Islamic finance and economic development: risk management, regulation, and corporate governance.

Abstract

Islamic fi nance is introducing challenges to the global fi nancial landscape. Islamic fi nancial assets, despite the turbulence across all global fi nancial markets, have grown from around US$55 billion in the late 1980s to around US$1.2 trillion in 2011. 1 They represent 0.5 percent of global fi nancial assets. Deutsche Bank’s Global Islamic Banking Report (November 2011) anticipates a 24 percent compounded annual growth rate (CAGR) in Islamic assets over the coming three years. Islamic fi nance is built on different foundations from conventional fi nance. An institution offering Islamic fi nancial services (IIFS) adheres to Shari’ainspired principles and rules, which take precedence over profi t taking. The building blocks of Islamic fi nance are: (1) promotion of fairness in transactions and the prevention of an exploitative relationship and of fraud; (2) sharing of risks and rewards between all parties involved in fi nancial and commercial transactions; (3) a tangible economic purpose for each transaction, sometimes referred to as the principle of materiality; (4) the prohibition of interest; and (5) the prohibition of engaging in activities prohibited by Shari’a laws. These characteristics, particularly the asset-backed nature of Islamic fi nancial assets and risk-sharing arrangements, have played a major role in mitigating the impact of the 2008 global fi nancial crisis on Islamic fi nance. These features ensure a tighter link between the growth of economic and fi nancial transactions than would be permitted with conventional fi nance, and contribute to a clearer identifi cation of where risks lie.2 They can be expected to limit the scope for leverage. Kenneth Rogoff, a leading Harvard University economist, suggests that Islamic fi nance demonstrates the advantages of more equity and risk sharing over the bias in favor of debt instruments in conventional fi nance. 3