Realizing the Potential of Islamic Finance

The concept of Islamic or Shariah-compliant finance is based on core tenets of Islam concerning property rights, social and economic justice, wealth distribution, and governance. One of the key features of the system is prohibition of riba (interest) and gharar (ambiguous contracts or deals) (Kabir and Mahlkrecht 2011, 74; El-Gamal 2009, 58–60). There is consensus among scholars that the prohibition of interest is not limited to usury but refers to interest on debt in any form (Iqbal and Mirakhor 2011, 10). The prohibition of gharar is to discourage excessive uncertainty in contracts, enhance disclosure, and proscribe all forms of deception. In addition to the prohibition of riba and gharar, Islamic finance has seven key precepts. Implemented fully, Islamic finance: 1. Eliminates pure debt securities from the financial system, replacing interest by the rate of return earned ex post on contracts of exchange or risk sharing. Islamic finance has been growing rapidly in recent years. Motivated by a heightened interest in financial instruments that emphasize risk sharing, it has been attracting greater attention in the wake of the recent financial crisis. This class of instruments appears to have avoided many of the most severe consequences of the crisis. Several features underpin the expansion and performance of Islamic finance. Addressing key regulatory and governance issues will be essential for Islamic finance to achieve its full potential. Several multilateral development institutions, including the World Bank, have longstanding programs to support the development of the industry and have used Islamic instruments, to varying extents, to tap capital markets. In the coming years, Islamic finance could account for a substantial share of financial services in several countries, meeting the preferences of significant numbers of people, enhancing financial inclusion and intermediation, and contributing more broadly to financial stability and development.