Islamic finance & oil prices

Press Release

Islamic finance & oil prices

23 Feb 2016

Islamic finance & oil prices: where to now?

Modern banks started offering Islamic finance in the mid-1970s. During that period, there were major developments in the Muslim world which included the oil boom, coupled with a greater sense of cultural awareness and pride as to the fact that the teachings of Islam encompass all aspects of life including how an individual conducts their financial and business affairs.

Since then and as a result of which, Islamic finance begun maturing into a global industry, with total assets today believed to exceed $2 trillion and Islamic financial services available throughout most of the Islamic world as well as parts of Europe and North America given the prevalence and increase in demand.

Approximately 80% of these assets are concentrated in Islamic banks or Islamic divisions of other commercial banks (so-called “Islamic windows”). Sukuk (the Islamic equivalent of bonds) represent about 15% with Islamic investment funds and Takaful (Islamic insurance) making up the remainder.

Geographically, the vast majority of Sharia’a compliant assets are estimated to be concentrated in the Gulf Co-operation Council (GCC) countries and the wider MENA region. However, a significant amount is to be found in Asia and Malaysia, which has been a leading industry player since at least the 1980s.

Islamic finance really started to capture world headlines in the early years of the past decade as annual growth rates often exceeded 15-20% accompanied by rising commodity prices. Islamic finance started to attract the world’s attention as new institutions launched themselves to the market while global players like HSBC, Deutsche Bank, JP Morgan and others invested in Islamic Finance and the growth story.

In the last five years, Islamic finance assets have been growing at a double digit rate. However, with declining oil prices and the looming US interest rate rise, many market commentators are questioning how sustainable this can be over the next few years and whether the growth of Islamic finance is inevitably driven by the fortunes of oil prices.

Despite enviable recent growth rates, Islamic finance assets remain concentrated in the Gulf Co-operation Council (GCC) countries, Iran and Malaysia and still represent less than one percent of global financial services assets.

Oil-exporting countries are some of the key drivers of the global Islamic finance industry. As such, those countries’ public finances are likely to be most affected by the decline in the oil prices. Governments of those oil-exporting countries have often used Islamic finance to diversify their funding profiles but also to demonstrate their support for the growth and development of what is seen as an ‘indigenous’ industry with many local stakeholders.

All six energy-exporting Arabian Gulf states have ambitious development plans and are likely to continue to spend to support overall growth, but if oil prices fall further they may rethink their investment strategy and policies, which will inevitably have an impact on Islamic finance.

Crude settled at $30.44 a barrel, on 12th January 2016, with the U.S. benchmark price dropping to its lowest level since December 2003. While prices now and 12 years ago are the same, the differences in the oil market fundamentals between the two periods are severe.

The last time oil was at these levels, prices were on their way up, not down. China’s oil imports were rising at a double-digit-percentage pace to fuel a rapidly expanding economy while the Organization of the Petroleum Exporting Countries was limiting output to keep prices aloft. Iraq was repairing wells that were ravaged by the Second Gulf War and the Iranian economy was still closed off by sanctions.

Fast forward to today, China’s energy demand could slow together with its economy. Saudi Arabia is pumping oil at a fast pace as it competes with the newfound U.S. producers, and investors will now be bracing for a possible flood of oil from Iran.

However, a recent report by the IMF studied the correlation between oil prices and bank profitability as a result of the global credit crunch in 2008/09. The research revealed that the impact of the last oil price shock on banking profitability was invariably indirect with direct implications for some institutions with weaker risk management frameworks, more aggressive business models and poorer quality asset books.

The study’s results suggested that the impact of oil price shocks was found to be greater with (non-Islamic) investment banks due to a variety of factors including a funding profile dependant on turbulent wholesale markets and revenues driven by trading income and transaction fees both of which are vulnerable to large market swings. Islamic banks typically have a more conservative business model and risk management framework while many source their funding from retail depositors making them less susceptible to fluctuations in the market.

It should be noted though that several Islamic investment banks suffered some of the same stresses of their conventional counterparts. Similarly, the reduction in oil prices is likely to impact conventional financial institutions as well as the Islamic ones.

As such, the decline in oil prices will be a challenge that the Islamic financial services industry needs to closely manage. However, while the industry is still ‘young’ compared to its conventional counterparts, it is far more experienced now having had to weather several economic crises over the years while its regulators and professionals are more seasoned now, having more risk management and diversification tools that they can utilise than perhaps was the case 20 or 30 years ago.

While many GCC states have been withdrawing global cash reserves from asset management institutions around the world, the need for this has often been driven by political developments as much as the impact of oil prices.

According to Standard & Poor’s Ratings Services, growth in the Islamic finance industry may moderate in 2016, growing at a slower pace but will be to some extent counterbalanced by the opening up of Iran and more issuance from non-core markets such Europe, Russia, CIS countries and Africa. S&P, though, expects growth to pick up in the next decade. Iran could be a key market for growth as it emerges out of decades-old sanctions, thanks to the nuclear deal with the West (expected lifting of sanctions in 2016).

At the same time, Malaysia has always been a significant player in the global Islamic finance industry and often dominates global sukuk issuance volumes and yet it would be hard to argue that its economy is heavily dependent on oil prices. Many non-Muslim governments also continue to study Islamic finance as an avenue to diversify their budgets as they maintain their spending momentum in a low oil price environment but also to attract inward foreign investment from new sources.

The British Government made a landmark sovereign sukuk issuance in 2014 to demonstrate its commitment to Islamic finance and the fact that the British economy was ‘open for business’ with Islamic finance.

As for the outlook for oil prices going forward, it seems difficult for the market to reach a consensus. Some local banks believe oil prices will reach $40-50 per barrel within 12 months. Other banks are more cautious and cannot see the price of oil exceeding $30 for 2016.

The variation of petrol prices also would not just affect the Islamic banking industry specifically, but have a systemic effect on the entire banking field. The way in which a particular bank is run, including its type of investment portfolio, will have a large role to play in its success, rather than whether it opts for Islamic or conventional banking.

Hence, it would be difficult, from a legal standpoint, to conclude that the Islamic banking system is in a more vulnerable position compared to the conventional one should there be a continued decline in oil prices.

Most oil producing nations enjoy a stable legal structure that allows for the effective operation of Islamic banking structures side-by-side with conventional institutions. If the wider banking industry suffers from declining oil prices, presumably, policies of both legal and regulatory in nature would be formulated for the banking sector rather than just for conventional or Islamic banks specifically.

On the flip side, Islamic banks are by nature, risk averse. Given their prohibition against gambling, uncertainty and speculation, they are arguably better positioned to protect themselves against high risk and volatile investments.

To conclude, the global economy remains in a difficult place due to the steep fall in oil prices, challenging global equity markets, high regional political tensions and continued reform of global financial markets. Islamic banks only seem more affected by this drop solely due to the fact that the majority of the concentration of Islamic banking takes place in oil rich regions.

Conversely however, the performance of Islamic banks in comparison to conventional banks during these times of crisis and as demonstrated historically, can be deemed more resilient due to more stable and conservative business models.

Written by Samer Hijazi, Partner and Head of Islamic Finance, as featured in the February edition of Business Islamica Magazine.