Islamic finance products can enhance the financial system's stability but shortcomings in their standardisation and liquidity management must be tackled, European Central Bank policymaker Yves Mersch said on Thursday.
A lack of liquidity tools is seen as one of the key challenges to the emerging Islamic finance industry, which is worth $1 trillion, with sharia banks handicapped partly due to the limited range of products they can invest in.
Mersch said Islamic banks' lack of exposure to "opaque and complex assets" and their absence of excessive leverage should protect them from financial crises. Reliance on deposits rather than wholesale funding added another layer of stability.
"On the other hand, the asset-based and risk-sharing nature of Islamic finance can make the business model more vulnerable to second round effects of a financial crisis," added Mersch, pointing to greater exposure to downturns in the "real economy".
"Moreover, the lack of product standardisation and the missing harmonisation of Islamic standards in general pose risks to the management of liquidity," Mersch, an ECB Governing Council member, added in the text of a speech to be given at the Euro Finance Week conference in Frankfurt.
Islamic banking is overhauling rules that govern the conduct of its influential sharia advisers, with competition for investor dollars and a growing market putting pressure on the once-arcane industry to adopt clearer, more uniform guidelines.
Key to these challenges is the small number of scholars advising a growing number of banks on increasingly complex financing structures, raising issues such as transparency of rulings, independence of advisers and how to groom new scholars.
But varying sharia standards, different regulatory approaches and vast disparities in development across markets stand in the way of reforms to streamline and boost supervision, which are critical to growth.
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