Tougher Times Ahead For Islamic Finance As Core Markets Slow

DBS Bank’s recent decision to wind down its joint venture with Gulf investors highlights emerging difficulties for the Islamic finance sector. Once experiencing rapid growth, the industry now faces significant hurdles amid a broader economic slowdown. Over the past decade, Islamic finance expanded at double-digit rates, driven by economic booms in key markets like the Gulf and Southeast Asia. As Islamic financial assets surpassed $2 trillion, the sector began extending its reach beyond traditional boundaries, attracting interest from countries like Britain and South Africa with Sharia-compliant debt offerings.

However, the recent decline in oil and commodity prices poses a threat to the Gulf and Malaysian economies, which could lead to prolonged periods of slower growth. This downturn challenges Islamic banks and insurers, which are smaller than their conventional counterparts, in investing in new products and expertise necessary to remain competitive. The complexity and higher costs of Islamic financial products may deter customers and investors, particularly in a less prosperous economic environment.

Standard & Poor’s forecasts a slowdown in growth, projecting a drop from the previous decade’s 10-15% annual increase to single-digit figures in 2016. Mohamed Damak, S&P’s global head of Islamic Finance, acknowledges the positive impact of high economic performance in Islamic banking regions but anticipates a decline in growth.

Islamic finance, which emerged in its modern form in the 1970s, was once touted as a stable alternative during the global credit crisis. It achieved mainstream status in Gulf Arab countries and Malaysia, representing around 25% of banking assets. Yet, signs of deceleration were evident even before this year, with banks and insurers struggling to attract new customers beyond those with purely religious motivations. For instance, the annual growth of Islamic bank assets in Indonesia, home to the world’s largest Muslim population, decreased from 20% to 8.1% in June compared to previous years.

Recent corporate decisions reflect this trend, including DBS’s plan to close the Islamic Bank of Asia due to failure in achieving economies of scale and Halkbank’s cancellation of its Islamic unit plans. The International Bank of Azerbaijan also shut its Islamic banking department, citing regulatory and industry challenges.

Despite these issues, Islamic finance has made strides in standardizing Islamic bonds (Sukuk), making them less complex and costly. Some Muslim countries, like Tunisia and Morocco, are expanding their Islamic finance sectors post-Arab Spring. However, the sector’s reliance on regulatory support in countries like Pakistan and Indonesia makes it vulnerable to economic shifts.

Global Sukuk issuance fell 40% to $48.8 billion in the first nine months of the year, largely due to reduced issuance by Malaysia’s central bank. Experts like Monem Salam of Saturna in Malaysia anticipate a period of reduced new investments but suggest that existing investments may persist. If slow economic growth continues in core markets, the Islamic finance sector may face further pressures.