Could post-revolutionary North Africa become the next big market for sharia-compliant finance? That is the question some of the Gulf’s top banks are asking themselves as the mostly Islamist governments of Egypt and the Maghreb look to reform their economies.

The potential is massive. Egypt is the Middle East’s most populous nation with 82 million people. Libya has fewer people, but massive energy reserves. Morocco and Tunisia have a large urban middle class and strong business traditions. Algeria, should it move towards economic liberalisation, would also offer significant opportunities.

Growth potential for Islamic banks

“We expect the banking segment to be the most dynamic growth area,” says Nicolas Hardy, Middle East banking analyst at ratings agency Standard & Poor’s. “There are incentives for North African countries that are largely cash economies with low banking penetration to boost financial intermediation. This is especially true in Egypt.

“In Tunisia and Morocco, there are also incentives to reduce liquidity pressures on banks by enhancing the customer deposit base. Various initiatives are being considered to expand formal banking sectors, especially for retail customers and small to medium entreprises. Islamic finance is one of them.”

A number of countries have already laid the groundwork to support the growth of Islamic finance. Soon after the overthrow of Muammar Gaddafi’s regime in 2011, Libya’s National Transitional Council (NTC) began work on amending the country’s banking legislation.

Proposals for a new Islamic finance regulatory structure were drafted by the central bank. In May, the NTC adopted a draft framework and within weeks central bank governor Sadik Kabir raise the potential for UAE sharia-compliant banks to enter the Libyan market.

Morocco has also drafted a legislative framework for a much enlarged Islamic banking sector. In some North African countries, sharia-compliant services are already part of the financial sector, but are now likely to play a more significant role.

“Islamic banking is already established in Egypt and Tunisia. Several conventional banks in Egypt already offer Islamic banking products, including the largest government-owned banks. The expertise is already there,” says Hardy.

Even so, Islamic finance is, Hardy says, “at an early stage of market development”.

Beit Ettamouil Saoudi Tounsi (Best Bank), established in 1983 and part of the Al-Baraka Banking Group since 2010, was a pioneer of Islamic financing in Tunisia. Noor Islamic Bank, from Dubai, opened a Tunis unit in 2008.

But it was not until 2010 that Mohamed Sakher Al-Materi, son-in-law of the then president, Zine al-Abidine Ben Ali, founded Banque Zitouna as the Maghreb’s first indigenous commercial Islamic bank. In October 2011, the Tunisian Association for the Islamic Economy was established after the revolution ended.

In Egypt, 14 licences for the provision of Islamic banking services are currently in force. There are three fully-fledged Islamic institutions, while several other lenders, including the country’s biggest bank, National Bank of Egypt, have Islamic windows.

But the sector has not grown as fast as expected. According to recent central bank data, there are only 200 Islamic branches and £E120bn ($19.9bn) in sharia-compliant assets in Egypt today, compared with assets of £E1.3 trillion in the banking sector as a whole.

Moreover, there are signs that the development of more Islamic institutions could encounter resistance from parts of the ruling establishment. Parliamentarians from the Freedom and Justice Party (FJP), the political arm of the Muslim Brotherhood, have proposed changes to banking laws to encourage the growth of Islamic finance. They hope to expand its share of banking activity from 5 per cent now to 35 per cent in five years’ time.

But it is still unclear how the power balance will develop between the government led by President Mohamed Mursi and the military, still a force to be reckoned with in Egyptian politics.

Furthermore, in May, the Central Bank of Egypt said that although it would permit conventional banks to open Islamic windows it would block the creation of new purely Islamic institutions.

Challenges ahead for Islamic finance sector

One of the key challenges facing North African countries seeking to develop their Islamic finance sectors is the establishment of consistent structures to monitor sharia compliance. In Egypt, the FJP proposes each Islamic bank form its own independent sharia board, a panel of at least three scholars, who would be registered with the central bank. No expert could serve on the sharia panel of more than two banks simultaneously.

Islamic banks would have to create sharia-compliant financial instruments. They would also have to develop a money market to handle surplus cash and insure customer deposits through takaful (sharia-compliant insurance) products.

S&P’s Hardy cautions that the development of structures for consistent supervision of sharia compliance will take time.

Developing banking expertise

“We believe that among the tasks ahead, it will be equally important to acquire expertise and to develop rapidly a commonly accepted level playing field. In our view, it will likely take two to three years before Islamic banking takes off in North African countries. Oman is a good example of this lengthy process,” says Hardy.

The picture is complicated by the fact that the development of an Islamic banking regime is taking place in a context where North African countries are tackling broader issues of financial sector reform.

“Banking reforms aiming at introducing gradually Islamic banking products could help to address some issues like the low level of banking penetration or liquidity pressures on banks,” says Hardy.