Islamic banks in GCC countries have become systemically important and continue to increase their market penetration, outpacing conventional banks, Moody's Investors Service said in its report on Islamic banks. In Saudi Arabia, where even conventional banks offer Islamic products, Islamic finance assets represent more than 50% of system financing. In Saudi Arabia, the largest Islamic banking system by assets in the GCC region, the retail deposits at Islamic banks represent more than 80% of their deposit bases. The retail focus of Islamic banks in GCC countries provides greater stability for their funding profiles and hence typically offers a significant advantage over their conventional peers in terms of LCRs. The strong historical presence of Islamic banking in GCC countries is reflected in long-established Islamic financial institutions, such as Al Rajhi Bank or Kuwait Finance House, which are the two largest, and among the oldest, Islamic lenders in the world. They had total assets of about $88 billion and $56 billion respectively, as of June 2016. Such a long history, coupled with a higher preference for Shariah-compliant products among their majority Muslim populations and the Islamic banks' extensive distribution networks, are key reasons behind the success of the retail businesses of these banks across the region. In Kuwait and Qatar, such assets account for around 40% and 29% of the system, respectively; higher than 23% in Malaysia and just over 5% in Indonesia. In Qatar, the segregation of Islamic and conventional banking operations since 2011 has helped Islamic banks to build solid franchises with loyal retail customer bases. However, the Islamic banks are not yet large enough to establish a retail base comparable to those of Saudi Arabia and Kuwait. In contrast, banks in GCC countries which are more reliant on corporate deposits and institutional funding display lower LCRs because of the higher outflow rates that their funding bases attract. Sustained lower oil prices continue to reduce the flow of deposits from the government and government-related entities in the region, creating funding and liquidity pressures for the banks, pushing up market funding levels. In addition, a tougher economic environment has also resulted in an overall slowdown in corporate deposits inflows in most GCC countries. In contrast, the granularity and relative stability of retail deposits continue to provide support to Islamic banks' deposit bases. As deposit growth slows, we expect banks to increase market funding in order to bridge the funding gap and support credit growth, which will in turn pressure their LCRs. For example, in Saudi Arabia, the system average LCR declined from around 184% at end-2015 to 158% at end-June 2016 because of continued credit growth coupled with slowing deposit growth and a greater reliance on market funding. Despite tightening liquidity in the region, Islamic and conventional banks have generally coped well. Liquid assets remained at around 20%-30% of banks' total assets at end-June 2016. In Malaysia, Islamic banks are much more reliant on corporate depositors than conventional banks and, as these corporate deposits attract higher run-off rates than retail deposits, they are punitive for the banks' LCRs. Malaysia's banking sector is saturated and highly competitive, with banks vying with higher-yielding wealth management products for depositor funds. Due to the close alignment of Islamic and conventional products in Malaysia, both types of banks compete with one another for deposits. However, the Islamic banks' smaller branch networks constrain their ability to tap new retail deposits. Instead, Islamic banks have been successful in securing wholesale corporate deposits to fund asset growth. Unlike retail banking, the wholesale banking business is less dependent on the size of branch networks for growth. The larger Islamic banks are wholly owned subsidiaries of their parent banks and the largest, such as CIMB Islamic, Maybank Islamic and RHB Islamic, which operate on a "leverage model"2, are highly integrated with their parent banks in terms of product development, marketing and risk management. These banks rely heavily on the resources and branches of their conventional parents in growing their customer base. As such, they benefit from advantages of scale and are more successful in gathering retail deposits than those Islamic banks which function on a standalone basis. Such standalone banks operate a small number of Islamic branches and typically have high cost-to-income ratios because of their lack of scale. As small branch networks limit exposure to the retail segment, these banks tend to have a smaller percentage of retail deposits than the larger integrated Islamic banks. For