KembaraXtra – Islamic Banking – Introduction-Summary of the Major Factors in the Development of Islamic Financial Institutions (IFIs)


In summary, several key factors have contributed to the growth and development of Islamic financial institutions. Islamic economic thought played a foundational role by creating demand for financial institutions that could address both the social welfare needs and religious obligations of Muslims, whether at the individual or corporate level.


Another important factor was the cross-border and international initiatives led by the Organisation of Islamic Cooperation (OIC), which aimed to support the economic development of member countries through the use of Islamic financial instruments. In addition, the oil boom of the 1970s significantly increased liquidity in Muslim-majority, oil-producing economies, providing the financial resources necessary for the expansion of Islamic finance.


The formal application of Shari’ah principles to financial activities also played a crucial role. This led to the establishment of both single and dual Islamic banking systems, supported by either exclusive or parallel legislative frameworks, depending on national circumstances. The rapid growth of the Islamic financial services (IFS) industry further encouraged the development of innovative Shari’ah-compliant financial products and instruments.


Equally important was the contribution of Shari’ah-based expertise, which guided product development, ensured compliance, and enhanced stakeholder confidence. Over time, comprehensive Shari’ah governance, regulatory structures, and institutional frameworks were established to promote harmonisation, transparency, and adherence to best practices. The increasing participation of global financial institutions has also strengthened the industry and facilitated its integration into the wider international financial system.


As a result of these combined factors, the Islamic financial services industry has experienced strong and sustained global growth, estimated at approximately 15% to 20% annually. An examination of these influences allows the development of IFIs to be categorised into five distinct phases, as illustrated in the table below.

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Kembaraxtra-Islamic Banking-Introduction-Islamic Financial Systems and the Underlying Structure

In any financial system, a range of institutions and markets work together to channel funds from surplus units to deficit units. These include banking institutions that accept deposits, non-banking financial institutions, and organised securities exchanges that facilitate capital and money market activities. Collectively, these entities perform the core functions of financial intermediation, capital mobilisation, and risk management. The efficiency and stability of financial flows within a system depend largely on the nature of these institutions, the instruments they use, and the mechanisms through which funds are transferred.


The structure of a financial system is shaped by financial legislation, licensing requirements, and regulatory oversight. Regulatory authorities establish supervisory frameworks, reporting standards, and disclosure requirements to protect the interests of depositors and investors while maintaining confidence in the financial system. Effective regulation is therefore essential to ensuring financial stability, transparency, and market discipline.


A well-developed Islamic Financial System (IFS) contains all the essential components found in a conventional financial system, but with an additional and distinctive feature: Shari’ah governance. This governance may take the form of a national Shari’ah board operating at the regulatory level or Shari’ah committees established within individual financial institutions. These bodies ensure that all financial activities, products, and instruments comply with Islamic law.


the Islamic financial system operates through both indirect financing and direct financing channels. Indirect financing is conducted through Islamic financial institutions such as Islamic banks, Islamic non-banking institutions, and Takaful (Islamic insurance) operators. These institutions mobilise funds from savers and allocate them to productive uses while adhering to Shari’ah principles. Each of these institutions is overseen by Shari’ah boards to ensure ongoing compliance.


Direct financing occurs through Islamic financial markets, which include Islamic money markets and Islamic capital markets. The capital market facilitates equity-based financing and Sukuk issuance, while Islamic funds and instruments allow investors to participate directly in Shari’ah-compliant investment opportunities. These market-based activities are also subject to Shari’ah oversight to ensure compliance at every stage.


All components of the Islamic financial system are aligned to achieve the Maqasid al-Shari’ah, or the objectives of Islamic law. These objectives focus on promoting the common good of society by ensuring justice, fairness, and economic well-being. Within the financial context, this involves encouraging wealth creation, facilitating wealth transfer, and ensuring equitable wealth distribution in a manner that benefits society as a whole.


The primary purpose of the Islamic financial system is to mobilise global and regional resources to support sustainable economic development while fulfilling Shari’ah objectives. This is achieved through financing principles that emphasise profit sharing, risk sharing, and partnership between individuals and institutions. Unlike conventional finance, Islamic finance is grounded in real economic activity, recognising trade rather than usury as the legitimate basis of financial transactions.


A defining characteristic of the Islamic financial system is the strict prohibition of Riba (usury), which refers to any form of interest or effortless gain. Shari’ah forbids both the charging and the payment of Riba at any stage of a financial transaction. Instead, Islamic finance promotes asset-based, debt-based, and service-based financing structures that link financial returns to real economic activity and shared risk.



The Islamic financial system mirrors the structure of the conventional financial system but is distinguished by Shari’ah governance, the pursuit of Maqasid al-Shari’ah, the emphasis on risk sharing and real economic activity, and the prohibition of Riba.

