New report outlines actions to leverage Islamic finance for development

The World Bank Group and the Islamic Development Bank published the first Global Report on Islamic Finance, which details the prospects for the global Islamic finance industry and its potential to help reduce worldwide income inequality, enhance sharing prosperity, and achieve the Sustainable Development Goals. Subtitled “A Catalyst for Shared Prosperity?”, the report provides an overview of trends in Islamic finance, identifies major challenges hindering the industry’s growth, and recommends policy interventions to leverage Islamic finance for promoting shared prosperity.

Islamic finance advocates for just fair and equitable distribution of income and wealth. With a strong link to the real economy as well as risk-sharing financing, Islamic finance can help improve the stability of the financial sector. It can also bring into the formal financial system people who are currently excluded from it due to cultural or religious reasons. Unlike conventional finance, Islamic finance is based on risk-sharing and asset-based financing. By making people direct holders of real assets in the real sector of the economy, it reduces their aversion to risk.

The report outlines a theoretical framework to analyze Islamic economics and finance based on four fundamental pillars:

• Institutional framework and public policy
• Prudent governance and accountable leadership
• Promotion of an economy based on risk sharing and entrepreneurship
• Financial and social inclusion

The report notes, however, areas where policy interventions are needed to develop Islamic finance’s effectiveness and fulfill its potential in helping to reduce inequality. These interventions include:

• Enhance harmonization, implementation and enforcement of regulations
• Create institutions that provide credit and other information to support equity-based finance, particularly for micro, small and medium-sized enterprises (MSMEs)
• Develop capital markets and ṣukūk products to help finance large infrastructure projects
• Provide regulatory recognition of products from other jurisdictions to expand the markets through cross-border transactions

What’s needed to overcome these challenges?

The Islamic finance industry needs to expand beyond banking, which is currently a dominant component of Islamic finance, accounting for more than three-quarters of the industry’s assets.

However, for the banking sector, the report recommends creating an enabling regulatory and supervisory environment that addresses systemic risk across jurisdictions; introducing innovative risk-sharing products and services, rather than replicating conventional risk-transfer products; unifying cross-country sharī‘ah rulings on Islamic finance; enhancing access to Islamic finance; and bolstering Islamic finance human capital and literacy.

Another area of development is Islamic capital markets. While still relatively young, they can provide opportunities to build assets but through equity- and asset-based finance. Particularly, the ṣukūk markets (Islamic bond) are suitable for financing infrastructure and encouraging entrepreneurship. The use of sovereign ṣukūk to mobilize financing is essential to develop the market, as well as to promote transparency and efficiency of the asset pricing, according to the report.

The report also notes that policy makers should prioritize the development of non-bank financial institutions, which are currently underdeveloped and underutilized. For example, Islamic insurance, takāful, could provide important benefits to households and firms, improving their access to financial services.

Lastly, the report notes that using Islamic social finance can alleviate poverty and create a social safety net for the extremely poor, considering that these institutions and instruments (qard hasan, zakāt, sadaqāt, waqf) are rooted in redistribution and philanthropy. The report recommends to create governance systems to support orderly function of the Islamic social finance sector.

By tapping into the potential of the institutions like zakāt and waqf, the report estimates that resource needs for the most deprived in most countries in South and Southeast Asia and Sub-Saharan Africa could be met.