Islamic banking is characterized by compliance to the Islamic laws, or Sharia. The defining characteristic is the banning of all interest-based finance, from deposits to loans, from assets buyable to all bank operations. Of particular note is the Prophet Muhammed’s injunction against interest but encouragement of trade, “…usury is forbidden but trade is allowed”, leading to the Profit-and-Loss Sharing paradigm which underpins many of the Islamic transactions and financial instruments.
In the course of 50 years, Islamic banking has grown from a secretive experiment in Egypt in the 1950s to the trillion-dollar industry that it is today. While the historical growth rate is by no means stellar, recent estimates of growth rates of between 15% to 20% have placed this industry among the fastest-growing in the world. However, the industry grows in an environment already saturated with numerous large incumbents whose interest rates currently dictate the Islamic banks’ rates of return. The other key issues with regard to Islamic banking are that the reasons for participating in the industry will be reduced to religious and ethical concerns in the long run, and intrinsic problems in the Profit-and-Loss Sharing paradigm upon which the banking operations are based. The industry also faces significant long-run challenges, such as a lack of a convincing macroeconomic theory based on Islamic principles, and an acute lack of qualified Sharia scholars, which may together constrain the growth of the industry.
Nevertheless, the long-run prospects are good. The market for banking is yet underdeveloped in the largest Muslim country in the world, Indonesia, and the industry’s costs should fall as a result of standardization in accounting practices and financial instruments offered. This ...