The Future of

Islamic Banking
Declining growth rates and eroding profitability
suggest it is time to better leverage the Islamic banking
potential. In order to do this, Islamic banks should
revisit their strategic positioning and improve their
operational efficiency.

The Future of Islamic Banking 1

For years, many Islamic banks have witnessed double-digit growth rates, surpassing their
conventional peers. At first glance, all seems well for the Islamic banking industry. There is
ample room for growth as Islamic banking rarely exceeds a third of total market share, even
in the Gulf Cooperation Council (GCC) countries and Malaysia. Several potential markets with
large Muslim populations remain largely untapped, such as India and the Commonwealth of
Independent States countries, made up of the former Soviet republics. In addition, overall
banking penetration in many of the industry’s core markets is still low. For example, GCC
countries have not yet achieved the banking penetration levels of countries such as France
or the United Kingdom. At the same time, several new markets have opened up for Islamic
banking, with even more on the horizon (see sidebar: A Market Overview on page 4).

The Changing Dynamics of Islamic Banking

A closer look, however, suggests the market dynamics are changing. Two key indicators should
be cause for reflection in the Islamic banking industry: growth rate and profitability (see figure 1).

Figure 1
Declining growth rates and profitability suggest Islamic banks revisit their strategies

Banking asset outgrowth

(%)
30 27% 25%
22% 21%
20 17%
11%
10 6% 8% 6%
3%

KSA UAE Kuwait Bahrain Malaysia

2006-2008 CAGR 2009-2010 CAGR

Cost income ratio

(%) +82%

77% -8%
+37%
50 +21%
48%
42% 44%
+11% 41%
40
34%
28% 29% 30%
30 26%

20

10

KSA UAE Kuwait Bahrain Malaysia

2006-2008 average 2009-2010 average

Note: Outgrowth is defined as the difference between Islamic banking asset growth and conventional banking asset growth.
Source: A.T. Kearney analysis

The Future of Islamic Banking 2

Slowing growth. After years of rapid growth in which Islamic banks outpaced conventional
banks in most markets, outgrowth is waning in key geographic regions, including Saudi Arabia
and the United Arab Emirates. Soon, growth in Islamic banking could match the general market,
suggesting that Islamic banks may have exhausted their “natural” share.1 While the data at this
time remains inconclusive, it should be viewed as an early warning sign.

Eroding profitability. Although Islamic banks have generally outperformed conventional banks
in terms of growth over the past decades, they have not consistently outperformed them in
terms of profitability. For example, several small Islamic banks in the GCC have been struggling
for years to turn profitable; others have been badly affected by the regional economic crisis
(see sidebar: Challenges in Islamic Banking). More importantly, some major Islamic banks, notably
in the GCC, have witnessed declining profit margins over the past five years.2

To sustain profitable growth, a more sophisticated leveraging of the Islamic banking potential—
much of whose potential has not yet been exploited—is required. Strategically, this means that
Islamic banks, which so far often purely emulate a conventional bank’s offering, need to revisit
their positioning. Operationally, they need to seek greater efficiency across the value chain.

Challenges in Islamic Banking

Given the slowing growth and were for Islamic banks; Malaysia’s central bank,
decreasing profitability of Islamic meanwhile, conventional banks discourages the sale of Islamic
banking, we looked at some of the continue to launch Islamic banking products that are
main challenges facing the windows.3 As a result, merely deemed unacceptable in the GCC
industry. being Sharia compliant is not a to increase industry standard-
major differentiator. ization. Regulation issues also
Size. Many Islamic banks are stem from some countries’ lack of
considerably smaller than their Standardization and regulation. specific Islamic banking rules.
conventional competitors in their Standardization and regulation
domestic markets. Moreover, present ongoing challenges for Cost structure. Despite strong
even the biggest Islamic banks Islamic banks. Different interpre- growth, most Islamic banks have
are typically small compared to tations of the acceptability of not been consistently profitable,
international conventional various products from a Sharia particularly since the global
competitors. There is no Islamic perspective makes standard- financial crisis. Structural factors
Citibank or Islamic Goldman ization difficult. For example, the are partly to blame as Islamic
Sachs—that is, no global same Islamic financial instrument products are typically more
pure-play Islamic banking leader can be rejected by one Sharia complex than conventional
with a broad or specialized board and approved by another, products, which add develop-
business model. as the Sharia rulings of these ment and manufacturing costs.
boards are based on their under- Bank-specific weaknesses, such
Competition. The number of standing of the underlying Sharia as risk management and opera-
Islamic banks and financial principles. Moreover, historically, tional effectiveness, also play
services firms is growing even as there have been marked differ- a role.
market growth slows down. For ences in product acceptance
example, the only new banking between Southeast Asia and the
licenses in the United Arab Middle East. There is a converging
Emirates issued in recent years trend now, as Bank Negara,

