Islamic finance to grow in 2010 as geographical reach widens
Islamic finance is likely to advance in 2010 on firm growth and a widening geographic reach, according to a new report by Standard & Poor's.
"In our view, Islamic finance is poised to make further inroads in developed Western markets while Southeast Asian countries will likely fuel the Islamic finance advance in Asia during the coming year," say S&P analysts.
Even in 2009, a year when many of the world's financial systems found themselves deleveraging amid the capital market dislocation and its spread to economies around the world, growth of Islamic finance stayed more or less intact.
According to the S&P report, assets of the top 500 Islamic banks expanded 28.6 per cent to total $822 billion (Dh3,019bn) in 2009, compared with $639bn in 2008. Total assets at Islamic financial institutions in the GCC grew continuously between 2003 and 2008, representing $288.2bn at end-2008.
The main reason why Islamic financial institutions seem to have weathered the crises better is due to their principles prohibiting interest. "This is the reason why Islamic banks didn't invest in structured products and so have not suffered from the fall in some of these instruments' values," says the report.
Even though Islamic financial institutions fared better than their conventional counterparts, they did not escape the pressures of the economic slowdown.
"We consider that the deepening economic recession in many countries, scarce liquidity, pronounced stock market declines, and plummeting real estate prices in some countries have hit the profitability of Islamic banks, especially in GCC countries. Some of the negative rating actions that Standard & Poor's has taken on some Islamic banks over the past 18 months reflect our view of the impact of these adverse changes."
There was some bad news as well in the sukuk market as there were a couple of defaults, namely the sukuk issued by Saad Group and The Investment Dar Co KSCC.
"These reminded all those involved in the market that defaults can and do happen in Islamic finance. We believe they are also shedding light on the possible consequences of defaults for creditors – ranging from recovery perspectives to access to underlying assets for investors," believe the authors of the report.
However, going forward, the near-term sukuk pipeline looks healthy. As per the S&P report, issuance of Shariah-compliant sukuk notes currently accounts for about 10 per cent of the global Islamic finance industry, following fast growth over the past decade.
"Cumulative total issues topped the symbolic mark of $100bn at end-2009, compared with less than $500 million at year end 2001. In our view, the market is slowly reviving after a major slowdown in 2008. Sukuk issues totalling $23.3bn in 2009 clearly outpaced the $14.9bn registered in 2008 and regained some ground against record issues of $34.3bn in 2007, according to our calculations. We believe medium-term growth prospects for the world sukuk market are good. The pipeline is sizable and we have noted that interest from issuers in both Muslim and non-Muslim countries is increasing. In our view, Asia confirmed itself in 2009 as the major locomotive for sukuk market growth."
During the year, 63.9 per cent of global issuance occurred in Asian countries. Malaysia led the pack, serving as the host country to 54.1 per cent of the region's issuers.
According to S&P estimates Shariah-compliant assets worldwide currently total about $1trn after brisk growth during the past decade. "With this expansion, we believe Islamic finance has become a recognised and a specific segment of finance on its own with still-bright growth prospects."
In time to come, S&P sees external factors shaping growth in non-Muslim countries, especially Europe.
For instance, following the UK, France is introducing Islamic finance into its financial system. The sector is still in its nascent stage but prospects seem bright.
Other European countries, such as Italy and Malta, also seem to be warming up to the idea and are showing interest.
"We understand they are also considering whether it is possible to implement an Islamic finance offer in their respective domestic markets. We have noted that some Asian and African countries are also striving to develop Islamic finance by establishing Islamic banks or by joining the league of countries issuing sukuk," the report says.
However, questions about Islamic finance's future growth and broadened geographic reach still linger on. S&P sees various factors setting the pace of Islamic finance growth in non-Muslim nations, particularly in Europe.
Firstly, the size of demand for Shariah-compliant products and whether or not the market can achieve critical mass is, in S&P's view, uncertain. The authors of the report cite a lack of visibility on how Muslim customers are interested in an Islamic banking offering and whether the principles of Islamic finance will attract non-Muslim customers.
