The Role of Islamic Finance in Financing Long-term Investments - Global Report on Islamic Finance 2018 - IRTI
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Global Report on
Islamic Finance 2018
Overview
The Role of Islamic
Finance in Financing
Long-term Investments
ISLAMIC DEVELOPMENT BANK GROUP
The Role of Islamic
Finance in Financing
Long-term Investments
I
Global Report on
Islamic Finance 2018
Overview
The Role of Islamic
Finance in Financing
Long-term Investments
IIIThis booklet contains the overview, as well as list of contents, from Global Report on Islamic Finance 2018: The
Role of Islamic Finance in Financing Long-term Investments. An electronic copy of the final, full-length report,
once published, will be available at http://www.irti.org/English/Pages/Publications.aspx and
https://openknowledge.worldbank.org/ and print copies can be ordered at http://amazon.com. Please use the final
version of the report for citation, reproduction, and adaptation purposes.
Copyright © 2018 by Islamic Development Bank Group
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Report on Islamic Finance: The Role of Islamic Finance in Financing Long-term Investments” Overview
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IVContents
Foreword VII
Acknowledgment IX
Executive Summary XI
Key impediments to raising long-term financing XII
Risk-sharing and Islamic finance XII
Challenges for Islamic finance XII
Policy Recommendations XIII
Overview 1
Political and macro-economic environment 6
Dominance of an over-exposed Islamic banking subsector 6
Lack of prerequisites for Islamic finance based on risk sharing 7
Market failures and policy distortions 7
Financial education and consumer protection 7
Underutilization of the Islamic social sector 7
NextGen Islamic finance 7
Chapter Attributions 14
VForeword
The development community is facing the challenge embarked on a new initiative to reposition the bank
of mobilizing financing for long-term investments in the changing development finance landscape in
needed to eradicate poverty, provide education, ac- the wake of the 2030 global agenda for sustain-
cess to clean water and fight climate change. It ap- able development. Under the new initiatives, the
pears that there is no shortage of funds as trillions IDB Group is committed to forging partnerships
of dollars are invested in securities earning negli- with both public and private sector, insists on the
gible or sometimes negative returns. The question development of financial markets and financial in-
remains: what are the key impediments to attracting frastructure, and the wider role of private sector in
funds for long-term investments? This joint report economic development. In addition, the emphasis is
by the Islamic Development Bank (IDB) Group and on enhancing the governance mechanism to provide
the World Bank Group (WBG) attempts to address close monitoring and risk mitigation required for
this question. The theme of the report is quite rel- risk-sharing system. In this context, the IDB Group
evant, timely and has been well justified. is providing support for the development of finan-
cial sectors conducive to Islamic finance globally.
The report rightly proposes incentivizing “risk shar-
ing” and asset-backed finance as the potential mech- The joint initiative of the IDB Group and the WBG
anism to attract financing for long-term investments. also reflects a global view regarding the Islamic
One of the major features of risk-sharing finance is finance and the role it can play to improve the fi-
that all participants have ‘skin-in-the-game’ result- nancing for the long-term investments. I believe
ing in alignment of interests. By its very nature, Is- the periodic publication of the Global Report on Is-
lamic finance based on the principles of risk sharing lamic Finance will not only help to direct the future
(equity and asset-backed financing) offers the right growth of Islamic finance but also boost the eco-
ingredients to mobilize long-term financing provid- nomic development.
ed an enabling legal, regulatory, and financial eco- I congratulate the technical teams from both institu-
system is developed. Therefore, Islamic finance can tions on completion of this important report.
and should occupy this space to make a difference.
For more than 40 years, the IDB has been practicing Dr. Bandar M. H. Hajjar
Islamic finance and striving to promote economic President, Islamic Development Bank Group
development through its operations. For attaining April 2018
long-term sustainable development, the IDB has
VIIAcknowledgments
This Report was prepared as a joint initiative of The team would also like to thank the peer review-
World Bank Group (WBG) and Islamic Develop- ers, Samuel Munzele Maimbo, Senior Advisor and
ment Bank (IDB) Group, by a team led by Abayomi Head, Finance for Development Unit, World Bank;
Alawode, Head of Islamic Finance, Finance, Com- and Mohammad Ahmed Zubair, Lead Country
petitiveness & Innovation (FCI) Global Practice, Economist, Islamic Development Bank for their
World Bank, and Dawood Ashraf, Senior Research- valuable comments and feedback, which helped the
er–Islamic Finance, Islamic Research and Training team enrich the Report.
Institute (IRTI), a member of the IDB Group. Spe-
cial thanks are owed to Zamir Iqbal, Vice President The teams at the Islamic Research and Training In-
Finance & CFO, the IDB, for his commitment and stitute (IRTI) and World Bank Global Islamic Fi-
contributions in preparation of this Report. We are nance Development Center are recognized for their
also thankful to Mohamed Azmi Omar, Former Di- commitment and efforts in writing, updating, edit-
rector General, IRTI for his support on this project. ing, and assembling this Report. They were led by
Dawood Ashraf (IDB) and Ayse Nur Aydin and Mu-
The team would like to thank and acknowledge the harrem Cevher (World Bank Group). We thank all
contributions of the Technical Editor, Prof. Hossein the team members from both institutions for their
Askari, George Washington University; and the Ed- valuable expertise and contributions, including
itorial Board, comprising Ishrat Husain, Chairman, Fatih Kazan, Financial Sector Specialist from the
Centre for Excellence in Islamic Finance, Institute World Bank; and Syed Salman Ali, Lead Research
of Business Administration, Karachi-Pakistan; Prof. Economist and Mohammed Obaidullah, Senior Re-
Abbas Mirakhor, First Holder, INCEIF Chair of Is- search Economist from IRTI.
lamic Finance; and Ghiath Shabsigh, Assistant Di-
rector, Monetary and Capital Markets Department, In addition, the team benefited greatly from discus-
International Monetary Fund (IMF) who guided the sions, valuable input, and constructive comments
team with their wisdom, experience, and expertise. provided by Prof. Habib Ahmed, Sharjah Chair in
They provided extensive feedback and comments Islamic Law and Finance, Durham University; Alaa
throughout the conceptualization and review stages Alaabed, Senior Financial Analyst, The Islamic In-
of the Report. Their comments helped the team en- ternational Rating Agency; and Rasim Mutlu, Grad-
hance the content of earlier versions of the Report. uate Assistant, The University of Lausanne (UNIL),
IXwho served as consultants to the team for select tor, Research Management Centre, INCEIF; Anwar
chapters. The team would also like to thank Prof. Allah Pitchay, Universiti Sains Malaysia; and Prof.
