For centuries, there was no need for Islamic finance as there was no financial system existed to “Islamize.” Up until the second half of the 19th century, the vast majority of the Muslim population around the world was unbanked and the prohibition of interest was applied on transactions by tradition rather than by law or regulatory bodies. During the colonial era, Western banks and financial institutions penetrated Muslim countries and imposed interest-based methods on the Islamic world. In the 1940s and 1950s, independence movements pushed for the revival of Islamic culture and religious scholars in countries such as India, Pakistan and Egypt started to condemn the use of interest by banks. They proposed to prohibit interest and replace it with Islamic risk-sharing. Localized Islamic finance experiments took place in the 1960s in Egypt and Malaysia.
The first Islamic Bank
In 1975, Dubai Islamic Bank became the world’s first Islamic commercial bank. Abu Dhabi Islamic bank became the second Islamic financial institution established in 1998. Sharjah Islamic Bank was the world’s first to convert from conventional to full-fledged Islamic bank in 2002.
Advantages over conventional banking
Islamic banking is commonly seen to have two advantages over conventional banking. The first is a perception that Islamic banks are bound to a higher moral standard. They will not take on irresponsible amounts of risk or pay outsize bonuses to their top bankers. The second is that earnings come from identifiable assets, not opaque combinations of derivatives and securities. Because Islamic banks cannot make money through interest, they rely on ties to tangible assets, such as real estate and equity, charging rent’ instead of interest.
How Islamic financial institutions work?
Each Islamic finance institution has a Shariah Supervisory Board (SSB). The board is composed of at least three jurists. They are paid by the bank but act as independent consultants. Their role is both consultative and regulatory: They answer the staff’s questions, advise on charity contributions (zakat), verify operations and certify products. SSBs decide what is allowed (halal) or forbidden (haram) based on the two main sources of Islamic law: the Quran and the Sunnah — or what the Prophet Muhammad (PBUH) reportedly said and did during his lifetime. Board decisions are taken by majority vote and binding on the bank. SSB members are typically religious scholars who specialize in Islamic jurisprudence. In Western countries like the UK, they can also be non-Muslims experts who have studied such matters extensively.Over the past 10 years, Islamic finance has rapidly expanded across the world and finding qualified people to sit on SSBs has become challenging. In the world of Islamic finance, reputation is key and Shariah non-compliance can be fatal to a bank.
At International level, there are two supervisory bodies for Islamic finance: the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Malaysian Islamic Financial Services Board (IFSB). These bodies collaborate with institutions such as the International Monetary Fund (IMF) or the World Bank to promote Shariah compliance globally. The AAOIFI sets basic standards for the Islamic finance industry while the IFSB issues recommendations based on risk assessment. In Bahrain and the United Arab Emirates, AAOIFI standards are mandatory but in most countries, their standards and recommendations are not binding. If a bank doesn’t comply, there are no sanctions. It is up to each country’s government to enforce certain rules through their central banks who impose those rules on Shariah boards. A number of private firms have emerged over the past few years offering Shariah compliance services or consultancies. Their clients are Islamic banks but also conventional lenders and companies who wish to develop products or acquire certifications that will allow them to tap into the Islamic market. These consulting firms usually employ a group of Islamic scholars who function like an externalized Shariah board, providing guidance and issuing Islamic rulings (fatwas). In all countries, except Sudan and Iran, the Islamic finance exists alongside conventional banking. The Islamic banks are required to steer a dual regulatory framework i.e. the country’s laws and regulations as well as Shariah compliance.
Global total shariah-compliant assets
According to a report of State of Global Islamic Economy 2019, the total Shariah-compliant assets are expected to grow to $3.5 trillion by 2024. Though the Islamic finance is roughly existed 30 years ago yet today is a $2.5 trillion industry with hundreds of specialized institutions located in more than 80 countries. Islamic banks are by far the biggest players in the Islamic finance industry and account for $1.75 trillion or 70 percent of total assets. It is interesting to note that Islamic finance only represents about 1 percent of global financial assets but with an 11.4 percent growth in 2019, it was expanding quicker than conventional finance. Due to pandemic COVID-19 this growth is likely to slow down but remain positive. In Gulf Cooperation Council (GCC) countries or Sub-Saharan Africa, Islamic banks are now competing directly with Western banks to attract Muslim clients.
