A window of opportunity in Islamic finance

Merger and acquisition activity, soaring demand for Shari’ahcompliant products together with proactive government legislation are driving the growth of Islamic banking assets in the Middle East

The Islamic finance market has grown considerably over the past decade, with several reasons driving the increased demand for global Shari’ah-compliant finance. The industry has inarguably demonstrated positive growth in 2021/22 albeit at a slower rate compared to the previous fiscal year on recovering oil prices and extensive rollout of COVID-19 vaccine.

The current challenging environment has created opportunities to accelerate and unlock the long-term potential of the Islamic finance sector, according to S&P Global. The pandemic crisis is expected to put the Islamic finance industry back on environmental, social, and governance (ESG) investors’ radar, streamline Sukuk issuance to encourage the industry’s attractiveness and leverage technology to create a nimbler finance industry.

“As the GCC region has grown in relevance for emerging market investors in recent years, so too has the Sukuk market,” according to FTSE Russell. The global could put Shari’ah-compliant banks at a disadvantage.

The standardized supervision of Islamic finance is expected to lead to greater market confidence and restoration of Islamic bonds’ attractiveness to issuers. Following the adoption of Shari’ah Standard Number 59 by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the traditional Murabaha structure is no longer held to be Shari’ah-compliant by the Bahrain-based organization.

provider of benchmarks, analytics and data solutions said that the market value of the global Sukuk sector has grown from $15 billion in February 2011 to $126 billion in March 2021—representing a CAGR of 23%.

The issuance of Islamic bonds is expected to stabilize in 2021 after five years of expansion, as recovering oil prices have reduced sovereign funding needs in the Gulf region. Moody’s sees total gross short- and long-term Sukuk issuance in 2021 reaching between $190 billion and $200 billion after a record $205 billion in 2020.

The improving economic conditions and high funding needs in core Islamic countries have also improved the assetquality metrics of Islamic banks in the Middle East and the lenders’ liquidity is also projected to remain strong. Although there are no striking differences between Islamic and conventional banks in the GCC region owing to their real economyfocused models, Moody’s said that the absence of late payment fees and higher exposure to the real estate sector

Driving sustainability

Though green Sukuk issuances have been a rare sight in the Middle East, many corporates and sovereigns borrowers have been issuing fixed-term securities to raise funds for projects with environmental benefits such as renewable energy projects. Moody’s said that Shari’ah-compliant multilateral development banks (MDBs) are well-positioned to benefit from the growing focus on ESGs themes and

sustainable investing, given that Islamic finance principles prohibit investment in certain industries.

The outbreak of the pandemic pushed ESGs to the fore and the trend is expected to enhance the appetite for sustainable instruments as governments and corporates in core Islamic countries seek to spur amid diversification from hydrocarbon-based economies and transition to sustainable financing.

Shari’ah-compliant financial instruments offer a framework that embodies the social and ethical values of ESG investing, offering investors in the Middle East 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, Zakat, Waqf, and Social Sukuk,” said S&P Global.

Green Sukuk and other 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. As core Islamic countries in the Middle East and Southeast Asia are tapping into sustainable sources of energy and moving away from heavy reliance on oil, S&P Global expects increased green Sukuk issuance but does not see it as a game-changer.

A study that was conducted by HSBC showed that 48% of issuers in the Middle East rank ESGs issues as “very important” and while only 6% of issuers have set targets for their net-zero commitments, 78% are already working towards doing so.

GCC Islamic banks are seeing a growing frenzy for green bonds although the appetite is still in its infancy as more investors are committing to responsible investment. Last year, the overall green bond market was worth over $230 billion, and it reached $2 billion in the Middle East region with the potential to grow further.

Sustainable debt covers a variety of instruments, from the well-established green bonds to the fast-emerging category of sustainability-linked loans, according to Bloomberg. With a new global record of sustainable debt issuance hitting $465 billion in 2019, a 78% increase compared to $261.4 billion in 2018, sustainable finance is a fast-growing category of fixed-income securities.

Abu Dhabi’s Etihad Airways established a Sustainable Development Financing Framework in 2019, under which it raised $117.14 million for cooperate use. The airline also issued a five-year “transition” $600 million green Sukuk to support its shift to a greener future in October 2020 and is currently working on what would be its third financing transaction linked to sustainable investment considerations. billion in 2019 because more issuers tapped the conventional markets, where it is easier and quicker to get the funds. Sukuk issuance remains more complex and time-consuming than conventional bonds, hence when Islamic finance issuers need swift access to capital markets, they typically use conventional instruments, said S&P Global.

