EXECUTIVE SUMMARY
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. Other key issues include the desirability of Government protection, which has arguments both for and against; and the growing importance of adherence to Islamic principles, which while forging consensus amongst industry practitioners, also sets the industry on a collision course with the regulatory authorities.
The industry faces a number of specific challenges. First, there are intrinsic problems in the Profit-and-Loss Sharing paradigm upon which the banking operations are based. These result from the asymmetry of information and moral hazard, further exacerbated by the banks’ lack of managerial control in the firms with whom they enter a joint-venture partnership.
Second, the industry needs to develop a deep, stable pool of funds for their lon ...