Why Islamic banking is booming, but the systems are a bust

Over one trillion dollars passed through the Islamic financial services industry in 2015 as demand recovered from the turbulent previous year. Reform and innovation are now needed to take the sector to new customers, and new heights.

By Victoria Wah, edited by Francesca Ross

The global Islamic financial services industry is booming, handling a record-breaking US$ 1.88 trillion in a year, according to the most recent data. The figures come from transactions in 2015 and show not only growth but also a marked recovery from dipping demand.

The takaful sector, which offers a form of insurance, expanded by 26.8% from US$ 18.3 billion in the first half of 2013 to US$ 23.2 billion two years later. In that same period, the banking sector grew from US$ 1.28 trillion to US$ 1.48 trillion.

The same data does show some negative trends, in particular in 2014. Increased regulatory cost deterred smaller firms struggling to build their financial viability from participating in the industry during this period. This meant that growth increased by only 8.4% in that year, from US$ 21.4 billion to US$ 23.2 billion.

Mohammed Ali Londe, an analyst at Moody’s Insurance team, explained, “Complex regulation, as well as compliance and operational challenges… slowed growth in the takaful industry”.

Source: Islamic Financial Services Industry Stability Reports 2014-16

The banking assets sector expanded by 0.68% over the same 12 months, from US$ 1.47 trillion to US$ 1.48 trillion by the first half of 2015. This was an improvement on the area’s previous performance. A sample of 59 Islamic banks across 11 countries showed that the annual growth rate of deposits fell from an average rate of 16.1% between 2008 and 2014 to 12.5% in 2015.

Liquid assets also saw a tumble. Banking leaders said that, as an average, their institutions had assets on hand to meet 71.32% of the total 90 days’ liabilities as at end-2014. 2015’s short-term asset-liability ratio was 81.8%. Banks also suffered from weakened liquidity with higher short-term liquidity risk. This poor performance was not unexpected. This period saw fears of a Eurozone recession, oil prices plunging to a five-year low, and exchange rate depreciation in emerging markets.

Macroeconomic pressures impacted the Sukuk industry

Falling oil prices and the Malaysian Central Bank’s halt on a short-term issuance of Sukuk, an Islamic financial certificate and Shari’ah compliant bond, also had a significant effect on Islamic banking products globally. Short-term Sukuk issuance plunged by 71.7% from US$ 56.6 billion in 2014 to US$ 15.9 billion in 2015. There was a 12.5% year-on-year decline in the first half of 2016 as compared to the same period the year before.

This was because financial upheavals caused most Gulf Cooperation Council (GCC) nations to rely on large stocks of government-accumulated fiscal assets and conventional debt issuance for public sector deficit financing and project financing rather than on Sukuk. Mohamed Damak, the global head of Islamic finance at S&P Global Ratings, explained this was because conventional debt issuance was less complex and time-consuming than Sukuk issuance and this pushed down demand.

Sukuk market may recover despite volatility of international capital markets

Standard & Poor’s reported this gloomy performance will continue. The US Federal Reserve’s expected rate hike and Brexit will cause higher volatility of international capital markets and make it more difficult for investors to do business. This means demand for Sukuk will fall.

Faisal Hasan, Head of Investment Research at Kamco, still believes the overall outlook for this area remains positive for 2017. The GCC economies might return to issuing Sukuk instead of conventional financial instruments to fund their deficits as oil prices stabilise. Governments might integrate Sukuk into their debt-management strategy.

Sukuk ownership could also be made easier. The Accounting and Auditing Organization for the Islamic Financial Institutions (AOIFI) considered standardising Sukuk procedures, like the legal documentation needed and how Shari’ah principles are interpreted globally. Infrastructure might also be strengthened and tighter regulations would encourage the use of these methods over conventional bonds.

Islamic banking industry remains resilient and must maintain its liquidity

The Islamic banking industry remained resilient over the longer term said the Islamic Financial Services Industry (IFSI). Their assessment, based on their sample of 59 Islamic banks’ performance from 2008 to 2014 was that they were, “sufficiently capitalised above minimum regulatory requirements while maintaining non-performing financing at rates much lower than those witnessed during the financial crisis years”.

However, the short-term liquidity health of Islamic banks that have limited recourse to Shariah-compliant liquidity arrangements remained an area of concern. The IFSI advised banks to diversify their revenue portfolio and reduce their exposure to sensitive sectors like oil and gas to maintain their financial health over the longer term.

Regions with high potential for growth in Islamic financing methods can help the broader industry to mature. Nadim Najjar, Managing Director at Thomson Reuters, Middle East and North Africa explained, “Islamic banking remains strong in many countries and its growth is also supported by the continued development and introduction of it, and other Islamic finance sectors, in new countries.”

An increasing number of non-Muslim jurisdictions, such as the United Kingdom and United States of America have introduced Shari’ah-compliant financial products into their markets to meet the demands of the Muslim population. Global Islamic banking assets are now expected to exceed a whopping US$ 3.4 trillion in 2018.

Overall, 2017 could be a better year for the Islamic finance industry but it will need to weather the double threats of American rate rises and Brexit by innovating and reforming processes to make products simpler to access and easier to administrate. There is huge scope for growth in the sector, particularly when incomes in Asia are rising and swathes of currently unbanked potential customers may require new services in the years to come. The need is there. The money in the industry is rising. Service providers need to step up and ensure they can give people what they need for both to grow together.