This document discusses the role of Islamic finance in global financial stability. It makes three key points: 1) Islamic finance bolstered financial stability during the 2008 crisis by maintaining growth and stronger links to the real economy compared to conventional finance. 2) Challenges like improving regulation, standardizing products, and ensuring liquidity need to be addressed to further enhance Islamic finance's contribution to stability. 3) International organizations like the World Bank are working with the Islamic finance industry on knowledge sharing and establishing principles around insolvency and governance to support the continued development of the sector.

1. Global Financial Stability – The Role of Islamic
Finance
Mahmoud Mohieldin*
Managing Director
The World Bank
Presentation to the
Executive Master Class
Global Islamic Finance Forum
Kuala Lumpur, Malaysia
September 18, 2012
*Disclaimer: The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors
of The World Bank or the governments they represent. The World Bank does not guarantee the accuracy of the data included in this work.

2. Key questions
 Why does financial stability matter?
 Does Islamic finance bolster financial stability?
 How can the contribution of Islamic finance to stability
be enhanced?
 How is the World Bank engaged on this agenda?
Introduction
2


3. 3

Financial Stability Matters
 Financial sector development and wealth creation go
hand in hand.
 Poverty levels fall in countries with deeper financial
markets.
 When financial markets malfunction, they can jeopardize
hard-won development gains.
The financial sector and financial stability are essential
for reducing poverty and building prosperity.

4. 4

 Deepening financial intermediation and wealth creation
(Credit to the Private Sector as a share of GDP)
Source: World Development Indicators database, The World Bank, April 2012
Financial Stability Matters
Azerbaijan
Jordan
Afghanistan
Albania
United Arab
Emirates
Uganda
Pakistan
Bangladesh
Benin
Burkina Faso
Turkmenistan
Chad
TogoTunisiaAlgeria
Djibouti
Saudi Arabia
Senegal
Syrian Arab
Republic
Iraq
Guyana
Guinea
Comoros
Kyrgyz Republic
Kazakhstan
Cameroon
Mali
0
1000
2000
3000
4000
5000
6000
7000
8000
0 20 40 60 80 100 120 140 160 180 200
Credit to Private
Sector
% of GDP
GDP per
Capita
(Current US$)
Non-GCC OIC
Australia
AustriaBelgium Canada
Czech Republic
Denmark
Estonia
Finland
FranceGermany
Greece
Hungary
Iceland
Ireland
Israel
Italy
Japan
Korea, Rep.
Luxembourg
Netherlands
New Zealand
Norway
Poland
Portugal
Slovak Republic
Slovenia
Spain
Sweden
Switzerland
United
Kingdom
0
10000
20000
30000
40000
50000
60000
70000
0 50 100 150 200
GDP per Capita
(Current US$)
Credit to Private
Sector
% of GDP
OECD

5. Financial Stability Matters
5

Source: Levine 2012
 Deepening financial intermediation and poverty reduction
(Credit to the Private Sector as a share of GDP)

6. Financial Stability Matters
6

 Global Financial Development Report 2013:
Rethinking The Role of the State:
…. and financial systems before and during the crisis
Financial Institutions Financial Markets
0
10
20
30
40
50
60
70
80
90
100
0 10 20 30 40 50 60 70 80 90 100
Average2008-2010
Average2000-2007
Stability
0
10
20
30
40
50
60
70
80
90
100
0 10 20 30 40 50 60 70 80 90 100
Average2008-2010
Average2000-2007
Depth
Source: World Bank, Global Financial Development Report 2013

7. Leveraging and Vulnerability
7

96.4
53.0 53.0
28.1
109.0
56.7 56.7
29.1
0.0
50.0
100.0
150.0
200.0
250.0
300.0
Scenario 1 Scenario 2 Scenario 3 Scenario 4
Impact on emerging market credit due to Euro zone deleveraging as a result of the
European Banks Authority capital shortfall (€bn)
LAC
Middle East
Asia
CIS
CEE
Africa
Scenario 1 Scenario 2 Scenario 3 Scenario 4
Fraction of shortfall reached via deleveraging (%) 100% 100% 50% 50%
Fraction of deleveraging via loans (%) 100% 50% 100% 50%
Source: World Bank Global Financial Stress Watch.
 Threat of deleveraging and the global real economy

