Islamic Banking and Finance

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Establishments offering Islamic banking services comprise a noteworthy and rapidly growing share of the overall financial system in several nations (Rose & Hudgins 27). Since the commencement of Islamic banking and finance (IBF) in the decade of the 1970s, the number and reach of Islamic banking establishments globally have grown from one establishment in one nation in 1975 to over 300 financial establishments operational in over 75 countries (Siddiqi para 2; Husain 54).

In some countries such as Iran and Sudan, Islamic finance ideologies govern the entire banking system. Islamic financial establishments are mainly found in the Middle East and parts of Southeast Asia, but they have started encroaching on Europe, Africa, and the United States where they present themselves as niche players, thus causing considerable realignments and transformations in the banking sector. The conventional banks, on their part, have also undergone considerable shifts in business strategies and regulations to keep the focus of the changing trends of 21st century banking (Rime & Stiroh 2130).

It can be argued that these momentous realignments have inarguably assembled impetus for IBF to become a noteworthy feature of the global financial landscape in contemporary times (Pollard & Samers 313). By 2007, the total assets of Islamic financial establishments globally were approximated at $250 billion, with all pointers indicating that the industry was anticipated to grow by over 15 percent annually (Nielson 55).

Presently, according to Pollard & Samers, over 25% of Islamic banks fully operate in countries where Muslims are the minorities. In many other countries, interest-based financial institutions are operating ‘Islamic windows’ to draw the rising number of Muslims relocating to these countries (313). The UK, Luxemburg, and France have registered considerable incorporation of Islamic financial systems into their mainstream banking systems, with the U.S. and Spain closely following (Kwan 107; Thomas 23). It, therefore, becomes relevant to take a closer look at IBF to evaluate what it has to offer to mainstream banks.

Aims of Study

The general objective of this study is to critically evaluate if IBF can become viably incorporated into the mainstream banking system. The following are the specific objectives:

  1. To critically evaluate the financial stability of Islamic banking by evaluating its operating frameworks such as total deposits, total equity, total investments, among others, with the aim of evaluating if it could become a viable alternative to conventional banking
  2. To demarcate the growth patterns of Islamic banking and finance with the aim of understanding its viability

Rationale of Study

The literature on Islamic banking has tremendously grown to reflect the increased role and function of Islamic banking, not only in Islam-oriented nations but also in capitalistic countries. A large portion of the literature, however, attempts to compare the instruments and products of Islamic banking vis-à-vis what is offered by commercial banks (Rime & Stiroh 49). A large part of the literature also concerns itself with evaluating the regulatory, managerial, and supervisory issues related to IBF (Samad & Hassan 13). To date, there exists comparatively little empirical evaluation of the role and viability of Islamic banking in conventional banking systems (Persky 227).

This paper, therefore, attempts to fill the void in the empirical performance of Islamic banks about conventional banks in a cross-country context, and if these banks can be relied upon to provide a new alternative to the conventional banks. Analyzing the stated agenda in a cross-country context is fundamental because data and information on IBF in individual nations are not adequate to discern the impact of Islamic banking from the multiplicity of other influences that have an impact on the conventional banking system.

Towards Understanding Islamic Banking and Finance


According to Chiu et al, “…Islamic finance is the act of providing financial products or services that conform to Islamic law” (64). Abdelkader posits that the financial industry referred to as Islamic banking must be consistent with the rules and regulations of Islamic banking, and must be governed by Islamic economics. Islamic banking is firmly rooted in a profit and loss framework rather than the conventional lender-borrower relationship practiced by most mainstream financial institutions.

A profit and loss framework obliges the Islamic financial establishments to enter into a binding joint venture with its clients for purposes of providing capital, which must never be advanced at an interest (Chiu et al 64; Saeed 497). In particular, the Sharia law strictly forbids the collection and disbursement of interest, also known as Riba or Usury. According to Islamic regulations, the banks must neither engage in speculative transactions nor invest in businesses that are against Islamic values (Saeed 499).

