Good for Growth?

• Author: Patrick Imam and Kangni Kpodar
• Position: an Economist in the IMF's Monetary and Capital Markets Department and is an Economist in the IMF's African Department.

Islamic Banking

IN Islamic countries, many of them poor and not highly developed, large segments of the Muslim population do not have access to adequate banking services—often because devout Muslims are unwilling to put their savings into a traditional financial system that runs counter to their religious principles (see box). Islamic banks seek to provide financial services in a way that is compatible with Islamic teaching, and if Islamic banks can tap that potential Muslim clientele, that could hasten economic development in these countries.

There is evidence of close correlation between financial sector development and growth. Countries whose financial systems offer a variety of services—including banking and insurance—tend to grow faster. Banks, whether Islamic or traditional, play a fundamental economic role as financial intermediaries and as facilitators of payments (King and Levine, 1993). They also help stimulate saving and allocate resources efficiently.

Globally, the assets of Islamic banks have been expanding at double-digit rates for a decade, and Islamic banking is an increasingly visible alternative to conventional banks in Islamic countries and countries with many Muslims. Our study identifies the sources of Islamic banking’s expansion and ways to stimulate its continued growth. Knowing what drives the development of Islamic banking will help developing countries in Africa, Asia, and the Middle East catch up.

The rise of Islamic banking

Four decades ago, Islamic banking emerged on a modest scale to fill a gap in a banking system not attuned to the needs of the devout. Two events were crucial to its development. First, the early 1960s appearance in rural Egyptian villages of microlending institutions following Islamic banking principles demonstrated the feasibility of Islamic banking. These experiments thrived and spread to Indonesia, Malaysia, and sub-Saharan Africa.

Second, top-down support following the 1975 esÂtablishment of the Islamic Development Bank in Jeddah, Saudi Arabia, further spurred diffusion of Islamic banking by centralizing expertise. In its infancy, Islamic banking required much interpretation of Shariah law by Islamic scholars. In the first few years, basic implementation tools—such as legislation allowing such banks to be set up and the training of staff—were key ingredients for the spread of Islamic banking. And the past few years have seen rapid innovation, most recently improved regulation of liquidity...