Andrew Sheng, Distinguished Fellow of the Asia Jahangir Sultan, Bentley University for their efforts
Global Institute, University of Hong Kong, who and contributions in the second part of the Report.
provided guidance as a technical expert. The team
would also like to recognize the valuable contribu- Finally, we acknowledge the support of Mahmoud
tions of Tarik Akin, Senior Associate, the Republic M. Rashad of IRTI’s Information and e-Programs
of Turkey Undersecretariat of Treasury. Division; and Nancy Morrison, Editor, the Morri-
The team would also like to thank Rami Abdelkafi, son Group, for her invaluable efforts in editing this
Senior Economist and Training Specialist, IRTI; Report.
Assist. Prof. Amin Mohseni-Cheraghlou, Universi-
ty of Tehran; Assist. Prof. Adam Ng, Deputy Direc-
XExecutive Summary
Long-term finance plays a major role in sustainable Market factors under existing conditions, together
economic development because it helps advance with systemic biases toward short-term debt and
structural transformation of economies, stimulates risk transfer mechanisms, substantially reduce the
development of infrastructure, and provides funds availability of funding for long-term financing,
for fixed investments to enhance production capac- which creates deficiencies in resource allocation
ity. The need for funding long-term investments is and a gap in long-term funding, despite the ample
so huge that resources by governments, multilateral supply of global savings. While the gap exists glob-
development banks, and other traditional develop- ally, it is particularly critical in developing econo-
ment partners remain insufficient. The role of the mies because it hampers the implementation of
private sector is critical in meeting the challenges much-needed investment projects to enhance wel-
of long-term financing needs. However, the existing fare. This edition of the Global Report on Islamic
financing patterns clearly indicate the preference of Finance presents a global perspective on the needs
investors for assets with short-term maturity despite for and impediments to long-term financing. To deal
their meagre returns. Thus, extending the maturity with the ongoing underfunding problem in long-
structure of finance is a key policy challenge for the term investments, it proposes the use of Islamic fi-
development community. nance, which is based on risk sharing rather than
risk transfer, and thus offers many advantages.
XIKey impediments to raising long-term and mobilization of funds on the basis of sharing
financing risks among parties.
The report identifies many impediments on both Challenges for Islamic finance
the systemic and the usual demand and supply level
in mobilizing funds for long-term investments. Al- The exceptional growth of the Islamic finance indus-
though there are several issues stifling the financing try in the last decade is a remarkable development,
for long-term investments, the report finds that the but it began from a low base and still constitutes
most important impediments are the over-allocation a small fraction of global finance. The risk-sharing
of savings to short-term and medium-term instru- nature of Islamic finance has attracted attention in
ments, excessive leveraging, and incentives for risk all financial sectors, including banking, capital mar-
transfer. The risk-transfer paradigm of convention- kets, and insurance. The report provides a compre-
al finance not only constrains funding for long-term hensive review of the status and development of
investment but also reinforces the plight of overlev- various sectors and how each sector is contributing
erage and short-termism in the current global finan- to long-term financing. The main finding from this
cial system that is responsible for many more chal- analysis is that despite the huge potential, Islamic
lenges for the contemporary global economy. financial sector is a small player in the global finan-
cial markets and requires a concerted push for the
Risk-sharing and Islamic finance regulatory and legal changes to take root.
The potential of long-term finance can be unlocked The report highlights several challenges for Islamic
by adopting a risk-sharing structure that reduces the finance in mobilizing funds to long-term impactful
systemic risk and moral hazards associated with the investments. To reduce uncertainty and provide pro-
conventional risk-transfer structures. The sharing of tection of property and investors rights, macroeco-
risks and contingency of returns can allow socially nomic and political stability, institutional develop-
optimal projects to be undertaken that might other- ment, and an enabling legal and regulatory regime
wise seem unfeasible from a risk-transfer perspec- are necessary. At the micro level, the organizational
tive. Risk-sharing also enables the commitment to framework of financial institutions and the diversity
mutuality and long-term horizons in investing. of financial instruments offered determine the ex-
tent to which long-term financing needs are met.
Against this backdrop, the report introduces Islamic Currently, Islamic financial institutions are subject
finance as one of the possible ways to meet the chal- to the similar regulatory regime as conventional
lenges of providing adequate funds to long-term institutions, thus forcing them to develop financial
investments on a sustainable manner. Risk sharing instruments similar to conventional instruments,
is the preferred organizational structure for Islamic even if those instruments are Sharīʿah-compliant.
economics and finance. Islamic economics and fi- However, this stricture limits the full benefits that
nance offer a framework based on risk-sharing that could be obtained through the risk-sharing feature
can serve a viable means of long-term investment of Islamic finance.
