A risk shared: why Islamic finance is a safer option
Islamic finance's approach to risk sharing makes it less speculative and more disciplined than its conventional counterpart. However, says Dr Ahmad Mohamed Ali Al Madani, the president of the Islamic Development Bank, if the industry is to reach its full potential, more collaboration and innovation is needed.
No country can develop and prosper without an efficient and accessible financial system. However, even though the international financial system has become highly sophisticated and has rendered a great deal of service to mankind, it has also become plagued over the past decades by recurring financial crises.
A frequent reason for these crises is excessive and imprudent lending and, in particular, lending for speculative purposes, which accentuates risk without adding any real value to the economy. This raises the question of what is it that makes it possible for banks to resort to such unhealthy behaviour that does not only hurt their own self-interest but also destabilises the international financial system. The reason is essentially the absence of risk sharing: any financial system that does not have risk sharing will lead to inadequate market discipline promoting, for instance, the tendency among banks to lend excessively in order to maximise their profits, on the wrong assumption that they are immune from losses.
A safer option
This tendency and the risks that go with it are less marked in the Islamic financial system, which relies on risk sharing and links the growth of credit to the growth of the real sectors in the economy. In addition, purely speculative transactions that aggravate risk without creating value are also forbidden in Islamic finance. Furthermore, the sale of debt is restricted in Islamic finance to ensure that the creditor evaluates the debt proposal carefully, and does not pass on the risk to an unsuspecting third party.
One has to underline that the principles of Islamic finance are not specific to the Islamic faith. They are part of not only divine religions, but also secular paradigms. Therefore, the underlying principles of Islamic finance are often described as ethical and universal. The Islamic Development Bank does believe that Islamic finance offers some basic features that can help in a renewed approach to build a robust financial system that ensures greater stability.
These features of Islamic finance, including the avoidance of excessive speculation and excessive debt as well as observing ethical norms, may explain how it has grown beyond traditional boundaries, and many developed financial markets are increasingly opening up to it. Currently, the development of Islamic finance is a high priority for many countries.
The Islamic finance instruments can indeed be applied in a wide variety of economic sectors and for different socio-economic development purposes. For instance, these instruments have been applied in infrastructure, energy, food, water, sanitation, trade, housing and other economic sectors. They can meet the needs of governments, the private sector and voluntary sectors to finance mega-projects as well as micro-level operations.
Challenges to meet
Islamic Finance has grown and strengthened, as knowledge sharing and awareness raising about its fundamental objectives and characteristics are improving. However, one must recognise that the potential of Islamic finance is not fully realised and the sector is facing key challenges that need to be resolved through coordinated efforts of all stakeholders.
In particular, many players in the industry are still focusing on short-term financing, whereas the long-term developmental focus should be the hallmark of Islamic finance. Correcting this may require the industry players to go back to the drawing board in order to develop genuine Islamic finance products that are not only profitable but also support the socio-economic development of the society.
There is a need to focus on human capital development in all areas of Islamic finance; to create innovative business models and offer new Islamic financial services; to enhance inclusion by focusing on the funding for small and medium-sized enterprises and providing microfinance solutions; to increase the awareness about the role and function of Islamic finance among the population; and to get actively involved in a global dialogue on the financial system architecture to put forward Islamic finance as a viable solution. There are successful experiences in applying Islamic microfinance in Indonesia, Bangladesh and Sudan that could be studied and replicated in other countries.
The Islamic finance industry, despite its high growth rate, has not realised its full potential. There is a need for more co-operation, collaborative research and innovation in order to benefit from the vast opportunities that Islamic finance offers for sustainable socio-economic development. Islamic financial institutions need to expand their size and scope through conglomeration in order to better contribute to the stability and resilience of the global financial system, which is essential to the development and growth of the inter-connected and inter-dependent world we live in.
Dr Ahmad Mohamed Ali Al Madani is the president of the Islamic Development Bank.
