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Capital Markets Best Practice

The Emergence and Development of Islamic Banking

by Umar Oseni and M. Kabir Hassan

Executive Summary

  • Islamic banking is an interest-free banking system which emerged on the global scene barely four decades ago.

  • The definition of the Islamic banking system is essentially a banking system that complies with the economic value system of Islam.

  • The Islamic banking business has emerged as an ethical banking system which is designed to cater for the interests of about a quarter of the world’s population.

  • Islamic banks engage in three major services: free services; services rendered by banks on fixed exchange, commission, or discount; and creation and development of funds.

  • The development of the Islamic banking system has demonstrated its potential to be used as a viable global financial intermediary.

  • The crystallization of the Islamic banking system in the 21st century has made it a force to be reckoned with to avert any future global economic crunch.


As an alternative banking system, Islamic banking emerged in the global landscape with the advent of Islam. This form of interest-free banking has developed over a long period of time with the introduction of new products in the industry. The crystallization of interest-free banking based on Islamic legal principles has won a positive global image for Islamic banking in the modern world. The underlying philosophy in Islamic banking is to facilitate financial intercourse and spur symbiotic commercial relations that will ultimately bring benefit to the parties involved. One must work for whatever he or she earns in the long run. According to Rodney Wilson, “The Islamic banking industry has grown rapidly since the 1970s, reflecting the demand by pious Muslims to manage their finances in a way that avoids interest and complies with Islamic law” (Wilson, 2006). This emerging discipline of banking business in the modern world has reached a crescendo where it has become a force to be reckoned with in the global banking business. The best practices in the Islamic banking industry are worth exploring with a view to harmonizing practices in global banking to strengthen the world economy.

It is, however, important to emphasize that Islamic banking and Islamic finance are two inextricable disciplines in Islamic commercial law, but it is believed by most experts that the former is a subset of the later. Meanwhile, the global banking business needs several alternative banking models in order to cushion the effects of economic meltdown that may arise in the future. The experiences of Islamic banking in Muslim countries as well as Muslim-inhabited countries in Europe and America have been very encouraging, even though some problems were encountered at the outset (Hassan, 1999). The emergence and development of Islamic banking in the modern world has witnessed dramatic changes, especially in the recent global financial plummet. As an urgent step toward cushioning the effects of the global financial crisis, American International Group Inc. (AIG) had to offer Islamic insurance to the United States. This was after it had earlier reached two major bailout agreements, worth US$152.5 billion in taxpayer dollars. As a further move to step up its deals, AIG has established subsidiaries in some Muslim-majority countries such as Bahrain, Malaysia, and the United Arab Emirates. It is axiomatic to observe that Islamic insurance (takaful) is an aspect of Islamic finance which was one of the Islamic financial mechanisms embraced during the troubled times that engulfed most financial-cum-insurance heavyweights in recent years.

Emergence of Islamic Banking

Although Islamic banking was practiced during the classical period, the modern experiment of profit and risk-sharing business, which is the cornerstone of Islamic banking business, was first undertaken in 1963 in Mit Ghamr, a city in the Nile Delta in Egypt. “Its purpose was to explore the possibilities of mobilizing local savings and credits as an essential requirement for socioeconomic development in the area.” (El Naggar, 2005). The ripple effects of this successful experiment were felt in some other Muslim countries after some years. “Few years before the bank consolidated its services in 1981, other banks such as the Islamic Development (IDB) and Dubai Islamic Bank opened their doors to customers in 1975. Also, Malaysia followed suit with the enactment of the Islamic Banking Act 1983. This brought about the establishment of the first formal financial institution in Malaysia in 1983 known as the Bank Islam Malaysia Berhad (BIMB)” (Oseni, 2009). The Islamic banking and finance industry has continued to grow in leaps and bounds over the years. The industry grows at a rate of 10–15% per year (Khan et al., 2007). It is now the fastest-growing segment of the global financial system, with the unremitting establishment of Islamic banks in the Muslim world and beyond.

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Further reading


  • Ayub, Muhammad. Understanding Islamic Finance. Hoboken, NJ: Wiley, 2007.
  • El Naggar, Ahmed A. “Islamic bank in Egypt: A model and the challenge.” In Ataul Huq Pramanik (ed). Islamic Banking: How Far Have We Gone? Kuala Lumpur: International Islamic University Malaysia, 2006; 247–259.
  • Iqbal, Munawar, and David Llewellyn (eds). Islamic Banking and Finance: New Perspectives on Profit-Sharing and Risk. Cheltenham, UK: Edward Elgar, 2002.
  • Islam, Tajul. “Mechanics of Islamic banking.” In Ataul Huq Pramanik. Islamic Banking: How Far Have We Gone? Kuala Lumpur: International Islamic University Malaysia, 2006; 127–142.
  • Lewis, Mervyn, and Latifa Algaoud. Islamic Banking. Cheltenham, UK: Edward Elgar, 2001.
  • Oseni, Umar A. Dispute Resolution in Islamic Banking and Finance: Common Trends and Future Perspectives. Kuala Lumpur: International Islamic University Malaysia, 2009.
  • Siddiqi, Muhammad Nejatullah. “Islamic banking: Theory and practice.” In Mohamed Ariff (ed). Islamic Banking in Southeast Asia. Singapore: Institute of Southeast Asian Studies, 1988; 34–66.
  • Vogel, Frank, and Samuel Hayes. Islamic Law and Finance. The Hague, The Netherlands: Kluwer Law International, 1998.


  • Ahmad, Abu Umar Faruq, and M. Kabir Hassan. “Riba and Islamic banking.” Journal of Islamic Economics, Banking and Finance 3:1 (January–June 2007). Online at:
  • Hassan, M. Kabir. “Islamic banking in theory and practice: The experience of Bangladesh.” Managerial Finance 25:5 (1999): 60–113. Online at:
  • Khan, Mohammad Saif Noman, M. Kabir Hassan, and Abdullah Ibneyy Shahid. “Banking behavior of Islamic bank customers in Bangladesh.” Journal of Islamic Economics, Banking and Finance 3:2 (July–December 2007): 159–194. Online at:
  • Khan, Mohsin S., and Abbas Mirakhor. “The framework and practice of Islamic banking.” Finance and Development 23:3 (1986): 32–36.
  • Lawai, Hussain. “Key features of Islamic banking.” Journal of Islamic Banking and Finance 11:4 (1994): 7–13.
  • Wilson, Rodney. “Regulatory challenges facing the Islamic finance industry.” Journal of Financial Transformation 14 (September 2005): 142–145. Online at:


  • Chapra, M. Umer, and Tariqullah Khan. “Regulation and supervision of islamic banks.” Occasional paper no. 3. Islamic Research and Training Institute, Islamic Development Bank, 2000. Online at: [PDF].
  • Čihák, Martin, and Heiko Hesse. “Islamic banks and financial stability: An empirical analysis.” Working paper 08/16. International Monetary Fund, 2008. Online at:
  • El-Hawary, Dhalia, Wafik Grais, and Zamir Iqbal, “Regulating Islamic financial institutions: The nature of the regulated.” Policy research working paper WPS3227. World Bank, March 2004. Online at:
  • Errico, Luca, and Mitra Farrahbaksh. “Islamic banking: Issues in prudential regulation and supervision.” Working paper 98/30. International Monetary Fund, 1998. Online at:
  • Iqbal, Zubair, and Abbas Mirakhor. “Islamic banking.” Occasional paper no. 49. International Monetary Fund, 1987.

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