The Broadening Appeal of Islamic Finance

The standardisation and integration of the Islamic finance sector, which includes aspects of Shariah interpretation and legal documentation, is expected to lead to greater market confidence and broaden its appeal to global investors

The Islamic banking and finance sector continues to demonstrate considerable growth globally, driven by continued standardisation and integration of the industry, the robust global appetite for Shariah-compliant products and funding diversification goals. S&P Global projected that the global Islamic finance industry will grow by 10% to 12% in 2021/22 after slowing to 10.6% in 2020.

The economic recovery in the Middle East, Africa and South Asia (MEASA) region on the back of higher oil prices and strong response to COVID-19 will boost credit growth and demand for Shariahcompliant products. The improving operating environment and high funding needs will also enhance the growth of Islamic banks’ asset and liquidity position in core Islamic finance markets as the lenders are expected to continue outperforming their conventional peers.

On the sustainability front, the prolonged health crisis has thrust the Islamic finance industry back on environmental, social and governance (ESG) investors’ radar while encouraging the streamlining of the sector to boost its attractiveness. Digitalisation in the Islamic finance sector is also creating a nimbler finance industry.

Moody’s said that the issuance of green Sukuk will accelerate in the coming years, particularly in Southeast Asia and the Gulf region, as regional governments seek to attract private capital to low-carbon and climate-resilient infrastructure projects.

Though analysts projected that issuance would decline further this year following several years of high growth, improving market conditions will remain supportive for Islamic bond issuance. Sukuk issuance edged down by 12% in 2021 to $181 billion due to lower sovereign funding needs in the GCC and Indonesia thanks to the rally in oil prices and a rebound in the economy.

“We expect issuance activity to further decline in 2022, to between $160 billion and $170 billion, as high oil prices continue to support GCC countries’ fiscal positions,” said Moody’s.

Meanwhile, the standardisation of the global Islamic finance legal and regulatory framework represents a huge opportunity for the industry to streamline as well as strengthen processes and practices to broaden the appeal of Shariah-compliant financial products.

Standardising Islamic finance

Islamic finance, which bans interest payments and pure monetary speculation, has been on the rise for many years across key Islamic markets in the MEASA region but the industry has remained largely fragmented with the uneven implementation of its rules.

The overall volume of Sukuk issuance in 2020 plunged to $139.8 billion from $167.3 billion in 2019 despite the plunge in the oil price and the significant increase in financing needs in core Islamic finance markets. This was because more issuers

tapped the conventional markets, where it is easier and quicker to get the funds.

The challenge that several issuers are facing is the implementation of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) standards without changing the credit characteristics of the transaction. Sukuk instruments remain more complex and time-consuming for issuers than conventional bonds.

With the adoption of Shariah Standard Number 59 by AAOIFI, the traditional Murabaha structure is no longer held to be Shariah-compliant by the Bahrainbased organisation and compliance became an obligation throughout the lifetime of the transaction.

However, S&P Global noted that the adoption of AAOIFI standards by some jurisdictions already created challenges some issuers last year, particularly those with hybrid structures that combine a commodity Murabaha with tangible assets.

Therefore, standardisation is expected to make Islamic bond issuance comparable with conventional instruments from a cost and effort perspective, in that it will gain prominence among both issuers and investors. “Over the next 12 months, we could see progress on a unified global legal and regulatory framework for Islamic finance that Dubai and its partners are developing,” said S&P Global.

AAOIFI and Malaysia’s Islamic Financial Service Board (IFSB), two institutions that have traditionally worked independently on their respective mandates in the past, signed an MoU in 2018 to create a level playing field and foster harmonisation and standardisation of regulations.

The UAE took the first step towards the standardisation of Islamic finance in May 2020 by launching the Higher Shariah Authority. Overseen by the central bank, the Higher Shariah Authority is a national regulator entrusted with overseeing the Islamic financial sector, approving financial products, and setting rules and principles for banking transactions per Islamic jurisprudence.

