Islamic Finance

Introduction

Islamic finance has established itself on the global financial system, with total assets under management around $1.7 trillion, while maintaining a double-digit annual growth rate even amidst financial crisis and political turmoil (EY, 2016). The fast growth of the sector and its differences from the conventional one have spurred interest from practitioners and academics alike.

Islamic finance refers to these financial institutions where practices emanating from the Islamic law (Shariah) are accommodated into the business model. The prohibition of interest and speculative activities, the shunning of investments in industries that are considered unlawful - alcohol, gambling and tobacco to name but a few – as well as investments in complex derivative products, debt instruments and short-selling are some of the most commonly acknowledged restrictions. As a consequence, Islamic financial institutions use two types of financial products: equity/participation type and fee-based services. Mudarabah is a commonly used equity/participation type of contract where an investor (usually an Islamic bank) and an entrepreneur (individual or institutional) enter a joint venture with the bank providing the necessary funds, the entrepreneur the know-how, and they agree to share the profits on a pre-determined ratio. Fee-based services include the widely used contracts of Murabahah and Ijarah. Murabahah is in essence a cost-plus-profit sale. The bank arranges to sell a good to a customer at a premium which incorporates risks, costs and a profit margin. Ijarah is a lease contract where the bank leases an asset to an investor (or consumer) and the latter pays fees for utilizing the asset.

Despite their restrictions and unique model, Islamic banks are considered as more profitable (Bitar, Madiès, & Taramasco, 2017; Hasan & Dridi, 2011), featuring superior asset quality and capitalization (Beck, Demirgüç-Kunt, & Merrouche, 2013), of similar risk profile to their conventional counterparts (Abedifar, Molyneux, & Tarazi, 2013; Baele, Farooq, & Ongena, 2014; Čihák & Hesse, 2010; Pappas, Ongena, Izzeldin, & Fuertes, 2017), and of higher technical efficiency (Bitar, Hassan, & Walker, 2017; Johnes, Izzeldin, & Pappas, 2014).¹ Like conventional banks, Islamic banks are also affected by economic shocks albeit in a more muted manner (Di, Shaiban, & Shavkatovich Hasanov, 2017; Olson & Zoubi, 2017), a fact that regulators should be wary of. Contrary to the conventional perception that firms are more likely to connect to a bank that is close by, firms wishing to connect to an Islamic bank are willing to do some extra sacrifices in terms of distance (Beck, Ongena, & Şendeniz-Yüncü, 2019), which may have important implications for Islamic bank branching strategies.

The distinct profile of Islamic banks, and Islamic finance in general, is of particular relevance to investors, as it enhances their diversification opportunities particularly during financial crises, as documented in Akhter, Pappas and Khan (2017), Alexakis, Pappas and Tsikouras (2017), Sorwar, Pappas, Pereira and Nurullah (2016) among others. Yet these benefits may be limited in countries where Islamic stocks may be particularly responsive to economic shocks due to religious restrictions on conventional stock trading (Alhomaidi, Hassan, Hippler, & Mamun, 2019). It is also argued that the performance of Islamic and conventional stock returns can create segmented financial markets consistent with investor recognition effects that grant Islamic stocks higher liquidity, lower risk, better integration with macroeconomic factors and higher systematic turnover (Alhomaidi et al., 2019). The presence of Islamic banks has important implications for the financial development and economic welfare of, particularly low income, countries (Abedifar, Hasan, & Tarazi, 2016), a fact which may be in part explained to the higher liquidity creation of these banks (Berger, Boubakri, Guedhami, & Li, 2018).²