Joining the mainstream

Zubair Iqbal

While the Islamic banking sector has seen impressive growth since first coming on the scene in the 1980s, common standards, improved management and tighter regulation are required for the industry to compete with conventional banking institutions and respond effectively to global economic fluctuations, writes Zubair Iqbal

Practised informally over several centuries in the bazaars of the Middle East, the Islamic banking and financial system emerged on the global scene in the early 1980s and has grown rapidly since then, including in Muslim-minority countries. There are over 300 Islamic financial institutions, supplemented by an equally large number of mutual funds, that comply with the Is­lamic principles or shariah. 

The central concept that distinguishes Islamic banking and fi­nance from the conventional mode is the absence of a predeter­mined interest rate, which is deemed as equivalent to riba (usury) and viewed as a form of exploitation, and is therefore inconsistent with the notion of fairness and justice. Instead, returns are deter­mined on the basis of risk sharing between the borrower and the bank, and the lender and the bank. In essence, while conventional banking is largely debt based, which allows for risk transfer, Islam­ic banking is asset based and is driven by risk sharing. It should, however, be stressed that Islamic banks are not religious institu­tions, but are profit-maximising intermediaries subject to shariah-based constraints on contracts. 

By the end of 2010, international Islamic finance had assets exceed­ing $1 trillion. Although relatively small, at less than 5 percent of the global financial assets, its growth, ranging between 10 and 15 percent per year over the past two decades, has been impressive. While Is­lamic banks remain the dominant component of the market (around 80 percent of the total), other modes such as takaful (mutual funds) and sukuk (bonds) have grown briskly, helping to widen the market. 

So, what caused the Islamic banking sector to evolve from an insignificant niche market to a vibrant player on the global finan­cial scene? While the dramatic increase in the earnings of the oil-exporting countries following the rise in global oil prices since the mid-1970s is a major factor, the growth and diffusion of Islamic banking is more complex. A study by the International Monetary Fund (IMF) in 2010 showed that the growth of income per capita in Muslim countries and the ratio of Muslims to non-Muslims in national populations appear to have been important determinants in the rise of Islamic banking. Economic integration between Mid­dle Eastern countries, especially oil exporters, and the proximity to Islamic financial centres have also had a positive effect. 

Notwithstanding its wide diffusion, Islamic banking is prima­rily concentrated in the Middle East – especially within the Persian Gulf states which make up the Gulf Cooperation Council (GCC) – where 70 percent of the banks are located. Bahrain and Malaysia are the major regional hubs. 

It is important to note that while at national levels, the number of Islamic banks is significantly large relative to the total banking system in most of these countries, their share in total credit re­mains relatively low. Except for Iran where the entire banking sys­tem presumably operates on Islamic principles, such share varies from about 30 percent in Yemen to less than 3 percent in Pakistan. Similarly, excluding Iran, the ratio of conventional bank credit to GDP is substantially higher than the same ratio of Islamic banks. Unsurprisingly, assets managed by major Islamic institutions are also concentrated in the Middle East, which accounts for about 65 percent of total assets – GCC countries alone account for 30 percent of total assets – followed by about 20 percent in Asia. 

In recent years, Islamic financial institutions have developed a growing presence in the major global financial centres, including London, New York, Tokyo, Hong Kong and Singapore. In addi­tion, the big name banks have sought to access this segment of the market by establishing specialised ‘Islamic finance windows’. Inter­estingly, much of the Islamic institutions’ business is driven not by the demands of the local Muslim population, but by high net worth investors from the GCC countries and other countries with major Islamic banking interests such as Malaysia and Turkey. The UK has shariah-compliant assets of around $15 billion and London has emerged as an important global hub for Islamic finance, with the Financial Services Authority showing keen interest in the enlarge­ment of such presence and of Islamic hedge funds. Growth in the US market has been equally robust, now with over 20 institutions. The international regulatory authorities have expressed their will­ingness to accommodate this specialised niche within the existing supervisory rules. 

While Islamic banks were more resilient than conventional banks during the recent global financial crisis, they encountered larger losses when the crisis hit the real economy. A comprehen­sive study by the IMF in 2010 showed that the underlying business model allowed Islamic banks to limit the impact of the crisis in the early stages. In particular, smaller investment portfolios, lower leverage and adherence to shariah principles that prohibit invest­ment in risky assets – such as toxic assets and derivatives – helped. In part, better performance also reflected the fact that much of their lending was to the consumer sector, which was less affected by the crisis. However, as the malaise spread to the real economy in 2009, the profitability of Islamic banks took a deeper plunge owing to weaknesses in risk-management practices and the absence of proper corporate governance. 

Challenges remain to the sustainable growth of Islamic banking and finance in the post-financial-crisis world. In particular, liquid­ity and risk-management practices have to be strengthened, the su­pervisory and legal infrastructure further developed in consonance with shariah and the evolving global financial system, and manage­ment at the supervisory and industry level improved. The weak in­frastructure for liquidity risk management reflects shallow money markets and the lack of instruments that could be used to manage liquidity more efficiently, thus reducing costs. While the establish­ment of the International Islamic Liquidity Management Corpora­tion in 2010 will help, monetary authorities need to develop ap­propriate liquidity-management instruments such as Islamic bonds. 

Steps should also be taken to harmonise accounting and regula­tory methods and to help develop standard financial contracts and products. Finally, the lack of expertise in Islamic finance needs to be tackled – this has not only inhibited product innovation and hin­dered effective risk management, but has also constrained Islamic bankers’, regulators’ and supervisors’ ability to address conso­nance of new products with shariah. 

The outlook for Islamic banking remains bright but sustained strong growth calls for banks to enhance their ability to compete with the conventional banking institutions. The development of uniform accounting standards, the establishment of the Islamic Fi­nancial Services Board (the industry’s standard-setting body) and continuing steps towards common rules for compliance with sha­riah should help to facilitate this continued growth.

About the author:

Zubair Iqbal is an adjunct scholar at the Middle East Institute, Washington, DC


Sorry, the comment form is closed at this time.

Amnesty International