Islamic finance is expanding across Southeast Asia, attracting new players and products as institutions seek to tap what is still a relatively small sector in most countries.

The region accounted for some $859 billion, or 17% of the $4.9 trillion global market in 2023 after growing by 11% in 2022, according to the latest study by the Islamic Corporation for the Development of the Private Sector (ICD) and London Stock Exchange Group (LSEG). This compared to $730 billion, or 20%, of $3.49 trillion in 2020.

The report attributed the slight decline in market share to multiple crises: post-COVID inflation, the Russia-Ukraine war, Pakistan's floods straining finances, global supply chain disruptions, and a tech and crypto market crash.

It also gives each nation an Islamic Finance Development Indicator ranking -- a barometer of the whole industry. Malaysia has topped this for years, with Saudi Arabia overtaking Indonesia to take second place in 2022 and the UAE moving into third last year. However, both Southeast Asian nations' scores soared last year, with Malaysia jumping 40% and Indonesia 46.5%, illustrating how fast the sector is maturing.

Islamic finance assets are those that comply with Shariah, or Islamic law, avoiding interest and prohibited industries such as alcohol, gambling, arms sales and conventional insurance. These assets include sukuk (Islamic bonds), banking products, takaful (insurance), equities and funds -- all structured in accordance with Islamic law.

Long dominated by Malaysia, the industry in Southeast Asia is seeing aggressive moves from Singapore, Indonesia, the Philippines and Thailand, as they harness a combination of digital transformation, sustainable finance initiatives and regulatory support to capitalize on rising demand for ethical and Shariah-compliant financial products. Malaysia comprises about 80% of the Southeast Asian market, or $682 billion, the ICD/LSEG report said.

Globally, Iran topped the chart at $1.68 trillion followed by Saudi Arabia at $1.13 trillion. Indonesia stood at $162 billion behind the UAE ($371 billion) and Kuwait ($198 billion).

Bank Negara Malaysia Gov. Abdul Rasheed Ghaffour said at the Islamic Finance Forum 2024 that the Islamic banking sector accounts for nearly half of total financing in Malaysia. He pointed out that the Islamic interbank money market volume covers about one-third of the entire market, while Shariah-compliant stocks account for 81% of listed shares.

Islamic financing costs are generally on par with conventional loans but can be higher due to its asset-backed and risk-sharing structures. Unlike conventional banking, it profits through trade, leasing, or partnerships, offering more stability in times of fluctuating rates.

"Malaysia is also home to the world's largest sukuk market, accounting for 42% of the global outstanding sukuk," he said. Malaysia issued a total of 27.6 billion ringgit ($6.19 billion) of sukuk in 2023, up from 10.6 billion ringgit in the previous year. Sukuk are Shariah-compliant bonds that provide returns through asset ownership, avoiding interest, or riba, which is prohibited in Islamic finance.

Malaysia's Maybank Islamic, the region's largest Islamic bank and part of the Maybank group, in January partnered with fintech solutions provider audax and cloud services giant Amazon Web Services to modernize its digital banking capabilities.

"This partnership with Maybank Islamic is not just about modernization -- it's about making financial services more accessible, scalable and fully Shariah-compliant," said Mike Breen, chief commercial officer at audax. He added that Islamic banks can "lower costs, increase efficiency and reach more customers" without compromising Shariah principles by leveraging cloud-based digital banking infrastructure.

In the first nine months of 2024, Maybank Islamic reported a 7.1% year-on-year increase in profit before tax and zakat (charitable donations), reaching 2.97 billion ringgit. Maybank Islamic's contribution to Maybank Malaysia's total loans and financing increased to 70.0%, up from 68.5% in the same period of 2023.

Meanwhile, Japan's Aeon Bank launched Malaysia's first fully digital Islamic bank in 2024, a move that could redefine financial accessibility for so-called micro-entrepreneurs and the unbanked. The Japan-based bank is bringing a retail-driven approach to Islamic banking, targeting micro-entrepreneurs and underserved communities.

"Aeon Bank is not just a bank; it is an extension of a retail business. Our retail DNA has been strong for 40 years in Malaysia," said Aeon Bank Chief Executive Raja Teh Maimunah. She added that the opportunity in digital Islamic banking lies in integrating financial services seamlessly into everyday spending habits.

"Let's start with Malaysia -- Islamic banking here is faith-based. For many Muslims, it is not an option but a fundamental tenet because, as stated in the Quran, conventional interest (riba) is prohibited-period. The key difference in Islamic finance lies in its structure which includes various contracts such as mudarabah (profit-sharing), musyarakah (partnership financing) and murabaha (cost-plus financing)," Teh said.

Despite having the world's largest Muslim population, with more than 240 million people, Indonesia's Islamic finance sector has struggled to gain significant market share. Shariah-compliant assets account for just over 8% of Indonesia's total banking sector, a stark contrast to Malaysia. However, that figure is growing by about 1 percentage point every couple of years.

