Islamic banking is regarded as the fastest growing segment in the banking sector with a growth rate of 20 to 30 percent per year recorded over the past decade. With more than 390 Islamic banks in over 75 counties, this segment offers products and services compliant with the sharia that is the backbone of Islamic religious law. As a large percentage of the world’s Muslim population are located in the Middle East and North Africa region (MENA), it is logical that this region accounts for nearly 56 percent of total Islamic banking assets. The top three Islamic banks, Al Rajhi bank (KSA), Kuwait Finance House (Kuwait) and Dubai Islamic Bank (UAE) are all located in the MENA region. Since this sector is still in its early stages of development, with market opportunities yet to be exploited, estimates about the size of the industry still differ.
The International Monetary Fund (IMF) estimates total assets of Islamic banks in the world to be $250 billion and they are expected to reach $1 trillion by 2016. Conversely, McKinsey, a consulting firm, and Euromoney magazine are more optimistic as they expect total assets of Islamic banks to reach $1 trillion and $2 trillion, respectively, as early as 2010. In addition to geographic expansion, Islamic banking is also witnessing expansion in the financial services it offers, including retail banking, insurance and capital market investments.
Contrary to popular belief, Islamic banking does not target Islamic populations only. Non-Muslim customers are also demanding Islamic products and services that offer competitive products. As a result, non-Muslim countries are adopting this new trend and offering Islamic banking services. According to HSBC, more than half the customers for Islamic services in the UK were non-Muslims. It is worth noting that Islamic products and services can be offered either through Islamic windows at conventional banks or through newly established Islamic entities.
Sharia and the global financial crisis
The Islamic banking industry does face some challenges as no Islamic interbank market is present. Moreover, similar to conventional banks, Islamic entities were affected by the drop in equity valuation and Gulf property to which they are exposed. Even though the financial crisis did not affect the Islamic banking industry in particular, the drop in Gulf real estate and oil prices had repercussions on the industry since its sources of funds and liquidity were distressed.
Nonetheless, the impact of the crisis was lower on Islamic banks due to the asset-backed nature of their operations. As a result, the Islamic banking sector will continue to grow. However, it will grow at a pace expected to reach 10-15 percent in 2009, which is slower than its previous rate.
Islamic Banking in the MENA Region
The MENA region holds the largest share of the Islamic banking industry. In the four years leading up to 2007, the industry recorded a compounded annual growth rate (CAGR) of more than 31 percent. Islamic bank assets in the MENA outperformed their conventional counterparts that witnessed a lower CAGR of 24 percent.
Within the region, countries can be divided into two groups: Gulf Cooperation Council (GCC) countries and non-GCC countries that account for 51.4 percent and 48.6 percent of total Islamic assets in the MENA region, respectively. On one hand, the Kingdom of Saudi Arabia (KSA), with strong religious traditions, accounts for 35 percent of total GCC Islamic banking assets, representing 18 percent of the total MENA region. On the other hand, Iran represents 95 percent of total non-GCC Islamic banking assets, equivalent to 46 percent of the total MENA region.
Although the development of Islamic banking is dependent on the establishment of Islamic banking laws in Western countries, consumer demand is the main driver in the Arab world. Nonetheless, government support is still an important aspect as it controls barriers to entry in the industry. Oman for example, does not allow Islamic banking — the sultanate encourages conventional banking products and services. Contrarily, Islamic banking in Saudi Arabia and Bahrain is highly supported by the government, making the latter a regional hub.
Products and services
Despite its recent entry to the market, Islamic banking offers a variety of products and services that correspond to conventional banking sector services and are compliant with the Sharia. Murabaha, mudaraba, takaful, sukuk, ijara and qard hassan are only a few of the Islamic products offered.
The murabaha facility occurs when a lender buys an asset and sells it back to the customer at a higher price. The latter allows the lender (i.e. the bank) to make profit through an agreed mark up in price, without violating Islam’s interdiction on lending with interest. This fixed income loan is only used for the purchase of tangible assets such as real estate or a vehicle.