The total worth of the global Islamic financial services industry has increased 11.4 percent year-on-year to an estimated US$2.44 trillion in 2019, the IFSB said in its latest Islamic Financial Services Industry (IFSI) Stability Report 2020. The growth is based on significant improvement across the three segments of the Islamic financial services industry. The Islamic banking segment’s performance grew 12.7 percent in 2019 compared with a recorded growth of 0.9 percent in 2018, the Islamic capital market sector accounted for 26.5 percent of the global assets of the Islamic financial services industry, and Islamic funds recorded a growth of 29.8 percent.
Concentration of Islamic Finance
Islamic finance is today a $2.5 trillion industry spread over more than 80 countries with the bulk of it concentrated in very few markets. Data compiled by the Union of Arab Banks’ research department shows that just 10 countries account for almost 95 percent of the world’s Shariah-compliant assets. Iran leads the way with 29 percent of the global total followed by Saudi Arabia 25 percent, Malaysia 11 percent, UAE 8 percent, Kuwait 6 percent, Qatar 6 percent, Turkey 2.6 percent, Bangladesh 2.1 percent, Indonesia 2 percent and Bahrain 1.8 percent.
The region’s 10 largest Islamic banks are GCC-based and accounted for nearly $477 billion in assets in the second quarter of 2020. These banks sometimes branch out abroad. Bahrain’s Bank al Baraka for instance, has offices in more than 15 countries.
Share of North African countries
Up until recently, North African countries considered Islamic finance to be an unwelcome interference from Gulf states. Islamic banks and financial products were outlawed or strictly monitored. Then in 2017 these countries took important steps to boost “participatory finance” as they call it. The Central Bank of Morocco allowed five Islamic banks to start operating in the kingdom. The country also issued its first Islamic bond or Sukuk in 2018. In Algeria and Tunisia where Islamic banks already existed, governments are pushing for conventional banks to develop and commercialize Shariah-compliant products.
These countries drive the growth of Islamic finance, set industry standards and foster innovation. Over the past decade, Islamic finance grew at an exponential yearly pace of 10 to 12 percent. According to Arab News’ 2019 State of Global Islamic Economy report, total Shariah-compliant assets will grow to $3.5 trillion by 2024 although that depends on the economic well-being of these 10 markets.
The Asian-Pacific region
They represents almost 25 percent of the global Islamic finance market. In Malaysia, Shariah-compliant institutions account for close to one-quarter of the financial sector. Kuala Lumpur is one of the main drivers of the global Sukuk market and weighs in on international compliance with the Islamic Financial Services Board, one of the world’s two major Islamic finance regulatory bodies. Other mature Asian Islamic finance markets include Bangladesh, Brunei and Pakistan where Shariah-compliant assets make up more than 15% of total bank assets. Surprisingly, Islamic finance is still in its infancy in Indonesia even though its population is 90 percent Muslim. In 2020, Shariah-compliant assets accounted for only about 8% of total banking assets. In recent years, the authorities began to see the potential of Islamic finance and developed a roadmap to develop the sector with the help of Malaysian expertise. Three Indonesian Islamic lenders are expected to merge in the coming months, creating one of the world’s biggest Shariah-compliant banks. The country is also a pioneer of green Islamic bonds.
Australia is about to be the new kid on the block. The country is expected to welcome it first Islamic bank early 2021. Fully digital, it will target the growing Australian Muslim population.
The Sub-Saharan Africa only represents about 1.5 percent of the global Islamic finance industry but with the world’s fastest-growing population, 80 percent of people unbanked and a 16 percent of the world’s Muslims, opportunities seem endless for Islamic financiers. Several countries have already started to adapt their laws and regulations to allow Islamic finance to grow. South Africa pioneered the trend decades ago with the first African branch of Bahraini Bank el Baraka back in 1989. Kenya has Shariah-compliant banks, several conventional banks offering Islamic products. As east Africa’s largest economy, Kenya wants to position itself as the region’s Islamic banking hub. The government is undertaking structural reforms so that it can begin issuing Sukuks as soon as possible. In Ethiopia regulators has granted the country’s first full-fledged Shariah-compliant banking license in October 2020. The new Zamzam bank will operate alongside conventional banks already offering Islamic windows. Though Nigeria has about 90 million Muslims bit still there are only two banks providing Islamic services. The African market is huge but lacks in financial education and regulatory frameworks.
