The Islamic banking industry was resilient during 2022 where several Islamic banks showed consistent growth in terms of profitability and enhanced liquidity. There was clear evidence in terms of progress toward sustainable Sukuk. The overall Islamic banking market continued to grow with positive impact from oil prices; however, it was impacted by the economic policies adopted by the US Federal Reserve of increasing the policy rates in addition to the key impact from the war between Ukraine and Russia that had a global impact on the overall financial industry.
Review of 2022
Despite key challenges, the risk landscape of Islamic banks was positive in terms of liquidity and profitability, for instance global outstanding Sukuk reached US$749.6 billion as of the third quarter of 2022 with total Sukuk of US$48.2 billion issued in the core markets of the GCC, Malaysia, Indonesia, Turkey and Pakistan (including multilaterals).
Further, Islamic finance is rebounding from the effects of the COVID-19 pandemic, with Islamic banks’ profitability recovering after 2020 drops. Several major investments, an upswing in Islamic fintech and the funding of OIC start-ups are the key contributors.
However, in 2022, the following were the key risks that Islamic banks had to overcome:
• Rising inflation impacting upward revising of policy rates
The increase in inflation was mainly due to soaring oil and commodity prices, and disruptions in global supply chains. This impacted the contraction in loan originations as the overall rates had significant impact, especially in terms of retail lending in Islamic banks as result of an upward review of policy rates. In the UAE and Saudi Arabia, the interbank offered rates were revised as result of the upward revising of Federal Reserve rates.
Islamic banks had a major challenge in generating new business among corporate clients due to the rapid increase in policy rates. Despite the challenges, several Islamic banks continued to show positive growth during 2022 in terms of profitability.
• Geopolitical unrest
The outbreak of war between Russia and Ukraine was a major hit for several economies and impacted the overall global financial market. Islamic banks faced a contraction in terms of Sukuk issuance. Despite the challenges, Russia opted to open opportunities for Islamic finance that assisted the overall growth of the global Islamic finance industry.
• Tight cyber resilience
Ransomware attacks now pose not only a cybersecurity risk, but also an enterprise-wide risk, threatening business continuity and operations. There were several regulatory updates in terms of cybersecurity control across several jurisdictions during 2022. For instance in Saudi Arabia, the Financial Sector Cyber Threat Intelligence Principles were outlined in the first quarter of 2022, seeking action from banks and financial institutions to ensure compliance especially in terms of proactive action to mitigate cyber threats.
Preview of 2023 and conclusion
Islamic banks will face tougher conditions in 2023 in an environment marked by slowing economic growth, spiking prices, uneven rising interest rates and sharpening of international political tensions. A majority of the outlooks as follows show that there will be an expected recession by 2023 affecting the global economy which will badly affect the overall credit growth among the total banking industry:
• Managing market risk of Islamic banks will be challenging
The following outlook for policy interest rates shows that Islamic banks will have a major challenge as the policy rates are expected to rise further. It is important to note that Islamic banks have a limited landscape in terms of managing market risk.
However, as per Moody’s Investors Service’s analytics, high commodity prices and the easing of pandemic restrictions will support strong economic recovery across major Islamic finance markets over the next 12 to 18 months, boosting the financial performance of Islamic banks for 2022–23.
• Liquidity risk of Islamic banks will be positive
As the policy rates are expected to be increased, the overall liquidity of Islamic banks may increase which will result in an increase in the high-quality liquid asset ratio as well as ample liquidity available among Islamic banks. However, this may cause an impact on the overall profitability of the banks since excess liquidity may squeeze the potential of enhanced profitability. On the other hand, Islamic banks will have a tough time in terms of meeting the requirements on displaced commercial risk to ensure a good return for depositors.
• Islamic fintechs will be put to the test
Based on the forecast by the Economic Intelligence Unit, the incumbents of the financial industry will be affected in 2023, but their upstart competitors, including fintech companies, may fail in large numbers. Funders such as venture capital and private equity firms are insisting in the current market environment that financial challengers stop making losses and chart a path to profitability. This will prove terrible for some upstarts in consumer credit, payments and robo-advised fund management. Islamic fintechs will have to sharply curtail their expenses, including for marketing and customer acquisition. Thus, the culling of competition will ease pressures on established banks, insurers and fund managers.
• Negative outlook on credit risk and strict regulatory requirements
The corporate and SME sector will be affected in specific jurisdictions such as Pakistan and Bangladesh as there will a requirement to create excess provisioning for expected defaults with an expected contraction in terms of credit growth.
Further, it is important to note that the final implementation dates for Basel III (also known as Basel IV) will come into effect on the 1st January 2023, after having been postponed by one year due to the pandemic. Customers will not notice the changes, which require new government regulations and will change the way that banks account for base capital and credit risk using standardized or internal models, as well as mandatory disclosures.
Mohamed Afzal is the enterprise risk manager of the Risk Department at Saudi Home Loans. He can be contacted at [email protected].