Islamic banks derive much of their profits from profit-and-loss sharing agreements (PLS), acquisition and resale of goods and services, and the provision of Islamic-oriented services for fees and commissions (Cihak & Hesse 4). In PLS contracts, the rate of return on bank-client financial transactions must never be premeditated, while in the acquisition-resale contracts, a mark-up is usually established based on a standard rate of return, normally a return determined in global Islamic markets such as LIBOR (Cihak & Hesse 4).

According to Ahamed, “…the underlying principle of Islamic banks is the principle of justice which is an essential requirement for all kinds of Islamic financing…if a financier is expecting a claim on profits of a project, he should also carry a proportional share of the loss of that project” (para 3).

Strong Points of Islamic Banks

At the heart of this research report is the issue of whether Islamic financial institutions can be able to offer a viable alternative to other financial establishments, in particular current commercial financial establishments. From the IBF sector’s humble beginning, Siddiqi asserts that “currently, about $800bn is deposited in Islamic banks, mutual funds, insurance schemes and Islamic branches (windows) of conventional banks. By contrast, the market was valued at only $140bn in 2000” (para. 2).

Pollard & Somers are of the opinion that there may be in excess of $1.1 trillion held by Islamic global funds, implying that IBF is officially a player in the big league. As the IBF sector continues to evolve and play a significant function in capital markets transactions, many financial analysts are beginning to think along the lines of applying IBF as an alternative to conventional banking (Shahimi et al 24 ; Pollard & Samaras 314).

According to Shahimi et al, “…the successful operation of these [Islamic] institutions and the experiences in Iran, Sudan, Malaysia and Bahrain are satisfactory to show that Islamic banking offers an alternative method of banking” (25). Islamic banking can also be deemed as successful and viable by the very fact that many conventional financial institutions, including major multinational powerhouses such as Citibank, Standard & Chartered, Barclays plc, and HSBC have also started employing Islamic banking techniques.

Seminal research studies over the last few decades have demonstrated that IBF is not only feasible and viable, but also an efficient, dynamic, and fruitful way of financial intermediation (Shahimi et al 25). The Islamic financial institutions generate their profit “…from various banking activities including; financing such as equity-financings (mudarabah & musharakah), debt-financings (bay’ bi thamanajil and ijarah), participation in direct investment (investment securities and dealing securities), and non-financing income such as fee and other operating income” (Shahimi et al 26). Fee income, in most occasions, comprise of commissions, service fees, and guarantees. Table 1 captures how fee income transactions continue to grow in Islamic banking.

Table 1: Fee Income Transactions of Malaysian Islamic Financial Institutions by type of Funds.

(RM’000) Shareholders / IB fund Depositors fund
2002 2003 2002 2002
Commission & guarantee 14,693 40,966 1,901 3,964
Service charge 2,381 27,123 552 3,185
Other fee income 12,336 29,746 1,582 2,515
Total fee income 29,410 97,835 4,035 9,664

Overall, the table above reflect the considerable increase in the generation of fee income, and “…is an evidence of increasing specialization of Islam banks especially in managing the depositors’/Islamic banking fund by utilizing fee-based products” (Shahimi et al 26).

Unlike other conventional banks, Islamic banking was not affected by the 2008 financial crisis. Afaq Khan, CEO of Islamic banking in a leading financial institution asserted that “…Islamic banking operates in real economy…This banking has no room for gambling, speculation, excess leverage, or the greed for windfall profit” (Rahman para. 3). On his part Al-Hamzini argues that Islamic banks were unaffected by the receding financial meltdown to the fact they neither engage in debt trading nor market speculation (para. 2). Conventional banking models become much more risky due to debt trading and market speculation (Rahman para. 7).

The era of financial liberalization have heralded a new wave of competition not previously witnessed in the banking market, forcing financial institutions the world over to become more innovative, creative, and entrepreneurial in order to survive. Conventional banks are continually entering new markets and developing new products to keep up with the pace since “…their traditional intermediation business of accepting deposits and offering loans has been steadily declining especially in the US and UK” (Shahimi et al 24).

