Since the launch of the first modern-day Islamic bank 60 years ago, Sharia-compliant finance has emerged as one of the world’s fastest-growing banking segments, with a market value of about $4 trillion.

This growth is being driven by several factors, including its “ethical” appeal to global investors and banking customers and the sector’s digital transformation, which has made it increasingly accessible to consumers in both Muslim and non-Muslim countries since the COVID-19 pandemic.

But what exactly is Islamic finance, and how does it differ from conventional banking services? This article looks at the industry, what it offers, and its outlook for the future.

Islamic banking: A definition

There are several ways in which Islamic banking differs from conventional banking. The Islamic banking model adheres to Sharia-compliant principles based on the Quran and covers three primary activities – banking services, insurance (takaful), and financing.

Interest – known as riba in Arabic – on loans is prohibited in Islamic banking, as are any investments related to gambling, alcohol, cigarettes, pork, drugs, weapons, or other activities that may negatively affect society.

But there are two central principles that it abides by: the sharing of profit and loss and the prohibition of interest collection and payment by lenders and investors. Islamic banks use equity participation to make a profit, which means the borrower shares their profits with the bank instead of paying interest.

According to the World Bank, the primary instruments of Islamic banking include:

  • Murabaha: Cost-plus financing
  • Mudaraba: Profit sharing
  • Ijara: Operational or financial leasing contracts
  • Musharaka: Equity participation contracts
  • Bay’salam: Forward sale
  • Sukuk: Certificates of ownership

These instruments constitute the “basic building blocks” for developing a wide range of more complex financial instruments, the World Bank says. Islamic banking is also considered a culturally distinct form of ethical investing and shares numerous synergies with ESG investing as both are sustainable, stakeholder-focused, and socially responsible.

The evolution of Islamic banking

The modern Islamic banking era began in Egypt in 1963 when economist Ahmed El-Naggar founded the Mit-Ghamr Local Savings Bank, which eliminated the concept of interest and focused on decentralization and partnership.

Since then, Islamic financial institutions have grown to number more than 1,670 globally, including 566 banks and more than 1,900 mutual funds that comply with Islamic principles, according to the Islamic Finance Development Report 2022, published by the Islamic Corporation for the Development of the Private Sector (ICD).

The report also states that between 2015 and 2021, Islamic financial assets grew from $2.17 trillion to about $4 trillion and are expected to reach around $5.9 trillion by 2026.

Today, Islamic banking is the largest sector in the Islamic finance industry, with 70 percent of its assets, followed by sukuk, which grew by 14 percent in 2021. The third-largest segment in the industry is Islamic funds, which jumped 34 percent to $238 billion worth of assets under management, the ICD says in its report.

According to the Islamic Finance Development Report 2022, published by the Islamic Corporation for the Development of the Private Sector (ICD), between 2015 and 2021, Islamic financial assets grew from $2.17 trillion to about $4 trillion and are expected to reach around $5.9 trillion by 2026.

Who are the major players in Islamic banking?

The growth in Sharia-compliant financial services globally has primarily been driven by the rising economies of Muslim countries, particularly the six-member Gulf Cooperation Council, led by Saudi Arabia and the UAE, and in Southeast Asia, such as Malaysia.

However, advances in digital banking and fintech services have opened the sector to non-Muslim customers worldwide. Investors are also placing greater importance on sustainability, which can attract non-Muslim investors to Islamic finance products and services due to their ethical and responsible investing qualities.

According to a report by BNY Mellon, this broader appeal is necessary to drive growth in Islamic finance assets globally as it is currently concentrated in jurisdictions where Islamic finances are of “systemic importance.” However, BNY Mellon says there are significant opportunities elsewhere in the world, including Africa, which offers “growth potential as African sovereigns and financial institutions use sukuks as alternative funding sources”.

“Issurance is supported by increasing financing needs in Africa, especially for infrastructure projects,” BNY Mellon adds.

The Islamic finance market is also taking off in the UK. In 2014, the UK became the first Western nation to issue a sovereign sukuk and is presently the largest center for Sharia-compliant finance in the West, according to BNY Mellon. The world’s first actively managed equity Sharia-compliant exchange-traded fund was also launched in the UK in 2020. 

Russia is another country that is moving into Islamic finance. On September 1, the government launched a two-year Islamic banking pilot scheme that will be rolled out in four of Russia’s Muslim-majority republics: Chechnya, Dagestan, Tatarstan, and Bashkortostan. The pilot program comes after Russian President Vladimir Putin signed a law to assess the feasibility of Islamic banking in the country.

“As more awareness and knowledge of Islamic finance starts to build up in non-Muslim countries, we expect to see steady growth in Islamic finance assets and expansion in Sharia-compliant investment products and services to cater to the rising demand,” BNY Mellon says in its report on the industry.

The benefits of Islamic banking for consumers

According to the World Bank, the global financial system has recognized Islamic finance as an efficient means of financing development, even in non-Muslim countries. There is also growing consensus that Islamic finance has been integrated into major financial markets and has the potential to contribute toward eradicating extreme poverty and promoting shared prosperity.

Islamic finance offers customers equity-based, asset-backed, sustainable, and environmentally and socially responsible banking services, as well as promoting risk sharing, connecting the financial sector with the real economy, and emphasizing financial inclusion and social welfare, the World Bank says.

Picture: Islamic finance offers customers equity-based, asset-backed, sustainable, and environmentally and socially responsible banking services.
Islamic finance offers a wide range of benefits to consumers. © Getty Images

Challenges in the Islamic banking sector

According to BNY Mellon, continued efforts are needed to standardize industry practices to drive globally accepted standards in the Islamic finance industry.

Having uniform standards will result in improved scalability of services and industry efficiencies, boost public confidence, increase cross-border marketability, and enhance transparency and consistency in financial reporting, BNY Mellon says.

Regulators have also recognized the significance of establishing an international, structured, and comprehensive legislative framework for Islamic finance to accelerate growth and reduce discrepancies globally.

How Sopra Banking Software can help

The Sopra Banking Platform for Islamic Banking offers a comprehensive range of financial services, including Islamic investments, trade finance, deposits, and Global Pool Managment. While standardization efforts have evolved significantly in the sector, local regulations, and context, demand customized approaches to practicing Islamic finance. Sopra Banking assists Islamic financial institutions in addressing challenges such as innovation and creating Sharia-compliant products.

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Adil El Medraoui

Islamic Banking Project Manager

Sopra Banking Software