A diverse portfolio of investments and good risk management are key to the continued growth of the Gulf’s Islamic banks.

Islamic finance is starting to catch on. New Islamic institutions are springing up across the Gulf, and a group of GCC banks plan to launch a new investment bank in 2009 with the aim of developing instruments to help Islamic banks raise capital.

With competition clearly hotting up in the sharia-compliant finance market, the challenge for Islamic banks is to diversify and expand beyond the Gulf – both geographically and in terms of their investment portfolio – while at the same time maintaining a balanced risk profile.

The reasons to focus on risk management are no different from those of mainstream banks. But the current dearth of sharia-compliant financial instruments available to hedge GCC currencies means that spreading the risk is not so easy.

Spreading risk by diversifying business beyond the GCC is a bit easier, thanks to the attractiveness of Asia’s property market as a target for investment, and the much-publicised, sharia-friendly allure of private equity.

Another popular route to diversification within the Gulf is project finance. The explosion of major projects heralded by the region’s mounting oil wealth means this is an area where there is no shortage of investment opportunities. By joining the consortiums of banks lending to big projects, the Gulf’s sharia-compliant financiers are increasing the number of sectors in their investment portfolios, which broadens their risk exposure.

But the largest growth area for risk diversification may be just around the corner. Saudi Arabia’s long-awaited mortgage law, which is still in the process of negotiation, promises to provide a legal framework for housing finance in the kingdom for the first time. Once it is introduced, banks will have a platform to develop a whole new range of Islamic finance instruments.