The state of Islamic finance: challenges and prospects

24 October, 2023Natalie Schoon

The growth potential that Islamic finance showed during the late 1990s and early 2000s has failed to materialise and has been adjusted downward since the financial crisis. Why is Islamic finance, which could serve at least a quarter of the world’s population, not more of a force on the global stage? Natalie Schoon outlines the challenges – and the potential avenues for future growth – that Islamic finance must explore to reach its full potential in the years ahead.

Islamic finance since 2000

In the early 2000s Islamic finance was riding high and expected to enjoy double-digit

Islamic finance

 growth. It also proved resilient during the 2007 financial crisis – despite its excessive concentration in property and general lack of diversification. At the time, proponents mainly cited the prohibition of interest as the reason. However, the Islamic finance industry fared as well as it did during the crisis mainly because of its prohibition on speculation and because of its limited presence in the US markets at the centre of the storm. It was a close call though, particularly given that the industry was considering developing Sharia'a-compliant derivatives just before the crisis broke.

Outside of countries with a predominantly Muslim population, the UK is one of the few to show a consistent interest in Islamic finance. In 2010, the UK Government amended the Financial Services Market Act (FSMA) to facilitate alternative financial products, such as Sukuk, or Sharia’a-compliant bonds. The new rules had to consider whether Sukuk – which can be structured in different ways but always assume that risk and profit (or loss) will be shared, or a rental fee will be paid – are collaborative investment schemes (CIS), or conventional bonds. The regulator created a definition of alternative finance investment bonds to fit at least some Sukuk into the bond market.

In 2014, seeking to strengthen the UK’s position as a centre for Islamic Finance, the UK Government issued a £200m5-year sovereign Sukuk, which attracted an order book of £2.3bnwith a profit rate of 2.036%. That made the UK the first country outside the Islamic world to issue a Sharia’a-compliant sovereign bond. In 2021 the UK issued another 5-year sovereign Sukuk, this time for £500m at a profit rate of 0.333%.

However, since then, it all seems to have gone relatively quiet and Islamic finance remains a backwater. As of 2022, the industry's size was estimated at $2.2trn, according to S&P. It’s a commendable figure but dwarfed by conventional banking giants like HSBC. Why the sluggish growth? Several factors contribute to it, as outlined below.

Branding and perception

The inclusion of 'Islamic' in the names of financial institutions and the use of Arabic terms for financial products have, regrettably, led some individuals to form inaccurate and negative associations between Islamic finance and involvement in financing illegal activities, including terrorism. Even without that misconception, only 6% of the global population speaks Arabic, so Arabic product names can be a barrier. After all, it’s difficult enough for anyone working in the sector to distinguish a musharakah from a mudarabah or a murabaha, and to remember the different characteristics that belong to the rather lengthy terms for the different types of leases. For someone who is just trying to open an account, apply for a loan, or to change some money, it’s likely bewildering. 

Lack of standardisation in Islamic finance

The standardisation of terms, legal languages, and transaction structures is the bedrock of global capital markets. Islamic finance, though, is characterised by differences in interpretation by different schools of Islamic thought about what is Sharia’a compliant. The nature of ijtihad - the individual interpretation of the rules following from the Quran, Hadith, Qiyas, and Ijma – means that each Islamic scholar or Sharia’a Advisory Board may have a different opinion on what is permissible, including sometimes on critical transaction terms.  


The differences in interpretation may result in protracted negotiations, causing delays and increasing costs for businesses. Although institutions like the Islamic Financial Services Board (IFSB) and the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) are pushing hard for standardisation, others are pushing back equally hard to retain the principle of ijtihad in the widest possible way. As a result, it is not uncommon for the Sharia’a Supervisory Board of one bank to approve a transaction which is subsequently declined by the Sharia’a Supervisory Board of their counterparty. Back-and-forth-negotiations follow and, while generally some form of agreement is reached, the process can be lengthy and may result in clients abandoning it part-way through. There are even cases where disputes about Sharia’a compliance have emerged post-completion further undermining confidence in the industry and Islamic institutions. 


The negotiations involved in ensuring Sharia’a compliance, the associated uncertainty, long negotiations, and dispute resolution are costly, and those additional costs are invariably passed on to customers, reducing demand. Research shows that although a small part of the population is willing to pay for a service that aligns with their belief system, most are much more price sensitive and would opt for a cheaper product. Cursory examination of UK mortgage rates shows that Sharia’a compliant mortgages in the UK are in the region of 100 – 200 basis points costlier than high-street mortgages for the same amount and duration.  

Go local

Despite the relatively small size and slow growth of the industry, Islamic financial institutions continue to attempt to integrate into global markets, which can be an expensive undertaking. Success remains limited and one cannot but wonder whether this is the best strategy for this sector. 

Competing successfully with the large established global banks for the business of large corporates might be unrealistic at this stage for most Islamic banks. They are relatively new, small, expensive, and most of them are based in emerging markets associated with higher country risks. None of those factors make them the first choice for large international corporates.

There is, however, a natural growth market for Islamic financial services. It is in the financing of local businesses, ranging from SMEs to larger domestic corporates. Local shops and restaurants, influencers, IT businesses, manufacturers, and agricultural businesses all require financial services. Islamic financial institutions are well positioned to use their underlying principles of transparency, honesty, low leverage, and prohibition on speculation to establish trust in local markets and to build closer relationships with borrowers. They have the potential to gain a comparative advantage when tailoring services and pricing risk. Moreover, staying local will also reduce the Sharia’a compliance complexities that have plagued international transactions because differing religious interpretations will be limited. A local focus would, then, enable Islamic financial institutions to compete on price while offering a value-aligned proposition.

Looking to a bright future for Islamic finance

In conclusion, the Islamic finance industry faces numerous challenges that have impeded its growth and its global acceptance. While aspirations to compete with international financial institutions are commendable, it may be more prudent to first prioritise local markets. By working closely with their customer base and developing products that meet local needs while still complying with regulations and Sharia'a requirements, the industry can find a path to sustainable growth. However, resolving issues such as lack of standardisation and problems of outside perception remains essential for a truly bright future in Islamic finance. As long as some conventional home purchase methods such as the UK’s shared ownership can be more Sharia'a compliant than those offered by Islamic financial institutions, there is work to be done.

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