As such, many conventional banks have been forced to depend on non-interest income charged as commissions and fees. This, according to Nielson, is a very strong area for IBF since it has never relied on interest transactions to fund its operations (56). According to Ahamed, “…in contrast with conventional finance methods, Islamic financing is not centred only on credit worthiness and ability to repay the loans and interest; instead the worthiness and profitability of a project are the most important criteria of Islamic financing while the ability to repay the loan is sub-segmented under profitability” (para. 4).

IBF have increasingly diversified its range of products to compete favourably with mainstream banking. Rahman notes that Islamic banking has initiated around 100 financial products and solutions to serve both the consumer and wholesale banking (para. 13).

The nature and arrangement of Islamic banking makes it to be favoured by customers since it recognizes their input when it comes to profit sharing. Rahman postulates that IBF traditionally creates its profits from engaging in Sharia-compliant investment activity (para. 14). The profit is then shared back with the institution’s clients at a pre-arranged ratio, that is, a bank customer is entitled to a share of the profits accrued according to the money or savings he holds in his account. Conventional banks, on the other side, belittle customers with their structures as they are often too capitalistic and profit-oriented at the customer’s expense (Iqbal & Llewellyn 56). One of the Islamic banking tenets, that money cannot be made from money and instead has to be created through investment and trading, has made IBF to attract a lot of interest and customers (Samad 117).

Limitations of Islamic Banking

The Islamic financial principles in the Islamic law, especially the Riba, are interpreted differently across the banking institutions and countries, leading to a perceived lack of standardization in IBF (El-Gamali 10). In some countries, Islamic banking is accused of deviating from the norm to incorporate conventional banking standards and regulations. According to Pollard & Samars, “…Islamic banking, at least as practiced in Malaysia, deviates from the PLS paradigm, and in practice is not very different from conventional banking” (315) Second, Islamic banks meet fierce competition from commercial conventional banks especially due to financial liberalization and deregulation of banking rules. Accordingly, “…to compete in local and global deposit markets, Islamic banks have to design and innovate Islamically acceptable instruments that can cope with the continuous innovations in financial markets” (Hassan & Bashir 4).

Third, Islamic financial institutions pose risks to the overall financial system that in more than one way deviate from those posed by other commercial conventional banks. According to Cihak & Hesse, “…risks unique to Islamic banks arise from the specific features of Islamic contracts, and the overall legal, governance, and liquidity infrastructure of Islamic finance” (5). For example, the PLS financing largely shifts the direct credit risk from financial establishments to their investment depositors, not mentioning the fact that it increases the general level of risk on the asset the establishment’s balance sheet as it occasions the Islamic banks to become susceptible “to risks normally borne by equity investors rather than holders of debt” (Cihak & Hesse 5).

Fourth, the threat of losses resulting from insufficient or failed internal or external processes, otherwise known as operational risk, is considered bigger in Islamic banking than it is in conventional commercial banks. In particular, PLS transactions cannot in anyway rely on collateral or guarantees to curtail credit risks (Vayanas et al 7). As such, “…product standardization is more difficult due to the multiplicity of potential financing methods, increasing operational risk and legal uncertainty in interpreting contracts” (Cihak & Hesse 5 ).


Data &Sample

The report use data on selected Islamic and conventional commercial financial institutions from 24 banking systems operating in Organization of Islamic Conference (OIC) countries. The sample covers financial establishments in the jurisdictions offering both Islamic and convention al ban king facilities. Data of Twelve Islamic banks from several countries was used. For comparative objectives, another sample of twelve conventional commercial institutions was used. These financial establishments were selected from exactly the same nations from where the Islamic establishments were selected, and a concerted effort was made to come up with data of conventional financial institutions that are roughly of the same stature as the Islamic establishments. The secondary data used covers the 2000-2008 period. The data for these financial establishments has been compiled from various sources such as BankScope and Banker’s Almanac. The names of the financial institutions included in the study are shown below.

