After remaining resilient in 2020, the Islamic finance segment is performing strongly this year, as an improving economic environment, an increase in the number of large projects and a greater focus on environmental, social and governance (ESG) factors combine to drive demand. Despite the twin challenges of COVID-19 and falling global oil prices, the segment's assets grew by 10.6% last year, according to global ratings agency S&P.
While this was below the 17.3% growth rate recorded in 2019, it was a solid performance in light of the global recession, and many suggested that the segment's positive growth was a sign of its strong future potential. On this basis, S&P forecast that the global Islamic finance industry will grow by 10-12% per annum over the course of 2021 and 2022.
This positive projection is largely based on an expected economic recovery in key Islamic markets in the Gulf and Southeast Asia, driven by the rollout of large infrastructure projects in countries such as Saudi Arabia and Qatar, and an increase in sukuk (Islamic bond) issuance, which S&P expects to reach $140-155bn this year, up from $139.8bn in 2020.
Indeed, some individual lenders have experienced much more spectacular growth, with Dubai-based Emirates Islamic posting a 358% year-on-year growth in net profits for the first nine months of the year.
Perhaps unsurprisingly, the continued growth of Islamic finance is translating into greater prominence within global financial markets, particularly in Muslim-majority countries in the Middle East and Southeast Asia.
For example, in the Gulf Cooperation Council (GCC), the world's largest Islamic finance market, with around 45% of the global share, Shari'a-compliant banking assets as a proportion of total banking assets have grown significantly in recent years.
In Saudi Arabia, Shariah-compliant assets increased from just 29% of total banking assets in 2018 to 50.6% in 2020, while corresponding figures rose from 37.9% to 42.5% in Kuwait and from 19.7% to 26.6% in Qatar. Elsewhere, in Malaysia, the world's third-largest Islamic finance market, the share of Shariah-compliant finance increased from 22.8 per cent to 30.1 per cent over the same period.
However, this trend is not universal, as Islamic banking assets in the United Arab Emirates experience a slight decline in terms of their share of total assets, and the corresponding figures in Bahrain and Oman increase only by a small margin.
This increase in asset value and market share has naturally led many conventional banking institutions to turn their attention to Islamic finance. Coinciding with a broader trend of mergers and acquisitions (M&A) in the Gulf, several conventional institutions have sought to buy or merge with Islamic banks in recent years.
For example, in 2019, Abu Dhabi-based Islamic financial institution Al-Hilal Bank joined forces with Abu Dhabi Commercial Bank and Union National Bank in what is the region's largest tie-up to date. The merged entity became the third largest bank in the UAE, with an estimated 114.4 billion in assets.
M&A activity continued in 2020, with National Bank of Bahrain (NBB) acquiring a 78.8% stake in Manama-based commercial lender Bahrain Islamic Bank (BisB) in January, while in the same month Qatar's Masraf Al-Rayan completed a merger with Al-Khaliji Commercial Bank, creating Qatar's second largest lender and one of the region's largest Shariah-compliant groups. Meanwhile, in July last year, Oman Arab Bank completed the acquisition of fellow Omani institution Alizz Islamic Bank.
"On a strategic level, the integration of conventional and Islamic banks provides stronger balance sheets through a sound risk management framework," Yaser Alsharifi, group chief strategy officer at NBB, told OBG. "It can also lead to accelerated funding and capital synergies, as well as opportunities for joint bids for larger corporate deals."
While entering the lucrative Islamic banking markets is often a motivation for conventional banks, there are also a number of benefits that M&A can bring to Islamic lenders, which tend to be smaller than their conventional counterparts.
"Given that NBB owns 80% of BisB, there have been two major benefits," Hassan Jarrar, chief executive officer of BisB, told OBG. "In terms of talent development, employees of both banks now have more opportunities for career progression, while in terms of expanding BisB's operations, the acquisition by NBB has contributed the financial backing we needed to expand our reach."
Despite the considerable benefits associated with mergers and acquisitions, industry figures indicate that there are some challenges associated with bringing two different institutions together.
"Key integration challenges include unlocking the value of synergies early in the integration plan," Alsharifi told OBG. "This can be achieved through a clearly communicated governance framework and a well-structured integration plan with effective performance monitoring and control. In addition, it is important to have an effective change management plan that focuses on talent retention and culture alignment during the initial years of integration."
Looking ahead, the shift towards ESG in global finance is also expected to provide Islamic banking with substantial growth opportunities, particularly in the Gulf. Indeed, there are many key parallels between ESG values and those of Islamic finance, which similarly address social and environmental factors. For example, in its discouragement of self-interest, strong focus on profit and loss sharing and belief in not financing activities that cause social harm, Islamic finance has social factors deeply embedded in its core principles.
Some socially minded products include Qard Hassan, which is a loan given primarily for social welfare purposes; Zakat, something similar to a tax levied on people earning above a certain threshold, which is used for social welfare purposes; and Waqf, a philanthropic work or donation.
"Islamic finance, in and of itself, is no more inherently risky than conventional finance," Sabeen Saleem, executive director of the Islamic International Rating Agency, told OBG. "While traditionally they may have been more exposed to risks in real estate and construction given the ease of structuring, their innate avoidance of speculative transactions limits their exposure to riskier areas such as derivatives, and their inherent empathy for society and avoidance of interest allows their clients room to recover when necessary."
Meanwhile, with the principle of "protection of life", Shari'a-compliant finance also aligns with the environmental aspect of ESG, as both seek to avoid financing projects or developments that could be harmful to the environment or the well-being of people in general.
Indeed, growing ESG awareness in global finance has also coincided with a rise in demand for green or socially responsible sukuk. Following the first issuance of a green sukuk by Malaysian company Tadau Energy to finance a 50 MW solar project in 2017, interest in the product has grown steadily. Although it still comprises only a small part of the overall Islamic finance market, green and socially responsible sukuk is expected to have significant growth potential, particularly in the Gulf.
"With respect to capital markets, although the Islamic capital market in the GCC is not yet as deep as in Malaysia or Indonesia, financial institutions in the region are increasingly experimenting with sukuk, including green or ESG-oriented facilities," Saleem told OBG. "However, a lot of work is still needed to define and set the standards for what comprises a Shariah-compliant sukuk in general, and to set regulatory standards for 'green' or 'ESG' focused instruments."