Most Islamic banks were founded as Islamic banks. A growing number, however, began life as conventional banks and changed course. Conversion is one of the hardest projects a bank can undertake: every asset, liability, product, system and contract must be reviewed while the bank keeps serving customers. This article explains why banks convert, how a conversion is planned and governed, and what happens to each part of the balance sheet.
It is an educational overview by ifSPACE. Institutions should follow their own Shari'ah supervisory board's rulings, their regulator's requirements and the published text of the relevant standards.
Why banks convert
Banks convert for a mix of reasons, and most conversions involve more than one:
- Conviction: shareholders, often in a region where Islamic finance is well established, want the bank's business to be consistent with their beliefs.
- Customer demand: a large share of customers prefer Islamic products, and the bank risks losing deposits to Islamic competitors.
- Strategy: a full conversion can be cleaner than running an Islamic window beside a conventional book.
- Law and policy: in some countries public policy pushes the whole system towards Islamic finance. In Pakistan, for example, a 2022 ruling of the Federal Shariat Court called for an interest-free system within a few years, and several banks there have converted or announced plans to do so.
A well-known earlier example is Sharjah Islamic Bank in the United Arab Emirates, which was previously the National Bank of Sharjah and completed its conversion in the early 2000s.
The decision and the plan
A conversion starts with a formal decision, normally taken by the shareholders in general assembly and backed by the board of directors. The date of this decision matters a great deal, because the Shari'ah rules on new transactions and on interest income are measured from it.
The decision is followed by a written conversion plan. A good plan sets out:
- the target date for full conversion and the milestones along the way;
- how each category of assets and liabilities will be handled;
- the new governance structure, products, policies and systems;
- the budget, the people responsible and how progress will be reported to the board, the Shari'ah supervisory board (SSB) and the regulator.
The role of Shari'ah Standard No. 6
AAOIFI Shari'ah Standard No. 6, Conversion of a Conventional Bank to an Islamic Bank, is the main reference for the Shari'ah side of the process. As ifSPACE courses describe it, its core rules are straightforward:
- Once the decision to convert is made, the bank stops entering new interest-based contracts.
- For existing loans, the bank recovers the principal; interest received after the decision is not taken into income but is given to charity.
- Conventional deposits are converted into current or investment accounts, with the depositors' consent, and interest-bearing borrowings are repaid or replaced as soon as possible.
- Where the bank is bound by legacy contracts it cannot exit, it works to settle or restructure them quickly, under the SSB's supervision.
- The standard also addresses income earned before the decision, encouraging purification where the bank still holds it.
- The whole process follows a plan with a timetable.
Governance
A converting bank needs Shari'ah governance from the first day, not the last. In practice this means:
- appointing a qualified SSB early, so that it can approve the plan, the new products and the contracts;
- setting up a Shari'ah compliance function that reviews transactions and advises management day to day;
- building an internal Shari'ah audit function that gives the board and the SSB independent assurance that controls work.
AAOIFI's GS 1 (2024), Shari'ah Governance Framework, provides a useful map. It treats Shari'ah compliance as the job of the whole institution: the board sets the tone, management implements, and the SSB, the compliance function, internal Shari'ah audit and external Shari'ah audit each play their part.
Assets: loans and investments
The asset side usually takes the longest. A bank holds loans of different maturities, bonds, interbank placements and sometimes derivatives. For each, the options are broadly:
- Run off: let short-term loans mature and recover the principal.
- Convert: with the customer's agreement, replace a loan with an Islamic contract, such as murabahah, ijarah or diminishing musharakah, structured as a genuine new transaction and not a relabelled loan.
- Exit: sell or settle conventional bonds and other interest-bearing investments, replacing them with sukuk or other compliant assets.
Long-term fixed-rate loans are the hardest case, because borrowers may have little reason to change, so a small conventional tail may remain for a time.
Liabilities and deposits
On the liability side, savings and term deposits that pay interest are converted, with the customer's consent, into Islamic accounts:
- Current accounts are usually treated as qard, a loan from the customer to the bank, which the bank guarantees and on which it pays no return.
- Investment accounts are typically structured as mudarabah, where the customer shares profit and bears loss on the funds invested, or as wakalah investment, where the bank invests as the customer's agent for a fee.
Customers who do not agree to convert are generally offered the chance to withdraw their funds when their deposits mature.
Treasury
The treasury must replace interbank deposits, repos and interest-rate hedges with Islamic tools: commodity murabahah placements, wakalah placements, sukuk portfolios and, where available, Shari'ah-compliant hedging. Liquidity management is often the tightest constraint during conversion, especially in markets where Islamic interbank instruments and central bank facilities are limited.
Interest received during the transition
Some interest will continue to arrive on legacy contracts after the decision. The rule is clear: it is not income. The bank records it in a separate charity account and disposes of it under SSB supervision, without using it for its own benefit.
People, systems and reporting
- Staff training: everyone from tellers to the board needs training on the new contracts, their sequence of steps and their risks. Relationship managers must be able to explain the changes to customers.
- IT: core banking systems must handle sale-based pricing, profit distribution to investment accounts, charity accounts and new product records. This is often one of the largest costs.
- Accounting: the bank moves to Islamic accounting policies, whether AAOIFI financial accounting standards or IFRS with suitable disclosures, as its regulator requires.
- Regulatory approval: the central bank must normally approve the conversion, the licence change, the plan and often each new product.
- Customer communication: customers need early, clear and repeated explanations of what will change, what they must sign and what choices they have.
A phased timeline
Every bank is different, but a conversion often follows phases like these:
- Preparation: feasibility study, shareholder decision, regulatory engagement, SSB appointment.
- Design: products, contracts, policies, systems and the detailed plan.
- Launch: new business written only on Islamic terms; deposit conversion begins.
- Run-down: legacy assets collected, converted or sold; interest sent to charity.
- Completion: final legacy items resolved, Shari'ah audit of the converted bank, formal announcement.
Full conversions have commonly taken several years from decision to completion.
Common pitfalls
- Relabelling instead of restructuring: renaming loans as murabahah without a real purchase and sale.
- Starting governance late: appointing the SSB after products are designed.
- Underestimating IT: systems that cannot record Islamic contracts properly create errors and compliance risk.
- Mixing funds: allowing interest received in the transition to flow into income.
- No timetable: a plan without dates allows the conventional book to linger.
Key points
- Conversion starts with a formal decision and a written, time-bound plan.
- Shari'ah Standard No. 6 stops new interest-based deals from the decision and sends later interest to charity.
- Governance (SSB, compliance and internal Shari'ah audit, guided by GS 1 (2024)) must be in place early.
- Assets are run off, converted or sold; deposits move to qard, mudarabah or wakalah accounts with consent.
This article is educational material by ifSPACE. It is not a fatwa or legal advice.