Durham

 Islamic  Finance  Summer  School  2011  

in  Istanbul  

Risk-Sharing and Financial Inclusion:

Foundations of Islamic Financial Systems

Mahmoud Mohieldin
Managing Director
The World Bank

Presented  at  the    

Durham  Islamic  Finance  Autumn  School  2011  
jointly  organised  by    
Durham  Centre  for  Islamic  Economics  and  Finance  and    
ISAR-­‐Istanbul  FoundaBon  for  Research  and  EducaBon  
Istanbul  Commerce  University,  Istanbul  
19th-­‐22nd  September  2011  

1  
* Views in this presentation may not necessarily represent those of the World Bank

Outline

• The Rapid Growth of Islamic Finance

• Islamic Finance Vs. Conventional Finance
• Performance of Islamic Finance During the
Global Financial Crisis
• The Role of Risk-sharing in Islamic Finance
• Financial Inclusion in Islamic Finance
• Outstanding Policy Issues in Islamic Finance
• World Bank’s Engagement with Islamic
Finance

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Mahmoud  Mohieldin,  Risk-­‐Sharing  and  

Financial  Inclusion:  Founda?ons  of  Islamic  
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The Growth of Islamic Finance

• Since the early 1970s, global Shariah-compliant financial assets have grown at about 10%
annually
• Shariah-compliant assets were estimated by IFSB to be around US$1 trillion in 2010*
representing almost 0.5% of Global Financial Assets that totaled to around US$ 228
trilion**.
• Islamic finance industry’s profits totaled USD15 billion and is expected to more than double
to USD32 billion over the next 5 years
• Islamic banks deposits ratio to total deposits widely varies between countries (March 2011:
Indonesia:3%, UAE:11%, Malasyia:19%), some studies suggest that it will account for up to
a range of 40-50% of total deposits in countries with majority Muslim populations within 8 to
10 years.
• The global Islamic Bonds market has been expanding rapidly, with the number of Islamic
Bonds issues rising from 87 in 2005 to 730 by end-2010. The corresponding value of
issuances also increased from $11.2 billion to $47.8 billion. Total value of Islamic Bonds
outstanding is roughly $180 billion. ***

* Source: Islamic Finance and Global Financial Stability, April 2010, Islamic Finance Stability Board
and Islamic Development Bank
** Source: Global Financial Stability Report, April 2010, International Monetary Fund
*** Source: Islamic Finance Information Service, Global Islamic Bonds Market Report, H2-2010

3  

Share of Global Shariah-Compliant

Assets
Global  Shariah-­‐Compliant  Assets   Shariah-­‐Compliant  Assets  
4%  
USD  Billion   12%  
1200   1000  
1000   822   1%  
800   Islamic  Funds  
639  
600   500   Sukuk  
386  
400   Takaful  
200   Islamic  Banking  
0  
2006   2007   2008   2009   2010  
83%  
Distribu?on  of  Shariah-­‐Complaint  Assets  
5%   3%   MENA  
Global  Islamic  Finance  Industry,  2010  
10%   700   628  
GCC  
3%   600  

Iran   500  
43%   400  
Other  Asian    
300  
Malaysia   200  
100   48  
36%   Australia,  Europe  &  
America   0  
Number  of  countries   Financial  Ins?tu?ons  

Source:  The  Banker,  PricewaterhouseCoopers,  MIFC   4  

Mahmoud  Mohieldin,  Risk-­‐Sharing  and  

Financial  Inclusion:  Founda?ons  of  Islamic  
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Growth of Global Shariah-Compliant

Assets
• IFSB estimated Islamic assets to reach about USD1,600 billion, with
revenues of USD120 billion by 2012
• Continued expansion expected in countries with sizeable Islamic
Finance sectors (e.g. Bahrain, Brunei, Indonesia, Iran, Malaysia,
Pakistan, Sudan and the UAE)
• In addition, strong prospects for further growth in financial centers (e.g.
Ireland, UK and Luxembourg)
3   USD  Trillion  

