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Islamic Finance In The U.K. Is Still Learning To Crawl

This report does not constitute a rating action.

Islamic finance is still a nascent segment in the U.K. This is despite the government having issued two sovereign sukuks and the listing of several sukuks on the London Stock Exchange (LSE). S&P Global Ratings believes that Islamic finance will likely remain a very minor player in the U.K. Routes emerging from the fintech space or even environmental, social, and governance (ESG) considerations could generate more attention, particularly among non-Muslim clients. However, we don't anticipate greater traction until the industry shows a real economic added-value compared with conventional banking solutions and beyond the compliance with Sharia principles.

Islamic Banking Has Found A Niche In Real Estate Financing

At end-2021, U.K.-based Islamic banks held total assets of £5.7 billion, representing less than 0.1% of the domestic assets. Globally, U.K. banks hold nearly 0.5% of total Islamic banking assets at end-December 2021, according to the Islamic Financial Services Board (IFSB). Sukuk issuances have not taken off either, with the two transactions issued by the U.K. government amounting to £750 million and one Islamic bank's residential mortgage-backed sukuk for £250 million. There are four Islamic banks in the U.K. now that one of the initial five banks converted its presence to a nonregulated branch of its parent group to focus on commercial real estate financings. There are no reports on the size of the Islamic assets of conventional banks providing Islamic financial services, but we understand that it is also marginal.

Table 1

U.K.-Based Islamic Banks And Their Shareholders
Bank Country of origin Shareholders

Abu Dhabi Islamic Bank PJSC*

United Arab Emirates Abu Dhabi Islamic Bank

Al Rayan Bank PLC

Qatar Masraf Al Rayan

Bank of London and the Middle East PLC

U.K. Boubyan Bank
Gatehouse Bank U.K. Shareholders from Kuwait among others
QIB UK Qatar Qatar Islamic Bank
*Converted to a non-regulated branch.

Most of the U.K.-based Islamic banks' business comprises lending and remains concentrated on real estate financing. The banks remain primarily deposit funded with an average loan to deposit of 97.5% at end-2021. Asset quality is still solid, with a nonperforming loans (NPLs) ratio of about 1.5%, according to the IFSB. Although this ratio has more than doubled since the start of the COVID-19 pandemic, the NPL coverage ratio of 30.3% at end-2021 suggests good backing by collateral. That said, considering these banks' material concentration on retail activities, alongside encroaching risks of recession and high inflation, we expect some pressure on Islamic banks' asset quality indicators.

High provisions and low margins are probably the main factors underpinning Islamic banks low profitability. At end-2021, the return on assets was 0.1% and return on equity reached 1.2%, despite a relatively good efficiency with a cost to income of 49.5% at the same date. It remains to be seen if the banks will benefit from an increase in interest rates. The current structure of their balance sheets, with mortgages on the asset sides and short-term deposits on the liabilities side, suggests that higher rates would likely have a negative impact, at least over the next few quarters.

A tier 1 ratio of 16.8% at end-2021 shows that Islamic banks in the U.K. are adequately capitalized. Their liquidity appears solid, with a liquidity coverage ratio at 4.4x. In December 2021, the Bank of England (BoE) opened the Alternative Liquidity Facility (ALF) to allow Islamic banks to deposit their excess liquidity with the BoE and receive a remuneration based on the performance of an underlying portfolio of high-quality sukuk. In its first iteration, the fund included sukuk issued by the Islamic Development Bank. We consider this to be a positive development for the Islamic finance industry since it offers the needed high-quality liquid assets for banks to comply with regulation.

Table 2

U.K.-Based Islamic Banks' Key Numbers
2017 2018 2019 2020 2021
Total assets (bil. £) 3.8 4.5 5.5 5.6 5.7
Total financings (bil. £) 3.0 3.8 4.8 5.1 5.3
Tier 1 capital ratio (%) 21.0 17.9 16.2 16.2 16.8
Total capital ratio (%) 22.3 19.3 17.3 17.6 18.3
Credit risk
Nonperforming financing ratio (%) 1.8 1.3 0.6 1.4 1.5
NPF coverage ratio (%) 31.9 49.0 37.7 19.8 30.3
Return on assets (%) 0.6 0.4 0.3 0.3 0.1
Return on equity (%) 4.3 2.9 3.1 2.6 1.2
Cost to income ratio (%) 78.5 49.9 48.2 44.1 49.5
Funding and liquidity
Liquid assets/total assets (%) 14.8 11.8 7.1 5.2 6.8
Liquidity coverage catio (x) 3.9 3.2 4.0 2.5 4.4
Source: Islamic Financial Services Board, S&P Global Ratings.

Sukuks Are No Game Changer

More than a year after the repayment of the £200 million sukuk it issued in 2014, the U.K. returned to the sukuk market with a new £500 million Ijara sukuk in March 2021. However, market appetite for this sukuk was markedly lower than the for the first one; issuance of the Ijara sukuk closed with 1.25x oversubscription (order book of £625 million), while the first sukuk was oversubscribed by 10.0x. The pricing of the latest issuance was similar to that of conventional instruments, and its structure is similar to the sale/leaseback structure of the 2014 sukuk. The underlying assets of the latest issuance include several office properties owned by the government, which will then lease back the buildings for a rental amount that is expected to be equivalent to the periodic distribution amount. At the maturity of the sukuk, a purchase undertaking is expected to be executed to repay investors.

However, over the eight years since the U.K.'s debut sukuk, U.K. corporates or financial institutions have not ventured into Islamic finance, except for the one £250 million residential mortgage-backed sukuk. Despite significant exposure to real estate financings, we have not seen other banks tapping the market. This leads us to believe that private sector issuers in the U.K. see little added value for sukuks in their funding profile. We understand that some issuers have been deterred by the Islamic finance's complexity compared with conventional bonds. What's more, the adoption of some of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) standards seems to increase the perceived difficulties.

Where London continues to make a difference is in the listing of sukuk. The LSE continues to be one of the main destinations for listing sukuk, although competition from Luxembourg and Dubai has risen over the past few years. At the end of July 2022, 15 sukuks were listed on the LSE with a total nominal amount of about $13 billion. According to the LSE, a cumulative total of 68 sukuks (including matured transactions) have been listed over the past two decades, exceeding a nominal amount of $50 billion.

Fintech And ESG Alignment Could Spark Attention

We see a couple of avenues for the Islamic finance industry's growth in the U.K.: fintech and ESG. We have observed a few Islamic fintech entities, one of which is affiliated with a U.K.-based Islamic bank, with activity ranging from neo-banking to money management or crowdfunding. We believe that the presence of young, tech-savvy Muslim customers could yield some growth opportunities. On the other hand, ESG alignment may also attract interest from non-Muslims or other atypical clients. The use of sustainability sukuk or a stronger focus on the social responsibility of the industry could up Islamic finance's prominence for investors and other interested parties that are not participating purely for the Sharia-compliant nature of the transactions.

Primary Credit Analyst:Mohamed Damak, Dubai + 97143727153;
Secondary Contact:Dhruv Roy, Dubai + 971(0)56 413 3480;

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