Total assets of the global Islamic finance industry continues on its growth path. S&P Global Ratings expects high-single-digit growth in 2024-2025 after a growth of 8% in 2023 (excluding Iran). Although Islamic banks in Saudi Arabia grew at a slightly lower pace than peers in other countries, there was a significant drop in Kuwait as 2022 numbers were inflated by a large acquisition. In the United Arab Emirates (UAE), Islamic finance growth quickened in 2023 thanks to the robust performance of the non-oil economy. Other Islamic finance countries contributed only 15% of the industry's incremental growth in 2023.

The sukuk market also saw good but softening growth in issuance volumes. We expect sukuk issuances to hover between $160 billion and $170 billion in 2024, furthering the industry's asset growth in 2024. The sukuk market has started 2024 strong, with total issuance reaching $46.8 billion at March 31, 2024, compared with $38.2 billion at the same date a year prior. Moreover, the Islamic funds and takaful sectors are likely to expand further. We continue to exclude Iran from our calculations due to Iranian banks' lack of disclosure.

Familiar challenges for the industry have spilled into 2024, namely concentration in a small number of countries and complexity of transactions and standards. Islamic finance struggles to attract interest beyond its core markets--countries across Central Asia and Africa, and parts of Europe. This has kept the Islamic banking industry embryonic in these markets and sukuk activity sporadic. The way standards are evolving could also compound the limited geographic diversification. In its exposure draft on sukuk (Standard 62) published in late 2023, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) proposed fundamental changes in many of the foundations of the market. In our view, if the standard is adopted as proposed, headwinds may emerge from 2025 and beyond.

The drive for digitalization and sustainability initiatives have yielded mixed results. While opportunities related to sustainable finance are significant as the industry is concentrated in oil exporting countries, progress has been relatively slow and limited in the global context. Similarly, digitalization has helped the banking side of the industry, but we have yet to see strides in the capital market activities through tokenization and digital sukuk. The prerequisite of having global and supportive standards is a major hurdle.

Strong But Concentrated Growth

The Islamic finance industry continued to expand in 2023, with assets increasing 8.0% in 2023 compared with 8.2% in 2022. This stemmed from growth in banking assets and the sukuk industry (see chart 1).

Chart 1

Banking assets are behind more than half of Islamic finance's growth story

Islamic banking assets growth contributed to 56% of the industry growth in 2023 compared with 72% in 2022. Kuwait Finance House's acquisition of Ahli United Bank in 2022 and the lower growth in Kuwait in 2023 are the main driver of this drop. Overall, financial institutions across the Gulf Cooperation Council (GCC) accounted for 86% of the asset growth in 2023, with Saudi Arabia as the chief contributor, having generated 56.7% of the growth. We expect the implementation of Vision 2030 and growth in corporate and mortgage lending to continue supporting the Islamic finance industry over the next 12-24 months. In addition, the UAE showed a stronger contribution in 2023 thanks to the good performance of the nonoil sector. Elsewhere, we observed some growth, particularly in Turkiye and Indonesia. The performance in Malaysia and Turkiye was somewhat tempered by the depreciation of the ringgit and the lira (see chart 2).

Chart 2

We expect activity in Saudi Arabia to continue supporting the growth of Islamic banking assets in 2024-2025. In other GCC countries, mid-single-digit growth appears plausible in the absence of new major investment cycles.

We expect the Islamic banking industry in Asia-Pacific to deliver high-single-digit growth over the next couple of years. Robust demand for Islamic products and services and considerable untapped market potential in Indonesia, Bangladesh, and Pakistan uphold this trend. Nonetheless, the Islamic banking market in Asia-Pacific will remain concentrated with Malaysia controlling the lion's share. Financing growth of Islamic banks will continue to outshine conventional banks' credit growth, facilitating market share gains. The growth, in U.S. dollar terms, could be somewhat tempered by the depreciation of local currency, though.

Volatility of local currencies is also relevant for Turkiye and Egypt. We expect local currency growth in these two countries to continue to be strong, but the overall performance will be dimmed by the weakening local currencies. We therefore expect the overall contribution of these two countries to the industry total assets to remain modest.

