Can the UK Become the Leading Western Hub for Islamic Finance?

Western Hub, The UK’s Role in Global Sukuk Markets

The London Stock Exchange (LSE) is a key venue for the listing of US dollar-denominated sukuk, holding a 35% global market share with approximately $80 billion in outstanding sukuk by the end of the first half of 2024. This positions the LSE as the third-largest sukuk listing venue globally, underscoring the UK’s pivotal role in Islamic finance. English law, known for its robustness and global acceptance, governs the majority of dollar sukuk and Islamic syndications worldwide. This legal framework enhances the confidence of international investors and issuers in the UK market, further solidifying the UK’s role as a central player in the Islamic finance ecosystem.

UK-based banks are also among the leading arrangers of Sukuk and play a crucial role in the Islamic interbank market. These banks have developed specialized expertise in structuring complex Islamic financial instruments that comply with Shariah principles while meeting the needs of global investors. Additionally, the London Metals Exchange (LME) is frequently utilized by Islamic banks across various countries to facilitate cash financing through tawarruq contracts, a popular Islamic financial instrument. This access to global markets and resources makes the UK an attractive destination for Islamic finance operations.

Foreign Direct Investment and Islamic Banking in the UK

The UK’s appeal to foreign investors, particularly from the Gulf Cooperation Council (GCC) and other Organization of Islamic Cooperation (OIC) countries, remains strong. This is reflected in the presence of four Islamic banks in the UK, all with GCC ownership. These banks cater primarily to high-net-worth individuals and institutional clients from the Middle East, offering wealth management, real estate financing, and other tailored financial services. A fifth Islamic bank is expected to launch soon, likely increasing competition and adding depth to the sector.

A notable development in 2024 is the conversion of Ahli United Bank (UK) PLC to an Islamic bank. This transition follows the acquisition of its Bahraini parent by Kuwait Finance House in 2023, marking a significant step towards expanding the UK’s Islamic banking landscape. The conversion process involves aligning the bank’s operations with Shariah principles, which include prohibitions on interest (riba) and engaging in speculative activities (gharar). Once completed, this will enhance the diversity and competitiveness of the UK’s Islamic banking sector.

Despite these developments and supportive regulatory frameworks, Islamic banks account for only 0.1% of the UK banking system’s assets as of the end of 2023. Several factors contribute to this limited market share, including low-demand drivers. Muslims comprise about 6.5% of the UK’s population, and there is generally limited awareness of Islamic finance principles among potential customers. Additionally, Islamic banks often have a narrower range of products, and fewer branches, and may struggle to compete with conventional banks that offer a broader array of financial services.

The Challenge of Raising Awareness

One of the key challenges facing the Islamic finance industry in the UK is raising awareness and understanding of Sharia-compliant financial products among the broader population. While the Muslim community in the UK is growing, the awareness of Islamic finance remains relatively low, even within this demographic. For Islamic finance to gain mainstream traction, there needs to be a concerted effort to educate both Muslims and non-Muslims about the benefits and ethical underpinnings of Islamic finance.

Financial literacy programs targeted marketing campaigns and partnerships with educational institutions could play a vital role in bridging this gap. Moreover, promoting the ethical and socially responsible aspects of Islamic finance could attract non-Muslim consumers who are increasingly looking for financial products that align with their values. For instance, the principles of risk-sharing, avoiding excessive speculation, and investing in socially beneficial projects resonate with the growing demand for ethical and sustainable finance.

Government Initiatives and Sukuk Issuance

While the UK government issued sukuk in 2021 to reinforce the country’s position as a Western hub for Islamic finance, there are no current plans to issue sukuk in 2024 or 2025. Unlike conventional debt instruments, sukuk issuance by the UK government is not part of its regular debt management strategy. Instead, these issuances aim to deliver broader benefits, such as attracting Islamic investors and reinforcing the UK’s status in the global Islamic finance industry. Corporate and bank sukuk issuances from the UK remain rare, reflecting the niche nature of the market.