Recent developments indicate that Indonesia is taking steps to strengthen its Islamic finance sector and attract new investments. Bank Syariah Indonesia (BSI), created from the merger of three state banks and now the country's largest Islamic lender, has been growing rapidly, reporting a 33% jump in net profit last year.

"BSI benefits from being the only large sharia bank in the country, making it the obvious first choice for the part of the population who require sharia bank services," said Lucky Ariesandi, a director at Fitch Ratings. However, industry experts argue that without significant scale, Indonesia's Islamic banks will struggle to compete with conventional lenders.

To address this, the Indonesian government is actively encouraging consolidation within the sector. In January, state-run Bank Tabungan Negara acquired Bank Victoria Syariah to strengthen its position in the market. At the same time, fintech startups are rolling out digital-first Islamic banking solutions, aiming to attract Indonesia's young and tech-savvy consumers.

In Singapore, regional banks are expanding their Islamic finance offerings, leveraging the city-state's position as a financial hub. Malaysia's Maybank group, now positions its Singapore office as its regional offshore hub for Islamic wealth management, serving clients beyond Malaysia and Indonesia.

"The ASEAN-5 -- Indonesia, Malaysia, the Philippines, Singapore and Thailand -- are getting more affluent. The region is home to 250 million Muslims, and it is set to grow," said Anurag Mathur, Maybank's head of group Islamic wealth management.

As part of its efforts, Maybank Singapore became the first bank in 2023 to offer end-to-end Islamic wealth solutions, including Shariah-compliant deposits, unit trusts, sukuk and takaful, with a particular focus on affluent and high net worth individuals.

Mathur added that the bank is soon planning to offer "more sophisticated products," such as Islamic dual currency investments and Lombard financing -- a loan backed by liquid assets such as equities, bonds or fund units. The offshore focus includes clients from across the Asia-Pacific region and the Middle East.

He also said that the bank is "actively looking" at potential partners from the Gulf Cooperation Council to collaborate in Southeast Asia.

The Philippines saw its first Islamic bank established in 1973. Al-Amanah Islamic Investment Bank of the Philippines later became a universal bank in 1990. According to the Asian Development Bank, the institution "paved the way for the development of Islamic finance" in the country, owing to a need to establish a banking system on the southern island of Mindanao.

Some decades later, the introduction of the Islamic Banking Law bolstered the sector, granting Bangko Sentral ng Pilipinas the authority to regulate and establish Islamic banks. Philippine Amanah Bank was created through a presidential decree.

In 2023, the Philippines successfully debuted in the global Islamic financial market with the issuance of a $1 billion sovereign sukuk. Maybank Philippines started its Islamic banking operations in August 2024, becoming the second Islamic banking unit to be licensed.

Meanwhile, in Thailand, where Muslims make up 10% of the population, the Islamic banking sector has struggled due to regulatory constraints.

The state-owned Islamic Bank of Thailand (IBank) holds just $3.6 billion in assets, representing less than 1% of the country's total banking system. Regulatory hurdles, including double taxation on Islamic financial transactions, have slowed the sector's growth.

"Some customers turned to conventional banking because Islamic banking services in Thailand were late to adopt digital banking," said IBank President Thaweelap Tittapirom. Regulatory change to encourage the growth of Islamic finance would come at a time when Thailand is becoming a hub for halal tourism from neighboring Malaysia, Indonesia and Brunei. It has also looked to court investment from the wealthy Middle Eastern since the thawing of relations with Saudi Arabia in 2022.

LSEG predicts that the global Islamic finance market value will exceed $7.5 trillion by 2028 and that Southeast Asia's share is likely to grow.

Despite the growth, challenges remain. The Islamic Financial Services Board's 2024 "Stability Report" highlights that higher funding costs and tighter monetary policies could slow the pace of expansion if inflation remains sticky.

"Islamic fintech firms are rapidly gaining a foothold. A plethora of startups have launched in recent years, offering digital financial services that follow Shariah law," the report said. These include peer-to-peer lending, digital sukuk platforms and artificial intelligence-based Shariah compliance solutions.

The global Islamic fintech sector expanded by 61% in 2021 and is gaining traction in Southeast Asia, but growth remains niche, contributing only 0.8% of the global fintech industry, according to S&P Global Ratings. While regulators are adapting frameworks to support digital Islamic banking, challenges linger in capital market integration, tokenization and cross-border compliance.

"We expect further collaboration between financial institutions and fintech players to bridge the gap in Islamic financial inclusion," S&P Global Ratings noted, underscoring the critical role of partnerships in scaling Islamic finance across ASEAN.

Muhd Ramadhan Fitri Ellias, Maybank Islamic's strategic program director, agrees. "The future of Islamic finance will be shaped by key trends such as digital transformation, sustainable financing, fintech partnerships, and the growing demand for Shariah-compliant wealth management solutions."

Additional reporting by Nana Shibata in Jakarta, Tsubasa Suruga in Singapore, Ramon Royandoyan in Manila and Francesca Regalado in Bangkok.