Asia-Pacific is proving fertile ground for Islamic banking. Financing growth in core markets, such as Malaysia and Indonesia, is eclipsing that of conventional banking. And we believe the stable economic conditions in these markets will ensure steady expansion and broadly stable asset quality for Islamic banks for the next few years, at least.

S&P Global Ratings expects Islamic bank financing in Asia-Pacific to increase at a high single digit, in local currency terms, during this period. Depreciation of local currencies could, however, temper the growth in U.S. dollar terms.

The momentum will be uneven. The sector is not homogenous. In the core markets, the top end of the Islamic banking segment is heavily concentrated, with a few large players holding a sizable share of the market. In contrast, the bottom end of the scale is highly fragmented, with banks holding a small market share each.

In our view, Malaysia will remain the biggest Islamic banking market in Asia-Pacific, with about two-thirds of the sector's total assets of about US$400 billion. But some large Islamic banks in the country could find it difficult to maintain their overall high growth if their retail deposit growth doesn't keep pace. Banks will have to diversify into other funding sources such as investment accounts or rely on wholesale deposits, which are generally more expensive.

But there's still room to grow. The launch of new Islamic banks in Malaysia and other Asia-Pacific markets this year could improve access to financial services for underserved regions and segments, such as small businesses. Indonesia is likely to be a growth hotspot, given its significant untapped potential. Bangladesh also has potential, but a liquidity shortage and weak external demand there are likely to weigh on financing growth over the next one to two years.

Risks in Asia-Pacific are tilted toward the downside, due to higher-for-longer rates and rising geopolitical tensions. Small businesses and low-income households are vulnerable to sustained higher costs of living and rates. In such a scenario, we would expect both financing demand and asset quality to falter. Banks' ample capital and provisions provide a buffer against rising stress.

Why Market Share Is Rising

In our view, demand for Sharia-compliant products and services will continue to propel the financing growth for Islamic banks and increase their market share across Asia-Pacific. The momentum is largely coming from two areas. First, the "Islamic first" strategy in Malaysia, in which customers are offered Sharia-compliant products by default. And, second, untapped demand in Indonesia.

These factors helped Islamic banks' financing growth outpace the credit growth of conventional banks in 2023. The banking sector's overall loan and financing growth dipped in Malaysia and Indonesia last year due to higher rates.

For Malaysia, we forecast 9% financing growth, in local currency terms, for the next two to three years. This is slightly higher than the 8.5% achieved in 2023 and reflects our expectation that economic expansion will strengthen to about 4.5% over 2024 and 2025, compared with 3.7% for 2023.

Stable labor market conditions and a steady policy rate of 3% should continue to support financing demand in the country. Malaysia's Islamic banks had a market share of about 41% of sector loans and financing as of end-2023. This figure is likely to exceed 45% by the end of 2026.

Chart 1

Momentum for sustainable financing is gaining traction in Malaysia. We believe Islamic banks will play a key role in advancing inclusive financing, in line with the central bank's value-based intermediation (VBI) principles. The VBI framework provides sector-specific guidance to local Islamic banks on delivery of financial services. It shows Bank Negara Malaysia's clear focus on the segment making a positive impact on the economy, the community, and the environment.

As of end-2022, VBI financing made up about 11% of total financing in Malaysia. Of this, 79% was related to social financing and the remainder to net zero and green-related financing. Social financing is largely directed towards small businesses, affordable housing, and public infrastructure. About half of net zero and green financing goes to the corporate sector, mainly for renewable energy and green buildings.

Chart 2

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New Islamic Banks Could Unlock Growth

Malaysia's first Islamic digital bank, Aeon Bank, will start to operate by the end of the second quarter of this year. The bank plans to target underserved segments, mainly small businesses. We anticipate that Aeon will initially offer higher deposit rates to attract funds, a move common to all digital bank launches in the region.

We don't anticipate competition for deposit rates will intensify on the entry of a new player, given large banks have a sticky and diversified customer base.

Digital banking could improve access to Sharia-compliant digital services for small businesses. However, such banks are likely to be niche players in Malaysia's saturated banking sector. This is because market segments that are underserved by conventional banks are small.

In addition, competition from conventional banks is intense, given many of them have been ramping up lending to small businesses in search of growth and stronger margins. Large Malaysian banks have also been stepping up digital investments to improve services to this segment.

Regulations cap digital banks' operations during the foundational phase (three to five years from launch) to Malaysian ringgit (MYR) 3 billion in assets. In comparison, Maybank Islamic, the largest Islamic bank in Malaysia, has an asset base of MYR287 billion.