2.5   2.4  

2  
2   1.75  
1.6  
1.5   1.25  
1  
1  

0.5  

0  
2010e   2011f   2012f   2013f   2014f   2015f  

Source:  Maybank  Islamic   5  

How is Islamic Finance Different from

Conventional Finance?
• Conventional financial institutions operate within a system
based on debt and transfer of risk
• This raises the probability of disconnecting financial
instruments from their underlying assets
• Some of the financial tools created to share risk actually
resulted in a concentration and intensification of risk
• In contrast, Islamic finance emphasizes asset-backing for
transactions and is anchored on the principle of risk sharing
• Shariah principles ensures a direct link between financial
transactions and real sector activities
• Shariah principles also prohibit(Gharar) , the use of excessive
leverage and avoids forms of controversial complex
securitization

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Financial  Inclusion:  Founda?ons  of  Islamic  
Financial  Systems   3  
Durham  Islamic  Finance  Summer  School  2011  
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7  

Performance of Islamic Finance During

the Global Financial Crisis
• The recent Global Financial Crisis underscored the dangers of
debt-based financial transactions and the speculative use of
financial instruments
• Irrational lending practices, high levels of leverage, and the
so-called “atomization” of risk through imprudent securitization
undermined the very foundations of financial systems in
advanced countries
• The crisis generated significant adverse effects:
– Global economic slowdown with many advanced countries
experiencing recessions and sharp increases in
unemployment
– Emerging and developing countries also suffered a sharp
fall in export volumes, a deceleration in GDP growth,
increased unemployment and a rise in poverty levels in the
low-income and middle-income countries
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Mahmoud  Mohieldin,  Risk-­‐Sharing  and  

Financial  Inclusion:  Founda?ons  of  Islamic  
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Performance of Islamic Finance During

the Global Financial Crisis
• A recent World Bank policy research working paper emphasized that the
global financial crisis has not only shed doubts on the proper functioning of
conventional “Western” banking, but has also increased the attention on
Islamic banking. Academics and policy makers alike point to the advantages
of Shariah compliant financial products, as the mismatch of short-term, on-
sight demandable deposits contracts with long-term uncertain loan contracts
is mitigated with equity elements. In addition, Sharia-compliant products
are very attractive for segments of the population that demand financial
services that are consistent with their religious beliefs. However, little
academic evidence exists on the functioning of Islamic banks, as of yet.
• Islamic banks escaped the direct impact of the crisis, as they were not
exposed to sub-prime and toxic assets
• A recent IMF Working Paper** found that the business model of Islamic
banks helped them to mitigate the impact of the crisis
• As Islamic banking services are more connected to the real sector, initially
performed well during the crisis yet were severely hit by the second round
effects:
– Increased losses threatened the viability of some Islamic financial institutions
– Some Sukuk issuers defaulted

* Beck, Demirguc-Kunt and Merrouche (2010)

* *Hassan and Dridi (2010)
9  

Some Reflections on the Global Financial

Crises …Seeking Islamic Finance
Solutions?
• “Western policymakers and economists often portray Islamic financial
systems, with their emphasis on shared risk and responsibility in lending,
as less efficient than western systems that put no strictures on debt. Yet
one can equally argue that Western financial intermediation is far too
skewed towards debt, and as a consequence generate many unnecessary
risks.” Kenneth Rogoff, Banque de France Conference , Paris, March 2011

In an attempt to identify a better link between credit-expansion and GDP

growth, some macro-prudential measures have been developed:
• Credit-to-GDP gaps, play a key role in distinguishing between “due and
undue” momentum in financial cycles and thereby function as a trigger for
many of the countercyclical measures (including capital buffers).
• Setting economically meaningful trigger points is however far from
obvious, considering cross-country heterogeneity.
• The BIS has found that lower and upper thresholds of 2% and 10% for
credit-to-GDP gaps do a reasonable job in anticipating excessive credit
10  
growth.

