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The purpose of this paper is to examine the short-run and the long-run relationships between Islamic banking development and economic growth in the case of Iran and Indonesia, with this regard we use quarterly data (2000:1-2010:4), this paper utilizes the bound testing approach of cointegration and error correction models, developed within an autoregressive distributed lag (ARDL) framework. Also in this paper addresses some of the issues and challenges that Islamic banking has been facing in Iran. It also seeks to examine modes of Islamic financing and the commitment of commercial banks to implement the Islamic banking law. The results show a significant relationship in short-run and long-run periods between Islamic financial development and economic growth. The relationship appears to be bi-directional relationship. This paper uses empirical evidence to show the role of Islamic banks' financing towards economic performance of a country.(ProQuest: ... denotes formulae omitted.)1. IntroductionThe theory of Islamic banking is based on the concept that interest is strictly forbidden in Islam, and that Islamic teachings provide the required guidance on which to base the working of banks. The basic principle that has guided all theoretical work on Islamic banking is that although interest is forbidden in Islam, trade and profit is encouraged.Islamic banking is a financial system whose key aim is to fulfill the teachings of the Holy Quran. Islamic law reflects the commands of God and this law regulates all the aspects of a Muslim's life and hence Islamic finance is directly involved with spiritual values and social justice (Gudarzi Farahani and Dastan, 2013).The basic principle in Islamic law is that exploitative contracts or unfair contracts that involve risk or speculation are impermissible. Under Islamic banking, all partners involved in financial transactions share the risk and profit or loss of a venture and no one gets a predetermined return. This direct correlation between investment and profit is the key difference between Islamic and conventional banking which its main objective is maximizing shareholders' wealth (Dar and Presley, 2000).Islamic banking has introduced itself as an emerging alternative to conventional banking system and has grown rapidly over the last two decades both in Muslim and non-Muslim countries. Islamic banks have recorded high growth rates in both size and number and have operated in over 60 countries worldwide and bankers predict that Islamic banking would control over 50% of savings in the Islamic countries within the next decade (Ahmad, 2004 and Muhamad. A and Azmi Omar. M, 2012).Recent articles and theoretical papers have called on economies to consider Islamic economic theories as an alternative solution to the current capitalist system. There are also numerous good and well-organized papers respecting Islamic banking system which attempt to clarify the effects of Islamic banking on economic growth in comparison to the effects of conventional banking on it. However, most of empirical studies conducted in this field were not able to explain the overall effect of Islamic bank's financing on economy, due to the fact that they consider a single-country sample.Islamic banking activities can be classified into two groups: In one group, their activities are without any competition with conventional banking based on interest rate, due to the domestic laws and regulations of some Islamic countries which do not allow any activities based on interest rate (ribah) for financial institutions, banks in those countries. In the second group, there is a high competition between these two banking systems which is because of this fact that they are operating in non-Muslim countries or Muslim countries which do not forbid interest rate-based banking system (Gudarzi Farahani and Dastan, 2013).Out of the extensive research carried out in this field, there are no sufficient works conducted within the Islamic financial framework. …
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