After a decade of growth that transformed Islamic finance from an obscure niche into a mainstream alternative, the industry has suffered its first major setback. The market for sukuk, or Islamic bonds, tanked last year, as the global economic slowdown hit the Gulf region hard and forced governments to bail out many lenders, including Islamic financial institutions.

These problems, although very real, haven’t diminished bankers’ enthusiasm about the sector’s long-term prospects. Indonesia and Bahrain have issued major new sukuk in recent weeks, raising hopes for an imminent rebound in issuance. Islamic banks and mutual funds are expected to continue to grow at a rapid rate in the Gulf, driven largely by increasing customer demand and the region’s expanding wealth. And new initiatives, such as efforts to develop Islamic mortgages for home ownership in Saudi Arabia, promise to broaden the industry and enable banks to diversify their income streams.

Perhaps just as important, bankers say, the global financial crisis promises to boost the Islamic sector by prompting investors to look for alternatives to now-tarnished conventional Western banking products and institutions.

"The financial crisis has challenged the assumption that conventional financial solutions are the most desirable," says Hussein Hassan, head of structuring MENA for Deutsche Bank. "Many experts in the conventional space are looking seriously at alternative approaches. The principles of Islamic finance look very strong."

Spurred by the Middle East’s oil-fueled economic growth and fast-rising wealth, the trickle of money into Islamic finance products has become a flood. Bankers at State Street Corp. estimate that the industry has grown at a compound annual rate of about 15 percent over the past five years, with total assets under management at Islamic institutions now exceeding $600 billion. Before the 2008 slump in the sukuk market, issuance had grown more than sixfold in recent years, from $5 billion in 2004 to $33 billion in 2007, according to Moody’s Investors Service.

....