example, Maybank Islamic and CIMB Islamic are able to offer their products and services through their network of 300-400 branches in Malaysia, as compared to standalone Islamic banks like Bank Islam (unrated) and Bank Mamualat (unrated) with smaller network of less than 150 branches. In Indonesia, Islamic banks remain very small relative to the operations of their conventional parent banks but their business focus has been towards the retail and SME sectors. This strategy has enabled them to establish a higher reliance on retail deposits than conventional banks. Overall banking penetration remains low in Indonesia, presenting significant opportunities for Islamic banks to expand their retail deposits, particularly among the more Shariah-sensitive rural populations. At the same time, growth in the Islamic banking business is often constrained by small branch networks and capital bases. The further development of domestic sukuk markets will continue to be positive in improving the availability of HQLAs for Islamic banks, particularly in GCC countries. Islamic banks globally face a greater challenge than their conventional peers in sourcing HQLAs, in view of the continued scarcity of Shariah-compliant instruments in the market. The large amounts of cash and bills held by Islamic banks are positive from an LCR standpoint, but negative from a profitability perspective. However, the governments of Malaysia, Indonesia and Qatar are regular sukuk issuers, providing a more supportive environment for their Islamic banks. In Kuwait, the scarcity of HQLA-eligible instruments mainly affects the Islamic banks, as exemplified by their higher proportion of liquid assets in cash and central bank placements. Meanwhile, conventional banks in Kuwait – as in other GCC countries have access to regular issuance of bonds and treasury bills from the central bank. We attribute the banks' low holdings of HQLA securities to the small pool of outstanding Shariah-compliant sovereign and corporate sukuk in the Kuwaiti market. This situation is due to (i) consecutive years of government budget surplus – until 2014 – which has reduced the need to borrow through public debt issuance, and (ii) the absence of a legal framework for sukuk, which continues to hamper domestic issuance. However, with a budget deficit forecast of around 10% of GDP for 2016 and a new sukuk legislation in progress, "we expect the government to launch its first issuances before year-end, and thereby provide the banks with this much-needed instrument for liquidity management," Moody's said. Similarly, in Saudi Arabia, a scarcity of Shariah-compliant HQLAs is apparent. The Saudi government has thus far chosen to issue only bonds and not sukuk. Such a situation puts Islamic banks at a disadvantage relative to conventional banks as it means that Islamic banks only have cash and short-term, very low yielding, Shariah-compliant bills with the central bank, Saudi Arabian Monetary Agency (SAMA) as their only forms of HQLA-eligible assets. Since mid-2015, the government has issued more than $40 billion of conventional domestic bonds to local banks as it seeks to cover a budget deficit of about 12% of GDP for 2016. It is also expected to borrow again in October and is targeting to attract liquidity from the US and Europe where investors are less familiar with sukuk structures. Future issuances are likely to be in the conventional format, similar to those seen recently in the UAE and Qatar, and hence the shortage of Shariah-compliant HQLAs in Saudi Arabia is unlikely to improve in the near future, Moody's noted. Further sukuk issuances by the GCC sovereigns will also support the development of the domestic corporate sukuk markets and increase the availability of HQLA for Islamic banks. In contrast to Saudi and Kuwait, Malaysia, Indonesia and Qatar have been frequent sovereign sukuk issuers in recent years, providing a solid stock of Shariah-compliant HQLAs for both their domestic Islamic and conventional banks. In Malaysia, Islamic banks are also supported by a deep and vibrant domestic corporate sukuk market, reflecting a long history of regulatory support and adding to the stock of HQLA-eligible instruments in the system. In Indonesia, the Islamic banking sector remains very small relative to the overall economy, and hence the supply of government sukuk remains fully adequate in meeting the LCR needs of its Islamic banks. In addition, specialized multilateral institutions, such as the Islamic Development Bank (IDB), the International Islamic Liquidity Management Corporation (IILM) and the Arab Petroleum Investments Corporation (Apicorp), have become regular sukuk issuers and will continue to play a key role in adding to the pool of HQLA-eligible assets much needed by Islamic banks.
