Islamic banks are increasingly visible features of national financial systems not only in Muslim countries but even in those that have Muslim minorities, such as Singapore and the United Kingdom. Globally, these institutions’ assets are growing by 15 to 20 percent a year—so quickly that in 2006 they reached nearly $400 billion. But though our analysis shows that Islamic banks have plenty of room for continued growth, regulations that try to balance religious conformity with economic reality are hampering their development.

Islamic institutions provide financial services and products that comply with Sharia, the Islamic legal code. The main facets of Sharia include prohibitions against interest payments, speculation that involves future risks (such as gambling or conventional derivatives), and investments in forbidden areas, such as alcohol or weapons. In practice, a key requirement for the creation of a large number of products is that financial instruments must be founded on a physical transaction, such as the underlying sale and repurchase of a commodity. This guideline increases the costs and complexity of such instruments as compared with those from conventional banks.

Formerly concentrated in North Africa, the Middle East, and Southeast Asia, Islamic banking is spreading rapidly. Today about 270 Islamic banks—including subsidiaries of conventional banks, such as HSBC Amanah and Citi Islamic Investment Bank—dot the globe. Aided by the growing desire of many Muslims to conform to Sharia in their day-to-day lives and by an inflow of petrodollars into some regions, Islamic banking has grown faster than the banking sector as a whole in countries from Malaysia to Saudi Arabia. Even so, profitability and returns on assets present a mixed picture.

Despite recent growth, assets held by Islamic banks remain at less than 1 percent of global banking assets. In Islamic countries, penetration varies considerably: Islamic banks hold slightly more than 1 percent of total banking assets in Indonesia and more than 21 percent in Kuwait (Exhibit 1). Yet recent research of Islamic banking customers in the Gulf Cooperation Council (GCC) states—Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates (UAE)—reveals tremendous growth potential: 75 percent of the respondents prefer Islamic banks and would switch to this format if their products were at least on par with those of conventional banks.¹

What is preventing Islamic banks from capturing this potential? One problem is their legacy of serving a core of devout customers who accept lower product and service standards in exchange for Sharia compliance. Many long-standing Islamic institutions thus can’t respond to greater competition from conventional banks, which generally offer better service and a wider product range—including, in some cases, their own Islamic products. Also to blame is a patchwork of different national regulators. Some shield Islamic banks from real competition, relieving them of external pressure to improve their performance; few have done much to harmonize industry standards and facilitate the development of a global market.

Regulators will have to tackle these issues to propel Islamic banking further out of its niche and into the mainstream. If well regulated, the Islamic sector would be stronger than it is today. What’s more, a competitive and harmonized banking environment will improve the quality of services and make it possible to offer better products to customers who prefer Islamic financial institutions. Moving toward standardization will also help create the platform for Islamic banks to expand beyond national borders and become truly global.

Too many regulatory models

The regulatory frameworks governing Islamic banks are a vital influence on the banks’ overall performance in each national market. Indeed, the wide variation in regulations from country to country is probably the main explanation for the similarly wide variations in growth and performance across markets. It will continue to be a strong influence on them as they evolve.

In Kuwait, the UAE, and Saudi Arabia, for example, the Islamic banking sector is relatively dominated by a single player: the Kuwait Finance House, Dubai Islamic Bank, and Al Rajhi Banking and Investment, respectively. All three institutions have a long history in markets that have evolved economically in roughly the same way, but their performance varies widely, as do the regulatory environments in which they operate. In Kuwait and the UAE, where Islamic banks have historically enjoyed a somewhat protective environment (although over the past years the UAE has become more liberal in issuing licenses for Islamic windows), their performance lags behind the national average for banks in general. But in Saudi Arabia, where competition is the rule, Al Rajhi outperforms the market average (Exhibit 2). Strategic choices and management obviously play an important part in the outcome, but regulation is a key factor.

Countries starting to develop their own Islamic banking regulations—and other countries examining whether their policies foster or hinder the sector’s growth—should consider how their efforts contribute to the international harmonization of Islamic banking practices. No such standards have been developed, so it is difficult for players to exchange best practices across markets and to expand abroad. The lack of standards inhibits the development of international Islamic banking markets and results in an industry that is little more than a collection of national strongholds.

Ideally, the regulatory model that evolves should put all institutions—Islamic and conventional—on the same competitive footing and create a transparent market. Banks should not be able to hide lax customer service or operations behind Sharia credentials. In addition, policies should promote the use of separate Islamic banking balance sheets and income statements that would provide complete information on the Islamic banking market and reduce the asymmetry of present information.

Two areas of focus

The primary objective of banking regulation everywhere is to protect customers by promoting the sector’s stability and performance while ensuring proper, fair, and transparent practices in product development, pricing, risk and liquidity management, accounting practices, investment practices, governance, and other areas. In most countries with Islamic banks, regulators also face the challenge of allowing two very different banking formats to coexist. Two choices in particular—general licensing policies and the regulators’ involvement with Sharia compliance—will have a strong influence on the development of the domestic (and global) market.

The licensing choice

At the extremes of policy, licensing is not a choice: in Sudan, for instance, only Islamic banks are allowed to operate—in direct contrast to Oman, where they have so far been prohibited. Between these extremes, licensing regulations determine the degree of separation between Islamic and conventional banking.

