Quo vadis Islamic finance?

Heiko Hesse, Andreas Jobst, Juan Solé

24 November 2008



Since the summer of 2007, the global financial system has undergone a period of dramatic turbulence, which has caused a widespread reassessment of risk in both developed and emerging economies. The global financial turbulence appears to have had a limited impact on the Islamic finance industry, which has been in an expansionary phase in recent years (Economist, 2008; Financial Times, 2008). This rapid growth has been fuelled not only by surging demand for Sharia’ah compliant products from Muslim financiers but also by investors around the world, rendering the expansion of Islamic finance a global phenomenon. In fact, there is currently over $800 billion worth of deposits and investments lodged in Islamic banks, mutual funds, insurance schemes (known as takaful), and Islamic branches of conventional banks.

Besides its wide geographical scope, the expansion of Islamic finance has been also taking place across the whole spectrum of financial activities, ranging from retail banking to insurance and capital market investments. But perhaps the most striking has been the growth of sukuk, the most popular form of securitised credit finance within Islamic finance. Sukuk commoditise capital gains from bilateral risk sharing between borrowers and lenders in shari’ah-compliant finance contracts into marketable securities without interest rate charges.

The sukuk market has held its own amid groundswell concern about the credit crunch and dysfunctional money markets. Although the current level of issuance remains a fraction of the global volumes of conventional bonds and ABS, the sukuk market had soared in response to growing demand for alternative investments before the first episode of severe market disruptions in 2007 showed first effects (Jobst et al, 2008). Gross issuance of sukuk has quadrupled over the past few years, rising from $7.2 billion in 2004 to close to $39 billion by the end of 2007, owing in large part to enabling capital market regulations, a favourable macroeconomic environment, and large infrastructure development plans in some Middle Eastern economies (see Figure 1).

By 2008, however, sukuk volumes dropped to $15.2 billion (about 50%) while the structured finance market dried up with just $387 billion issued (down by about 80%) during the same time. Factors contributing to this decline include the presentation of new rules on sukuk, the global financial crisis, and Gulf states’ currency risk. The slowdown in issuance was most pronounced in Malaysia, where fewer domestic transactions at smaller volume have balanced the market shares of Gulf Cooperation Council and Southeast Asian countries.

Figure 1. Global sukuk issuance

The rapid evolution of Islamic finance activities points to the available profit opportunities that beckon. This in turn has prompted a vetting process among a number of jurisdictions around the world to establish themselves as leading Islamic financial centres. In this regard, the case of London is perhaps the most remarkable insofar as it has managed to extend its leading position in world financial markets to become a centre for Islamic finance. Similarly, Hong Kong, New York, and Singapore are also making important advances to accommodate Islamic finance within their jurisdictions and aspire to join the ranks of the more established Islamic centres such as Bahrain, Dubai, and Kuala Lumpur.

In the authors’ opinion, all these developments underscore the fact that Islamic finance has established itself as a permanent element within the global financial landscape. Nevertheless, important challenges lie ahead especially in light of the current global financial turbulences.

Main challenges ahead for Islamic finance

Islamic finance faces many challenges, including recent regulatory changes, illiquidity issues, liquidity risk management concerns, need for harmonised regulation, regulatory disparity amongst national supervisors, and a potentially unlevel playing field.

Recent regulatory changes concerning the structure of sukuk warrant careful consideration and might temper some of the recent enthusiasm for Islamic capital market products. In February 2008, the shari’ah committee of the Accounting and Auditing Organisation of Islamic Financial Institutions issued recommendations regarding the role of asset ownership, investment guarantees, and the shari’ah advisory and approval process in sukuk origination and trading. These proposed rules attracted significant attention prior to their release, following a statement by the chairman of the shari’ah committee in November 2007 indicating that 85% of sukuk issues in the GCC do not concur with shari’ah principles. Shari’ah scholars raised objections to principal guarantees via repurchase agreements, among other concerns. Most sukuk have been sold with a borrower/creditor guarantee to repay the full notional at maturity, or, in the event of default or early redemption, mirror the structure and payout of a conventional bond. Such a promise (and not the option) to repay capital violates the principle of risk-sharing in Islam. The debate about the general applicability of these recommendations with regard to the approval process of sukuk (and the screening of both their structure and characteristics of underlying assets) has raised concerns about the economics of Islamic securitisation and the shari’ah governance of Islamic capital markets at large.

The sukuk market is also still plagued by illiquidity due to high originator concentration, large diversity of deal structures, and regional fragmentation (Hesse et al, 2008). In addition, the lack of information from private sources about securitised assets in many sukuk and the prevalence of “buy-and-hold” investments inhibit efficient price discovery and information dissemination. Since only a handful of large banks and managers are behind the bulk of transactions completed by a small number repeat issuers, origination and servicer risk from narrow asset supply poses challenges to investor diversification. Moreover, sukuk are typically not available at short-term maturities, which significantly limits their application for money markets. Notwithstanding the compelling value proposition of sukuk, without efficient and transparent capital markets and appropriate legal frameworks to operate within, Islamic capital markets will not continue to grow meaningfully in the near future (Jobst, 2007).