financing. Importantly, Islamic finance can mobi-
lize resources to the real sector, rather than chan- The report reviews the status and developments of
neling much-needed funds to the money markets. Islamic finance for a sample of 12 member coun-
This risk-sharing framework attempts to address the tries of the Organisation of Islamic Cooperation
shortcomings of the conventional model. It is based (OIC) in the light of the 10 years that have elapsed
on four pillars: institutional foundations in line with since the foundational report, Islamic Financial
Islam’s rules of behavior; accountable governance Services Industry Development: Ten-Year Frame-
and legal system; a long-term investment horizon; work and Strategies 2007 (IRTI and IFSB 2007),
XIIwas issued. The findings suggest that countries are financial supervision for the efficient mobiliza-
at different levels of development with respect to tion of resources on the basis of risk sharing.
the key recommendations related to the develop-
ments in national plans and strategies, the legal and • Adhere to strong corporate governance values
regulatory frameworks, the Sharīʿah governance re- that increase the accountability and transpar-
gime, liquidity infrastructure, and deposit insurance ency of the financial system.
schemes. Some countries, such as Indonesia, Ma- • Enhance coordination among standard-setting
laysia, Oman, and Pakistan, have adopted national bodies to provide unified Sharīʿah, regulatory,
action plans for the development of the Islamic fi- and accounting treatments.
nancial sector, including separate Islamic financial
laws. In other member countries, adoption is still at • Develop secondary markets to provide liquidity
very early stages. in the markets for long-term financing instru-
ments.
Policy Recommendations Enhance the institutional framework and
diversity of instruments for long-term
Despite the remarkable growth of Islamic finance,
financing
policy interventions are needed in several areas to
better utilize the merits of Islamic finance in mobi- This report finds that institutions and instruments
lizing funds for long-term investments. The report’s associated with risk-sharing finance can mitigate
policy recommendations have a dual aim: not only agency conflicts because all parties partake of the
to promote Islamic finance to make the provision risks as well as the rewards: that is, they have “skin
of long-term financing more efficient, but also to in the game.” However, few instruments are avail-
encourage a global paradigm shift away from over- able to serve this purpose, mainly because universal
reliance on short-term instruments toward adding regulatory requirements are commonly adopted to
economic value. To these ends, the report offers two cover both conventional and Islamic financial insti-
main sets of recommendations: tutions. The report emphasizes that innovations in
financial institutions and instruments that promote
Strengthen the financial system
risk-sharing and asset-backed financing are essen-
by developing a supportive legal, tial not only to deleverage the financial system but
administrative, and regulatory environment also to make it more conducive to long-term finance.
A financial system based on asset-backed financing
A financial sector with weak governance and lack would encourage real transactions and growth in the
of transparency is hampered by market frictions, real sector. To this end, the report makes the follow-
inefficiencies, and financial exclusion. Fundamen- ing policy recommendations:
tal institutional problems and market failures need
to be addressed to reduce uncertainty and protect • Promote the development of capital markets
property and investors rights, which are impeding for Sharīʿah-compliant instruments to mobilize
the mobilization of long-term financing at both the resources for long-term projects by engaging
systemic and the usual demand and supply levels. institutional investors, including pension funds,
The report recommends the following: sovereign wealth funds, asset management
firms, venture capitalists, and private equity
• Introduce a supportive legal, administrative, firms.
and regulatory infrastructure that establishes
and protects investors’ rights, provides effec- • Engage Islamic banks in Sharīʿah -compliant
tive mechanism for dispute resolution, institutes syndicated financing to finance long-term and
a sound insolvency framework, and strengthens larger projects.
XIII• Introduce regulations to unlock the potential of • Capitalize on blended finance and public-pri-
Islamic banks to provide long-term financing vate partnerships (PPPs) by developing new
using investment accounts. products and expanding existing ones to in-
crease the use of Islamic finance for projects of
• Provide incentives for Islamic financial innova- mutual benefit to the public and private sectors.
tion based on FinTech solutions, especially for
mobilizing the dormant Islamic social sector The report demonstrates how risk-sharing finance
to support investments with environment and can play a key role in mobilizing funds to long-term
social as well as economic impacts (impact in- investments and provides examples of the ways that
vesting). Crowdfunding, for example, can pool Islamic finance can be utilized to release the poten-
resources (Zakāt, Ṣadaqāt, Waqf) from small tial of long-term financing that advances social, en-
surplus units and channel them toward invest- vironmental, and economic goals.
ment in large-scale projects that would other-
wise be beyond the scope of any one individual.
XIVOverview
The adoption of the Sustainable Development Goals sociated with the refinancing of the debt) and fund
(SDGs) by the development community testifies to crucial societal needs. Access to long-term invest-
a shared responsibility toward the well-being and ment vehicles can also improve households’ welfare
empowerment of mankind. To achieve the desired by allowing them to smooth their consumption over
sustainable development, there is a huge need for time and share the benefits of economic growth.
investment in capacity-building assets. The United Long-term financing is often considered to be an
Nations estimates a gap of $2.5 trillion between the important driver of sustainable economic develop-
annual investment needs of the SDGs of $3.9 tril- ment, helping in structural transformation, infra-
lion and current annual investments of $1.4 trillion structure investments, and budgetary support.
(UNCTAD 2014). The challenge posed by the scale
of funding requirements is further aggravated by the Although estimates of long-term investment financ-
need to commit funds for long-term horizons. More- ing needs vary considerably and are not necessar-
over, there is broad consensus that to deal with the ily precise, studies conclude, unanimously, that the
complex challenges of climate change, growing ur- needs are extremely large. Over the next 15 years
banization, and social imbalances, the world needs (2016−30), the global economy will need to invest
to invest more in long-term sustainable projects. $50 trillion to $90 trillion in infrastructure assets
such as urbanization investments, transport sys-
The need for long-term funding for investment to tems, energy systems, water and sanitation projects,
expand the sustainability and productive capacity of and telecommunication systems (Woetzel et al.
the modern economy was explored in a World Bank 2016; Bhattacharyna, Oppenheim, and Stern 2015).
