Islamic banking is one of the fastest growing sectors in the global financial services industry. Driven by strong demand on both the individual and corporate sides, the total value of Islamic assets now approaches US$500 billion, and the number of institutions offering Islamic financial services is multiplying. More than 50 new financial institutions have opened for business in the last three years alone.

However, according to a new Booz & Company report, Islamic financial institutions face some significant challenges going forward, including a lack of product differentiation, the inherent complexity of Islamic banking operations, and the absence of universal standards governing what initiatives are admissible under Islamic law, or Sharia.

The report tracks the growth of the Islamic finance sector since its emergence in Dubai in the mid-1970s. From its early days when Islamic banks offered only a limited range of retail banking products, the industry has gradually evolved in sophistication, so that most conventional financial products now have an Islamic equivalent. Over the last five years, the total value of Islamic financial assets has grown 15 to 20 percent per year. Growth has been particularly strong in asset management: there will be an estimated 925 mutual funds next year, up from only 102 mutual funds in 2000.

The impact of the current turmoil in world financial markets on the Middle East will to some extent slow growth in the Islamic finance sector going forward. However, a reasonable level of economic activity and favorable long-term demographic trends are likely to continue to spur growth going forward.

Some of most dramatic growth in Islamic finance in the last few years has occurred on the corporate side. Issuers of Sukuk—the Islamic version of bonds—raised $85 billion between 2003 and 2007, as many companies came under pressure from governments, shareholders, and the public to forgo traditional financing in favor of the Islamic equivalent. That in turn has encouraged many non-Muslim sovereigns, such as the U.K., China, and Japan to prepare Sharia-compliant debt issues to target liquidity-rich Middle Eastern markets.

The Sukuk market recently faced a serious setback, however, demonstrating the wider risks to the Islamic finance sector from regulatory uncertainties. The Sharia board of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), a Bahrain-based standardization body, decreed that many innovative Sukuk structures ran counter to religious laws, meaning that some services had to be withdrawn. New guidelines are likely to lay the foundations for continued expansion of Sukuk, but the episode nonetheless demonstrated regulatory risks associated with the Islamic finance sector. Harmonization of laws in different parts of the Islamic world—probably based on the more influential, and stricter, regulations in the Gulf—will probably take place over the next 10 to 15 years, the report finds.

An uncertain regulatory environment isn’t the only hurdle facing Islamic financial institutions. Another is a problem of differentiation. In times gone by, offering Sharia-compliant products was enough for providers to stand out from the crowd. Now it is simply a first prerequisite. In the UAE alone, there are now eight full-service Islamic banks, along with many conventional banks with Islamic banking arms. Increased competition is putting pressure on pricing and eroding margins. At the same time, consumers are starting to demand returns on their bank deposits, negating the traditional advantage Islamic banks have had in not having to offer interest on deposits.

Another major issue is risk management. The report says Islamic banks need to develop new techniques and capabilities to counter and mitigate the special risks inherent to their businesses. These include inventory risks where banks in effect purchase assets and commodities on their customers’ behalf. Banks need to work together, and with their retailer partners, to share data and know-how, thus spreading best practice, the authors say. They also need to focus on developing techniques to manage short-term liquidity and longer-term financing.

Meanwhile, the rapid growth of the Islamic finance industry is putting pressure on human resources. Institutions report that there are simply not enough qualified personnel to fulfill functions adequately. The situation is particularly acute at the Sharia Board level, where there is a shortage of scholars with the requisite educational and practical knowledge. With so few scholars available, scholars are frequently called on to sit on more than one board, raising conflict of interest issues.

Finally, Islamic banks face a number of legal and regulatory challenges as they attempt to compete outside the Muslim world. For example, in several jurisdictions disadvantageous tax treatment will act to turn potential customers away from Islamic banks in favor of conventional banks. While some non-Muslim states, such as the UK, have moved to accommodate Islamic finance, many governments have yet to pass necessary legislation.

Islamic finance has the potential to continue its rapid progress from the last few years, despite the current economic slowdown. Going forward, Islamic banks will need to go about signing up new customers, developing new products and services, and deploying enhanced capabilities.

Doing all this will not be easy, however. Islamic finance institutions will need to accept the need to change, recognizing that what got them this far will not get them to the next stage of development.

Download "Competing Successfully in Islamic Banking."

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