Sukuk issuance: cautiously optimistic for 2024, uncertain afterward

We expect global sukuk issuance will reach $160.0 billion-$170.0 billion in 2024, from $168.4 billion in 2023 and $179.4 billion in 2022. The drop in issuance volumes in 2023, which mainly resulted from tighter liquidity conditions in Saudi Arabia's banking system and Indonesia's lower fiscal deficit, was somewhat compensated by an increase in foreign currency-denominated sukuk issuance. The market has started 2024 on a strong footing, with total issuance reaching $46.8 billion at March 31, 2024, compared with $38.2 billion at March 31, 2023 (see chart 3). Saudi Arabia was a key contributor to this performance.

Chart 3

Better visibility on the medium-term trajectory of interest rates, particularly toward the end of 2023, benefited foreign currency-denominated sukuk issuance, which increased by a third in 2023, compared with 2022. This trend has continued in the first quarter of 2024 with foreign currency issuances increasing by almost 80% (see chart 4).

Chart 4

Financing needs in core Islamic finance countries remain high, given ongoing economic transformation programs, particularly in Saudi Arabia. We expect the sukuk market to fill in some of these needs. Specifically, we see some opportunities in the structured finance space with banks tapping the sukuk market to refinance their sizable mortgage books (either directly or indirectly through the Saudi Real Estate Refinance Company). At year-end 2023, mortgage lending reached SAR607.2 billion ($161.9 billion), representing a 7.6x increase over the past decade. Long-term financing represented 48.6% of banks' total financing at year-end 2023 compared with 27.2% at year-end 2013, accentuating banks' maturity mismatches. As banks strive to balance their funding profiles, the sukuk market appears as a natural partner, in our view.

A key hurdle remains investor confidence regarding banks' capacity to foreclose on mortgages in case of default. Legal reforms and a stronger track record could help kickstart issuances in this segment. In the meantime, banks could resort to offering back-up coverage to cater for that risk if accepted by Sharia scholars. The development of a residential mortgage-backed sukuk market in Saudi Arabia, whether in riyal or in U.S. dollar, leveraging the credible peg between the two currencies, could also act as a catalyst for similar movement in the GCC region. The key risk that we anticipate for this trend is the backpedaling of some standard-setters through new requirements that could affect market equilibrium. However, the time needed to develop and implement standards makes this an area to watch only from 2025 and beyond.

Takaful and fund industries still play their role

Despite their small contribution to the industry, we expect the takaful and fund sectors to grow further. We expect takaful to expand at an annual rate of about 10%, underpinned by ongoing business growth and profitable investment returns. Fund growth will hinge on the performance of the capital markets given the dominance of money market and sukuk funds, followed by equity funds.

Overall, we believe a high-single-digit growth rate is achievable for the industry over the next two years. We continue to exclude Iran from our calculations due to the lack of disclosure and volatility of the country's exchange rate.

New Standards, Old Challenges

We expect the adoption of AAOIFI Standard 62--in its current proposal--would have a significant effect on the sukuk market. Among others changes, the standard requires that the ownership and the risks related to the underlying assets are transferred to sukuk holders. While this could help the development of residential mortgage-backed sukuk markets in countries that adopted AAOIFI standards, other forms of sukuk--especially those backed by sponsors' contractual obligations--might become more difficult to structure. These sukuk transactions currently account for the bulk of the market. Also, sovereigns may be unwilling to transfer their assets since it could be perceived as a disguised privatization. In addition, corporates may be reluctant to lose control of their assets, considering the move could markedly increase their cost of funding or deprive them from the future appreciation of these assets.

The market may not be ready for these material changes. Yet, some scholars think that this is the only way forward. S&P Global Ratings doesn't comment on Sharia compliance. We do think, however, that a more determined move to alter established standards may result in a weakening in the sponsor contractual obligations, or worse, the introduction of new contractual obligations, that sponsors may have to breach, in order to maintain the fixed income characteristics of the sukuk. Inevitably, some conventional fixed income investors might shy away from the sukuk market, and this could change the pricing dynamics of such transactions to account for potential additional risks.

