Growth in Islamic finance will likely slacken in 2016, in Standard & Poor's Ratings Services' opinion. The industry has achieved critical mass--Islamic finance assets worldwide exceed $2 trillion by our estimate. But we now think the industry faces three main challenges:
• The decline in oil prices and its implications for the economic performance of core markets;
• The rapid changes in the global regulatory framework for banks and insurance companies; and
• Its fragmented nature, still made up of a collection of small industries and lacking truly global coverage.
Still, Islamic finance will have the impetus to continue progressing and maintain some growth, in our view. Governments in core markets see in Islamic finance a tool to maintain their investment spending, somewhat countering the negative impact of oil prices on their budgets. The regulatory changes could help the industry in resolving issues related to the lack of liquidity management instruments and applying more stringently its principle of profit and loss sharing. Standardization of documents and Sharia ruling could enhance industry integration and free stakeholders' capacity to focus on innovation.
Overview
• We think Islamic finance growth will drop to single digits in 2016 from between 10% and 15% over the past decade.
• Islamic finance is facing the fall in the oil price, rapid regulatory changes, and lack of integration.
• Governments in some core markets for the industry will likely maintain their investment spending while looking for alternative funding sources, including through Islamic finance.
• Current headwinds could result in more stringent application of the profit and loss sharing principle and higher standardization.
We expect the industry will be worth $3 trillion sometime in the next decade. Islamic finance stakeholders' efforts and the industry's contribution to development of the real economy will likely fuel growth. This development is capturing the interest of major financial institutions, such as the International Monetary Fund and the World Bank, and some advanced countries.
Islamic Finance Growth To Fall To Single Digits
We anticipate single-digit growth in Islamic finance in 2016, after a decade of 10%-15% growth on average. The decline in oil prices and its implications for core market economies, the rapid changes in the global regulatory framework for banks and insurance companies, and the industry's fragmented nature are the main contributors to the expected slowdown.
We are currently witnessing the end of the global commodities super-cycle that started in 2005, which we think will Islamic Finance To Still Grow In 2016 But With A Sag drag down economic growth in some core markets and consequently reduce opportunities for Islamic finance. Standard & Poor's now assumes that oil prices will average $63 per barrel between 2016 and 2018 (see "Standard & Poor's Revises Its Crude Oil And Natural Gas Price Assumptions," published Sept. 24, 2015, on RatingsDirect). The decline in oil prices is taking a toll on oil exporting countries governments' public finances, and most of these countries are core markets for Islamic finance. Positively, we expect governments in Gulf Cooperation Council (GCC; Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, United Arab Emirates) countries will protect their investment spending to support growth. Still, if oil prices fall much below our current expectations and government balances weaken further as a result, we think GCC governments will increasingly cut investment spending.
The rapid changes in the global regulatory environment for banks and insurance companies are also affecting Islamic finance. In particular, Basel III for banks and Solvency II (or risk-based capital requirements for insurance companies), and the implementation of bank resolution regimes implementation in major EU countries are raising the bar for Islamic financial institutions to keep pace with developments in conventional finance.
We see the need for further strengthening of integration in Islamic finance. Despite its non-negligible size, with assets we estimate at more than $2 trillion, the industry remains fragmented. It's more a collection of small industries in specific geographies than a truly global industry Some Benefits For Growth Despite The Tough Landscape .Although the industry is facing the oil price decline, we think there are still some unexploited pockets of growth. We see Iran as one of these pockets (see "Lifting Sanctions Augurs Well For Iran's Economy And The Growth Of Islamic Finance," published Sept. 14, 2015). The country has been under sanctions for more than 35 years, hurting its economic performance and investments. If and when sanctions are lifted, we think that a significant amount of investment projects will naturally find its way to the Islamic finance industry, seeking financing. The Iranian banking sector alone cannot cope with these projects because it has its own challenges. Issuing sukuk might be a viable financing route, provided that Iran makes the necessary regulatory adjustments. Iran's banking sector currently represents about 40% of Islamic finance industry assets are concentrated in Iran
Apart from Iran, governments in the GCC countries will likely try to maintain their capital spending. Consequently, they may look for alternative financing sources, such as the domestic or international capital markets, support economic growth, build debt capital markets, and slow the depletion of their asset positions. Since early August 2015, the Saudi Arabian government has issued Saudi Arabian riyal (SAR) 35 billion ($9.3 billion) in local currency debt subscribed by public institutions, local banks, and non-bank Saudi financial institutions. Looking ahead, we understand that the Saudi government is likely to continue issuing debt to finance its burgeoning fiscal deficit. We understand Kuwait may also seek to sell local currency sovereign bonds by the end of the year (see "Gulf Governments Protect Investment Spending To Support Growth," published Oct. 7, 2015). Moreover, some GCC governments still have among the lowest indebtedness indicators globally, meaning they retain leeway to raise funds to continue financing their investments. Islamic finance is a natural partner for infrastructure financing given the industry asset backing Principle. The list of newcomers to Islamic finance keeps on lengthening. We have recently seen a string of successful sukuk issues by issuers domiciled in non-core markets. The average participation of Middle Eastern and Asian investors in the sukuk arena reached 65% in 2014, with European and U.S.-based investors representing the remainder. These investors are primarily interested in the slightly higher yields offered by some sukuk, versus similar conventional financial instruments. We estimate the Islamic sukuk investor base at just over $500 billion, excluding sovereign wealth funds, official investors (central banks and multilateral), and other conventional investors.
