LONDON: Is the Islamic financial sector better able to withstand shocks during times of crisis, such as the global COVID-19 pandemic, now entering its second year? In the 1980s and 1990s, the World Bank indeed published two research papers inter alia by the likes of pioneer economists Abbas Mirakhor and Mohsin Khan which concluded that the industry may be in a better position to absorb and mitigate the shocks associated with economic and financial crises.

During the Turkish financial crisis of 2001, some 21 conventional financial institutions collapsed compared to one participation (Islamic) bank, Ihlas Finance, whose failure had more to do with mismanagement and unlawful exposure to group companies rather than the impact of the industry per se.

Malaysia’s Islamic banking sector

Islamic financial institutions (IFIs) have held their own since the 2008 global financial crisis and there is every indication that they have done the same during the current COVID-19 pandemic, albeit with the caveat that the financial sector per se, like other sectors of the economy, has received government and regulatory support in economies the world over.

The resilience of the Islamic finance industry could not be better illustrated than by Malaysia's Islamic banking sector. The ‘Big Three’ international rating agencies, Fitch Ratings, Moody’s Investors Services and Standard & Poor’s (S&P) Global, in recent reports have all projected robust expansion of the Islamic finance industry in 2021, especially in Malaysia and Saudi Arabia, the two largest such markets in the world.

Fitch, in a commentary in February 2021, maintained that the Malaysian Islamic banking sector “continued to expand in 2020 amid economic challenges from the coronavirus pandemic”. The country continues to be the largest Islamic banking, sukuk and takaful market in ASEAN.

“In 2021,” added Bashar Al Natoor, Global Head of Islamic Finance at Fitch, “we expect the Malaysian Islamic banking sector’s credit profile to remain stable with adequate loss-absorption buffers, despite near-term pressure on asset quality and profitability. In the medium term, penetration of Islamic finance is likely to continue to rise on the back of an economic recovery, a supportive regulatory environment, and banks that continue to promote Islamic products.” This on the back of an increased GDP growth forecast of 6.7% in 2021, up from the projected contraction of 5.6% in 2020.

Moody’s similarly stressed in its report that “Saudi Arabia will remain the world’s largest Islamic banking market, while the sector will continue to expand in Malaysia. Oman and Turkey will also continue to grow rapidly in Islamic banking”.

S&P Global echoed these sentiments: “We expect Islamic banking to show, at best, stable total assets or low single-digit growth. This follows 6.6% growth in 2019 thanks to good performance in the Gulf Cooperation Council (GCC) countries, Malaysia, and to a lesser extent Turkey and Indonesia.”

Financing post-COVID recovery

A regulator’s perspective of the resilience and suitability of the Islamic finance sector in helping to mitigate the economic impact of the pandemic comes from none other than the Bank of England (BoE), arguably the most proactive supporter of Islamic finance in the non-Muslim countries.

“Some worry that COVID-19 might slow the pace of growth in Islamic finance, as economic activity declines and market participants revert to more conventional tools to meet the daunting financing needs of the crisis,” explained Andrew Hauser, Executive Director, Markets at the Bank of BoE at the recent UK Islamic Finance Week.

“That needn’t be so – because key aspects of Islamic finance make it particularly well suited to financing the post-COVID recovery,” he maintained.

“The philosophical focus on equity-like sharing of risk and reward,” he observed, “will become increasingly relevant as market participants get to grips with the scale of debt accumulated in response to COVID. The attractions of debt are obvious when interest rates are so low – particularly for those able to lock in long-term fixed rates in local currencies. But those borrowing at floating rates, at short maturities, or in foreign currencies, face sharp negative income shocks when rates rise, debt rolls over, or local currencies depreciate.”

To him, risk-sharing contracts, including those promoted by Islamic finance, pose materially lower medium-term risks to stability. “The Bank of England has long advocated the risk-sharing merits of GDP-linked instruments, which could be packaged in Sukuk form. Together with HM Treasury and the FCA, we have recently announced a high-level working group to consider ways to foster a longer-term financial markets culture to support productive investment,” he revealed.

