Since the inception of Islamic banking about three decades ago, the number and reach of Islamic financial institutions worldwide has risen from one institution in one country in 1975, to more than 300 institutions operating in more than 75 countries.
The entire banking systems of Sudan and Iran are based on Islamic finance principles. Although Islamic banks are concentrated in the Middle East and Southeast Asia, they are also niche players in Europe and the United States. According to McKinsey & Co., Islamic banking assets and assets under management reached $750 billion in 2006, and the Islamic finance sector is expected to reach $1 trillion by 2010.
Islamic or Shariah-compliant banking provides and uses financial services and products that conform to Islamic religious practices and laws, which, in particular, prohibit the payment and receipt of interest at a fixed or predetermined rate. In practice, this means that instead of loans, Islamic banks use profit-and-loss sharing arrangements (PLS), purchase and resale of goods and services, and the provision of services for fees form the basis of contracts.
A prudential perspective
Are Islamic banks more or less stable than traditional banks? A majority of the relevant literature suggests that the risks posed by Islamic banks to the financial system differ in many ways from those posed by conventional banks. Risks unique to Islamic banks arise from the specific features of Islamic contracts, and the overall legal, governance, and liquidity infrastructure of Islamic finance.
For example, PLS financing shifts the direct credit risk from banks to their investment depositors. But it also increases the overall degree of risk of the asset side of banks' balance sheets, because it makes Islamic banks vulnerable to risks normally borne by equity investors rather than holders of debt. Also, because of their compliance with the Islamic law, Islamic banks can use fewer risk-hedging techniques and instruments (such as derivatives and swaps) than conventional banks.
Moreover, most Islamic banks have operated in environments with less developed or non-existent interbank and money markets and government securities, and with limited availability of and access to lender-of-last-resort facilities operated by central banks. These differences have been reduced somewhat because of recent developments in Islamic money market instruments and Islamic lender-of-last-resort modes, and the implicit commitment to provide liquidity support to all banks during exceptional circumstances in most countries.