Mahmoud  Mohieldin,  Risk-­‐Sharing  and  

Financial  Inclusion:  Founda?ons  of  Islamic  
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Some Reflections on the Global Financial

Crises …Seeking Islamic Finance
Solutions?

• “Yet perhaps scholars who argue that Islamic financial systems’ prohibition
on interest generates massive inefficiencies ought to be looking at these
systems for positive ideas that Western policymakers might adopt. ….. In
the meantime, the IMF and the G-20 can help by finding better ways to
assess the vulnerability of each country’s financial structure – no easy
task, given governments’ immense cleverness when it comes to cooking
their books. Policymakers can also help find ways to reduce barriers to the
development of stock markets, and to advance ideas for new kinds of
state-contingent bonds, such as the GDP-linked bonds that Yale’s Robert
Shiller has proposed. (Shiller bonds, in theory, pay more when a country’s
economy is growing and less when it is in recession.)” Kenneth Rogoff,
Project Syndicate, March 2011

11  

Some Reflections on the Global Financial

Crises …Seeking Islamic Finance
Solutions?
• “The Islamic financial system has so far been able to gain a very small
share of the global financial market and, even if it operates perfectly as
desired by the Shari‘ah, it may not be able to create a significant impact
on the international financial system in the near future.” Umer Chapra,
October 2008

• However, he emphasized that the only option for further development of

Islamic Financial Services is to explain the system rationally and
implement it seriously and sincerely to enhance effectiveness and
promote financial health and stability.

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Risk-sharing in Islamic Finance:1

• Risk-sharing characteristics of Islamic finance can also foster
financial stability
• By design, Islamic financial instruments do not rely on interest
rate-based debt contracts
• Mudaraba (profit-sharing) and Musharakah (joint venture)
emphasize equitable risk allocation among different parties
• Musharakah in particular ensures that the impact of an
adverse development is spread among the participants
• Takaful also has the potential to spread risk among a large
number of participants
• Sukuks (certificates of ownership) use the concept of joint
ownership of an asset by several financiers, making it more
like equity-type financing as opposed to a bond which is a
debt instrument

13  

Risk-sharing in Islamic Finance:2

• Reliance on equity and equity-type financing
arrangements helps to restrain excessive leveraging
• The close linkage between the amount of financing
and an underlying asset also helps to 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 financing requests carefully and exercise
prudence in extending such financing

14  

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Financial  Inclusion:  Founda?ons  of  Islamic  
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Risk-sharing in Islamic Finance:3

• As “business partners”, financial institutions

are also more likely to assist borrowers in
working through bad times, thus reducing the
pressures to sell assets as “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 also reduces the
probability of contagion to the rest of the
financial system
15  

Risk-Sharing in Islamic Finance: 4

• Nonetheless, imprudent behavior of some

market participants cannot be completely
ruled out
• Strong supervisory oversight therefore is
required to ensure proper use of risk-sharing
instruments
• Financial institutions also need to enhance
their capacity to assess clients through ex-
ante screening in terms of ability to manage
the project and business, and follow that with
ex-post monitoring
16  

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Financial  Inclusion:  Founda?ons  of  Islamic  
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Financial Inclusion in Islamic Finance

Islamic finance addresses the issue of
“financial inclusion” or “access to finance” from
two directions:
– Promoting risk-sharing contracts which provide a
viable alternative to conventional debt-based
financing (including Shariah-compliant
Microfinance, SME financing, and micro-
insurance to enhance access to finance)
– Providing specific instruments of redistribution of
the wealth that target the poor and offer a
comprehensive approach to eradicating poverty
and to build a healthy and vibrant economy (such
as Zakah, Sadaqat, waqf, and qard-al-hassan)

