Islamic Banking and Finance. Forty Years on; A Reality Check

Abstract

Islamic Banking and Finance (IBF) has had forty years of impressive growth, yet, within the Muslim world, there is a paradox of huge accumulated wealth and seriously underdeveloped financial markets. This paper examines whether over its 40-year existence, IBF has lived up to its anticipated goals and objectives. It argues that growth has been patchy with huge gaps, missing links and missed opportunities. IBF has progressed not through innovation but imitation. Having replicated conventional banking and capital market products, IBF products like sukuk have largely mimicked conventional coupon bonds. Thus, IBF has not been able to offer new asset classes that can add value. Its products have the same interest rate risks and contagion effects. Given the higher transaction costs involved in structuring shariah compliant products, it is hard to see how they can offer even similar, if not superior returns. Further, with lower liquidity from less active and incomplete secondary markets, IBF cannot continue to play the same game as conventional players and hope to come out ahead. Yet, the paper argues, that the shariah offers huge latitude for innovation, especially of risk sharing instruments. A funding transaction or a sukuk based on a risk-sharing structure like Mudarabah, would have an entirely different risk return profile, no interest rate risk, very low correlation and no contagion. Further. increased reliance on risk-sharing contracts would move the financial system away from the fractional reserve framework, and closer to a mutual fund model. Such a move minimises systemic risk through risk dissipation and reduces the liquidity mismatch inherent to banking. Where the macro economy is concerned, system stability is enhanced by reducing risk concentration within the banking system and minimizes the contingent liabilities of governments by minimizing the use of deposit insurance. If IBF is to move on to a more successful and effective next phase, the gaps and inadequacies identified here, will have to be addressed.