WHY ISLAMIC FINANCE MATTERS?

This post is based on sections of IMF Staff Discussion Note titled "ISLAMIC FINANCE: OPPORTUNITIES, CHALLENGES AND POLICY OPTIONS" published on April 2015 by Alfred Kammer, Mohamed Norat, Marco Piñón, Ananthakrishnan Prasad, Christopher Towe, Zeine Zeidane, and an IMF Staff Team.

WHAT IS ISLAMIC FINANCE?

Islamic finance refers to the provision of financial services in accordance with Islamic jurisprudence (Shari’ah).Shari’ah bans interest (Riba), products with excessive uncertainty(Gharar), gambling (Maysir), short sales, as well as financing of prohibited activities that it considers harmful to society. It also requires parties to honor principles of fair treatment and the sanctity of contracts. Transactions must be underpinned by real economic activities, and there must also be a sharing of risks in economic transactions.

Islamic finance products are contract-based and may be classified into three broad categories:(Hussain, Shahmoradi, and Turk 2015):

1. Debt-like financing structured as sales, which could be sales with mark up and deferred payments (Murabahah) or purchases with deferred delivery of the products (Salam for basic products and Istisna’ for manufactured products), and lease (Ijārah) with different options to buy. Pure lending is allowed only on benevolent basis (Qard, which is often used for current deposits);

2. Profit-and-loss-sharing (PLS)-like financing with two modalities: (i) profit-sharing and loss-bearing (Mudarabah) whereby the financier (investor, bank) provides capital and the beneficiary provides labor and skills (profits are shared, but losses would be borne by the financier who does not have the right to interfere in the management of the financed operation, unless negligence, misconduct, or breach of contract can be proven); and (ii) pure profit-and loss- sharing (Musharakah) where the two parties have equity-like financing of the project and would share profits and losses; and

3. Services, such as safe-keeping contracts (Wadi’ah) as for current deposits, or agency contracts (Wakalah), which are also increasingly used for money market transactions.

Islamic finance now encompasses a wide range of services. Nonetheless, banking still dominates and represented about four-fifths of total Islamic finance assets in 2013 (IFSB 2014). The Sukuk market is also a fast-growing segment with assets equivalent to about 15 percent of the industry. Other services include leasing, equity markets, investment funds, insurance (Takaful), and microfinance.

IB differs from conventional banking in several dimensions. As a result of the prohibition on interest, Islamic banks are funded by non-interest-bearing current accounts (benevolent loans or safe-keeping contracts), as well as profit-sharing investment accounts (PSIA) where investors receive a return that is determined ex-post by the profitability of the bank or the pool of assets financed by these accounts. Correspondingly, on the asset side, banks do not engage in lending, but in sales, lease, profit-and-loss-sharing financing, and fee-based services. The return to the banks on these transactions is based on the profitability of the underlying transactions. There are some differences on the treasury side: Islamic banks are prohibited by nearly all jurisdictions from undertaking certain types of derivatives, such as foreign exchange forwards and futures.

Sukuk, the Islamic equivalent of bonds, are similar to asset-backed securities. Whereas a conventional bond is a promise to repay a loan, Sukuk constitutes partial ownership in receivables (Sukuk al Murabahah), a lease (Ijārah), a construction project (Istisna’), a deferred delivery of assets (Salam), a joint partnership (Mudarabah or Musharakah), or investment (Istithmar); the principal amount is typically not guaranteed and the return is linked to the performance of the underlying assets (Maziad and AlSaeed 2015). Sukuk can take the form of asset-backed securities, which involve true securitization of underlying assets, or they can be asset-based securities.

In practice, Islamic finance often involves structuring transactions in a manner that closely mimics conventional finance in so far as a periodic rate of return is provided. In certain types of Sukuk instruments, a predetermined rate of return is often paid to the investor; this rate is based on the expected return of the underlying assets that collateralize the Sukuk. In the case of debt-like financing by Islamic banks, interest is not charged; instead, debtors will provide predetermined and periodic payments to the bank, based on the expected profit that would accrue to the underlying asset (in the case of a capital investment), or on the rent that might be charged for the use of the underlying asset (in the case of a home or car loan). This leads to minimal differences in substance with conventional finance and, in some cases, requires a complex layering of transactions, involving third parties. These can create operational and other risks that may have to be managed carefully.

WHY ISLAMIC FINANCE MATTERS.

