From A Niche Market To The Mainstream: What Has Driven Islamic Banking Growth?

By Patrick Imam and Kangni Kpodar

Despite the rapid growth in Islamic banking during the past decade, challenges remain, pointing to the need for further reforms and greater harmonization in the interpretation of what is Shariah compliant between Islamic scholars and bankers.


Islamic Countries are “Underbanked”

Islamic countries and regions are geographically concentrated in Africa, the Middle East, South and Central Asia as well as East Asia. A characteristic of large segments of Muslim populations—with notable exceptions such as the oil producing Gulf countries—is that they are poor1 and largely lack access to banking services (see graph). That poverty and underbanking go hand-in-hand is a reflection of the importa-nce of banking as an engine for economic development. Financial institutions stimulate growth by promoting savings, allocating capital efficiently, and helping risk diversification. But finance can also reduce poverty, by facilitating access to deposits and allowing individuals to take advantage of opportunities that require upfront costs. This could be in the form of allowing entrepreneurs who lack funding to launch their own businesses.




That the Islamic world, as a whole, has a lower level of financial development than other regions is in part because conventional banks do not satisfy the needs of devout Muslims, because their products may run counter to Muslims’ religious principles (see Box 1). The result is that savings are not mobilized and invested as efficiently as they could be. In addition, conventional banking has shown some limitations in adapting to the low-income environment that Islamic countries share with other developing countries. Access to finance is limited as borrowers often lack collateral against which they can borrow. When collateral is available, the lack of an efficient judiciary and well-defined property rights may hinder conventional banking from recouping the collateral in case of a failed venture. In addition, from the poor’s point of view, the failure of a loan could lead to a poverty trap from which it may be difficult to rebound. Islamic banking, in contrast, seeks to provide financial services in a way that is compatible with Islamic teaching and that is more adapted to the low-income environment, thereby overcoming some of the limitations of conventional banking.

Against this background, Islamic banking has the potential to accelerate financial development in two main ways. One is through increased financial intermediation. Providing financial services compatible with Islamic teaching encourages pious households to deposit their savings in a bank, which can in principle be allocated more efficiently.




Moreover, because Islamic banking prohibits interest payment, and requires borrowers and lenders to share the risk of failure, it provides a shock-absorbing mechanism, thereby encouraging investment. Being partly shielded from the negative consequences of a failed venture is important for poorer populations where a safety net is non-existent. Most Islamic countries, in addition to being poor, tend to be undiversified, with commodity producing countries being subject to boom-bust cycles and the vagaries of nature; thus, such a form of banking that takes into account the inability of individuals to take on too much risk will stimulate investment and growth more than traditional banking. The relative stability and continued growth of Islamic banking during the global financial crisis attest to its resilience and potential.2


The rise of Islamic banking

In most Islamic countries, the seeds of the modern banking system were put in place by the colonizers, who were interested in establishing banks that could support mining exploration, agriculture, manufacturing, and the public sector. After gaining independence, many Islamic countries nationalized the banks, established development banks responsible for credit allocation, and tasked their central banks to encourage lending by repressing interest rates with the aim of spurring industrialization. Governments used banks to finance expansion of the public sector, especially in the Middle East and Africa, or to expand certain favored industries, as in East Asia. In this repressive environment, banks’ profitability was low at best, and banking systems remained underdeveloped.

Fifty years ago, Islamic banking emerged on a modest scale to fill a gap in a banking system not attuned to the needs of the devout. In the first wave, two events were crucial to its development.

• First, in the early 1960s, the appearance in rural Egyptian villages of micro-lending institutions following Islamic banking principles demonstrated the feasibility of Islamic banking. These experiments thrived and spread to Indonesia, Malaysia, and sub-Saharan Africa.

