History and Growth of Islamic Banking and Finance

How Islamic banking started

From a very early stage in Islamic history, Muslims were able to establish a
system without interest for mobilizing resources to finance productive
activities and consumer needs. The system worked quite effectively during
the heyday of Islamic civilization and for centuries thereafter. As recorded by
Professor S. D. Goitein, partnership and profit-sharing rather than interestbased borrowing and lending formed the basis of commerce and industry in
twelfth and thirteenth centuries in the Mediterranean region.1 However, as
the centre of economic gravity shifted over the centuries to the Western
world, Western financial institutions (including banks) became dominant and
the Islamic tradition remained dormant. In recent years, however, there has
been a significant revival of interest in developing a modern version of the
historic Islamic financial system in the wake of Muslims desire to stay clear
of interest.
When commercial banking emerged after the industrial revolution, a very
large majority of Muslim scholars expressed their serious reservations with
this model of financial intermediation due to its reliance on interest rate
mechanism and they called for the development of alternative mechanisms
to perform the financial intermediation function in Muslim societies. Muslim
masses to a very significant extent refrained from dealing with commercial
banks. However, the growing needs of traders, industrialists and other
entrepreneurs in rapidly monetizing economies were pressing. The Muslim
economists and banks took up the challenge of developing alternative
models of financial intermediation. Valuable theoretical work was done in the
early nineteenth century. At that time most of the Muslim world was under
colonial rule. When Muslim countries gained their independence after the
Second World War, practical experiments in interest-free financing started on
a modest scale and gradually expanded in scope.
While credit societies and cooperatives (working on an interest-free basis)
existed in several Muslim countries even during the colonial period, the
semblance of banking institutions started emerging in the early 1960s. A
pioneering experiment of putting the Islamic principles governing financial
dealings into practice was conducted in Mit Ghamar, Egypt, from 1963 to
1967. Deriving inspiration from the idea of German saving banks, the Mit
Ghamar initiative mobilized small savings from the rural sector largely
through savings accounts. No interest was paid to the account holders.

However, as an incentive they were eligible for small, short-term, interestfree loans for productive purposes. They were allowed to withdraw their
deposits on demand. In addition, investment accounts on the basis of profit
sharing were also introduced. The funds so mobilized were invested on the
basis of profit-sharing with entrepreneurs. The first interest-free institution
with bank in its name, Nasser Social Bank, was also established in Egypt in
1971. This was the first time that a government in a Muslim country had
shown an interest in incorporating an interest-free institution. Even though
the objectives of the Nasser Social Bank were mainly social, such as
providing interest-free loans to the poor and needy, scholarships to students,
and micro-credits to small projects on a profit-sharing basis, the involvement
of a public authority in interest-free banking sent important signals to Muslim
businessmen who had surplus funds. A group of such businessmen took the
initiative of establishing the Dubai Islamic Bank in 1975 in Dubai in the
United Arab Emirates (UAE). This was the first Islamic Bank established on
private initiative. However, official support was crucial with the governments
of the UAE and Kuwait contributing respectively 20 per cent and 10 per cent
of the capital. The most important development in the history of Islamic
banking took place with the establishment of the Islamic Development Bank
(IDB) in 1975. The IDB was established as an international financial
institution in pursuance of the declaration of intent issued by a conference of
finance ministers of Islamic countries held in Jeddah, Saudi Arabia, in
December 1973. The declaration was signed by the representatives of 23
member countries of the OIC. The second conference of finance ministers,
held in Jeddah in August 1974, adopted the Articles of Agreement
establishing the Islamic Development Bank. The inaugural meeting of the
Board of Governors of the IDB took place in Riyadh, Saudi Arabia, in July
1975 and it started functioning on 20 October 1975. The period between
1975 and 1990 was the most important period in the history of development
of Islamic financial industry. During this period, it matured into a viable
alternative model of financial intermediation. It won respect and credibility in
terms of both theoretical developments and practical experiences. On the
one hand, several financial products compatible with the Sharijah were
developed and, on the other hand, Islamic banks showed good results while
using these products. The period was not.
only marked by the establishment of a large number of Islamic financial
institutions in the private corporate sector under different socio-economic
conditions, but also witnessed the expression of intent from three countries
Pakistan, Iran and Sudan gradually to eliminate interest from their entire

