Policy Innovations Digital Magazine (2006-2016): Briefings: Moral Interest in Banking

Islamic finance is booming. The market is estimated at $1 trillion with an expected growth rate of 15 percent per year, as reported by Forbes.com. Although Islamic banking emerged in the 1970s in the Muslim world, the global economy is now realizing that non-Muslims can also take advantage of the sector. Hong Kong is looking to establish its own market for Islamic bonds, or sukuk. Western companies are starting to target Muslim consumers with halal products. And conventional banks like HSBC are offering Islamic financial services.

For many Muslims, the importance of Islamic finance derives from its adherence to Islamic law, or sharia. The principles that serve as ethical investment guidelines are laid out in the Koran and the Sunnah. Most schools of Islam forbid interest and speculation, as well as investment in products considered immoral, such as alcohol. These guidelines prevent against unearned or immorally earned profit, and they also protect the investor against exploitation and the risks of excessive leverage.

To meet these requirements, Islamic finance relies on asset-based transactions, rather than money alone. It also employs profit- and risk-sharing mechanisms that distribute risk and reward among borrower and lender, and contracts base ROI on the outcome of the venture rather than a predetermined rate. This system reflects Islam's teachings on wealth distribution and social and economic justice.

Despite the seeming rigidity of these strictures, the Islamic financial services industry has not been impeded. Bonds, mortgages, insurance, and other conventional services have been adapted for compliance with sharia, and the need for continued innovation is widely recognized by experts in the field.

Modern Islamic banks are supervised by a body of Muslim jurists who ensure that transactions adhere to the principles of Islam and the standards of conventional financial institutions. Their expertise encompasses Islamic law, commercial law, and finance, making these jurists hard to come by. The Internet and satellite television have enabled existing Islamic jurists to gain popularity, and growing access to translations of the Koran in print and electronic copies has led to an increasing number of self-taught or amateur jurists.

Adherence to and interpretation of sharia varies by country and financial institution, due to different schools of Islam and different national and subnational laws. This means cross-border transactions and international competition can be difficult. For this reason, multilateral institutions, such as the Accounting and Auditing Organization for Islamic Financial Institutions and the Islamic Financial Services Board, are working to increase coordination among governments and harmonize international standards. The International Monetary Fund and the Islamic Development Bank (IDB) also facilitate understanding of Islamic banking, issue guidelines for the industry, and advise governments and supervisory agencies.

Pakistan, whose constitution requires that all laws be brought in conformity with sharia, is transitioning to a completely interest-free economy. The country began pursuing this goal in the 1980s but ran into difficulties when it tried to convert the entire banking system too suddenly. In 2001, the State Bank of Pakistan (SBP) launched the Islamic Banking Policy, which promotes simultaneous development of Islamic and conventional financial industries. The policy is meant to establish a full-fledged Islamic banking system in an evolutionary and flexible manner that allows markets and customers to gain confidence in Islamic banks and prepare for an eventual launch of the new system.

Six Islamic banks currently exist in Pakistan, and 13 conventional banks with roughly 170 branches offer Islamic financial services. In five years, Islamic deposits have reached a 2.9 percent market share in Pakistan, a benchmark that took Malaysia and Bahrain, notable for the success of their Islamic banking systems, ten years to realize.

Another distinguishing aspect of Pakistan's banking system is its attention to financial inclusion. In light of Islam's emphasis on economic justice, Islamic banks have come under criticism for not doing more to help the poor. Examples of sharia-compliant development initiatives do exist. The IDB was established in 1975 to provide development financing to Muslim communities and offers interest-free loans to member countries for agricultural and infrastructural projects.

Yet there is valid concern that Islamic banks in general cater to the wealthy. The World Bank reports that no more than 30 percent of people in the developing world have access to any banking services. In the poorest countries this figure is as low as 10 percent. In Pakistan, where the majority of the population lives in rural areas, all of the country's Islamic banks are in urban locations.

Recognizing this problem, the government issued a Microfinance Institutions Ordinance in 2001 to provide a legal framework to regulate the establishment and operations of microfinance institutions. SBP recently developed a separate financial inclusion strategy to extend financial services, including those that are sharia-compliant, to the country's rural poor.

In addition to the proposed development of Islamic microfinance banks and opening of branches of commercial Islamic banks in rural areas, SBP is working with private sector companies to develop sharia-compliant insurance products to encourage small lending to the agricultural sector. The Chairman of the Senate of Pakistan, Muhammedian Soomro, echoed the need for such a strategy at a recent conference, calling for Islamic banks to issue loans to rural areas for agricultural development, education, and vocational training.

While it will take time for the results of this strategy to actualize, Pakistan is one of few countries with the coordination and framework necessary to extend banking services to low-income sectors of the population. With a growing demand for Islamic financial products and a concurrent need for sustainable and equitable development financing, Pakistan's strategy may serve as a model for the sector.

Related Materials

"Paradox of Contemporary Islamic Finance," Mahmoud A. El-Gamal, Rice University.

"Islamic Finance and Its Critics," Landon Thomas, Jr., New York Times, August 9, 2007.