Since the inception of the Islamic finance industry in the 1970s, there has been steady growth in the demand for Shariah-compliant products and services. The industry’s total assets reached a high of USD 2.5 trillion globally in 2019. But given the challenges posed by the COVID-19 pandemic, the volatility in oil prices and the uncertain macroeconomic environment, the Islamic finance industry faces unprecedented challenge to its development in the coming months and perhaps even expanding over the next few years.
While it is known that the COVID-19 pandemic will have implications across all financial markets, the effects on the Islamic finance market have the potential to be more severe and create deeper impact. This is mainly due to the fact that the current crisis is affecting small and medium enterprises (SMEs) as well as low income and minimum wage individuals particularly hard. In comparison to conventional banking, Islamic finance has much larger exposure to SMEs, microfinance, and retail lending, exposing them to greater risk of client default or increased claims.
However, Islamic finance has proven to be resilient due to the nature of its offerings and instruments. Islamic banks were able to demonstrate this resiliency in surviving the 2008 global financial crisis with minimal impact. The main reason Islamic financial institutions weren’t affected to the same degree as conventional banks is that Islamic banks provide interest free services and prohibit executing unethical and high-risk transactions. The Islamic banking system also encourages transparency between institutions and their customers. In addition, all cash flows are attached to real assets in the economy — this means that it’s very difficult to create unsustainable levels of debt, as can be seen with conventional banking where debt can be created without much of a limit. These principles insulated Islamic finance institutions from the risk of bankruptcy which many conventional banks faced during the last crisis.
With that said, the future of Islamic finance is ultimately unknown. There is ample room for growth and for Islamic banking solutions to become critical in aiding the recovery following the crisis, but there are many challenges that must also be faced to witness this potential growth. The ultimate outlook will depend on the longevity and severity of the COVID-19 pandemic and its resulting effects – particularly in OIC countries.
Responding to COVID-19 through Islamic Finance
As global governments and development institutions respond to the COVID-19 pandemic, a diverse, dynamic and inclusive set of stakeholders must be engaged to address the enormous challenge of providing support. The UN Secretary-General’s Call for Solidarity outlines three components: tackling the health emergency; focusing on social impact in the response and recovery; and helping countries recover more sustainably for the long term. ICIEC and the Islamic Development Bank (IsDB) mirror these components in their commitment to the 3 Rs – Respond, Restore, and Restart.
Solutions like social distancing policies and government enforced lockdowns are flattening the infection curve at the cost of steepening the recession that is leading the financial system into potential crisis. Economic shutdown has created issues for both supply and demand, creating shocks that reverberate through the global economy. Industries across most sectors have had to cut down production, resulting in job losses. Due to this, both business and civilians are facing significant cash flow constraints.
Islamic finance is an interest free system that is responsible, ethical, sustainable and shock-preserving, thus positioning it well to be part of the COVID-19 response. Islamic financial institutions offer a range of financing instruments that can positively impact every group from SMEs in least developed countries to policy makers in highly developed countries. In April of 2020, the United Nations Development Program (UNDP) highlighted several Shariah-compliant financing instruments that could be part of the integrated pandemic response plan to help countries prepare, respond, and recover from the pandemic.
In the short-term recovery, there is potential for Zakat to be an important component of national and NGO emergency support programmes. Donors typically require that Zakat be disbursed within one year of being given. The focus on immediate benefit is well suited for a crisis response and Zakat donors support both the economically insecure and people living in poverty, an area of increased attention in the pandemic. Zakat donors also often give cash transfers, which can be especially important for liquidity in emergencies.
For the response and recovery in the medium or on-going term, the financing of equipment, resources, and other sources of livelihood through trade finance is a key mechanism in which Islamic banks and financial institutions can support recovery. Social Sukuk and impact investing – private investment prioritizing businesses with social impact – can play a central role in the recovery. Aligning financing activities with the SDGs is another significant opportunity for Islamic banks. Takaful trade credit insurance solutions (as provided by ICIEC) are a critical offering to keep trade flowing.
