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Across Southeast Asia there's growing belief in its US$290 billion Islamic banking market. Over the next three years, we expect the market to grow at a compound annual growth rate of about 8%, primarily led by Malaysia and Indonesia. The region currently forms 17% of the US$1.7 trillion in global Islamic banking assets. This makes it the third largest market after the Gulf Cooperation Council--comprising Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates--and the Middle East. Malaysia and Indonesia hold 81% and 15%, respectively, of Southeast Asia's Islamic banking assets. Brunei holds 4% of the assets while other markets in the region are tiny.

In Malaysia, the sector's potential for long-term growth is promising. And it's a similar story in Indonesia where the profitability of Islamic banks is gradually catching up to that of conventional peers. In Brunei, Islamic financial institutions constitute about half of the total financial system assets. In the Philippines, the sector is small but there is an untapped market and regulators are striving to increase transparency in a bid to encourage local and foreign investment. As they increase their market share, Islamic banks have become more digitally adept and alive to the growing interest in responsible investing. Malaysia's Islamic banks, in particular, are likely to benefit from the issuance of international sustainable sukuk.

This trajectory will of course face inevitable hurdles. The region's recovery from COVID-19 has been uneven. And in Malaysia, for instance, pandemic-related loan relief has distorted the true health of asset quality. Meanwhile, geopolitical shockwaves have pushed up energy and commodity prices, which could affect domestic demand. Although Indonesia is a net energy exporter, much of its surplus is driven by coal exports. The country is also an oil importer. Oil product consumers will still feel the pinch of higher crude prices. Similarly, while oil majors in Malaysia benefit from much higher oil price, the rest of the economy will need to shoulder the surging energy bill.

Then there are interest rates. We forecast a rate hike of 50 basis points (bps) in 2022 for both Malaysia and Indonesia. Higher interest rates can potentially improve loan yields and profitability, but the higher repayment burden along with inflationary trends can affect asset quality. This could be particularly burdensome for small and midsize enterprises (SMEs) and low-income households, which are still struggling to recover from the pandemic.

Islamic Banks Will Increase Their Market Share

Malaysia

The Malaysian Islamic banking sector remains highly attractive. It has promising long-term growth potential, which is supported by the country's favorable policy environment, a vigorous and innovative industry landscape, and local banking groups' "Islamic first" business strategy. We estimate GDP growth of 5.8% in 2022, higher than the 3.1% in 2021. We forecast Malaysian Islamic banks to grow at a compound annual growth rate of 6%-8% over the five-year period of 2022-2026. This means local Islamic banks could account for close to 45% of the overall commercial banking loan book by the end of 2026, up from 37.5% in January 2022. That said, short-term headwinds may hinder the recovery in loan growth. This is because of Islamic banks' retail and SME-focused portfolios, which will recover gradually from the pandemic following the economic trends. Like their conventional peers, the portfolio of Islamic banks is tilted more toward mass-consumer banking and SMEs and less toward large corporates, which fulfill a large part of their financing needs through capital market borrowings. This skew could mean a slower rebound of loan growth in 2022 and a need to maintain elevated credit costs for longer.

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Indonesia

We anticipate Islamic banks in Indonesia will also continue to grow faster than conventional banks, given ample growth opportunities and low penetration. In Indonesia we expect GDP growth of 5.1% in 2022, higher than the 3.7% in 2021. The country's banks should benefit from improving economic conditions. We forecast credit growth of 12%-14% for the Islamic banking sector, closer to pre-COVID levels, compared to 8%-10% growth for conventional banks. The key driver of growth will be the consumer portfolio, which forms about half of the sector's loans, and comprises mainly mortgages and payroll loans. In 2021, economic disruptions from COVID-19 caused Islamic banks' credit growth to dip to 7% from 8% in 2020. However, this was still higher than the 5% credit growth for conventional banks.