That Islamic finance seeks to avoid investing in socially detrimental activities is also a major advantage. In fact, according to Hauser, “it was pro-ESG before the term was ever invented! Issuance of so-called ‘green Sukuk’ has risen sharply in the past three years – and the Islamic Development Bank issued an innovative US$1.5 billion sustainability Sukuk in June. But these are still quite modest numbers relative to the vast sums of money now looking to invest in credible ESG assets. There’s plenty of scope for further growth.”

Malaysia’s march towards achieving dual financial system parity in a mere three decades or so has been truly remarkable and impressive, arguably setting the template which many other countries are following. Ever since the then Governor of Bank Negara Malaysia (BNM), the late Tan Sri Jaafar Hussein, declared in the early 1980s: “I have a dream that in my lifetime Malaysia would have a dual banking system – a conventional system operating side-by-side an Islamic one cooperating but not inter-mingling,” Putrajaya has never looked back.

The share of Islamic financing in the banking system reached 37% by end-2020, up from 35% at end-2019, with Islamic financing contributing nearly all of the banking sector's growth in 2020. This was driven by household financing and banks that promoted Islamic products as part of their "Islamic First" strategy.

It is a stated aim of both the Malaysian Government and BNM for the country’s Islamic finance sector to reach a 50% market share of the total banking sector assets by 2030. This is the dual financial system parity that Tan Sri Jaafar was dreaming of. He did achieve establishing the dual system in his lifetime, but when the Malaysian Islamic banking sector eventually hits that 50% market share target it would be a remarkable achievement in the global financial system, albeit of a niche phenomenon. It would also be the realisation of Tan Sri Jaafar’s bold dream and a vindication that Islamic finance can eminently work at a macro-economic level and be a transformative alternative financing model in an era of ESG, sustainable and SRI finance in line with the UN’s SDG agenda.

The COVID-19 pandemic did adversely affect the Malaysian economy, as it has economies the world over. The government responded with several rescue packages. The progress of the Islamic banking sector may have been consumed by the general anxiety over health well-being and livelihoods, giving the impression that the sector in Malaysia was in hibernation. The reality is the opposite.

Islamic banks in good stead

In fact, the measures taken by the Islamic banks during the pandemic have stood them in good stead in 2020 and, by projection, in 2021. Loan moratorium and other reliefs provided by Islamic banks to vulnerable borrowers since 2Q 2020 have masked the banks’ underlying asset quality. Islamic banks’ gross impaired financing rose by 9% quarter-on-quarter in 4Q 2020, similar to the conventional banks’ trend but, says Fitch, the Islamic banks’ impaired financing ratio remains low amid a growing portfolio base.

“We expect impairments to accelerate and credit provisions to remain high in 2021, despite advance provisioning in 2020 that boosted Islamic banks’ reserve coverage to 1.5% of financing, up from 1.1% in 2019.”

Malaysia’s Islamic banking sector's capitalisation and liquidity buffers in 2020 appear adequate, with stable common equity Tier 1 and financing/deposit ratios of 14% and 94.4% respectively (more-or-less comparable to the 14.1% and 93.6% in 2019). The liquidity coverage ratio, according to Fitch, is comfortably above the minimum requirement despite falling to 137% from 153% in 2019. Islamic banks’ presumed net cash outflows are higher as deposit tenors were cut by more than at conventional banks.

Malaysian Islamic banks have a bevy of unique investment accounts such as risk-sharing Mudarabah and Musharakah) investment accounts, which accounted for 6% of Islamic customer deposits in 2020. True, they are not guaranteed under Malaysia’s deposit insurance scheme (DIS). In other jurisdictions, these accounts are typically covered by DIS or government guarantees. “Although they are contractually loss absorbing, we have not seen cases of depositors bearing losses,” explained Fitch’s Bashar Al Natoor.

