Islamic finance is slowing as the global financial crisis hits its hubs in Malaysia and the Gulf, but the sector now has a chance to move on to Western economies seeking to boost their financial centers.

Regulatory differences still plague efforts to build cross-border Islamic banking, and harmonization among different schools of thought is one of the nascent industry's main obstacles as it looks to grow in European countries with large Muslim communities.

There is a need for petrodollars in the West so more countries will be pandering to the rhetoric of Islamic finance to try to recycle petrodollars to their own financial capitals, be that London, Singapore or Kuala Lumpur, said Mahmoud El-Gamal, chair of Islamic Economics at Rice University.

In a sign that cultural barriers may be coming down, some experts see sovereign wealth funds injecting cash into global financial centers with the aim of advocating Islamic finance.

As the industry expands into non-Muslim or secular states, the need to educate others about the sector has become greater.

With much high-flying banking talent available after the collapse of the Western banking system, a shortage of staff with Islamic finance knowledge may no longer be a challenge.

But with crisis comes opportunity. The easing market has provided scholars, lawmakers and bankers a window to reassess structures including the sukuk, known as Islamic bonds, which are still under the spotlight as different bodies debate on how compliant instruments are with Islamic law.

Sukuk, once the industry's hottest product, have dried up, with the Gulf Arab region seeing no issues in the first quarter of 2009.

Activity in the Islamic loan sector is picking up with two Dubai government entities managing to refinance about $2.8 billion through Islamic instruments in April, but experts remain unconvinced the market will return to its previous highs.

There has been a sharp slowdown in Islamic financing, said Mohsin Khan, senior fellow at the Peterson Institute for International Economics in Washington.

So much so that last week last, when Dubai's Department of Civil Aviation renewed $600 million, eyebrows went up thinking it was a big deal, but relative to a couple of years ago it isn't.

Next week, Reuters journalists in London, Dubai, Bahrain, and Kuala Lumpur will bring together the industry's heavy hitters to ask them how they will overcome those challenges, and where they see future opportunity.

Interviewees at the Reuters Islamic Banking and Finance Summit include the chief executive of Bursa Malaysia, a senior official of the UK treasury, some of the world's largest Islamic financial institutions as well as regulatory and ratings agencies.

KEEPING UP THE DEMAND

Demand from the world's 1.3 billion Muslims for investments that comply with their beliefs has soared, and assets that comply with Islamic law range between $700 million and $1 trillion, with some estimates seeing assets growing to $1.6 trillion by 2012.

Islamic finance instruments were structured the same way as conventional finance instruments so I think it was propaganda to say they were insulated, said Gamal. In 2009, Islamic finance could grow faster because many multinational banks had to cut back quite a bit on lending...

Islamic law bans interest, and bond holders are paid returns derived from underlying assets. Investing in sectors such as alcohol, pornography and gambling is also prohibited, and deals must also be structured so that risk and reward is shared.

The industry needs to diversify from property loans and ordinary lending to include advanced treasury services, innovative asset management, balance sheet and securitization management, consultancy Oliver Wyman said this week.

This will allow them to address needs of underserved market segments such as Islamic financial institutions, corporates, sovereign wealth funds and private wealth clients, it said.

Islamic and other Arab lenders have spent on expensive schemes to reconcile an ethical image with the possibility of mortgage foreclosures, an increasing possibility as economies feel the pinch of the global financial crisis.

Former boomtown Dubai has suffered the sharpest downturn in its property market, where prices could fall almost 40 percent this year according to a Reuters poll. Standard and Poor's has said Dubai's economy could shrink 2-4 percent in 2009 as thousands of expatriates leave the Gulf's commercial hub.

Islamic banks have been active in trade finance and property and -- both of them falling -- these are the two main profit centers for Islamic finance, said Khan, a former IMF director. If these don't recover they will face problems building up their loan portfolio.

The financial crisis is also raising questions about whether consolidation in the sector is the right way to go given the mixed success in conventional markets.

Despite the popularity of Islamic banking and the desire by bankers to develop a greater range of products, the days of Islamic derivatives may still be further down the road as the industry looks to avoid taking a riskier direction.

(Additional reporting by Ruben Ramirez in New York; Editing by Hans Peters)

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