Islamic finance has seen tremendous growth over the past few decades.
Total Islamic financial assets topped $1.8 trillion in 2013, close to double that in 2009. And by all indications, it is poised for more expansion, particularly in shariah-compliant funding for public infrastructure projects. But as the IMF pointed out in a recent report, substantial growth will require substantial improvements in how the Islamic financing industry currently operates.
Experts point to several constraints that are holding back a more wholesale adoption of Islamic finance. Large differences in practices across countries—due to a supervisory framework that’s geared for conventional finance—creates uncertainty for customers. So, too do inconsistent regulations. These shortcomings lead to products that are overly complex, thus increasing risks.
Moreover, Islamic banking requirements for issuing sukuk—loans which are tantamount to asset-backed securities—sometimes result in a concentration of investments in real estate and commodities. For start-ups, Islamic banking rules tend to leave managers to deal with complex corporate structures. Indeed, Islamic banks’ greater focus on consumer financing rather than business financing reflects greater confidence in that market’s guarantees and the value of collateral.
The flip side to all of this is that sukuk, which do not pay interest, are well-suited for infrastructure financing because of the risk-sharing approach that’s at the core of Islamic rules governing lending. In addition, appropriately structured sukuk have a track record in funding infrastructure upgrades, including airports and roads.
At the moment, however, the supply of sukuk falls well short of demand. That gap is leading to oversubscription on most issuances—and thus, lower yields. And since many investors prefer to buy and hold, Islamic banks often suffer from a shortage of shariah-compliant liquid assets.
To build up domestic markets for sukuk, monetary authorities will need to promote true securitization and better define investors’ rights. An increase in sovereign issuance, which would provide benchmarks for the private sector, wouldn’t hurt, either.
