Study Shows Larger islamic Banks need Prudential eye

• Author: Martin Cihak and Heiko Hesse
• Position: IMF European Department
• Pages: 96-97

Page 96

Institutions offering Islamic financial services constitute a significant and growing share of the financial system in several countries.

Since the inception of Islamic banking about three decades ago, the number and reach of Islamic financial institutions worldwide has risen from one institution in one country in 1975 to more than 300 institutions operating in more than 75 countries.

The entire banking systems of Sudan and Iran are based on Islamic finance principles. Although Islamic banks are concentrated in the Middle East and Southeast Asia, they are also niche players in Europe and the United States. According to McKinsey & Co., Islamic banking assets and assets under management reached $750 billion in 2006, and the Islamic finance sector is expected to reach $1 trillion by 2010.

Islamic or Shariah-compliant banking provides and uses financial services and products that conform to Islamic religious practices and laws, which, in particular, prohibit the payment and receipt of interest at a fixed or predetermined rate. In practice, this means that instead of loans, Islamic banks use profit-and-loss sharing arrangements (PLS), purchase and resale of goods and services, and the provision of services for fees for the basis of contracts.

Benchmark rate

In PLS modes, the rate of return on financial assets is not known or fixed prior to undertaking the transaction. In purchase-resale transactions, a markup is determined based on a benchmark rate of return, typically a return determined in international markets, such as the London interbank offered rate (LIBOR).

Islamic banks also determine return on deposits differently. In a commercial bank, the rate of return is set contractually (fixed in advance or tied to a reference rate) and does not depend on the bank's lending performance. In an Islamic bank, the rate of return on a deposit is directly dependent on the quality of the bank's investment decisions.

If the bank records losses as a result of bad investments, depositors may lose some (or all) of their deposits. The contractual agreement between depositors and the Islamic banks does not predetermine any rates of return, it only sets the ratio according to which profits and losses are distributed between the parties to the deposit contract.

There is a large body of descriptive literature about Islamic...