Approaches vary considerably. In Saudi Arabia, a single license and compliance framework covers all banks—a system that avoids any differentiation between conventional and Islamic institutions and allows every bank to offer both conventional and Sharia-compliant products. Banks can be fully conventional, fully Islamic, or a mix of both. That is also true in Malaysia; although it offers three kinds of licenses (one for each kind of bank), the effect is to create the same competitive environment that prevails under Saudi Arabia’s single-license system and to let banks choose their own strategy. In Kuwait, by contrast, a separate banking license is needed for Islamic and conventional banking, and the mixed format is not allowed.²

Experience shows that the Saudi and Malaysian models have fostered the strongest competition: almost all banks in these countries offer a wide range of Islamic products. In Kuwait and the UAE, where new Islamic banking licenses are not as easy to obtain, few banks offer such products extensively. In general, a system that removes all regulatory barriers to competition fosters a healthier environment. From this perspective, the most suitable framework is one that allows banks to choose what they offer and doesn’t constrain them through a tight licensing policy.

When a broader group of banks offers Islamic products and services, banks compete more on performance and costs than on Islamic credentials

Requiring banks to be either Islamic or conventional might seem necessary to create a clear distinction between the two formats and to raise the credibility of the Islamic banking sector. Although that kind of system might indeed quickly meet the banking needs of customers with the strictest Islamic standards, it creates a walled garden around Islamic banks, insulating them from competition. Protected Islamic banks, convinced that religious credentials alone will sustain them, are often complacent. Innovation, the quality of service, convenience, and operational improvements suffer, so these banks fall further behind their conventional counterparts by such measures as customer satisfaction and cost controls.

At the extreme, a dual system becomes highly detrimental. Islamic banks could ultimately fail to attract customers from outside their base—a development that would severely limit their growth prospects. This outcome could leave a country with a two-speed banking system: conventional banks that grow, and Islamic banks that don’t.

When a broader group of banks offers Islamic products and services, banks compete more on performance and costs than on Islamic credentials. Of course, Islamic credibility remains essential. In Malaysia, conventional banks offering Sharia-compliant products create Islamic windows that are separate from other operations. In Saudi Arabia, conventional banks usually offer Sharia-compliant products through distinct subbrands, especially in retail banking. Amid all this competition, customers gain a wider range of products, lower prices or higher returns, and better service and convenience.

While both the single- and three-license systems create competitive environments, the Malaysian system has the added advantage of ensuring that banks report their Islamic activities separately, thereby increasing transparency. In Saudi Arabia, performance data on Islamic banking activities are not reported separately; since regulations make no distinction between the two types of banks, such data are generally impossible to obtain. A more transparent market strengthens the industry, rewarding the best players and making weaker ones more vulnerable.

Compliance with Sharia

Islamic banking depends fundamentally on the interpretation of Sharia and its application to previously unknown situations—for example, developing a credit card that doesn’t charge interest. Because there is no single authority on how to interpret and apply Islamic law, individual banks appoint Sharia committees of recognized Islamic scholars to rule on whether new products or services are compliant, as well as to audit a bank’s day-to-day operations. Sharia committees can be more or less strict in their approach, and these rulings, or fatwas, can vary widely from one bank to another and from one country to another. The existence of a religious authority within a bank also creates clear governance challenges, particularly when the opinions of its management and board, with their focus on financial results, diverge from those of the Sharia committee.

If Islamic banks are to compete with conventional ones for customers willing to consider both options, innovation and speed are crucial. A Sharia committee can slow down product development or halt it altogether: an Islamic bank in the Gulf region developed a new product in two months, for example, and then had to wait three months for the committee to approve it, in part because the committee became involved in marketing decisions. In addition, a shortage of Islamic scholars with financial knowledge means that qualified people often serve on several Sharia committees, raising potential conflicts of interest and taking away from the time members can devote to an individual bank’s ideas.

The system adopted in Malaysia helps to alleviate some of these issues. The country’s central bank convenes a national Sharia board. Eminent Islamic scholars serve on it and hold the ultimate authority to approve new products and practices. Banks, however, still have their own individual Sharia committees, whose role is to decide how to apply the central board’s opinions and how to enforce Sharia compliance within the bank.

A prime advantage of this system is that it goes a long way toward creating a level playing field in Sharia compliance rather than a series of sometimes contradictory rulings from Sharia committees at individual banks. In essence, the system creates a minimum threshold for Sharia compliance. Islamic banks can still be stricter (much as conventional banks may decide to hold cash reserves higher than those mandated by regulators), but the ground rules are clear.

The transparency created by the central Sharia board’s rulings can also diminish the impact of governance issues. These rulings create a benchmark of acceptable practices, which can reduce the tension between a bank’s management and its Sharia committee and encourage meaningful dialogue about the acceptability of new products and services. In Malaysia, the central board discusses innovative concepts openly and issues public judgments. (The details of the structure behind products aren’t revealed, to protect the banks’ intellectual property.)

This model also provides for the more efficient use of a very scarce resource in Islamic banking: Sharia scholars with financial expertise. A central Sharia board benefits from precedents and experience. Over time it should make faster and more uniform decisions. This approach then lightens the burden for the scholars on the committees of individual banks and perhaps means that these committees need fewer scholars, since they can draw upon the central board’s opinion rather than having to explore each fresh topic from scratch.

A central Sharia board benefits from precedence and experience and lightens the burden for the committees of individual banks

Pakistan too may set up a central Sharia board. If this regulatory structure spreads, the national boards could meet in international forums and hasten the process of globally harmonizing the industry. But in countries with established Islamic systems, such changes could encounter considerable structural friction. Sharia boards at individual banks will lose some power as they focus more on internal auditing and less on the more visible role of approving products. Moreover, a transparent central board will put more pressure on bank management, since Sharia compliance will no longer be an acceptable excuse for poor performance.

As in most commercial sectors, more competition would compel Islamic banks to improve their performance and offer customers greater benefits. While there is much that individual Islamic banks can do to raise their game, national regulators will play a vital role in creating a vibrant sector. Rational licensing policies that don’t insulate Islamic banks from competition and a central Sharia board that creates national standards can further move Islamic banking from a niche to the mainstream, opening great opportunities for growth and customer value.