IT IS a market that could be worth as much as $1,000 billion (£540 billion) today, but with the potential to treble within five years.

For years it was regarded as an exotic niche in the financial world. But, since 2001, a quiet, yet extraordinary, revolution has occurred: a host of western investment banks have been beating a path to the doors of leading Islamic clerics, seeking their help to create a raft of new financial products for Muslims.

What has emerged is a burst of creative activity in the wholesale financial markets as international bankers try to find ingenious ways to create products that comply with Islamic law, or sharia.

“The market is exploding. Islamic finance is growing at an incredible speed,” said one senior investment banker. Estimates of the size of the Islamic finance industry today range from $250 billion to $1,000 billion.

Earlier this year, Moody’s, the rating agency, calculated that there are 250 Islamic mutual funds with assets of $300 billion and a further 300 Islamic financial institutions holding $250 billion. Meanwhile, the Malaysian government claimed recently that the overall market for Islamic finance had mushroomed to $1,000 billion.

Some bankers believe the market is set to grow at an annual rate of 20%-30% over the next few years. Certainly, everyone agrees it is growing fast and could create a bonanza of fees and profits for investment banks.

The surge in Islamic finance is being driven partly by high oil prices, which has led to huge cash windfalls and a wider business boom — including a frenzy of construction projects — across the Middle East; but also by a growing sense of religious identity in the Muslim world since the September 11 attacks in 2001.

This has fuelled a reluctance to invest in conventional assets, particularly in America, and a desire to find sharia-compliant investment and financing options.

According to Humayon Dar, managing director of Dar al Istithmar, a sharia consultancy co-founded by Deutsche Bank, most Muslims “want to give a positive signal” to the wider world after September 11 and are prepared to deal with “anyone who observes the Islamic way of doing business”.

“Islamic finance is probably the only genuine bridge between the Islamic world and the western world,” he said. “In many cases, western banking is influencing and reshaping the Muslim way of doing business in the modern world.

“The clergy have been working with western institutions — the bearers of capitalism. There is now a fine kind of marriage emerging between the Islamic world and western banks in the form of sharia-compliant finance.”

Islamic teaching bans riba, loosely translated as the payment of interest, and insists wealth can only be generated through legitimate trade and investment. Money made from money is strictly banned.

Under Islamic law, financial products are designed so that investors either share risks and profits with a company or get cash returns from a business enterprise.

The western investment banks are scrambling to grab a slice of the action and their main weapon is innovation. According to the Swiss bank UBS, there is a big market to play for: only 15% of Islamic investors’ funds are held in sharia-compliant products.

“Islamic finance has been around for only 30 years. But a lot of innovation has taken place in the past few years as the western banks have become involved,” said Ahmad Salam, head of Islamic finance at Credit Suisse and a founder of the Islamic Bank of Britain, which was launched in 2004.

“There are some practitioners in the Islamic industry who say that if Islamic banking had been created in the West it would be streets ahead of where it is now. It is a slightly tongue-in-cheek comment, but there may be some truth in it,” he said.

Companies such as Barclays Capital, HSBC, Deutsche Bank, Citigroup and BNP Paribas are all creating structured products such as sukuk — the issuing of Islamic bonds — which can be sold to investors worldwide. Sukuk are asset-backed bonds where the cashflow from the underlying asset is distributed. According to Moody’s, the market has gone from nothing five years ago to $41 billion.

By the standards of the international loan market the sums may be small, but they are growing fast. This year, Barclays Capital co-managed one of the biggest deals to date — a $3.5 billion sukuk issued by the Ports, Customs and Free Zones Corporation of Dubai.

Later this month, UBS will launch what it claims are the world’s first sharia-compliant investment products linked to commodities.

Investment bankers are also seeking to create new Islamic finance areas — from derivatives, such as call options, to clever methods to protect Islamic companies from wild swings in foreign currencies.

Dar believes Islamic versions of all types of investments could be created: “You will find private-equity funds, real-estate investment trusts and Islamic hedge funds. There is growth in all directions.”

Peter Ghavami, the global head of commodities at UBS, said: “There is huge pent-up demand. There are more and more investors wanting to invest in an Islamic way and huge liquidity searching for a home.”

Others, like Credit Suisse’s Salam, are more cautious: “The industry has been guilty of creating a bit of hype. But this is not a fad or a fashion, it is a market here to stay. It will expand at a healthy clip, but there will be growing pains.”