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Islamic Finance: One to Watch? - Arshiya Hendi

Islamic finance is a minor sector that currently accounts for less than 1% ($4 trillion) of total global assets ($431 trillion), and one which may appear only to serve a specific religious group, representing around 25% of the world's population.

However, in a world where investors, governments, and corporations are turning their focus to Environmental, Social and Governance (ESG) principles, closer examination reveals that Islamic finance offers a complementary approach for incorporating such ethical and sustainable practices. This relationship emerges from how Islamic finance is governed by the Shariah, which requires that financial activities align with values such as equality, social justice, and environmental sustainability.

This article explores the evolution of Islamic finance through history and its rapid growth in both core markets such as the Middle East and Asia and non-core markets such as the UK, Canada, and Australia. It then examines key drivers of that growth before delving into the potential to take advantage of the overlapping connection between Islamic finance and ESG principles.

What is Islamic finance?

Islamic finance is centred upon the belief that money itself holds no intrinsic value; it is simply a means by which one can exchange products and services that hold value. Therefore, earning income through money itself through interest (riba) is forbidden. Moreover, risk sharing is central to Shariah-compliant investing, which seeks to balance the relationship between creditor and debtor. Investors and financial institutions that lend to corporations and governments share in their profit and loss (mudarabah), rather than taking a fixed interest payment. Therefore, debt financing through fixed-income securities is forbidden (haram), since it involves riba.

Islamic finance provides an alternative security, a Shariah-compliant bond known as a sukuk. Unlike a bond, a sukuk involves asset ownership and its valuation is dependent on the asset backing the sukuk rather than the interest rate. In both cases, the investor receives a stream of payment, but the owner of a sukuk receives a percentage of the profit generated by the asset, and the issuer buys back the sukuk at par value when it matures.

Shariah-compliant equity financing is also permitted. The business in question must not engage in haram activities, which include gambling, arms, and the production of pornography.

Other assets include Islamic Banking (the largest asset class), Islamic Funds (assets under management have grown 300% in a decade), takaful (Shariah-compliant insurance where members contribute money into a pool system to guarantee each other against loss and damage), and waqf (the donation of a fixed asset - building, land, cash - which in turn provides returns or a benefit for the local community).

The growth of Islamic finance

Historically, Islamic finance has been concentrated in the oil-exporting countries of the Middle East and has struggled to attract the interest of foreign investors. Nor has the geographical distribution of assets changed much in the last decade. In 2012, 66% of assets were found in the Gulf Cooperation Council (GCC) and in 2021 that remained the case. Further, 80% of total assets belonged to just five countries - Iran, Saudi Arabia, Malaysia, the UAE and Qatar.

However, recent growth in both core and non-core countries suggest that Islamic finance may be poised to acquire a more powerful position in global markets. This growth can be attributed to several factors. Before considering these, I will first explore how Islamic finance assets have performed recently and consider future projections.

Islamic finance has shown incredible resilience in the face of the current macroeconomic headwinds, and is currently projected to grow 8% a year on average until 2026, making it one of the fastest growing industries in the market:

Islamic Debt Capital Markets, for example, continues to show great strength, with sukuk issuance growing 9% in 2021 to an all-time high of $202.1bn, of which a record $5.3bn consisted of ESG sukuk. Takaful, which currently accounts for 2% of the industry, is expected to grow at an average of 10% a year until 2026. Regarding banking, the total global net income reported by Islamic financial institutions trebled between 2020 and 2021, and 2022 saw vast increases in in net profit from banks such as Saudi's Al Rajhi (16%), Qatar Islamic Bank (13%), and Abu Dhabi Islamic Bank (55%).

What are the factors behind the growth?

The core market:

A crucial driver behind the growth in Islamic finance's core market has been the increased investment in Islamic fintech and the move towards a more digitalised banking system. This was primarily caused by the pandemic and the way in which it highlighted the inefficiencies within the existing banking system.

The numbers reflect this drive in investment in Islamic fintech. For example, Saudi Arabia’s fintech division grew 79% between 2021 and 2022, with personal finance and treasury management growing 175% and financial markets growing 129%. Overall, the market size of Islamic Fintech reached $79bn in 2022 and is expected to grow by 18% on average annually, reaching $179bn by 2026.

