* Islamic banking assets to reach $1.8 trillion in 2013
* Top 20 Islamic banks have grown at 16 pct/yr over last 3 yrs
* Greater role for fully fledged Islamic banks expected
* Drop in profitability, now lower than for conventional banks
By Bernardo Vizcaino and Al-Zaquan Amer Hamzah
MANAMA/KUALA LUMPUR, Dec 10 (Reuters) - Islamic banks are set to expand as they compete increasingly with conventional lenders in attracting mainstream customers, according to a report by consultancy Ernst & Young released on Monday.
The total of all commercial banks' Islamic assets is estimated to reach $1.55 trillion this year, $1.8 trillion in 2013 and over $2 trillion mark, the report said. Gulf-based Islamic banks now have $450 billion in assets, about 30 percent of the total.
Islamic banks will grow as they focus on customers who expect more than just sharia-compliance in terms of products and service and have traditionally relied on conventional banks.
"Success will be defined in the core markets through the transformation of Islamic banks so they are able to compete with the much bigger, conventional boys for mainstream customers," Ashar Nazim, Islamic financial services leader at Ernst & Young, said.
Islamic finance follows religious guidelines such as a ban on interest and on pure monetary speculation, with its core markets in the Middle East and Southeast Asia.
The role of pure Islamic banks will also become important by comparison with banks that deliver products just through Islamic windows at their existing branch networks.
"There is no truly fully fledged Islamic bank (that stretches) across international markets or even regional," Nazim said.
He identified a group of 20 Islamic banks as likely candidates to become significant regional institutions. They now account for 55 percent of total Islamic banking assets after having grown over the past three years at an average rate of 16.2 percent a year, Nazim said.
"It is a lopsided industry at this point ... only 13 Islamic banks have $1 billion or more in equity," Nazim said, adding that the difference between small and large Islamic banks will widen.
Between 100 to 150 new financial institutions could be launched in the next five to seven years to cater to markets that are new to Islamic finance or have low rates of penetration including Egypt, Libya, Indonesia, Pakistan and Bangladesh, he predicted. Ten of the 25 fastest growing emerging markets have large Muslim populations.
Even while growing, Islamic banks have experienced a decline in profitability, and their average return on equity lags behind that of conventional banks by 20 percent, Nazim estimated.
Return on equity for both Islamic and conventional banks has deteriorated since 2008 in the wake of the financial crisis, dropping to 12 percent in 2011 for Islamic banks, compared with 15 percent for conventional banks, the report showed.
This 3 percent gap is much wider than the 1 percent difference observed in 2008-2010.
The return on assets for Islamic banks dropped to 1.3 percent in 2011 from 1.7 percent in 2008, while rising for conventional banks to 1.7 percent in 2011 from 1.5 percent in 2008.
Operating expenses are 50 percent higher for Islamic banks, while their cost of funds still remain more competitive than for conventional banks, the report said.
Some banks have started to focus on improving efficiency and reducing costs, which could boost their profit margins by about 25 percent within two to three years, Nazim said.
"The severity of this performance challenge has put many Islamic banks in a difficult place. They have taken the decision to transform the way their businesses work," Nazim said. (Editing by Jane Baird)