The Opportunity in Interest-Free (and Islamic) Finance

May 11, 2015

It is one of the under-appreciated ironies of financial history: While financial instruments like derivatives were first introduced around 2,000 B.C. in Mesopotamia, today most of the countries in the region that was once the cradle of civilization have only rudimentary financial services sectors. This has stifled economic growth and suppressed living standards throughout much of the Middle East and also the majority-Muslim countries in Africa and Asia. But the wider adoption of Islamic financial products in recent years—the subject of a Milken Global Conference panel discussion one of us moderated recently—suggests the potential to unlock expanded opportunity for adherents to the world’s fastest-growing major religion.

The Middle East and North Africa—a region with more than 300 million Muslims—highlight the untapped potential of Islamic finance. According to World Bank data, just 18 percent of adults there have any kind of bank account, the lowest percentage of any region in the world. A broader view tells a similar story. Among the 57 countries in the Organization of Islamic Cooperation (49 of which are majority Muslim), per capita gross domestic product is just $10,825—a figure that would be even lower without a few extremely wealthy countries such as Qatar (its per capita GDP exceeds $123,000).

One factor contributing to the relative impoverishment of Muslims living in OIC countries is their low rates of participation in the financial services sector, thus depriving them of the ability to borrow, save, and invest. Some of this stems from banks not targeting them as customers; this, in turn, reflects that one of the fundamental principles of Islam is a prohibition on charging interest when lending money. Those who accept interest, says the Koran, will “be apprised of war from Allah and His Messenger.” (Islamic finance also cannot be associated with alcohol, gambling, pork, or anything else that’s impermissible under Islamic law.)

But these prohibitions are not absolute roadblocks. Countless workarounds have been devised over time to enable observant Muslims to remain faithful to their religious principles while also being able to benefit from financial services. One approach, also prescribed by the Koran, is for banks to focus on asset-backed transactions. So rather than extending an interest-based loan to an individual to buy an asset (such as a car or a house), a bank will often buy the asset and then require the borrower to make payments totaling some higher amount.

Even more complex financial products have arisen on the Islamic financial landscape, typically serving corporate clients. But in order for any financial product to be deemed sharia-compliant, it must first be certified by an Islamic scholar. Financial firms employ boards of scholars to provide opinions, but there is often opacity regarding the precise criteria used to certify products—perhaps because, says Reuters, “there is no single, universally accepted interpretation of religious principles.” Some Islamic financial products end up approved in one Islamic jurisdiction but not others, a confusion which slows the industry’s growth.

The challenges facing Islamic finance are partly a byproduct of the industry still being in the equivalent of adolescence. While Islam dates back to the 7th century, the first bank to be fully sharia compliant began operating only 40 years ago. As recently as 2001, Islamic banks only held $230 billion in assets. Today, they hold about $1.5 trillion, according to Moody’s. But even with a 17-percent compound annual growth rate in Islamic banking assets from 2009-13, the industry still represents only about 2 percent of global financial assets.

Islamic finance is almost certain to grow. One reason is the contraction in conventional finance as regulations kick in and large companies like GE exit finance altogether. Another is simple population growth. A Pew Research study released last month projects that Muslims will account for 30 percent of the world’s population by 2050, up from 23 percent today. It will behoove the financial industry to continue evolving to serve the needs of this expanding population and to develop the sector’s attractiveness as a global asset class. There has already been significant growth in the issuance of sharia-compliant bonds known as sukuk. There was less than $15 billion of global sukuk issuance outstanding in 2001, but $300 billion by the end of last year.

Particularly encouraging over the past year has been governments of non-Islamic countries (including the United Kingdom, South Africa, and Hong Kong) issuing Islamic bonds. There is considerable demand for these bonds – the UK generated £2.3 billion of demand for its £200 million sukuk—and much of this demand comes from the Middle East. As sovereign sukuk issuance grows, more companies are likely to follow suit.

With 1.6 billion people identifying themselves as Muslim, there is a massive pool of potential customers for financial products that adhere to Islamic principles. One of the keys to global growth will be greater cross-border standardization of regulations (akin to the ISDA master agreement that governs most of the world’s derivatives transactions). Yes, this standardization work is far from glamorous. But it will be fundamental to the long-term globalization and growth of Islamic finance—and thus to the expansion of economic opportunity for Muslims throughout the world.

Articles © 2015 Matthew Slaughter and Matthew Rees. All rights reserved.
Publication © 2015 Trustees of Dartmouth College. All rights reserved.