Report in 2015. The findings of the report (World This translates into almost doubling the current
Bank 2015) suggest that by its nature, long-term fi- infrastructure spending of $2 trillion to $3 trillion
nance exerts a stabilizing influence on the financial per year. At the firm level, long-term financing is
system. Long-term investors can provide necessary generally used to acquire fixed assets, equipment,
support during economic downturns, given their ex- and the like. Empirical evidence suggests that the
tended investment horizon, countercyclical strate- use of long-term finance is associated with better
gies, and emphasis on long-term value. In contrast firm performance. Access to long-term financing
to short-term liquidity-chasing investors, long-term was significantly constrained after the global fi-
investors mitigate investees’ rollover risks (risks as- nancial crisis of 2007−09. While the impact var-
1ied across countries of different income grouping, Islamic economics and finance, owing to its nature
small and medium enterprises in lower-middle- and of risk-sharing and equity participation, provide an
low-income countries were hardest hit. Lack of alternative perspective and solution to the ongoing
long-term finance exposes deserving firms to roll- challenges mentioned.
over risks, which may in turn dissuade longer-term
fixed investments, with adverse effects on economic To explore the potentially pivotal role of Islamic fi-
growth and welfare. The World Bank Group esti- nance in long-term financing, the World Bank Group
mates a funding gap of $2.1 trillion to $2.6 trillion and Islamic Development Bank Group decided to
for micro, small, and medium enterprises (MSMEs) focus on the topic of “Financing Long-Term Invest-
globally (Stein, Ardic, and Hommes 2013). ments” as the general theme for the second edition
of the Global Report on Islamic Finance (GRIF).
The mobilization of funding for long-term invest- This report has five main objectives:
ments is faced with many impediments on both the
systemic level and through the usual demand and To deepen understanding of the significance of
supply factors. Leveraging and incentives for risk long-term financing by documenting why long-term
transfer, the unavailability of financially viable financing is needed.
long-term projects, political myopia, macroeco-
nomic instabilities, high entry barriers, inadequate To provide a critique of the traditional financing
risk assessment frameworks, weak legal and institu- model of transferring risk by presenting the theoret-
tional frameworks, illiquidity in the financial mar- ical rationales and discussing policy issues related
kets, fiscal consolidation, and restrictive lending en- to financing of long-term investments from the per-
vironments are the main issues stifling the financing spective of Islamic economics and finance.
for long-term investments.
To formulate a theoretical framework that empha-
On the other hand, it is obvious that the problem is sizes the central role of risk-sharing as a mechanism
not the paucity of financial resources, as there is an for acquiring long-term investment for sustainable
ample supply of global savings to meet the needs economic development and provide some empirical
of long-term investment. According to World Bank evidence of widespread needs for long-term invest-
estimates, more than $10 trillion is invested in nega- ments.
tive interest rate bonds; $24.4 trillion is invested in
low-yield government securities; and $8 trillion is To review recent developments and trends in Islam-
sitting in cash, waiting for better investment op- ic finance as a means of long-term financing, and
portunities (World Bank 2017). Thus, the problem to discuss challenges that Islamic finance faces in
is the “allocation” of these resources, which vastly mobilizing long-term finance.
underfund long-term investment.
To explore policy options to remove key barriers
In this regard, various policy initiatives have been impeding the development of Islamic financial in-
endorsed to mobilize international organizations dustry for long-term financing.
(including the International Monetary Fund, the
Organization for Economic Co-operation and De- The report identifies the existing tendency of con-
velopment, the World Bank Group, and Islamic ventional finance to transfer risk to be one of the
Development Bank Group) to address the potential underlying reasons for over-allocation of savings
detrimental effects of a prolonged underfunding of to short-term and medium-term instruments. This
long-term investment. While there are small differ- tendency not only constrains funding for long-term
ences of opinion as to the specifics of the proposals investment, but is also responsible for many more
to addressing the gap, they agree on the diagnosis. problems and challenges for the contemporary
2global economy, including stagnation of economies the default of the borrower. However, in the event of
around the world, constrained private investment, default, the lender still pushes for recovery from the
the decline in productivity, and the sizable increase borrower and restricts further lending. In such a sce-
in global debt since the global financial crisis. nario, any of the potential causes of distress in the
financial system may perpetuate a vicious cycle of
This report suggests adopting a risk-sharing solu- defaults and crisis due to borrowing restrictions and
tion to address the risk-transfer problem impeding liquidity constraints. There is mounting evidence
long-term investments. Risk-sharing financing may suggesting that interest-bearing debt and leveraged
resolve some of the major problems and meet the balance sheets pose systemic problems and can po-
challenges associated with risk transfer. The risk- tentially undermine sustainability.
sharing mechanism has the potential to create a cul-
ture of trust, increase investment (by funding proj- One of the important elements in the collateral and
ects that are rationed out of risk-transfer markets), risk premium approach is the unilateral motives
reduce individual risk aversion through collective of the lender for the recovery of loan and interest
risk taking, and increase financial inclusion (Bowles without regard to the fate of the venture. This under-
2013). All these advantages increase x-efficiency mines the commitment to mutuality among the par-
in the economy, which is the ability to get maxi- ties in a financing relationship, enhances individual
mum output from the inputs, leading to expanded risk aversion, and discourages investment for long-
productivity (Leibeinstein 1966). More importantly, term projects.
risk-sharing finance reduces inequality of income
and wealth distribution by allowing lower-income In this regard, these problematic aspects of lever-
classes to become holders of real assets and builders age-based risk-transfer type of financing have been
of wealth. under question for years, especially after the global
financial crisis. A number of recent studies have
Given the benefits of risk sharing, the report ad- offered fundamental critiques of the collateral and
dresses the question as to why there is so much re- risk premium approach. Taleb (2008) regards the
luctance to risk-sharing financing and suggests that higher amount of equity as a necessary condition to
current economic development models rely heavily control extraordinary and unexpected risks, which
on the leverage and liquidity in the financial mar- he referred to as black swans.1 Taleb posits a view
kets. However, both these factors impede the provi- of risk relationships that is systemic. A player that
sion of long-term funding due to the higher uncer- thinks systemically looks at the system organically,
tainty associated with the long-term contracts and rather than mechanically, recognizing that the sys-
the procyclical nature of credit markets. tem must adapt itself to the changing context and
environment, from both endogenous and exogenous
Another reason for the prevalence of leverage-based sources of change. By contrast, conventional debt
risk-transfer instrument is the set of market imper- finance models have a partial and fundamentally
fections leading to ex ante adverse selection by the self-interested view of risk relationships.
lenders and ex post moral hazard of the borrowers.
