowers may also suffer large-scale liquidity problems as a result of high lending rates.

Problem Statement

Developing countries should have a solid support for further improvement in economical terms. Therefore, the development of the Islamic banking system can considerably foster this process.

Aims and Objectives

The purpose of this paper is to establish the role that has been played by financial institutions and enterprises in reducing inflation in developing countries. Financial institutions include banks and other providers of funds.

Research Questions

Based on the objective mentioned above, the main questions arise concerning the methods of influence of banking institutions on the improvement of economic situations in developing countries. Further, it is crucial to consider economic impact of different banking institutions and private organizations. In particular, it is necessary to define the role of Islamic banks in facilitating and enhancing the welfare of economics in transition. Finally, there is a necessity to pursue the relations between interest rate and inflation.


To underline the seriousness of the problems and to comprehend the connection between bank activities and economic improvement, it is worth mentioning that the spreads in interest rates in developing countries and economies in transitions are generally much higher than in industrialized countries (Cukierman, et al. 2000). This is, perhaps,

Literature Review

The Islamic Perspective

Hence, Hassan and Lewis (2007) state that Islamic finance establishments can take responsibility for direct investments and regulate the management of different financial projects. The books also regard different kinds of transactions carried out by Islamic banks to advance the financial stability of developing countries, especially those who have effective ideas and economic projects. In a study by Debelle & Fischer (1994), it was found that the role of the banking system in the countries of eastern and central Europe has been completely transformed by the transition to a market economy, where professionalism has been introduced into banking, and the bankers are required to do more than disbursement of credit.

Islamic Bank

In a study by Moshirian & Szegö (2003), it was found that allocation of credits is negatively affected by wide spreads, because it may lead to non-funding or delay of finances to viable projects. In a study by Dethier, Ghanem, and Zoli (1999), it was found that a substantial increase in inflows of foreign capital through the intermediation of domestic banks has accompanied the deregulation of financial systems in developing countries and economies in transitions. This has demonstrated how important the health of the financial system is for maintaining overall macroeconomic stability.

Growth of Islamic Banks

Discussing the main problems of Islamic banking it is necessary to define the main shortcomings of their major transactions. In a study by Maliszewski (2000), it was found that the lack of experienced staff to perform credit and risk analysis has made it difficult for banks in developing countries and economies in transitions to expand their balance in real terms. In a study by Knack & Keefer (1995), it was found that in such economies, there is a poor banking culture, and information regarding the financial position or creditworthiness of potential clients is not readily available. This fact was also proved by Saeed who stated that “the Islamic bank cannot guarantee a positive return to the depositor” (1996:98).

Relation between Interest and Inflation

Wilczyński & Piotr (1994) defined that some economies in transition have however made significant progress in transforming their banking system, despite all these problems. Grilli, Masciandaro, Tabellini (1991) constituted that government policies usually include recapitalization and privatization of state-owned banks, the formation of new private banks, the liberalization of interest rates, as well as the creation of a two-tier banking system.

In a study by Ades & Tella (1999), it was proven that even though many economies have tried to transform their banking system by pursuing a comprehensive system, available data on the percentage of GDP accounted for by broad money indicate that the banking system is still very limited in intermediation.


The research paper is aimed at investigating the main peculiarities of the Islamic banking system, including its strengths and weaknesses. Then, it will be focused on the impact of the banks and other institutions on the development of financial infrastructure in the countries of the third world. When examining the adverse consequences of depositor relationships on the depositor rather than on the lender. Returning to history, Islamic banking theory started its development in the first half of the twentieth century both in the industrial world and in the developing countries. The fact is that the religion presupposes that deposits generally depend on an interest-free basis that maximizes the risk of inevitable losses. Still, there is some similarity between an Islamic bank and conventional finance institution lying indirect participation in all financial operations. Therefore, the role of Islamic banks in shaping the economies of developing countries is significant.


In our research, we use a comparative analysis to establish the strengths and weaknesses of the Western and Eastern banking systems and their influence on economic development. It also defines the role of different financial institutions in different spheres of life. To pursue the development of Eastern financial establishments, it is necessary to use historical analysis and define the changes that occurred during a particular period.

Presentation, Analysis, and Discussion

Moshirian (2001) found that the fragility of the banking system in developing countries and economies in transitions should be dealt with as a matter of high importance. Hence, Jacome & Vaszquez (2005), established that in such economies, there are no security markets, and a few state-owned insurance companies are the only non-bank financial institutions. McNulty & Harper (2001) believed that such banks are now required to meet the financial needs of their clients, and adhere to regulations regarding capital adequacy and provision for bad debts.

From the findings in this paper, it is evident that financial institutions and enterprises play a major role in reducing inflation in developing countries.

In some instances, financial institutions have led to an increase in inflation, for example, where they have advanced credit to customers who are unable to repay the loans while denying other customers who would have spent the funds on viable projects to improve the economy and enable them to repay the loans.

Reference List

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Cukierman, A., G. Miller, and B. Neyapti. 2000. Central bank reform, liberalization and inflation in transition economies: An international perspective. Working Paper 19-2000, Institute for Economic Research.

Debelle, G., and S. Fischer. 1994. How independent should a central bank be? Working Papers in Applied Economic Theory 94-05, Federal Reserve Bank of San Francisco.

Dethier, J.-J., H. Ghanem, and E. Zoli. 1999. Does democracy facilitate the economic transition? An empirical study of Central and Eastern Europe and the Former Soviet Union. World Bank Policy ResearchWorking Paper 2194.

Grilli, V., D. Masciandaro, and G. Tabellini. 1991. Political and monetary institutions and public financial policies in the industrial countries. Economic Policy 13:341–92.

Grogan, L., and L. Moers. 2001. Growth empirics with institutional measures for transition countries. Economic Systems 25 (4): 323–44.

Hainz, C. 2003. Bank competition and credit markets in transition economies. Journal of Comparative Economics 31 (2): 223–45.

Hassan K., and Lewis, M. 2007. Handbook of Islamic banking. US: Edward Egar Publishing.

Havrylyshyn, O., and R. van Rooden. 2000. Institutions matter in transition, but so do policies. Imf Working Paper 70.

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WilczyĹ„ski, R., Piotr G., P. 1994. The Role of International Financial Institutions in Poland’s Transition to a Market Economy.

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