Ernst and Young (E&Y), in their latest World Islamic Banking Competitiveness report, shows the assets of Islamic banks grew at an average rate of 17% per year between 2008 and 2012.
This is two to three times faster than the rate at which conventional banks grew over the same period, due in part to the global financial crisis.
Islamic banks differ because they have to run their operations in a way that is consistent with the principles of Islamic law or sharia.
This prohibits banks from dealing with businesses that are considered sinful or haraam such as pork, alcohol and gambling. Admittedly, this is not much of a constraint.
However, usury or riba is also prohibited under sharia law so in principle banks cannot charge fees or interest for money lending.
How it works
Given this is how banks generally make their money, you may ask how Islamic banks prosper?
The answer is they still make money by lending out their capital but do so in ways where interest and fees are not explicit.
For instance, Mudharabah is a profit sharing arrangement like a venture capital deal where the bank provides the finance and the borrower the labour and entrepreneurship.
If the business were to fail, the lender loses their money and the borrower the time and effort committed to the enterprise.
Similarly, Musharakah describes a joint venture between a bank and business where the profits are divided according to their relative capital inputs.
In this way, bank returns are tied to company profits and the partnership ends when the loan is repaid.
This approach could be used to provide mortgage financing to buy a property. The property earns rent from the occupier which is paid to the buyer and the bank in relation to their share of the equity.
At the same time, the buyer agrees to buy the bank's share in instalment payments, so over time their equity increases and the bank's falls, until the mortgage principal is paid off.
Another way of profiting from providing credit is a simple form of sale and buy-back agreement known as Murubahah.
Here, the bank buys the house, car or other commodity and sells it to the buyer at a profit but allows them to pay in instalments.
In this case, the profit margin should be clear, agreed upfront and be reflect the bank's costs in providing the service.
Fast growth explained
It is partly because economic growth has been strong in several emerging market countries with a large Muslim population.
E&Y identify 25 "rapid growth market" countries which they predict will account for half of global GDP by 2020. Of these, 10 have a high Muslim population.
Iran accounts for nearly half of the banking assets in Islamic banks worldwide.
Three-quarters of the rest is in the QISMUT nations [Qatar, Indonesia, Saudi Arabia, Malaysia, UAE and Turkey] where growth has averaged 6.5% per year for the last five years.
The rapid expansion of Islamic banking has been mainly through Islamic windows in conventional banks rather than in pure Islamic banks.
This has allowed existing banks to easily enter the Islamic banking market and is likely to continue being a mechanism for growth for the foreseeable future.
'Huge untapped Muslim populations'
There is certainly space for E&Y's estimate of 20% growth for each of the next five years.
Even in countries where Islamic banking has a strong foothold, such as the Gulf states and in South East Asia, its share rarely accounts for more than one third of the market.
In Indonesia, the world's most populous Muslim country, Islamic banking currently has less than 5% market share.
There are also huge untapped Muslim populations around the world including India, Pakistan and Bangladesh in South Asia; Egypt, Nigeria, Morocco and Nigeria in Africa; and a number of the former Soviet Republics.
It is also expected that growth will not just be limited to regions with a high Muslim population.
Last month, the UK issued a £200 million sovereign sukuk or Islamic bond.
Although the amount is small, a fraction of the value issued by Malaysia each year, it was a clear signal of intent.
It comes on the back of the Islamic Finance Task Force launched last year by the British government with the aim of making London a western hub for Islamic finance.
Challenges ahead
Many of the rapid growth market countries face ongoing economic and political instability.
As the era of cheap money ends and the huge monetary stimuli from central banks is withdrawn, growth in these regions may slow down, especially in the banking sectors.
Islamic finance is also less profitable than conventional banking.
The E&Y report finds that shareholder returns are 20% lower as a result of higher costs and operational inefficiencies.
Islamic banks tend to be much smaller than their conventional counterparts, making it hard to achieve economies of scale.
There is also far less standardisation in the products available because of different interpretations between banks and jurisdictions of what is acceptable under sharia law.
Islamic banking products are also more complex which adds to their cost.
The importance of face-to-face relationships means the branch network is important, but has resulted in an under-development of phone and internet banking.
And, Islamic banks are relatively poor at cross-selling with an average of 2.1 products per customer compared to 4.9 products per customer in conventional banks.
When regulators in Qatar acted to prevent banks from offering both Islamic and conventional banking products forcing a choice between the two, many decided to close their Islamic banking operations in the country.
Islamic banks have tremendous scope to keep growing within the niches, compatible with sharia law and in certain parts of the world. But, unless they face up to these challenges, they might struggle to take the conventional banks head on.
(BBC News Business/18 July 2014)