At this stage, Islamic finance in Africa tends to spread through private or sovereign bonds rather than brick-and-mortar banking. African governments see Islamic finance as a tool to raise development funds on international markets and diversify their pool of investors. According to Moody’s latest rating theAfrican governments are enhancing their presence in Islamic capital markets with numerous debut issuances. Average annual Sukuks issuance for Africa was negligible until 2012 but during 2013-19 has averaged $433 million per year. Expanding into Islamic Finance would diversify funding sources for African economies and reduce funding shortfalls, currently exacerbated by the pandemic COVID-19.
In the aftermath of the 2008 crisis, Islamic finance appeared as a relatively safe alternative to the teetering Western banking system. Sukuks seemed like a good way to tap into new markets, Islamic funds represented opportunities to access large amounts of liquidity and Islamic banking was a way of monetizing local Muslim communities. London positioned itself to become the hub for Shariah-compliant finance in the Western world. Today, the UK boasts five licensed Islamic banks, over 20 conventional banks offering Islamic financial products.
Luxembourg, the first eurozone country to issue a sovereign Sukuk and where 49 Shariah-compliant funds are domiciled. Germany has several Sukuk issuances over the past decade and its first full-fledged Islamic bank (KT Bank AG) in 2015. Switzerland with more focus on Islamic insurance or Takaful.
France—which has the largest Muslim population in Europe—is also a promising market. Authorities (including France’s former minister of finance and IMF director Christine Lagarde) have pushed hard for the development of Islamic finance there, yet banks have largely failed to respond due to fears that being associated with Islam at a time when the country is targeted by terrorist attacks would damage their reputation.
United States of America
Elsewhere in the world, some US banks have started offering Shariah-compliant products but such offerings remain a very small niche. South America is the last continent where Islamic finance is taking root. In December 2017, TrustbankAmanah, the continent’s first Islamic bank, bank opened in Surinam.
Key market trends
Islamic banking is the largest sector in the Islamic finance industry, contributing to 71%, or USD 1.72 trillion, of the industry’s assets. The sector is supported by an array of commercial, wholesale, and other types of banks. Yet commercial banking remains the main contributor to the sector’s growth. There were 505 Islamic banks in 2017, including 207 Islamic Banking windows. However, the number of players is not necessarily indicative of the size of the industry, in terms of assets. Islamic finance’s second-largest market, Saudi Arabia, has 16 Islamic banks, including windows, which is less than the smaller markets of Malaysia and the United Arab Emirates.With the rapidly growing popularity of mobile banking, particularly among younger people, according to PwC’s 2018 Digital Banking Consumer Survey, a growing number of digital-only, or disruptor banks’ with no physical branches, have emerged. Islamic banks are also catching up on this trend, with the launch of digital-only subsidiaries, such as Gulf International Bank’s Meem in Bahrain and Saudi Arabia, and AlbarakaTrksinsha in Germany and other European countries with large Muslim communities.
Status of Islamic Banking in Pakistan
Pakistan currently has five full-fledged Islamic banks while 17 conventional banks have standalone Islamic banking branches (IBBs) with 3,250 branches offering financial products.
Despite COVID-19, Islamic banking maintained a strong growth in 2020 as the government borrowed over Rs700 billion from Shariah-compliant banks during the year to partly finance its budget deficit and to reduce circular debt in the energy sector.Accordingly, the Islamic banking industry deposits grew 28% in one year to Rs3.39 trillion in December 2020 compared to Rs2.65 trillion in the same month of previous year. Similarly, the assets grew 30 percent in one year to Rs4.27 trillion in December 2020 compared to Rs3.28 trillion in the same month of previous year, according to the SBP. Over the last five years, both assets and deposits of the Islamic banking industry have more than doubled. The Islamic banking industry had left behind conventional banking on multiple fronts. For example, it holds a 60 percent market share in the housing and construction loans. Similarly, it enjoys almost 50 percent market share in car financing. State Bank of Pakistan (SBP) is targeting an increase Islamic banks’ market share (in terms of deposits) to 25 percent by 2023. The SBP Islamic Banking Bulletin for the quarter ended December 31, 2020 narrated that the growth witnessed in the Islamic banking sector shows a promising transition to the new decade even amidst COVID-19. The International Monetary Fund (IMF) and the Asian Development Bank (ADB) had also suggested to the government to focus on Islamic financing for budgetary borrowing.