economies and substitute it with a complete banking system based on

Islamic principles. Several practical steps were also taken in these countries
towards achieving that objective. Even more important was the fact that
several important multinational banks started offering Islamic financial
products. That was a clear recognition of the viability of the new model and
its acceptance by international players. The International Monetary Fund
(IMF) and the World Bank also recognized Islamic financial products as a
genuine means of financial intermediation and produced papers to that
effect. In the 1990s, while the growth of the banking industry continued
(though at a slower rate), attention was also given to non-bank financial
institutions. Islamic financial institutions other than banks started coming on
the scene in increasing numbers. These included insurance companies and
investment funds. While the Islamic insurance sector has not registered
sufficient growth, Islamic investment funds have witnessed significant
progress. Initiatives for the establishment of some of infrastructure
institutions supporting the Islamic financial industry also started in the
1990s. At the beginning, Islamic banking institutions had to work within the
institutional framework that supports conventional banking. They were at a
comparative disadvantage because that framework was not specifically
geared to their needs. A beginning has been made towards constructing a
network of supporting institutions for the Islamic financial industry.
Iqbal, M., Molyneux, P., & Conermann, S. (2006). Thirty years of Islamic banking. History, Performance
and Prospects. Bankhistorisches Archiv, 32(2),

From a situation nearly 30 years ago when it was virtually unknown,Islamic

banking has expanded to become a distinctive and fast growing segment of
the international banking and capital markets.There are well over 200 Islamic
banks operating in over 70 countries comprising most of the Muslim world
and many Western countries
Many people are interested in the phenomenon of Islamic banking and in the
question of how it differs from conventional banking, yet, despite the
expansion over the last 30 years,Islamic banking remains poorly understood

in many parts of the Muslim world and continues to be a mystery in much of

the West

M. Kabir Hassan and Mervyn K. Lewis 2007 p1

EMERGENCE OF ISLAMIC BANKING

Although Islamic banking was practiced during the classical period, the
modern experiment of profit and risk-sharing business, which is the
cornerstone of Islamic banking business, was first undertaken in 1963 in Mit
Ghamr, a city in the Nile Delta in Egypt. Its purpose was to explore the
possibilities of mobilizing local savings and credits as an essential
requirement for socioeconomic development in the area. (El Naggar, 2005).
The ripple effects of this successful experiment were felt in some other
Muslim countries after some years. Few years before the bank consolidated
its services in 1981, other banks such as the Islamic Development (IDB) and
Dubai Islamic Bank opened their doors to customers in 1975. Also, Malaysia
followed suit with the enactment of the Islamic Banking Act 1983. This
brought about the establishment of the first formal financial institution in
Malaysia in 1983 known as the Bank Islam Malaysia Berhad (BIMB) (Oseni,
2009). The Islamic banking and finance industry has continued to grow in
leaps and bounds over the years. The industry grows at a rate of 1015% per
year (Khan et al., 2007). It is now the fastest-growing segment of the global
financial system, with the unremitting establishment of Islamic banks in the
Muslim world and beyond.

ISLAMIC FINANCE INSTRUMENTS AND MARKETS

The major developments in modern Islamic economics and finance are

summarized in table 1.1
TABLE1.1 Developments in modern Islamic economics and finance

Pre-1950s
Barclays Bank opens its Cairo branch to process financial transactions
related to construction of the Suez Canal in the 1890s. Islamic scholars
challenge the operations of the bank, criticizing it for charging interest. This
criticism spreads to other Arab regions and to the Indian subcontinent, where
there is a sizable Muslim community.
The majority of Shariah scholars declare that interest in all its forms
amounts to the prohibited element of riba

1950s60s
Initial theoretical work in Islamic economics begins. By 1953, Islamic
economists offer the first description of an interest-free bank based on either
two-tier mudarabah ( profit - and loss-sharing contract) or wakalah
(unrestricted investment account in which the Islamic bank earns a at fee).
Mitghamr Bank in Egypt and Pilgrimage Fund in Malaysia start operations.
1970s
The first Islamic commercial bank, Dubai Islamic Bank, opens in 1974.
The Islamic Development Bank (IDB) is established in 1975.
The accumulation of oil revenues and petrodollars increases the demand
for Shariah complaint products .
1980s
The Islamic Research and Training Institute is established by the IDB in
1981.

 Banking systems are converted to an interest-free banking system in the

Islamic Republic of Iran, Pakistan, and Sudan.
Increased demand attracts Western intermediation and institutions.
Countries like Bahrain and Malaysia promote Islamic banking parallel to
the conventional banking system.
1990s
Attention is paid to the need for accounting standards and a regulatory
framework. A self-regulating agency, the Accounting and Auditing
Organization of Islamic Financial Institutions, is established in Bahrain.
Islamic insurance ( takaful ) is introduced.
Islamic equity funds are established.
The Dow Jones Islamic Index and the FTSE Index of Shariah -compatible
stocks are developed.

