Is the Islamic Finance Industry a Success or Failure?

Since 1975, when the first Islamic commercial bank was established in Dubai, Islamic finance has come a long way. It has grown rapidly in recent decades and its global assets are now estimated to be around US $1.5 trillion across the banking sector, capital markets, and takaful, or Islamic insurance.

Given the available track record, how do informed observers characterize the development of this most prominent form of faith-based finance? And what criteria do they use? Let's look at some of these opinions. (If you are new to Islamic finance and want a clear but brief introduction, read pages 1–12 of Islamic Finance: Ethics, Concepts, Practice, a literature review published by CFA Institute Research Foundation.)

One Industry, Many Opinions

One of the foremost critics of the industry, Mahmoud Amin El-Gamal, a professor of economics at Rice University in the United States, considers modern Islamic finance to be “Shari’a arbitrage” wherein what is prohibited in conventional finance becomes permissible when deemed “Shari’a compliant” despite having similar, if not the same, economic substance. Duke University economist Timur Kuran claims that Islamic banking is "based on an operational principle [of profit and loss sharing] that is simply unfeasible."

Professor Mehmet Asutay, from the University of Durham in the United Kingdom, is more concerned with the “social failure” of Islamic finance. He says that Islamic finance does not share the aspirations or the foundational claims of Islamic moral economy.

The London-based writer Tarek El Diwany is critical of Islamic finance for not relying on risk-sharing financing in practice, arguing that “If Islamic banking adopts a genuinely Islamic paradigm it can offer a solution to a world hungry for alternatives. If it does not, it will enjoy a brief life as a get-rich-quick bandwagon and then disappear into the relics of financial history.”

Although sympathetic to its ideas, economist Volker Nienhaus, while comparing Islamic finance and responsible investing, opines that “Islamic finance as it is practiced today is not so well received by the average Muslim.” But Nienhaus sees potential for it in some areas, such as expanding access to finance, and wants it to do more to integrate environmental, social, and governance (ESG) issues.

Tufts University professor Ibrahim Warde takes a wider historical and political-economy perspective and believes that “Islamic finance is still in its early stages of development and is still beset by tensions and problems.”

Assessments by practitioners and journalists are more sanguine. Attorney Oliver Agha states that blaming Islamic finance for the credibility challenges associated with its adherents is not fair. He believes that if Islamic finance is to be genuinely implemented, however, it must return to its spiritual roots.

Islamic finance, according to the Italian journalist and political analyst Loretta Napoleoni, “represents the sole global economic force that conceptually challenges rogue economics,” and it does not allow investment in pornography, prostitution, narcotics, tobacco, or gambling — areas which Napoleoni thinks have flourished in a free market, globalized economy.

Camilla Hall, a correspondent for the Financial Times, appreciates Islamic finance’s growth. She says that “no one could have foreseen that sharia-compliant banking could grow into the US$1.1tn global industry that it has become today.”

There are many others who are still bullish on the prospects of the industry. For instance, the investor Mark Mobius thinks that opportunities in Islamic finance "are great," and The Economist reports that "despite strong recent growth for Islamic financial products, there still is room for further expansion."

If the practice of Islamic finance is met with skepticism, its underlying principles can appeal to a broad cross section of opinion-makers. In 2009, Bloomberg quoted the Vatican’s official newspaper, L’Osservatore Romano, as saying, “The ethical principles on which Islamic finance is based may bring banks closer to their clients and to the true spirit which should mark every financial service.”

Commenting on the foundations of Islamic finance, economist Willem Buiter maintains that “if too much debt and too little capital are (part of) the problem, then the conversion of debt into equity is (part of) the solution.” In arguing against excessive debt and in favor of equity, Harvard economist Kenneth Rogoff suggests that “perhaps scholars who argue that Islamic financial systems’ prohibition of interest generates massive inefficiencies ought to be looking at these systems for positive ideas that Western policymakers might adopt.”

Gillian Tett of the Financial Times notes that Islamic finance's “core principles — if not all the practice — are fascinating. After all, the idea of tethering our financial system more closely to the ‘real’ economy and tangible, productive enterprises seems distinctly appealing these days. Likewise, building a system around equity, not debt, with less financial candyfloss.”

My Opinion

While no claim is made that the above is a comprehensive set of opinions on Islamic finance, looking at these different views, it seems that those who consider Islamic finance a success story often refer to its higher-than-expected growth in the past as well as its prospects for further growth. Those who consider it a failure point to its tendency to favor legal form over economic substance and the lack of substantive differentiation from conventional finance — to which it was supposed to offer an alternative. More importantly, some of these observers make a distinction between the principles and practices of Islamic finance. While its practices often invoke sharp critiques, it seems that the underlying principles tend to strike a sympathetic chord.

So far Islamic finance has probably been more successful in offering an alternative perspective on finance than in providing a substantively different way of financing. The emphasis of its theory on social consciousness, risk-sharing, redistribution of wealth and opportunity, and making finance the servant and not the master of the real economy are what many observers want to hear. But Islamic finance has found it hard to put theory into practice. Why? The list of reasons ranges from history, law, politics, regulation, taxation, consumer behavior, and beyond. But an important reason is that Islamic finance is generally made to fit into a system designed for conventional finance, and in the process of making concessions, it seems to lose what its critics regard as its substance.

The Final Word on Islamic Finance

Has the final verdict on Islamic finance been rendered? Probably not. The Islamic finance industry and its literature as of 2015 are materially different in breadth and depth from where they were in the early 1970s or, for that matter, in the early 1990s. The industry continues to evolve, and there is no reason why, in the next two decades, the field won't evolve considerably more from where it stands today. In the wake of the global financial crisis, the ideas underpinning Islamic finance might appeal to those who aspire for a relatively restrained financial system and are concerned about the broader impact of the finance industry on society.

In November 2014, CFA Institute Research Foundation published a literature review, Islamic Finance: Ethics, Concepts, Practice. This literature review is available to everyone without any fee or registration.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author's employer.

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