Moody’s said the initiative by the UAE is credit positive for Islamic finance institutions because it addresses the sector’s main impediment to growth - the complexity and diversity of legislative frameworks and practices across regions and geographies, which creates additional risks and uncertainty in case of litigation.

Malaysia’s central bank, Bank Negara Malaysia, also started implementing a revised Shariah Governance Framework last year to strengthen board oversight and the responsibilities of Shariah governance. However, standardisation poses challenges in terms of implementation and adoption, particularly in realigning existing products, and AAOIFI Sharia Standard 59 has reportedly depressed Sukuk issuances in the UAE.

Driving ethical investing

The challenging economic environment brought about by COVID-19 has created opportunities to accelerate and unlock the long-term potential of the Islamic finance sector. “The natural crossover between sustainable investing and Shariah-compliant social principles will appeal to investors whose investment decisions are guided by environmental, social and governance considerations, creating opportunities for the Islamic finance industry,” said Moody’s.

The pandemic pushed “green” or ethical investing to the fore and the trend is expected to enhance the appetite for sustainable instruments as governments and corporates in key Islamic finance markets seek to diversify their economies from heavy reliance on oil revenues.

The energy transition agenda across MEASA region is also expected to create opportunities to expand social Islamic finance instruments and green Sukuk products. However, adoption will likely remain slow given the additional complexity related to these instruments and core Islamic finance countries’ slow implementation of policies to manage the energy transition.

Though not mutually exclusive, Shariah-compliant financial instruments offer a framework that embodies the social and ethical values of ESG investing, offering investors in the Middle East and Southeast Asia the opportunity to adopt more sustainable and conscious investment strategies while tapping into the potential value of impact investing.

“Islamic finance social instruments can help core countries, banks, companies and individuals economically affected by the pandemic navigate current conditions, with market participants eyeing Qard Hassan (Charitable Loan), Zakat (Zakah tax – obligatory almsgiving), Waqf (Charitable Trust), and Social Sukuk,” said S&P Global.

Meanwhile, the issuance of green and sustainable Sukuk continued to grow in 2021, exceeding the $7 billion mark for the first time while issuance tenors also surged thanks to Indonesia and Malaysia’s debut 30-year certificates.

Moody’s said that the demand from investors for these certificates will ensure a boost to issuance activity in the years to come and the rating agency expects a wave of new issuers to join the market. Green Sukuk and other sustainable Islamic finance instruments targeting social needs may appeal to investors with ESG objectives and could help make an even bigger impact if they are leveraged properly.

Sustainable debt covers a variety of instruments, from the well-established green bonds to the fast-emerging category of sustainability-linked loans. Proceeds from green Sukuk issuance typically support investments in renewable energy or other environmental assets such as solar parks, biogas plants, wind energy projects as well as renewable transmission and infrastructure projects.

“Green and sustainable Sukuk volumes expanded 17.2% year-on-year in 2021 to %15 billion, with the theme likely to remain prominent in 2022,” said Fitch Ratings.

GCC Islamic banks are also seeing a growing frenzy for green bonds although the appetite is still in its infancy as more investors are committing to responsible investment. Nasdaq Dubai set a record

$23.1 billion debt listing last year and $11.9 billion of the total listings were Islamic bonds.

Saadiq, Standard Chartered’s Islamic arm, also joined forces with the Malaysian Halal Development Corporation last November to launch a $100 million Islamic finance program aimed at funding SMEs and corporates in key halal markets including the UAE, Saudi Arabia and Bahrain.

The Islamic finance sector continues to gain momentum with borrowers and investors globally, driven by an increasing understanding of the asset class and a strong alignment of Islamic Shariah core principles with ESG principles.

Sukuk issuance

Islamic bond issuance this year is projected to stabilise or to be slightly lower after a record $205 billion in 2020 and five consecutive years of growth amid lower sovereign funding needs as higher oil prices and the economic recovery is likely to allow GCC governments generate fiscal surpluses, thus lowering the need to tap debt markets. Moody’s also sees interest rates hikes globally to deter some issuers from resorting to debt markets in 2022.

However, higher issuance by financial institutions to support asset growth together with government refinancing needs and new issuers joining the market could partially offset the negative trend from higher oil prices and interest rates.

