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The IMF and Islamic Finance

Islamic Finance and the Role of the IMF

March 2015

Islamic finance has grown rapidly, even though it is still a small share of the global financial market. The Islamic banking segment has increased its penetration in many International Monetary Fund (IMF) member countries. It has become systemically important in Asia and the Middle East, while the global issuance of Sukuk - the Islamic equivalent of bonds - is expanding with remarkable international reach of issuers and investors. This trend is expected to continue, driven, in particular, by strong economic growth in countries with large, and relatively unbanked, Muslim populations.

Reflecting the importance of Islamic finance for many of its members, the IMF has had a long-standing interest in its implications for macroeconomic and financial stability, and played a key role in the establishment of the Islamic Financial Services Board (IFSB). The IMF has also engaged its members on the implications of Islamic finance, in the context of its policy advice and capacity development efforts, notably in the areas of regulation and supervision of Islamic banks, and development of domestic Sukuk markets.

This recent growth of Islamic finance has led to increased demand on the IMF. To foster its preparedness, the IMF has formed an Interdepartmental Working Group with the objectives to develop an institutional view on the industry, build in-house expertise and better coordinate with different stakeholders. This working group has stepped up the analytical work on Islamic finance in key areas, including Islamic banking regulation and supervision, macro-prudential policy, safety nets, resolution, financial inclusion, consumer protection, monetary policy, Sukuk markets, public financial management, and tax policy. The IMF established an External Advisory Group, comprised of standard-setters for Islamic finance and leading international experts, to assist in identifying policy issues and to enhance coordination with different stakeholders interested in Islamic Finance.

Islamic Finance Factsheet

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What Is Islamic Finance?

Islamic Finance refers to the provision of financial services in accordance with Shari’ah Islamic law, principles and rules. Shari’ah does not permit receipt and payment of "riba" (interest), "gharar" (excessive uncertainty), "maysir" (gambling), short sales or financing activities that it considers harmful to society. Instead, the parties must share the risks and rewards of a business transaction and the transaction should have a real economic purpose without undue speculation, and not involve any exploitation of either party.

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Recent Developments

Islamic finance currently encompasses banking, leasing, Sukuk (securities) and equity markets, investment funds, insurance ("Takaful") and micro finance, but the banking and Sukuk assets represent about 95 percent of total Islamic finance assets.

Islamic finance assets grew at double-digit rates during the past decade, from about US$200 billion in 2003 to an estimated US$1.8 trillion at the end of 2013. However, despite its growing spread, Islamic finance assets are still concentrated in the Gulf Cooperation Council (GCC) countries, Iran and Malaysia, and represent less than one percent of global financial assets.

For instance, Islamic banking outperformed conventional banking over the past decade, increasing its penetration rate above 15 percent in a dozen countries in the Middle East and Asia. Over the same period, Sukuk issuance increased twenty-fold to reach US$120 billion in 2013, and its issuer base is broadening with new issuances in Africa, East Asia and Europe.

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Islamic Banking

Islamic banking differs from conventional banking in several ways. Unlike conventional banks that operate on the basis of borrowing and lending with pre-specified interest rates, Islamic banks are funded by current accounts that do not attract interest or by profit-sharing investment accounts (PSIA) where the account holder receives a return that is determined ex-post by the profitability of the banks. On the asset side, Islamic banks use a number of contracts such as sales at a profit margin (Murabahah), lease (Ijarah), profit-sharing (Musharakah and Muḍarabah), and fee based services (e.g., Wakalah). All banking business based on sale or lease must have an underlying asset. This is in contrast to conventional banking where the asset's importance lies only in terms of collateral security but the asset is not necessarily part of the loan transaction.

The operations of Islamic banks give rise to a unique set of risks, in addition to the standard risks associated with banking activities such as credit, market, liquidity, operational and legal risks. These unique risks include:

  • Shari’ah compliance risk which arises from the fact that the products offered to customers may, ex-post , not be certified to be compliant with Shari’ah principles;
  • Displaced commercial risk which arises from the fact that while the returns to Profit Sharing Investment Account (PSIA) holders are supposed to depend on the profitability of their investments, PSIA holders would expect similar returns to those offered by conventional banks, and therefore shareholders may have to forego part of their profits;
  • Equity investment risk which emanates from profit-sharing financing instruments that are unique to Islamic banking.

The industry also faces additional risks related to the business model and the nascent nature of the industry. For instance, managing liquidity risk is more difficult for Islamic banks when there are limited or no Shari’ah compliant financial markets and Lender of Last Resort facility. The requirement that transactions have to be underpinned by assets has resulted in complex transactions as well as corporate structures that include non-financial corporations in the groups.

These differences raise specific policy issues in terms of regulation and supervision, consumer protection, monetary policy and liquidity management, and tax policy. To deal with some of these issues, jurisdictions have cooperated to put in place specialized institutions to develop regulation standards (IFSB), governance, auditing and accounting standards (Accounting and Auditing Organization for Islamic Financial Institutions), financial markets instruments (International Islamic Financial Markets) and short-term liquidity infrastructure (International Islamic Liquidity Management Corporation).

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Sukuk

Sukuk, the Islamic equivalent of bonds, are similar to asset backed securities and differ from conventional bonds in a number of ways. Whereas a conventional bond is a promise to repay a debt with a specified interest rate, Sukuk have to be structured in a manner that ensures that there is an underlying asset, the principal amount is not guaranteed and the return to investors is linked to the performance of the underlying assets.

Sukuk assume a variety of structures. They can be issued as asset backed where investors have a claim on the underlying asset or asset based where the claim is on the originator and not the underlying assets. Since Sukuk issuance began to accelerate, a number of different structures have developed, including partial ownership in receivables, lease-based and profit and loss sharing partnerships as well as convertible and exchangeable trusts.

Sukuk could be well suited for infrastructure financing, but there are also important implications for financial stability as well as specific issues in terms of consumer protection that deserve attention. Sukuk resemble Public Private Partnership financing whereby investors finance the assets, and then own them which leads to real securitization and, finally, transfer them at maturity to the government.

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Islamic Finance: Unlocking its Potential and Supporting Stability

Overview Though still a small share of global finance, Islamic finance is growing rapidly and has enormous potential for further growth. The Islamic banking sector is now systemically important in several member countries and the internationalization of the Sukuk market has increased cross-border financial flows and linkages. Islamic banking also has the potential to foster greater financial intermediation and inclusion, especially among Muslim populations that may be underserved by conventional banks, and to facilitate lending in support for small- and medium-sized enterprises, while Sukuk can facilitate investment in public infrastructure projects. However, for this potential to be realized and to allow this industry to develop in a safe and sound manner, it will be important, among other measures, that countries adapt their regulatory, supervisory, and consumer protection frameworks to address the unique risks in Islamic finance, take further steps to develop Shari`ah-compliant financial markets and monetary instruments, and strengthen the international architecture for the growing cross-border operations.

The event is jointly organized by the Group of Twenty (G-20) and the IMF.

For more information and details visit the Joint Spring Meetings website

IMF and the Group of Twenty