An Overview Of Islamic Finance; By Mumtaz Hussain, Asghar .
WP/15/120An Overview of Islamic Financeby Mumtaz Hussain, Asghar Shahmoradi, and Rima Turk
2015 International Monetary FundWP/15/120IMF Working PaperAfrican, European, and Middle East and Central Asia DepartmentsAn Overview of Islamic Finance1Prepared by Mumtaz Hussain, Asghar Shahmoradi, and Rima TurkAuthorized for distribution by Zeine ZeidaneJune 2015IMF Working Papers describe research in progress by the author(s) and are published toelicit comments and to encourage debate. The views expressed in IMF Working Papers arethose of the author(s) and do not necessarily represent the views of the IMF, its Executive Board,or IMF management.AbstractIslamic finance has started to grow in international finance across the globe, with someconcentration in few countries. Nearly 20 percent annual growth of Islamic finance in recentyears seems to point to its resilience and broad appeal, partly owing to principles that governIslamic financial activities, including equity, participation, and ownership. In theory, Islamicfinance is resilient to shocks because of its emphasis on risk sharing, limits on excessive risktaking, and strong link to real activities. Empirical evidence on the stability of Islamic banks,however, is so far mixed. While these banks face similar risks as conventional banks do, theyare also exposed to idiosyncratic risks, necessitating a tailoring of current risk managementpractices. The macroeconomic policy implications of the rapid expansion of Islamic financeare far reaching and need careful considerations.JEL Classification Numbers: E44, E52, E58, G15, G21, G28Keywords: Islamic Finance, Islamic Banking, Monetary Policy, Financial Stability, SukukAuthor’s E-Mail Address: MHussain@imf.org; AShahmoradi@imf.org; RTurk@imf.org1The authors would like to thank Gerard Almekinders, Khalid AlSaaed, Samar Maziad, Mohamed Afzal Norat,and Zeine Zeidane for their helpful comments and suggestions.
2ContentsPageAbbreviations .3I. Introduction and Background .4II. The Framework of Islamic Finance .5A. Key Principles of Islamic Finance .5B. Three Principles Govern Islamic Finance .6C. Key Instruments of Islamic Finance.6D. Islamic Banking Model .10III. Stylized Facts about Islamic Finance .12A. Islamic Finance and Banking .12B. Sukuk Markets.14IV. Growth Drivers of Islamic Finance .16V. Comparison of Islamic and Conventional Finance .17A. Efficiency and Profitability .17B. Risk Management .17C. Sukuk and Conventional Bonds .19VI. Macroeconomic Implications of Islamic Finance.21A. Financial Stability .21B. Monetary Policy .25C. Fiscal Policy .28VII. Conclusions and Policy Implications .28Annex I. Key Instruments of Islamic Finance .30References .32Table I. Islamic Bank Balance Sheet .11
3ABBREVIATIONSAAOIFIAccounting and Auditing Organization for Islamic Financial InstitutionsADBAfrican Development BankBCBSBasel Committee on Banking SupervisionCARCapital adequacy ratioFSAPFinancial Sector Assessment ProgramGCCGulf Cooperation CouncilIAHInvestment account holdersIsDBIslamic Development BankIFSBIslamic Financial Services BoardIIFMInternational Islamic Financial MarketIILMInternational Islamic Liquidity Management CorporationIRRInvestment risk reserveIRTIIslamic Research and Training InstituteLCRLiquidity coverage ratioLMELondon Metal ExchangeLOLRLender-of-last resortMENAMiddle East and North AfricaMGISAMit-Ghamr Islamic Saving AssociationsPERProfit equalization reservePFCPilgrims Fund CorporationPLSProfit-and-loss sharingRWARisk-weighted assetsSLOLRShari’ah-compliant lender- of-last resort
4I. INTRODUCTION AND BACKGROUNDIslamic finance is growing within international finance. In its modern form, Islamic bankingstarted with pioneering experiments in the early 1960s in Egypt. The Mit-Ghamr IslamicSaving Associations (MGISA) mobilized the savings of Muslim investors, providing themwith returns that did not transgress the laws of the Shari'ah.2 The MGISA attracted a flurry ofdeposits, which grew at the rate of more than 100 percent per year in the first three years ofoperations. Later, the Pilgrims Fund Corporation (PFC) enabled Malaysian Muslims to savegradually and invest in Shari’ah-compliant instruments, with the purpose of supporting theirexpenditures during the Hajj period (pilgrimage). In 2012, the PFC had eight million accountholders and deposits of more than 12 billion. Formally, Islamic banking started in the late1970s with a handful of institutions and negligible amounts, but it has increasingly grownover the past two decades, with total assets reaching about 2 trillion at end-2014.The establishment of the Islamic Development Bank (IsDB) in 1975 was a watershedmoment for Islamic banking, coming just after the establishment of the first major Islamiccommercial bank—the Dubai Islamic Bank—in the United Arab Emirates. The success ofthe latter led to the establishment of a series of similar banks, including Faisal Islamic Bank(Sudan) and Kuwait Finance House (Kuwait)—both in 1977. As early as the late 1970s, stepswere taken in Pakistan for making the financial system compliant with Shari’ah principles.The legal framework was then amended in 1980 to allow for the operation of Shari’ahcompliant profit-sharing financing companies, and to initiate bank finance through Islamicinstruments. Similarly, Iran enacted a new banking law in August 1983 to replaceconventional banking with interest-free banking. The law gave banks a window of threeyears for their operations to become compliant with Islamic principles. Sudan’s efforts toalign its entire banking system with Shari’ah principles began in 1984.The financial infrastructure, including standards setting and regulatory institutions, has alsobeen catching up with the rapid growth of Islamic financing. International standard-settinginstitutions were established to guide the operations of the industry around the world,although standardization of Islamic products across different countries remains a challenge.Since 1991, the Accounting and Auditing Organization for Islamic Financial Institutions(AAOIFI), based in Bahrain, has been issuing accounting, auditing, and Shari’ah standardsfor financial reporting at Islamic financial institutions. The Islamic Financial Services Board(IFSB), established in 2002 in Malaysia, is responsible for issuing supervisory and regulatory2Shari’ah or Islamic jurisprudence is based on primary and secondary sources of law. The first primary sourceis the Quran, the divine revelation that contains legal injunctions, and the second primary source is the Sunna,which relates the practice or code of conduct of the Prophet. Secondary sources of law are Ijma’ or consensus,Qiyas or analogical deductions, and Ijtihad or interpretations to explain the law, with differences among variousschool of thoughts (such as the Sunni and the Shia).
5standards and guidelines.3 It also promotes the adoption of these standards and guidelines byrelevant regulatory authorities. In 2001, the International Islamic Financial Market (IIFM) inBahrain was mandated to develop guidelines for the issuance of Islamic financial instrumentsand to encourage active secondary market trading. Most recently in 2010, the Malaysia-basedInternational Islamic Liquidity Management Corporation (IILM) started issuing short-termShari’ah-compliant financial instruments to facilitate cross-border Islamic liquiditymanagement.This paper is mostly intended to provide an overview of key policy issues and challengesfacing practitioners and policy makers. It provides an overview of Islamic finance, discusseskey macroeconomic implications from its expansion across the globe, and gives a broadperspective on key elements of Islamic finance and banking. Instead of exploring deeply afew controversial issues or introducing new solutions to current challenges in Islamicfinance, it tries to provide a general overview of the Islamic finance industry which, as arelatively new branch of finance, is often difficult to understand and prone to beingmisunderstood. While Islamic finance has expanded beyond Muslim-majority countries,reaching Europe and Sub-Saharan Africa, Shari’ah-compliant financial assets remainconcentrated in Iran, Malaysia, and a few Gulf Cooperation Council (GCC) countries, whereit has become systemic. The paper raises a number of policy-related questions, but in manycases, it will defer the detailed answers to other, companion papers.4The next section summarizes the fundamentals of Islamic finance and describes its keyinstruments. Section III presents stylized facts about the growth of the Islamic financeindustry. Section IV briefly discusses the key drivers for the growth of Islamic finance, andSection V provides a brief comparison between Islamic and conventional financial systems.Section VI focuses on key macroeconomic and financial stability implications of Islamicfinance, discussing its role in the conduct of monetary and fiscal policies, as well as financialstability. The last section presents conclusions and recommendations.II. THE FRAMEWORK OF ISLAMIC FINANCEA. Key Principles of Islamic FinanceIslamic economics and finance derive from immutable principles rooted in the rulings of theShari’ah legal code. Unlike legal systems that are limited to secular aspects of daily life,Shari’ah jurisprudence does not distinguish between religious and other aspects of life,3As of April 2015, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) hasissued 88 Shari’ah, accounting and governance standards for Islamic institutions. Similarly, the IslamicFinancial Services Board (IFSB) has issued 17 regulatory and prudential standards and six guidance notes.4Over the last six months, IMF staff have produced a Staff Discussion Note (Kammer et. al., 2015) and anumber of working papers addressing specific policy issues relevant for Islamic banking and finance (forexample, Song, I. and Oosthuizen, C. (2014), López Mejía et al., (2014), Ben Naceur and others (2015).