Table 2: Financial Institutions Included in the Sample

No. Islamic Banks Conventional Banks
1. Al Barakah Turkish Finance House, Turkey (BKTFH) Finansbank AS , Turkey
2. Qatar Islamic Bank, Qatar ( QIB) Qatar National Bank SAQ , Qatar
3. Faysal Islamic Bank, Bahrain (FIBB) National Bank of Bahrain BSC, Bahrain
4. Kuwait Finance House, Kuwait (KFH) National Bank of Kuwait SAC, Kuwait
5. Jordan Islamic Bank, Jordan (JIB) Bank of Jordan Plc, Jordan
6. Bank of Islam Malaysia Behard, Malaysia (BIM) The Pacific Bank Behard, Malaysia
7. Al Baraka Islamic Investment Bank, Bahrain ( BKBN) Arab Banking Corporation BSC, Bahrain
8. Islami Bank Bangladesh, Bangladesh (IBBG) Arab Bangladesh Bank Ltd, Bangladesh
9. Bahrain Islamic Ban k, Bahrain (BIB) Bank of Bahrain & Kuwait BSC, Bahrain
10. Dubai Islamic Bank, UAE (DIB) Masreq Bank PSC, UAE
11. Faysal Islamic Bank, Egypt ( FIBE) Egyptian American Bank, Egypt
12 Al Rajhi Banking & Investment Corporation, Saudi Arabia (Rajhi) Royal Bank, Saudi Arabia
Source: BankScope and Banker’s Almanac (2000-2008)


This study employs a quantitative research design in evaluating if Islamic financial establishments can offer a viable alternative to conventional commercial banks. The comparisons among Islamic banks and conventional banks will be based on credible secondary data drawn from internet sites such as Bloomberg. According to Persky, a quantitative research approach is advantageous in this type of scenario since it will allow a deeper evaluation of the correlations that exist between the Islamic banks on the one hand and conventional banks on the other (230). The quantitative design will employ an experimental approach since the secondary data from the targeted financial institutions was not measured once as is the case with descriptive approaches; rather, the data was measured over a period of time.

The Stochastic Frontier Approach (SFA) was employed to evaluate the viability and efficiency of both Islamic and conventional banks. This approach has been widely utilized by a number of studies to specifically evaluate profitability and cost effectiveness of financial institutions (Husain 55; Pollard & Samers 317).

According to Mohamad et al, “…the SFA starts with a standard cost or profit function and estimates the minimum cost or maximum profit frontier for the entire sample from balance sheet data…the efficiency measure for a specific bank observation is its distance from the frontier” (113). Other frameworks such as total equity, total deposits, total investments, and total assets were used to evaluate viability of Islamic banks vis-à-vis conventional establishments.

Reliability & Validity

Several broad issues relating to the secondary data used need to be discussed. First, to be able to evaluate the viability of Islamic banks as an alternative banking system, the data will focus on nations where Islamic financial institutions have a considerable share of the financial system. El Qorchi asserts that Islamic financial institutions operate in more than 75 nations, yet they continue to have an insignificant market share in most of these nations (23). To achieve consistency of measurement, the study will only be interested in financial systems where Islamic banks account for more than 1 percent of the overall asserts. To attain validity, the study will only utilize consolidated bank statements of both conventional and Islamic banks. It is prudent to note that, Bloomberg data, while being one of the most inclusive commercially available data of the financial and investment sector, is not exhaustive.

Results & Analysis


The results for general viability in terms of cost and profit effectiveness of all the sampled banks are documented in the table below. The results also include figures for conventional versus Islamic financial institutions, and uses the Stochastic Frontier Approach, described in the methodology section, to arrive at the figures.

Table 3: Cost and Profit Effectiveness of Selected Conventional & Islamic Financial Institutions

Bank category Descriptive Statistics Cost Effectiveness Profit Effectiveness
All Banks N 24 24
Mean 0.307 0.752
Std. deviation 0.012 0.028
Maximum 0.665 0.878
Minimum 0.130 0.727
Islamic Banks N 12 12
Mean 0.317 0.751
Std. deviation 0.127 0.025
Maximum 0.666 0.878
Minimum 0.130 0.731
Conventional Banks N 12 12
Mean 0.292 0.753
Std. deviation 0.094 0.753
Maximum 0.652 0.860
Minimum 0.165 0.725

The table below demonstrates annual growth rates for the sampled Islamic banks against some key variables.

