The Potential of Islamic Finance

Proponents claim that Islamic finance contributes to the stability of the financial system. During the recent financial crisis, Islamic financial institutions were affected by the adverse second-round effects of the crisis: when the real economy contracted, real estate prices got depressed, and in some cases, issues of Islamic bonds (Sukuk or certificate of ownership) defaulted. However, Islamic banks generally escaped the worst effects of the 2008 financial crisis, because they were not exposed to subprime and toxic assets, and had maintained their close connection to the real sector. Hence, some observers have suggested that conventional banking can learn from the alternative systems offered by Islamic finance, which is less skewed toward debt instruments, uses equity for greater risk sharing, and limits the mismatch of short-term demand deposits with long-term loan contracts.

The performance and relative stability of Islamic financial institutions during the crisis stems from the distinctive features of the instruments they offer. As mentioned above, Islamic finance emphasizes asset backing and the principle of risk sharing, ensuring a direct link between financial transactions and real sector activities. The return on savings and investment is closely linked (determined by the real sector, not the financial sector), giving Islamic finance instruments a flexible adjustment mechanism in the case of unanticipated shocks. The adjustment mechanism ensures that the real values of assets and liabilities will be equal at all points in time, and prohibits excessive risk taking, thereby avoiding several forms of complicated securitization. Ex post, Islamic finance is also more equitable, because investors or partners share in the outcome of the partnership, be it profit or loss.

Whether both partners provide capital and have the right to manage the project (musharakah), or one partner provides the capital and the other works with it (mudarabah), there is an emphasis on equitable risk allocation among partners. The same principals are extended in the mutual insurance contracts (takaful), which also have a mechanism for fair risk sharing among participants.

Reliance on equity-type financing arrangements helps restrain excessive leveraging. The close link between the amount of financing and an underlying asset also helps limit leverage. The sharing of risk and reward (al ghonm bel ghorm) implies that long-term targets become more important and excessive short-term risk taking is discouraged. Financial institutions are more like business partners with their clients, and have stronger incentives to evaluate funding requests carefully and exercise prudence in extending such financing. As business partners, financial institutions are more likely to assist borrowers in working through bad times, thus lowering the pressure to sell assets at "fire-sale" prices. This protects the system against a general fall in asset prices and reduces the probability of cascading defaults. The sharing of losses reduces the probability of contagion to the rest of the financial system. Moreover, Islamic finance protects the exchange/transaction role of a banking system by limiting the risk on deposit balances.