17  

Survey of Islamic Micro-Finance Case Studies

Paper/ Institution Purpose Business Size Client Islamic instrument of
Country size/volume financing
(Asaad 2007) UNDP supported The village funds are self-managed and • Between Sep 2000 and Dec • Average loan Murabahah
village funds autonomous in their decision-making, 2002, 22 village funds were balance per
Syria which has included the adoption of established. borrower/per
financial practices consistent with local • UNDP contributed $370,000 capita GDP is
values. in equity. 61%.
• Repayment rate as of 31 Dec
2002 was 99.7%. ROE was • Till the end of
17% 2003, 5,674 loans
were disbursed.
(Ahmed 2007) Islamic Bank RDS is a Shariah based microfinance • Up to Dec 2006, 1,368 Field 294,908 Bai-Muajjal, Bai-
Bangladesh model of poverty alleviating program, Officers engaged in supervision borrowers, 92% Murabaha, Bai-Salam, and
Bangladesh Limited (IBBL): mainly for the poor woman of the rural • An investment amount of or which are Hire Purchase under
Rural area of Bangladesh. Target group includes $135 mln woman. Sherkatul Melk (HPSM).
Development destitute women, distressed people, and • 118 branches in 8,057
Scheme (RDS) households with less than 0.5 acres of land. villages
• Recovery rate was 99%.
(Mannan Social Investment Helping poor family to purchase materials • As of 2005, the family n.a. Waqf and Mosque
2007) Bank Ltd commodities for trading, manufacturing and empowerment micro credit properties, cash-waqf
“SME programs” service concern. program has a total outstanding certificate, joint-venture
Bangladesh and “Family of $0.3mln, with a recovery rate projects for management of
Empowerment of 96% Hajj affairs
Micro enterprise • SME program has a total
Program” outstanding of $1.1mln, with a
recovery rate of 94%
(Kazem 2007) 1,229 Qard-al- With the objective of helping low-income • Total value of loans is $169 • 6,480,237 Qard-al-Hassan Funds
Hassan Funds group through short-run credit grant, GFs mln depositors
Iran (GFs) provide Shariah compliance services to • Total value of deposits is • 1,777,583
individuals who are unable to fulfill banks $227 mln borrowers
loan collateral requirements and thus were • 60% of the total loans had
deprived from obtaining credit. been paid back.

(Arabmazar Bank keshavarzi Finance women producers and farmers of • A revolving fund is about $44 • 117,322 Qard al-hassan funds,
2007) of Iran agricultural sector with loans under $600 mln women Qard al-hassan saving
Iran "Hazrat Zeynab with the maximum repayment period of 5 borrowers accounts
Project" years.
1
(Kholis, AG BMT Al-Ikhlas, BMT is a unique Islamic micro finance • Up to November 2006, there n.a. Murabahah contract for
and SH 2007) BMT Bina institution established by Indonesian are more than three thousands SMEs, Mudarabah saving
Ummah, and moslems to abolish ceti or rentenir (Usurer) BMTs in the country. account, Pendidikan
Indonesia BMT Dana in Indonesian moslem societies by • About 65 BMT's of them are saving account,
Syariah providing many financing schemes for located in Yogyakarta. HajiSaving Account,
helping micro and medium entrepreneurs. • Only 42 BMT which reported Qurban/Aqiqah saving
their performance to PINBUK account, Walimah saving
Yogyakarta regularly. account, Wadi ‘ah
Damanah Aidil Fitri,
Saving Account, Amanah
saving account

1
BMT, Baaitul Maal wat Tamwil, or Islamic Savings and Loan Cooperatives

18  
Source:  Mohiedin  et  al.  2011  (forthcoming)  

Mahmoud  Mohieldin,  Risk-­‐Sharing  and  

Financial  Inclusion:  Founda?ons  of  Islamic  
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Inclusion through Risk-sharing in Islamic

Finance
• Islamic economics promotes the notion of risk-sharing based on
the principle of liability.
• It states that profit is justified on the basis of taking
responsibility, same case applies for loss and its related
consequences.
• Islam prohibits, and without any exceptions, explicit and implicit
interest-based contracts of any kind.
• Qoran clearly renders exchange and trade of commodities or/
and assets the foundation of economic activity in the Islamic
Paradigm.
• Islam proposes a mutual exchange (al-bay’) in which one
bundle of property rights is exchanged for another, thus allowing
both parties to share the risks of the transaction.

