Finance: Research, Policy and Anecdotes

I just attended a very interesting conference on Islamic finance in Dhahran, Saudi Arabia. For me the highlights were the paper I discussed as well as a discussion on the future of research in Islamic finance.

The paper I discussed, by Nicola Limodio, identifies the effect of deposit volatility on loan maturity using a natural experiment in Pakistan, where volatility of silver prices influences the outflow of deposits around the date of Zakat (religious donation, similar to the Christian tithe).   The author shows a dampening effect of deposit volatility on long-term lending, which results in less fixed asset investment by firms.   While one can see this as Islamic finance paper, one can also simply regard the exogeneity of the liquidity withdrawal as helpful identification strategy and the results as being applicable beyond the specific setting.  A great paper addressing an important question across the developing world (lack of long-term finance), with rather unique data (credit and corporate registry, branching map and religious composition map).

There were many other interesting papers in the conference on different aspects of Islamic finance – banking, corporate finance, household finance and regulation.   Which brings me to a more general point – the basic laws of finance – asymmetric information resulting in agency problems – hold in Islamic as much as in conventional finance.  There are some innovative solutions to the problems in Islamic finance, though also a lot of more nominal adjustment to standard financial contracts to thus make them compatible with Sharia law.  Most importantly, there is an astounding variation in Islamic finance across countries.  Many papers in the conference referred back to my 2013 paper with Asli and Ouarda on Islamic banking, but the most interesting result in this paper was for me the enormous cross-country difference in efficiency and stability indicators of Islamic vs. conventional banks across countries. To put it simply, the difference between Islamic banks in Sudan and Malaysia seems larger than the differences between conventional and Islamic banks in Malaysia. This is also consistent with other work. In recent research (with Zamir Iqbal and Rasim Mutlu) we gauged whether a higher share of Islamic banking is associated with higher consumption smoothing.  Our finding – no significant results. However, there are some weak results that a higher share of risk-sharing products within Islamic banking is associated with higher consumption smoothing. This certainly calls for a much more differentiated view on Islamic banking, going from the bank- down to the product level.

Where does the future of research in Islamic finance lie? There has been a general trend to move away from cross-country work across finance research and I think this is even more needed for Islamic finance, given the cross-country differences mentioned above.  There is a need to go down to micro-level data, for example from credit registries (such as used by Nicola, but also by Lieven Baele, Moazzam Farooq and Steven Ongena in this paper). Similarly, data from individual banks (possible one with both conventional and Islamic financial products) might be useful.  Survey data from firms and households could be explored.  Finally, randomized control trials focusing on the role of religion might be useful, as for example in this paper by Martin Kanz and co-authors.  Of course, there are still big questions to be answered – to which extent can Islamic finance contribute to financial inclusion and development and to real sector outcomes, but the future seems to be really in micro data to explore these questions.

Islamic finance is often seen as marginal field, which makes publishing papers in this area rather difficult.  However, one can see Islamic finance also in the broader context of non-profit maximizing banking across the globe.  Profit-maximizing banking is not as widespread as finance academics often assume; in Germany, for example, more than 60 percent of the banking system are either state-owned or cooperatives.  Similarly, there has been an increasing trend towards double or triple bottom-line banking around the world, taking into account both social and environmental sustainability as objectives. Behavioural constraints and effects are increasingly being recognized as important also in finance.  If one sees Islamic banking in the same vein, research on Islamic finance also moves into the mainstream of finance research rather than staying on the margins.

Overview