“Islamic finance remains a collection of local industries rather than a truly globalized one. Even after 50 years, the industry is still concentrated in oil-exporting countries and seems unable to attract interest beyond its original territory.”
S&P Global Ratings isn’t pulling its punches in its latest Islamic Finance Outlook publication. There’s plenty to be positive about – Islamic finance assets up 10.2% year-on-year in 2021, the potential for digital innovation as a spur to further growth – but there’s no getting away from the fact that momentum is chiefly within domestic territories and that a truly global architecture seems as far away as ever.
In 2012, 66% of Islamic banking assets were in the Gulf Cooperation Council (GCC) countries, followed by 13% in Malaysia. And in 2021, 66% of Islamic banking assets were still in GCC countries, followed by 14% in Malaysia. “There was no major change in the distribution of Islamic finance banking assets over the past decade,” S&P says.
Why is that? S&P blames two things: the lack of competitiveness for some Islamic finance products, and complexity around the structuring of sukuk. And this might actually be getting worse.
Last year, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the Bahrain-based institution that sets standards for Islamic finance around the world, introduced Standard 59, which changed the rules around refinancing of murabaha transactions, which are basically cost-plus financing products that provide an Islamic alternative to a conventional loan. It also altered the standards around what’s called the tangibility ratio on hybrid sukuks, which means the proportion of an issue that should be tangible assets and the proportion that is made up of commodities at inception.
When the standard was introduced in the UAE it caused some markets, such as hybrid sukuks combining commodity murabaha with tangible assets, to freeze up, as issuers had to work out how to implement the standards without changing the credit characteristics of the transaction.
Opposing forces
The scholars who develop these standards do so with good intentions, but the more tweaking that goes on, the more one senses that a standardized and homogenous global industry is further away than ever.
“In our view, the opposing forces of Sharia scholars advocating more equity-like characteristics and investors preferring more debt-like characteristics could disrupt the market,” S&P says. That could happen when scholars question the valuation mechanisms for underlying assets, the setting of a purchase price at the time of issuance, or the payment of rent uncorrelated with the value of the underlying assets. S&P considers that "if sukuk become equity-like instruments, investor and issuer appetite will likely diminish significantly.” Standardizing and satisfying the requirements of all stakeholders, it says, is a plausible way for the industry to remain attractive.
On the other side, we’ve written before about how the explosive growth in ESG as an investment priority represents an opportunity for Islamic finance, an idea which Malaysia in particular has sought to embrace.
A viable, significant industry exists, powerful in many Muslim countries, but is that enough?
There’s also hope that digitalization will help the industry. Blockchain could be a useful tool for issuing digital sukuk, given the amount of information that can be put on to the chain. There are a number of regulatory sandboxes up and running in the Gulf to try out fintech ideas in this space.
The plunge in sukuk issuance, to $74.5 billion in the first half of 2022 from $93.3 billion in the same period in 2021, is less of an issue and more of a reflection of the market forces of the day (plus that AAOIFI tweak). Global liquidity has dropped, and financing needs have declined in both the conventional and Islamic markets roughly in tandem in light of the world economy.
Instead, the S&P report feeds into a question we have asked before: having come this far, just what does Islamic finance want to be? A viable, significant industry exists, powerful in many Muslim countries, but is that enough?
Economic case
Certainly Islamic finance can grow perfectly well without taking on the world any more than it already has. S&P projects a compound 8% annual increase in southeast Asia’s $290 billion Islamic banking market over the next three years, for example, and believes that the long-awaited critical mass in Indonesia’s Islamic sector is finally close at hand, accounting for 10% of overall commercial lending by the end of 2026 (in Malaysia, far more entrenched, it expects 45%).
But the same report also offers this headline: “Islamic finance in the UK is still learning to crawl.” It’s not for want of effort: the UK has issued two sovereign sukuks and developed supportive regulation. Yet UK-based Islamic banks’ total assets represent less than 0.1% of the entire banking system and there is simply no compelling case for it to get any bigger without a clear demonstration that there are better economics to be had in Shariah-compliant financing than conventional.
The same is true of any nation without a majority Muslim population. Simply inventing the industry and enabling it with regulation isn’t enough. There needs to be an economic case.
And so to today’s status quo, which hasn’t changed in a decade. Whether that represents the successful conclusion of a journey, or a stumble along the way to a bigger objective, depends on what you want Islamic finance to be.
