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Starting Towards its Potential
The improved operating environment in the MEASA region, and growing interjurisdictional cooperation will sustain the growth of Islamic banks’ assets and liquidity position as the lenders are expected to continue outperforming their conventional peers
The Islamic finance sector continues to demonstrate considerable growth globally, driven by continued standardisation of the industry, the robust appetite for Shariah-compliant products and the alignment of its financial instruments with environmental, social and governance (ESG) values.
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The war in Ukraine has disrupted commodity supply chains, driving up consumer prices and fuelling inflation worldwide while hawkish interest rate hikes by the US Federal Reserve to cool down inflation is driving other central banks to raise their policy rates despite the risk of derailing growth. However, “the economies of GCC countries, Malaysia and Indonesia will remain strong in 2023 processes as well as end-to-end customer journeys in lockstep with their conventional peers. According to S&P Global, “accessing bank services digitally, issuing Sukuk on a digital platform using blockchain technology and enhancing cybersecurity will be the three main factors to help improve the industry’s resilience.”
Meanwhile, the alignment of certain Islamic financial products with environmental, social and governance (ESG) factors has thrust the industry back on the radar of conscious investors while encouraging the streamlining of the sector to boost its attractiveness. ESGlinked Islamic bonds will likely remain a key issuance theme in core Islamic finance markets supported by government initiatives focusing on sustainability and economic diversification.
because of the high prices of oil and other commodities that boost both corporate and government coffers,” said Moody’s.
The growth in the Middle East, Africa and South Asia (MEASA) region on the back of soaring prices of crude oil and other commodities and the relaxation of pandemic-related restrictions is projected to remain strong over the next 12 to 18 months.
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.
Islamic banks are accelerating and strengthening the digitalisation of complex
Islamic banking
The high crude and palm oil revenues are creating positive spill over effects on the other sectors of the economy where Islamic banks do most of their lending. Meanwhile, inflation across most Islamic banking markets will remain moderate relative to the US as governments are providing substantial subsidies to offset inflationary pressure.
The improved operating environment in the MEASA region will sustain the growth of Islamic banks’ assets and liquidity position as the lenders are expected to continue outperforming their conventional peers. S&P Global projected that the global Islamic finance industry will see double-digit expansion again in 2022-2023 after a 10.2% growth in total assets in 2021.
Over the longer term, Islamic banks in the Gulf region will benefit from the economic diversification agendas of countries, which aim to promote higher employment levels among citizens in the private sector.
The profitability of Shariah-complaint banks will also improve this year as provisioning needs decline and net profit margins widen. “After declining in 2020 when the pandemic first struck, the return on average assets for most Islamic banking systems improved in 2021 partly because of lower provisioning needs as economies recovered,” Moody’s said in September adding that the provisions will drop to pre-pandemic levels in 202223—which will further boost profits.
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 GCC 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.
Over the years, all M&A deals in the GCC region involved at least one Islamic bank. Kuwait Finance House (KFH) closed its four-year acquisition of Bahrain’s Ahli United Bank for $11.6 billion—a rare crossborder merger that will make KFH the could be the missing link. The tokenisation of Islamic bonds by leveraging blockchain technology is expected to reduce the various costs associated with the issuance process—potentially opening the field to start-ups and small and medium enterprises (SMEs).
Blockchain technology has the potential to accelerate and unlock the long-term potential of the Islamic finance sector while enhancing its appeal beyond its traditional borders. It allows for all transactions to be unalterably timestamped and uniquely cryptographically signed—increasing operational efficiency, cost reduction and enhancing transparency.
Meanwhile, digital banks are emerging in Islamic finance markets because of new licensing frameworks introduced by financial authorities in core Islamic markets in line with global trends. “More digital banks will emerge given that the central bank in Kuwait will also issue digital banking licenses by the end of 2022,” said Moody’s.
Leading Shariah-compliant digitalexclusive banks in the MEASA region include the UAE’s Zand, Saudi Arabia’s D360 Bank and STC Bank and Bank Fama and Bank Allo. Islamic banks have ample liquidity to support their expansion thanks to strong inflows of deposits.
second-largest Islamic bank globally by assets behind Saudi Arabia’s Al Rajhi Bank. “This transaction will position KFH as a dominant bank in the GCC as the addition of AUB’s solid corporate banking franchise complements its large and strong domestic retail customer base,” said Moody’s.
