Accelerating Islamic finance growth

Geopolitics and fluctuating oil prices restricting market expansion

According to S&P Global Ratings, the global Islamic finance industry will continue to expand slowly in 2019-2020. Total assets increased by only around 2% in 2018, compared with 10% in 2017, after a decline in the sukuk market, which saw strong performance the previous year. The market is unlikely to fare much better in the next two years in the light of geopolitical volatility and fluctuating oil prices. The growth of banking assets has slowed in almost all core Islamic finance markets.

Turkey and Iran lead the decline, and the trend seems likely to continue for the next 12-24 months. Malaysia, Indonesia and the Gulf Co-operation Council countries were among the few sources of industry growth. It is possible the economic cycle will turn at some stage, so it is fair to assume a low-single-digit growth rate over the next two years.

Three potential accelerators could see the return of strong growth in the industry: inclusive standardisation, financial technology, and environmental, social and governance opportunities.

‘Inclusive standardisation’ calls for uniformity of sharia interpretation and legal documentation, factoring in all stakeholders’ requirements. Ideally sukuk issuance should be equivalent from time, effort and price perspectives to issuing conventional bonds. For issuers, this would mean taking a set of standard legal documents, plugging in their underlying assets, and going to market. For investors, it would mean the capacity to understand the risks related to their instruments. For sharia scholars, it would mean factoring the requirements of the market and creating some room for innovation.

The industry’s standard-setters – the Accounting and Auditing Organisation for Islamic Financial Institutions, Islamic Financial Service Board, and International Islamic Financial Market – are collaborating to advance this agenda. Regulators, sukuk issuers and investors should also have their say. A more inclusive consultation process can help the market move forward more quickly. This would lead to the standardisation of the full spectrum of sukuk, from fixed-income to equity-like instruments.

Financial technology could benefit the industry by facilitating easier and faster transactions, improving the traceability and security of transactions using blockchain, enhancing the accessibility of Islamic financial services, and improving governance. Fintech could also help the industry broaden its reach and tap new customer segments currently excluded from the banking system. However, this assumes access to a minimum amount of physical and nonphysical infrastructure.

Blockchain could resolve three challenges related to sukuk issuance and management. These include the traceability of underlying assets to understand better the risk, the traceability of cash flows for prompt corrective action in case of underperformance, and the traceability of investors. This, together with smart-contract protocols, could create faster and even out-of-court resolutions for sukuk disputes.

Finally, regulatory technology could help the Islamic finance industry with more robust tools to achieve compliance with regulations and sharia requirements, assuming agreed sharia standards are in place. It could also minimise the reputation risk related to a potential breach of sharia requirements, and free up sharia scholars to focus on innovation.

The goals of sharia share some links with ESG considerations and broader sustainability aims. Islamic finance’s aim to protect life aligns with sustainable finance principles, which emphasise environmental and social protection. Green sukuk are one example of instruments that could be used to finance environmentally friendly projects.

Islamic banks and instruments are typically subject to an additional layer of governance compared with their conventional counterparts. However, for now, this additional ‘sharia governance’ layer has not enhanced market discipline vis-a-vis Islamic financial institutions and instruments. External audit and higher disclosure requirements could make this happen. On the social side, several instruments (such as waqf, zakat and qard hassan) already exist, and their size is reportedly substantial. However, they have not been leveraged in modern Islamic finance in a transparent and systematic manner. These products could make a difference to socially responsible financing. A proper governance framework for their use will be required to prevent the risk of diverting these instruments from their original purpose.

The fundamental principles of Islamic finance mean it is well placed to contribute to shared prosperity and inclusive growth. However, to enhance this contribution, the industry is more than ever in need of strong and decisive reforms. Almost 50 years ago, the promoters of Islamic finance succeeded in unearthing a new industry; it is now the responsibility of all stakeholders to ensure that it can reach its full potential.

Mohamed Damak is Senior Director and Global Head of Islamic Finance at S&P Global Ratings.

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