The presence of such market imperfections creates a Bowles (2013) emphasizes that risk-sharing con-
consistent rift between the borrower and the lender. tracts have characteristics that mitigate the risk of
In a debt contract, the lender attempts to address the contract violations arising from the agency con-
market imperfections by requiring collateral and flict. Gintis (2002) argues that the self-interested
charging a risk premium to compensate lenders for “rational” actor (Homo economicus) depicted in
1
Taleb discusses in his seminal book (2007) that unexpected events which are considered extreme outliers play significantly larger roles than regular
occurrences. Thus, any analysis omitting outliers lacks substantial portion of information. This idea has implications on finance as well as history,
science, finance, and technology. In finance, Taleb’s Black Swan Theory is acknowledged in the discussion of tail risks. A conservative approach to
leverage, i.e. strong equity capital, may limit the probability of tail risks.
3neoclassical economics is one of the types of hu- risk sharing and asset-backed financing could make
man subjects characterized as engaging in strategic the financial system more conducive to long-term
interactions. finance. The development of equity-based capital
markets could play an important role in mobilizing
On the other extreme of the Homo economicus, Gin- resources without creating leverage in the economy.
tis posits Homo reciprocans, who exhibits strong Islamic finance is well suited for long-term financ-
reciprocity, and a propensity to cooperate and share ing because of its emphasis on materiality, proper-
with others— even when there are no plausible ty rights, risk sharing, and addition of value. The
future rewards or benefits from so behaving. This report, however, highlights several challenges for
reciprocal approach emphasizes mutuality, commit- Islamic finance in mobilizing funds for long-term
ment (“skin in the game”), incentives to focus on investment that supports broader goals of serving
the common good of the parties to the contract, and the economy, society, and the environment. The big-
horizontal governance, which is self-enforcing (in gest challenge in achieving the potential of Islamic
contrast to the top-down governance of risk-transfer finance for funding long-term investments lies in
contracts). the dominance of the Islamic banking subsector.
The underdevelopment of Islamic capital markets
Islam endorses risk sharing as the preferred orga- is another impediment that undermines an impor-
nizational structure for all economic and financial tant channel through which long-term investment
activities. From this perspective, Islamic econom- financing is normally provided. Further challenges
ics and finance offer a framework based on risk are the lack of prerequisites for risk-sharing-based
sharing that can serve a viable means of long-term Islamic finance, including property rights and good
investment financing. Importantly, Islamic finance governance; market failures and policy distortions;
can mobilize resources to the real sector, rather than lack of awareness of the full cost of risk transfer;
channeling much-needed funds to the money mar- and under-utilization of the Islamic social sector as
kets. This risk-sharing framework attempts to ad- an area of long-term investment.
dress the shortcomings of conventional model. It is
based on four fundamental pillars: 1) institutional To advance discussion about the state of acquiring
foundations in line with Islam’s rules of behavior; long-term funding using the risk-sharing mecha-
2) an accountable legal system and modes of gov- nisms, the report provides an empirical review of
ernance; 3) a long-term investment horizon; and 4) long-term investment financing from the perspec-
mobilization of funds on the basis of sharing risks tive of Islamic finance. The review identifies a well-
among parties. functioning financial system as one that is based
Establishing efficient institutions and an institu- on appropriate governance mechanisms, support-
tional framework in line with the objectives of Is- ing infrastructure that enhances risk sharing, and
lam is essential to creating an enabling environment institutional arrangements to promote trust and
for long-term finance. While institutions lay the cooperation to support financing for long-term in-
foundation of a system, a sound legal system and vestments. With this standard in mind, the review
an appropriate governance mechanism is needed to then considers the broader challenges in creating
ensure smooth functioning of the financial system. an enabling environment for long-term financing.
The need is more pronounced in contracts based Specifically, the review compares the relative state
on risk sharing, given the contingent nature of par- of member countries of the OIC with respect to
ties’ claims and the limitation of human foresight. the rest of the world in terms of their ability to and
The core principle of risk sharing in Islamic finance progress in creating this enabling environment. The
stipulates that investors and users of funds share review analyses factors affecting the supply of and
the outcome of the project or asset being financed. demand for risk-sharing long-term finance, such as
Encouraging financial instruments that promote macroeconomic and political stability, institutional
4development, and risk-sharing friendliness. It also vestments, the report concludes by providing a set
examines the relative status of financial develop- of policy recommendations to address the issues
ment and long-term financing in the member of the highlighted and to ensure that prerequisites are in
OIC countries. place to unlock the potential of Islamic finance
for long-term financing in OIC member countries.
Having drawn an accurate picture of Islamic finance Table O.1 summarizes the recommendations and
as a means of mobilizing funds for long-term in- policy interventions suggested in the report.
5Table O.1. Policy Recommendations
Policy recommendations
Challenges
Public policies Financial institutions
Political and • Enhance political and macroeconomic stability to reduce • Provide appropriate tax incentives for extending maturities.
macro-economic long-term risks. • Enable Sharīʿah compliant risk-mitigating mechanisms for extending maturities.
environment • Pursue prudent monetary and fiscal policies to keep • Review the regulatory and accounting treatments of assets held with long-term horizons
inflation low. to assess their systemic impact on the appetite for long-term investment.
