Iran is one of the two countries that have full-fledged Islamic banking in their banking systems. Although there are many criticisms about the operation of the Islamic system in Iran, this country has the greatest proportion of Islamic banking assets in the global Islamic financial system. Islamic banking in Iran, as one of the milestones of the reorganization of Iranian society after the Iranian Revolution, continues its operation by the contracts which take their roots from the economic and social factors. The banking system in Iran contains commercial state banks, specialized state banks, qard al-hassan banks, and private banks. In addition to contributing to economic development by supporting economic activities, the banking system also supports the strategies of income distribution equality. Some portion of the banking sources in Iran is used to support individuals who are below adequate income level. In this study, the performance of the Islamic banking system in Iran will be analyzed. The study consists of three parts. In the first part, the historical development of Islamic finance and Islamic banking and in the second part, the current situation of the Iranian banking sector will be discussed. In the last part, challenges related to the local economic problems as well as the sanctions initiated by the US, other countries, and organizations will be explained. Besides, some policy recommendations to improve the performance of Islamic banking in Iran will be put forth. Keywords: Islamic Economy, Iran, Islamic banking, Islamic finance.