Islamic finance—understood as achieving maximum risk sharing—diversifies risk and allows it to be shared widely. Implications that follow are: (i) a close relationship between finance and real economic activities and (ii) the rate of return to finance determined by the rate of return to real economic activities rather than the reverse. This system’s full operation leads to financial stability, growth of income and employment, and, as a result, reduction in poverty. To obtain these results, preconditions must exist, including a developed financial system; rule of law; legal institutions that protect investors, creditors, and property rights; good governance; policy discipline to ensure macroeconomic stability; and trust in government and institutions. The network of rules and norms mandated by Islam, if implemented, satisfy these preconditions. A vast potential for financial engineering effort in Islamic finance could span each of its basic transaction modes into a menu of instruments for risk-sharing opportunity. The period since 1990 has witnessed dramatic and rapid change in the structure of financial markets and institutions around the globe. It is believed that the benefits of financial globalization would grow as economies are liberalized; legal, institutional and financial development in countries reach and surpass threshold levels; and greater variety of financial instruments of risk sharing are designed and developed. The paper explores the potential convergence of Islamic and conventional finance as these systems continue their progress in designing and developing better risk-sharing structure and much expanded menu of financial instruments. It discusses the legal, institutional, governance, and financial preconditions that should exist for equity finance to dominate debt financing. Finally, it suggests that most of the preconditions for Islamic finance to achieve its potential could be realized with operationalization of behavioral rules and norms mandated by Islam.