We see new regulatory developments in developed markets as a source of opportunities for Islamic finance. As Basel III helps the banking industry to enhance its capitalization and resilience to unexpected shocks, it will also tackle the lack of available liquidity management instruments for Islamic financial institutions (see "Basel III Requirements Could Strengthen Islamic Banks' Liquidity Management," published March 31, 2015). The International Islamic Liquidity Management Corporation (IILM) was created to offer Islamic banks the necessary instruments for liquidity management by issuing short-term dollar denominated sukuk. The IILM's second objective is to create an Islamic finance "profit" curve and reduce the industry's dependence on other headline interest rates associated with conventional financial instruments.
However, the IILM cannot deal singlehandedly with the weaknesses of a $2 trillion industry given the relatively small size of its own issuances.
Governments, central banks, and other official organizations have a role to play. Bank Negara Malaysia (BNM) tried to offer solutions for liquidity management for Islamic financial institutions a few years ago and subsequently became the largest issuer of sukuk globally . However, in the beginning of 2015, BNM withdrew from the sukuk market because its issuance didn't satisfy the ultimate goal. Instead, it sukuk instruments became very successful and attracted a broad array of investors. BNM has since switched to other liquidity management instruments reserved for banks "Global Sukuk Issuance Stalls In 2015 As Major Issuer Exits The Market," published July 7, 2015).
We think that other central banks may emulate BNM over time. The implementation of a liquidity coverage ratio under Basel III will be progressive over the next five years. We will see full implementation only in 2019, as per the recommendation of the Basel Committee for Banking Supervision. We think bank resolution regimes will be easier to implement for Islamic financial institutions, compared with conventional players in some core countries. We will likely see stricter application of profit and loss sharing, a core principle in Islamic finance. A few UAE banks and one Saudi bank have already tried, launching sukuk eligible for additional Tier 1 capital treatment under Basel III (see "Standard & Poor's Says Saudi Arabian Bank NCB's Tier 1 Capital Sukuk Issues Have Intermediate Equity Content," published Aug. 4, 2015) that can absorb losses under specific circumstances.
The rollout of resolution regimes in Western countries will create an improved financial environment and set precedents that can be built on for Islamic finance. For instance, profit sharing investment accounts might be used as bail-inable liabilities, up to the alpha factor recommended in the Islamic Finance Service Board standards under the scenario of an Islamic bank resolution. However, this means funding costs will probably increase for Islamic financial institutions, as they will need to compensate depositors for this additional risk. In insurance, the implementation of Solvency II, or risk-based capital requirements for insurers, could aid in strengthening the resilience of the takaful industry, in our view. Takaful insurance remains small, and lacks scale and profitability compared with conventional insurers . Takaful companies' investment portfolios also remain concentrated on a few risky and volatile asset classes, specifically equity and real estate. The deepening of the sukuk market could help them to further diversify their investment portfolio and improve performance. Islamic finance also stands to benefit from standardization of industry products and Sharia opinions, helping to attract new issuers and free stakeholders' capacity to focus on innovation and catering to specific issuers' needs. Standardization is happening but not at the market-desired speed. A review of documentation used by some issuers in recent sukuk transactions illustrates movement toward increasingly standardized sukuk legal documents. As recent examples, the legal documents for the sukuk issued by Luxembourg closely resembled those used in the South African government's issuance (see our presales "Luxembourg Treasury Securities SA," published Sept. 18, 2014, and "Republic of South Africa Sukuk Certificates," published Sept. 9, 2014). In Asia, the legal documents of Malaysian government-issued sukuk resemble those used by the Hong Kong government (see "Malaysia Sovereign Sukuk Bhd.,"published April 23, 2015, and "Hong Kong Sukuk 2015 Ltd.," published May 13, 2015).
