Does Islamic finance spur banking sector development?

Abstract

Islamic finance is one of the most prominent phenomena over the last decade in the banking industry in the Middle-East and South-East Asia. In spite of the substantial size and growth of this segment recently, the role of Islamic banking in the economy is still heavily debated and very few empirical work is available. This paper studies the empirical impact of Islamic banking on banking sector development. It circumvents the lack of data through a newly constructed and comprehensive database, “IFIRST”, covering Islamic commercial banks worldwide over the period 2000–2005. This database is, to our knowledge, unique in the industry.We find strong and consistent empirical evidence that the development of Islamic banking in Muslim countries leads to a higher banking sector development, as measured by the amount of private credit or bank deposits scaled to GDP. This effect occurs through the development of a new, Shariah-compliant, banking industry, which does not crowd out the conventional banking system. Additionally, we provide evidence that the Islamic banking sector acts as a complement to the conventional banking in Muslim countries, when both systems co-exist and the Islamic sector reaches a medium penetration in the total banking sector.