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Islamic banks and business units account for 7% of total loans in Indonesia, which is small, although their market share has been growing because of their higher credit growth. This market share could increase to 9% by end-2026. The planned conversion of a few conventional lenders into Sharia banks could further lift the market share. The newly formed Bank Syariah Indonesia (BSI) has a 42% share of Sharia financing and is growing at a higher pace than the sector average. The bank was formed in February 2021 through a merger of Sharia subsidiaries of the three largest state-owned conventional banks. A stronger state-owned Sharia bank will play a major role in increasing Sharia finance literacy among the public, thereby supporting increased penetration of Sharia financing products and services.

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Brunei

Islamic financial institutions constitute about half of the total financial system assets in the hydrocarbon-dominated economy of Brunei. We expect performance of these institutions to mirror that of the broader banking system. We anticipate overall bank credit growth will be 3%-5% in the next 12-18 months. The bulk of the expansion is likely to come from wholesale customers as the government looks to boost the economy and support local firms through contracts from government-linked companies, foreign direct investment projects, the oil and gas sector, and infrastructure development. Retail activity could remain constrained by regulations on the total debt service ratio and the saturated market.

The Philippines

In the Philippines, the market share of Islamic banks will remain insignificant despite a regulatory push. About 5%-6% of the Philippine population is Muslim, who live in highly underbanked regions, and thus form an untapped segment. Regulators are pushing for Islamic banks to gain a greater share of the market to promote inclusive growth. However, we have seen little interest from major commercial banks in serving this market. We expect this is due to the high cost of setting up branches in the region and higher credit risk due to the low-income profile of borrowers. State-owned Al Amanah Islamic bank, a subsidiary of Development Bank of the Philippines, is the only Islamic commercial bank in the country. The bank's growth and earnings should improve in 2022 as it is likely to benefit from the ongoing recovery in the Philippines. However, the bank's market share will remain very small (less than 0.1%).

Over the past two years, the Philippines central bank, Bangko Sentral ng Pilipinas (BSP), has issued various guidelines for the development of Islamic banking, including the setting up of a Sharia supervisory board, and framework for licensing, reporting and liquidity risk management for Islamic banks. The central bank recently issued guidelines for separate reporting of Islamic banking and finance transactions to provide clarity on the treatment of these transactions and to facilitate the generation of industry statistics on the Islamic banking system. This will improve transparency in the sector, in our view. The central bank is also evaluating lower minimum capital requirements for Islamic banks as compared to conventional banks. While this could encourage both local and foreign participation in the sector, it could also result in Islamic banking sector being less resilient and having narrower capital buffers compared to conventional banks.

Malaysia's Uneven Recovery

The recovery from COVID-19 among the Islamic banks in Malaysia has so far been uneven. We expect that the polarization in the Islamic banking system will persist, and the performance of small lenders will continue to pale compared the top-tier Islamic banks affiliated with large local banking groups. For example, the largest five Islamic banks, namely Maybank Islamic, CIMB Islamic, RHB Islamic, Public Islamic, and Bank Islam (BIMB), have reported a steady recovery back to pre-pandemic profitability in 2021. All except BIMB are Islamic banking subsidiaries of large conventional banking groups. At the other end of the spectrum, small players, especially foreign-owned ones, are still struggling to regain their footing. They have reported moderate net profits in the past year and in some cases a loss.

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Asset Quality: Loan Relief May Mask A Bigger Hit

Large Malaysian Islamic banks aren't out of woods just yet. Our view on local Islamic banks is like the one we have on their conventional parents. That is, the benign reported asset quality numbers of local Islamic banks don't reflect the real picture. This is because of the distortion and delay caused by the multiple suspensions of loan repayments and restructurings since the beginning of the pandemic. In fact, Islamic banks may well take a bigger hit from COVID-19 because of their retail-focused business profile and inflexibility to adjust for interest rates for relief loans. As of February 2022, 52.7% of Islamic banks' financing book comprises retail lending, for example, hire purchases, personal loans, and mortgages; whereas their conventional counterparts' exposure to the same products is about 43.6%. And many Islamic subsidiaries, unlike their conventional banking parents, have a higher portion of their retail portfolio--for instance, hire purchases--contracted at a fixed interest rate. These subsidiaries suffered a proportionally much larger modification loss during the two rounds of six-month blanket moratorium schemes granted to all retail and SME customers. This was especially the case during the 2020 round. In our base case, Malaysia's Islamic banking sector could see its gross nonperforming loan (NPL) ratio increase by 100 bps in the next 12-24 months--up from 1.3% as of February 2022--once the various moratorium and relief programs expire in mid-2022.

