Dubai: Customer deposits which is a major cost effective funding source of Gulf Cooperation Council (GCC) Islamic banks have been weakening during the last two years and is expected to deteriorate further in 2017-18.

Growth in customer deposits slowed to 6 per cent in 2016, compared with 9 per cent in 2015 for the Islamic banks.

“We expect this trend will continue in 2017 and 2018, as governments and their related entities, whose deposits largely depend on oil prices, contribute between 20 per cent and 40 per cent of the total deposits in GCC banking systems. This is somewhat counterbalanced by Islamic banks’ natural tendency to attract retail depositors because of their Sharia-compliant nature,” said S&P Global Ratings Head of Islamic Finance Dr. Mohammad Damak.

The funding profiles of GCC Islamic banks remain strong by international standards. Core customer deposits mostly dominate in funding profiles, and banks’ use of wholesale funding sources remains limited. The use of sukuk as a funding source is limited, and this is unlikely to change dramatically anytime soon. Recent sukuk issues by GCC banks were mostly capital-boosting sukuk (primarily in the form of Tier 1 sukuk) as their pricing was attractive compared with banks’ cost of common equity, but not many sukuk issues from GCC Islamic banks are expected in 2017-2018.

Overall, GCC Islamic banks’ liquidity remains strong by international standards. Banks tend to keep sizeable amounts of cash and money market instruments (about 19 per cent of total assets at year-end 2016), owing to the lack of high-quality liquid assets.

Despite the deterioration in operating environment, the GCC Islamic banks continue to display strong capitalisation by international standards, with an unweighted average Tier 1 ratio of 17.2 per cent at year-end 2016. A mix of still-good profitability, somewhat conservative dividend payouts, and lacklustre growth explain the slight increase in this ratio compared with last year. However capitalisation still remains lower than past highs because previous rapid growth of financing was not matched with additional capital raising exercises for most banks.

A few GCC banks have issued capital boosting sukuk, primarily in the UAE, Qatar, and Saudi Arabia. The common characteristic of these sukuk is that they allow for loss absorption at some point. Analysts see these sukuk helping the industry to inch closer to one of Islamic finance’s cardinal principles, profit and loss sharing

“We think that extension of loss absorption to some categories of liabilities could strengthen the resilience of GCC Islamic banks. Moreover, as the global financial system moves toward bailing in some categories of liabilities under bank resolution regimes, local regulators could follow suit, but only in the next several years, in our view. We have incorporated some of these instruments in our total adjusted capital calculation for the GCC banks we rate,” said Damak.