How Digital Solutions Are Driving the Growth of Islamic Banking

The globalization of financial markets has contributed to a rise of digital banking and, in turn, a growing global demand for Islamic finance services. However, the core principles of Islamic finance differ from conventional banking practices and present unique challenges. Fortunately, just as digital banking is driving demand for Islamic banking services, it is also offering unique solutions.

Technologies like blockchain, AI, and digital platforms offer innovative ways to enable digital Islamic banking, improve liquidity management, and expand product offerings. These advancements can not only help Islamic banks remain competitive but also enhance financial inclusion by providing accessible, customer-centric banking services to underserved populations.

In this article we’ll explore how, through digital transformation, Islamic banking can evolve and thrive in today’s rapidly changing financial environment.

How Does Islamic Banking Work?

Islamic finance is based on a belief that money shouldn’t have any value in itself, enabling customers to manage their finances and conduct business while staying true to their religious beliefs and values. The Islamic finance model operates differently than conventional financial systems, as it is Sharia-compliant adhering to a number of key principles:

• Prohibition of Interest (Riba): The cornerstone of Islamic banking is the prohibition of Riba, which refers to any increase in a loan or debt repayment. The Quran explicitly forbids Riba in all its forms, declaring it as exploitative and unjust. Instead of charging interest, Islamic banks are structured differently to generate profits, using methods such as profit-sharing arrangements and fee-based services.

• Risk-Sharing: Risk-sharing is a fundamental principle in Islamic banking that promotes fairness and equity. Unlike conventional banking, where the risk is typically transferred to the borrower, Islamic finance encourages the sharing of risks and rewards between the bank and the customer. This approach aligns with the Islamic concept of partnership and mutual responsibility. For example, in a Musharrakah contract, both the bank and the customer contribute capital and share profits or losses according to a pre-agreed ratio.

• Asset-Backed Financing: Islamic banking emphasizes asset-backed financing, which means that financial transactions must be supported by tangible assets. This principle ensures that money is used productively in the real economy rather than for speculative purposes. Islamic banks often use instruments like Murabaha (cost-plus financing) and Ijarah (leasing) to provide asset-backed financing solutions. These methods allow banks to earn profits while complying with Sharia principles.

• Ethical Investments: In Islamic banking, financial institutions are prohibited from investing in industries or activities considered harmful or unethical according to Islamic principles. This includes businesses involved in alcohol, gambling, pork products, and other activities deemed haram (forbidden). Instead, Islamic banks focus on investments that contribute to the well-being of society and promote economic development.

By adhering to these fundamental principles, Islamic banking aims to create a financial system that is not only profitable but also socially responsible and ethically sound. This approach has gained traction globally, with many non-Muslim countries recognizing the potential benefits of Islamic banking solutions.

Challenges and Opportunities in Islamic Banking

Islamic banking presents a unique set of challenges and opportunities in the global financial landscape. While it offers an alternative to conventional banking for Muslim communities, it also navigates the complexities of diverse Shariah interpretations shaped by the diversity in Shariah interpretations across regions, the limitations in Shariah-compliant financial instruments, and the need for product innovation to stay competitive in dual banking markets. Some of these challenges include:

• Standardization Issues: Islamic banking continues to work towards greater standardization across various jurisdictions. To address this, international Islamic standard-setting organizations are working towards harmonizing Shariah interpretations and developing global prudential standards. However, the process is slow due to the complexity of Islamic financial products and the need for better cooperation between Islamic and conventional financial standard-setters.

• Liquidity Management: Liquidity management poses a unique challenge for Islamic banks due to the limited range of Shariah-compliant instruments available. Unlike conventional banks, Islamic financial institutions cannot access interest-bearing liquidity facilities, which puts them at a disadvantage. To address this issue, some countries have introduced Islamic repo facilities and central bank Islamic liquidity facilities.

• Competition with Conventional Banking: Islamic banks face stiff competition from conventional banks, especially in dual banking markets where both systems operate side by side. To remain competitive, Islamic banks need to focus on product innovation and develop a broader range of offerings that fulfill the needs of individuals and businesses while adhering to Shariah principles.

Despite the challenges, Islamic banking has significant potential to promote financial inclusion, particularly in Muslim-majority countries. Islamic banking can serve as an effective avenue for financial inclusion by providing Shariah-compliant alternatives to conventional banking products.

How Technology Can Solve Challenges in Islamic Banking

Digital technologies have the potential to address many of the challenges that Islamic banking faces, particularly in standardization, liquidity management, competition, and financial inclusion. For instance, blockchain technology can create centralized repositories for Shariah-approved contracts, helping to harmonize interpretations across different regions and simplify compliance. Similarly, digital platforms can offer new Shariah-compliant liquidity management solutions, such as blockchain-based smart contracts or digital crowdfunding, allowing Islamic banks to better manage their financial resources while adhering to religious principles.

Moreover, the use of AI, data analytics, and cloud technology can help Islamic banks develop personalized, customer-centric products that compete with conventional banks. These technologies enable Islamic digital banks to offer faster, more efficient services while maintaining compliance with Shariah law. Additionally, digital banking apps and mobile wallets can greatly enhance financial inclusion, particularly in underserved Muslim-majority regions, by making it easier for individuals to access Islamic online banking services remotely. By embracing digital innovation, Islamic banks can overcome traditional barriers and create more accessible, competitive, and inclusive financial services.

Unlocking the Potential of Digital Islamic Banking for a Growing Global Market

With approximately 1.9 billion Muslims in the world today, access to Islamic finance is increasingly recognized as an important step. The Islamic fintech market is rapidly growing with total assets projected to reach $128 billion by 2025 at a rate of at 21% CAGR, compared to 15% for conventional fintech’s in the same period.

Millennials are a key audience for opening up access to digital Sharia-compliant banking. Recent research indicates that 56% of young Muslins said they would use Islamic banking if it was more accessible, with 32% claiming they do not have access to Sharia-compliant banks.

At Hexaware, we see banking as an essential part of everyday life and utilize our digital innovation and technical expertise within financial services to develop unique opportunities that enhance financial inclusivity and create more sustainable banking offerings. With that in mind, we recently launched a digital Islamic bank MVP (minimal viable product) for banks and financial service providers to support the needs of the growing Muslim community.

Hexaware’s Islamic Banking MVP

The prototype, a Shariah-compliant front-end solution, enables financial institutions to enhance their offerings and deliver ethical digital Islamic banking to customers. The application is core banking platform agnostic and can be integrated and extended with any of the bank’s systems.

This MVP demonstrates how technology can expedite the time to market of smaller and niche service offerings, allowing banks to prioritize social consciousness and offer customers personalized, value-add experiences that serve their needs and wants.

View below our Murabaha car finance demo:

Closing the Gap on Financial Inclusion

Through our own research we have found that the role of financial providers is changing. The global trend towards sustainable banking opens ample opportunity for more environmentally and socially conscious services. Ethical motivations are an increasingly important factor in how consumers are choosing their primary financial institutions. Consumers expect eco-conscience, convenient digital banking solutions. And in the case of the Muslim community, it is important for them to be able to conduct their financial needs while abiding by their religious beliefs.

It is evident that there is a need for financial inclusion to support this underserved community, which can help to improve people’s livelihoods, reduce poverty, and advance economic development. By closing this gap, it simultaneously provides an opening for banks to embrace innovative technology, attract new customers and develop new revenue streams.

Get started creating Shariah-compliant digital banking for your customers with Hexaware today!