Table 4: Annual Growth Rates for Sampled Islamic Banks against Key Variables.

Bank Total Equity Total Deposits Total Investment Total Assets Total Revenue
BKTFH 9.1 14.8 13.4 10.4 4.0
QIB 5.1 5.1 7.0 7.8 7.6
FIBE 10.7 4.7 22.6 9.5 12.8
KFH 17.6 3.0 8.0 5.2 11.5
JIB 18.6 13.3 13.6 13.2 8.9
BIM 27.4 8.7 11.0 12.0 13.6
BKBN 1.6 -3.8 -3.6 -2.3 19.0
IBBG 18.5 15.9 15.2 16.0 13.0
BIB 9.7 4.6 5.8 5.6 4.7
DIB 20.3 11.8 11.0 11.5 11.5
Rajhi 7.6 10.8 9.6 9.4 5.7
Simple average 12.0 7.6 10.0 8.4 9.4
Std. deviation 8.6 6.0 6.3 5.1 5.2
Wt. average 10.2 7.2 9.1 7.8 7.3
N.B: Look at the methodology table for meanings of the initials

Analysis & Discussion

Results from the SFA analysis (table 1) revealed that both conventional and Islamic financial institutions are more profit effective and less cost efficient. According to the figures, the average cost and profit effectiveness for conventional financial institutions operating in OIC countries stands at 29.3 and 75.3 percent, respectively, while figures for Islamic financial institutions stands at 31.8 and 75.0 percent.

This scores demonstrate that Islamic establishments are more cost-effective, a scenario that can be attributed to the principles of Islamic banking, where a profit and loss framework obliges the Islamic financial establishments to enter into a binding joint venture with its clients for purposes of providing capital, which must never be advanced at an interest (Chiu et al 64; Saeed 497). Although the difference of Islamic banks cost effectiveness is not statistically significant to that of conventional banks, it is a vivid pointer that Islamic banking sector is viable.

The results for the selected key variables (table 2) reveals that Islamic growing is growing, albeit at a much slower rate than it used to in the 1980. Below, the results are analyzed according to the key variables used.

Total Deposits

Indeed, table 2 clearly reveals that the total deposits for Islamic banks grew at an average of 7.2 percent from 2000 to 2008. According to Chapra, Islamic financial institutions were growing at a rate of 15 percent in the decade of the 1980s (47). The huge growth of Islamic banking in the 1980s could have been triggered by the advent of Islamic banks, whereby many Muslims who were previously keeping their money in lockers due to absence of a viable alternative finally found a banking system that took care of their faith.

Another explanation as to why the growth in total deposits for Islamic banks continues to decline is the fact that conventional banks started offering Islamic products in the 1990s, and have continued to do so during the decade of the 2000s (Abdelkader 18). According to Chiu et al, these western multinational financial institutions brought with them their cutting-edge marketing skills, international connections, superior customer relations, and advanced technology, thereby attracting more Muslims into their banking halls (67).

Thirdly, some of the Islamic deposits that characterized the era of the 1980’s may have found their way into Islamic mutual funds, which gained ground in the 1990s and early 2000s (Abdelkader 22). The above explains why the overall growth in terms of total deposits of the selected Islamic banks appears to decline. Still, the banks present a formidable alternative to mainstream banks as they have been able to achieve an average growth rate of 7.2% between 2000 and 2009.

Total Equity

Equity is the most fundamental variable in evaluating the viability and strength of an establishment (Chapra 18). Table 2 clearly reveals that total equity for the selected Islamic banks grew at an estimated average rate of 10.2 percent (weighted average) from 2000 to 2008 for the selected Islamic banks. An interesting finding is that there is a constant upward trend for total equity throughout the period, a significant indicator that Islamic banking have come of age and can be used as an alternative to mainstream banking if such a need ever arises. Such an arrangement is known to enhance the capital asset ratio, a factor that makes financial institutions to improve their productivity (Chiu et al 66). The constant upward trend on total equity reveals that more people are increasingly using Islamic banking services, not mentioning the fact that there exist immeasurable opportunities for growth.

