Islamic Finance Unbound

WASHINGTON, DC – While uncertainty continues to roil global markets, driving many investors into full retreat, one part of the financial sector is expanding exponentially: Islamic-law-compliant financial assets have grown from about $5 billion in the late 1980’s to roughly $1.2 trillion in 2011.

This asset class, which is characterized by shared risk between institutions and clients, avoided many of the most severe consequences of the global financial crisis that began in 2008. This resilience, along with several other key features, underpins the high performance and growing popularity of Islamic finance.

The global financial crisis adversely affected a small number of Islamic financial institutions as the real economy contracted and some issuers of Islamic bonds defaulted. But the risk-sharing inherent to Islamic finance made such instruments more resistant to the first round of financial contagion that hit in 2008. Leading economists, such as Harvard University’s Kenneth Rogoff, have suggested that Islamic finance demonstrates the advantages of more equity and risk-sharing over the conventional bias in favor of debt instruments.

Several distinctive features have made Islamic financial institutions relatively stable throughout the crisis. One such feature is that Islamic finance emphasizes asset-backing, thereby ensuring a direct link between financial transactions and real economic activities. Institutions’ savings and investment returns are closely linked, because they are determined by the real sector, not the financial sector.