Some of the Arabian Gulf's major Islamic banks have increased their asset base by acquiring smaller rivals and may now take advantage of historically low interest rates to issue long-term sukuk that can help fund their further expansion.

Global volumes of sukuk — an Islamic finance certificate similar to a bond — plunged in the first quarter of 2020 and issuance will likely shrink 40% in value terms this year versus 2019, according to S&P Global Ratings estimates, as large capital outflows from emerging markets and uncertainty over the economic impact of the coronavirus pandemic deter would-be issuers.

But the respective currency pegs in Gulf Cooperation Council, or GCC, countries have made the flight to safety less pronounced there, and most sukuk from the region are priced in dollars.

"The banks would like to issue sukuk opportunistically, whenever it's cheapest for them — right now isn't a bad time to borrow," said Anita Yadav, partner and advisory board member at Aspire Capital in Dubai.

"Banks' credit quality will probably come under pressure 12-18 months down the line and their credit spreads might widen, so banks might want to take advantage of the low benchmark yield curve now. I wouldn't be surprised if Saudi Arabia's Islamic banks come to the market now."

Some markets front-loaded sukuk, such as in Saudi Arabia, where "such issuances stemmed from the proactive sourcing of funds by the Islamic Development Bank and Riyad Bank before the market turbulence began," Ratings said.

Alternative funding options

Four of Saudi Arabia's 12 commercial banks are Shariah-compliant, while the remaining eight conventional banks provide Islamic products. Combined, the Islamic quartet hold around a quarter of total banking sector assets, according to a note from AlJazira Capital.

"If those banks need liquidity, then they have to think about sukuk and about issuing in local currency because the way risk weighted capital is calculated, it's a lot easier to do that if your reserve money is in the local currency," said Yadav.

Saudi Arabia's Al Rajhi Banking & Investment Corp. is the GCC's largest Islamic bank by assets, S&P Global Market Intelligence data shows, with Kuwait Finance House KSCP, or KFH, second and Dubai Islamic Bank (PJSC), or DIB, third.

KFH in April postponed its acquisition of Bahrain's Ahli United Bank BSC until December due to the coronavirus, while DIB in January completed its takeover of local rival Noor Bank PJSC, creating an entity that at that time had assets of around $75 billion. Saudi state-run National Commercial Bank has long stated plans to become fully sharia-compliant, has attempted to buy domestic rivals and owns Türkiye Finans Katılım Bankası AŞ, an Islamic bank in Turkey.

"There has been significant consolidation among Gulf Islamic banks and we may expect substantial sukuk issuance to fund these newly enlarged banks' banking activity. They now have the scale to issue bigger sukuk and to raise funding," said Maya Marissa Malek, CEO of Dubai's Amanie Advisors, a specialist sharia advisory firm.

Islamic banks can also take out Islamic loans, which can be cheaper than doing a sukuk.

"A loan gives more flexibility," said Yadav.

'Systemic credit fragility'

Yet despite the low interest rates, growing investor risk aversion is widening spreads making it more difficult for issuers with weak credit quality, Ratings warned. Government moves to boost banking sector liquidity has also lessened the need for corporations to issue sukuk, with most financing instead coming directly from local lenders.

"Quality credits can fund themselves for 10 years for a few percentage points — levels that were unimaginable a decade ago," said Khalid Howladar, senior managing director and head of credit and sukuk advisory at R.J. Fleming & Co in Dubai.

"We're in a new paradigm for debt and sukuk service costs. All else being equal, this would actually be a fantastic time to borrow; however, at the same time we have a pandemic that is highlighting systemic credit fragility and a massive oil price shock."