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04 March 2024

Sukuks to enjoy double-digit growth until 2010

By Safura Rahimi


Growth in new sukuk, or Islamic bond, issues is expected to remain in double-digits in the next two years despite current constrained liquidity, according to a latest research report.

US-based firm Morgan Stanley said in its industry report on Islamic banks that it expects sukuk, one of the fastest growing financial instruments globally, to be the largest contributor to sustained double-digit growth in Islamic finance.

Although it does not expect the cost of debt to retract significantly from the current levels this year, the global financial services firm said GCC firms cannot afford to postpone their expansion plans for much longer.

The firm expects Gulf banks – particularly the Islamic banks – to emerge as sukuk issuers since growth in customer deposits has been lagging growth in assets.

“Competition for deposits has also intensified in a negative real interest rate environment,” the report said.

Morgan Stanley also forecast a “high ‘teens CAGR [Compound Annual Growth Rate] in assets in the next few years”, which it said should push banks to raise more sizeable medium to long-term funding.

Outstanding issued sukuk are at more than $90 billion (Dh330bn) today – almost 40 per cent of which are international issues – up from less than $1bn in 2002, the report said.

Sukuk worth $40bn were issued in 2007.

The report said that the figures would have crossed $50bn had international liquidity crunch not taken its toll on the industry in the second half of last year.

“A dozen or so deals were postponed to the first half of 2008 as issuers did not accept the wider spreads in the second half of 2007.”

Although sukuk has been dominated by Malaysia and the UAE, which issued 55 per cent and 20 per cent of sukuk to date, the trend is increasingly going global to non-Muslim countries.

China, Japan and Thailand plan to issue sovereign sukuk this year, and the United Kingdom’s Treasury said on Sunday it will probably support plans to issue sterling Shariah law-compliant bonds, amid continuing debate about the application of Islamic laws in the UK.

According to the Morgan Stanley report, international banks dominate the top rankings of sukuk lead managers, while Gulf banks are more subscribers to sukuk than issuers.

This is because complex sukuk structures involve challenging regulatory and legal procedures, and require extensive and costly advisory services.

“The distribution and transaction costs involved in pioneering such instruments are very high relative to conventional issues,” the bank said in the report.

However, it added that Dubai Islamic Bank is ranked in the top 10 lead managers on cumulative sukuk issues since 2002 due to Dubai-based property developer Nakheel’s $3.52bn convertible Ijara sukuk – the largest to date – issued in late 2006.


The key growth drivers for Islamic banking are the macro-drivers for growth in the GCC banking industry in general, and the increasing demand for and supply of Islamic banking services.

Morgan Stanley estimated that Islamic assets are growing in the UAE with growth reaching 29 per cent in 2007.

The firm forecast these assets to increase from Dh156bn in 2007 to Dh460bn by 2012 – a 24 per cent CAGR.

Islamic banking is growing at a faster pace than conventional banking, the bank said, forecasting a 16 per cent Islamic banking penetration in 2010 and 18 per cent in 2012, from the current 13.8 per cent penetration.

According to its research, government backing for the development and promotion of Islamic banking is one of the major drivers of growth for the sector.

Governments of countries including Bahrain, Malaysia and Pakistan have been committed to the development of a strong Islamic banking sector or transforming the entire conventional banking sector into an Islamic one.

More favourable industry dynamics are another driver of growth for this sector, the research showed.

“Customer stickiness” tends to be greater for Islamic banks, as customers are motivated by conviction and loyalty, rather than seeking the highest return or best quality of service,” Morgan Stanley said.

“Management estimates religiously-sensitive customers are around 20 to 30 per cent of Islamic banks’ users, particularly household depositors. This customer stickiness allows an Islamic bank to secure cheaper funds than its conventional peers,” the report stated.

Hurdles to overcome

The fact that most Islamic banks lack scale is one of the main obstacles to the growth of this sector.

Most Islamic banks are not only small but also exclusively domestic players, even those based in Malaysia. The report finds that the only Islamic banks with significant scale are Al Rajhi Bank in Saudi Arabia, ABC Islamic Bank in Bahrain, Kuwait Finance House in Kuwait, Dubai Islamic Bank in the UAE and Albaraka Banking Group in Bahrain.

The complex structure of Shariah-compliant banking products and operational limitations under Shariah law also hinder the growth of the Islamic banking sector.

Islamic banks may not invest in fixed income securities or interbank instruments, which limits their capacity to manage liquidity. They are also not permitted to hedge against on-balance sheet interest and exchange rate risks inherent in banks’ normal course of business.

Morgan Stanley added that the lower transparency and financial disclosure compared to conventional banks is another major challenge Islamic banking faces.

Asset quality and capital adequacy disclosures, and detail on the level of assets and liabilities, are often unavailable in Islamic banks’ annual reports.

The lack of a single regulatory body that governs the industry worldwide also impedes the sector’s growth.

Islamic banks in Saudi Arabia, Kuwait and the UAE are only supervised by their respective central banks, where almost the same requirements are applicable on both conventional and Islamic banks.

Since each Islamic bank must have its own scholars’ board to verify how well the bank’s practices conform to Shariah law, Islamic banks differ to some extent in the application of Shariah law, and are often inconsistent in their product offerings, the report said.


The underlying risk of Islamic banks is higher than conventional banks.

Morgan Stanley concluded that default risk is higher for Islamic banks and their collateral levels tend to be theoretically higher, as they need an underlying asset or trade for advancing a funded Shariah-compliant facility to a customer.

Islamic banks are not permitted to charge defaulting customers penalty interest, “customers could be more inclined to default on debts to Islamic banks, if they have to choose between defaulting on repayment of outstanding debts to an Islamic bank and a conventional bank,” it said.

The business model of Islamic banks is another factor that makes them riskier than conventional banks. Islamic banks have limited access to liquidity and risk management tools.

They tend to run a wider asset-liability maturity mismatch, and are reliant on short-term deposits than conventional banks.

“Since Shariah-compliant financing facilities must be asset-backed, Islamic banks have higher exposure to long-term financing. At the same time, [they] are constrained in their ability to raise long-term funds as they cannot issue bonds or sell any fixed income notes,” the report said.

Asset concentration risk is also higher, reflecting the greater exposure to equities, as access to the debt market is prohibited.

The profit and loss sharing principal of Shariah-compliant financing and investing assets exposes Islamic banks to higher potential risk than conventional banks, Morgan Stanley said.

The firm added that structuring competitive Shariah-compliant banking products is a complex process that incurs higher costs and settlement risks.

However, Islamic banks are in line with conventional banks when it comes to market risk, the report showed.