Arbitration in Islamic Banking Disputes: Legal-Economic Implications for Enhancing Financial Stability and Governance

Abstract

Islamic banking disputes often occur within hybrid legal systems where Shariah-based contracts interact with state arbitration and enforcement laws. While arbitration is common in Islamic finance, existing research tends to treat legal validity, economic efficiency, governance, and stability as separate issues. This approach underestimates how arbitration practices impact broader governance and stability. This study examines how arbitration aligns with Shariah and state law, influences economic outcomes for Islamic financial institutions, and affects governance quality and financial stability. Using a qualitative method—doctrinal legal analysis, comparative institutional analysis, and law and economics—the research relies solely on publicly available academic and policy sources. Findings show that the risk of enforcement failure in Islamic banking arbitration mainly stems from legal ambiguity and public policy reviews, rather than the validity of arbitration clauses. Shariah principles are often sidelined during enforcement and in arbitration design. Economically, arbitration can increase costs by creating endogenous risk through uncertain enforcement, affecting contract choices, risk distribution, provisioning, and liquidity. The analysis highlights trade-offs, such as confidentiality and arbitrator selection, and a diminished role for Shariah boards during disputes. Overall, arbitration supports financial stability only under specific conditions, such as credible enforcement and regulatory transparency, positioning it as a governance tool for stability rather than just a procedural formality.