Islamic finance industry experts expect standardization of Sukuk issuance, which includes both aspects of Shari’ah interpretation and legal documentation, to lead to greater market confidence and restoration of its attractiveness to issuers. Standardization is expected to make Islamic bond issuance comparable with conventional instruments from a

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

– Fitch Ratings

Finance raised from green Sukuk typically supports 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, according to S&P Global.

Although overall Sukuk issuance is gathering steam in some of the world’s largest financial hubs like London, the market for green Islamic bonds remains small compared to the conventional Sukuk market. Last year total Sukuk issuances reached $205 billion and only $6.2 billion of that was in green Sukuk, said Moody’s.

Call for standardization

The overall volume of Sukuk issuance in 2020 plunged to $139.8 billion from $167.3 cost and effort perspective that it will find a prominent place on the radar for issuers and investors.

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 harmonization and standardization of regulations. The AAOIFI focuses on accounting and auditing standards while the IFSB develops prudential rules in areas including capital adequacy and disclosure requirements.

The adoption of Shari’ah Standard Number 59 by the AAOIFI and the Central Bank of the UAE (CBUAE) is causing some consternation for those involved

in Islamic finance transactions structured as commodity Murabaha. A Murabaha cannot be directly refinanced by another Murabaha, hence the traditional Murabaha structure is no longer held to be Shari’ah-compliant by AAOIFI.

The UAE took the first step towards the standardization of Islamic finance in May 2020 by launching the Higher Shari’ah Authority. Overseen by the CBUAE, the Higher Shari’ah Authority is a national regulator entrusted with overseeing the Islamic financial sector, approve financial products, and set 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.

Since its inception, the Higher Shari’ah Authority ordered the Shari’ah boards of financial institutions in the UAE to apply the Shari’ah Standards issued by AAOIFI as of September 2018.

In Southeast Asia, Bank Negara Malaysia started implementing a revised Shari’ah Governance Framework to strengthen board oversight and the responsibilities of Shari’ah governance. Meanwhile, the central bank of the Philippines, Bangko Sentral ng Pilipinas, implemented the Islamic Banking Act in January 2020. The legislation is seen as the foundation of Islamic finance in the country.

However, standardization poses challenges in terms of implementation and adoption, particularly in realigning existing products.

Sukuk issuance

Islamic bond issuance this year is projected to stabilize or to be slightly lower than after a record $205 billion in 2020 and five consecutive years of growth as higher oil prices have reduced sovereign funding needs in GCC countries. “We expect total gross short- and long-term

AS THE GCC REGION HAS GROWN IN RELEVANCE FOR EMERGING MARKET INVESTORS IN RECENT YEARS, SO TOO HAS THE SUKUK MARKET

– FTSE Russell

Sukuk issuance in 2021 to reach between $190 billion and $200 billion after a record $205 billion in 2020,” Moody’s.

However, stronger financing growth in the Islamic finance sector is expected to continue in 2021 due to broader adoption and innovative structuring of Shari’ah-compliant products and new, fastgrowing franchises in some Islamic banks compared to their conventional peers.

After a record $205 billion in 2020, this year started strongly with some $102 billion in Sukuk issued in the first six months of the year compared to $99 billion in the same period last year. Increased Sukuk issuance in the corporate sector is credited for partly offsetting reduced issuance from sovereign borrowers in the Gulf region and significant activity in Southeast Asia.

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.

Last month, FTSE Russell said that Saudi Arabia’s Sukuk will be added to its widely followed local currency Emerging Markets Government Bond Index (EMGBI) starting April 2022. Saudi Arabia’s Aramco raised $6 billion from its debut US dollardenominated Sukuk sale in June 2021 as the state-owned oil giant was looking for funds to pay its large dividend.

Though issuance declined by 65% to $4 billion in the UAE and Bahrain in the first half of the year, notable issuances include UAE property developer Emaar Properties’ $500 million Sukuk, Kuwait Finance House’s $750 million additional Tier 1 Islamic bond and Oman’s nine-year $1.75 billion Sukuk in June that drew more than $11.5 billion in orders.

Islamic banking

The current challenging 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.

M&A, soaring demand for Shari’ahcompliant products together with proactive government legislation are also driving the growth of Islamic banking assets in the Gulf region. Moody’s said that there has been a flurry of deal-making in the Gulf region in the past few years and the trend accelerated in 2020 due to changing operating environments.

In 2020, all M&A deals in the GCC involved at least one Islamic bank. The merger of Saudi Arabia’s National Commercial Bank and Samba Financial Group into Saudi National Bank, a banking giant with around $223.2 billion (SAR 837 billion) in assets, in April create 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 is also set to create the fourth largest Islamic financial institution in the GCC region, said Moody’s.

Though Kuwait Finance House shelved its proposed merger with Bahrain Ahli United Bank due to the pandemic, upon completion the merger is likely to create the world’s second-largest Shari’ahcompliant bank.