Islamic Finance: A Trend Too Significant to Ignore

Jaseem Ahmed, Secretary General, Islamic Financial Services Board | December 8, 2014 |

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The year 2014 has seen a flurry of international activity in Islamic finance with important issuances of Islamic securities—in the form of sovereign Sukūks—by the United Kingdom and Luxembourg in Europe, as well as by South Africa and Senegal in Africa, among others. These issuances come in the wake of sustained growth of the industry in recent years. Although the origins of Islamic finance go back many centuries, its re-emergencies relatively recent.

The modern revival of Islamic finance dates from the 1960s and is closely linked to the emergence of newly independent countries that found the means and incentives to respond to the unmet need of their citizens for a form of finance that they could trust, and which was in accordance with their ethical and moral principles. Banking the unbanked—before that memorable phrase was invented—has been a part of the Islamic finance success story among Muslims. But many non-Muslims have also been drawn to Islamic finance, attracted by the value it places on high ethical standards and its resilience and stability during the global financial crisis.

The Principles and Conventions of Islamic Finance

A distinctive aspect of Islamic finance is that it is a form of financial innovation in which legal contracts for real sector productive activities serve as the basis for financial intermediation—intermediation that must serve a socially useful purpose.

Many of these contracts have their origins in classical times. Some of the contracts in Islamic finance share features with contracts in western societies. For example, the medieval contractual form of the commenda, which helped to sustain trade by sea, was a form of contract involving trust and profit sharing similar to contracts in Islamic finance. And yet, some aspects are very new: the Sukūk for instance, while derived from Islamic securities that are very old have been adapted into a modern form in different ways.

Islamic finance is all about different permutations of contracts. Innovation is inherent in this process. One of the central principles of Islamic law that shapes this process is a principle that is shared with the legal systems of western nations: this is the fundamental principle of “negative liberty” which says that anything that is not prohibited is permissible.

Islamic financial contracts must be consistent with Islamic law, or the Sharia, but can be enforced in jurisdictions where the governing law is not that of the Sharia. Three pillars of the Sharia that have shaped our understanding of Islamic finance, among others, are the prohibition of Riba (usury), Gharar (excessive uncertainty) and Maysir (gambling). Underlying the proscription of Riba, is the requirement that economic returns should be closely linked to entrepreneurial risk: there should be no riskless, guaranteed return. There is also the deep concern, rooted in pre-biblical societies, regarding the adverse consequences of high levels of debt burden on individuals and societies. This concern is of profound relevance today with the high incidence of balance-sheet-constrained households in the crisis economies.

The prohibition on excessive uncertainty is focused on limiting the possibility of deception based on informational asymmetries. As for Maysir, or gambling, the objective of Islamic jurisprudence in its prohibition is the promotion of a productive work ethic that increases welfare (both at the individual level and to society) as opposed to concentrating on the unearned gains of gambling with all its associated antisocial behavior. The idea of shared risks and returns, and of materiality or a direct link between finance and the real economy, are central to Islamic finance. The above principles have helped to shield Islamic finance from exposure to the imprudent conduct and toxic assets that were at the heart of the global financial crisis.

A Growth Industry

From its modern beginnings in Egypt and Malaysia, Islamic finance is now a growth industry and its recent performance contrasts sharply with that of its conventional counterpart.

Prior to the financial crisis, according to a report by McKinsey in 2013, Financial Globalization: Retreat or Reset?, global financial assets had grown at about 8 percent per annum during the period 1990 to 2007. Since 2007, this growth rate has slumped to just under 2 percent per annum. In contrast to overall growth of the global financial sector, according to the Islamic Financial Services Board (IFSB)’s Islamic Financial Services Industry Stability Report of 2014Islamic finance has grown at over 20 percent per annum since 2007; and Sukūk issuances have grown at a rate of about 24 percent per annum in this period. We see similar rates of growth for Takāful, or insurance in Islamic finance, as well as for Islamic capital markets. Over longer periods, growth rates are a little lower, at about 15 percent per annum. Thus, the distinguishing feature of Islamic finance in the post-crisis period is that of rapid and sustained growth.

Rapid growth and innovation are transforming the industry, fostering economic development in an increasing number of jurisdictions, while also raising new opportunities and challenges. While the industry is still quite small, accounting for less than 2 percent of global financial sector assets, sustained high growth rates have resulted in the emergence of an Islamic finance sector that is now too large to ignore. The Islamic finance sector represents more than 15 percent of the entire financial sector in terms of assets in 11 jurisdictions across Asia, Africa, and the Middle East.

However, some of the most far-reaching reforms are taking place in countries where the sector is still small, but are expected to grow significantly. In these countries, such as Indonesia and Turkey, reforms are following in the path of Malaysia, where there is a robust policy and regulatory framework that has facilitated the integration of Islamic finance into expenditure and investment programs of both public and corporate sectors. About 65 percent of market capitalization on the Kuala Lumpur Stock Exchange, for example, is Sharia compliant.

The rapid expansion of the Sukūk market is especially striking. This reflects both supply- and demand-side factors. On the demand side, there is the huge need for infrastructure financing in Asia and in the Middle East. On the supply side, reforms to the legal, tax, and regulatory frameworks are helping to remove supply-side impediments to Sukūk issuances in a number of key jurisdictions.

The emergence of the Sukūk market is thus likely to generate sustained and structural changes in global financial markets, to the extent that it reflects actions taken by a growing number of countries to integrate Islamic finance into their expenditure programs for economic and social development.

Positively Disruptive Business Model

To summarize, Islamic finance is a disruptive business model, in the best sense of that phrase. Its rise reflects the recognition, and empowerment, of a whole new set of consumers whose needs today are being met by an increasingly globalized industry. It is helping to redefine our understanding of what we mean by the financial sector, through the introduction of a new and expanding asset class.

The values and ethics embedded in Islamic finance constitute its social and moral capital. They contribute to the stability of Islamic finance, and to its broader appeal. But they must be complemented by other measures to promote resilience and stability, which also requires a robust financial infrastructure, in the form of legal and regulatory frameworks, and strong transparency and disclosure regimes that ensure that finance serves the real sector.

The global financial crisis has led to heightened surveillance of the financial sector to prevent the buildup of excesses and financial imbalances, such as high levels of leverage and asset price bubbles. At the same time, it is important to strengthen legal and regulatory frameworks to keep abreast of international developments. It is here, in the relative lack of development of policy and institutional frameworks in a number of countries, that Islamic finance faces the greatest challenge.

A broad assessment of the performance of Islamic finance is best made in terms of its achievements, its potential, and the challenges ahead. Its achievements as an innovative asset class are gaining greater recognition, especially in the area of infrastructure finance. Its potential for financial inclusion, and for serving underserved groups, remains to be fully realized and yet is recognized by all. It is already contributing to global financial stability by diversifying the structure of economic and financial risk, but its own resilience faces a considerable policy and regulatory test.

For a standard-setting body such as the IFSB, the challenge is to align our mission—which is to promote a sound and resilient Islamic finance industry—with that of the goals of regulators and policy makers, in an expanding range of countries, who are tackling the significant challenge of  integrating Islamic finance into their existing legal and regulatory frameworks. In this context, the standards and guidelines from the IFSB are helping to provide a common, international benchmark for regulators.

This Viewpoint accompanies the launch of the new Islamic finance section of the Global Knowledge Gateway.

  

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