For long-term recovery and resilience, Waqf endowments can be important contributors to long-term resilience. With Waqf, financial or non-financial assets such as land or buildings are permanently dedicated to social purposes. This can be an important way for stakeholders to contribute to social infrastructure that serves the SDGs and recovery over the longer term. SDG-aligned Sukuk can also be an important source of long-term capital for governments and companies. Unlike conventional bonds which are essentially debt, the underlying asset in Sukuk may be an alternative as Sukuk grants partial asset ownership. ICIEC CEO Oussama Kaissi spoke on ICIEC’s role in enhancing new entrants to the Sovereign Sukuk Origination Market.
“By accessing Sukuk, companies can increase their investor base through stronger ratings, raise loan tenors and decrease borrowing costs,” he claims. ICIEC’s Sovereign Sukuk Insurance Policy provides credit enhancement in transactions involving sovereign and sub-sovereign entities. It insures the Sukuk investor against default on Sukuk issued by sovereign entities of member countries.
Looking to the Future
COVID-19 is shifting the dynamics in the industry. The necessary public health measures have created the need for businesses to change their course of action and overall outlook for the future. Beyond the immediate economic implications, COVID-19 is creating new opportunities by forcing the Islamic finance industry to adapt to rapidly evolving market conditions and speeding up the pace of emerging trends in socially responsible investing, sustainability, and digitalization to mitigate the impact of the outbreak.
Even before the COVID-19 pandemic, Islamic banks have been trying to catch up with conventional banking counterparts by stepping up investment in digitalization to reduce operating expenses, boost revenue and automate internal processes. As financial institutions around the globe implement remote work policies and homebound safety measures, there has been a considerable increase in digital banking transactions and activity, which in turn is providing added force to drive the digital transformation push across Islamic banks. This includes increased automation of processes to minimize the need for human contact as well as digital structures for liquidity management.
Against the backdrop of the COVID-19 pandemic, fintech will continue to play a significant role in the industry’s development in the coming years by improving access to financial services and transforming Islamic social finance. Fintech is an area in which IsDB and ICIEC have already made significant strides in developing. The OIC Business Intelligence Center (OBIC, an initiative which aims to provide accessible and affordable business information and credit data on businesses across the OIC) has been approved and is currently underway.
There are other challenges Islamic banking must face in order to boost growth. Islamic finance is still lacking a global set of standards that is accepted by all stakeholders. In an effort to produce a solution, the United Arab Emirates Ministry of Finance, the Islamic Development Bank, and the Dubai Islamic Economy Development Centre (DIEDC) have recently established a partnership to develop an international legislative framework for Islamic finance. The goal of the framework is to accelerate the growth of the Islamic finance industry and reduce discrepancies around the globe. The partnership will hopefully lead to the standardization of Sukuk by factoring in the requirements of regulators, Sukuk issuers, and investors. When Sukuk becomes comparable to conventional instruments, from a cost and effort perspective, Sukuk is believed to find a more prominent place in the global financial ecosystem.
Prior to the pandemic, the Islamic finance market was poised for strong performance in 2020, but COVID-19 and lower oil prices changed the outlook. Despite the challenging conditions, rating agency Standard & Poor’s has projected that the Islamic finance industry will still show low to mid-single-digit growth in 2020-2021 after the 11.4% growth in 2019 led by strong performance in the Sukuk market. The global rating agency also predicts that the volume of issuance will reach $100 billion in 2020 compared with $162 billion in 2019. S&P claims that coordination between different stakeholders and institutions is key to the industry leveraging these opportunities for sustainable growth. In other words, teamwork is essential. As a leader in multilateral Shariah-compliant insurance solutions, ICIEC stands ready to unite with relevant partners and grow the Islamic finance industry.
