Islamic Banking and Economic Growth

Introduction

Islamic finance is one of the fastest growing segments in global financial services. It has become important in many markets and too big to ignore in others. Total assets of Islamic Banks (IBs) increased from USD 386 Billion in 2006 (Mohieldin, 2012) to USD 1.9 Trillion in 2016 (IFSB Stability report, 2017).

The global financial crisis offered IBs an opportunity to show their resilience being a relatively safe alternative investment (Wilson, 2009). IBs were better capitalized, had higher asset quality and lower disintermediation than conventional banks (CBs) during the last financial crisis (Beck et al., 2013). There is a strong evidence that IBs were more cost efficient than CBs during the crisis (Hasan & Dridi, 2010). As a consequence of the GFC, new IBs inaugurated their business, some CBs have converted into Islamic, and several multinational banks have established Islamic windows. Islamic banks, as expected, mainly exist in countries with Muslim majority population, however this business is developing in other countries as well. The interest in Islamic finance increased in European countries accordingly. Currently, more than twenty banks in UK and eight banks in EU (France, Switzerland and Germany) offer Islamic financial services. The industry is expected to grow in the EU after the “Brexit” (Masiukiewicz, 2017).

Some of the work introduced IBs as an alternative financial intermediation system able to attain the role of conventional banks (CBs) with more security (Al Bahar, 1999; Iqbal & Mirakhor, 2012). Others argue that they both complement each other by balancing debt-based and asset-based financing (Imam & Kpodar, 2010; Ali & Azmi, 2017…). Islamic finance is not only limited on commercial services, but it includes as well investment banks, insurance companies, and leasing services. The expansion of new financial products, such as equities, Sukuk (Islamic bonds) and Takaful (Islamic Insurance), has also extended the range of facilities available (Rafay, Sadiq, Ajmal, 2016).

There is mounting evidence that the financial sector performance enhances economic development ever since Schumpeter (1911). A well-established banking system supports mobilize savings, enables capital allocation to high return projects, monitor investments wisely, and allows for diversification of risk. However, do these findings of the relationship between financial sector and economic growth apply for Islamic banking? Following Levine & Zervos (1998) and Beck et al. (2000), this chapter analyzes the effect of Islamic Banking on economic growth in an attempt to explore this emerging banking system.

Empirical findings need to confirm theoretical expectations that although Islamic Banking still represents a relatively very small share of the financial system, yet it is growing generating an economy boost and insuring a stable banking industry. This is because they are less prone to financial markets shocks, closer to tangible economic activities and attracts savings and investments of devout Muslims thus enhancing economic cycle.

Iran and Sudan are the only countries that applied Islamic Banking solely. Sadr and Yazdan (2012) use time series methods to evaluate the aftermath of this change on the economy of Iran. Although, Iran had an endogenous shock, from 0% to 100% of Islamic Banking system after the crisis, but it is hardly to consider this case as a model to study. Mainly economic sanctions, political closeness and missing data are factors that complicates any empirical work to study the impact of financial system conversion on economic development.