KembaraXtra – Islamic Banking– Introduction-Factors Influencing the Development of Islamic Financial Institutions (IFIs)

Move to Islamic Finance


One of the most significant drivers behind the growth of the Islamic financial industry was the oil boom of the 1970s. This period generated substantial liquidity in Muslim-majority, oil-producing countries, particularly in the Middle East, creating favourable conditions for the emergence of Islamic financial institutions. As a result, IFIs first gained prominence in this region.


Among the early pioneers were Dubai Islamic Bank, established in 1975, Kuwait Finance House in 1977, and Bank Islam Malaysia Berhad in 1983. Unlike conventional banks, these institutions pursued both commercial objectives and broader social goals aligned with Islamic principles. One of their main initial challenges was operating within legal and regulatory frameworks originally designed for conventional banking systems. The strategies adopted to overcome these challenges are discussed in subsequent sections.



Single versus Dual Banking Systems


Financial reforms across the Muslim world have varied in speed and scope, ranging from rapid transformation to gradual change. These differences have significantly influenced national financial systems, particularly in terms of whether countries adopted a single or a dual banking system.


Under a single banking system, all financial institutions are required to operate in full compliance with Shari’ah principles. In contrast, a dual banking system permits Islamic and conventional financial institutions to operate side by side within the same market.


During the early 1980s, countries such as Pakistan, Sudan, and Iran were among the first to pursue a single banking system aimed at the comprehensive implementation of Shari’ah principles. Within a short timeframe, all financial institutions in these countries were required to offer only Shari’ah-compliant products and services, leading to the formation of a unified Islamic financial system. However, full implementation in some of these jurisdictions remains incomplete.


Other countries, including Malaysia, the United Arab Emirates, Kuwait, and Bahrain, adopted a more gradual reform process, resulting in the establishment of dual banking systems. Within these systems, different approaches emerged. In countries such as Malaysia and Bahrain, conventional banks were permitted to offer Islamic banking products through dedicated Islamic “windows” or counters. In contrast, some jurisdictions restricted Islamic financial services exclusively to fully-fledged Islamic banks.


Malaysia stands out for introducing separate legislation to govern Islamic finance. It was the first country to enact dedicated laws for Islamic banking through the Islamic Banking Act of 1983 and for Islamic insurance through the Takaful Act of 1984. In many other countries, Islamic banking activities continue to be regulated under existing conventional banking and insurance laws.

Product Development


The adoption of dual banking systems led to rapid growth and diversification in Islamic financial products and services. In the early stages, many Islamic financial products were adapted from conventional instruments, such as loans and advances, and restructured to meet Shari’ah requirements. Over time, however, products directly derived from the interpretation and application of Shari’ah principles were developed.


A notable example is the investment account based on a Mudarabah contract, which operates on a profit-sharing basis. Under this arrangement, investment account holders provide capital to finance the bank’s assets and share profits with the bank according to an agreed ratio. Unlike fixed-term deposits in conventional banking, returns are not predetermined and are linked to actual business performance.


In capital markets, the Sukuk instrument represents another major innovation. Sukuk certificates signify proportionate and undivided ownership in underlying assets, allowing investors to earn returns generated by those assets. Based on asset securitisation and Shari’ah principles, Sukuk have no direct equivalent in conventional finance.


As Islamic financial products and instruments expanded, the demand for Shari’ah expertise increased significantly. Such expertise is essential to ensure compliance and to provide confidence to investors and customers. The shortage of qualified professionals has encouraged the development of training programmes, seminars, and educational initiatives to support the industry’s sustainable growth.

Standard Setting


The 1990s and early 2000s marked the establishment of international standard-setting and benchmarking bodies for Islamic finance. These included organisations such as the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board.


These institutions were created to develop internationally accepted regulatory standards, best practices, and prudential guidelines tailored to the unique characteristics of Islamic finance. Their objectives include enhancing transparency, promoting market discipline, facilitating harmonisation across jurisdictions, and supporting effective risk management in IFIs.


During this period, many major Western financial institutions also began offering Islamic financial products. Leveraging their advanced research capabilities, technological infrastructure, and experience in financial innovation, these institutions played a significant role in expanding Islamic finance into the global financial system and increasing its international visibility and acceptance.



Key Points
• The oil boom of the 1970s was a major catalyst for the early development of Islamic finance, particularly in the Middle East.
• A single banking system requires full Shari’ah compliance across the entire financial sector, while a dual banking system allows Islamic and conventional finance to coexist.
• The expansion of Islamic finance led to significant innovation in products, increased demand for Shari’ah expertise, and the establishment of international standard-setting bodies.