2000the present
The Islamic Financial Services Board is established to deal with regulatory,
supervisory, and corporate governance issues of the Islamic financial
industry.
Sukuks (Islamic bonds) are launched.
Islamic mortgages are offered in the United States and United Kingdom.
Source:
Khan (1996); IDB(2005)
13
Van Greuning, H., & Iqbal, Z. (2008). Risk analysis for Islamic banks. World Bank Publications.

Khan, Mohsin. 1987. Islamic Interest-Free Banking: A Theoretical Analysis. In

Theoretical Studies in Islamic Banking and Finance, ed. M. Khan and A. Mirakhor.
Houston, TX: IRIS Books

Khan, Tariqullah. 1996.An analysis of risk sharing in Islamic finance with

special reference to Pakistan,Doctoral Thesis,Department of
Economics,Loughborough University,United Kingdom.

Islamic banks have grown in numbers, but the average size of assets is still
small compared with that of a conventional bank. No Islamic bank is on the
list of the top 100 banks in the world. According to some estimates, more
than 60 percent of Islamic banks have assets that are below the level ($500
million) that theoretical studies suggest as being the minimum to be viable.
Aggregate assets of all Islamic banks are still less than those of any of the
top 60 banks in the world. Finally, the size of assets of the largest Islamic
bank amounts to a meager 1 percent of the assets of the largest bank in the
world (see table 2.3).

Van Greuning, H., & Iqbal, Z. (2008). Risk analysis for Islamic banks. World Bank Publications.

4.1 The Emergence of Islamic Banking

The first Islamic bank was established in Egypt in 1963 and was called the
Mit Ghamr Local Savings Bank. The bank operated on the basis of Shariah
law and prospered because it was able to meet the savings and credit needs
of its customers. The success of the Mit Ghamr Local Savings Bank proved
that a bank operating according to Islamic principles could ourish. It was
followed, in 1967, by the Nasir Social Bank. This was the first social bank to
be constituted according to Shariah principles. Apart from managing various
forms of financial transactions, the bank also granted interest-free loans to
its customers.
Following these initial successes ,a number of Islamic banks were founded in
various other Muslim countries in the Middle East from the mid-1970s
onwards. They included:
The Islamic Development Bank in Saudi Arabia (1975)
The Dubai Islamic Bank (1975)
The Faisal Islamic Bank in Egypt (1976)
The Faisal Islamic Bank of the Sudan (1977)
The Jordan Islamic Bank (1978)
The Jordan Financial and Investment Bank (1978)
The Islamic Investment Company Ltd in The United Arab Emirates (1978)
Kuwait Finance House (1979)
In order to coordinate Shariah rulings between the various Islamic banks in
different countries, an International Association of Islamic Banks was
established in 1977, with its headquarters located in Saudi Arabia. More
Islamic banks followed in the 1980s, including the first Islamic bank to be
established in a non-Muslim country. This was the International Islamic Bank
of Investment and Development in Luxembourg, which was founded in 1980.
Other Islamic banks established in the 1980s included:
The Abu Dhabi Islamic Bank (1980)
The Qatar Islamic Bank (1981)
Islamic counters in Pakistan banks (1981)

 The Malaysia Islamic Bank Ltd (1983)

The Mauritania Islamic Bank (1985)
The Tanzibar Islamic Bank (1985)
The Iraq Islamic Bank (1985)
The Turkey Islamic Bank (1986)
With the new generation of wealth creation of the Asian Tigers through the
mid-1970s to the mid-1990s, came greater awareness of Islamic finance as
an alternative to trading and banking in South-east Asia. Malaysia has been
particularly energetic in her efforts to popularise its Shariah compliant
products and services to position itself to become the centre of the
international Islamic capital market in the region. Securities Commission (SC)
market policy and development division director, Dr Nik Ramlah Nik
Mahmood, has made it known that the country will continue its efforts to
develop innovative and competitive instruments to heighten its profile
internationally. The challenges include addressing the lack of awareness of
products and services as well as Shariah requirements. Shariah scholars
and jurists are to be involved in the development process and the application
of new technologies such as e-commerce. Among the significant progress
made to date is the good take-up rate for Malaysias sovereign US$500
million (US$1=RM3.80) global Islamic debt securities launched in June 2002.
The debt papers, which were twice oversubscribed, signal Malaysias
penetration into the West Asian market and the immense appetite the
market has for Islamic-based financial instruments. It was a confirmation that
the people there were exposed to the product and they were looking for
Shariah-compliant investments.54 Whilst Malaysia promoted Islamic banks
as a constructive outlet for religious fervour, Saudi Arabia would not allow
Islamic banks in, lest they imply that the kingdoms existing banks were unIslamic. (The Saudi royal family, not incidentally, subsists largely on income
from conventional investments.) The government finally allowed one Islamic
bank to open in 1987, though the word Islam was nowhere in its name.
Today, in banking centres like Kuwait, Dubai and especially Bahrain, which is
known for its strict regulatory measures, Islamic banking is serious business.
A respected group known by the acronym AAOIFI (Accounting and Auditing
Organisation for Islamic Financial Institutions) has codified Shariah rulings
into a set of industry standards. The early zealots have given way to more
pragmatic professionals. Even the Shariah scholars once recruited from

