This article first appeared in The Edge Malaysia Weekly on March 8, 2021 - March 14, 2021

GROWTH prospects for Islamic banking will remain strong in South and Southeast Asia (SEA) over the long term with demand expected to be driven by young, growing populations as well as government efforts to develop the sector, says Moody’s Investors Service.

The region, which includes key Muslim-majority markets like Malaysia, Indonesia, Pakistan and Bangladesh, is deemed one of the world’s brightest spots for Islamic banking growth.

According to Moody’s analyst Tengfu Li, the driving forces for growth in the region far outweigh the challenges.

“I think South and SEA is a bright spot in the sense that its population is still big and growing compared with many other countries where there seems to be a downward trajectory,” he tells The Edge in an interview.

He points out that prime-age populations, or those aged 25 to 54, are growing fast in this region, with Pakistan and Malaysia taking the lead among the Muslim-majority markets (see chart).

This aspect, along with a cultural affinity towards halal products and services, will underpin demand for Islamic financial services.

Li notes that Malaysia stands out as a prime candidate to come out with the region’s first digital-only Islamic bank. The government plans to give out up to five digital banking licences.

“Given these, we expect that Islamic financing will continue to expand faster than conventional lending, resulting in the share of Islamic financing in total financing further increasing,” he says.

In Malaysia, he projects that Islamic financing will grow at around 10% this year. Growth last year as at Sept 30 stood at above 9%, double that of the overall banking industry’s 4.4% despite the Covid-19 outbreak.

As for Indonesia, he sees Islamic financing growing at “slightly more than 10%” this year. Last year, it grew at 9.42%, in contrast to the 0.55% loan growth of conventional banks. President Joko Widodo said last month that Islamic banking assets grew almost 11% last year compared with the 7.7% growth of conventional banking assets.

“Islamic financing growth in Malaysia and Indonesia will still be driven by the consumer segment, and that ties back to the structural demand in terms of the young population and the demand for housing there,” Li says.

Governments in South and SEA are also pushing for Islamic banking development, given the sector’s role in increasing financial inclusion and inherent alignment with environmental, social and governance (ESG) principles.

The Indonesia government, in particular, is catching up with peers in terms of efforts to develop the sector. In January, an Islamic megabank — Bank Syariah Indonesia — was created from the merger of three government-owned Islamic banks. The move, part of a five-year plan the government unveiled in 2019 to develop the halal ecosystem, is expected to increase the Islamic banking sector’s economies of scale and improve its competitiveness.

“Indonesia is really underpenetrated, in our view. Although there were a lot of plans in the past to develop the sector, nothing much happened. But in the last couple of years, we’re really seeing some strong implementation coming through,” Li remarks.

Despite being the world’s most populous Muslim nation, Indonesia’s Islamic banking penetration rate is low, at under 10%. As a matter of comparison, Brunei’s penetration rate, at almost 60%, is the highest in the region mainly because of one large state-owned bank that dominates the whole banking system, while Malaysia’s is the second highest at almost 40%.

Malaysia, which is the region’s Islamic finance leader, is already “fairly developed”, notes Li. While it may be challenging to increase the Islamic banking penetration rate much further, the government is nevertheless focusing on doing so through the ESG front.

According to Li, this year, as part of a push for Islamic banks to adopt value-based intermediation (VBI), an impact-based approach underpinned by shariah principles, Bank Negara Malaysia will expand guidelines for the banks to incorporate ESG considerations in financing.

“This will help them avoid prematurely writing down or devaluing assets because of uncertainty surrounding governments’ environment policies, and identify new growth opportunities, such as those related to the renewable energy sector,” Li says in a recent report on the sector.

“For public consultation, the central bank will issue draft guidelines for providing financing to the manufacturing, oil and gas, and infrastructure and construction sectors, as it did for the palm oil and renewable energy sectors and energy efficiency projects in 2020,” he adds.

Meanwhile, in Bangladesh, the central bank last year approved three requests from banks, including Standard Bank Ltd and NRB Global Bank Ltd, to convert into Islamic banks. This was a major development for the sector considering that the central bank had not approved any in the prior 10 years. More conversions will raise awareness of Islamic finance and drive demand, says Li.

As for Pakistan, its central bank in July 2020 started allowing conventional banks to have Islamic banking “windows” — basically, dedicated counters within branches — on condition that those branches become fully shariah-compliant within three years.

In the Philippines, two local banks and one foreign bank have expressed interest in setting up Islamic banking units. This follows the passing of the Islamic Banking Act in the country in August 2019.

According to Li, Islamic banks in the region are in a good position to meet the increased demand for financing this year as economies bounce back from the Covid-19 pandemic.

“Although Islamic banks’ profitability in these regions weakened in 2020, their capital buffers remain mostly robust, supported by government measures to soften the impact of the coronavirus outbreak. Strong capitalisation will in turn enable Islamic banks to meet increased demand for financing as economies recover,” he says.

Li expects non-performing financing (NPF) in the region to peak only towards the end of this year or early 2022. This is because most governments still have some form of regulatory forbearance in place that allows banks to temporarily restructure repayment terms for stressed accounts without having to classify them as default.

“In Malaysia, the targeted repayment assistance will expire in June 2021 … it may take a couple of months before accounts turn non-performing, and that’s why we think the NPF will peak towards the end of the year or even early 2022. For Indonesia, it could be even later because the restructuring programme there goes all the way to March 2022,” he says.

Given that, Moody’s is of the view that Islamic banks’ profitability will recover at a fairly modest level this year from the low base last year, with a stronger recovery seen only in 2022.

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