The Philippine push

In the Philippines, the regulator has taken steps in recent years to improve financial access in the underbanked, Muslim-majority region of Mindanao. These include publishing guidelines for establishing an Islamic bank or unit, reporting requirements, management of liquidity risk, and setting up of a Sharia supervisory board.

The Philippine central bank recently granted an Islamic bank license to Card Bank, a rural bank primarily involved in microfinance. The bank launched its Islamic operations in February 2024. A window remains open for further applicants, given there are only two Islamic banks currently.

Malaysian banks that already operate in Philippines could also be interested in extending their products and services to this area. Their expertise in this field and search for higher profitability segments in the region support our view.

Consolidation Could Increase In Indonesia

In Indonesia, we forecast financing growth will slow to a still-healthy 14%-15% in local-currency terms over the next two to three years, due to higher rates. The Indonesian regulator made a surprise rate hike in April 2024 to rein in rupiah depreciation, bringing the policy rate to 6.25%.

Our forecast for financing growth remains higher than our forecast for the overall banking sector's loan and financing growth of 8%-10% for the next two to three years. The share of Islamic financing in sector loans and financing has crept up to 8% as of end-2023 (6% as of end-2017) but is still low. This reflects Indonesia's low Sharia financial literacy and tough competition from conventional banks.

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The regulatory framework could spur consolidation, increase efficiency, and promote competition. Currently, state-owned Bank Syariah Indonesia dominates the sector, with 40% of assets. The regulator mandates that larger Sharia business units must be divested into a new entity or merged with an existing Islamic bank within two years if:

• they reach a size of Indonesian rupiah (IDR) 50 trillion in assets; or
• form more than 50% of the parent bank's asset base.

Asset Quality Should Be Stable

Stable economic and labor market conditions in core markets should support asset quality. Consumer financing constitutes the bulk of financing for both Malaysian and Indonesian banks, and are mainly in the form of secured products, such as properties and vehicles.

We forecast a moderate rise in the nonperforming financing ratio in Malaysia to 1.7% as of end-2024 from 1.5% as of end-2023. This could come from restructured financing of low-income households and small businesses. As of end-2023, restructured loans and financing formed 2.4% of the overall banking sector's loans and financing in the country. Sustained currency depreciation could affect import-reliant sectors such as manufacturing, construction, and agriculture.

Spillover risks from currency depreciation should be manageable, in our view, given the banking sector's limited direct exposure to external debt. Further, exposure to corporates with unhedged foreign currency exposure forms just 0.5% of the sector's total loans and financing.

Chart 5

In Indonesia, the expiry of COVID-driven restructuring forbearance measures on March 31, 2024, could add 150-200 basis points to the nonperforming financing ratio of 2% for the Islamic banking sector as of end-December 2023. In our opinion, this increase will be manageable because banks have built up meaningful provisioning buffers in the past few years.

In Brunei, asset quality is likely to remain stable, underpinned by our forecast of healthy nominal GDP growth. This should be driven by steady expansion in non-oil and gas (O&G) segments and ongoing recovery in production of O&G since 2023. High-income levels also support borrowers' creditworthiness.

Islamic banks in Bangladesh will continue to face the same structural challenges and trends as conventional banks. These include weak governance, less-sophisticated underwriting and lending standards, and low capitalization.

The capitalization of Islamic banks in Malaysia, Indonesia, and Brunei is generally healthy and provides an adequate loss absorption buffer. We believe the banks' capitalization should remain steady across the region, with the exception of Indonesia. Here, high growth could moderate the extremely high regulatory Tier-1 ratio of about 20%.

Profitability Trends Will Vary

Malaysia:  We forecast that Islamic banks' net financing margin will contract by a high single-digit in 2024 due to rising competition for property financing--even though the policy rate has peaked and deposit competition appears to have subsided. Return on assets could decline by 10 basis points to 0.9%, by our estimates.

Islamic banks' higher share of term deposits and corporate deposits makes their funding costs highly sensitive to rate increases.

The profitability of Malaysian Islamic banks is generally in line with the overall banking sector's, but in 2023 the gap widened to 1.0% versus the sector's 1.2%. This is because the net financing margins of Islamic banks significantly contracted during 2023, given the upward repricing of term deposits and intense deposit rate competition. This was sharper than the contraction in net interest margins at conventional banks. For the Islamic bank subsidiaries of rated Malaysian banks, margins contracted 37 basis points on average compared with 28 basis points at the group level.