Total Investment

According to Ahmad et al, the increment in total investments naturally depends in the increment in total deposits and total equity (29). Consequently, the total investment variable is fundamentally important since the overall viability and performance of the financial institutions is dependent on total investment. According to findings posted in table 2, the rate of growth of total investment for the Islamic banks for the entire period (2000-2008) stands at 9.1 percent. It can be observed that the declining rate of total deposits in Islamic banks have a direct effect on the growth of total investments (Cyril & Erwan 1005). Overall, the rate of growth of total investment for the Islamic banks is enough evidence that the banks have been able to establish themselves in the global financial scene, especially in Organization of Islamic Conference (OIC) countries.

Total Assets

The total assets of the selected Islamic financial institutions grew at an average rate of 7.8 percent during the 2000-2008. From the figures in table 2, it can be reviewed that most of the Islamic financial establishments posted double figures in the growth of total assets for the period between 2000 and 2008, yet another vivid indicator that the sector is viable to be incorporated into the mainstream banking system. The finding on the constant growth of total assets of Islamic banks reinforces the earlier literature that assets held in Islamic banks, especially in sukuk or Islamic banks are so huge that several governments, UK included, had expressed interest to engage in offering Islamic bonds to attract the immense capital that is normally held by OIC countries (Vogal & Hayes 48). This reinforces the fact that that the Islamic finance sector has matured enough to be incorporated into the mainstream banking system.

Total Revenue

The total revenue base for the selected Islamic banks grew at a handsome average rate of 7.3 percent for the period between 2000 and 2008. According to Wilson, Islamic banks mostly derive their revenues from non-interest income such as fees, commissions, and PLS arrangements (39). Fee-based income is usually perceived as relatively safe for banking institutions, and its increment has obvious ramifications for the overall profitability Islamic financial institutions (Chapra 12). A larger revenue base means a larger muscle for the Islamic banks to effectively conduct their business and achieve their growth targets.

Conclusions and Recommendations


The study revealed that Islamic banks are more cost effective than conventional banks in OIC countries. The growth of Islamic banks in terms of total deposits has slackened to about 7.2% yearly from a massive 15% recorded in the 1980’s. This can be attributed to the entry of conventional banks into the business of offering Islamic products, thereby offering stiff competition to Islamic banks. The total equity for selected Islamic banks grew at an average rate of 10.2 percent from 2000 to 2008, yet another vivid indicator that Islamic banks could offer a viable alternative to mainstream banks. The study has demonstrated that the overall viability and performance of the financial institutions is dependent on total investment. The findings demonstrate that the rate of growth of total investment for the Islamic financial institutions was healthy to guarantee the viability of the sector.

Apart from the above, it is evidently clear that Islamic financial establishments posted double figures in the growth of total assets for the period between 2000 and 2008, another vivid indicator that the sector is viable to be incorporated into the mainstream banking system. Also, the interest showed by various capitalistic nations to trade in Islamic bonds (sukuk) reveals that reinforces the fact that that Islamic finance sector has matured to be incorporated into the mainstream banking system.

It can be revealed that the total revenue base for the selected banks constantly grew to reflect that the sector is viable to be incorporated into mainstream banking system. Lastly, the study has demonstrated that fee-based income is usually perceived as relatively safe for banking institutions, and its increment has obvious ramifications for the overall profitability Islamic financial institutions.


According to this paper, it is clear that Islamic banking can be incorporated into the mainstream conventional banking system. It should, however, be noted that it was not the purpose of this paper to evaluate if Islamic banking can replace conventional banking systems. To the contrary, the paper was interested in evaluating if IBF can become a viable alternative to conventional banking systems. It has been revealed that this is possible if:

  1. Conventional banks workout more strategies that will enable them to offer Islamic financial products to mainstream customers who may be interested.
  2. Islamic banks harness their efforts and strategies to offer products that follow strict interpretations of Islamic law so as to attract devout Muslims. As it stands now, some Islamic financial products on offer are largely conventional.
  3. Massive awareness campaigns are carried out by financial institutions and other stakeholders to ensure customers are made aware of the nature and operations of Islamic banking.

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