ISLAMIC FINANCE AND INCLUSION.

(This article fully extracted from 'Global Financial Development Report 2014:Financial Inclusion'published by World Bank 2014 page 36. Some tables were omitted.)

Shari‘a-compliant financial products and instruments can play a significant role in enhancing financial inclusion among Muslim populations. About
700 million of the world’s poor live in predominantly Muslim-populated countries. In recent years, there has been growing interest in Islamic finance as a tool to increase financial inclusion among Muslim populations (Mohieldin and others 2011).

The main issue relates to the fact that many Muslim-headed households and micro, small, and medium enterprises may voluntarily exclude themselves from formal financial markets because of Shari‘a requirements. Islamic legal systems, among other characteristics, prohibit predefined interest bearing loans. They also require fi nancial providers to share in the risks of the business activities for which they provide financial services (profit and loss sharing). Given these requirements, most conventional financial services are not relevant for religiously minded Muslim individuals and firms in need of financing.

Based on a 2010 Gallup poll, about 90 percent of the adults residing in Organization of Islamic Cooperation (OIC) member countries consider religion an important part of their daily lives (Crabtree 2010). This may help explain why only about 25 percent of adults in OIC member countries have an account in formal financial institutions, which is below the global average of about 50 percent. Also, while 18 percent of non-Muslim adults in the world have formal saving accounts, only 9 percent of Muslim adults have these accounts (Demirgüç-Kunt, Klapper,
and Randall, forthcoming). Moreover, 4 percent of respondents without a formal account in non-OIC countries cite religious reasons for not having an account, compared with 7 percent in OIC countries (table B1.4.1) and 12 percent in the Middle East and North Africa.

Muslim countries are far from uniform in terms of financial inclusion. For example, 34 percent of the unbanked Afghan population cite religious reasons for not having an account in a formal financial institution, while only 0.1 percent of Malaysians do so, although both countries have similarly high Gallup religiosity indexes (97 percent and 96 percent, respectively; see the Statistical Appendix). This can be traced to the extent to which Islamic financial institutions are present in a given country. An analysis suggests that the size of Islamic assets per adult population is negatively correlated with the share of adults citing religious reasons for not having an account. This correlation is particularly strong if one focuses on the group of OIC countries and, even more, on those OIC countries that show a religiosity index exceeding 85 percent.

Based on the Global Findex, for religious reasons, some 51 million adults in the OIC countries do not have accounts in a formal financial institution. Given that a majority of the OIC population lives in poverty, Islamic microfinance could be particularly attractive. For example, 49 percent and 54 percent of adults in Algeria and Morocco, respectively, prefer to use Islamic loans even if these loans are more expensive than conventional loans (Demirgüç-Kunt, Klapper, and Randall, forthcoming).

Global surveys on Islamic microfinance completed by the Consultative Group to Assist the Poor (CGAP) in 2007 and 2012 provide some initial insights into the rapidly growing Islamic microfinance industry. The 2007 CGAP survey found fewer than 130 and 500,000 Islamic MFIs and customers, respectively (Karim, Tarazi, and Reille 2008). Within five years, these figures more than doubled, reaching 256 MFIs and 1.3 million active clients (El- Zoghbi and Tarazi 2013). These figures are on the conservative side because they are based on data for 16 of the 57 OIC member countries (excluding economies such as the Islamic Republic of Iran, Malaysia, and Turkey, which have active Islamic finance industries). In short, the estimated unmet demand for Shari‘a-compliant financial products, in conjunction with the rapid growth of Islamic MFIs, as well as the astonishing growth of the overall Islamic finance industry, all point to the growing attractiveness of Shari‘a-compliant financial products and the supply shortage of such products.

Religiosity also has an impact on the access of firms to finance in OIC countries. The number of Islamic banks per 100,000 adults is negatively correlated with the proportion of firms identifying access to finance as a major constraint. The negative correlation is greater if one focuses on OIC countries and greater still if one focuses on a subset of OIC countries with a religiosity index above 85 percent. These findings, which are mainly driven by small firms (fi gure B1.4.1), suggest that increasing the number of Shari‘a-compliant financial institutions can make a positive difference in the operations of small firms (0–20 employees) in Muslim populated countries by reducing the access barriers to formal financial services.

Efforts to increase financial inclusion in jurisdictions with Muslim populations thus require sustainable mechanisms to provide Shari‘a-compliant fi nancial services to all residents, especially the Muslim poor, estimated at around 700 million people who are living on less than $2 per day. One obstacle is the lack of transparency and the absence of a broadly accepted standardized process for assessing the compliance of financial institutions with Shari‘a guidelines, which makes it difficult for many individuals to distinguish between financial institutions that are operating based on Shari‘a specifications and institutions that are not.

Another difficulty has been the lack of information and training on Islamic finance. For example, only about 48 percent of adults in Algeria, Egypt, Morocco, Tunisia, and the Republic of Yemen have heard about Islamic banks (Demirgüç-Kunt, Klapper, and Randall, forthcoming). Finally, in their infancy and smaller in scale, Islamic financial products tend to be more expensive than their conventional counterparts, reducing their attractiveness.