8. Islamic Finance and Stability
8

 Islamic finance is contributing meaningfully to financial
stability, by:
o ‘Keeping own house in order’ and not contributing to the
2008 financial crisis (sustained growth).
o Ensuring a strong link between the financial sector and
the real
o Boosting financial inclusion.

9. Islamic Finance and Stability
9

0
200
400
600
800
1000
1200
2006 2007 2008 2009 2010
US$billions
Global Shariah-Compliant Financial Assets
Banking Assets (1) Sukuk Outstanding (2) Assets Under Management (3)
Sources: (1) Deutsche Bank 2010;(2) International Islamic Financial Markets database, March 2012; and (3) Ernst and Young 2011a.
 Shariah compliant assets are showing remarkable growth

10. 10

 Link to real economy – Islamic finance:
o Encourages banks to have greater capitalization.
o Eliminates pure debt securities from the financial system.
o Calls for bank deposits to be collected on a profit/loss- (PLS)
sharing basis rather than fixed predetermined liabilities.
o Ensures a close link between the real economy and financial
sector.
o Affirms property rights and contract enforcement (honoring
of debt obligations).
o Advocates the sharing of risk and reward.
Islamic Finance and Stability

11. Islamic Finance and Stability
11

 At its core Islamic Banking warrants 100% reserve banking
Sources: Benes and Kumhof, IMF Staff Papers August 2012
(1) Much better control of a major source of business cycle
fluctuations, sudden increases and contractions of bank
credit and of the supply of bank-created money.
(2) Complete elimination of bank runs.
(3) Dramatic reduction of the (net) public debt.
(4) Dramatic reduction of private debt, as money creation no
longer requires simultaneous debt creation.
Recent
Theoretical
Findings
A carefully
calibrated model of the banking
system in a DSGE model of
the U.S. economy, found
support for all four of
Fisher's claims.
Output gains approach 10
percent, and steady
state inflation can
drop to zero without
posing problems for
the conduct of
monetary policy.

12. Islamic Finance and Stability
12

Crisis Recovery
-40-20
0
2040
2005q1 2006q1 2007q1 2008q1 2009q1 2010q1
Islamic banks Conventional banks
 Stronger links to real economy contribute to better stability
(Average bank stock return by bank type, 2005-2009)
Sources: Beck, DemigrucKunt and Merrouche 2012
Recent
Empirical
Findings

13. 13

Islamic Finance and Stability
Post - CrisisPre - Crisis
ROA*
average (2006 – 2008)
Account at a formal financial
institution (% age 15+)**
ROA*
average (2009 – 2011)
Account at a formal financial
institution (% age 15+)**
Non OIC Countries
(72 Countries)
* Source: http://fsi.imf.org/fsitables.aspx, The International Monetary Fund, April 2012
** Source: www.worldbank.org/globalfindex , The World Bank, August 2012

14. 14

Islamic Finance and Stability
Post - CrisisPre - Crisis
Selected OIC Countries
(24 Countries)
ROA*
average (2006 – 2008)
Account at a formal financial
institution (% age 15+)**
ROA*
average (2009 – 2011)
Account at a formal financial
institution (% age 15+)**
* Source: http://fsi.imf.org/fsitables.aspx, The International Monetary Fund, April 2012
** Source: www.worldbank.org/globalfindex , The World Bank, August 2012

15. 15

Source: www.worldbank.org/globalfindex , World Development Indicators database, The World Bank, April 2012
Islamic Finance and Stability
 Islamic finance has a long way to go towards expanding
financial inclusion in OIC countries.
0
10000
20000
30000
40000
50000
60000
70000
80000
90000
0 20 40 60 80 100 120
GDPpercapita(currentUS-Average:2000-2010)
Account at a formal financial institution (age 15+)
OIC - Non GCC countries
Non OIC countries