Second, following the 1975 establishment of the Islamic Development Bank in Jeddah, Saudi Arabia, top-down support spurred diffusion of Islamic banking by centralizing expertise. In its infancy, Islamic banking required much interpretation of Shariah law by Islamic scholars. In its early years, basic implementation tools—such as legislation allowing Islamic banks to be set up and the training of staff—were key ingredients for the spread of Islamic banking. And the past few years have seen rapid innovation, most recently improved regulation of liquidity management and accounting.

Islamic banking seeks to provide financial services in a way that is compatible with Islamic teaching and that is more adapted to the low-income environment.

Similarly, the development of sukuk (Islamic bonds) has revolutionized Islamic finance in recent years: Islam prohi-bits conventional fixed income interest-bearing bonds. Harnessing sophisticated financial engineering techniques, sukuk are now a multibillion-dollar industry.

Rising oil prices since 2000 were a catalyst for the second wave of Islamic banking development, leading to a massive transfer of resources toward the large oil-producing countries, which have been more inclined to adopt Islamic banking. During the past decade, Islamic banking industry assets grew at an average 15 percent annually, and more than 300 Islamic institutions claim total assets of several hundred billion dollars. Two-thirds of Islamic banks are in the Middle East and North Africa, with the rest mainly in East Asia and sub-Saharan Africa. However, even in countries with many Islamic banks, they are overshadowed by conventional banks. In the Gulf region, Islamic banks—in terms of their assets—account for one-quarter of the industry (see chart). Elsewhere, their share is in the single digits.




How Islamic banking has spread

Globally, Islamic banking is an increasingly visible alternative to conventional banks in Islamic countries and countries with many Muslims. Identifying the sources of Islamic banking’s expansion and ways to stimulate its continued growth is therefore of interest to policymakers. Knowing what drives the development of Islamic banking will help developing countries in Africa, Asia, and the Middle East catch-up economically.

Against this background, Imam and Kpodar(2010)3 have analyzed econometrically how Islamic banking has diffused throughout the world. Islamic banking is likely to continue to grow because many of the world’s 1.6 billion Muslims are underbanked; understanding how Islamic banking spreads will help guide the formulation of policy recommendations to accelerate its progress. To that end, the factors behind the diffusion of Islamic banking around the world were estimated using a sample of 117 countries during 1992–2006. A test of whether Islamic banking is a substitute for—or a complement to—conventional banking was also carried out.

Imam and Kpodar(2010) find, unsurprisingly, that the probability of increased Islamic banking in a given country rises with the share of Muslims in the population, income per capita, and the price of oil.4 Interestingly, macroeconomic stability is found to spur the development of Islamic banking, while proximity to Malaysia and Bahrain (the two main Islamic financial centers) and trade integration with Middle Eastern countries also make the diffusion of Islamic banking more likely.

Interest rates negatively affect the diffusion of Islamic banking, reflecting the implicit benchmark they pose for Islamic banks. Although pious individuals may have accounts only with Islamic banks, other consumers allocate their savings based on interest rates set by conventional banks. High interest rates hinder the diffusion of Islamic banking by raising the opportunity cost for the less pious (and non-Muslims who are increasingly attracted to Islamic banking) to put their savings in Islamic banks.

Some of Imam and Kpodar’s results, however, were unanticipated.

• First, Islamic banks spread more rapidly in countries with established banking systems. Islamic banks offer products not delivered by conventional banks and thus complement rather than substitute for conventional banks.

Second, the quality of a country’s institutions, such as the rule of law or the quality of the bureaucracy, was not statistically significant in explaining the diffusion of Islamic banking. This is not true for conventional banking. Because Islamic banking is guided by Shariah, it is largely immune to weak institutions: disputes can be settled within Islamic jurisprudence.

Third, the September 11, 2001 attacks on the United States seemed not to be an important factor in the diffusion of Islamic banking. These events simply coincided with the rising price of oil, which appears to be the actual driver of Islamic banking.


Policy implications and outlook

During the past decade, Islamic banking has grown from a niche market into a mainstream industry. It has also contributed to growth in the Islamic world by drawing underbanked populations into the financial system and allowing risk sharing in regions that are subject to large shocks but few buffers. Islamic banking is not only growing in size, but also in sophistication, with products offered ranging from Shariah-compliant credit cards to insurance and investment products.

