Growth in Islamic finance will likely slacken in 2016, in Standard & Poor’s Ratings Services’s opinion. The industry has achieved critical mass, with total assets exceeding US$2 trillion by our estimate. But we now think the industry faces three main challenges: The decline in oil prices; the rapid changes in the global financial regulation; and its fragmented nature.
Still, Islamic finance will have the impetus to continue progressing and maintaining some growth in our view. Governments in core markets see in Islamic finance a tool to maintain their investment spending, somewhat countering the negative impact of oil prices on their budgets. The regulatory changes could help the industry in resolving issues related to the lack of liquidity management instruments and applying more stringently its principle of profit and loss-sharing. Standardization of documents and Shariah rulings could enhance industry integration and free stakeholders’ capacity to focus on innovation.
We expect the industry will be worth US$3 trillion sometime in the next decade. This growth will likely result from the combination of the efforts of Islamic finance stakeholders and its contribution to the development of the real economy, which is fueling the interest of major development institutions and some advanced countries.
Commodities super cycle is over
We are currently witnessing the end of the global commodities super cycle that started in 2005, which we think will drag down the economic growth in some core markets and consequently reduce opportunities for Islamic finance. Standard & Poor’s now assumes that oil prices will average US$63 per barrel between 2016 and 2018. The decline in oil prices is taking a toll on oil-exporting countries’ governments’ public finances, and most of these countries are core markets for Islamic finance.
Positively, we still see some pockets of unexploited growth for Islamic finance. We see Iran, whose banking sector currently represents about 40% of the Islamic finance industry, as one of these pockets. The country has been under sanctions for more than 35 years, hurting its economic performance and investments. If and when sanctions are lifted, we think that a significant amount of investment projects will naturally find its way to the Islamic finance industry, seeking financing. The Iranian banking sector alone cannot cope with these projects because it has its own challenges. Issuing Sukuk might be a viable financing route, provided that Iran makes the necessary regulatory adjustments.
Governments in GCC countries maintaining their investment spending will be another source of growth for Islamic finance. We expect these governments to protect their investment spending to support growth. That will undeniably result in higher Sukuk issuance from some of these governments. As an example, since early August 2015, the Saudi Arabian government started to issue conventional debts in local currency in a trend that we expect will continue. We think that at some stage, the Saudi government will target the liquidity sitting in the country’s Islamic banks’ through Sukuk. We understand Kuwait may also seek to sell local currency sovereign bonds or Sukuk by the end of the year. Some GCC governments still have among the lowest indebtedness indicators globally, meaning they retain leeway to raise funds to continue financing their investments. However, if oil prices fall way below our current expectations, we think GCC governments will cut back on investment spending.
Finally, the list of newcomers to Islamic finance keeps on lengthening. We have recently seen a string of successful Sukuk issues by issuers domiciled in non-core markets. The average participation of Middle Eastern and Asian investors in these Sukuk reached 65% in 2014, with European and US-based investors representing the remainder. We estimate the Islamic Sukuk investor base, those looking primarily for the Shariah compliant nature of the instrument, at just over US$500 billion, excluding sovereign wealth funds, official investors (central banks and multilateral) and other conventional investors.
Islamic finance can benefit from the rapid change in financial regulation
The rapid changes in the global financial regulation are also affecting Islamic finance. In particular, Basel III for banks and Solvency II (or risk-based capital requirements for insurance companies), and the implementation of bank resolution regimes in major EU countries are raising the bar for Islamic financial institutions to keep pace with developments in conventional finance. The regulatory changes could help the industry in resolving issues related to the lack of liquidity management instruments and applying more stringently its principle of profit and loss-sharing.
As Basel III helps the banking industry to enhance its capitalization and resilience to unexpected shocks, it will also tackle the lack of available liquidity management instruments for Islamic financial institutions. The International Islamic Liquidity Management Corporation (IILM) was created to offer Islamic banks the necessary instruments for liquidity management by issuing short-term dollar denominated Sukuk. The IILM’s second objective is to create an Islamic finance ‘profit’ curve and reduce the industry’s dependence on other headline interest rates associated with conventional financial instruments. However, the IILM cannot deal single-handedly with the weaknesses of a US$2 trillion industry given the relatively small size of its own issuances. Governments, central banks, and other official organizations have a role to play. Bank Negara Malaysia (BNM) tried to offer solutions for liquidity management for Islamic financial institutions a few years ago and subsequently became the largest issuer of Sukuk globally. However, at the beginning of 2015, BNM withdrew from the Sukuk market because its issuances did not satisfy the ultimate goal. Instead, its Sukuk instruments became very successful and attracted a broad array of investors. BNM has since switched to other liquidity management instruments reserved for banks. We think that other central banks may emulate BNM over time. The implementation of a liquidity coverage ratio under Basel III will be progressive over the next five years. We will see full implementation only in 2019, as per the recommendation of the Basel Committee for Banking Supervision.
We think bank resolution regimes will be easier to implement for Islamic financial institutions, compared with conventional players in some core countries. We will likely see a stricter application of profit and loss-sharing, a core principle in Islamic finance. A few UAE banks and one Saudi bank have already tried, launching Sukuk eligible for additional Tier 1 capital treatment under Basel III that can absorb losses under specific circumstances. The rollout of resolution regimes in western countries will create an improved financial environment and set precedents that can be built on for Islamic finance. For instance, profit-sharing investment accounts might be used as bailable liabilities, up to the alpha factor recommended in the IFSB standards under the scenario of an Islamic bank resolution. However, this means funding costs will probably increase for Islamic financial institutions, as they will need to compensate depositors for this additional risk.
In insurance, the implementation of Solvency II, or risk-based capital requirements for insurers, could aid in strengthening the resilience of the Takaful industry in our view. Takaful insurance remains small, and lacks scale and profitability compared with conventional insurers. Takaful companies’ investment portfolios also remain concentrated on a few risky and volatile asset classes, specifically equity and real estate. The deepening of the Sukuk market could help them to further diversify their investment portfolio and improve performance.
Higher standardization could accelerate innovation
Islamic finance remains more a collection of small industries in specific geographies than a truly global industry. Standardization of documents and Shariah rulings could enhance industry integration. Standardization is happening but not at the market-desired speed. A review of documentation used by some issuers in recent Sukuk transactions illustrates a movement toward increasingly standardized Sukuk legal documents. As recent examples, the legal documents for the Sukuk issued by Luxembourg closely resembled those used in the South African government’s issuance. In Asia, the legal documents of the Malaysian government-issued Sukuk resemble those used by the Hong Kong government.
Standardization could also help attract new issuers by reducing the time and costs attached to Sukuk issuance. Today, an issuer that wants to tap the Sukuk market has to go through a complicated process that could last several weeks, months or even years when the issuer regulatory environment is not ready for Sukuk issuance. Longer time, energy and costs make Sukuk issuance sometimes unattractive compared with bonds issuance where the issuer just picks off-the-shelf standard documentation, inputs the amount and the maturity and hits the market.
Finally, standardization could free stakeholders’ capacity to focus on innovation in order to create the next generation of products in Islamic finance. One of the common criticisms of market participants toward Islamic finance is that its products usually mimic conventional products using more complicated structures. While we think that Islamic finance principles and their economic added value make the difference between the industry and conventional finance, we believe there is a need to speed up innovation and focus on areas that could spur inclusive growth such as infrastructure financings or SME financings with profit and loss-sharing features.
Mohamed Damak is the global head of Islamic finance at Standard & Poor’s Ratings Services. He can be contacted at [email protected].