Similarly, liquidity risk management of Islamic banks is an important challenge and is constrained due to limited availability of tradable Islamic money market instruments and weak systemic liquidity infrastructure (Čihák and Hesse, 2008). At the moment, there is no widespread shari’ah-compliant short-term Islamic money market, and Islamic repo markets have not yet fully developed. Islamic money markets with longer maturities, which are based on commodity murabaha transactions (mark-up financing), sometimes suffer from unreliable brokers with low credit-worthiness. Some investment banks are currently designing new complex products, compliant with shari’ah law, that attempt to overcome the shortcomings of the Islamic money market.

Financial innovation in Islamic finance is still hampered by the need for harmonised financial regulation. As discussed, governance issues, especially the shari’ah compliance of products and activities, constitute a major challenge for the Islamic finance industry. Although shari’ah rulings by legal scholars are public, there is still considerable heterogeneity of scholastic opinion about shari’ah compliance, which undermines the creation of a consistent regulatory framework and corporate governance principles. Given the rising global integration of the Islamic financial services industry, greater supervisory harmonisation across national boundaries is essential.

There is also regulatory disparity among national supervisors, with each regulator typically working independently. Various Islamic countries have teamed up in a bid to create more liquidity and enhance market transparency with a view to becoming a centre of Islamic finance, while more specific regional initiatives provide a valuable platform for drawing further attention to structured finance as an important element of local capital market development.

Finally, the regulatory authorities are also called to foster an environment where Islamic banking can offer a suitable response to investors’ and depositors’ demand for Islamic products (Solé, 2007). This is not to say that regulatory advantages should be given to Islamic institutions, but rather that a level playing field should be provided. In fact, it is possible that in the initial stages of the process, some Islamic transactions will fall into legal voids and thus may not be permitted by the existing legal framework or may be viewed with reticence by the general public. Therefore, the authorities’ attitude should be akin to the British Financial Services Authority’s stated policy of “no obstacles, no special favours” (FSA, 2006)

Concluding remarks

Despite the number of challenges outlined above, the long-term prospects look promising for Islamic finance. Financial institutions in countries such as Bahrain, the United Arab Emirates, and Malaysia have realised considerable demand for shari’ah-compliant assets and are gearing up for more shari’ah-compliant financial instruments and structured finance. In addition, financial innovation, driven by both domestic and foreign banks, will promote alternatives modes of intermediation and contribute to further development and refinement of shari’ah compliant derivative contracts.

As Islamic finance comes into its own, greater regulatory harmonisation will be inevitable. Recent efforts have addressed legal uncertainty imposed by Islamic jurisprudence, discrepancies of national guidelines, and poorly developed uniformity of market practices. The Islamic Financial Services Board has moved ahead with its standardisation efforts of the Islamic financial services industry that will foster the soundness and stability of the system. Globally accepted prudential standards have been adopted by the Islamic Financial Services Board that smoothly integrate Islamic finance with the conventional financial system.

Finally, despite the declining global sukuk issuance in 2008, emanating from both the Accounting and Auditing Organisation of Islamic Financial Institutions decision and the impact of the financial crisis, the sukuk market will regain momentum, driven by demand from financial institutions, insurance companies, and pension funds across Islamic and non-Islamic countries. Many challenges still lie ahead, but the banks’ search for profitable opportunities and the ensuing financial innovation process in tandem with favourable regulatory developments at domestic and international levels will ensure that the Islamic finance industry will continue to develop at a steady pace in the long-run. The jury is still out how Islamic finance will be affected in the short-run by the repercussions of the global financial crisis.

The views expressed in this article are those of the authors and should not be attributed to the IMF, its Executive Board, or its management. Any errors and omissions are the sole responsibility of the authors.


Čihák, Martin and Heiko Hesse, 2008, “Islamic Banks and Financial Stability: An Empirical Analysis,” IMF Working Paper 08/16 (Washington: International Monetary Fund).

Economist, 2008, “Savings and Soul,” Briefing, 4 September 2008.

Financial Services Authority (FSA), 2006, “Islamic Banking in the UK,” Briefing Note BN016/06

Financial Times, 2008, “Islamic Finance, “Special Report,” 19 June 2008

Hesse, Heiko, Andreas A. Jobst, and Juan Solé, 2008, “Trends and Challenges in Islamic Finance," World Economics, 9(2), 175-193

Jobst, Andreas A., 2007, “The Economics of Islamic Finance and Securitization,” Journal of Structured Finance, Vol. 13, No. 1 (Spring), 1-22. Also published as IMF Working Paper 07/117 (Washington: International Monetary Fund).

Jobst, Andreas A., Kunzel, Peter, Mills, Paul and Amadou Sy, 2008, “Islamic Bond Issuance – What Sovereign Debt Managers Need to Know,” International Journal of Islamic & Middle East Finance and Management, Vol. 1, No. 4 (forthcoming).

Solé, Juan, 2007 “Introducing Islamic Banks into Conventional Banking Systems”, IMF Working Paper 07/175



Topics:  Financial markets International finance

Tags:  islamic finance, sukuk

Economist in the Strategy, Policy, and Review Department, IMF

Senior Economist in the European Department, IMF

Member of the Global Financial Stability Division in the Monetary and Capital Markets Department (MCM) of the International Monetary Fund (IMF)