Islamic finance has grown rapidly in recent years, but remains concentrated in a few jurisdictions. 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 (Ernst & Young 2014; IFSB 2014; and Oliver Wyman 2009). However, despite this growth, Islamic finance assets are still concentrated in the Gulf Cooperation Council (GCC) countries, Iran, and Malaysia, and represent less than 1 percent of global financial assets.

The growth of IB, in particular, outperformed conventional banking over the past decade. IB has thus increased its penetration in many countries, crossing the threshold of 15 percent as a share of banking system assets in 10 countries (Iran and Sudan with a full-fledged Islamic financial sector, Bangladesh, Brunei, Kuwait, Malaysia, Qatar, Saudi Arabia, the United Arab Emirates, and Yemen) (IFSB 2014). IB represents about 1¼ percent of global banking assets. During the recent global financial crisis, Islamic banks were less exposed to the toxic assets that contaminated the conventional banking world, but suffered from second-round effects, notably through the real estate slump. Asset quality and capitalization are still better on average than for conventional banks while profitability remains lower (although the industry averages mask wide variation across different jurisdictions, IFSB 2014).

Sukuk issuance has also increased rapidly. Global issuance has grown significantly since 2006, although from a low base. It reached US$120 billion in 2013, bringing the outstanding Sukuk to US$270 billion by end-2013, representing ¼ percent of global bond markets. Issuance is still concentrated in Malaysia and the GCC countries, although diversification is ongoing with new issuance in Africa, East Asia, and Europe. It is evenly split between sovereigns and corporate Sukuk, and mainly denominated in Malaysian ringgits or U.S. dollars. Demand is generally outstripping supply, leading to oversubscription on most issuances, lower yields (when the fundamentals of the issuer are strong), and less liquidity as investors prefer to “buy and hold.” These include particularly Islamic banks, which suffer from a shortage of Shari’ah-compliant liquid assets.

The strong growth reflects growing demand from Muslim populations, and strong economic growth in countries where the industry already exists. Islamic finance is also benefiting from innovation in products in trade, corporate, project, and consumer finance, improvements in the regulatory environment, ongoing diversification of Sukuk issuers eager to tap savings from the Islamic world, and strong interest in Sukuk issuance by banks seeking to strengthen their capital bases in line with the Basel III requirements. It remains to be seen, however, whether this strong growth will be sustained in light of the recent decline in oil prices as the industry is still concentrated in oil-exporting countries. Indeed, there is empirical evidence that the oil price is a determinant of IB diffusion (Imam and Kpodar 2010). Moreover, low yields and lack of liquidity could weigh on the long-term growth of the Sukuk market.

Islamic finance has the potential to contribute to higher and more inclusive economic growth. Large segments of the Muslim population are underserviced by conventional finance—only 24 percent of adults have a bank account and 7 percent have access to formal financing, compared with 44 percent and 9 percent, respectively, for non-Muslim populations (Demirgüç-Kunt, Klapper, and Randall 2013). Moreover, the principles of risk-sharing and the strong link of credit to collateral means that IB is well-suited to the financing of SME and startups, thereby contributing to more inclusive growth. And at the same time, Sukuk have shown their value in the area of infrastructure finance, and could also help in supporting investment and economic growth.

Islamic finance may also help promote macroeconomic and financial stability. The principles of risk-sharing and asset-based financing can help promote better risk management by both financial institutions and their customers, as well as discourage credit booms. Indeed, IB resembles the proposal made in the 1930s under the Chicago plan, which required full backing of bank loans, and which recent research has suggested would lower macroeconomic volatility and the risk of bank runs (Benes and Kumhof 2012; and Wolf 2014). In the case of Islamic finance, a large portion of bank deposits are offered on a profit-sharing and loss-bearing basis (for example, 55 percent in the Middle East and North Africa region; Ali 2011) and so are explicitly “bail-inable” in the event of a banking sector facing distress. Finally, the underlying ethical precepts of Islamic finance provide, in principle, an important basis for high levels of ethical conduct, governance, and consumer protection.

Islamic finance faces a number of other constraints that may be impeding its development. Although Islamic regulatory bodies and standard setters have created principles and detailed technical standards, there is further scope for their implementation by national authorities, who are often more focused on global conventional banking standards. Lower economies of scale, and sometimes an uneven playing field with conventional finance, play a role. Similarly, large differences in practice across countries and limited standardization and securitization create additional uncertainty for Islamic finance customers. Scarcity of Shari’ah scholars with financial sector expertise, and a slow pace of innovation are also weighing on the industry. These challenges may not only be impeding its development, but could also encourage practices and products that are complex, thus carrying heightened risks.