Islamic finance growing
Dubai - There couldn’t be a better time for the Islamic banking industry, with global assets expected to exceed $2.5 trillion in 2015 from $2.1 trillion in 2014, according to the Dubai-based AlHuda Centre of Islamic Banking and Economics. By 2018, Ernst and Young’s Global Islamic Banking Centre predicts this value could reach $3.4 trillion.
While the outlook may seem ambitious, the figures are certainly not far-fetched. During the past decade, Islamic finance assets have grown at double-digit percentage rates, rising from about $200 billion in 2003 to nearly $1.8 trillion in 2013, the International Monetary Fund (IMF) reported.
Over the same period, Islamic bond (sukuk) issuance increased 20-fold, reaching $120 billion in 2013. As the industry broadens its base into new international markets, the trend in assets growth is anticipated to continue.
In about two weeks’ time, Germany, Europe’s biggest economy and most populous country, will be getting its first Islamic bank. KT Bank AG, the new German subsidiary of the Turkish lender Kuveyt Turk, is not only eyeing Germany’s 4 million Muslims but plans to expand throughout Europe, where several markets have already embraced Islamic banking.
Indeed, the growing reach of the industry has extended into Asia and Africa, attracting considerable interest in sukuk from financial centres such as the United Kingdom, Luxembourg and Hong Kong.
“We see Islamic finance offering good potential to foster more inclusive growth by increasing access to banking services to Muslim populations who may not be willing or able to use conventional banks,” Prasad Ananthakrishnan, deputy chief of the Gulf Cooperation Council (GCC) Division at the IMF told The Arab Weekly.
“It has the potential for enabling easier access to financing for small and medium enterprises and public infrastructure and it has the potential to improve financial stability, because Islamic finance is asset-backed, reduces leverage and requires risk sharing between borrowers and lenders.”
This explains why Islamic banks weathered the last economic downturn better than their conventional counterparts, as indicated by the Islamic Financial Services Board (IFSB).
In its recently released Stability Report 2015, IFSB highlights that Islamic banks have consistently remained well capitalised, surpassing the capitalisation levels of some of the global systematically important banks. This supported the industry’s resilience during the global financial crisis of 2008-09.
“No Islamic bank had required a major government bailout as was the case for several large conventional banks across North America and Europe,” the report read.
Vulnerabilities remain, however, particularly as sukuk move further away from their traditional profit-sharing structures.
Sayd Farook, global head of Islamic capital markets at Thomson Reuters, highlighted that sukuk will be exposed to the main risks of bonds — credit risk of the issuer — to the extent that the credit profile replicates conventional bonds. Nevertheless, sukuk manage to have a better risk structure, as issuers need to have a fair proportionate amount of assets to issue sukuk.
“The reality is that current Basel regulations compel Islamic financial institutions — the main consumers of sukuk — to have fixed income instruments that replicate the credit profile of conventional instruments, without any recourse to the risk of profit-and-loss sharing,” he said.
The only way to get out of this cycle, according to Farook, is to move the system gradually, starting with bank deposits, to the profit-and-loss sharing format in its purest sense.
“Malaysia has just implemented regulations through the Islamic Financial Services Act to prompt banks to distinguish between profit-and-loss sharing accounts and capital-protected deposit accounts,” Farook said.
“The jury is out where the money will go, whether it goes to capital protected deposits (bank model) or to profit-and-loss sharing accounts (investment model). If we do see a sign of moving towards the investment model, then we can hope to see sukuk move towards profit-and-loss sharing format.”
Inconsistency in applying standards by the different regulators is another challenge plaguing the industry. While specific standards have been developed by organisations such as the IFSB, the Accounting and Auditing Organization for Islamic Financial Institutions and the International Islamic Financial Market, regulatory frameworks in many jurisdictions do not cater to the unique risks of Islamic finance.
Moreover, regulations in each country are set by the individual regulator. “It is up to each regulator to decide on which standards they apply and enforce in their jurisdiction,” Farook explained. To solve this problem, regulators need to enforce already-developed standards or develop adaptations of their own in each jurisdiction.
Islamic banking may have outperformed conventional banking over the past decade but the industry is relatively nascent and Islamic finance assets still represent less than 1% of global financial assets. Therefore, efforts must continue to strengthen supervisory mechanisms, especially if Islamic banks were to sustain another financial crisis.
As the IFSB warned in its latest stability report, increased fragility of emerging financial markets and sharp decline of oil prices may negatively affect the asset quality of Islamic banks. At the same time, the monetary policy of Western central banks could induce yield volatilities and shake investors’ confidence in emerging markets’ financial assets, including sukuk.