In the last two years, the Islamic financial sector, just like its conventional counterpart, has gone through an extremely challenging phase. Owing to capital and liquidity buffers built subsequent to the application of global regulatory reforms, the banking system, including the Islamic finance sector, has largely withstood pandemic-related shocks to the financial and economic systems in major Islamic finance markets of the GCC, the wider Middle East, Southeast Asia, South Asia and others. In this article, three main trends observed for the Islamic financial services industry during 2021 are presented. This review is followed by three observations which will impact the stability and future direction of the Islamic finance sector during 2022 and beyond.

Review of 2021
Firstly, for most major Islamic banking jurisdictions, the growth rate in this sector is expected to remain higher than the growth rate of the conventional banking segment.

Despite the uncertain pandemic trajectory at the beginning of 2021 and most countries experiencing one or more COVID-19 waves during the first two quarters, the second half of the year witnessed relatively faster vaccine rollout, gradual reopening of economies and increase in crude prices which have spurred credit demand in the GCC and Asia — two core Islamic finance regions.

However, continued disruptions in the global supply chain, rising commodity prices and risk of winter-induced upsurge of COVID-19 cases pose a threat to the economic and financial sector recovery, which will impact the sector’s outlook.

Secondly, forbearance measures and payment moratoriums announced by most authorities on the repayment of financing will mask the true extent of the weakness in the asset quality of Islamic banks’ portfolios.

Similarly, due to Shariah challenges in the restructuring of debt-based contracts and the impermissibility of profit-on-profit on delayed installments, the profitability of Islamic banks was also impacted.

Thirdly, due to the lower risk appetite of Islamic banks, reduced credit demand, central banks’ liquidity support measures implemented during the pandemic and concerns on credit quality of customers, the banking sector in many jurisdictions experienced a surplus liquidity situation during 2021.

Thanks to large sovereign bond and Sukuk issuances in the past two years, this excess liquidity has been mostly channeled to higher investments. The higher investment ratios of Islamic banks have thus increased the risk of the crowding-out of financing to the business sector, especially SMEs, which are the engine of economic growth and employment generation.

Preview of 2022
Firstly, some businesses and SMEs have suffered rather heavily from pandemic-related economic conditions, but payment moratoriums during most of 2021 have delayed the materialization of these credit risks on the banks’ balance sheets.

During 2022, this risk will ultimately get realized, impacting both the asset quality and profitability of Islamic banks, potentially significantly for some banks.

Secondly, on the regulatory front, two major developments will impact the Islamic finance industry. AAOIFI and IFSB are expected to finalize their first joint standard on the Shariah Governance Framework by mid-2022 which is aimed at providing consistent and harmonized Shariah governance guidelines for the various players of this industry.

This harmonization is expected to enhance public confidence on these institutions by offering greater transparency and more effective accountability of relevant organs. Another major development is related to the IFSB’s revision to its earlier Capital Adequacy Standard (IFSB-15) where amended guidelines on types of Sukuk eligible for additional Tier 1 and Tier 2 are expected to be included.

Once implemented, these revised guidelines will facilitate further capital-raising by Islamic banks through debt-based convertible Sukuk in Tier 2, which were not permitted in the earlier version.

Thirdly, some industry observers have long been expressing their disapproval for Islamic finance transactions to be benchmarked against interest-based indicators such as the London Inter-Bank Offered Rate (LIBOR) for ascertaining the cost of funds and pricing financing products.

However, in the absence of a reliable and widely acceptable indicator, Shariah scholars have generally permitted the use of conventional benchmarks for the time being.

Over time, industry practitioners have been citing problems such as non-availability of data, cost element in collecting pricing rates in various industries and risk of arbitrage in dual banking markets for not making progress in this direction.

Nonetheless, this permission does not absolve the industry of this responsibility to gradually move toward benchmarks tied to the real economy that are based on asset productivity and profitability of assets. The abolition of LIBOR has provided this golden opportunity to the Islamic finance industry.

Sadly, this opportunity seems to have been missed, apparently due to little appetite by Islamic financial institutions to move in this direction. International standard-setting body International Islamic Financial Market has made a commendable effort to bring the industry practitioners together on this subject and issue a white paper.

Nevertheless, most of the proposals in this document suggest ways to ‘adopt’ Islamic finance product structuring to meet the requirements of a new reference rate called the Risk-Free Rate (RFR), such as the application of a ‘look back’ principle (which requires that for a given repricing period, the accrued financial charges will only be determined at the end of the repricing period rather than at the start of the period).

This and many other requirements of RFR pose Shariah challenges for Islamic finance product pricing and structuring. However, going forward, instead of finding a way to ‘conform’ to RFR principles, the Islamic finance industry should move in the direction of its core value, ie to produce pricing benchmarks tied to the real economy. If the tone is not set right at this stage of abolition of LIBOR, there is a risk that the direction of the Islamic finance industry will be further lost for decades to come.

As the market share of the Islamic finance industry continues to rise in its major markets — even becoming a quarter or one-third of the entire financial system — it is time that the arguments of ‘nascent industry’, ‘niche market’ and ‘insignificant sector’ are put aside and a concerted, coordinated effort is made by the lead standard-setting bodies, regulators and market players to produce a reliable, replicable and robust pricing benchmark for Islamic finance transactions.

Conclusion
Despite macroeconomic challenges and volatility in the global economy, the Islamic finance industry is maintaining its resilience and growth trajectory. The ongoing pandemic as well as reforms and revisions in the global standards and benchmarks not only pose new risks to the Islamic finance sector but also offer an opportunity for its stakeholders to benefit from global developments for achieving the objective of shared prosperity and a just financial system.

Dr Zahid ur Rehman Khokher is the Islamic finance expert in the Islamic Banking Department of the Central Bank of Oman. He can be contacted at [email protected]