Islamic finance has yet to be fully tested, says study

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Islamic finance weathered the global financial crisis better than conventional banking, but it was not completely immune and has yet to address potential risks, a report by a standard-setting body for the industry says.

Growing pressure on Islamic banks' profitability, liquidity management, asset quality and capital adequacy were outlined by the Malaysia-based Islamic Financial Services Board (IFSB).

Islamic finance, which has its core markets in the Middle East and Southeast Asia, follows religious principles that ban interest and shun outright speculation.

As such, Islamic bank balance sheets were free from sub-prime loans and structured products that turned sour in 2007, triggering a chain of events that threatened to cause a global financial meltdown.

But the IFSB study, which relied on an analysis of data from 52 full-fledged Islamic banks, found that they were not fully insulated from the crisis.

"Economic slowdown, declining trends of commodity prices, and real estate crises that emanated from the financial crisis also affected Islamic banking performance," the report said.

It estimated net profit margins of Islamic banks had recovered to 1.06 percent by 2012, from a low of 0.87 percent in 2009 but still below 2.9 percent in 2007, before the global crisis.

Asset quality was also in the spotlight: non-performing loans peaked at 6.03 percent in 2010, with banks in the United Arab Emirates, Bahrain and Kuwait some of the worst-affected partly due to greater exposure to real estate.

This meant Islamic banks in those countries fared worse in terms of asset quality than their conventional peers.

Such exposure to real estate remains in the double-digits with no significant changes forecast, although the outlook for the Gulf's real estate sector is now positive, the report said.

Capitalisation levels have been a bright spot for Islamic banks, with levels consistently above those of conventional banks, although there is a catch.

"Islamic banks have generally maintained higher levels of regulatory capital, in part, due to an absence of well-functioning and healthy Islamic interbank money markets," IFSB said.

While liquidity has been a perennial concern, the introduction last year of sharia-compliant money market instruments by the International Islamic Liquidity Management Corp (IILM) has helped close this gap.

The IILM is now regularly issuing short-term Islamic paper since its three-month $490 million debut last August, and it is expected to ramp up issuance, the report said.

A lack of foreign currency deposits is also limiting the industry's ability to expand its customer base, with less than 10 percent of Islamic bank deposits held in foreign currencies across all countries except in Turkey and the UAE.

Sukuk, or Islamic bonds, have been a bright spot for the industry but these are also exposed to risks of withdrawal from conventional investors, the report said.

Investors with no specific sharia-compliant investment mandate could withdraw from sukuk in favour of higher-yielding conventional instruments and further research would be needed to evaluate those risks.

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