An IMF Working Paper entitled “Islamic Finance, Consumer Protection, and Financial Stability” by Inutu Lukong has been released. This is relevant because Islamic finance is growing rapidly in value and geographical reach. The banking sector is now systemically important in a dozen countries and growing in many other countries.
Consumers of Islamic financial products have increased to critical proportions, thus consumer protection frameworks that cater to the specifics of Islamic financial products should be an integral part of regulatory frameworks in countries where the industry exists. Although still a small share of global finance, Islamic finance is growing rapidly in value and geographical reach. The banking sector is now systemically important in a dozen countries and growing in many other countries. By end December 2013, consumers of Islamic banking products were estimated at 30 million (Enerst and Young (2013)). The Sukuk market has also registered phenomenal growth; the structures have become increasingly complex; and the issuer base has broadened to include advanced, emerging market and developing countries on one hand, and sovereigns and corporates on the other. The growing complexity of products can make it difficult for consumers and investors to discern risks while the broadening of issuers exposes investors to differing counterparty risks.
In the aftermath of the global financial crisis, many countries integrated consumer protection in their regulatory frameworks, but progress has been uneven across countries and few have tailored the frameworks to address the unique risks of Islamic finance. A number of international bodies, including the Islamic Financial Standards Board (IFSB), the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI); and the International Islamic Financial Market (IIFM), have issued standards to cater to the specifics of the Islamic finance industry, but adoption of the standards has been uneven across countries and the development of standards is still evolving.
This paper aims to contribute to ongoing efforts to strengthen the architecture for consumer protection in Islamic finance as part of the broader effort to safeguard the sound development of the sector. Outside the work of the regulatory bodies, research on the protection of consumers of Islamic financial products is limited and remaining gaps in the regulatory architecture for consumer protection in Islamic finance have not been assessed. The few studies on consumer protection in Islamic finance include the paper by Mamhood [2012] which analyzed the prospects of extending an Investor Protection Framework to the Islamic Capital Market in Malaysia; the IFSB [2013] paper that analyzes product regulation that could foster stronger protection for consumers of Islamic financial products; and the IFSB/IOSCO [2013] joint review on issues, risks and challenges arising from potential inadequate disclosure in the areas of Sukuk and Islamic Collective Investment Schemes.
The paper focuses on Islamic banking products and Sukuk, which together account for 95 percent of the Islamic finance industry. It highlights sources of information asymmetries that can result in consumers making uninformed decisions, as well as potential avenues for consumer exploitation in the design of Islamic financial products that could affect the sound development of the industry. It also evaluates the adequacy of current legal and regulatory frameworks for consumer protection, and discusses policy options for strengthening them. The analysis is based on the experiences of a sample of countries, including Bahrain, Egypt, Iran, Jordan, Kuwait, Lebanon, Malaysia, Oman, Qatar, Saudi Arabia, Sudan, the United Arab Emirates, the United Kingdom and Yemen.
The main conclusions of the paper are that Shar’iah principles, which govern Islamic finance, provide a strong foundation for consumer protection, but the features alone cannot guarantee adequate protection for consumers, because not all providers are motivated by ethical precepts, and the practice sometimes deviate from the principles. Consumer protection frameworks for conventional financial products are relevant to Islamic finance, but they need some adaptation to address risks specific to Islamic financial products. In particular, reforms are needed to address consumer vulnerabilities from current practices with respect to Profit Sharing Investment Accounts (PSIA), Ijārah Muntahia Bittamlīk, and conventional deposit insurance schemes as well as to address the legal risks for investors in Sukuk, particularly in cross border default cases.
Note that IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management.