However, the government continues to show its commitment to the growth of the Islamic finance industry through various initiatives. For example, the UK government is actively exploring the launch of a Shariah-compliant alternative student finance product. This initiative, expected to be introduced after 2025, aims to provide Muslim students with access to higher education financing that aligns with their religious beliefs. This could significantly enhance financial inclusion and create a new market segment for Islamic finance in the UK.

Growth and Expansion of Islamic Financial Institutions

Despite challenges, the Islamic finance sector in the UK is experiencing growth. Islamic banks’ total assets grew by 26% year-on-year, reaching $8.2 billion by the end of 2023. Most of these banks primarily offer wealth management and real estate financing solutions tailored to GCC clients. Two Islamic banks, in particular, are looking to expand their operations beyond the UK. Bank of London and the Middle East (BLME) began operations in Saudi Arabia in the first half of 2023 through its subsidiary BLME Capital. Al Rayan Bank is also pursuing expansion in Saudi Arabia and the UAE, with plans to increase business origination in Qatar.

These expansions into the GCC region highlight the strategic importance of the UK as a gateway for Islamic financial institutions looking to access Middle Eastern markets. By establishing a presence in the GCC, UK-based Islamic banks can tap into the growing demand for Sharia-compliant financial services in these rapidly developing economies. This not only enhances the global reach of UK-based Islamic banks but also strengthens the UK’s position as a Western hub for Islamic finance.

UK-domiciled public Islamic funds have also seen significant growth, with assets under management (AUM) expanding by 115% year-on-year to $1.8 billion by the end of 2023. This growth rate outpaced that of conventional public funds, which grew by 17.5% to $3.4 trillion in the same period. However, UK-based Islamic funds face stiff competition from other Western jurisdictions like Luxembourg, Ireland, the USA, and Jersey. These jurisdictions offer attractive regulatory environments and have established themselves as leading centers for Islamic finance, making it crucial for the UK to continue enhancing its competitive edge.

Tax and Regulatory Reforms

To further bolster its status as a Western hub for Islamic finance, the UK needs to address certain tax and regulatory challenges that currently hinder the growth of the industry. In January 2024, HM Treasury published a consultation document titled “Tax Simplification for Alternative Finance.” The document acknowledged the differences in tax treatment when a commercial or residential property is refinanced using alternative (Islamic) rather than conventional financing. These differences can lead to capital gains liabilities and potential loss of capital allowances, creating a disadvantage for those opting for Islamic finance.

The consultation document proposes legislative changes to level the playing field between Islamic and conventional finance. If implemented, these reforms could remove significant barriers to the growth of Islamic finance in the UK, making it more attractive for both investors and consumers. Fitch Ratings has indicated that they will closely monitor the impact of these potential changes on the Islamic finance industry.

The Future of Islamic Finance in the UK

Despite being a niche market, the UK’s Islamic finance industry is expected to grow, potentially reaching $15 billion in assets by the medium term, up from $10 billion at the end of 2023. This growth will likely be driven by the conversion of conventional banks to Islamic banks, continued asset growth in Islamic banks and funds, and supportive government regulations.

The UK government is also working on launching a Sharia-compliant alternative student finance product after 2025, which could enhance financial inclusion for Muslim students. In addition, the HM Treasury’s January consultation document on “Tax Simplification for Alternative Finance” highlights the government’s ongoing efforts to address challenges in tax treatment for Islamic finance products, which could further support the sector’s growth.

As the UK continues to attract Islamic finance investments and expand its offerings, it solidifies its role as a Western hub for the industry. While the domestic market may remain niche, the UK’s strategic initiatives, supportive regulations, and the expansion of Islamic financial institutions into global markets indicate a promising future for Islamic finance in the region. With ongoing growth and new developments on the horizon, the UK’s position as a key player in the global Islamic finance industry seems assured. As awareness of Islamic finance increases and barriers to entry are reduced, the UK is poised to become an even more significant player in this dynamic and ethically driven sector.