16. 16

 Yet, relatively few Muslims report religion as a
reason for not having a formal account.
Source: www.worldbank.org/globalfindex , The World Bank, August 2012
Islamic Finance and Stability
0% 5% 10% 15% 20% 25% 30% 35%
Because of religious reasons
You don't trust them
Because someone else in the family already has an account
You don't have the necessary documentation
Too far away
They are too expensive
Not enough money to use (only)
Reasons for not having a formal account (% Muslim adults)
Note: Based on 26,506 respondents in 94 countries.

17.  Improving supervision / regulatory oversight
 Strengthening insolvency frameworks
 Promoting standardization
 Ensuring adequate liquidity for long term financing
 Establishing sound risk-management practices
Enhancing the Contribution to Stability
17


18.  Improving regulatory oversight:
18

o Progress needs to be made on improving the regulatory framework
and strengthen regulations.
o International experience points to two approaches:
 Minimal alterations: United Kingdom
 Dual approach: Bahrain and Oman
o Consensus remains to be established on a widely accepted and
comprehensive risk based supervisory approach , essential for
mitigating the risk of systemic failures.
Enhancing the Contribution to Stability

19.  Strengthening insolvency frameworks:
19

o More work is needed to ensure convergence between best insolvency
practices on the conventional and Shariah-compliant sides.
o The need to establish reliable mechanisms for dealing with Sukuk
defaults, and addressing adverse outcomes, with special adaptations for
risk sharing.
o Setting up these mechanisms requires the specification of parties’
rights under Shariah-compliant finance, especially in the case of cross-
border transactions.
Enhancing the Contribution to Stability

20.  Promoting standardization:
20

o Lack of standardization and cohesion, especially in sukuk products,
hinders the growth potential of Islamic finance
o The industry would benefit from more widely accepted benchmarks
and indices.
o Innovation and knowledge sharing between various market players
are essential to facilitate the standardization and unification of global
markets for Islamic financial products.
Enhancing the Contribution to Stability

21.  Ensuring adequate liquidity for long term financing:
21

o The divergence between fully guaranteed Sukuk by sponsors, partially
guaranteed Sukuk, and those that are not covered by any guarantee.
o Uncommon and poor understanding of various Sukuk structures limits
diversification and hinders growth potentials of the industry.
Enhancing the Contribution to Stability

22.  Establishing sound risk-management practices:
22

o Basel III compliance and concerns about liquidity risk management
need to be addressed.
o Relying on equity-based finance, Islamic banks incur a higher cost
of capital, since by definition they hold more equity than
conventional banks.
o More work is needed to find a greater convergence on the rules
governing risk weighting and the treatment of investment accounts
in Islamic banks.
Enhancing the Contribution to Stability

23.  Knowledge sharing and capacity building.
World Bank Engagement
23

o Islamic Development Bank
o IFSB
o AAIOFI
o Collaboration with research centers and universities, including:
 INCEIF
 Oxford Center for Islamic Studies
 Harvard – Islamic Finance Project – Islamic Legal Studies Program

24.  Insolvency and Corporate Governance:
World Bank Engagement
24

o Collaborating with IFSB to establish widely accepted Principles
for Effective Insolvency and Creditor Rights Systems – the
essentials of an effective insolvency regime.
o The World Bank is in the process of finalizing the Supplemental
Corporate Governance Guidelines for Islamic financial
institutions.

25.  Islamic finance contributes meaningfully to financial
stability, by:
o Growth through the 2008 crisis.
o Stronger links to the real economy.
o Diversification with greater financial inclusion.
 Key challenges need to be addressed to enhance this
contribution to financial stability.
 More research is needed to gather evidence and lay firm
foundations.
 In this way, among others, the expansion of Islamic finance
is helping development.
Conclusion
25


26. Thank You
26