6including transactions falling under either the political, economic, or social sphere(muamalat). In Islamic economics, productive human activity is mandatory. Islam does notendorse every human wish, and it prohibits on moral grounds activities related to tobacco andother drugs, alcohol, pork products, gambling involving money and non-money assets(maysir), speculation, pornography, and armaments and destructive weapons.B. Three Principles Govern Islamic FinancePrinciple of equity: Scholars generally invoke this principle as the rationale for theprohibition of predetermined payments (riba), with a view to protecting the weakercontracting party in a financial transaction. The term riba, which means “hump” or“elevation” in Arabic, is an increase in wealth that is not related to engaging in a productiveactivity. The principle of equity is also the basis for prohibiting excessive uncertainty(gharar) as manifested by contract ambiguity or elusiveness of payoff. Transacting partieshave a moral duty to disclose information before engaging in a contract, thereby reducinginformation asymmetry; otherwise the presence of gharar would nullify the contract. Theprinciple of equity and wealth distribution is also the basis of a 2.5 percent levy on cash orin-kind wealth (zakat), imposed by Shari’ah on all Muslims who meet specific minimumlevels of income and wealth to assist the less fortunate and foster social solidarity.Principle of participation: Although commonly known as interest-free financing, theprohibition of riba does not imply that capital is not to be rewarded. According to a keyShari’ah ruling that “reward (that is, profit) comes with risk taking,” investment returnhas to be earned in tandem with risk-taking and not with the mere passage of time, which isalso the basis of prohibiting riba. Thus, return on capital is legitimized by risk-taking anddetermined ex post based on asset performance or project productivity, thereby ensuring alink between financing activities and real activities. The principle of participation lies at theheart of Islamic finance, ensuring that increases in wealth accrue from productive activities.Principle of ownership: The rulings of “do not sell what you do not own” (for example,short-selling) and “you cannot be dispossessed of a property except on the basis of right”mandate asset ownership before transacting. Islamic finance has, thus, come to be known asasset-based financing, forging a robust link between finance and the real economy. It alsorequires preservation and respect for property rights, as well as upholding contractualobligations by underscoring the sanctity of contracts.C. Key Instruments of Islamic FinanceIn Islamic finance, the term “loan” refers only to a benevolent loan (qard al hasan), a form offinancial assistance to the needy to be repaid free of charge. Other instruments of Islamic
7finance are not referred to as “loans’ but rather as financing modes falling under one of thethree categories: Profit-and-loss sharing (PLS), non-PLS contracts, and fee-based products.5PLS Financing ProductsPLS financing is closest to the spirit of Islamic finance. Compared with non-PLSfinancing, its core principles of equity and participation, as well as its strong link to realeconomic activities, help promote a more equitable distribution of income, leading to a moreefficient allocation of resources. There are two types of PLS financing: musharakah andmudârabah.Musharakah is a profit-and-loss sharing partnership and the most authentic form of Islamicfinancing.6 It is a contract of joint partnership where two or more partners provide capital tofinance a project or own real estate or movable assets, either on a permanent or diminishingbasis.7 Partners in musharakah have a right to take part in management; they seem to bear thegreatest risk among all Islamic financing modes with the potential for earning the highestreward. However, whereas profits are distributed according to pre-agreed ratios, losses areshared in proportion to capital contribution.Mudârabah is a profit-sharing and loss-bearing contract where one party supplies funding(financier as principal) and the other provides effort and management expertise (mudarib orentrepreneur as agent) with a view to generating a profit. The share in profits is determinedby mutual agreement but losses, if any, are borne entirely by the financier, unless they resultfrom the mudarib’s negligence, misconduct, or breach of contract terms. Mudârabah issometimes referred to as a sleeping partnership because the mudarib runs the business andthe financier cannot interfere in management, though conditions may be specified to ensurebetter management of capital. Islamic banks mainly make use of mudârabah financing toraise funds; mudârabah contracts are also used for the management of mutual funds.5See Annex 1 for more details. A recent paper, Song and Oosthuizen (2014), surveyed cross-country practicesrelated to legal and prudential frameworks governing Islamic banking activities.6Musharakah can be limited (shirkat al-inan) or unlimited (mufawadah). In the case of shirkat al-inan, themusharakah is limited in scope to a specific undertaking; different shareholders have different rights and areentitled to different profit shares; and each partner is the agent only, but not the guarantor of the other partner.In the case of mufawadah, which is an unlimited and equal partnership, all participants rank equally in everyrespect (initial contributions and final profits), and every partner is both the agent and the guarantor of the other.7Diminishing musharakah (musharakah mutanaqisa) is mostly used in home financing: one partner promises tobuy the equity share of the other party gradually until the title of ownership of the equity is completelytransferred to the buying partner. This type of contract is widely used in Iran.
