Islamic banks are increasingly visible features of national financial systems not only in Muslim countries but even in those that have Muslim minorities, such as Singapore and the United Kingdom. Globally, these institutions’ assets are growing by 15 to 20 percent a year—so quickly that in 2006 they reached nearly $400 billion. But though our analysis shows that Islamic banks have plenty of room for continued growth, regulations that try to balance religious conformity with economic reality are hampering their development.

Islamic institutions provide financial services and products that comply with Sharia, the Islamic legal code. The main facets of Sharia include prohibitions against interest payments, speculation that involves future risks (such as gambling or conventional derivatives), and investments in forbidden areas, such as alcohol or weapons. In practice, a key requirement for the creation of a large number of products is that financial instruments must be founded on a physical transaction, such as the underlying sale and repurchase of a commodity. This guideline increases the costs and complexity of such instruments as compared with those from conventional banks.

Formerly concentrated in North Africa, the Middle East, and Southeast Asia, Islamic banking is spreading rapidly. Today about 270 Islamic banks—including...