Regulating Islamic Finance in Emerging Market Economies

Saturday, June 25, 2016: 10:45 AM-12:15 PM
87 Dwinelle (Dwinelle Hall)
Fulya Apaydin, Institut Barcelona d'Estudis Internacionals, Barcelona, Spain
Over the past few decades, financial globalization exposed countries in the Global South to greater market risks, which were further accentuated by the 2008 crisis. However, in Muslim-populated countries, Islamic banks stand out as exceptional cases with stronger asset quality (Beck 2013) and higher liquidity, increasing profits and a growing consumer base even when international markets came to the brink of collapse. While the proponents of Islamic banking suggest that the faith-based codes (Shari’a) on economic transactions such as mutual risk-sharing, the ban on interest and contractual ambiguity explain this relatively solid performance, critics suggest that Islamic financial tools are nothing more than baptized versions of conventional banking instruments (Kuran 2006, El-Gamal 2009, Bassens 2012) and highlight diversities in their capacity to weather systemic risks (Ahmed 2013).

This paper seeks to move beyond unreservedly optimistic or gloomily pessimistic accounts of the Islamic Financial Institutions (IFIs) by focusing on the regulatory environment that governs these actors by problematizing variations in their risk-taking behavior. An initial glance at IFIs reveals that they are far from demonstrating universal immunity to growing market instabilities and vary in their responses to shocks depending on the institutional context. Recent accounts highlight the deployment of new products with varying risk-levels, point out notable contrasts in their composition across the IFIs and cite contestation over the Shari’a compatibility of these instruments among Islamic jurists and scholars. The diversity of these findings presents an intriguing puzzle. What explains variations in the risk-taking strategies of IFIs in the aftermath of the 2008 crisis? More generally, under what circumstances do faith-based limitations on financial transactions reinforce or enfeeble bank capacities to accommodate systemic risks?

In developing an answer, this paper adopts a political-economy framework, paying a closer attention to the institutional framework in which IFIs operate across three illustrative cases: Malaysia, United Arab Emirates, and Turkey. Specifically, the paper unpacks political and religious institutions that frame financial exchanges and reveals how they have a notable impact on Shari’a-compatible product design and trading. While religious authorities (such as Shari’a board members) play a central role in the approval of new financial tools, the framing of halal risks are not only constrained by varying interpretations of religious codes but also shaped by autonomous and/or non-autonomous regulatory bodies that oversee these activities. More specifically, political institutions, including autonomous or non-autonomous regulatory bodies, define investor and consumer rights, oversee financial exchanges (i.e. by establishing liquidity and foreign reserve requirements, approving financial products or defining the terms of market exchanges), lay out conflict-resolution mechanisms and generally set the tone of domestic market stability. Religious institutions, like Shari’a, define the terms of how IFIs make profits without using interest and speculation, and impose limitations on how they engineer and trade new products, among others. Yet, not all countries that accommodate IFIs have National Fatwa Councils authorized by the State to oversee their activities. For example, while IFIs in Malaysia operate within a system where officially recognized religious and secular institutions together regulate IFIs, Islamic banks in Turkey are exclusively bounded by secular laws while other countries like UAE rely on Shari’a inspired principles under a civil framework. In that sense, the interactions between Islamic banks and the distinct contexts they are embedded in are likely to yield distinct set of incentives to IFIs in structuring their assets.

This variation offers an important starting point to explain how incentives created by these institutional configurations may enhance or moderate IFIs’ appetite for risk-taking in the post-crisis period. First, we expect a mixed legal framework characterized by the presence of formal secular and religious codes to provide opportunities for controlled risk-taking. Under these circumstances, contesting definitions of morally acceptable risks among rival Shari’a experts, Muslim intellectuals and secular proponents may push these actors to reach a common ground regarding the interpretation of Islamic codes. This may simultaneously encourage a controlled financial innovation process and explain why modern variants of Sukuk made a debut in Malaysia.

In settings characterized by the absence of formal and institutionalized Islamic regulatory agencies, however, Islamic banks may turn into ambitious risk-takers. Specifically, in liberalizing financial markets where competition over product design and investment faces no official barriers informed by faith-based codes, IFIs may accommodate products with more erratic risk prospects. Under these circumstances, banks with lower profit margins are expected to welcome greater risks and opt for a more relaxed interpretation of religious codes, especially when their expected profit margins remain below the targeted levels. A good example to this would be the case of Ihlas Finans in Turkey, where low-profit levels of this bank pushed it to adopt more risky strategies that drove it to bankruptcy during the 2001 Turkish financial crisis.

However, the presence of informal institutions that govern Islamic financial exchanges under a non-religious framework may have a moderating effect. For example, IFIs in the UAE are subject to same regulations as conventional banks, and the UAE courts are generally not compelled to take the Shari’a pronouncements into consideration when determining a case in case of a dispute. However, in most cases, UAE law is very much informed by Shari’a and reflects its core guiding principles. Under these circumstances, IFIs are informally bounded by customary practices that caution against excessive reliance on exotic variants. This may impose additional limitations on their investment strategies and encourage IFIs to prefer less risky Shari’a compliant products while avoiding highly disputed contracts and financial tools. 


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El-Gamal, M.A. 2009. Islamic Finance: Law, Economics, and Practice. Cambridge: Cambridge University Press.

Van Greuning, H. and Z. Iqbal. 2007. “Banking and the Risk Environment.” in S. Archer and R.A.

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Kuran, T. 2006. Islam and Mammon: the Economic Predicaments of Islamism. Princeton: Princeton University Press.