Mudarabah is another service offered by Islamic entities that allows the bank to finance a business without receiving interest payments. Instead, both parties (the lender and the borrower) share profits made by the business, according to a predetermined ratio. In case of loss, the bank loses its capital, while the borrower forgoes the labor and management provisions.
Takaful is the Islamic substitute for insurance, in the form of a murabaha, mudaraba or as a combination of both. In principle, takaful allows policyholders to pay an amount of money and place it in a single pool. The latter will then be used to aid those in need of assistance.
Sukuk is the Islamic equivalent of a bond. It is a financial certificate that is sold to a lender who rents it back to the original issuer at a higher price. It is worth noting that the issuer is obliged to buy back the certificate at a future date at par value. At that point, the issuer would have borrowed money and the lender would have made a profit margin without the use of interest payments.
Unlike the previously mentioned products, qard hassan does not have a counterpart in Western banking. It is a loan granted on a good will basis. The borrower is only required to repay the original amount of the loan. No profit margin is passed on to the receiver of the loan. However, an extra amount may be paid by the debtor as a token of appreciation.
Growth drivers
The key aspects behind the success of Islamic banking vary widely. The most important of these is the world’s rapidly growing Muslim population, which recorded a higher growth rate (1.9 percent) than that recorded by the total world population (1.2 percent) during the period 2002 to 2006. This represents around 24 percent of the total world population and it is expected to reach 30 percent by the end of 2025. Additionally, the world’s Muslim population is very young. Another major reason behind the rise of Islamic banking is the increasing wealth of Muslim nations. This is due to the discovery of vast oil deposits in the Gulf region accompanied by higher oil prices in previous years. The planet’s oil dependence has helped the region to benefit from abundant liquidity, which in turn has created enormous development opportunities. Projects worth more than $2.91 trillion are either underway or in the pipeline in oil-rich countries.
The acceptance of Islamic banking activities and its demand by non-Muslims has helped the industry overcome geographic and religious barriers. Western countries and non-Muslim populations are attracted to Islamic banking due to its perceived stability. The attractiveness of the profit-loss sharing schemes has also contributed to the wide acceptance of Islamic banking products. Furthermore, the spiritual appeal of the industry, its focus on the Islamic identity, the support granted by governments and its regulatory systems have also contributed to Islamic banking’s growth.
Opportunities and challenges
Like other industries, Islamic banking is faced with many opportunities and challenges. One of the most important challenges for the sector today is the interpretation of the sharia, which differs among countries and the various religious schools due to the lack of a unified Islamic regulatory body. As a result, an Islamic product may be accepted in some parts of the world while it is rejected in others.
However, the most important challenge faced by the Islamic banking sector is the unavailability of experts schooled in both banking and Islamic issues. An Islamic banker must possess a profound knowledge of Islam, in addition to finance. The shortage in experienced and qualified scholars is forcing them to field positions on multiple sharia boards, which in turn increases the risk of a conflict of interest. What is also important is that for an Islamic product to enter the market it ought to be approved by two sharia boards, one at the bank level and the other at the state level.
The financing of the many development projects in the Gulf region represents a growing opportunity for Islamic banking. As most Arab governments encourage Islamic banking practices, an increasing number of sharia-compliant financial institutions have benefited from the financing contracts of these projects. The latter has been made possible through the issuance of sukuk. Some economists believe that the sharia-compliant finance deals will account for more than 25 percent of the total project finance market in the coming years.
In brief, the Islamic banking industry is a fast growing sector that offers an array of opportunities yet to be exploited. Although the MENA region still represents the biggest share of the total Islamic banking sector, Western countries are gearing towards this new trend that presents a unique opportunity to diversify. With a growing market share and a considerable growth rate recorded over the past decade, it is essential for a unified Islamic banking authority to be established. The latter will be charged with standardizing Islamic banking operations and facilitating communication between the different entities, leading to the full exploitation of the sector’s potential.
