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Countdown To Brexit: implications of A No-Deal Brexit for Islamic Finance

Is the UK worried about the impact of a no-deal Brexit on Islamic banks? What factors will protect the sector from a destabilisation effect?

A no-deal Brexit could have a significant negative impact on U.K.-based Islamic banks No deal will have a limited effect on global Islamic finance, as well as for sukuk structuring activities The U.K. has always been a popular destination for real estate investment for investors in core Islamic finance countries

By: S&P Global Rating

As we get closer to the scheduled Brexit date, investors are asking questions about the exposure of the Islamic finance industry, especially in the case of a "no deal." The U.K. is home to five fully-fledged Islamic banks (all unrated; see table 1), with more than 15 other banks (affiliates of conventional banks) offering Islamic financial services.

Given these banks' primary focus on U.K. domestic banking business, we see their exposure to Brexit risks as similar, if not more significant, to that of rated U.K. domestic banks (see "The 2019 Outlook For U.K. Banks Hinges On Brexit," published Jan. 10, 2019 on RatingsDirect).

The potentially damaging effect of a no-deal Brexit on the U.K. economy and asset prices, particularly in real estate where most of the Islamic banks' activity is concentrated, will likely have a knock-on effect on U.K. Islamic banks' asset quality. However, we believe these banks' relatively strong capitalization provides a buffer against a slide in asset quality.

Given the small size of U.K. Islamic finance compared to the U.K. domestic banking sector, we do not expect stresses arising in U.K. Islamic finance will lead to systemic risks for the U.K., or that a no-deal Brexit will make a difference to the global Islamic finance industry. In addition, local affiliates of U.K.-based law firms and banks, for example, in other financial centers such as Dubai, generally undertake sukuk structuring and, we also understand that only a few sukuk buy-to-hold investors are from the U.K. Finally, we do not see any reason why English law would be substituted as the law of choice for any sukuk contracts. On a positive note, a no-deal Brexit could revive Islamic finance investors' appetite for U.K. assets, typically popular investments for investors in the Gulf, assuming a significant drop in their prices, due to lower valuations because of Brexit or a depreciation of the pound.

The risk of a no-deal Brexit on March 29, 2019, continues to be high, because it remains the default legal option in the absence for any agreed alternative. That said, we do not yet consider a no-deal outcome our base case for rating purposes, because we view the political incentive for the U.K. and the EU to negotiate an orderly outcome as still very strong.

Most of U.K.-based Islamic banks' business comprises lending with a focus on real-estate financing

According to the Islamic Financial Services Board (IFSB) database, the five U.K-based Islamic banks' total reported assets were £4.1 billion on June 30, 2018, which is less than 0.15% of the total size of the domestic assets of the U.K. banking system. There are no reported figures on the size of the Islamic assets of conventional banks providing Islamic financial services in the U.K., but we understand that it is also marginal. The banks' contribution to the global Islamic finance industry is also limited, at about 0.3% of total assets on June 30, 2018. Most of the Islamic banks' business comprises lending and remains concentrated on real estate financing, with total lending representing about 70% of total assets. 

The banks also invest in sukuk, accounting for about 11% of total assets on June 30, 2018, and 84% of their funding is from deposits, mostly via murabaha contracts. The banks' asset quality remains relatively good, with a non-performing -loans (NPLs) ratio of about 2.2%, according to the IFSB. However, their return on assets is modest, at 0.5% at mid-2018, mostly underpinned by their high cost base (84% cost to income ratio at mid-2018). These banks are also highly capitalized in conformance with local standards, with a total capital adequacy ratio of 21.4% and a tier 1 capital ratio of 19.9%. Finally, the banks' liquidity appears adequate, with their liquidity coverage ratio at 256%.

Table 1