Dubai: Asset quality of GCC Islamic banks remains slightly weaker than their conventional counterparts, according to Standard & Poor’s.

Due to the asset-backing principle of Islamic finance, Islamic banks tend to have higher exposure to the real estate sector. Furthermore, because Sharia forbids charging repayment delay penalties, some clients tend to prioritise their repayments to conventional banks.

“As we do not foresee any significant changes in these two structural factors, we believe that the asset-quality indicators of Islamic banks will remain slightly weaker than their conventional peers’,” said S&P Global Ratings Global Head of Islamic Finance, Mohammad Damak.

Over the past 12 months, the asset-quality indicators of Islamic banks deteriorated slightly, similar to those of their conventional peers. However, analysts said the deterioration was not commensurate with the economic slowdown experienced in their various home countries. In a normal cycle, banks restructure their exposures to adopt the financing payables to the new cash-flow realities of their clients. At some point during the cycle, some of these financings generate new non-performing loans (NPLs), which are beginning to show up.

With the recent adoption of IFRS9 [International Financial Reporting Standards and FAS30 [Financial Accounting Standards], the impact of these loans on Islamic and conventional banks’ cost of risk will become more visible. Loans that are restructured, or past due but not impaired, will generally necessitate lifetime expected loss provisioning instead of 12-months expected loss provisioning. Therefore, when the economic cycle turns, these banks are likely to to see a spike in provisions.

“We think that banks will try to front-load some of the impact, in 2018, to avoid future result volatility (as they charge the initial impact to equity). We think that the success of IFRS9 or FAS30 adoption will depend largely on how aggressive management teams are in recognising asset-quality issues. We expect cost of risk to increase in the next 24 months to reflect the transition to the new regulations,”

Overall funding and liquidity profiles of Islamic banks are expected to remain strong this year. Growth in customer deposits recovered slightly in 2017, a trend that analysts expect will continue. This was the result of stabilised oil prices and the channelling of higher public-sector deposits to the banking systems. In the GCC, both Islamic and conventional banks enjoy strong funding profiles, thanks to the predominance of core customer deposits and their relatively low financing-to-deposit ratios.

The GCC Islamic banks in general have strong capitalisation levels. Banks included in the S&P study sample continue to display strong capitalisation by international standards, with an unweighted average tier 1 ratio of 17.6 per cent at year-end 2017. A mix of still good profitability, somewhat conservative dividend payout, and low growth explain the slight increase in this ratio compared with the previous year.

The study notes that for most banks, capitalisation remains below the highs that were observed in the past because previous rapid growth of financing has not been matched with additional capital-raising exercises. A few Islamic banks have issued capital-boosting sukuk, primarily in the UAE, Qatar, and Saudi Arabia.