• Strengthen the institutional framework to promote pro- • Establish sectionally specific investment banks and deepen their involvement in the
tection of property rights, rule of law, good governance, economy in order to boost the mobilization of funds for long-term investments through
and sound infrastructure to enhance credit information risk-sharing–based mechanisms.
and information about long-term projects.
• Establish stable and predictable legal and regulatory
environments to reduce long-term risks.
• Provide appropriate incentives for long-term financing to
6
all stakeholders.
• Ensure effective enforcement of contracts over longer
terms.
• Work on changing the investment culture and behavior
to favor long-term investments.
Dominance of • Amend the legal and regulatory framework regard- • Establish Islamic NBFIs, such as leasing/Ijārah companies and Islamic investment banks.
an over-exposed ing financial markets, institutions and instruments to • Develop and expand Islamic institutional investors (mutual funds, pension funds, and the
Islamic banking pave the way for the development of nonbank Islamic like).
subsector financial sector. • Encourage the establishment of risk-sharing insurance and reinsurance (Takāful and
• Increase competition in the financial sector by promot- re-Takāful) companies owned by the stakeholders of risk-sharing Islamic financial institu-
ing other nonbank financial institutions (NBFIs). tions to help mitigate the reluctance to engage risk-sharing–based financing.
• Improve market infrastructure to support and expand • Adopt best-practice guidelines to reinforce long-term horizons in the governance and
Islamic capital and Ṣukūk markets. portfolio management of Islamic institutional investors and sovereign wealth funds
(SWFs).
• Increase the efficiency of structural surpluses in national savings by redirecting them to
SWFs with a long-term horizon.
table continues next pageTable O.1. Policy Recommendations (continued)
Policy recommendations
Challenges
Public policies Financial institutions
Lack of prerequi- • Create an enabling environment for risk-sharing–based
sites for Islamic fund mobilization. • Establish organizations that utilize asset- based and equity-based financing (leasing com-
finance based on • Ensure the level playing field for risk-sharing–based panies, venture capital firms, private equity firms, crowd-funding platforms, and the like).
risk sharing finance by eliminating the relevant legal and regulatory • Improve the quality of corporate governance to support firm’s long-term viability and
impediments as well as the debt-equity tax bias. financing.
• Reorient institutional environment to support asset- and • Consider providing risk mitigation mechanisms such as risk-sharing public-private part-
equity-based long-term financing. nerships that enhance long-term investment prospects.
• Strengthen the information infrastructure to enhance • Improve skills to manage long-term risks.
credit market information on long-term projects.
Market failures and • Change regulatory and tax regimes to create a level play-
• Develop efficient products that promote long-term savings and investment.
policy distortions ing field for debt and equity.
• Create incentives that promote equity- based long-term financing.
• Create credit information schemes to assess the credit
7
• Strengthen accounting and disclosure rules, internal and external auditing systems,
history and ratings of firms and individuals.
corporate governance, auditing systems that verify Sharīʿah compliance, and Sharīʿah
• Create incentives to promote long-term savings.
compliance screens.
• Provide guarantees and risk insurance to reduce uncer-
tainty related to long-term investments.
Financial education • Improve financial literacy of Islamic financial products • Highlight the benefits of long-term risk-sharing modes to both investors and financial
and consumer for entrepreneurs and households. institutions.
protection • Strengthen the legal and institutional environment for
contract enforcement protecting investors’ rights.
Underutilization of • Develop innovative solutions to re-invigorate the Waqf sector for investing in long-term
• Reform the legal and regulatory environment to support
the Islamic social projects.
long-term investment in the Islamic social sector.
sector
NextGen Islamic • Develop an enabling regulatory framework to ensure the • Develop financial institutions reflecting the broader goals of serving the economy, soci-
finance smooth functioning of Fintech markets. ety, and the environment.
• Establish educational institutions to develop adequate • Develop innovative fintech-based financial institutions to provide diverse financial
knowledge and skills exist on Islamic finance in general products.
and capital markets and institutions in particular.
• Promote innovation by providing supporting institutional
set-ups.Overview of the Chapters myopia, macroeconomic instabilities, and high en-
try barriers, among other impediments. The supply
The report consists of two parts. The first part, cov- of long-term investment financing is constrained by
ering chapters 1 to 4, constitutes the theoretical the lack of adequate risk assessment frameworks;
background by providing discussions on the signifi- weak legal and institutional frameworks; and il-
cance of long-term finance, policy challenges, and liquidity and investors’ short-termism, which are
recommendations to address these issues, as well main obstacles in the way of the efficient allocation
as an investigation of the effectiveness of the Is- of savings and capital.
lamic finance framework in promoting financing for
long-term investments. The second part, covering The chapter deals with the issue of sustainability
chapters 5 to 9, is derived from the selected papers in long-term investment financing. It criticizes cur-
presented at the 2nd Annual Symposium on Islamic rent financial systems, which are characterized by
Economics and Finance: Developing Long-Term financialization, and the supply of a narrow range
Financing and Islamic Capital Markets, jointly or- of debt-based instruments that transfer risk, such
ganized by the World Bank and the Islamic Devel- as bank credit and bonds, by entities that lack com-
opment Bank and Guidance Financial Group in Ra- mitment to long-term horizons. As a viable alterna-
bat, Morocco on December 8−9, 2016. tive, the chapter proposes risk-sharing long-term
finance. Risk sharing can provide the necessary fi-
Chapter 1 discusses the importance of long-term nancing without the need to take on excessive lever-
financing in driving sustainable economic develop- age, which could in turn help stabilize government
ment and helping in structural transformation, infra- spending and reduce debt servicing pressures. Un-
structure investments, and budgetary support. Esti- like other modes of finance, risk sharing is favorable
mates of long-term investment financing needs vary to long-term impact financing made in companies,
considerably and are not necessarily precise. How- organizations, and funds with the aim of generat-
ever, studies conclude, unanimously, that needs are ing social or environmental benefits alongside (or
extremely large and are unlikely to be met by the instead of) a financial return. Sharing the risks of
public sector alone. Capital from the public, private, economic and financial transactions also ensures the
and voluntary sectors must be mobilized to fill fund- stability of the financial system. This in turn will in-
ing gaps. crease the allocation of resources to the real sector,
rather than channeling excessive financial flows to
Mobilization efforts are faced with various impedi- the financial sector, leading to over-financialization
ments with respect to both systemic factors and the of the economy.