the local mosque and barely uent in English, much less financial statements
are now armed with advanced degrees in economics.
Since 2000, eight countries consisting of Malaysia, Indonesia, Iran, Saudi
Arabia, Pakistan, Sudan, Bahrain and Kuwait have been making efforts to
establish a common and harmonious Islamic banking system. In a meeting in
Kuala Lumpur on 3 November 2002, these countries inked an agreement to
establish the Islamic Financial Services Board to promoteIslamicbanking.55
In the last five years, the industry has accomplished more than it did in its
first 20, says Shamil Banks Jaroudi, in 2002.56
63
ISLAMI BANKING & FINANCE IN SOUTH-EAST ASIA Its Development & Fututre
Angelo M. Venardos

Islamic banking has established itself as an emerging alternative to

conventional interest-based banking and is expanding rapidly over the last
two decades in both Muslim and non-Muslim countries.

islmic banking and interest based banking 13

2.5 History of Islamic banking

ISLAMIC BANKING: ORIGIN, SCOPE, AND GROWTH

The first modern experiment with Islamic banking was undertaken in Egypt under
cover, for fear of being labeled as a manifestation of Islamic fundamentalism,
which was anathema to the government in power. It took the form of a saving bank
based on profit-sharing in the town of Mit Ghamr, lasted until 1967, by which time
there were nine such banks in the country. These banks neither charged nor paid
interest, invested mostly in trade and industry, directly or in partnership with
others, and shared profits with depositors. The 1970s heralded the arrival of a new
age in Islamic finance witnessing the establishment of the Nasr Social Bank in 1971
(Egypt), Philippine Amanah Bank in 1973, the Dubai Islamic Bank in 1975, the
Kuwait Finance House, the Faisal Islamic Bank of Sudan, and the Faisal Islamic Bank
of Egypt, all in 1977, the Bahrain Islamic Bank in 1979, and the Qatar Islamic Bank
in 1981, to mention a few. By the end of 1996 the number of Islamic banks, IBs,
rose to 166 with a total paid-up tier-one capital of $7.3 billion, and total assets of
$137 billion. Moreover, if one excludes the Iranian and Pakistani IBs, the countries
that operate under the Islamic system of banking (along with Sudan), only 40
percent of the paid-up capital and 30 percent of total assets are commanded by
those from other countries. These percentages do not tell the whole picture. The 19
Gulf Cooperative Council, GCC, states command 18 percent of the total paid-up
capital, and 13 percent of total assets of all IBs. In other words, 10 Iranian, 46
Pakistani, and 19 GCC IBs totaling 75 out of 166, command 78 percent of total paidup capital and 83 percent of total assets for the IBs. These numbers appear
impressive if one ignores the size of a single large commercial bank in many
developed economies of the West. Thus, it is quite obvious that IBs are relatively
very small and a few of them are not even profitable

Table 1 shows the number of IBs by region, their capital, total assets, and capitalto-asset ratios for the year-end 1996. Of the 50 financial institutions in South Asia,
5 are in Bangladesh (total capital of $20.6 million, total assets of $594 million), 1 is
in India (total capital of $1.2 million, total assets of $3.5 million), and the remaining
46 are in Pakistan. Of the 35 institutions in Africa, Algeria, Djibouti, Gambia,
Guinea, Mauritania, Niger, South Africa, Senegal, and Tunisia have 1 bank each,
and the remaining 26 are in Sudan. Total capital of those 9 countries' institutions is
$102 million with assets of $376 million representing roughly 48 and 19 percent

respectively of those of all Africa. Of the 30 IBs in Southeast Asia, 3 are in Brunei, 4
are in Malaysia, 1 is in the Philippines, and the remaining 22 are in Indonesia. Two
Malaysian Banks-Bank Islam Malaysia Berhad and Lembaga Tabung Haji-together
account for $3.3 billion of the total assets of $3.8 billion for the entire region.

Middle East is defined here as Egypt, Iran, Iraq, Jordan, Lebanon, Turkey and
Yemen. Egypt has 4 IBs (total capital of$337 million with assets totaling $4. billion),
Iran has 10 (total capital of $32.4 billion with assets totaling $50.2 billion), Iraq has
1 (capital $402 million with assets of $9.9 billion), Jordan has 2 (capital of $23.5
million