Indonesia:  The profitability of Islamic banks could moderate in 2024 due to slower financing growth and rising funding costs. Islamic banks' return on assets will likely continue to trail that of conventional banks, due to the weaker operating efficiency and asset quality of smaller Islamic banks. Bank Syariah Indonesia's operating efficiency and asset quality have improved over the past two years and are broadly in line with that of its parent bank, Bank Mandiri.

Brunei:  Banks' earnings will be good in 2024, in our view, as interest rates remain higher for longer. The banks' margins should remain healthy, given the financing rate repricing while deposit costs say low.

Bangladesh:   We expect profitability to be low for Islamic banks in Bangladesh over the next two years, and broadly in line with the industry average of a return on assets of about 0.5%-0.7%.

Similar to other banks, Islamic banks' financing rates should also continue to benefit from the introduction of a new lending rate benchmark for commercial banks (SMART, or six-month moving average treasury rates) in July 2023. Under this, a bank can price loans up to 375 basis points above the benchmark rate. The increase in the cost of funds should temper some of the benefit.

Funding Remains A Challenge In Malaysia

The funding profiles of Malaysia's Islamic banks will likely stay weaker than that of the overall sector, reflecting structural weakness in attracting low-cost retail deposits. Islamic banks tend to have higher concentration in wholesale funding, given their traditional reliance on non-retail deposits to support financing growth. This is due to legacy reasons such as difficulty in getting customers to switch from conventional banks for low-cost deposits.

Promotional rates on term deposits generally work. However, banks are likely to avoid offering a big rate differential over a conventional deposit product to keep the cost of funds in check. Islamic banks therefore end up negotiating slightly higher rates for wholesale deposits to increase funds. These tend to be sticky because the process to switch can be lengthier than that for a retail customer, i.e., switching involves board approval and negotiation.

Chart 6

The financing-to-deposit ratio of Malaysia's Islamic banks was 105% as of end-December 2023, and will continue to creep up as deposit growth lags financing growth. For large banks, we believe funding could restrain incremental growth as Islamic financing increases as a share of the total group loans and financing. To overcome this challenge, the sector has been gradually diversifying funding sources; for example, by increasing funding from investment accounts.

Funding conditions in other markets

Indonesia:  The financing-to-deposit ratio of Indonesian Islamic banks is also rising but is still below 90%. We believe Indonesian banks' wide margins give them ample space to let funding costs rise slightly if they need to fund incremental growth through higher-cost deposits in the retail or wholesale space.

Brunei:  Brunei banks' financing-to-deposit ratio is well below that of peers such as Malaysia and Indonesia. Brunei banks put excess liquidity into instruments such as government bonds, interbank deposits, and placements to generate satisfactory risk-weighted returns.

Chart 7

Bangladesh:  Liquidity challenges will persist for the Bangladesh's Islamic banks. The segment is more vulnerable to liquidity challenges than conventional banks. The regulatory statutory liquidity ratio limit for Islamic banks is 5.5% of the total demand and time liabilities--much lower than the 13% for conventional banks.

Islamic banks in Bangladesh have a limited amount of Shariah-compliant investments, such as sukuk bonds for liquidity management. The sector has also shown vulnerability due to weak depositor confidence.

In addition, a foreign exchange scarcity in Bangladesh has made it difficult for banks, including Islamic banks, to service their obligations in U.S. dollars. Islamic banks witnessed deposit withdrawals in 2022 and 2023 triggered by allegations of loan irregularities at a few banks, including the largest bank by assets, Islami Bank Bangladesh PLC.

A Market Ripe For Development

The fundamentals are positive for growth. Asia-Pacific has the largest Muslim population in the world, at more than half of the total. Yet the region is only the second largest Islamic banking market, after the Gulf Cooperation Council. As of end-2023, Asia-Pacific Islamic banks had a global market share of about 20% of Islamic banking assets (excluding Iran).

We believe rising awareness, a regulatory push, and new competition from the digital space will invigorate the sector. But funding and liquidity challenges in certain pockets of the region could constrain the robust growth.

While untapping the potential of Islamic banking in Asia-Pacific won't be easy, the effort is already paying off.

Related Research

• Islamic Finance 2024-2025: Resilient Growth Anticipated Despite Missed Opportunities, April 29, 2024
• Malaysian Banking Sector Review: Standing Firm In The Face Of External Headwinds, April 22, 2024