8Non-PLS Financing ProductsNon-PLS contracts are most common in practice. They are generally used to financeconsumer and corporate credit, as well as asset rental and manufacturing. Non-PLS financinginstruments include murâbaḥah, ijārah, salam, and istisna’.8Murâbaḥah: is a popular Shari’ah-compliant sale transaction mostly used in trade and assetfinancing.9 The bank purchases the goods and delivers them to the customer, deferringpayment to a date agreed by the two parties. The expected return on murâbaḥah is usuallyaligned with interest payments on conventional loans, creating a similarity betweenmurâbaḥah sales and asset-backed loans. However, murâbaḥah is a deferred payment saletransaction where the intention is to facilitate the acquisition of goods and not to exchangemoney for more money (or monetary equivalents) over a period of time. Unlike conventionalloans, after the murâbaḥah contract is signed, the amount being financed cannot be increasedin case of late payment or default, nor can a penalty be imposed, unless the buyer hasdeliberately refused to make a payment. Also, the seller has to assume any liability fromdelivering defective goods. Murâbaḥah transactions are widely used to finance internationaltrade, as well as for interbank financing and liquidity management through a multisteptransaction known as tawarruq, often using commodities traded on the London MetalExchange (LME).10 However, in some jurisdictions, tawarruq transactions are not consideredcompliant with Shari’ah principles.Ijārah is a contract of sale of the right to use an asset for a period of time. It is essentially alease contract, whereby the leaser must own the leased asset for the entire lease period. Sinceownership remains with the leaser, the asset can be repossessed in case of nonpayment by thelessee. However, the leaser is also responsible for asset maintenance, unless damage to theleased asset results from lessee negligence. This element of risk is required for making ijārahpayments permissible. A variety of ijārah takes a hire-purchase form, whereby there is apromise by the
4 I. INTRODUCTION AND BACKGROUND Islamic finance is growing within international finance. In its modern form, Islamic banking started
Director of the Center for Islamic Economics and Finance, College of Islamic Studies, Hamad Bin Khalifa University, Doha, Qatar Keywords Islamic Finance Community-Based Devel-opment Islamic Moral Economy Blended Finance Received: 15December2016 Accepted: 05 February 2017 Abstract. Contemporary Islamic Finance is seen by many as
4 Islamic Finance Development Report 2017 FOrEWOrD the Islamic finance industry has been accommodating growing demand for shariah-compliant finance for more than 40 years, but as it moves towards greater maturity it has become essential that there is a simplified tracker of its ongoing development. he Islamic Finance Development Indicator (IFDI) t
Islamic Grave Voodoo 57 Allah Will Grow Humans from their Graves 57 Islamic Interrogation in Graves 58 Islamic Torment in Graves 59 Islamic Rewards in Graves 61 CHAPTER 8 63 Islamic Medicine Voodoo 63 Islamic Cauterizing and Cupping 63 The Qur'an and Honey are Cures for All Illness 65
The Evolution of Islamic Banking System in Muslim countries: Before describing the evolution of the Islamic banking it is important to understand what Islamic banking is and what are its principles or features. 1.1) What is Islamic Banking? Islamic Banking is banking or financing activity that is based on Shariah (Islamic Law) and all
INTRODUCTION TO ISLAMIC INVESTING . Islamic finance principles embody a unique form of investment . management which corresponds with the values of socially responsible investing. Islamic finance is an ethical and equitable mode of finance that derives
Islamic finance assets have a compound annual growth rate of 12.7%. While Western countries like UK and Switzerland were listed in the top 20 largest countries in total Sharia-compliant assets. Conventional financial institutions have extended their operations to provide Islamic financial products targeting Islamic investors.
Inform yourself and others about the basics of Islamic finance. 27 Meezan Bank's Guide to Islamic Banking by Dr. Imran Usmani A detailed description of the industry's core products from one of its leading scholars. 94 Islamic Finance Contracts Sample contracts for you to use as the basis of transactions at your bank or in your community. 297
3 Riba, Gharar, and the Moral Economy of Islam in Historical and Comparative Perspective 55 4 The Evolution of Modern Islamic Finance 73 5 Islamic Finance and the Global Political Economy 90 . 8.2 Management, Control, and the 'Islamic Moral Hazard' 154 8.3 Marketing Issues and Challenges 158 8.4 Problems of Liquidity 160 8.5 Cultural .