It is widely held that customers fall into three categories. The first two include "Islamic bank loyalists" and "conventional bank loyalists",
1

both with clear-cut preferences. The third and largest category is "floating mass"—in some estimates about 60 to 70 percent. They
typically make their banking decisions based on pricing and service quality, and will require an Islamic offering to be at least on par
with a conventional one.
2
While profitability may not be a key driver for some Islamic banks, it certainly remains important for most.
3
Qatar is a notable exception, as the central bank has ordered Islamic windows to be closed.

The Future of Islamic Banking 3

A Market Overview

Islamic banking—financial In terms of Islamic banking There are three main types of
activity consistent with Sharia, penetration (that is, Islamic players in the Islamic banking
or Islamic law—has become a banking assets as percent of total industry: full-fledged Islamic
material part of the global banking assets), markets can be banks, Islamic windows of
financial services industry, broadly categorized into three conventional banks, and Islamic
growing rapidly in both size and clusters: established, emerging finance companies. Full-fledged
stature. Total Islamic assets are and untapped (see figure B on Islamic banks are either fully
estimated around $1,200 billion page 5). The established cluster independent entities or subsid-
in 2010. Islamic banking assets of Islamic banking activity is the iaries of conventional banks,
make up around 90 percent of Middle East and South East Asia, holding banking licenses. Islamic
this, while outstanding Islamic with some of the world’s most windows are secluded Islamic
sukuk and Islamic investment active markets such as Kuwait, banking departments within
funds comprise the rest. the Kingdom of Saudi Arabia, conventional banks. Islamic
the United Arab Emirates and finance companies focus on
The major geographic markets Malaysia. Emerging markets such supplying Sharia-compliant
are Iran, the Kingdom of Saudi as Pakistan and Indonesia have financing products such as auto
Arabia, the United Arab Emirates, vast Muslim populations and offer and home finance, and are not
Malaysia, Kuwait, Qatar and significant growth prospects. allowed to take deposits.
Turkey (see figure A). Over the Large yet untapped markets such
past several years, Islamic banking as India offer great potential to
has seen double-digit growth daring investors. To date, there
rates. For example, the compound are no major initiatives under-
annual growth rate between 2006 taken to promote Islamic banking,
and 2010 has been 21 percent in and if tackled strategically,
the Kingdom of Saudi Arabia and markets such as India present a
24 percent in Malaysia. vast opportunity for expansion.

Figure A
Islamic banking has become a material part of the global financial services industry

Islamic banking assets breakdown

(100% = ~$1,100 billion)
Turkey Others
3% 4%
Qatar
3%
Kuwait
6%

Malaysia
8%

Iran
55%
UAE
9%

KSA
13%

Source: A.T. Kearney analysis

The Future of Islamic Banking 4

Figure B
Islamic banking markets can be broadly categorized into three clusters

Islamic banking markets

Examples

Established Emerging Untapped

Kuwait KSA UAE Malaysia Pakistan Turkey Indonesia India China

Muslim population
3 27 6 17 175 73 209 162 22
(Million, 2010)

GDP per capita

40,517 23,201 59,533 15,022 2,516 13,150 4,250 3,408 7,544
($, 2010)

Islamic assets
62 142 94 86 6 28 10 - -
($ billion, 2010)

Islamic assets as % 40% 38% 22% 17% 7% 5% 3% - -

of total assets

Source: A.T. Kearney analysis

Niche Market or Head-on? Consider the Implications

Fundamentally, Islamic banks have two strategic choices—exploit the Islamic banking niche or
compete head-on against conventional banks.4 Before moving along either path, or considering
a blend of both strategies, we suggest looking at the implications of each.

Exploiting the niche. Fully exploiting the Islamic banking niche means targeting customer
segments that care most deeply about Sharia compliance in their financial dealings as well
as offering products and services that meet not only general financing but also Muslim-specific
customer needs. While Islamic banking products for basic banking abound (for example, auto
finance and credit cards), and while there is still “white space” in some more sophisticated
areas (for example, asset management and wealth management), such products tailored to
Muslim-specific needs provide a platform for true differentiation (see figure 2 on page 6).