However, the most striking display of the growing strength of Islamic finance is the recent trend of mergers between Shariah-compliant banks and their conventional counterparts. November 2021 saw the closing of the $2.2bn merger between Al Khalij Commercial Bank and the Islamic bank Masraf Al Rayan to create Qatar's second-biggest lender, which will be entirely Shariah-compliant. This deal, which was the second of its kind, suggests that Shariah-compliant banks are stronger than their conventional counterparts in the region, a strength that will only continue to grow.

Traditionally low-income countries with significant Muslim populations have also seen substantial growth, especially those with a large proportion of unbanked individuals. For example, in Uganda, the Finance Trust Bank launched the country’s first shariah-compliant checking account, named Halal, which does not charge interest on loans. The logic is twofold: to provide a permissible banking option for 14% of Uganda’s (Muslim) population, and to provide a banking option for all low-income individuals so that they too can have access to credit. The second reason demonstrates how Islamic finance can, in exposing borrowers to less risk, be used to promote sustainability, and this will be discussed further in the final section of this article.

Pakistan, too, recently announced that it will move to an interest-free Islamic banking system by 2027. In Tanzania, sukuk was issued for the first time in 2021, and was oversubscribed by 36%. This increased investor interest (if I can use that word) and resulted in more banks opting to issue sukuk. For example, KCB Bank Tanzania, a commercial bank, floated a $4.4mn sukuk offering. Finally, Bangladesh, a country where around half of its 170 million population are unbanked, is poised for 25% growth in Islamic banking.

The non-core market:

Most interesting, however, is the growth of Islamic finance in non-Muslim countries. Wanting to enable their growing Muslim populations to invest their money and obtain mortgages and loans, these countries have begun integrating shariah-compliant financing and banking options.

Australia, for example, recently licensed its first-ever Islamic bank, Islamic Bank Australia, which began operating in July 2022. After a 2-year testing period, the bank will be able to serve Australia’s 800,000-strong Muslim population, giving them access to shariah-compliant banking. Similarly, in Canada, the Canadian Halal Finance Corporation created a shariah-compliant investment vehicle that allows Muslim Canadians to finance home ownership.

The biggest player in the non-core market, however, has been the UK, which holds $7.5bn in Islamic finance assets. This constitutes 85% of the total European market, and far more than the US’ $636m- - though still only 0.1% of global Islamic finance assets. Further, the UK has been the second-largest producer of Islamic FinTech's behind Indonesia, hosting 27 of the 375 firms identified around the world. Finally, the UK has issued two sovereign sukuks: a £250m issuance in 2014, and a £500m issuance in 2021, and has raised more than $50bn through 68 sukuk issuances on the London Stock Exchange.

The potential for more growth: ESG and the growing attraction of the Middle East

The growth of Islamic finance has been promising globally, but there is still potential for faster expansion. This can be done by leveraging the connection between shariah-compliancy and ESG, investing in Islamic fintech to reach more of the world's Muslim population, and enhancing the Middle-East's appeal as an investment hub.

Islamic finance and ESG:

As has been discussed on this Blog before, ESG considerations have become increasingly central to both companies’ long-term growth plans and investors’ decision-making. With this in mind, I argue that Islamic finance presents an opportunity to facilitate and support the transition towards sustainability. Its principles of ethical investing and responsible finance provide a valuable alternative for businesses and investors alike to align commercial and moral considerations and contribute to a more sustainable future.

This is so because Islamic finance is 'founded on the intended outcomes of Shariah or Maqasid Shariah, which promotes value creation and the prevention of harm'. It urges corporations and investors to push for a positive impact to the environment, economy and society, such as by prohibiting investment in weapons, or business ventures that harm the environment.

A preliminary connection between ESG and Islamic finance has already emerged, namely through the issuance of "green-themed" or "sustainable" sukuk. These reached a market size of $15bn in 2021. Specific examples include Abu Dhabi-based Etihad Airways’ issuance of its first transition sukuk, designed to assist the airline in reducing its carbon emissions, as well as Dubai Islamic Bank’s inaugural issuance of a $750m sustainable sukuk, which was 2.3x oversubscribed.

It must be borne in mind, however, that the connection between ESG and Islamic finance is in its infancy. Partners at White & Case have recently observed that so far the story has simply been Islamic finance with ESG 'bolted on', without a formalised relationship between the two. The reliance of many of Islamic finance's core-market economies on fossil fuels may explain why the link has yet to be made with full force. As those countries begin to move away from oil and gas, however, there is real potential to leverage the alignment between ESG principles and the values behind securities such as sukuk and waqf and enable Islamic finance to play a crucial role in funding the energy transition in Asia and Africa.