Our Role In Islamic Finance
Standard & Poor's doesn't structure transactions or provide opinions on Sharia compliance. Our role consists in providing the market with our independent and objective credit opinions that help bridge financial gaps and reduce information asymmetry in Islamic capital markets and in sukuk issuance. In doing so, we rely on our published criteria. In Islamic finance, we rate sukuk and Islamic financial institutions, including takaful companies. Although we do not have a dedicated set of criteria for Islamic financial institutions and takaful companies, we use our criteria for conventional counterparts and our qualitative assessment where necessary to reflect specificities of operations under Sharia compliance. For sukuk, the story is different. Sukuk can entail risks that do not exist in the conventional space . Sukuk Or Bonds: Are The Risks Really Different Nature Trust certificates Pure debt Yes
Asset backing A minimum percentage of tangible assets Not required Yes Principal and return Purpose Raise long-term funding Raise long-term funding No Risks Sukuk with sufficient contractual obligations and no conditionality: Risks Sukuk with insufficient contractual obligations or with conditionality: Source: Standard & Poor's.
We recently updated our methodology for rating sukuk, originally published in 2007, to capture the fundamental differences between sukuk and conventional bonds (see "Methodology For Rating Sukuk," published Jan. 19, 2015).
Our updated criteria clarify the five conditions that sukuk must fulfil to be rated at the same level as senior obligations of the sponsor and identify cases where a sukuk rating might be de-correlated from its sponsor's creditworthiness, reflecting investors' exposure to residual asset risk. This could occur when contractual obligations provided by the issuer do not cover asset risks in all scenarios, and specifically in case of events that make the underlying assets unfit for economic use, commonly defined as total loss event in sukuk legal documents. In Islamic finance, destruction of the underlying asset would result in the immediate halt of all related contractual obligations related. Under such a scenario, if there are no back-up obligations from the sponsor to address this risk, sukuk investors' might find themselves exposed to nonrepayment risks without any breach of contractual obligations by the sponsor. Put differently, investors would have to take the risk without any recourse against the sponsor or the issuer. Under these scenarios, Standard & Poor's might cap the sukuk rating, depending on its views of the risk of occurrence.
Sukuk Bonds Difference
Derived from the underlying assets and/or from the contractual commitments of the sponsor Exposure to the issuer's credit quality. Residual exposure to the assets.
Related Criteria And Research
Related criteria
• Methodology For Rating Sukuk, Jan. 19, 2015
Related research
• Gulf Governments Protect Investment Spending To Support Growth, Oct. 7, 2015
• Standard & Poor's Revises Its Crude Oil And Natural Gas Price Assumptions, Sept. 24, 2015
• Lifting Sanctions Augurs Well For Iran's Economy And The Growth Of Islamic Finance, Sept. 14, 2015
• Glossary Of Islamic Finance Terms: August 2015 Update, Aug. 10, 2015
• Standard & Poor's Says Saudi Arabian Bank NCB's Tier 1 Capital Sukuk Issues Have Intermediate Equity Content,
Aug. 4, 2015
• Global Sukuk Issuance Stalls In 2015 As Major Issuer Exits The Market, July 7, 2015
• Hong Kong Sukuk 2015 Ltd., May 13, 2015
• Malaysia Sovereign Sukuk Bhd., April 23, 2015
• Basel III Requirements Could Strengthen Islamic Banks' Liquidity Management, March 31, 2015
• Luxembourg Treasury Securities SA, Sept. 18, 2014
• Republic of South Africa Sukuk Certificates, Sept. 9, 2014
We have determined, based solely on the developments described herein, that no rating actions are currently warranted. Only a rating committee may determine a rating action and, as these developments were not viewed as material to the ratings, neither they nor this report were reviewed by a rating committee.
