Muscat – Oman’s Islamic banking sector is likely to sustain its strong growth trajectory in the short-to-medium term despite a number of structural challenges, according to Fitch Ratings.

Growth in Islamic banking, Fitch said, will be driven by growing awareness, strong retail demand for Islamic products, supportive regulations, and a strong push from the Islamic windows of conventional banks.

‘An improving operating environment, expected positive real GDP growth, higher oil prices, the easing of coronavirus restrictions, and the rise in interest or profit rates will also support growth in both Islamic and conventional banking in the sultanate,’ Fitch said in a statement.

Islamic banking sector’s financing growth in Oman topped 11.6 per cent year-on-year in 2021, in contrast to the conventional banking sector’s 3.1 per cent growth, with a compounded annual growth rate of 9 per cent during 2017-2021.

Surging public demand and low-base effect propelled the growth. As a result, the market share of Islamic banking and Islamic windows increased to 15.2 per cent at end-2021 (from 14.3 per cent at end-2020), with total assets of RO5.9bn.

Fitch, however, noted that key structural challenges persist mainly due to the sector’s recent inception in Oman (around ten years ago). These include gaps in the distribution channels, limited product offerings, a still-developing regulatory framework, a small capital base, limited sukuk investment options and insufficient Islamic liquidity management products.

‘Consolidation is credit-positive’

Fitch said it continues to see consolidation in Oman’s Islamic banking industry. In January 2022, Bank Nizwa and Sohar International Bank received Central Bank of Oman’s (CBO) approval to start due diligence for a potential merger. This follows the takeover of Alizz Islamic Bank by Oman Arab Bank in 2020.

As per the ratings agency, consolidation could be a credit-positive as it generates cost-efficiencies, deepen distribution channels, and strengthen capitalisation levels.

‘Consolidation could also support faster growth in the Islamic subsidiary or window through the larger conventional banks’ capitalisation and liquidity profiles,’ Fitch said.

The ratings agency expects a mild asset quality deterioration at Islamic banking entities following the end of payment holidays and flexibility as banks will not have to classify financing as impaired when payments are deferred.

‘This is likely to arise in the more vulnerable sectors, particularly in real estate, construction, tourism and manufacturing. We expect profitability to improve with rising rates and lower impairment charges, but a return to pre-pandemic levels is unlikely before 2023-2024,’ Fitch noted in its statement.

Omani Islamic banks have in the past been adequately capitalised, but at lower levels than conventional banks. The sultanate’s Islamic banking regulatory framework allows Islamic banks to use a 30 per cent alpha factor which can uplift capital ratios, unlike conventional banks, Fitch said.

Fitch believes that the capital bases of Islamic banks in Oman are also smaller than those of conventional peers, which may limit the scale of participation in large government financing projects.

‘However, amid rising core capital and reserves at Islamic banks and windows, Islamic banks are increasingly financing government and public enterprise projects, with their share of total financing jumping to 10.4 per cent at end-2021 (from 4.6 per cent at end-2020). It was lower than that of conventional banks whose share was 16.1 per cent at end-2021,’ the ratings agency added.

The CBO, Fitch further said, is developing a medium-term strategy for the Islamic banking sector, including a lender of last resort facility for Islamic banking entities, with a sharia-compliant deposit insurance scheme.

Oman’s share of global Islamic banking assets is growing but was small at 0.7 per cent as of the end of third quarter of 2020, according to the Islamic Financial Services Board.

‘The long-term growth potential remains positive given Oman’s Muslim-majority, with a sizeable sharia-sensitive and unbanked population,’ the ratings agency added.