Even the impact of the transition from LIBOR (London Interbank Offered Rate) which will be discontinued by end-2021, will be contained. “Discontinuation would require legacy Islamic contracts to be individually renegotiated and this is made more complex by Syariah requirements. Islamic banks’ exposures to Libor benchmarks are nevertheless small and manageable, and with the cessation of most US dollar Libor settings likely to be deferred to June 2023, aggregate remaining exposures should be contained,” he added.

The sustainability of the progress of the Malaysian Islamic banking sector in 2021 was underlined by the various reliefs, extensions and incentives announced in the National Budget 2021 by Finance Minister Tengku Datuk Seri Zafrul Tengku Abdul Aziz.

There is another area where the Malaysian government has assumed pole position which augurs well for the Islamic finance sector in 2021 and beyond. Putrajaya is pushing the sustainability, ESG and socially responsible investments (SRI) agenda in cooperation with BNM and the Securities Commission Malaysia (SC). In January 2021, for instance, the SC expanded its Green SRI Sukuk Grant Scheme to encourage more companies to finance green, social and sustainability projects through SRI Sukuk and bonds issuance.

“With this expansion, the grant is now renamed as SRI Sukuk and Bond Grant Scheme and applicable to all Sukuk issued under the SC’s Sustainable and Responsible Investment (SRI) Sukuk Framework or bonds issued under the ASEAN Green, Social and Sustainability Bond Standards (ASEAN Standards),” explained SC Chairman Datuk Syed Zaid Albar.

Tengku Zafrul, in his budget speech, keen to further encourage the issuance of SRI Sukuk and bonds that meet green, social and sustainability standards in Malaysia, extended the existing income tax exemption on grants amounting to RM6 million to finance the external review expenses, limited to RM300,000, for Green SRI Sukuk to all SRI Sukuk and bonds which meet the ASEAN Green, Social and Sustainability Bond/Sukuk Standards approved by the SC; and extending the income tax exemption period by five years. These exemptions are for applications received by the SC from 1 January 2021 to 31 December 2025.

Sustainability agenda

In the Islamic capital market (ICM) too, Malaysia has led from the front in pushing the sustainability, ESG and SRI agenda in the Islamic debt market. Ever since the SC introduced its SRI Sukuk Framework in 2014, the first of its kind in the global ICM, Malaysia has pioneered facilitating SRI, Green Sukuk and ESG products, primarily through tax exemptions and other incentives. This latest measure brings grant and other government support for sustainability, ESG and SRI debt instruments under one umbrella scheme. The government is committed to the UN’s Sustainable Development Agenda.

In August 2020, the Government issued its first digital Sukuk online, the RM500m (US$123.4m) Sukuk Prihatin, which was oversubscribed to the tune of RM666m. Putrajaya will also continue the Green Technology Financing Scheme 3.0 with a fund size of RM2 billion for two years up to 2022 which will be guaranteed by Danajamin, the state-owned financial guarantee insurer of bonds and Sukuk, to encourage the issuance of SRI Sukuk.

Malaysia made up 19% of Sukuk and bonds issued under the ASEAN Standards. As at December 2020, says the SC, RM5.4 billion SRI Sukuk have been issued under the SRI Sukuk Framework, out of which 58% or RM3.1 billion are also recognised under the ASEAN Standards, and another RM635 million bonds issued under the ASEAN Standards. This, added Datuk Albar, signified the demand for an asset class that meets the criteria for Shariah as well as sustainable and responsible investing.

The above developments also come under the Sustainable & Responsible Investment Roadmap (2019-2024) for the Malaysian Capital Market which aims to create a facilitative SRI ecosystem and chart the role of the capital market in driving Malaysia’s sustainable development.

