Now that the results of the US Treasury’s stress test of US banks have been released, it seems apt to also turn the attention to other financial systems. Islamic Finance has been touted as an alternative model, less exposed to securitization, with ethical guidelines, and its proponents hoped better insulated from global trends.

However, Islamic banking and finance faces many of the same vulnerabilities as conventional finance (See more on the outlook for Islamic financial institutions in this recent presentation). These financial institutions, both Islamic banks and those issuing Sharia-compliant investment products, are vulnerable to changes in liquidity and growth conditions globally and in the targeted regions.  The countries of the Gulf Cooperation Council (GCC) a particular source of growth in demand for Islamic financial products continue also to suffer from tight liquidity.

In this piece we look at some of the vulnerabilities but also the opportunities of Islamic finance, to discuss how one might test this financial model. We focus on the dynamics in the GCC especially in relation to GCC investors, sovereign and private, and to Islamic banks operating in the GCC and MENA region though some of the analysis is also relevant to South East Asia.

Just as Nouriel Roubini has noted frequently with respect to the US stress tests, it is essential to perform such tests based on plausible stress scenarios that could come to pass. As such the relative optimism of the US stress scenarios in terms of unemployment projections could imply that the banks capital needs are even greater than those announced in a worse case scenario. For Islamic financial institutions, a plausible scenario means factoring in possible contractions in several of the economies that have been the centers for Islamic finance. as well as significant asset market corrections which would weaken the balance sheets of Islamic financial institutions. We now look at a few of these factors to lay out how one might test their balance sheets.

Preliminary estimates for the sector (but not individual banks) suggest that most are relatively well capitalized but most still have relatively small market shares. Moreover the rate of growth of Islamic bank assets and of funds placed in Sharia-compliant securities and funds is likely to be significantly slower than many predicted in 2008 as slower growth and tighter liquidity restrict the funds to be invested.

Growth outlook