This paper investigates the determinants of the pattern of Islamic bank diffusion around the world using country-level data for 19922006. The analysis illustrates that income per capita, share of Muslims in the population and status as an oil producer are linked to the development of Islamic banking, as is economic integration with Middle Eastern countries and proximity to Islamic financial centers. Interest rates have a negative impact on Islamic banking, reflecting the implicit benchmark for Islamic banks. The quality of institutions does not matter, probably because the often higher hurdle set by Shariah law trumps the quality of local institutions in most countries. The 9/11 attacks were not important to the diffusion of Islamic banking; but they coincided with rising oil prices, which are a significant factor in the diffusion of Islamic banking. There is convincing evidence of a close correlation between financial sector development and growth. Countries with larger financial systems tend, all else being equal, to grow faster (King and Levine, 1993) because banks perform a fundamental economic role as financial intermediaries and as facilitators of payments.

They help stimulate savings and allocate resources efficiently. Banks also allow for diversification of risk, monitor managers, and exert control (Levine, 1997). Moreover, even in a world of apparent capital mobility, the evidence suggests that domestic savings and investment rates are highly correlated which makes domestic saving and financial development a major driver of economic growth. This paper looks at Islamic banking around the world, identifying the sources of its expansion and formulating policy advice on how to stimulate its further growth. Knowing the factors that stimulate Islamic banking is crucial to helping Islamic countries which have remained largely underbanked and therefore also underdeveloped—to catch up. These factors could also help developing countries with minority Muslim populations to benefit from an alternative source of financing and deepen their financial sectors.