Keynote speech delivered at the Seventh Islamic Finance Expo and Conference, Karachi, August 2, 2018.
While it has long been practiced in some Muslim countries for centuries, Islamic Finance (IF) emerged on the world scene in a more substantive manner in the last four decades or so. Its rise was partly linked to the accumulation of financial wealth in the oil-rich Gulf countries since the 1970s and partly to the increase in global prosperity which has raised the financial savings of many among the 1.8 billion people in the world who are Muslim. By emerging in a more substantive manner, I refer to the growth of national and international banks and capital market entities based on IF principles and the establishment of an international regulatory structure for these entities.
By now, about 130 countries feature some financial transactions based on IF principles while about 10 countries have IF banks accounting for a significant share of their financial systems. Among these countries are Malaysia, Bahrain, UAE, Oman and Pakistan. In Malaysia, the share of IF in the total banking system is close to 25% while in Pakistan it is close to 15%.
However, despite signs of emergence in many countries and substantial presence in some countries, the IF component remains a miniscule part of global finance. Recent estimates put total IF assets globally at $2 trillion or less than 1% of the global financial assets stock of $250 trillion. 
This is especially puzzling in the wake of the global financial crisis of 2008-09. That crisis involved excessive risk-taking by conventional banks and finance companies related to investments made in the real-estate sector using complex derivative financial instruments. It is widely recognized now that certain aspects of the conventional financial system and its regulatory oversight allowed such excessive risk-taking to occur, throwing the global economy into a prolonged period of recession and stagnation.
In contrast to the conventional finance system, the IF system provides a bias in favor of financial stability. Recall that IF principles prevent lending on the basis of fixed rates of return and so do not allow for conventional bonds or bank loans. IF financial advances are based on risk-sharing where the return comes from profits of the underlying business. All IF financial advances are linked ultimately to some real economy asset and there is no room for financial engineering where some instruments are linked solely and entirely to other financial assets.
Why did the IF system not grow more substantially in the wake of the global financial crisis in the last ten years or so? Why, despite their clear and strong bias in favor of financial stability, were IF principles not more substantially incorporated into the revised architecture and regulatory framework that arose in the post-crisis period? This is a puzzle well worth exploring.
I come now to another issue. By most accounts, the pattern of lending in which IF institutions have engaged in the last four decades or so mimics that of conventional finance institutions. By this I mean that IF institutions have also shown a strong preference for avoiding long maturities (such as would be involved in infrastructure financing) and for lending minimally to perceived risky sectors such as SMEs, agriculture and low-income housing. And, when asked what policy changes they would like to see in Pakistan, IF managers inevitably ask for access to government paper under sukuk arrangements. In other words, they would like access to risk-free assets just like their counterparts in the conventional finance segment. They are just as keen to take the easy path of investing in risk-free government paper and no keener to finance national development priorities than their counterparts in conventional finance.
The risk-sharing basis of all IF instruments would have suggested a greater role in, say, long term infrastructure finance than has turned out to be the case. While the asset-deposit ratio of IF banks tends to be higher than that of conventional banks (67% versus 51% in Pakistan, for example), the type of assets involved tend to be short-term in maturity. IF can be thought of as the closest thing the banking system has to venture capital arrangements. However, it does not seem like IF banks are delivering on their potential in this area.
This is the context that explains the title of my brief talk today. The Islamic Finance venture is reasonably well established in a number of countries but the glass is no more than half full in terms of meeting expectations.
1Reported in I. Husain, Financial Stability and Islamic Finance, IBA-CEIF Working Paper Series, 2018/01.