Risk-Sharing and Financial Inclusion: Foundations of Islamic Financial Systems

Transcription

1 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 19 th - 22 nd September 2011 * Views in this presentation may not necessarily represent those of the World Bank 1 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 2 Financial Systems 1

2 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 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, H Share of Global Shariah-Compliant Assets Global Shariah- Compliant Assets Shariah- Compliant Assets USD Billion % 12% 1% Islamic Funds Sukuk Takaful Islamic Banking Distribu?on of Shariah- Complaint Assets 3% 10% 5% 3% MENA GCC % Global Islamic Finance Industry, Iran % Other Asian Malaysia % Australia, Europe & America Number of countries Financial Ins?tu?ons Source: The Banker, PricewaterhouseCoopers, MIFC 4 Financial Systems 2

3 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 Source: Maybank Islamic 2010e 2011f 2012f 2013f 2014f 2015f 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 6 Financial Systems 3

4 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 8 Financial Systems 4

5 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, onsight 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. Financial Systems 5

6 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 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. 12 Financial Systems 6

7 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 Financial Systems 7

8 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 exante screening in terms of ability to manage the project and business, and follow that with ex-post monitoring 16 Financial Systems 8

9 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 microinsurance 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 Stud 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 2007) Iran Bank keshavarzi of Iran "Hazrat Zeynab Project" Finance women producers and farmers of agricultural sector with loans under $600 with the maximum repayment period of 5 years. A revolving fund is about $44 mln 117,322 women borrowers Qard al-hassan funds, Qard al-hassan saving accounts (Kholis, AG and SH 2007) Indonesia BMT 1 Al-Ikhlas, BMT Bina Ummah, and BMT Dana Syariah BMT is a unique Islamic micro finance institution established by Indonesian moslems to abolish ceti or rentenir (Usurer) in Indonesian moslem societies by providing many financing schemes for helping micro and medium entrepreneurs. Up to November 2006, there are more than three thousands BMTs in the country. About 65 BMT's of them are located in Yogyakarta. Only 42 BMT which reported their performance to PINBUK Yogyakarta regularly. n.a. Murabahah contract for SMEs, Mudarabah saving account, Pendidikan saving account, HajiSaving Account, Qurban/Aqiqah saving account, Walimah saving account, Wadi ah Damanah Aidil Fitri, Saving Account, Amanah saving account 1 BMT, Baaitul Maal wat Tamwil, or Islamic Savings and Loan Cooperatives Source: Mohiedin et al (forthcoming) 18 Financial Systems 9

10 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 Financial Systems 10

11 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. 22 Financial Systems 11

12 Estimated Zakah funds can cover poverty GAP in 20 of OIC countries (1) Country name (2) Survey year (3) GDP PPP Current USD (4) Muslim pop. (%) (5) Adjusted GDP PPP USD (Billion) (6) Domestic Zakah (Billion USD) (7) Incoming remittances (Billions USD) (8) Domestic savings rate (% of GDP) (9) Zakah considering Remi-ttances (10) resource shortfall under $1.25 per annum as % of (11) Does Zakah cover (10)? (Billion) (% of GDP) GDP Albania y Algeria y Azerbaijan y Bangladesh n Benin n Burkina Faso n Cameroon y Comoros n Cote d'ivoire n Djibouti y Egypt y Gabon y Gambia n Guinea n Guinea-Bissau n Guyana n Indonesia y Iran y Iraq y Jordan y Kazakhstan y Kyrgyz Republic y Malaysia y Maldives y Mali n Morocco y Mozambique n Niger n Nigeria n Pakistan y Senegal n Sierra Leone n Suriname n Syrian Arab y Tajikistan n Togo n Turkey y Uganda n Yemen y Source: Mohiedin et al (forthcoming) 23 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 Financial Systems 12

13 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 Financial Systems 13