At this stage, it is hard to tell whether Sharia Standard 62 will be adopted as proposed and how countries that adopted AAOIFI standards may react to the potential impact on their sukuk markets. Another potential outcome of Sharia Standard 62, as proposed, is the eventual higher fragmentation of the sukuk market and a more pronounced difference between adopters and non-adopters of the standard. We note that, even if the standard is approved, as proposed, this year, its implementation may be deferred to the following years; this could cause an increase in the volume of issuance of sukuk before the standard's adoption.

Fragmentation Prevails

We see the Islamic finance industry as a collection of local industries rather than a truly globalized sector. In 2023, the GCC accounted again for the bulk of the growth of the industry's banking assets. Similarly, Malaysia and GCC countries accounted for a large portion of the sukuk market during the same period. We saw some activity from new issuers (such as Egypt, Air Lease Corporation and Philippines), but it remained rather opportunistic and sporadic. The industry is yet to resolve challenges related to its competitiveness and appeal beyond Sharia compliance. In our view, achieving this objective may hinge on stronger action from regulators. Technology has helped the Islamic banking industry expand, particularly during the pandemic. Leveraging the opportunities related to disintermediated financing is still a work in progress. From digital sukuk to tokenization, the opportunities appear significant on paper, but the road to get there is rocky. The lack of physical and nonphysical infrastructure is not helping either.

Sustainable Issuances Are Rising But From A Low Base

The GCC region was home to 70% of the Islamic banking assets and 37% of sukuk issuance in 2023. Many of these economies rely on the recycling of oil revenues and the overall sentiment related to oil price dynamics. We therefore consider that the effect of oil and gas production and prices, as well as investors' and customers' appetite for carbon-intensive sectors, is a long-term risk for GCC economies, sovereigns, and banking systems. However, we think GCC sovereigns have certain competitive advantages, such as low extraction costs and the ability to increase production capacity, that will likely act as mitigating factors for GCC economies and banking sectors. Given their ownership structure, GCC banks are likely to continue supporting their respective governments' climate transition objectives. All GCC countries, apart from Qatar, have already announced net-zero commitments. Some of them have also announced climate related investment commitments. These policy shifts highlight GCC countries' increasing focus on the energy transition.

In addition to supporting their governments' agenda, GCC banks are trying to advance their relatively nascent sustainability programs by increasing their sustainable finance offerings to customers and contributing to government efforts to decarbonize local economies. However, we have yet to see bold regulatory actions in the region to encourage banks to reduce climate transition risks.

The total volume of sustainable sukuk issuance continued to increase in 2023, compared with 2022 (see chart 5). We expect higher volumes as issuers meet investors' demands and core Islamic finance countries seek to reduce their carbon footprints. COP28 shed more light on the opportunities of Islamic finance in general and sukuk in particular to tackle climate change. This is being helped by the regulators such as the Dubai Financial Services Authority (DFSA) exemption of regulatory fees for issuers listing their sustainable securities in the Dubai International Financial Centre (DIFC) in 2024. The introduction of the green financing framework by Saudi Arabia is also helpful in identifying the types of eligible projects to be funded through green bonds and sukuk. Similarly, we think regulatory incentives will facilitate the increase in sustainable sukuk issuance in Malaysia. These include Malaysian Security Commission's grant scheme to cover 90% of the cost incurred by issuers on independent expert reviews of sustainable sukuk issuance and tax deductions on issuance expenditures until 2025 under its Sustainable and Responsible Investment Sukuk framework.

Chart 5

Trends That Will Shape The Future Of Islamic Finance

In our view, the future of Islamic finance is sustainable, collaborative, and digital. It is sustainable thanks to the alignment between Sharia principles, overarching pillars of sustainability, and the value proposition of Islamic finance that capture more than just financial objectives. The future is collaborative because it is not in the interest of stakeholders to disrupt the industry equilibrium and erase the development that was achieved over the past half century. Finally, digitalization will come into play because leveraging emerging technologies could help the industry enhance its efficiency and ultimately its value proposition for investors and issuers.