For Indonesian Islamic banks, nonperforming financing (NPF) ratios could rise by 100-150 bps by end-2023 and credit costs will stay elevated. This is because the regulatory forbearance allowing restructured loans to be classified as performing is set to expire in March 2023. The asset quality of Islamic banks is now better than that of their conventional peers. The reported NPF ratio for the Islamic banking sector declined to 2.6% by end-2021 from 3.1% as of end-2020. For conventional banks, NPL ratios were stable at 3% over 2021. Asset quality improvement in pre-COVID years reflects Islamic banks' focus on consumer financing, especially lower-risk products such as mortgages and payroll loans, where loan defaults were low. In 2021, consumer financing represented 50% of their total financing; whereas for conventional banks it represented 26%.

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The reason for benign asset quality trends throughout the pandemic is the extensive relief measures by banks and authorities. The proportion of restructured loans remains elevated for both Sharia and conventional banks, reflecting the long-running relaxation on restructuring. For example, BSI's restructured loans were sizeable at 12% of total loans as of the end of March 2022. Part of these restructured loans could potentially turn into NPFs in the absence of adequate business revival or improvement in incomes. We believe SMEs and low-income households are most vulnerable, having suffered greatly because of the pandemic. Corporate loans from the service sector--hotels, restaurants, airlines--will also take longer to recover. The Islamic banking sector's good capitalization should help absorb any unexpected rise in credit risks. Capitalization, as reflected in their average capital adequacy ratio of 25% as of the end of 2021, was in line with that of conventional peers.

We forecast credit losses in Brunei's Islamic banking system to be about 25 bps, similar to that of conventional banks. Economic growth should accelerate to more than 3% in the next 12 months. Some borrowers are enjoying COVID-19-related regulatory forbearance; we expect these measures to fall off at some stage. Banks currently have options to defer payment of principal on loans until June 2022 for wholesale clients, and deferment or tenor extension (by conversion into term loans) for retail loans such as credit-card debt, personal loans, vehicle loans, and home loans. More than 90% the deferment demand is from wholesale clients.

Key downside risks to our base-case credit loss estimates are a sharp reduction in economic activity, increase in interest rates, and large-scale job cuts, especially for locals.

Islamic banks in Brunei should post stable earnings (return on assets of 1.4% and return on equity of 8.5%) supported by healthy spreads on the loan book due to very low cost of funds balanced by low yields on their sizable liquid assets. Non-interest income contributes about a fifth of revenues and cost to income will stay at 40%-50% as they continue to enjoy economies of scale in a domestic context.

Improving Profitability Of Indonesian Islamic Banks

We expect the profitability of Islamic banks to stay a shade lower than conventional banks, particularly for small and midsize Islamic banks. This mainly reflects their lower cost efficiency relative to conventional banks. In our opinion, Islamic banks' cost-to-income ratio will stay elevated over the next two years as banks invest in digital transformation. Nonetheless, earnings have improved over the past few years, closing the gap to a large extent. This stems from a sustainable fall in provisioning expenses as underwriting standards have improved as has operating efficiency. Higher credit growth has also contributed to earnings improvement over the past few years. Return on assets for 2021 was 1.7% compared with 1.8% for the conventional banking sector. Lower rupiah reserve ratio requirements (RRR) for Sharia banks compared to conventional peers in 2022 limit near-term profitability headwinds for the sector. The RRR will be gradually raised from 3.5% to 5.0% by September 2022 for Islamic banks, lower than the 6.5% for conventional banks.

