A cursory glance at the Islamic banking industry shows that it is robust and profitable. In most countries with significant Islamic communities (Exhibit 1), financial institutions that cater to this segment are growing much faster than conventional banks, because of the strong demand among consumers for products and services that comply with Sharia, the Islamic legal code. The banks' financial ratios, such as return on assets, can be as high as those of the best-performing conventional banks. But these successes are built largely on regulatory advantages and on a unique value proposition. Both are being eroded by the market entry of players that combine Islamic products with superior marketing and customer service skills. For incumbents to survive, they must not only bring their fundamental banking skills up to competitive levels but also overcome a handful of challenges specific to Islamic banks.

In general, Islamic banks are governed by Sharia, which, among other aspects, prohibits the use of interest or speculation (Exhibit 2). There are about 270 Islamic banks around the world (including subsidiaries of conventional banks), and together they hold assets estimated at more than $265...