Can Islamic finance support stability and inclusion?

Since the global financial crisis, policymakers have sought to press the “reset” button to strengthen financial intermediation that is performed by conventional banks and non-bank financial institutions. The aim has been to address the fault lines that helped trigger one of the most devastating financial crises in a century, and to enable a more inclusive, stable financial system that promotes stability as well as economic development and growth.

Islamic finance offers several features that are consistent with these objectives. Islamic finance refers to financial services that conform with Islamic jurisprudence, or Shari’ah, which bans interest, speculation, gambling and short-sales; requires fair treatment; and institutes sanctity of contracts. And these principles hold the promise of supporting financial stability, since a key tenet of Islamic finance is that lenders should share in both the risks and rewards of the projects and loans they finance.

Islamic finance has an important potential to act as an engine of stability and inclusion. Since investors are required to bear losses that may arise on loans. there is therefore less leverage, and greater incentive to exercise strong risk management. These risk-sharing features also serve to help ensure the soundness of individual financial institutions and help discourage the types of lending booms and real estate bubbles that were the precursors of the global financial crisis.

The focus on asset-backed and risk-sharing financing also has the potential to improve access to finance by small- and medium-sized enterprises, and to support inclusive growth. It is well-suited to financing large-scale infrastructure projects, whereby—similar to public-private partnerships—investors finance the construction of roads, bridges, and similar projects, and receive the returns on these investments until the project reaches maturity. Finally, Islamic financial services also promise to improve financial inclusion for the large number of Muslims that are discouraged from using banks for religious reasons.

But what are the challenges to make this industry more mainstream and to allow it to grow in a safe and sound manner?

These and other issues are discussed in new work by IMF staff. It found that for the industry to flourish it needs to:

• Increase regulatory clarity and harmonization, in coordination with Islamic standard-setters, including on the treatment of profit-sharing investment accounts and disclosure requirements, but also on further clarification of the treatment of Shari’ah compliant instruments in the calculation of Basel III requirements;

• Stress the importance of greater consistency in Shari’ah-compliance across and within countries;

• Underscore the importance of developing safety nets—the protection of depositors and the provision of emergency liquidity—and frameworks that would allow Islamic institutions that may face difficulties to be resolved in a manner that avoids undue market disruption;

• Reduce tax and regulatory impediments to risk-sharing financing; and

• Deepen the market for Shari’ah compliant short- and long-term securities, through regular sovereign benchmark issues and clearer rules governing the treatment of collateral.

Strong demand 

Islamic financial assets have grown at double-digit rates over the past decade, from about $200 billion in 2003 to an estimated $1.8 trillion at end of 2013.( A large part of Islamic finance—around 80 percent—is composed of Islamic banking assets; the remainder is composed of Sukuk (15 percent, asset-backed or asset-based instruments), Islamic funds (4 percent), and Takaful (Islamic insurance).

Islamic banking now represents 15 percent or more of the banking system in ten countries in the Middle East and Asia.  Issuance of Sukuk has increased twentyfold over the same period to reach $119.7 billion by 2013. The number and variety of issuers of Islamic financial assets looking to tap into these markets has grown to include Hong Kong SAR, Luxembourg, Senegal, South Africa, and the United Kingdom. The economic and financial stability implications of the industry’s growth are huge, as is the demand for policy advice in this area.

Tackling the challenges together

To allow this industry to develop in a safe and sound manner, the important challenges described above will need to be tackled. The IMF, with its universal membership, its surveillance mandate, its capacity building efforts, and its close involvement with both the conventional and Islamic setting bodies, has an important opportunity to help.

This article is published in collaboration with IMF Direct. Publication does not imply endorsement of views by the World Economic Forum.

To keep up with the Agenda subscribe to our weekly newsletter.

Author: Mohamed Afzal Norat is a Senior Financial Sector Expert and Senior Economist in the Financial Supervision and Regulation Division in Monetary and Capital Markets Department of the International Monetary Fund (IMF). Marco A. Piñón is currently an Advisor at the Monetary and Capital Markets Department (MCM) of the International Monetary Fund (IMF). Zeine Zeidane is an Advisor in the Middle East and Central Asia Department at the International Monetary Fund (IMF).

Image: People are pictured at the Dubai International Financial Centre REUTERS/Omr Mohamed