19  

Inclusion through Risk-sharing

in Islamic Finance
• Providers of Islamic microfinance tend to be small in size.
– 80 percent of the global outreach of Islamic microfinance
concentrates in only three countries, Indonesia, Bangladesh, and
Afghanistan.
• Islamic microfinance products are also limited in their diversity.
– Over 70 percent of the Islamic finance products offered are
murabaha (cost plus), which is a lending product typically used for
working capital.
• Efforts are under way to broaden access to Shariah-based
finance.
– Egypt: Bank Misr plans to introduce Islamic microfinance activities
to its 33 Islamic branches, and also develop a mudaraba (profit
sharing agreement) product in addition to the murabaha product;
– Yemen: Tadhamon Islamic Bank opened a MSE division in late
2006;
– UAE: Noor Islamic Bank and Emirates Post Holding Group
announced plans to establish a company to offer Sharia-compliant
financial services to low income clients. 20  

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Financial  Inclusion:  Founda?ons  of  Islamic  
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Inclusion through Risk-sharing

in Islamic Finance
• Tools for Shariah compliant SME’s finance is not found
to be different from the Islamic financing main stream:
– murabhah (trust finance)
– musharkah (partnership finance)
– mudarbah (markup contract sale).
– This is in addition to Salam contracts, Ijarah and Qard
Hassan, and Awqaf.
– Other forms of long term and sophisticated forms include
salam forward purchase credit and istisna project
financing.
• More innovative structures are being introduced to
facilitate SME’s access to Shariah compliant finance.
(Example: Asutay 2011 proposed Wikalah agencies to
perform monitoring and minimize moral hazard)
21  

Inclusion through instruments of

redistribution in in Islamic Finance
• According to Islam, poverty exists not because
economic resources are scarce, but because they are
misallocated, inefficiently managed, unproductively
hoarded, and unevenly distributed.
• Property rights in Islam provide a firm foundation that
require transfer from those more able to the less able
and the individuals:
– Zakah is to be given willingly, not to be paid grudgingly
– Sadaqah which represent the voluntary social spending to
promote a more equitable distribution
– qard-ul-hassan is an interest free loan that has to be repaid
and is designed to meet the financing needs of the poor,
where term of the loan is determined by the borrower alone.

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Financial  Inclusion:  Founda?ons  of  Islamic  
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Estimated Zakah funds can cover poverty GAP

in 20 of OIC countries
(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11)
Country name Survey year GDP Muslim pop. Adjusted GDP Domestic Zakah Incoming Domestic savings Zakah resource shortfall Does Zakah
PPP (%) PPP USD (Billion) (Billion USD) remittances rate considering under $1.25 per cover (10)?
Current USD (Billions USD) (% of GDP) Remi-ttances annum as % of
(Billion) (% of GDP) GDP