In retail banking, target customer segments may include religious conservatives, muftis,
awqaf employees, or employees of ministries of Islamic affairs. One good example of a
Muslim-specific retail banking product is financing for the pilgrimage to Mecca. This is highly
relevant even for customers who generally place less importance on Sharia compliance in
their financial dealings. Such products exist already in some parts of the Islamic world, for
example, Tabung Haji Banking in Malaysia and Brunei. In private banking, target segments
may include owners of halal industry companies. Providing specialized advice to high-net-
worth individuals planning an awqaf set-up could represent a highly specialized, differentiated
service in this segment. In corporate banking, target segments may include Islamic charities
as well as the halal industry. A niche Islamic banking service for this segment will include asset
management for awqaf, or expertise on providing Islamic financing in Western countries
to companies acquired by Sharia-compliant private-equity firms. In institutional banking,

Regarding the first choice, the Islamic banking niche, assets rarely surpass 30 percent of total market share, and as such, Islamic
4

banking is still a niche market even in the GCC and Malaysia. A notable exception is retail banking in the Kingdom of Saudi Arabia,
where Islamic banking has a much larger share and has effectively grown out of the niche.

The Future of Islamic Banking 5

Figure 2
While Islamic basic banking products abound there is still white space in some areas

Product innovation opportunities

Selection

High: Tailored to
specific Islamic
needs Hajj savings products*
Awqaf asset
management

Level of
Islamic Novel path
specificity
Traditional path Wealth
management
Takaful
Mortgage Futures
Personal loans
Asset management Options
Current Credit cards Sukuk
Low: Emulating accounts SWAP
conventional Payments Commercial loan
banking products Spot FX

Basic Product portfolio Sophisticated

White space/emerging only – opportunity for innovation

*Tabung Haji is a notable exception.

Sources: Company websites, A.T Kearney project experience

other financial establishments may be targeted for the provision of pure-play Islamic banking
expertise to support the development of their Islamic finance offering.5

Fully exploiting the Islamic banking niche also requires pricing considerations. As target
customer segments will be less prone to accepting conventional bank offerings, products can
be priced more expensively than conventional products, as long as prices remain competitive
among competing Islamic offers. It also requires a reflection of Muslim values and heritage
throughout the entire marketing portfolio, including brand name, corporate slogan, product
names, and media and advertising campaigns.

Preserving a personal relationship is important in reaching Islamic banking “loyalists,” which

means providing brick-and-mortar branches where sales staff can meet customers face-to-
face. However, less traditional ways to reach customers via alternative channels, such as phone
banking, should also be explored. Beyond this, corporate social responsibility, such as supporting
local Muslim communities and creating new Islamic charities, will appeal strongly to Islamic
banking customers.

Some international banks have Islamic footprints in many countries, such as HSBC Amanah, and
some Islamic banking groups domiciled in the GCC have a remarkable geographic coverage.
However, most focus on one country, signaling geographic expansion as a clear growth

5
Muftis are Islamic scholars. Awaqf are religious endowments in Islamic law. Halal industry companies in the true meaning of the term are
companies selling halal products. In a broader sense, they include industries selling products which draw on the Muslim identity. For
more information, see “Addressing the Muslim Market” at www.atkearney.com.

The Future of Islamic Banking 6

opportunity for niche-focused banks—the market is under-served in many markets outside of
the GCC and Malaysia. Potential opportunities include Muslim-majority emerging markets such
as Indonesia and Iraq, and wealthy, Muslim-minority developed markets such as Germany and
France. Co-operative ventures might be the best entry strategy in these latter countries.

The market gaps are many and varied. Opportunities to better meet Muslim-specific client needs
with dedicated banking products aligned with Islamic core values are under-developed and
present attractive platforms for profitable growth for players willing to exploit the niche.

Competing head-on with conventional banks. It is a fact that many Islamic banks are competing
head-on against their conventional peers. However, not all may realize that a head-on strategy
has fundamentally different implications than a strategy of exploiting the Islamic banking niche.
Competing against conventional banks means attracting customers who place less importance
on Sharia compliance in their financial dealings, and more importance on competitive products
and efficient services vis-à-vis the banking market at large.

Three elements are key to targeting the right customer segments. First, identification of customer
segments least open to Islamic banking (for exclusion). Second, identification of segments with
needs not fully met in a Sharia-compliant manner (to address shortfalls). And third, identification of
segments open to ethical banking (to tap into a wider audience of both Muslims and non-Muslims).

