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The banking sector was historically the darling of investors, with stocks offering steady income and high secured yields universally. However, the 2008 global financial crisis laid bare the risky dealings by individual banks and the lack of regulatory oversight that made up leeway for such practices.

In the melee that ensued, regulators finally awakened to the risky dealings by the banks, and stringent regulations became the order of the day. Five long years after the Great Recession, which shattered the economic stability of the U.S. banking sector, banks are still struggling to put the past behind. In the first half of 2013, U.S. banks showed progress, signaling a bright future for the sector.  But it is too early to be confident about the sector’s growth prospects.

Many fear that structural changes in the sector will continue to impair business expansion and investor confidence. Yet, entering the new capital regime will ensure long-term stability and security.

Nevertheless, the sector is still clouded by many dampening factors. Tighter regulations aside, banks face asset-quality troubles, mortgage liabilities and run-ins with the government regulators. U.S. banks are also subject to never-ending lawsuits besides being subject to criminal and civil investigations from authorities. Therefore, five years on, the American banking system is yet to show any dramatic change.

Is There an Alternative?

It is hard to find an alternative to U.S. methods of banking. Risky endeavors and huge profits made these banks the poster boys of the financial world, till the reality check after recession. The resulting endeavor to find a viable option to U.S. banking has paused at an intriguing question: if high debt and inadequate equity were to a certain extent responsible for the financial crisis, might Islamic Banking be the solution?

Islamic principles prohibit financial transactions involving interest rate payment on debt and hence financial institutions rely on profit-loss risk-sharing measures. This culture of shared responsibility has led the think tank to see Islamic banking the answer to the debt crisis plaguing the U.S.

In fact, Wall Street major JPMorgan Chase & Co. (JPM - Analyst Report) operates an Islamic Banking unit in Middle East & North Africa. London-based Standard Chartered PLC and HSBC Holdings plc’s -- HSBC Amanah – also acknowledge that Islamic Banking is fast catching up and growing globally.

Notably, Britain is a world-leader in sharia banking. Evidently, 17 leading financial institutions including Barclays PLC (BCS - Analyst Report), The Royal Bank of Scotland Group plc (RBS - Snapshot Report) and Lloyds Banking Group plc (LYG - Snapshot Report) have already ventured into Islamic Banking in the past. Taking a cue from these British banking giants, many global banks such as Citigroup Inc. (C - Analyst Report) and UBS AG (UBS - Analyst Report) have also opened their Islamic banking units.

Islamic Banking: An Overview

First the highlight: the core of Islamic economics is a proscription on interest on debt. Almost instantly, a question arises on the profitability of these banks with interest ruled out of the picture. In sharia banking, an organization enters into a partnership with its depositors and invests their money in a sharia-compliant business. The profit from this investment is shared between the depositor and the bank after a certain period of time.

Islamic banking has developed products that bear a striking resemblance to those offered by conventional banks, just leaving out the interest rate payments and excluding fees and conditional payments.

This Islamic concept has fast grown in recent years primarily due to investments in the oil-rich Gulf and Asian regions that were relatively untouched by the global financial crisis. Islamic banking is growing globally at a rate of more than 20% a year, as a larger part of the world’s Muslims seek finance that agrees with sharia laws.

According to Ernst & Young, global Islamic banking assets are set to cross $1.1 trillion  by the end of this year, up from $800 billion a couple of years ago, driven in particular by strong growth in the Middle East and Malaysia.

The Underlying Risks

Beneath the rosy picture of debt free finance is the risk of lower profitability. Many large global banks like Morgan Stanley (MS - Analyst Report), Deutsche Bank AG (DB - Analyst Report) and Barclays have started downsizing their Islamic banking operations. The wider implications of banks shrinking Islamic banking services are doubts on the ability of Western banks to serve Muslim communities with a relatively small customer base and earn profits at the same time.

Pundits see two basic problems. First, is the challenge of expense management, elevated charges due to intricate structuring and legal overheads, constrained demand as well as profits, and the resulting revenue crunch. Second, the integrity of some products is a huge question. In many cases, these financial products have become an Islamic modification of interest-based debt. Therefore, many experts believe that the Islamic model, chiefly in the retail sector, is fundamentally troubled.

Conclusion

The fact that Islamic Banking is gaining popularity in the Western world is a major advantage for the business, which is still in its nascent stage. It is encouraging to see that investors have finally woken up to the advantages of interest-free finance, even though certain headwinds remain. Additionally, the business has to evolve. It is only 40 years old and is competing with a conventional banking system that has survived more than 800 years.

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