This connection between Islamic finance and the energy transition has been reinforced by recent events, with COP 27 held in Egypt and COP 28 to be held in the UAE. Following COP 27, there has discussion about the benefits of connecting large unbanked populations in African and Asia to the Islamic capital markets and giving them access to Islamic social finance products such as zakat (compulsory almsgiving collection), donations (sadaqah), interest-free loans (qard) and endowments (waqf).

This would result in increased proceeds that could be used to address both the climate emergency and the energy transition. For example, UNDP estimates that zakat alone could provide between $200 billion to $1 trillion annually for the Sustainable Development Goal agenda. Moreover, establishing a more robust financial ecosystem in Africa and Asia would enable Islamic financial institutions to invest in sustainability projects by leveraging higher deposit levels. For example, in Egypt around 50% of cash-flow sits outside of banks, which reduces the access financial institutions have to capital. A larger investment pool could, for example, allow for green sukuk issuance to grow at a rate similar to green bonds, which boomed from $5bn in 2010 to over $270bn in 2020. The proceeds from green sukuks would in turn be used to fund green projects and sustainability initiatives across Asia and Africa.

The Middle East:

Preliminary moves to diversify economies like Saudi Arabia and the UAE have caught the interest of international investors. This can be observed in the IPO market. In 2022, the Middle East saw a 209% increase in value year-on-year whilst global IPO values plummeted 57%. More evidence comes from the growing importance of Middle-Eastern sovereign wealth funds (SWFs) in the private equity space. Their average allocation to alternatives doubled between 2021 and 2022. As a result, an increasing number of private equity firms are seeking to establish connections with SWFs not only as passive limited partners, but also as co-investors, in order to decrease their need to resort to bank debt to fund deals in an environment of rising interest rates.

Saudi Arabia's Public Investment Fund (PIF) provides a good example. Its total assets under management have increased from $150bn in 2016 to over $600bn in 2023, and are projected to reach $1tr by 2025. PIF was recently reported as a co-investor in KKR and GIP's $15bn acquisition of Vodafone's Vantage Towers, and as a key investor in BlackRock’s infrastructure strategy in the Middle East. Speaking of Saudi, the country has launched its 'Saudi Vision 2030', a comprehensive plan aimed at leveraging the country’s investment power to create a more diverse and sustainable economy, with the ultimate goal of establishing itself as an important player in international trade and in connecting Africa, Asia and Europe. This increased presence of the Middle East in global markets, therefore, brings with it significant growth potential for its financial system.

Investor interest in the Middle East, then, is driven not only by the desire to diversify portfolios but also by opportunities for greater returns in emerging markets. This is an idea echoed by Morgan Stanley who claim that "The Decade of Emerging Markets has Begun". Offering Shariah-compliant investment opportunities would therefore clearly benefit companies, giving them access to a much greater proportion of the global population, many of whom now have access to banks and investment platforms.


Islamic finance has huge potential. Through Islamic fintech and the ongoing diversification of Middle Eastern economies in particular, it provides an opportunity for investors to broaden their portfolios and achieve greater returns, and for businesses to gain access to a vast Muslim population.

It should be noted, however, that there are significant regulatory challenges. A form of ‘death by paperwork’ emerges in which regulators have to ensure firstly that the business has substantial ESG policies in place, then ensure the Shariah-compliancy of both the business and the underlying asset on offer. In the sustainability-linked securitisation space, the risk is that there are simply not enough assets yet to make the time and money involved in this dual compliancy worthwhile. Such inefficiency could push businesses away from Islamic financial structures.

To fully realise the benefits of the connection between Islamic finance and ESG, regulatory bodies must create an efficient framework that is both ESG and Shariah-compliant and develop incentives to engage in Islamic finance. For example, countries could follow Malaysia in offering tax breaks for sustainable sukuk issuances. Further, businesses should appreciate the appeal of offering Shariah-compliant investment opportunities to reach a larger segment of the global population, an increasing number of which are becoming banked.

If these obstacles can be overcome, Islamic finance has the potential to become a market heavyweight, and in the coming years is truly one to watch.

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