1. Introduction

During the last three decades, the number of Islamic financial institutions has risen from one institution in 1975 to over 300 institutions operating in more than 75 countries worldwide (El Qorchi, 2005). These institutions are managing funds of around US$200 billion, with total assets of more than US$822 billion (Iqbal and Molyneux, 2005; Moin, 2008). More recently, Islamic finance markets have grown 15-20% on average, the fastest growth in the financial sector, over the last five years (Derbel et al., 2011). The fast growth rate of Islamic banking may be due to its advantages over conventional banking. The Islamic banking system has four main advantages over the conventional banking system (Goaied and Sassi, 2009).

Firstly, Islamic banks are more efficient than conventional banks (Alshammari, 2003; Al-Jarrah and Molyneux, 2005). This advantage is consistent with Friedman (1969) who demonstrated that a zero nominal interest rate is a necessary condition for an efficient allocation of resources. Secondly, the Islamic financial system is financially stronger and less risky than conventional banks. Using ‘z-scores’ analysis, Cihak and Hesse (2008) argue that the possessors of investment accounts in Islamic banking system do not have fixed value securities, which means that investment depositors automatically share the risk in the case of asset reduction due to macroeconomic or bank-specific crises. Thirdly, the main characteristics of Islamic banks (e.g. Al-Gharar (excessive uncertainty) and Al-Darar (harmful in contracts)) reduce the moral hazard, adverse selection problems (Goaied and Sassi, 2010). Fourthly, the experience of Islamic banks in alleviating poverty through the use of Zakah funds and interest-free loans can improve the socio-economic development in society. This is by either making the poor and needy people more productive, which in turn contributes to the economic development, financing human welfare activities, or both (Goaied and Sassi, 2010).

Previous studies have not extensively examined the impact of Islamic banking on economic growth in GCC countries. More specifically, many previous empirical studies on Islamic banking focus only on efficiency (Cihak and Hesse, 2008). In addition, previous studies on the impact of Islamic banking on growth are singlecountry studies and their findings are difficult to generalize (see for example, Hafas and Ratna (2009) for Malaysia). To fill this gap in literature, this paper empirically investigates the potential effects of Islamic banking on economic growth in GCC countries using dynamic panel data. The section that follows, section II discusses the main instruments and characteristics of Islamic banks. Section III is theoretical background and empirical specification. Section IV discusses the data sources. Section V analyses the empirical findings. Section 6 presents the conclusions and policy implications.