Secondly, S&P believes the regulatory environment for Islamic finance and the need to ensure the same treatment for Islamic and conventional banks from a regulatory and tax perspective are necessary pillars in building the foundation for Islamic finance development outside of its countries of origin.
For instance, the British and French regulators are deploying efforts to make their tax and regulatory frameworks more attractive to Islamic financial institutions.
Thirdly, gaining the support of different stakeholders, especially in the political and business communities, is likely to be among the critical factors in the view of S&P. "In the UK, we have seen major conventional financial institutions playing what we believe is an instrumental role in developing the local Islamic finance offering.
"We believe it is likely that replicating this strategy in other European nations that plan to extend their own local offerings would accelerate growth."
Fourthly, European sovereign sukuk issuance, currently lacking, could help to construct a remuneration curve against which private sector issuers could benchmark themselves in our view.
Several governments of non-Muslim countries – in particular the UK – have announced plans to issue sukuk in the past, but issues have yet to materialise, says the report.
Fifthly, whether or not the EU will forge a common strategy for Islamic finance development in Europe is an open question.
Moreover, the differing interpretations of Shariah law appear to have resulted in the fragmentation and lack of integration of the market for Islamic financial products.
Standardisation could help cut the costs of Islamic products and increase their attractiveness. It could also foster the emergence of a truly integrated global market for some Islamic finance products, in our view, suggest S&P analysts.
Another factor is that Islamic financial institutions typically lack the necessary instruments for liquidity management. The sukuk market is small size and limited liquidity is also a challenge in the context of assessing the possibility of future growth.
"However, we have observed that many major stakeholders are moving to create new markets for listing sukuk or enabling their listing in global markets. Transforming the sukuk market from an over-the-counter market to a more global and liquid market will in our view take time."
The scarcity of human resources and expertise in Islamic finance is another impediment to growth.
"Our perception is that bankers and financiers with conventional expertise and backgrounds have brought the sector forward so far.
"To expand knowledge of Islamic finance, major European business schools are launching tailored training and degree programmes."
Islamic Finance in the west – a dual objective
The West may benefit from Islamic finance and Islamic finance may be an opportunity for the West.
Islamic finance could improve the access to banking services for some Muslim customers that are avoiding conventional banks because they are not compliant with their beliefs.
Western financial institutions would be able to access a compartment of investors that are looking only to invest in Shariah-compliant transactions by offering Shariah-compliant products.
S&P has observed numerous big Western banks participating actively in developing modern Islamic finance since its inception.
These have also tended to be major contributors to innovation in this field. As long as the potential client base is there, S&P expects their role in broadening Islamic finance to remain important given their stated business interests in developing customised solutions for clients.
For instance, major global banks and law firms have participated in the structuring and offering of a large number of sukuk issued so far.
In addition, S&P considers that access to Western economies may mean that Islamic financial institutions gain entry into large and diversified economies with a wide array of asset classes for investment, and in case of most developed countries, strong legal frameworks.
The West may benefit in S&P's view to the extent that Islamic finance opens up new potential markets for banking services.
By developing a tailored financial offering, Western markets could achieve a dual objective:
- Islamic finance could improve the access to banking services for some Muslim customers that are avoiding conventional banks because they are not compliant with their beliefs
- Western financial institutions would be able to access a compartment of investors that are looking only to invest in Shariah-compliant transactions by offering Shariah-compliant products S&P believes that Islamic finance investments may emerge gradually in the medium term in Western countries, starting probably with a wholesale offering that mainly aims to attract foreign direct investments in eligible sectors, or through raising money on the Sukuk market.
Examples of this include Bahrain-based Arcapita Bank's (not rated) acquisitions of France-based Compagnie Europeenne de Prestation Logistiques (CEPL, not rated) and Irish energy company Virdian Group (not rated), alongside the General Electric Capital Corp (AA+/Stable/A-1+) and World Bank sukuk issues in November 2009 and October 2009, respectively.
In the longer run, S&P believes a retail offering could take shape in some western countries with large Muslim populations, such as France, the Netherlands, and Belgium, among others.
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