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The Promise of Islamic Finance: Further Inclusion with Stability

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:

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.

Stay tuned for more discussion of Islamic Finance at the upcoming IMF-World Bank Spring Meetings. Check this page for the webcast of a seminar on the topic.