KembaraXtra – Islamic Banking – Introduction-Phases in the Development of Islamic Financial Institutions (IFIs)

The development of Islamic Financial Institutions has taken place in a series of identifiable phases, each shaped by changing economic conditions, regulatory environments, and institutional maturity. These phases reflect the gradual transformation of Islamic finance from a conceptual framework into a globally recognised financial system.


Phase One: Prior to 1970 – Conceptual Foundations
Before 1970, the development of Islamic finance was largely theoretical. During this period, Islamic economic ideas were being articulated by scholars who sought to address economic issues from an Islamic perspective. The focus was on establishing the moral, ethical, and religious foundations of an Islamic economic system that could fulfil the social welfare and religious obligations of Muslims. However, practical implementation remained limited, and formal Islamic financial institutions were largely absent.


Phase Two: 1970s – Emergence and Liquidity Expansion
The 1970s marked a turning point in the development of IFIs, driven primarily by the oil boom. The substantial increase in oil revenues generated significant liquidity in Muslim-majority countries, particularly in the Middle East. This abundance of capital created both the opportunity and the motivation to establish financial institutions that complied with Shari’ah principles. As a result, the first modern Islamic banks began to emerge, transforming Islamic finance from theory into practice.


Phase Three: 1980s – Institutionalisation and Regulation
During the 1980s, the emphasis shifted towards formalising Islamic finance within national financial systems. Governments began introducing legislation and regulatory frameworks to support Islamic banking activities. Some countries adopted a single banking system, requiring all financial institutions to operate in accordance with Shari’ah principles, while others introduced dual banking systems that allowed Islamic and conventional finance to coexist. This phase marked the institutionalisation of Islamic finance and its recognition within the formal financial sector.


Phase Four: 1990s – Governance and Product Innovation
The 1990s witnessed significant advancements in governance structures, standard-setting, and product development. International organisations were established to develop Shari’ah governance standards, accounting rules, and best practices to enhance consistency and transparency across jurisdictions. At the same time, Islamic financial institutions expanded their range of products, moving beyond basic banking services to include investment accounts, capital market instruments, and risk management solutions. The demand for qualified Shari’ah scholars and Islamic finance professionals also increased substantially during this period.


Phase Five: 2000s onwards – Global Integration and Maturity
From the early 2000s onwards, Islamic finance entered a phase of global expansion and increasing maturity. Major international and Western financial institutions began offering Islamic financial products, contributing to innovation, market depth, and global reach. Enhanced regulatory frameworks, improved governance standards, and greater availability of Shari’ah-based expertise supported sustained growth. As a result, Islamic financial institutions evolved into an integral part of the global financial system, experiencing consistent and robust growth across multiple regions.
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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.

KembaraXtra- Islamic Banking - Introduction- Islamic Financial Institutions (IFIs)

The emergence of modern Islamic financial institutions dates back to the 1940s, when scholars and practitioners identified the need for Islamic economics to offer alternative solutions to economic and financial challenges distinct from those of Western financial systems. Islamic economics is rooted in an Islamic worldview that recognizes religious principles as integral to economic, commercial, and financial activities.


According to Islamic teachings, human beings are endowed with intellect, free will, and divine guidance, enabling them to distinguish between right and wrong in their worldly actions. Muslims believe that these actions are ultimately assessed according to Shari’ah, which serves as the criterion for attaining God’s pleasure in the Hereafter.


In Islam, human beings are regarded as servants of God Almighty and are required to conduct all aspects of life, including economic and financial pursuits, as acts of worship. This entails complete submission to God Almighty and adherence to Shari’ah, as revealed in the Qur’an and exemplified through the practices of the Prophet Muhammad, as recorded in his traditions.


The foundations of Islamic financial law and guidance are derived from two primary sources: the Qur’an and the traditions of the Prophet Muhammad. Based on these sources, certain elements commonly found in financial activities are strictly prohibited. These include usury (interest) and financial involvement in unlawful activities such as the production and trade of pork, intoxicants, and gambling. The prohibition extends across the entire economic chain, encompassing production, storage, transportation, marketing, and advertising.


Considerable effort has been made by Muslims to address the challenges posed by interest-based and other non-compliant economic transactions. Consequently, Islamic financial institutions have developed specialized processes, contractual frameworks, and operational systems to ensure that all financial activities comply with Shari’ah principles. Several of these mechanisms are examined in this module.​

Key Points

• All economic and financial activities must adhere to religious injunctions prescribed by Shari’ah.
• The legal framework and guiding principles of Islamic finance are derived primarily from the Qur’an and the traditions of the Prophet Muhammad.