Digital transformation has become a key driver of growth in many industries, and the banking sector is no exception. While fintech companies have been spearheading digital change, Islamic banks have been slower to embrace this shift. However, the COVID-19 pandemic has highlighted the need for modernization, and the demand for digital banking services is stronger than ever. In this article, we’ll explore why Islamic banks have been hesitant to digitize and how they can capitalize on the digital revolution to drive growth.

The Rise of Islamic Finance

Islamic banking operates on the principles of transparency and accountability, grounded in the belief that money is a “property of God.” This sets Islamic banks apart from conventional financial institutions, which rely on charging interest rates. Instead, Islamic banks offer unique services like Ijarah (leasing), Mudarabah (profit-sharing), Musharakah (joint ventures), and Murabahah (cost-plus), all designed to align with Sharia principles.

Islamic banking has grown significantly, especially in regions like the Middle East, Asia, and Africa, where demand for Sharia-compliant financial products is increasing. The industry is currently valued at $1.99 trillion and shows immense growth potential, though it still represents a small fraction of the global banking market.

Growth of Islamic Banking in APAC

Countries like Indonesia and Malaysia are leading the charge in the growth of Islamic finance. In Indonesia, Bank Syariah Mandiri dominates the market with around 28% of the market share. The Indonesian central bank is also pushing for greater digitization across financial institutions, which is accelerating the adoption of digital banking in the country.

In Malaysia, Islamic banking has seen explosive growth, with major institutions like CIMB Bank, Meezan Bank, and Maybank Islamic expanding their digital offerings. For example, CIMB Bank launched an integrated digital app to offer consumers a wide range of financial solutions, further cementing the growing influence of Islamic finance in the region.

Why Are Islamic Banks Hesitant to Digitize?

Despite the rapid growth of Islamic finance, many Islamic banks remain hesitant to fully embrace digital transformation. One significant challenge is the higher operational costs associated with maintaining a traditional banking model. Unlike conventional banks, which have automated many of their processes, Islamic banks still rely heavily on manual systems, resulting in inefficiencies and higher costs.

Additionally, many of the older generations in control of Islamic banks have been slow to adopt modern digital strategies. As a result, Islamic banks continue to operate with outdated systems, leading to higher operational costs and a lower volume of transactions compared to their more digitized counterparts.

The Change is Coming

As Generation Z comes of age, there is a growing demand for more tech-savvy banking solutions. Younger consumers are more open to embracing digital financial services, including Islamic banks. In APAC countries where Islamic finance is growing, fintech can help provide Sharia-compliant platforms that bring more people into the fold of financial inclusion. The shift to digital will allow Islamic banks to better serve remote and unbanked populations, which have been underserved by traditional branches.

Historically, Islamic banks relied on physical branches to interact with customers, but today, many of these institutions have lower customer penetration in digital banking than their conventional counterparts. With the rise of mobile and internet technologies, there is a unique opportunity for Islamic banks to tap into this market and serve more customers at a lower cost.

Other Challenges Facing Islamic Banks

While digital transformation poses significant challenges for Islamic banks, they are not alone in facing them. However, there are a few unique hurdles that Islamic banks must address:

1. Customer Acquisition

One of the main challenges for Islamic banks is reaching new customers. In countries like Malaysia, where the Muslim population is over 60%, Islamic banks still only hold 34% of the market share. Digital onboarding tools are essential for attracting new customers, especially younger, tech-savvy users. Qatar Islamic Bank (QIB), for example, recently launched a digital onboarding process that allows new customers to open accounts through a mobile app, making the process faster and more convenient.

2. Customer Experience and Retention

Another significant hurdle is improving customer experience and retention. Many customers perceive Islamic banks as not being fully aligned with Sharia principles, which affects their loyalty. Additionally, Islamic banks have been slow to adopt mobile banking, which makes them vulnerable to losing customers who prefer faster, more convenient digital services.

3. Compliance with Regulations

Islamic banks must also navigate the complexities of Sharia law to ensure their services remain compliant. This requires extra time and effort to review contracts, ensure products are halal (permissible under Islamic law), and maintain proper governance and risk management structures.

4. Risk Management

Risk management is particularly complex for Islamic banks. For example, products like Ijarah (leasing) are based on cost-plus financing, meaning that the return on investment isn’t fixed. This can lead to risks if customers are unable to repay their leased products.

The Opportunities of Digitization for Islamic Banks

Despite the challenges, digitization presents numerous opportunities for Islamic banks. By digitizing their operations, Islamic banks can:

• Increase customer loyalty: Digital tools allow Islamic banks to offer more personalized services, increasing customer satisfaction and retention.
• Boost operational efficiency: Automation and digital solutions can help Islamic banks reduce operational costs, allowing them to pass on savings to customers and increase profitability.
• Attract new customers: By offering easy-to-use digital platforms, Islamic banks can expand their customer base, particularly among younger, tech-savvy consumers.
• Improve compliance: Digital tools can help Islamic banks streamline compliance processes, ensuring that they remain in line with Sharia law while minimizing operational risks.

Conclusion

Islamic banks face unique challenges when it comes to adopting digital services, but the benefits of digitization far outweigh the costs. By embracing technology, Islamic banks can enhance customer loyalty, improve efficiency, and reach new markets. The pandemic has accelerated the need for digitalization, and as younger generations demand more modern banking experiences, Islamic banks must act quickly to stay competitive. By partnering with fintech companies and focusing on digital transformation, Islamic banks can continue to grow and thrive in a rapidly changing financial landscape.