Growth in Islamic finance will likely slacken in 2016, said Standard & Poor's Ratings Services in a report Monday titled "Islamic Finance to Still Grow in 2016 but With a Sag." "The industry has achieved critical mass – Islamic finance assets worldwide exceed $2 trillion by our estimate. But we now think the industry faces challenges from the decline in oil prices, changes in the global regulatory framework for banks and insurance companies, and its own fragmented nature," said Standard & Poor's Global Head of Islamic Finance Mohamed Damak," it said. The report forecast a single-digit growth in Islamic finance in 2016, after a decade of 10%-15% growth on average. "We are currently witnessing the end of the global commodities super-cycle that started in 2005, which we think will drag down economic growth in some core markets and consequently reduce opportunities for Islamic finance," the report noted. Standard & Poor's now assumes that oil prices will average $63 per barrel between 2016 and 2018. 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, though, S&P forecast that 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 report added. However, Islamic finance will have the impetus to continue progressing and maintain some growth, the report noted. 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 Shariah ruling could enhance industry integration and free stakeholders' capacity to focus on innovation. "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," Damak added. This development is attracting the interest of major financial institutions, such as the International Monetary Fund and the World Bank, and some advanced countries, the report said. "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. 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. Moreover, S&P believes 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. The report anticipates 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 that can absorb losses under specific circumstances, the report said. 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-in-able 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, S&P report remarked. In insurance, the implementation of Solvency II, or risk-based capital requirements for insurers, could aid in strengthening the resilience of the takaful industry. According to S&P report, 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 Shariah 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. — SG
