1. Introduction

Financial development has received, over the last decade, a great deal of attention as a source of economic growth. The theoretical argument given frequently to explain the relationship between financial development and economic growth was: a welldeveloped financial system performs several and critical functions and then, enhances the efficiency of intermediation by reducing information, transaction, and monitoring costs (Levine 1997, 2005). Since this time, the question about the determinants of the financial development has become important and explored by many economists. A number of key publications have also given special attention to macroeconomic and institutional environments to explain the development of the financial system.

The Islamic financial system has evolved as a viable and competitive component of the overall financial system. In addition, the Islamic financial system has been considered as a driver of economic growth and development specifically in the GCC region. In fact, the GCC region has known a remarkable economic growth in the past three decades. The growth rate of GDP of GCC countries exceeded 6% in 2010.

At the same time, acording to the International Monetary Fund (October, 2009), during the period 2002-2008, on average, Gulf Islamic banks’ assets represented 23.8% of the total banking assets, and the growth rate of Islamic banks’ assets was over 44% (the growth rate of assets of the global banking system in GCC is over 22.6%). In 2009, GCC countries control more than 42.9% of total Islamic financial assets in all over the world (The Banker, 2010).

All of these factors drive our attention to ask about the determinants of the rapid growth of the Islamic financial system, and whether or not the Islamic financial system can be a substitute for the conventional financial system or a complement.

In this paper, we try to study the determinants of Islamic financial development in the GCC region. Therefore, to better understand what drives Islamic banking we hypothesize that the following factors are likely to influence Islamic financial development: (i) Macroeconomic factors, (ii) 11th September attacks (iii) financial system (iv) institutional environment and (v) Islamic banking regulations.

The scope of our study covers 5 GCC countries: namely Saudi Arabia, UAE, Bahrain, Qatar and Kuwait over the period of 1996-2010. Using a panel data analysis under the fixed and random effects specifications, our findings show that while macroeconomic factors such as income per capita, economic openness, population and oil revenues are important determinants of Islamic banking in the GCC region, the institutional environment is not a good predictor of the promotion of Islamic banking in the GCC region. The 11th September attacks have appeared relevant to Islamic banking growth in the GCC region. Islamic banks also appear to be complements to, rather than substitutes for, conventional banks in GCC countries.