As competition intensifies, Islamic banks

will have to adopt more sophisticated,
customer-centric sales approaches.
Successfully attracting these customers requires meeting a broader set of customer needs,
while remaining on par with conventional banks in terms of ease of use and pricing. To achieve
this, product innovation is paramount both in terms of broadening offerings using existing
Islamic structures, as well as developing new Islamic structures. Banking services and
products for small- and medium-sized enterprises, which are still only emerging in Islamic
banking, and ethical banking products such as funds focused on investments in sustainable
energy, provide an opportunity to broaden the offering. New Islamic banking product struc-
tures not easily replicated in a Sharia-compliant manner include hedge funds—an alternative
asset class for high net worth individuals —and derivatives for corporate clients. While some
Islamic banks offer Islamic derivative products, such products are not generally accepted as
Sharia compliant (see sidebar: Islamic Derivatives: Moving the Frontier on page 8).

When competing against their conventional peers, Islamic banks typically are at a scale disad-
vantage, as they are often smaller in size (see figure 3 on page 9). In retail banking for example,
the disadvantage is most significant in the size and range of the branch network. To compete
successfully, head-on with conventional banks, particular focus on two areas is required. Firstly,
Islamic banks should explore the use of alternative channels such as online banking and phone
banking to gain market share. It will be important to use them much more as a sales channel rather
than the current service focus. Secondly, the use of different branch models should be explored,
depending on target segments’ needs, ranging from light, kiosk-style sales outlets focusing on
retail mass customers to full-service branches covering all customer segments. Alternative branch

The Future of Islamic Banking 7

Islamic Derivatives: Moving the Frontier

Derivatives are highly disputed could improve the Islamic terms upon which parties can
in Islamic finance. Some industry financial system. The bank enter risk management arrange-
officials condemn them as launched the first global Islamic ments for hedging transactions,
inherently incompatible with the derivative master agreement to standardizing structures, and
principles of Sharia. They believe document Islamic derivative documentation. If widely adopted,
two parties’ deferment of transactions in 2007. A Malaysian the new standards could boost
obligations to a future date is bank also created the world’s first the Islamic derivatives market.
tantamount to a debt exchange Islamic derivative product (an
without an underlying asset Islamic profit-rate swap) in 2005. Currently, Malaysian banks and
transfer, implying the possibility major international banks are
of gharar—prohibited transac- Another major milestone for driving Islamic derivative
tions associated with speculation. Islamic derivatives was the offerings. The most widespread
This is a main reason why deriva- Tahawwut Master Agreement, are profit-rate swaps, cross-
tives have not yet gained launched in early 2010 by the currency swaps, cross-currency
universal appeal in the Islamic International Islamic Financial profit-rate swaps, forward-rate
world, particularly in the Gulf Market, a Bahrain-based global agreements, and equity-linked
states. standardization body for the structured products. Contrary to
Islamic capital and money conventional derivatives, Islamic
Some leaders within the Islamic markets, and the International derivatives cannot be traded, as
financial services industry, Swaps and Derivatives they are intended for hedging
however, recognize the need for Association. The multiproduct purposes only, and not as specu-
managing risks and the potential agreement, including murabaha lative investments.
benefits of derivatives for (cost plus financing with known
hedging purposes. For example, cost of underlying asset at the
Bank Negara Malaysia has long time of entering arrangement),
advocated introducing deriva- musawama (cost plus financing
tives in Islamic banking, saying with unknown cost of underlying
that with an adequate legal, asset at the time of entering
regulatory, and corporate arrangement), and wa’ad
governance framework they (unilateral pledge) products set

models have the additional advantage of potentially reducing capital investments, operating
costs and set-up times, and are particularly powerful if coupled with alternative channels.

A modern, customer-centric image that emphasizes ethical values and social or environmental
efforts will reach the widest audience of both Muslim and non-Muslim customers. Alongside this
is the need for education programs on Islamic banking products and structures.

In deciding to compete head-on with conventional banks, a first step is to build a strong
domestic base before expanding internationally. Domestic mergers and acquisitions (M&A)
can offer attractive opportunities to achieve scale-related synergies from larger operations.
Strategic M&As allow Islamic banks to compete more effectively with the larger conventional
banks by expanding branch networks, taking advantage of operational synergies, and
expanding their financial clout.