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Digital Push Could Narrow The Tech Gap With Conventional Peers

The digitalization adoption could also enable Islamic banks to play catch-up with top-tier conventional players, in our view. COVID-19 has served as a wake-up call for Islamic banks to accelerate their digital transformation. Until this point, stand-alone Islamic banks were trailing larger, universal banking conglomerates when it came to investment in technology. In Malaysia, for example, two stand-alone Islamic banks--BIMB and Bank Muamalat--have notably increased their IT investments over the past two years. BIMB's IT investments/non-personnel operating expenses increased to 15.7% in 2021, up from 12.1% in 2019; for Muamalat it increased to 31.8%, up from 23.9% during the same period. The product offerings and business strategies of the upcoming two digital Islamic Banks (sponsored by AEON Financial Service and KAF Investment Bank Sdn. Bhd, respectively) may offer more clues as to how the business model of incumbent Islamic banks could evolve in response to the digital competition.

In Indonesia, the digital capabilities and technology of conventional banks remain superior to that of Islamic banks. Given their wide resources, conventional banks in Indonesia offer more comprehensive digital services and their mobile banking platforms operate on superior technology.

However, COVID-19 has accelerated the adoption of mobile and internet banking transactions, and digital payments have increased multifold. BSI's active mobile banking users trebled during 2021 and contributed 24% of fee income. Consequently, we believe IT and digital investments will be a key focus over the next two years as banks seek to ramp up their digital capabilities.

Some Islamic banks in Indonesia have recently stepped up their digital services on the back of foreign investor capital. These deals follow the decision by the financial regulator, Otoritas Jasa Keuangan (OJK), to relax ownership rules, allowing 99% foreign ownership of digital banks. We believe this will spur innovation in the sector. GoTo-backed Bank Jago and ZhongAn-backed Bank Aladin launched digital Sharia banking applications earlier this year. The accelerated shift to digital banking due to the pandemic and growing mobile phone penetration will facilitate growth of Sharia digital banks. These banks will however have to weather challenges such as cybersecurity, low Islamic financial literacy, and customer concerns regarding compliance of digital payments and other fintech services with Islamic law.

Malaysia's Islamic Banks Lead The Way On ESG

We expect Malaysian regulators and local Islamic players to focus more on integrating ESG considerations into Sharia banking. Steps taken by regulatory bodies have facilitated higher lending to priority sectors and issuance of green and sustainability bonds in the domestic market. It has also helped to increase the ESG-related transparency and reporting standardization of domestic sukuk issuers, including Islamic banks.

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In our opinion, top-tier Malaysian Islamic banks will benefit from the issuance of international sukuk with an ESG tag. Such benchmark issuances will lead to a wider investor base and eventually help to pave the way for broader awareness of Islamic finance and its intrinsic ESG connection in the international debt capital market. It could also lead to lower issuance costs thanks to the progressive standardization of the issuance process. Over the past two years, some large Malaysian banks have started to issue ESG-themed conventional bonds. For example, CIMB Bank successfully priced a US$500 million Sustainable Development Goals Bonds (SDG Bond) in January 2022, being one of the first local banks to tap such instruments in U.S.-dollar market. We expect the ESG-related international sukuk issuance will follow suit progressively.

In Indonesia, the government and large conventional banks are more active issuers of sustainability bonds. Both Bank Mandiri and Bank Rakyat have issued conventional sustainability bonds in the U.S.-dollar market in the past few years. National policies have helped to increase the focus on sustainable finance in the country. Key among these are OJK's regulation on green bonds issuance and its Sustainable Finance Roadmap Phase II, 2021-25, which aims to boost ESG-related funding over the coming years. This along with the growing investor interest in sustainability assets could facilitate an increase in ESG financing and sustainability bonds for the Islamic banking sector.

Related Research

• Asia-Pacific Economic Risks, Thy Name Is Inflation, March 28, 2022
• Asia-Pacific Banks And The Ukraine Crisis: Small Exposures But Secondary Impacts Could Bite, March 16, 2022
• Mixed Fate For Relief Loans Could Drag On Malaysia's Banking Recovery, Feb. 28, 2022
• Lower Global Liquidity And Increased Complexity Are Likely To Hold Back Sukuk Issuance In 2022, Jan. 18, 2022
• Banking Industry Country Risk Assessment: Indonesia, Dec. 7, 2021

Digital design: Halie Mustow, Writer: Lex Hall