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Home > Capital Markets Best Practice > The International Role of Islamic Finance

Capital Markets Best Practice

The International Role of Islamic Finance

by Andreas Jobst

Executive Summary

  • Islamic finance has become mainstream, with more than US$800 billion of assets worldwide. However, it still faces distinct developmental challenges from economic and legal constraints associated with sukuk, banking-specific issues, and fragmented financial regulation.

  • Although Islamic capital markets and banking have defied the impact of the financial crisis, some negative effects were felt in 2008 and are likely to inhibit further expansion.

  • Despite current challenges, most of which arise from the infancy of the industry, Islamic finance has promising long-term prospects.

Introduction

Since the summer of 2007 the global financial system has undergone a period of dramatic turbulence, which has caused a widespread reassessment of risk in both developed and emerging economies and the price it should command across different asset classes. After a rather painful reckoning, policy-makers and regulators are hastening a redesign of the financial sector architecture afflicted by the demise of self-regulation and a failure of market efficiency. As the global credit crisis continues to deepen, with investment banks and finance houses worldwide still reeling from the collapse of the US subprime mortgage market and the breakdown of the wholesale money markets, the soul-searching in conventional finance has directed attention to alternative modes of finance. In this context new investors, unsettled by excessive risk-taking and asset price volatility, are turning to Islamic finance as market ruptures caused by the headlong flight to safety during the initial phase of the credit crisis seem to be receding only slowly.

Although Islamic finance did not entirely escape the implications of persistent counterparty risk concerns and deep-seated investor distrust of credit-sensitive assets, it managed to harness the current market adversity as a result of greater focus on collateralization, the contempt for excessive leverage, and the near absence of “distressed legacy assets,” such as mortgage-backed securities (MBS). Islamic finance is driven by the general precept of extending religious doctrine in the shariah to financial agreements and transactions. Islamic finance is distinct from conventional finance insofar as it substitutes the (temporary) use of assets (or services) by the borrower for a permanent transfer of funds from the lender as a source of indebtedness. Predatory lending, empty short-selling, and a series of incentive problems between originators, arrangers, and sponsors, of which all have infested the conventional capital markets, go against fundamental Islamic principles, which ensure that contractual certainty and a mutually beneficial balance are maintained between borrowers and lenders (Wilson, 2008).1

Until the onset of the credit crisis at the end of 2007, the Islamic finance industry was in an expansionary phase, exhibiting average annual growth rates of about 15% in recent years. This rapid growth has been fueled by surging demand for shariah-compliant products not only from Muslim financiers, but also by investors around the world. Besides its wide geographical scope, the rapid expansion of Islamic finance is also taking place across the whole spectrum of financial activities, ranging from retail banking to insurance and capital market investments. There is currently over US$800 billion worth of deposits and investments lodged in Islamic banks, mutual funds, insurance schemes (known as takaful), and Islamic branches of conventional banks.

The rapid evolution of Islamic finance points to the considerable profit opportunities, which have prompted a vetting process among a number of jurisdictions around the world to establish themselves as leading Islamic financial centers. In this regard, the case of London is perhaps the most remarkable insofar as it has managed to extend its leading position in world financial markets to become a center for Islamic finance. Similarly, Hong Kong, New York, and Singapore are also making important advances to accommodate Islamic finance within their jurisdictions, and they aspire to join the ranks of the more established Islamic centers such as Bahrain, Dubai, and Kuala Lumpur. These developments underscore the fact that Islamic finance has established itself as a permanent element of the global financial landscape. Nevertheless, despite the recent advances, important challenges lie ahead.

Against this background, the present article first reviews the current situation of Islamic finance before discussing some of the challenges going forward. For expository purposes, the article follows a two-pronged approach in considering these challenges through a discussion of key banking issues and then selected capital market issues.

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Further reading

Books:

  • Bhambra, Hari. “Supervisory implications of Islamic finance in the current regulatory environment.” In Rifaat Ahmed Abdel Kareem and Simon Archer (eds). Islamic Finance: The Regulatory Challenge. Singapore: Wiley, 2007, 198–212.
  • DeLorenzo, Yusuf T., and Michael J. T. McMillen. “Law and Islamic finance: An interactive analysis.” In Rifaat Ahmed Abdel Kareem and Simon Archer (eds). Islamic Finance: The Regulatory Challenge. Singapore: Wiley, 2007, 132–197.
  • Sundararajan, V. “Risk characteristics of Islamic products: Implication for risk measurement and supervision.” In Rifaat Ahmed Abdel Kareem and Simon Archer (eds). Islamic Finance: The Regulatory Challenge. Singapore: Wiley, 2007, 40–68.

Articles:

Reports:

  • Damak, Mohamed, Emmanuel Volland, and Ritesh Maheshwari. “The sukuk market has continued to progress in 2009 despite some roadblocks.” Paris: Standard & Poor’s, September 2, 2009.
  • El-Hawary, Dahlia, Wafik Grais, and Zamir Iqbal. “Regulating Islamic financial institutions: The nature of the regulated.” World Bank policy research working paper 3227, Washington, DC: World Bank, 2004.
  • Errico, Luca, and Mitra Farrahbaksh. “Islamic banking: Issues in prudential regulation and supervision.” International Monetary Fund working paper 98/30, Washington, DC: IMF, 1998.
  • Islamic Financial Services Board (IFSB). “Capital adequacy standard for institutions (other than insurance institutions) offering only Islamic financial services.” Kuala Lumpur: IFSB, December 2005. Online at: www.ifsb.org/standard/ifsb2.pdf
  • Islamic Financial Services Board (IFSB). “Guiding principles of risk management for institutions (other than insurance institutions) offering only Islamic financial services.” Kuala Lumpur: IFSB, December 2005. Online at: www.ifsb.org/standard/ifsb1.pdf
  • Solé, Juan A. “Introducing Islamic banks into conventional banking systems.” IMF working paper 07/175. Washington, DC: IMF, July 2007.

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