Tashkent, Uzbekistan (UzDaily.com) -- The development of Islamic banking in Central Asian countries is happening from a low base. As of 30 September 2023, the volume of Islamic finance totaled about US$500 million, according to a report by S&P Global Ratings.

Although S&P Global Ratings considers the regulatory regime favorable to the development of Islamic banking, additional work remains in the areas of taxation and accounting.

The key success factor is the quality of financial products and their economic added value.

Islamic finance is at an early stage of development in six countries of the former Soviet Union with predominantly Muslim populations - Azerbaijan, Kazakhstan, Kyrgyzstan, Tajikistan, Turkmenistan and Uzbekistan. However, simply having a Muslim population is not enough to develop the growing Islamic finance industry. Even in countries where the authorities have created a significant regulatory framework, the level of penetration of such banking products among the population remains quite low.

The low level of penetration can likely be explained by several factors, including the relative complexity of the financial product, the low level of wealth of the population, and the likely secular heritage of the republics.

The rapid growth of Islamic banking in Tajikistan and Kyrgyzstan suggests that Islamic banks can compete with traditional ones.

The sector faces three main challenges

Financial intermediation in the region as a whole is underdeveloped.

Many countries in the region have small banking systems relative to the size of their economies. This is due to the following: 1) low level of welfare (Tajikistan or Kyrgyzstan); 2) the predominance of extractive industries in the structure of the economy (Azerbaijan and Kazakhstan); and 3) relatively low bank account penetration, with the exception of Kazakhstan. As a result, the development of Islamic banking is hampered not only by factors specific to this sector, but also by the insufficient level of penetration of banking services among the population of these countries.

Financial literacy is still low.

Shariah compliance in itself is not a competitive advantage in the region. The complexity of documentation for such financial products sometimes makes it difficult to access clients, especially corporate clients, due to legal and accounting difficulties. The low level of financial literacy of the population also has a negative impact on all financial organizations in the region, especially in rural regions.

More than 70 years of secular power.

Despite the fact that the majority of the population is Muslim, sharia principles do not influence the judicial systems of the six countries of the former Soviet Union, unlike Muslim countries in the Middle East, where sharia influences individual legal norms. For a long time, the difficulty of adapting the legal environment has been an obstacle to the development of the sector.

Regulation – both an advantage and a hindrance

Regulatory capital requirements generally have a favorable impact on Islamic banks.

Regarding the regulatory regime, the agency believes that the operating environment in Kyrgyzstan is the same for all banks. However, in Kazakhstan and Tajikistan, regulatory requirements are less stringent for Islamic banks. This is because the authorities view investment deposits, including unrestricted placements in wakala and mudaraba deposits, as having loss-absorbing capacity, and treat the pool of on-balance sheet assets financed by these placements as risk-free with zero capital requirements.

This is one of the most aggressive approaches in the world, as most countries apply the same risk weights to these asset pools as to any other assets, and few use discounts to take account of distributed commercial risk. In Islamic finance litigation, we do not consider deposits to be loss-absorbing and believe that such an approach may lead to undercapitalization of Islamic banks. This is confirmed by the fact that banks in Kazakhstan maintain distributable profits and/or reserves associated with outstanding customer obligations under these pools.

However, different regulatory rules create other problems.

Converting to an Islamic financial institution may take several years. An extreme example of this is EcoIslamicBank CJSC in Kyrgyzstan, which is still operating under a regular banking license as of 2011. Banking regulation does not always map well to the tax and accounting specifics of clients. Finally, Islamic banks, both globally and in Central Asia, lack liquidity management tools.

Slow growing industry

In 2023, the Islamic banking sector showed growth.

Despite the challenges, 2023 was a successful year for Islamic banking in the region, with its strengthening in Kyrgyzstan, new licenses issued at the Astana International Financial Center in Kazakhstan, and the transformation of Alif Bank OJSC in Tajikistan continuing. Moreover, in early 2024, Lesha Bank, a Qatari Islamic bank, signed a preliminary agreement to acquire a bank in Kazakhstan.

Demand for Sharia-compliant non-banking financial services is high throughout the region, including in Uzbekistan, where the necessary legal framework is not fully developed, creating a “gray area”. Gradually increasing levels of wealth, demand for Shariah-compliant products, as well as the active participation of international financial institutions, in particular the Islamic Corporation for the Development of the Private Sector, support the development of Islamic banking.

Financial products offered by Islamic banks remain a key competitive advantage.

Some clients may be willing to pay a premium for Shariah compliance, but most clients are interested in the economic added value of transactions. There is a need to increase the level of digitalization in the sector, especially given the active digital offering of services of some banking organizations in the region.

Pilot project of partner banking in Russia

In 2023, Russia launched a pilot “partnership” project with Sharia-compliant banks in Muslim-majority regions of the country. Despite the relatively large Muslim population (around 18 million), the agency remains cautious in its estimates of sector growth for a number of reasons:

Russia faces challenges similar to those of the former Soviet Union with respect to long-established secular traditions.

The economic added value of Islamic banking in Russia is unclear. In particular, it cannot be stated unequivocally that the population of the seven Muslim regions is underbanked when compared with regions with comparable income levels or when compared with other regions with a low share of deposits per capita relative to income, such as the Sakha Republic, the Republic of Tyva or Chukotka Autonomous Okrug.

In general, it is difficult to determine the real demand for Shariah-compliant banks or the percentage of the population willing to pay a premium for Islamic banking.

Challenge to current market leaders

Despite low financial literacy, a shortage of domestic financing and long-established secular traditions, Islamic banking and Islamic finance in general are gaining momentum in Central Asian countries. The economic value added of such financial products, rather than sharia compliance, drives growth.

In S&P opinion, Islamic banks would attract the attention of market participants if they could offer the same quality of services at a lower or similar price. However, S&P believes that the development of Islamic banking will be very gradual and do not expect Islamic finance to account for more than 5% in the region in the next five years, with the possible exception of Tajikistan.