usual demand and supply factors. The 2007−09
global financial crisis exposed flaws in finance theo- Risk sharing is one of the most important aspects of
ry and current practices and highlighted the need to Islamic finance. The chapter provides a theoretical
revisit some conceptual frameworks. Most notably, framework for acquiring long-term investment from
the chapter considers the financial infrastructure, an Islamic finance perspective. In a truly risk-shar-
peripheral supporting institutions, and legal envi- ing framework, Islamic finance can serve the real
ronment and finds that they reinforce bias toward sector of economy more effectively in an equitable
debt and risk transfer mechanisms, inducing over- and sustainable manner than conventional finance.
leverage and short-termism in the current global fi- Indeed, the vision of Islamic finance is to offer itself
nancial system. as a source of stability against the plight of overlev-
erage and short-termism in the current global finan-
The demand for long-term investment financing by cial system.
project planners is constrained by the availability
of financially viable long-term projects, political
8Chapter 2 empirically investigates the effective- Chapter 3 presents an overview of developments
ness of elements of the Islamic finance framework and challenges in the Islamic financial sector. It
put forward in chapter 1 in promoting financing for does so by analyzing the development in various
long-term investments. These elements are used to sectors of Islamic finance, with a special focus on
characterize a well-functioning financial system as risk-sharing and long-term financing aspects, where
one based on appropriate governance mechanisms, possible. At present, the bulk of Islamic finance is
supporting infrastructure that enhances risk-sharing, provided by Islamic banks. The future of long-term
and institutional arrangements that promote trust Islamic funding depends very much on the devel-
and cooperation. This comprehensive approach of- opment of non-bank financial intermediaries. These
fers a more functional view of a long-term sustain- include Islamic capital markets, Takāful markets,
able financial system than the narrow focus on tra- other institutional investors such as pension funds,
ditional one-dimensional proxies, such as the depth sovereign wealth funds, private equity funds, and
of financial markets. Awqāf (endowment funds). The long-term nature
of many of these non-bank financial intermediaries
The investigation depicts and compares the relative means that they can act as shock absorbers in many
state of member countries of the OIC with respect to financial markets.
the rest of the world in terms of broader challenges
in creating an enabling environment for long-term Awqāf are currently underutilized. They have the
financing. The chapter’s findings validate the hy- potential to engage the private sector and become
pothesis that financing based on risk-sharing princi- a systemic approach to overcome the shortages in
ples promotes long-term investments. The strength long-term financing. Awqāf are rich in one of the
of the presence of Islamic finance in a country important factors of production—land—as they in-
(measured by the share of Ṣukūk issuance and Is- volve the donation of a building, plot of land, or oth-
lamic banking in GDP) is positively correlated with er real assets. However, they are short on other fac-
the financial development index. tors such as capital, labor, and organization. Given
that the problem of long-term financing is not sim-
To assess the relative status of OIC countries with ply of time, but is also a problem of size and scale,
respect to long-term financing compared to their Awqāf may well be used to alter projects’ cash flows
counterparts, two proxies are used. The first proxy by providing a factor of production of significant
is the percentage of firms citing the maturity of value, so as to reduce the otherwise large upfront
loans as insufficient. The second proxy is fixed as- cost and make the project a viable business case for
set investment. the private sector.
With respect to the first proxy, the chapter finds that The chapter examines recent innovations in financial
firms in OIC countries are more likely to be denied technology (fintech)—such as “smart” contracts,
financing on the basis of the size and maturity of decentralized autonomous organizations (DAOs),
their loan application. Small firms are more vulner- block-chains, crypto-currencies, and crowd fund-
able than their counterparts in this regard. ing—that are closer to the spirit of Islamic law of
contracts, with an undiluted focus on cooperation,
With reference to the source of investments, small transparency, and avoidance of any kind of uncer-
and medium firms tend to prefer internal funds. tainty regarding the settlement of contracts.
Use of external finance, such as banks, seems to
be weaker in OIC countries compared to non-OIC Given the complexity and multidimensionality of
countries. Moreover, OIC countries lack a well-de- the challenges at hand, no single authority can drive
veloped institutional investor base. change and mobilize long-term finance alone. A
collaborative and concerted approach is needed by
9multilateral development banks and organizations. finance sector. The 2014 Mid-term Review by the
This would involve system-wide monetary, fiscal, Islamic Development Bank Group, the Islamic Re-
and structural policies to correct disincentives to search & Training Institute, and the Islamic Finan-
risk transfer that lie at the core of the current con- cial Services Board is used to gauge the status of the
ventional financial system. The recommendations business and regulatory environment, focusing on
proposed in the chapter are based on principles with key elements to promote a robust Islamic financial
universal application across geographical areas and services industry. They include:
financial systems.
