Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

Typical street scene in Santa Ana, El Salvador. (Photo: iStock)

IMF Survey: Islamic Banking Makes Headway

September 19, 2007

  • Islamic banking has grown by 10-15 percent per year over past decade
  • Despite fast growth, Islamic finance is still uncharted territory for some authorities
  • An understanding of the principles governing Islamic banking is essential

Islamic banking is steadily moving into an increasing number of conventional financial systems.

Islamic Banking Makes Headway

Islamic banks often appoint their own board of scholars to help interpret Shariah principles, rulings (photo: Karim Sahib/AFP)


It is expanding not only in nations with majority Muslim populations, but also in other countries where Muslims are a minority, such as the United Kingdom and Japan. Similarly, countries such as India, the Kyrgyz Republic, and Syria have recently granted, or are considering granting, licenses for Islamic banking activities.

In fact, there are currently more than 300 Islamic financial institutions spread over 51 countries, plus well over 250 mutual funds that comply with Islamic principles. And, over the past decade, the Islamic banking industry has experienced growth rates of 10-15 percent per year—a trend that is expected to continue.

Despite the rapid growth, many practitioners and supervisory authorities are unfamiliar with the process by which Islamic banks are introduced into a conventional system, or with the gamut of principles governing Islamic banking. While an understanding of both process and the principles is important for succeeding in the industry, this article focuses on the latter. More information on the process to be followed can be found in the IMF Working Paper "Introducing Islamic Banks into Conventional Banking Systems."

Four main principles

Besides the well-known Quran admonishment against riba (interest), gharar and maisir (contractual uncertainty and gambling), and haram industries (prohibited industries such as those related to pork products, pornography, or alcoholic beverages), practitioners and supervisors must observe other principles to comply with Islamic jurisprudence.

Paramount among these are: compliance with the Shariah (Islamic law), segregation of Islamic and conventional funds, accounting standards, and awareness campaigns (see Yaquby, N., "Sharia Requirements for Conventional Banks," Journal of Islamic Banking and Finance, Vol. 22, July-Sept. 2005, No. 3, for a similar discussion).

Shariah compliance. Islamic finance in based on the principles established by the Shariah as well as other jurisprudence or rulings, known as fatwa, issued by qualified Muslim scholars. Some of the issues covered by these rulings can be quite complex, forcing the institutions involved to often seek the assistance of experts in interpreting them. As a result, it has become a common practice for Islamic banks to appoint their own board of Shariah scholars.

Nevertheless, since expertise in these matters is still relatively scarce in some countries, different Islamic banks often share the same scholars. This phenomenon has the beneficial side effect that it promotes consistency across the services and products offered by these institutions.

Therefore, the first measure that an institution wishing to offer Islamic products must undertake is to appoint a Shariah board or, at a very minimum, a Shariah counselor. This initial step is essential for the future operations of the institution, as it will help minimize Shariah risk—the risk that the terms agreed in a contract do not effectively comply with Islamic jurisprudence and thus are not valid under Islamic law.

"Another important aspect for the regulator is that its rulings and decisions are consistent with those of the Shariah boards of foreign supervisory agencies."

Financial regulators should also appoint their own Shariah experts, a move that would provide advice on the instruments and services offered by the institutions in their jurisdiction. Consultation with these experts would be crucial to ascertain whether the regulations issued by the supervisor with regard to Islamic institutions, as well as the licensing of different activities, are compatible with Islamic principles.

Another important aspect for the regulator is that its rulings and decisions are consistent with those of the Shariah boards of foreign supervisory agencies. An important effort toward achieving international consistency was the creation of two multilateral institutions: the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), which issues internationally recognized Shariah standards on accounting, auditing, and governance issues; and the Islamic Financial Services Board (IFSB), which issues standards for the effective supervision and regulation of Islamic financial institutions.

Segregation of funds. An important principle behind Islamic finance is the desire to maintain the moral purity of all transactions. The funds intended for Shariah-compatible investments should therefore not be mixed with those of non-Islamic investments. The rationale behind this principle is rather one of prudence, in the sense of taking all the necessary precautions to ensure that Islamic funds do not become mixed with other funds that may be involved with riba, gharar, or haram activities.

Therefore, to ensure compliance with Islamic principles, conventional banks wishing to offer Islamic products must guarantee and publicize that the funds devoted to conventional activities will not be commingled with those destined for Islamic activities. In operational terms, this requires that banks establish different capital funds, accounts, and reporting systems for each type of activity.

Accounting and auditing standards. The rapid expansion of the Islamic financial industry that started in the 1970s was not initially accompanied by the creation of a set of internationally recognized accounting rules. Islamic institutions around the globe, therefore, had to resort to developing their own accounting solutions for their new products, rendering comparisons across institutions difficult, and sometimes even giving the impression of lack of transparency.

The need for a body of accounting standards purposely designed to reflect the specificities of Islamic products became even more pressing as new and more complex instruments were being marketed. To close this widening gap, the AAOIFI was created in 1990. One of the main goals of this organization is to design and disseminate accounting and auditing standards that can be applied internationally by all Islamic institutions.

The AAOIFI also plays a crucial role in pursuing the harmonization of Shariah-based rulings across jurisdictions. In those jurisdictions where Islamic finance is still nascent, regulators and financial institutions should familiarize themselves with the standards set by the AAOIFI, and apply them to the maximum extent possible.

The pursuit of international consistency not only eases the task of supervising internationally active institutions, but it would also ultimately favor the regulated institutions, as Islamic transactions would become better understood, and thus more attractive for Muslim and non-Muslim investors across the world. In addition, it would foster the integration of Islamic institutions into the international financial community.

Awareness campaigns. The speed and degree of success with which Islamic banking will emerge in conventional systems will largely depend on whether potential depositors and investors are well informed about the opportunities and risks at hand, and on whether Islamic banking is perceived as a transparent and well-regulated activity.

From a prudential standpoint, regulators should communicate to the public what types of Islamic institutions and products will be supervised. They should also require institutions offering Islamic products to actively pursue awareness campaigns. For instance, commercial banks should inform investment (mudarabah) depositors of the profit-and-loss nature of their deposits. In practice, these tasks can be easily accomplished by simply providing an explanatory prospectus to interested customers.

Source of support

A number of multilateral institutions have been recently created to provide assistance to governments and supervisory agencies to help them understand Islamic banking and to issue standards and best-practice guidelines for this industry. These organizations are the best places for governments to turn to initially for advice. They include the IMF, IFSB, AAOIFI, and the Islamic Development Bank. In addition, the authorities should engage in dialogue with the local interlocutors of this industry, to promote an open and fluid exchange of information and ideas.