IMF Endorses Islamic Finance, Warns It Must Be Implemented Better

The International Monetary Fund has endorsed the principles of Islamic finance, saying it could prove safer than conventional finance, but the multilateral lender warned Islamic bankers that they must tighten rules and follow them more consistently.

A report released by the IMF this week showed the lender’s growing interest in Islamic banking, which is expanding in much of the world. Last October, the IMF launched discussions with an external advisory group of Islamic finance experts and industry bodies.

The IMF’s report noted that because Islamic banking forbids pure monetary speculation and stresses that deals should be based on real economic activity, it could pose less risk than conventional banking to the stability of financial systems.

This claim has long been made by proponents of Islamic finance seeking to drum up business; the IMF’s endorsement is likely to add weight to their arguments.

“Islamic finance may…help promote macroeconomic and financial stability. The principles of risk-sharing and asset-based financing can help promote better risk management by both financial institutions and their customers, as well as discourage credit booms,” the IMF said.

However, the industry could fail to achieve its promise – and even have a destabilising effect – if it does not design its rules more carefully and implement them more consistently, the report added.

Christopher Towe, deputy director at the IMF’s monetary and capital markets department, said in a conference call that there were worrying differences in regulators’ handling of Islamic finance, particularly where the industry was relatively young.

“Our analysis suggests that these standards are not being applied consistently, and this could either stifle the development of Islamic finance or encourage its growth in a manner that creates systemic vulnerabilities.”

Towe added: “I think for Islamic finance to achieve the promise that we see it having, to reduce systemic risk, I think that the key criteria are that it has to be truly asset-based, and the requirements for risk-sharing that underly Islamic finance have to actually be applied in practice and not just in principle.”

Other issues which Islamic finance needs to tackle include a shortage of tools to manage the short-term funds of Islamic banks, the limited scope of sharia-compliant financial safety nets for banks, and the need for greater legal clarity on the rights of investors, the IMF’s report said.

Some of these issues are now being tackled by standard-setting bodies such as the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Malaysia-based Islamic Financial Services Board (IFSB).

Last week, the IFSB said it had finalised a standard on “core principles” for use by regulators as well as a guidance note on liquidity management.

This standard will provide a coherent framework for regulators to use in handling Islamic finance, said Mohamed Norat, senior economist at the IMF’s monetary and capital markets department.

One positive sign, he said, is the growing use of profit-sharing investment accounts by Islamic banks; such accounts have loss-absorption qualities which help investors share risk.

In the last two or three years, profit-sharing investment accounts have gone from around 2 to 3 percent of Islamic banks’ balance sheets to around 15 to 20 percent, and they are continuing to expand, Norat said.

“So we’ve seen an element of moving towards a more fully risk-based Islamic financial system, which is a good sign.”

The IMF will continue working in Islamic finance, conducting research and providing technical assistance to member countries, Towe said. The lender’s spring meetings in Washington next week will include a seminar on Islamic finance, and it plans a global conference on the subject in November alongside Kuwaiti authorities.

The G20 group of nations has included Islamic finance in its annual agenda for discussion.