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Islamic Banking: The current, the potential, and the challenges

Islamic Banking: The current, the potential, and the challenges
Islamic Banking

Cairo – Decypha: Islamic finance, as an industry, has been witnessing substantial growth in the past decade. From the business side, the sector has mainstreamed within the global financial system and started to gain a firm foothold especially in the Middle East and North African (MENA) region, developing as an effective tool for financial development. Among the first categories of institutions which provided the Islamic financial services were Islamic banks, catering to different financial needs in accordance with the principles Sharia, or Islamic law.

The mechanism of Islamic banking has its own nature and is different from that of conventional banking in some key ways. For example, traditional banks are based on debt and allow the transfer of risk, whereas Islamic banks are linked with the real economy (materiality) and promote risk sharing so they are less prone to risks.

Conventional banks charge interest and fees for loans and other services. Meanwhile, Islamic banks prohibit interest-based transactions and eliminate debt contracts, yet they earn their money by profit and loss sharing, trading and using other Sharia contracts of exchange.

Market overview

Islamic banks are growing in number and size all over the globe, they contribute around 80% of the total current $2.3 trillion Islamic finance industry, which is expected to grow to $2.7 trillion by the end of 2017, based on a forecast by UAE Business.com

Between 2009 and 2013, global Islamic banking assets grew at an average annual rate of more than 17% to reach $1.7 trillion, according to an article published by the International Journal of Financial Studies.

The trend of the Islamic banking has started to slow down in 2015, with Sharia-compliant assets’ growth falling to around 7% from 12% in 2014 due to lower oil prices and slow economic pace, according to a report by S&P. This slowdown was expected to persist in 2016 and 2017 with growth stabilizing at around 5%. Not only banks' asset growth is expected to fall, but profitability is forecasted to decline as well.

The MENA region has recorded the most important growth rates of Islamic banking assets, with the Gulf Cooperation Council (GCC) acquiring more than one-third of all Islamic banking assets worldwide. However, in terms of the largest domicile for Islamic banking assets, Iran takes the lead as it represented more than 37% of the global Islamic banking industry in the first half of 2015 (H1-15), according to figures released by Islamic Financial Services Industry Stability Report 2016.

Excluding Iran which has a unique domestic industry, Saudi Arabia is the highest contributor to total global Islamic banking assets and continues to acquire the largest share of the global market at 33%, followed by Malaysia at 15.5%, the UAE at 15.4%, Kuwait at 10.1% and Qatar at 8.1%, based on figured published in the World Islamic Banking Competitiveness Report 2016 from EY.

The total Islamic banking assets in Qatar, Indonesia, Saudi Arabia, Malaysia, the UAE and Turkey (known as QISMUT) are expected to reach $1.6 trillion by 2020, with EY’s expectations that the Kingdom, Kuwait, Bahrain and Qatar are expected to be the major players.

 

The GCC’s leading role

Islamic banks remain concentrated primarily in oil-exporting countries in the Gulf Cooperation Council (GCC) region. Over the past decade, the GCC has managed to have a firm ground as the most important Islamic banking market worldwide, and is forecasted to see further growth in terms of global market share.

By the end of 2014, the GCC posted $606 billion worth of Islamic banking assets, accounting for almost 69% of the global Sharia-compliant banking assets, which were valued at $882 billion, according to the EY 2016 report.

 

Challenges faced

Despite the growth potential in Islamic banking in recent years, the industry is facing several challenges when it comes to deeper global market penetration. The industry has a complex set of banking products as well as a complex structure, it additionally, faces other regulatory complications that require harmonisation at a global level to be able to expand in different countries.

Islamic banks follow the institutional framework of conventional banks as they lack a framework tailored to their needs. However, Islamic banks cannot completely follow global conventional standards as, for instance, their capital structure is different from that of conventional ones.

The banking laws in most of the Islamic countries follow a western pattern, containing provisions that narrow the scope of Islamic banking activities. Financial institutions need new laws adapted to their specific nature to help them operate in accordance with Islamic rules and give room for Sharia-compliant financial transactions.

The Islamic banking industry lacks regulation and supervision that are important to increase transparency for investors, ensure the soundness of the financial system, and minimize the risks related to its exposure to economic downturns. Reforms are needed to promote competitiveness in MENA banking markets, allowing Islamic banks to diversify their portfolio loans and provide more innovative products which would increase their market shares.

 

The slowdown

Islamic banks are facing a slower growth in recent years due to a number of factors, including government revenue shortfalls resulting from oil price decline and lower global economic growth.

Due to the fall of oil prices by more than 60% from $110 per barrel mid-2014 to a low $35 in 2016, many oil-dependent governments started to develop new sources of financing to support national income; and as the economy started to shift towards further diversification to secure the gap made apparent by the oil prices, deposits –which account for a significant percentage of Islamic banks’ assets—declined. Therefore, prolonged low oil prices and economic slowdown are likely to weaken the banks’ asset quality, liquidity, and profitability.

In addition, the exchange rate depreciation in emerging markets, and generally weaker investor and consumer confidence in the global economy have taken a toll on the performance of the sector.

Overall, conditions vary from one country to another, as each has its own unique set of domestic conditions that can significantly affect the industry’s performance in the coming period.

Although Islamic banks face a wide array of problems, they have a potential to sustain long-term resilience against the emerging headwinds and the current challenging environment. However, it remains critical for the sector to diversify its revenue pools, reduce dependence on public-sector deposits, as well as its dependency on sensitive volatile sectors such as oil and gas to avoid any future risks.

By Julian Nabil