• National plans and strategies for Islamic finance
In the sphere of Islamic finance, efforts to mobilize • The legal framework
significant funding for investments with a long-term • The regulatory framework
horizon are impeded by the dominance of the Is- • The Sharīʿah governance regime
lamic banking subsector; the lack of prerequisites • Liquidity infrastructure
for risk-sharing-based Islamic finance—including • Deposit insurance schemes
well-functioning institutions and rules of behavior
that protect investors, creditors, and property rights; On average, OIC member countries score better
trust in government and institutions; rule of law; than the world average in the Doing Business scale
good governance; and a developed financial sys- and lower than the world average in terms of their
tem; market failures and policy distortions; lack of regulatory environment.
awareness of the full cost of risk transfer; and unde-
rutilization of the Islamic social sector as an area of Drawing on the report’s discussions and findings,
long-term investment. the chapter concludes by providing a roadmap for
supportive public policy, a sound enabling envi-
Chapter 3 identifies a number of areas in which ronment, and conducive financial infrastructure to
policy interventions are needed to shift away from strengthen Islamic finance and provide appropriate
overreliance on short-term instruments toward add- incentives for long-term financing. The full spec-
ing economic value through a complete spectrum trum of necessary policy reforms extends beyond
of Islamic financial instruments and unlocking banks to include institutional investors, Islamic cap-
of maturities. The empirical analysis in chapter 3 ital markets, the Islamic social sector, and Islamic
lends support to this proposition. It indicates that a fintech. Policy makers are strongly urged to consid-
country characterized by better governance struc- er the impact of any policy regime on the incentives
ture comprising a sound regulatory and supervisory of different types of investors to participate in the
framework, rule of law, strong institutions, and an long-term financing market before implementing
effective government is more likely to issue long- that policy. Deliberation is necessary to avoid the
term Ṣukūk than short-term or medium-term Ṣukūk. pitfalls of some of the existing standards and regu-
lations, which are unintendedly detrimental to long-
Chapter 4 presents an overview of the overall sta- term investments.
tus of the business and regulatory environment in
the OIC member countries. It also discusses the spe- Most of the solutions proposed in the conventional
cific status of some key legal and regulatory infra- finance literature to overcome short-termism of fi-
structure institutions in a sample of 12 OIC member nancing deal only with creating new products, ener-
countries (Bangladesh, the Arab Republic of Egypt, gizing dormant players (such as revitalizing pension
Indonesia, Malaysia, Nigeria, Oman, Pakistan, Sau- funds and activating institutional investors), and im-
di Arabia, Senegal, Sudan, Turkey and United Arab proving the quality of institutions and governance.
Emirates) representative of different geographical
regions and the levels of development of the Islamic
10These measures will definitely help in extending the member countries that would satisfy the objectives
tenure of available financing, but they are not suf- and mandates of both the Islamic financial institu-
ficient. Similar policies are often recommended for tions and SWFs, while significantly contributing to
the Islamic finance sector. This recommendation is the economic prosperity of these economies in the
also beneficial, as approximately the same forces both the short term and long term.
that can help long-term investments in conventional
finance can help enhance long-term finance in Is- Chapter 6 sheds light on the potential of Islamic
lamic financial sector. crowdfunding for long-term financing. It is evident
However, these recommendations do not go far that economies have recently been constrained by
enough. Islamic finance has much greater potential tightening access to finance amid growing need for
to increase the proportion of sustainable long-term long-term investments. It is evident that countries
finance if a culture of risk sharing and equity financ- have recently been bound to face with incremental
ing is developed and the institutional environment challenges to close the funding gap amid growing
is improved. need for long-term investments vis-a-vis tightening
access to finance. New collective funding methods
Chapter 5 discusses sovereign wealth funds such as crowdfunding could provide solutions to the
(SWFs) in the context of Sharī’ah-compliant long- challenges in mobilizing long-term funds. Current
term infrastructure finance. The chapter provides demand for crowdfunding is high and crowdfund-
an overview of SWFs, as well as stylized facts and ing is increasingly viewed as an alternative invest-
trends in this segment. In addition to their transac- ment portfolio for investors to invest their surplus
tions, the chapter presents a sectoral analysis of SWF funds in specific projects. Providing the conceptual
investments. The chapter suggests that SWFs could framework of crowdfunding as a tool for SMEs
play a significant role in providing infrastructure and infrastructure development—particularly in the
financing because, at least theoretically, infrastruc- form of Waqf land—this chapter attempts to dis-
ture investment matches the profile of institutional cover the viability of crowdfunding, including Is-
investors such as SWFs. First, it matches the long- lamic crowdfunding, as a long-term investment in-
term duration SWFs’ liabilities, which can provide strument and source of portfolio diversification for
duration hedging. Second, it provides significantly investors. Crowdfunding takes advantage of crowd-
more attractive yields, exceeding those obtained based decision making and innovation and applies
in the fixed income market, although with more or it to the funding of SMEs project and infrastructure
less the same level of risk and volatility—and per- development. This mode of raising initial capital
haps even less. Third, investments in infrastructure has proven to be feasible in various countries. The
assets linked to inflation could hedge the fund li- potential of this mode to be as an alternative tool for
abilities of some SWFs with pension mandates long-term financing in Muslim-majority countries is
that are also linked to inflation. Therefore, SWFs great.
originating from Islamic countries should be invited
and encouraged by their governments to invest in Chapter 7 discusses the use of Ṣukūk in infrastruc-
Sharī’ah-compliant infrastructure funds established ture financing, particularly in PPP projects, while
by either the sovereign or public or private inter- highlighting the challenges in raising funds for in-
national financial institutions. After showing that frastructure projects through Ṣukūk issuances, and
SWFs around the world have mainly been shying measures to overcome these issues. This chapter
away from infrastructural investments, this chapter explores the reasons behind the underdevelopment
argues that the collaboration between Islamic fi- of Ṣukūk in financing infrastructure projects—even
nancial institutions and SWFs could provide a ripe though Ṣukūk are considered to be one of the instru-
opportunity for Sharīʿah-compliant public-private ments that might be highly efficient in mobilizing
partnership (PPP) infrastructure investments in OIC resources to finance infrastructure projects. In this
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