ISLAMIC banking has achieved some remarkable advances during the past 20 years as the system has emerged from the realms of theory into the realities of the modern world. More than 100 financial institutions now provide Islamic services, and the number continues to grow. Three countries – Iran, Pakistan and Sudan – have converted their entire financial systems to Islamic principles. And deposits held on Islamic terms are estimated to have reached $80,000 million.

In the Gulf, Islamic banks are among the most profitable financial institutions. Al-Rajhi Banking & Investment Corporation, Saudi Arabia’s only fully licensed Islamic bank, was the most profitable of the kingdom’s 12 commercial banks in 1994 in terms of return on equity.

Yet, the impressive facts and figures belie the challenges faced by Islamic bankers which the experts in Islamic economics are the first to point out. According to Khurshid Ahmad, chairman of the Islamic Foundation, only 10-14 per cent of all the Islamic services on offer are actually operated along strictly Islamic lines. Maintaining the principle of not charging interest is the primary task Islamic bankers face in a financial world where interest rates have assumed a supreme role (see box).

The principles of Islamic banking make exceptional demands of its practitioners, and set Islamic institutions apart from conventional banks. One distinction is that Islamic banks need to have their own sharia council, whose members must determine whether a product is acceptable under Islamic law. This not only affects the creation of new products but can also result in products being discontinued. In 1994, Al-Rajhi liquidated its currency fund because the council said it did not comply with Islamic law.

‘Here we don’t try and sell money, we only sell services,’ says Mohammad al-Thaqeeb, spokesman for Al-Rajhi. With the underlying principle that money cannot be used as a commodity, Islamic banks seek to make their profits through fees and investments in interest-free products. Islamic banks are also required to share risks with their clients, which encourages a more detailed survey of projects in which the bank is expected to act as a partner. Consequently, Al-Rajhi has staff with a background in engineering, architecture and surveying as well its more conventional financial staff.

Al-Thaqeeb illustrates the need for such expertise with a property development project. In conventional banking terms, a client who has borrowed money is still liable to continue payments even if the value of the property falls. In contrast, an Islamic bank takes on part of the project risk so both bank and developer are liable for any losses. In this respect, Islamic banking is more akin to venture capital than conventional banking activities.

In spite of such differences, Islamic banks can be exactly the same as their conventional competitors. Direct debit charge cards are a regular service offered by Islamic institutions, as are automated teller machines (ATMs). Al-Rajhi has about 170 ATMs, which customers use with the Al-Rajhi Express card. And the bank, which was only granted a licence in 1987, has the largest branch network in the kingdom with about 340 outlets.

But conventional banks are being forced to take more notice of the Islamic finance phenomenon as popular demand for such services increases. Jeddah- based National Commercial Bank (NCB) has made a major effort to cater for this growing demand. The bank’s Islamic unit has been in operation for almost three years, but in June 1994 NCB reorganised its Islamic services into a separate business division with its own profit centre. The bank now has 34 dedicated Islamic branches, and the number is continuing to rise.


According to Abdulaziz Mirza, business development manager of Islamic services, Islamic deposits have now reached about SR 1,500 million ($400 million) at NCB and are expected to grow at 20 per cent a year. Mirza, previously at NCB’s operations department, cannot hide his enthusiasm for the move into Islamic banking. ‘The deeper I go, the more excited I get about the concept of Islamic banking,’ he says. ‘The challenge as I see it now, is to design something that suits the client in a modern way.’

But developing new products is not always a straightforward process. There is no consensus on the parameters of what constitutes Islamic banking, so one bank’s Islamic product may be unacceptable to another. The Harvard Business School is now carrying out a comprehensive study intended to establish a benchmark for the Islamic financial system. The study will include a survey of the market and an examination of existing Islamic products. It will also consider ways of developing new ones. The project is sponsored by NCB and the Jeddah-based Islamic Development Bank, the US’ Goldman Sachs and Boston-based Wellington Management – a combination which is indicative of the growing international interest.

Yet, the study will have to be convincing if it is to persuade the sceptics that Islamic banks can really blaze a trail in financial markets. One of the most common criticisms is that Islamic banks still charge interest, but do so using different terms. ‘Islamic banking, whatever you call it, is taking into account the interest factor,’ comments one Riyadh-based managing director. ‘You can dress it up any way you want, it comes down to the mere fact, that money today has more value than money tomorrow.’

Many conventional banks do not try and hide the fact that their Islamic products cannot be entirely ring-fenced from interest driven balance sheets. Few are willing to go to the lengths of setting up an entirely separate institution with its own capital base, as the US’ Citibank is considering for its Bahrain outfit. ‘There are as many shades of grey in Islamic banking as there are in any other form of banking,’ says one Gulf bank head. ‘Many customers do not care where the money comes from, provided they don’t pay interest…The alternative is to get yourself tied up with some sharia council telling you what you can and can’t do, and even they can’t agree.’

Saudi Cairo Bank is one of Saudi Arabia’s conventional banks which operates an Islamic fund. However, the bank does not see its Islamic operations as a key growth area. ‘The bank has decided it is probably not a major field to engage in,’ says Andre van Hove, assistant general manager of the bank. He says the principle of risk and profit sharing at the centre of Islamic finance cannot attract the most profitable companies. He asks why a firm which can achieve a 35 per cent return on a programme of investment should wish to share the proceeds with the Islamic bank which helped finance the project. A loan from a commercial bank would prove far cheaper, he says. ‘I think Islamic banks will wind up with all loss-making companies,’ he says.

But dedicated Islamic institutions face more basic problems. Designing products to replace banking mechanisms which are interest-driven presents the greatest challenge. In technical terms the interbank market is something for Islamic banks to avoid, yet it is fundamental to managing liquidity. Islamic banks have to invent complex ways of placing these funds if they are to avoid any interest earnings. This job can be made harder when Islamic banks are trying to operate in markets that are dominated by conventional banks.

Yet, demand for Islamic products is continuing to grow rapidly. And for all the challenges, Islamic banks show no sign of tiring in their quest for new financing techniques. ‘Look at the trend in the last 10 years, very few banks had Islamic banking. But now look at the number of Islamic banks,’ comments one Al-Rajhi senior manager. And if Al-Rajhi’s profit performance is anything to go by, the financial world would be wise to watch closely.