Development of Islamic capital markets could help the sector better support the real economy

Islamic banks have been tremendously successful in the five decades since the first sharia-compliant lenders were launched and are growing at a faster rate than their conventional counterparts.

Yet some in the industry question whether the non-bank Islamic finance sector is better suited to providing long-term, risk-based funding for infrastructure and real-economy projects that would fulfil the industry’s mandate to support the communities in which it operates.

So, why do Islamic banks struggle to participate in long-term lending? The answer lies in their main source of funding, which is mostly from retail customer deposits, particularly in the Gulf. This means Islamic banks prefer to offer shorter-term lending; using retail deposits to provide 15-20-year infrastructure financing would be too hazardous a mismatch.

To play a greater role in infrastructure and project finance – currently the preserve of conventional banks – Islamic banks would have to issue 5- to 20-year sukuk. That would be difficult to justify when until recently they were paying nothing to savings and current account holders, while at the same time lending to corporate and retail borrowers at profit rates of around 7% and 10% respectively; issuing long-term sukuk would require the banks to pay 8-9% themselves, making it near-impossible to achieve similar margins.

Another consideration is that Islamic banking, like conventional banking, is more focused on debt-based, rather than equity-based financing.

“That creates some problems in Islamic finance because unlike conventional finance there’s little flexibility in terms of renegotiating the terms once the debt is created,” said Habib Ahmed, Professor of Islamic Law & Finance at Britain’s Durham University.

“Consequently, that means Islamic debt-based structures tend to be short-term to avoid the risks involved in long-term financing.”

Such issues led the World Bank to co-author a 2018 report that calls for the Islamic finance industry to expand its capital markets and focus on the likes of crowdfunding, leasing companies and venture capital firms to provide equity-based financing.

“The biggest challenge in achieving the potential of Islamic finance for funding long-term investments lies in the dominance of the Islamic banking subsector,” the report states.

Industry experts warn that in markets where corporate and institutional borrowers are used to easy bank financing, Islamic capital markets will take time to grow, although the oil price slump helped accelerate that process as Gulf governments responded by issuing sukuk and reforming regulations and infrastructure.

“Governments need to build the financial infrastructure and issue sukuk and other Islamic financial instruments in order to reach a threshold level, which will then encourage private sector entities to do likewise,” said Ahmed. “To invest in capital markets, investors must be confident the financial system can protect their rights. Without that, capital markets won’t develop.”

Islamic finance has two main centres: The Gulf and South East Asia. In the Gulf, there is an insufficient domestic investor base – pensions funds and mutual funds, for example – that wants to invest in fixed income, rather than equity markets. Smaller private sector companies do want to obtain more Islamic finance and would consider sukuk but are deterred by the exorbitant costs of issuing a public market sukuk and the lack of local investor demand.

“As well as developing more robust Islamic capital markets, the focus should also be on developing Islamic non-bank institutions,” added Ahmed. “This will enable us to meet the objectives of Islamic finance, which includes using risk-sharing modes of financing.”

Yousuf Mohamed Al-Jaida, Chief Executive Officer, Qatar Financial Centre added: “According to The World Economic Forum, in its Global Competitiveness Report 2017-18, the Qatari capital market “is the best and most important” financial market in the Arab region.

In line with Qatar National Vision 2030, the strengthening and development of the Qatari capital market is vital. At the QFC we see strong demand for financing in the local economy to stem government spending/projects, in particular those requiring foreign capital. This is where there is clear opportunity for Islamic capital markets to play a strong role.”

Equity-based financing tends to be higher risk and longer-term. Regulation and Islamic banks’ organisational structure prevent them from participating at present, so the industry is likely to turn more towards fintech alternatives such as sharia-compliant crowdfunding platforms. Currently, these tend to focus on funding real estate projects, although questions remain as to how investors can easily exit.

“The development of equity-based capital markets could play an important role in mobilizing resources without creating leverage in the economy,” the World Bank report adds. “Islamic finance is well suited for long-term financing because of its emphasis on materiality, property rights, risk sharing, and addition of value.”

Institutional investors in Islamic finance include Islamic pensions funds, endowments (waqf) and insurance firms (takaful) and they represent a small but growing component of the industry. Such funds could be better positioned to invest in longer maturities, although their take-up of sukuk products has so far been limited.

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