Bahrain’s Al Salam Bank completed the acquisition of Ithmaar Bank’s consumer banking division and several other assets in July in a deal valued at $2.2 billion. The integration of the two banks is expected to be completed within the second half of the year.
Oman’s Sohar International Bank is in talks for a potential merger with Bank Nizwa—no timeline was provided for the expected finalisation of the deal. Islamic banking has evolved over the year and so too have the product structures as the sector moves to offer tailored features to meet the needs of a growing investor base.
Tapping into the next generation
The pandemic demonstrated how the capacity of a bank to shift its business online is critical for its continuity. For the Islamic finance sector, banks and Sukuk, digitalisation and increased collaboration with fintechs could help strengthen the industry’s resilience and open new avenues for growth.
“Offering digital banking services, issuing Sukuk on a digital platform using blockchain technology and enhancing cyber security will be the three main factors for industry resilience,” said S&P Global.
Sukuk issuance, which bans interest payments and pure monetary speculation, has been gathering steam outside of core Islamic finance centers such as Luxembourg and London. However, the industry remains largely fragmented and plagued with several challenges including high costs and the probability of human error due to multiple intermediaries that are involved in the issuance process.
To address high costs, lack of transparency and the probability of human error, industry experts say blockchain
Harmonizing Islamic finance
The UAE is leading the charge in developing a unified global Islamic finance legal and regulatory framework. Islamic finance, which bans interest payments and pure monetary speculation, continues to expand across key markets in the MEASA region but the industry has remained largely fragmented with the uneven implementation of its rules.
Muslims make up about a quarter of the world’s population and are said to be the fastest-growing religious cohort and as such, the potential market for Islamic financial services is enormous. S&P Global forecasted that Sukuk issuance will decline in 2022 after a stabilisation at $147.4 billion last year versus $148.4 billion in 2020.
The plunge in issuance is attributed to lower financing needs for some countries and corporates in the MEASA region due to high commodity prices. However, more issuers are tapping the conventional markets where it is easier and quicker to get the funds.
Sukuk instruments remain more complex and time-consuming for issuers than conventional bonds. Most Sukuk issuers are facing the challenge of implementing Standard 59 of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) without changing the credit characteristics of the transaction. With the adoption of Standard 59, 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.
S&P Global said that the market for hybrid Sukuk that combine a commodity Murabaha with tangible assets almost froze in early 2021 when the standard came into force in the UAE. The risk of tangibility events is present for Sukuk issuers (mainly non-sovereigns) with limited tangible assets and low headroom.
“The amount that can be raised through the issuance of Islamic bonds can be capped by the value of an obligor’s tangible assets,” Fitch Ratings said adding that a built-in cap on leverage could be negative for issuers with limited tangible assets, asset-light firms and highly indebted issuers—for whom it could restrict access to funding.
While gaps remain, some standardisation has been achieved in language relating to tangibility events, delisting events, indemnity payments and partial-loss events. Standardisation is expected to make Sukuk issuance comparable with conventional instruments from a cost and effort perspective that it will gain prominence among both 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 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 while Malaysia’s central bank, Bank Negara Malaysia, also started implementing a revised Shariah Governance Framework in 2021 to strengthen board oversight and the responsibilities of Shariah governance.
Moody’s lauded UAE regulators saying the move 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.
– S&P Global
ESG alignment
The majority of Islamic finance countries are exposed to climate transition risks, and several are developing or implementing transition strategies, including significant investment in clean energy.
There has been an increase in the issuance of dedicated social Islamic finance instruments and green Sukuk as the industry realises and leverages its alignment with ESG values.
“Islamic finance does not relate only to the use of proceeds, but Islamic products also have to be structured in a way that complies with Shariah. The global ESGlinked Sukuk market has flourished in recent years, and we expect growth to continue in the medium term,” said Bashar Al-Natoor, Global Head of Islamic Finance at Fitch Ratings.
The energy transition agenda across the MEASA region is expected to create opportunities to expand social Islamic finance instruments and green Sukuk products. However, adoption will likely remain slow due to additional complexity related to these instruments and a shortage of ESG-focused investors and issuers in key Islamic finance markets.
Though not mutually exclusive, Shariahcompliant 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.
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.
Islamic finance has gained prominence over the last 50 years, but the industry remains a collection of local industries rather than a truly globalised one and there are no major changes in the distribution of Shariahcompliant financial products over the past decade. The lack of competitiveness for some Islamic finance products and Sukuk issuance-related complexities remain some of the major factors that are deterring the industry from moving more quickly into non-Muslim jurisdictions.
