Islamic Banking in Africa: Accelerating Financial Development and Growth?

Oct 21, 2011
Africa remains one of the least developed, and the most under-banked continent. This is not a coincidence, and reflects the importance of banking as an engine for economic development. Financial institutions stimulate growth, by promoting savings, by allocating capital efficiently and by helping risk diversification. But finance can also reduce poverty, by facilitating access to deposits and allowing individuals to take advantage of opportunities which require upfront costs. This could be in the form of allowing entrepreneurs who lack funding to launch their own businesses. Conventional banking has shown some limitations in adapting to the low-income environment. Access to finance is limited as borrowers often lack collateral against which they can borrow. When collateral is available, the lack of an efficient judiciary and well-defined property rights may hinder conventional banking from recouping the collateral in case of a failed venture. In addition, from the poor’s point of view, a failure of a loan could lead to a poverty trap from which it may be difficult to rebound. In such circumstance, if borrowers have a high level of risk aversion that discourages risk-taking, lending may also not take place.

In such an environment, Islamic banking has the potential to accelerate financial development. It seeks to provide financial services compatible with Islamic teaching, by reducing some of the risk elements of borrowing. Interest payments are prohibited for instance. In addition, even when banks provide all the financing, both borrowers and lenders share the risk of failure and success, creating a shock-absorbing mechanism that is essential to encourage risk taking. As African countries tend to be undiversified, commodity producing countries subject to boom-bust cycles and the vagaries of nature, such a form of borrowing that takes into account the inability for individuals to take on too much risk might stimulate investment and growth more than traditional banking. The relative stability, and continued growth of Islamic banking during the global financial crisis attests to its resilience and potential. In addition, Islamic banking promotes increased financial intermediation, as it satisfies the needs of devout Muslims, encouraging savings. Against this background, in our study (1) we have analyzed econometrically how Islamic banking has diffused throughout the World and drawn policy implications to accelerate its progress. With African home to one of the largest Islamic population, accounting for a little more than 40 percent of the population, Islamic banking could become a key engine for financial deepening. During the last decade, Islamic banking has grown from a niche market into a mainstream industry in many African countries. Within Africa,regional variations are visible, with Islamic banking having diffused more rapidly in Northern Africa—a region that is predominantly Muslim—than in the regions that have sparser Islamic populations such further south the continent. From Senegal to Kenya, and Mauritius, Islamic banks are being licensed across the continent, without major changes to existing banking regulations. The study finds that the probability of increased Islamic banking in a given country rises with the share of Muslims in the population, income per capital, the price of oil and macroeconomic stability. Proximity to Malaysia and Bahrain, the two main Islamic financial centers, and trade integration with Middle-Eastern countries also make diffusion more likely. Interest rates negatively affect the diffusion of Islamic banking, reflecting the implicit benchmark they pose for Islamic banks. Some results were more surprising. Islamic banks spread more rapidly in countries with established banking system. Islamic banks offer products not delivered by conventional banks and thus complement, rather and substitute for conventional banks. The quality of a country’s institutions, such as the rule of law or quality of bureaucracy was not found to statistically explain the diffusion of Islamic banking, unlike conventional banking. Because Islamic banking is guided by Shariah, it is largely immune to weak institutions: disputes can be settled within Islamic jurisprudence. Finally, contrary to conventional wisdom, the 9/11 attacks were not an important factor in the diffusion of Islamic banking. These events simply coincide with rising oil prices, which appear to the actual driver of Islamic banking diffusion (2). The research findings imply that Islamic banking can help accelerate financial development and growth throughout the continent. With the Muslim population expected to reach about 650 million by 2030 (3) —a large share of which will be unbanked—combined with ongoing macroeconomic stability, a low interest rate environment andan institutional setting that needs to be strengthened, the African region has the potential to become a fertile ground for Islamic banking development. However, more needs to be done to raise per capita income through structural reforms and strengthen trade ties with Middle-Eastern countries. Islamic banking diffusion could stimulate financial development and improve access to financial services, thereby spurring growth. However, it is nota panacea; developing Islamic banking is only part of an overall and well-coordinated policy package designed to achieve sustainable growth and poverty reduction. Kangni Kpodar is an economist in the Fiscal Affairs Department at the IMF, with a PhD in economics from the CERDI (Clermont-Ferrand, France). His research interest focuses on financial development, growth and poverty issues. Patrick Imam is an economist in the Monetary and Capital Markets Department at the IMF, with a PhD in economics from Cambridge University (Cambridge, UK). His research interest encompasses capital markets and financial stability. (1) Patrick Imam and Kangni Kpodar, 2010,“Islamic Banking, How Has it Diffused”, IMF Working Paper No.195
(2) Although high oil prices are found to stimulate Islamic banking development, they are likely to hurt nonoil exporting countries in Africa, offsetting the potential benefits Islamic banking development may bring to economic growth.
(3) Pew Research Center (2011)

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