Q&A: Seven Questions on Islamic Finance

Author:Inutu Lukonga
IMF Research Bulletin
Although still a small share of global
finance, Islamic fin ance has grown rapidly
over the past decade and i s projected
to continue to expand. Th e growth of
Islamic finance presents opportunities to
improve access to finance for the l arge
underserved Muslim popul ations, and
for small- and medium-sized ente rprises, opportunities to
facilitate investment in public infrast ructures and to promote
financial stability. However, for the potential to be realize d
and to safeguard financial sta bility, a number of challenges
will need to be addressed . In their IMF Staff Discussion
Note (SDN 15/05), entitled “Islamic Finance: Opportunities ,
Challenges and Policy Implication s,” the authors discuss
the macroeconomic and financ ial stability implications of
Islamic finance and the policy opt ions. This arti cle provides
brief answers to se ven commonly asked question s about
Islamic finance, drawing on the f indings of recently completed
analytical work.
Question 1. What is Islamic finance and why does
it matter?
Islamic Finance refers to the provi sion of nancial services
in accordance with Sha ri’ah Islamic law, principles, and rules.
e main tenets of Shari ’ah as applied to nance are: the pro-
hibition of interest; excessive uncert ainty and gambling; risk
sharing; the requ irement that nance supports real economic
activities; a nd the adherence to ethical standa rds.
e Islamic nance i ndustry mainly comprises ban king
and the Sukuk or Isl amic bond market which account for
80 percent and 15 percent of total Islamic na ncial assets,
respectively. e balance is accounted for by equit ies, invest-
ment funds, insura nce (Takafu l), and micronance. Islamic
nance is growing r apidly in terms of assets and geographica l
reach, although the a ssets are concentrated in Southeast Asia
and the Middle East , particularly the Gul f Cooperation Coun-
tries (GCC). e Islamic bank ing sector is now systemically
important in a dozen cou ntries and Sukuk is increasing its
global reach to include issuers from adva nced, emerging, and
developing ec onomies (Figure 1).
e growth of the Isla mic nance industry oers impor-
tant potential benets. It ca n facilitate nancial inclusion
by increasing access to ba nking services to underser ved
Muslim populations; the r isk-sharing characteristics of
Islamic nancia l products can facilitate access to na nce by
small- and medium-siz ed enterprises (SMEs); and the asset-
backed nature of Sukuk m akes them suitable for infrastr uc-
ture nancing t hat can help spur economic development,
including creating a n enabling environment for private
sector investment. Moreover, the requirement to nance real
economic activity c an reduce leverage while the risk-sharing
features enhance t he loss absorbency of capital.
However, to realize the potential and to sa feguard nancial
stability, countries need to adapt t heir regulatory, supervi-
sory, and consumer protection framework s to the specicities
of Islamic nance; to develop Sha ri’ah-compliant nancial
markets and monetar y instruments; and to build an enabl ing
environment for Sukuk market de velopment.
Question 2. What stability risks are unique to Islamic
banking and what changes are needed to regulatory
frameworks to safeguard financial stability?
Islamic nancia l transactions are struc tured dierently
from conventional products because of the need to comply
with Shari ’ah principles. Unlike conventional ba nks, Islamic
banks are f unded by current accounts that do not attract
interest or by prot-sharing investment accounts (PSIA)
where the investment account holder (IAH) receives a retu rn
that is determined , aer the fact, by the protability of the
underlying nanc ing and the IAH bears losses, i f any. On the
assets side, tra nsactions include sales with a prot markup
and deferred payments, leases, pa rtnerships, or joint ventures.
Additionally, to facilitate the i nvestments, Islamic banks are
permitted in some juri sdictions to establish subsidiaries of
non-nancial corporations i n their groups, resulting in con-
glomerate corp orate structures .
Consequently, in addition to standard ba nking risks (such
as credit, market, l iquidity, and operational risks), Islamic
banks als o face unique risks such as the displaced c ommercial
risk (DCR) whereby shareholders may forego a part of their
prots to provide competitive earnings to I AHs, equity
Seven Questions on Islamic Finance
Inutu Lukonga

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