Albania 2008 26.45 79.9 21.13 0.38 1.50 1.60 1.44 0.01 y
Algeria 1995 129.75 98 127.16 2.29 1.12 28.11 1.77 0.14 y
Azerbaijan 2008 76.73 99.2 76.12 1.37 1.55 64.89 1.82 0.01 y
Bangladesh 2005 163.73 89.6 146.70 2.64 4.31 18.06 1.62 5.58 n
Benin 2003 9.14 24.4 2.23 0.04 0.06 5.98 0.44 5.78 n
Burkina Faso 2003 12.09 59 7.13 0.13 0.05 4.51 1.06 9.83 n
Cameroon 2007 39.77 17.9 7.12 0.13 0.17 18.53 0.32 0.26 y
Comoros 2004 0.63 98.3 0.62 0.01 0.01 0.00 1.77 8.89 n
Cote d'Ivoire 2008 34.30 36.7 12.59 0.23 0.20 17.85 0.66 2.05 n
Djibouti 2002 1.24 96.9 1.20 0.02 0.01 4.87 1.75 1.49 y
Egypt 2005 333.22 94.6 315.22 6.30 5.02 15.71 1.90 0.04 y
Gabon 2005 17.84 9.5 1.69 0.03 0.01 58.35 0.17 0.03 y
Gambia 2003 1.46 95 1.38 0.02 0.06 11.05 1.72 5.42 n
Guinea 2007 9.78 84.4 8.25 0.15 0.15 9.68 1.52 6.71 n
Guinea-Bissau 2002 1.26 42.2 0.53 0.01 0.02 0.00 0.76 8.21 n
Guyana 1998 1.54 7.2 0.11 0.00 0.01 16.94 0.13 0.88 n
Indonesia 2009 965.57 88.2 851.63 8.52 6.79 33.76 0.89 0.39 y
Iran 2005 643.50 99.4 639.64 11.51 1.03 41.09 1.79 0.02 y
Iraq 2007 94.97 99 94.02 1.69 0.00 0.00 1.78 0.09 y
Jordan 2006 26.14 98.2 25.67 0.46 2.88 0.00 1.77 0.01 y
Kazakhstan 2007 169.63 56.4 95.67 1.72 0.22 43.84 1.02 0.00 y
Kyrgyz Republic 2007 10.62 86.3 9.17 0.16 0.71 0.00 1.55 0.02 y
Malaysia 2009 384.88 60.4 232.47 4.18 1.13 36.03 1.09 0.00 y
Maldives 2004 1.20 98.4 1.18 0.02 0.00 46.15 1.77 0.02 y
Mali 2006 12.67 92.5 11.72 0.21 0.21 14.75 1.67 8.20 n
Morocco 2007 127.85 99 126.57 2.28 6.73 23.37 1.81 0.06 y
Mozambique 2008 18.89 22.8 4.31 0.08 0.12 1.57 0.41 13.62 n
Niger 2007 9.25 98.6 9.12 0.16 0.08 0.00 1.77 8.31 n
Nigeria 2004 224.62 50.4 113.21 2.04 2.27 0.00 0.91 8.26 n
Pakistan 2005 340.26 96.3 327.67 5.24 4.28 15.21 1.55 0.91 y
Senegal 2005 18.21 96 17.48 0.31 0.79 14.09 1.74 3.05 n
Sierra Leone 2003 2.72 71.3 1.94 0.03 0.03 0.00 1.28 16.10 n
Suriname 1999 2.02 15.9 0.32 0.01 0.00 11.25 0.29 0.61 n
Syrian Arab 2004 70.02 92.2 64.56 0.97 0.86 20.20 1.39 0.02 y
Tajikistan 2004 8.77 84.1 7.38 0.13 0.25 0.61 1.51 1.70 n
Togo 2006 4.96 12.2 0.61 0.01 0.23 0.00 0.22 6.42 n
Turkey 2005 781.24 98 765.62 14.55 0.89 16.49 1.86 0.04 y
Uganda 2009 39.81 12.1 4.82 0.09 0.75 12.52 0.22 3.10 n
Yemen 2005 46.13 99.1 45.71 0.82 1.28 0.00 1.78 0.87 y
23  
Source:  Mohiedin  et  al.  2011  (forthcoming)  

Outstanding Issues in Islamic

Finance
• Need to address the currently favorable tax
treatment of debt in many countries, which puts
equity and profit/loss sharing arrangement at a
disadvantage and encourages leverage
• High concentration in banking business, small
size and institutional fragmentation
• Islamic capital markets are still relatively young,
small and underdeveloped
• Other non bank financial instruments: mortgage,
takaful, leasing, microfinance are still very much
underdeveloped
24  

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Financial  Inclusion:  Founda?ons  of  Islamic  
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Outstanding Issues in Islamic

Finance
• Inadequacy of exit rules relating to bankruptcy
and insolvency of Islamic financial institutions
and sukuk defaults
• Concerns about liquidity risk management
• Weaknesses in corporate governance in some
Islamic financial institutions
• Need for more qualified management: the proper
mix of skill and conviction
• Limited application: still in transition?
• Compliance with Basel III … and consistency
with global norms? 25  

Thank you

26  

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