Even though the findings suggest little need for institutional reform, policy changes can still boost the spread of Islamic banking. Encouraging regional integration through free-trade agreements, maintaining a stable macroeconomic environment that helps keep interest rates low, and raising per capita income through structural reforms will lead to further expansion.

The standardization of Shariah-compliant products needs to be encouraged to create a critical mass; more regulators and professionals in Islamic banking must be brought up to speed on best practices, through better training and sharing of experiences.

Recently, Islamic finance has been impacted by events in the Middle East and North Africa, but the confidence shock has only been mild, with instability in certain countries leading to the postponement of projects financed by Islamic banks or sukuks, for instance.

More worrying is the rise in criticism among some Islamic scholars that the Shariah-compliant products being developed are increasingly diverging away from the spirit of Shariah law, even if, with the help of financial engineering, they conform to the letter of the law. While, in certain cases, there may be some truth to this assertion, such criticism should not detract from the benefits provided by Islamic banks, which often exceed those offered by conventional banks. On the other hand, more harmonization is required in the development of newer products to dispel the reputational risk.

Despite rapid expansion, reforms are needed to spur the growth of Islamic Banking further. Reforms at the country level to create a more level playing field with conventional banks may be the next step.

Despite the rapid expansion of Islamic banking, reforms are needed to spur the growth of the industry further. Reforms at the country level to create a more level playing field with conventional banks may be the next step. In many jurisdictions, there are no liquidity instruments available for Islamic banks, hampering their ability to manage liquidity and creating a comparative disadvantage. Malaysia has been among the first to attempt to address this issue, with the creation of the International Islamic Liquidity Management Corporation (IILMC). The IILMC issues short-dated debt that can be used by banks and other companies to manage liquidity in a way that is Shariah compliant. Because of the way they are structured, many Shariah-compliant financial products are subject to double taxation in various jurisdictions, necessitating changes in the local legislation to create a more even environment with conventional banks. In addition, the regulatory framework needs to be strengthened, with issues such as how to handle the bankruptcy of an Islamic bank needing to be addressed explicitly.

Besides regulatory changes, the industry must work together to address two key challenges and so help the diffusion of Islamic banking.

• The standardization of Shariah-compliant products needs to be encouraged to create a critical mass. This is particularly important because the existence of a multitude of similar products can sow confusion among investors and render valuation more difficult.

More regulators and professionals in Islamic banking must be brought up to speed on best practices, through better training and sharing of experiences. The lack of experience among both the regulators and professionals is hampering growth. This is a binding constraint, and may take years to fully address, but the sharing of expertise could help to overcome the problem.

While significant challenges remain, recent progress in the field and the ongoing development of new products suggest that Islamic banking has a bright future. The spread of Islamic banking is not, however, a panacea—it is merely one of many elements needed to sustain growth and development.

About the author

Patrick Imam is an economist in the Monetary and Capital Markets Department at the IMF, with a PhD in economics from Cambridge University. His research interest encompasses capital markets and financial stability.

Kangni Kpodar is an economist in the Fiscal Affairs Department at the IMF, with a PhD in economics from the CERDI (Clermont-Ferrand, France). His research interest focuses on financial development, growth and poverty issues.



1. Pew Research Center, 2011, “The Future of the Global Muslim Population: Projections for 2010-2030”

2. See Hassan, Maher and Jemma Dridi, 2010, “The Effects of the Global Crisis on Islamic and Conventional Banks: A Comparative Study” IMF Working Paper No.201

3. Imam, Patrick and Kangni Kpodar, 2010, “Islamic Banking, How Has it Diffused ?”, IMF Working Paper No.10/195

4. Although high oil prices are found to stimulate Islamic banking development, they are likely to hurt non-oil exporting countries in Africa, offsetting the potential benefits Islamic banking development may bring to economic growth.

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