Meanwhile, stronger financing growth in the Islamic finance sector is expected to continue in 2022 due to broader adoption and innovative structuring of Shariah-compliant products and new, fast-growing franchises in some Islamic banks compared to their conventional peers.

GCC countries have grown in relevance for emerging market investors and several trends in the region such as economic diversification signal continued growth for Sukuk markets. Regional governments issued $35.3 billion Islamic bonds compared to $32 billion a year earlier while regional corporates’ Sukuk issuance grew 8.5% to $21.9 billion from $20.2 billion in 2020, according to KAMCO Investment.

Bahrain’s GFH Financial Group launched and seeded a $100 million Sukuk fund in February, following an agreement with Credit Suisse to offer financing and fund administration services across the GCC region.

Riyad Bank, which is 43% indirectly owned by the Saudi government, sold $750 million in sustainability-linked Additional Tier 1 (AT1) dollar-denominated Sukuk in February to support its capital base and meet financial and strategic needs. The Saudi National Bank, the country’s largest bank by assets, also raised 750 million in debut ‘sustainable’ Sukuk last month after demand topped $3.2 billion.

Saudi-based Islamic Development Bank (IsDB), a regular issuer in the capital markets, raised $1.7 billion in five-year Islamic bonds last October after the Sukuk drew more than $2.4 billion in demand. IsDB raised $2.5 billion in March 2021 with sustainability Sukuk finance projects including renewable energy. The multilateral lender also sold $1.5 billion in Sukuk in June 2020 to support its member states to mitigate the fallout from the pandemic.

In the UAE’s Dubai Islamic Bank, the country’s largest Islamic lender, raised $750 million in five-year senior unsecured Sukuk in February after the debt sale drew more than $1.6 billion in orders. The UK issued a $686 million (GBP 500 million) sovereign Sukuk in its second foray into the Islamic finance market in March 2021, doubling the amount it raised from its debut Sukuk in 2014.

Though Sukuk issuance is gathering steam outside of core Islamic finance markets in the Middle East and Southeast Asia, the market for green Islamic bonds remains small compared to the conventional Sukuk market. Overall, Moody’s expects Sukuk issuance to drop slightly to around $160 billion-$170 billion in 2022 from $181 billion in 2021 while S&P Global forecasted total Islamic bond issuance of about $140 billion–$155 billion this year.

Islamic banking

The economic recovery in Muslim majority countries including the Gulf region, Malaysia and Turkey is expected to boost credit growth and demand for Shariah-compliant products thus allowing Islamic banks’ asset growth to continue to outperform their conventional peers.

“The market share of Islamic financing assets in core Islamic markets increased to 34.6% of total financial assets (including conventional bank loans) in September 2021, from 33% in December 2020 and 31.3% in December 2019,” said Moody’s.

The retail focus of most Islamic banks will likely help preserve their asset quality going forward as retail asset quality is particularly resilient, thanks to the high proportion of borrowers who work in the public sector, prudent regulations and established credit bureaus.

However, the current operating environment is likely to put more pressure on Gulf region Islamic banks and lead to more tie-ups to create new national or regional champions. “We expect further merger and acquisition (M&A) activity as many Islamic banks have weaker franchises which lack strong competitive advantages, particularly in pricing, cost of funding and growth opportunities,” said Fitch Ratings.

In 2020, all M&A deals in the GCC region involved at least one Islamic bank. The merger of Saudi Arabia’s National Commercial Bank and Samba Financial Group into Saudi National Bank in April 2021 created one of the world’s largest Islamic banks along with Al Rajhi and Kuwait Finance House. The consolidation between Qatar’s Al Khalij Commercial Bank and Masraf Al Rayan last November also created one of the largest Shariah-compliant lenders in the region.

The Islamic finance sector has evolved over the year and so too have the product structures as the industry moves to offer tailored features to meet the needs of a growing investor base. Industry experts expect the coordination between different Islamic finance stakeholders and the wider Halal economy to create new sustainable growth opportunities and contribute to shared prosperity.