Prompted by rampant growth rates, the industry of Islamic finance is increasingly drawing the attention of investors, regulators and scholars. The peculiarity of Islamic financial activities is the compliance with Sharia, the Islamic law. According to Sharia’s precepts, generating revenues from money is prohibited and interest-paying arrangements are considered “riba” (aka usury). Therefore, Islamic financial institutions base their business on “risk-sharing” agreements between creditors and debtors.

Some examples of Islamic financial instruments might help clarify the functioning of this industry. Instead of classic deposit accounts, Islamic banks offer their clients “profit-and-loss sharing accounts”, which closely resemble equity ownership of a standard enterprise. A deposit in Islamic banking, thus, is not capital certain. Mortgages as well are substituted by “partnership in ownership” schemes (the so-called musharakah), for example in the form of “lease-to-own” contracts. Finally, interest-paying bonds have their Islamic equivalent in “sukuks”, i.e. financial arrangements whereby the issuer employs the proceeds to purchase an asset (e.g. a property or a commodity). The investor, on the other hand, is entitled to a predetermined share of the revenues generated by that same asset.

For its very nature, Islamic finance seems to produce a more stable financial sector. In the first place, risk-sharing features create more resilient financial institutions. In a traditional bank, asset losses (e.g. loans that are not paid back) might engender a mismatch with liabilities (private deposits that must be capital certain). Then, if financial conditions deteriorate, it could even lead to insolvency. In theory, this cannot occur in an Islamic bank, because changes of asset values entail changes in liability values: profits and losses are shared with the depositors. Furthermore, the ban on interest-paying investment has the collateral advantage of diverting capital into the real economy. This would help stemming market speculation and strengthen the link between financial intermediation and productive activities..

Both because of these advantages and the larger role played by Islamic countries in the global financial industry, Islamic finance is burgeoning. Global Islamic financial assets are expected to grow to US$ 3.8 trillion by 2022, at an average growth rate of 9.5% per year from US$ 2.2 trillion in 2016. In Europe, after the pioneers UK and Luxembourg, other countries, like Spain and Poland, are showing growing interest in Islamic finance. In fact, a broader development of the industry is thought to help European markets reduce the fragility of the Western financial system and promote a more inclusive growth worldwide. Furthermore, Islamic finance is advocated as a tool to cover the investment gap in capital-intensive public infrastructure projects.

However, stating that Islamic finance equal financial stability is not exactly true. The Islamic Financial Services Board (IFSB) in its 2017 Stability Report finds significant correlation between some macroeconomic variables and a set of surveyed Islamic banks. According to IFSB stress tests, risks of instability would be highly correlated with unemployment shocks, signalling that Islamic banks’ exposure to household/personal and retail markets might endanger bad returns in case of a downturn in the labour market. Quite tellingly, even interest rates bear stability implications for Islamic banks. Especially in dual-banking systems, financial arbitrage can threaten Islamic banks when interest rates rise, luring capital and deposits into conventional banks.

Finally, real estate prices are vulnerable spots for Islamic banks due to their strong reliance on the real estate market. These concerns are confirmed by an IMF working paper that analyses the impact of the global financial crisis on Islamic and conventional banks. Islamic banks were able to effortlessly withstand the initial wave of the crisis triggered by the subprime market breakdown but, as the crisis shifted to the real economy, Islamic banks experienced larger losses compared to their conventional peers.

Whatever stress test is performed, the real issue with Islamic finance is that it is still untested in a major Western crisis. Admittedly, a wider diffusion of Islamic financial activities across Europe would offer consumers (Muslims or not) more market choice and probably boost productive and infrastructure investment. Nonetheless, with greater participation of Islamic finance in Western financial markets, new issues of financial stability could arise, for instance increased risks of crisis contagion from the labour and real estate markets to the financial sector. The interaction between conventional and Islamic financial institutions would then require harmonised regulation and new prudential mechanisms. On the whole, Islamic finance is a promising branch of financial industry to which Western banks and intermediaries should pay more and more attention. Looking ahead, though, the panacea for financial instability risks has yet to be found.