Islamic finance sector needs to unlock its long-term potential

A higher degree of standardisation would support the growth of Islamic finance and reduce discrepancies between jurisdictions

Saudi Arabia has rolled out 142 stimulus initiatives with a total value of 214 billion Saudi riyals to support individuals, private sector businesses and investors since the outbreak of coronavirus. Reuters
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The Covid-19 pandemic has caused significant disruption to the global economy and financial markets, including the global Islamic finance industry. Lower oil prices, measures introduced to contain the spread of the virus and incentives to unlock bank liquidity have had a particularly negative impact on the industry and its different components.

Uncertain times naturally result in both governments and investors adopting a more risk-averse approach although lately we have started to observe some relaxation. A need for immediate funds amid the pandemic, and complexity related to sukuk issuances have pushed governments in core countries towards conventional markets to secure finance. As a result, the volume of sukuk issuance fell 38 per cent below the level it reached in the first five months of 2019.

Although we expect sukuk issuance to recover from the third quarter of 2020 onwards, this is unlikely to compensate for the first-half decline. We forecast around $100 billion (Dh367bn) sukuk issuance this year, which is around 40 per cent lower than in 2019. While such figures suggest a particularly challenging year for the Islamic finance sector, we highlight some opportunities in the current environment for accelerating and unlocking the long-term potential of the industry.

Covid-19 has certainly underlined the need for more integrated and multifaceted growth within the sector, and in particular a higher degree of standardisation. S&P Global Ratings believes that although those operating in the industry have developed a certain way of doing transactions, the Islamic finance sector still lacks clear global standards that those in the industry can follow. The positive news is that some stakeholders are trying to remedy this.

The UAE’s Ministry of Finance, the Islamic Development Bank and the Dubai Islamic Economy Development Centre recently established a partnership to develop an international legislative framework for Islamic finance, with the goal of accelerating growth and reducing discrepancies around the globe. While this is a step in the right direction, its success will depend on the degree of adoption by the different jurisdictions where Islamic finance is present.

We also believe that there is a strong need for a critical review of existing standards across the full spectrum of sukuk (from fixed-income-like instruments to equity-like) and the adoption of an inclusive approach, taking on board the views of all stakeholders, including regulators, sukuk issuers and investors. Ensuring that sukuk issuance becomes comparable to conventional instruments, from a cost and effort perspective, will allow Islamic financing to secure a more prominent place on issuers’ and investors’ radars, even during challenging economic times.

Various Islamic finance instruments can also help the governments, banks and corporations to navigate the current situation. Qard Hassan, or a benevolent loan through which a lender can extend repayment periods or waive off the primary amount, can be particularly helpful for those affected financially by the pandemic. For example, central banks could open free liquidity lines to enable financial institutions to provide subsidised lending to their corporate, small and mid-size enterprise clients.

Meanwhile, social sukuk could be used to bolster the education and healthcare systems amid the current slump and support in attracting environmental, social and governance (ESG) investors. We are seeing it with the recent issuance of the Islamic Development Bank and the issuance to come from Malaysia. Waqf could help provide affordable housing solutions or access to healthcare and education for people that might have lost a portion of their income.

Finally, Zakat could help compensate for lost household income as a result of Covid-19.  Such instruments, together with an additional layer of governance, could help to put Islamic financing more prominently on the radar of ESG investors – even beyond the pandemic.

The pandemic has also exposed the potential weak links in FinTech with respect to operational resilience. Workers' remittances were delayed in some core Islamic finance countries since exchange and money transfer outlets were unable to open due to virus containment measures.

Sukuk issuance and structuring were also delayed, despite the creation of a new platform last year that uses blockchain to streamline processes. Ensuring the security of transactions and resisting cyberattacks while remaining compliant with existing regulations has proven to be a concern for the industry; however, with the right regulatory technology, challenges around security could certainly be addressed. Of course, the success of such solutions is entirely dependent upon the provision of adequate physical infrastructure and the implementation of necessary supervision and regulatory frameworks.

Going forward, we can certainly expect to see an increased focus on the digital transformation of the Islamic finance industry to ensure that the sector is well equipped to support business continuity during times of crisis. Collaboration with FinTech companies, in addition to cost reduction measures, will be key to adapting to an evolving operating environment.

Notwithstanding recent improvements, conditions in global capital markets remain volatile. Therefore, we do not expect core Islamic countries to use sukuk as a primary source of funding despite their higher financing needs. Overall, we think that the global Islamic finance industry will experience low-to-mid single-digit growth over the next couple of years.

While the pandemic has certainly highlighted the need to standardise the sector and the advantages that digitalisation can bring, it has also demonstrated that the industry has plentiful opportunities for growth. Collaboration amongst stakeholders will be key in ensuring that the industry is able to unlock its full potential in the long term, even during challenging times.

Mohamed Damak is senior director and global head of Islamic Finance at S&P Global Ratings