Islamic banking has the potential to promote financial stability, boost SMEs, and contribute to greater financial inclusion. But the IMF recently stressed on the numerous challenges the industry has to face to unlock these potentials.
Islamic finance has experienced a swift expansion: Islamic assets recently reached the $2 trillion mark and Islamic finance outperforms the growth of conventional finance in many places. The IMF expects further growth for the industry.
At the beginning of the month, the Islamic Finance Meeting Global Aspirations Conference took place in Kuwait city, organised by the IMF and Central Bank of Kuwait. The IMF was keen to highlight the strong and key potentials of Islamic finance.
Islamic finance’s potential
According to the IMF, Islamic finance has three main potentials: the creation of greater financial inclusion, the support to small and medium sized enterprises (SMEs), and above all, the promotion of financial stability.
The risk-sharing and asset-backed features of Islamic finance explain the potential the industry has to provide a strong support for SMEs. This is because the principle of risk-sharing serves to promote a more sustainable diversification of risks.
Moreover, the risk-sharing feature, combined with prohibition of speculation, suggest that Islamic finance should, in theory, pose less systemic risk than conventional finance and therefore promote financial stability. The fact that Islamic financing is asset-backed means that it is fully collateralised, and therefore mitigates against risks.
In addition, as the Islamic Shariah law prohibits interest-bearing deposits, so Islamic banks raise deposits in the form of profit-sharing investment accounts (PSIAs). Such accounts have loss-absorption qualities, which help investors share risk. With profit-sharing and loss-bearing accounts, Islamic finance can also help curb losses and contagion when there is distress in the banking sector.
For instance, as the 2008 global financial crisis devastated financial systems in most places, Islamic financial institutions were comparatively untouched as they were protected by risk-sharing and avoidance of speculative financial products.
These several features specific to Islamic finance explain the great potential of financial stability it holds. However, according to the IMF, for these potentials to become a reality several challenges need to be addressed.
Necessity to improve
In order to unlock its great potentials, Islamic finance needs to enlarge its customer base, harmonise standards, and must improve regulatory frameworks.
If the Islamic finance industry has recently shown rapid growth, its market penetration still remains low; Islamic financial assets account for only 1% of global financial assets. The Islamic finance market is concentrated in only a few countries.
Moreover, a recent study from the IMF noted that the “rules of the road” established by the Islamic Financial Services Board are not being applied consistently across countries, which generates systemic vulnerabilities and weakens the industry as a whole.
Islamic finance needs to be improved, especially through the development of a stronger regulatory framework. Cross-border operations have expanded without regulatory harmonisation, and many regulations are not streamlined across countries.
In a recent survey, the IMF has shown that standards set by the two key standard setters institutions of the Islamic Finance industry – the AAOIFI (set up for Shariah accounting and auditing standards) and the IFSB (established for regulatory and supervisory standards) – are only applied in certain countries.
Only 8 countries out of 20 surveyed apply the AAOIFI accounting standards, and only 6 jurisdictions apply the IFSB standards concerning risk management and capital adequacy.
The role of the IMF
During the conference, the IMF announced that it would increase its involvement in the Islamic finance industry by supplying more bilateral surveillance and analytical help. In the future, the IMF is expected to help supervise the application of regulatory frameworks across Islamic finance countries.
The IMF will also help with the development of Sukuk markets, which are the Islamic equivalent of bonds. Sukuks represent an important growing market, and key instruments for infrastructure financing and sustainable development.
In order to develop the Sukuk market, it is essential to improve their legal and regulatory framework, and sovereign Sukuk plans need to be incorporated in governments’ debt management strategies. The IMF should also create international standards for accounting and statistical treatment of Sukuks.
In general, there is a lack of internationally comparable data within Islamic finance, which erodes the ability of stakeholders to get a precise picture of the stability of Islamic financial institutions.
In order to promote Islamic Finance, the IMF could play a role in covering this gap. The IMF could support the Islamic Financial Services Board’s Prudential & Structural Islamic Finance Indicators (PSIFI). It is important to have this metric in order to anticipate future prospects of the sector.
Christine Lagarde, IMF Managing Director, stresses the importance of the development of Islamic finance for financial stability and development in the region as she says “We at the IMF are keen to participate, to listen, to collaborate, innovate, and develop the promise of Islamic finance in a sound and sustainable way, by managing risks appropriately and ensuring financial stability”.
Today, the Islamic finance banking industry’s challenges are becoming more important, especially in the context of declining oil prices.