Islamic Finance Comes of Age

Amid rapid growth, Sharia-compliant banks are looking to expand beyond their traditional markets

From Standard & Poor's RatingsDirect

After more than three decades of modern Islamic finance, the industry's build-up continues at a rapid pace. Double-digit growth rates for assets compliant with Sharia—Islamic law based on the Koran—over the past decade, have naturally driven Islamic financiers to look beyond historical boundaries to explore new territories, both within and outside the Arab world.

In response to the increasing competitive pressure stemming from the entrance of new players into the market, existing Islamic banks have started to leverage their natural competitive advantages, which include customer loyalty, sensitivity to religious practices, and a stable base of cheap deposits.

Potential Market

Even conventional banks have moved to open Islamic branches, create Sharia-compliant subsidiaries, or undergo complete conversions to become fully Sharia compliant. The retail market, the key profit driver of banking in the Gulf, is attracted by what Islamic banking can offer.

The size of global Sharia-compliant assets is estimated today at up to $400 billion, whereas Standard & Poor's Ratings Services believes the potential market for Islamic financial services to be closer to $4 trillion, meaning that Islamic finance currently has only a 10% market share among the Muslim community globally and still has a long way to go.

Islamic banks in the Gulf have displayed, and should continue to show, strong profitability, so long as oil revenues pour into the Gulf economies, maintaining economic momentum through a powerful multiplier effect. It is important, however, that the Islamic banking industry does not become complacent.

Growth in Compliant Notes

A number of issues must be tackled, among which size and concentration risks are two of the most important. And the realization of a common conceptual framework that unites the approaches of the two historical centers of Islamic banking—the Gulf and Southeast Asia—would go a long way to enabling the Islamic banking industry to expand and diversify.

The market for Sharia-compliant notes, also known as sukuks, is set to expand rapidly. Standard & Poor's currently rates more than $5 billion of the $10 billion market for listed sukuk, which is expected to grow to more than $20 billion by the end of the decade. In the Gulf, investing in sukuk has become part of mainstream asset allocation and diversification, with Islamic banks in particular seeing these instruments as an important tool in managing their assets and liabilities, and recycling liquidity.

Islamic finance is currently being expanded beyond its historical borders of the Gulf region, where it began to emerge domestically in the 1970s as a result of the oil boom. Other Arab and non-Arab Muslim countries, particularly in Asia, are increasingly attracted by the principles of Islamic finance.

New Horizons

For the first time in the industry's history, several Islamic banks headquartered in the Gulf have recently set up business operations in Malaysia, while making clear that on their radar screens are Indonesia and China—large and deep markets only a short hop away from the Malaysian platform.

New horizons are also emerging for Islamic finance within the Arab universe: Lebanon, Syria, Egypt, Turkey, and, to a lesser extent, North Africa, have been identified as potential engines for unlocking franchise value.

Beyond the natural borders of the Muslim world, the advanced markets of both Europe and the U.S. promise niche segments in which Islamic finance can profitably gain momentum, as shown by the financial community's bullish welcoming of both the Islamic Bank of Britain and its investment banking counterpart, the European Islamic Investment Bank. This is internationalization, but not yet globalization, to which some challenges remain.