The Future of Islamic Banking 8

Opportunities to Improve Productivity
Whatever strategic positioning an Islamic bank chooses, it will typically need to seek greater
efficiency across the value chain. As with other GCC banks, key areas include sales effective-
ness, operational efficiency, and performance management.

Customer focus. The number of banking products and revenue per customer in the GCC
remains relatively low compared to developed markets. For banks to increase their share of
wallet, customer satisfaction is key, yet studies show that GCC banks generally do not seem
to consider customer satisfaction a priority. Based on our research, we see three main areas
for improving customer focus.

• Staff. Salespeople often are poorly prepared and have little understanding of the products they
are selling. This is even more pronounced in Islamic banking, where customers may require
additional explanations of Sharia-compliant product structures. There is a need to improve
responsiveness, as customers do not receive a callback within the promised time, if at all.

• Information. When customers do not receive important information about a product before
purchase—for example, discovering extra charges after a sale—this typically results in severe,
lasting damage to brand loyalty.

• Touch points. Customers often have limited call-center or website service options and are
repeatedly referred from one department to another. Few Islamic banks have a multi-channel
view of the customer.

Figure 3
Compared to conventional peers, most Islamic banks suffer a size disadvantage

Average size of assets

($ billion, 2010)
51
50
45

40

30 29

20
18 19
15 16

10
10

4 4

KSA UAE Kuwait Bahrain Malaysia

Size of conventional
2.5x 1.9x 1.9x 4x 12.7x bank compared to
Islamic bank
Islamic banks Conventional banks

Note: Islamic assets of conventional banks are included within the size of “conventional banks” as they are simply another product
offering by the conventional bank.
Sources: Country central bank websites; A.T. Kearney analysis

The Future of Islamic Banking 9

Improving customer service begins with a framework in which the brand promise is aligned with
every aspect of the organization—its people, culture, performance metrics, processes and
infrastructure. As competition intensifies, it is imperative for Islamic banks to adopt a more
sophisticated, customer-centric sales approach. A reorganization of the sales force from
a product focus to a customer segment focus, improvement of sales techniques and skills, and
installing an improved multi-channel offering through channel cooperation and organizational
integration will keep costs down and promote customer satisfaction. Maintaining a single view
of the customer across all channels is paramount.

Operational efficiency. Many bank processes in the GCC are still manual, involving a multitude
of documents and layers upon layers of decision makers. This can be particularly cumbersome
in Islamic banking as an asset transfer is often involved. Redesigned processes can yield signif-
icant efficiency improvements, in some cases reducing resource requirements by 50 percent.
While automation is important, it is not always required, particularly given the low labor costs in
the GCC. Targeted IT investments are important, as is aligning the entire organization on
strategy and streamlining the structure, which can significantly improve efficiency.

Improving customer service begins with

aligning the brand promise with every
aspect of the organization—its people,
culture, performance metrics,
processes, and infrastructure.
Outsourcing and offshoring provide options for centralizing business processes, improving
service levels, and increasing control. Although it is a relatively new concept in the GCC, several
regional banks have successfully outsourced less complex functions to India and Egypt.

A structured approach to procurement—analyzing spending and identifying savings for both

strategic and operational costs—can reduce costs by up to 30 percent in some categories.

Performance management. Monitoring and properly rewarding high achievers is key to

improving performance levels. Rewards can be in the form of financial compensation, career
progression, or acknowledgements such as tried and tested “employee of the month” awards.
A properly structured incentive system can become a powerful tool for retaining staff, particularly
important in Islamic banking given the general shortage of skilled resources. The key is linking
rewards directly to performance measures—pre-defined at the employee level—to ensure that
hard-won improvements are sustained.

The Future of Islamic Banking 10

Banking on the Future
Growth over the past several years continues to generate optimism for the future of Islamic
banking. But as competition ramps up, and early warning signs show growth slowing down,
Islamic financial institutions have plenty of work to do. Whether the strategy is to focus on niche
positioning, compete with conventional banks head-on, or a blend of both, sustaining growth
will require most Islamic banks to achieve greater efficiency across the value chain.

Islamic banks that take the time now to consider strategic choices and address operational
fundamentals will be in a stronger position to capture untapped market opportunities and
master the changing dynamics of their industry.

Authors

Cyril Garbois, Cyril Gourp,

partner, Middle East principal, Middle East
[email protected] [email protected]

Dr. Alexander von Pock, Mukund Bhatnagar,

principal, Middle East manager, Middle East
[email protected]

The Future of Islamic Banking 11

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