According to the SC, it is estimated that in the next 10 years, the world needs about US$5 trillion to US$7 trillion every year to fund the UN’s Sustainable Development Goals while in Malaysia, it is projected that in the next five years, the market will require RM45 billion to finance the long-term development goals. “The capital market can play a critical role to address this gap especially in the green, social and sustainable sectors,” added Datuk Albar.

The Roadmap identified 20 strategic recommendations to drive the development of a facilitative and vibrant SRI ecosystem and position Malaysia as a SRI centre in the region. These include widening the range of SRI financing instruments, increasing SRI investor base, building a strong SRI issuer base, instilling strong internal governance culture, and designing an information architecture in the SRI ecosystem.

Malaysia’s capital market is also beholden to the ongoing impact of COVID-19. Tengku Zafrul on Jan 18 unveiled his latest stimulus package designed to mitigate the impact of a resurgence of the virus and the new round of tightened social distancing measures.

Another sign of the ‘health’ trajectory of the Malaysian Islamic finance sector is the Sukuk and bond issuance activity of Cagamas Berhad, the National Mortgage Corporation of Malaysia, one of the most prolific issuers of Sukuk. In January 2021, Cagamas started the year with aggregate issuances of RM710 million in four tranches, followed by aggregate issuances of RM945 million in three tranches in February 2021.

Proceeds from the issuances will be used to fund the purchase of house financing and housing loans from the financial system. The total funds raised from the market in the first two months in 2021 has already reached RM1.7 billion. Last year the Corporation’s total combined issuances for 2020 amounted to RM11.7 billion, making it the most proactive Islamic mortgage securitiser.

According to Datuk Chung Chee Leong, President & CEO of Cagamas Berhad, “as optimism for an economic recovery rose due to the increased rollout of COVID-19 vaccinations coupled with more opening up of economic activities, fixed-income investors turned cautious, weighing in the downside risk stemming from ongoing uncertainties in the near term. Notwithstanding, demand for short-term papers remain well supported as evidenced by the successful conclusion of our issuances.”

Cagamas model

The Cagamas model is well regarded by the World Bank as the most successful secondary mortgage liquidity facility. Cagamas is the second largest issuer of debt instruments after the Government of Malaysia and the largest issuer of AAA corporate bonds and Sukuk in the market. Since incorporation in 1986, Cagamas has cumulatively issued circa RM318.3 billion worth of corporate bonds and Sukuk.

Another area where Malaysia is leading from the front is in Fintech especially related to the Islamic finance sector. The country inched forward to licensing the first digital banks (DGs) in the 57-member Islamic Development Bank (IsDB) member countries. BNM issued a Policy Document on Licensing Framework for Digital Banks on 31 December 2020 following a six-month public consultation.

The framework, added BNM, adopts a balanced approach to enable admission of digital banks with strong value propositions whilst safeguarding the integrity and stability of the financial system as well as depositors’ interests.

Digital banks will be required to comply with the requirements under the Financial Services Act 2013 (FSA) or Islamic Financial Services Act 2013 (IFSA), including standards on prudential, Syariah governance, business conduct and consumer protection, as well as on anti-money laundering and terrorism financing.

Currently, there are no dedicated Syariah-compliant digital banks anywhere in the world. Albaraka Türk Participation Bank established a Syariah-compliant digital offshoot, Insha, in Germany in 2018 with a €5 million investment, but it does not have a standalone full-banking licence. Other initiatives on the cards include MyMy in Malaysia and IBA in Australia, which hopes to get a licence from the Australian Prudential Regulation Authority in 2021.

It is interesting that BNM’s policy document, in a departure from previous policy, allows for a foreign shareholder to hold an aggregate equity interest of more than 50% in a Malaysia-licensed digital bank. The idea is to attract FDI into the banking digitisation services and help build up scale in digital banking operations, which may be limited due to lack of local resources.

-- BERNAMA

Mushtak Parker is a London-based independent economist and writer.