KUWAIT CITY - The fast growing, Sharia-compliant Islamic finance industry has the potential to promote financial stability because of its risk-sharing and asset-backed features, International Monetary Fund managing director Christine Lagarde said Wednesday.

“Islamic finance has, in principle, the potential to promote financial stability because its risk-sharing feature reduces leverage and its financing is asset-backed and thus fully collateralized,” Lagarde told an Islamic finance conference in Kuwait. Islamic banks also offer profit-sharing and loss-bearing accounts that can help mitigate losses and contagion in the event of banking sector distress, she said.

“This leads to higher total loss-absorbing capital, one of the key objectives of the new global regulatory reform,” Lagarde told the one-day event organised by the IMF and Central Bank of Kuwait. But she said that for the industry to unlock its full potential, it must expand its customer base, harmonise standards and improve regulatory frameworks.

Lagarde later told a press conference the IMF will increase its involvement in the Islamic finance industry by providing more bilateral surveillance and analytical help. The Islamic finance industry, which bans speculation and interest, still lacks effective regulatory and supervisory frameworks catering to its unique risks. It also bans dealing in products with excessive uncertainty, gambling, short sales and financing prohibited activities considered harmful to society.

Lagarde said Islamic assets have crossed the $2 trillion mark and has the potential to grow much larger. Around 40 million of the world’s 1.6 billion Muslims are clients of the Islamic finance industry, which has surged in popularity since its niche market days of the early 1970s.

Kuwait’s Central Bank governor Mohammad al-Hashel said Islamic finance can offer a system based on strong principles and social justice. “A system, which if implemented in its true spirit, will bolster growth, create jobs, reduce poverty and address inequality,” Hashel said.

He said the Islamic system channels credit into productive investments that are socially responsible and not in wasteful speculative activity. The objective is to create a system that is “ethically right, socially just, financially stable and economically productive”, Hashel said.

Officials and experts, however, acknowledged that the industry still faces tough hurdles, mainly setting consistent regulations for all markets. The Jeddah-based Islamic Development Bank president, Ahmad Mohamed Ali, said he believes the main obstacle is the failure to create a mega Islamic bank and the lack of sufficient tools to manage liquidity effectively.

In the meanwhile, Iraqi authorities agreed on Tuesday to have the International Monetary Fund monitor Baghdad’s economic policies as a basis for a possible funding program in 2016, the IMF said in a statement.

Mission chief Christian Josz said the Staff-Monitored Program would aim to rein in spending and reduce Iraq’s budget deficit, which is expected to approach 12 percent of economic activity next year. The move, he said, “will allow the Iraqi authorities to build a track record for a possible Fund financing arrangement.” An IMF loan would help the major OPEC oil exporter stabilise its finances as it grapples with lower oil prices and costs associated with the fight against Islamic State militants.

A senior IMF official told Reuters last month the new loan would be a “multiple” of the $1.24 billion in emergency funding which the IMF agreed to provide in July. Financial pressures on Iraq have become so heavy that Baghdad halted a plan to issue $2 billion of international bonds last month because investors were demanding too high a yield.

A big new IMF loan to Iraq would come with policy conditions, such as steps by Baghdad to reduce energy price subsidies and reform state-owned enterprises - steps which could be politically difficult. Prime Minister Haider al-Abadi is already struggling to sustain support for political reforms he announced in August aimed at reducing corruption and waste.

Josz said the IMF expected Iraq’s gross domestic product (GDP) to grow by 1.5 percent this year on higher oil production, and the current account deficit to expand to 7 percent of GDP. He predicted foreign exchange reserves, which amounted to $59 billion at the end of last month, would decline but remain high enough to cover nine months of imports through the end of the year.