Islamic banking helping to sustain the financial sector in Oman

Oman’s banking sector has continued to perform well in spite of economic headwinds. The growth of non-oil sectors has increased demand for credit and, as a result, banks’ lending and assets have continued to expand, although liquidity has tightened. Meanwhile, the vibrant Islamic financial services segment has supported the sector’s growth.

Structure

According to the Central Bank of Oman (CBO), at the end of 2018 there were seven local commercial banks operating across 420 branches; nine foreign banks with 31 branches; two local Islamic banks with 24 branches; and six Islamic windows, which are part of parent conventional banks, with a total of 58 branches. The local conventional banks are Ahli Bank, Bank Dhofar, Bank Muscat, HSBC Bank Oman, National Bank of Oman, Oman Arab Bank and Bank Sohar, while the international banks are Bank of Baroda, Bank of Beirut, Bank Melli Iran, Bank Saderat Iran, First Abu Dhabi Bank, Habib Bank, State Bank of India, Standard Chartered Bank and Qatar National Bank. Additionally, there are two specialised banks: Oman Housing Bank, which is dedicated to mortgage loans, and Oman Development Bank. All conventional banks are privately owned, but the government holds stakes in a small number of them. The banking sector’s total assets amounted to $88bn at the end of 2018. Of this total, conventional banks accounted for 87%, and Islamic banks and windows made up the remaining 13%. Bank Muscat is the largest bank in Oman with $32bn in assets, representing 36% of the sector’s total.

As there is a high density of banks in Oman, mergers are becoming increasingly common, a trend that can be seen throughout the GCC. In October 2018 Oman Arab Bank and Alizz Islamic Bank announced a potential merger and, according to local media, discussions were progressing well as of August 2019 However, in March 2019 a potential merger between Bank Dhofar and National Bank of Oman was cancelled after seven months of discussions, as the two parties were unable to agree on the terms of the deal. Nevertheless, with around $1trn worth of merger talks under way across the GCC, it is likely that other similar agreements will follow.

Oversight

Despite a difficult global financial climate, Oman’s banking sector has performed well since the oil price decline in 2014. As of September 2019 the capital adequacy ratio was high and rising, at 18.1%, and non-performing loans were relatively low, at 3%. The CBO’s prudent and conservative stance has contributed to these positive financial indicators. The bank has consistently followed international best practices through the implementation of Basel guidelines on capital requirements, risks, assets clarifications and liquidity measures.

There are a number of additional limits that restrict banks’ exposure to the real estate sector. Banks are only permitted to have a maximum of 15% of their loan book as mortgages. Total real estate loans and collateral cannot amount to more than 60% of time and savings deposits, excluding government deposits, and retail assets cannot exceed 50%. Banks are also prohibited from investing more than 10% of their net equity overseas. The investment limit for foreign equity is 2.5% of capital, and the limit for foreign bonds is 7.5%. Lending to a single borrower as a group is also restricted to 15% of capital.

In 2018 the CBO introduced a number of regulatory changes designed to create additional scope for lending. Net domestic inter-bank loans were permitted to be included in the calculation of lending ratios, and the minimum capital adequacy ratio requirement was reduced by one percentage point to 11%, and 12% for domestic systemically important banks. According to the CBO, this reform resulted in available credit increasing from OR5.2bn ($13.5bn) to OR7.8bn ($20.3bn). Other policies were aimed at making liquidity management more effective, such as permitting some provisions to be included in Tier-2 capital, revising gap limits for currencies and increasing limits on exposure outside Oman.

In May 2019 the sultanate launched the Oman Credit Bureau (OCB), which is expected to be rolled out fully by 2022. The bureau is affiliated with the CBO, working in partnership with Icelandic firm Creditinfo. Similar establishments have already been created in other GCC countries with the aim of broadening credit ratings and encouraging the growth of the financial sector, with a particular focus on lending to smaller companies.

The bureau will establish a central database of financial information, which will allow members to assess a client’s assets and debts. Membership is mandatory for all banks, licensed financial institutions, and companies or individuals engaged in financial activity. “The Oman Credit and Financial Information Centre will offer better transparency with more up-to-date and accurate credit information,” Khalid Al Kayed, CEO of Bank Nizwa, told OBG. “This is a milestone for the country as it will enhance the credit monitoring system within the financial industry. As this platform is set to benefit banks and other financial institutions, the centre also aims to reach non-banking entities, and when this established, it will open up for private ownership.”

New Banking Law

The government is in the process of developing a new banking law to update the sector’s regulatory framework in line with the emergence of new technologies such as electronic payment. In October 2019 the CBO’s board of governors discussed and reviewed the draft law, which is currently passing through the legislative system. According to local media, the new law will include reforms to the regulation of Islamic banking with a view to enhancing its role in the future, mechanisms for CBO intervention and regulations for systemically important banks. Despite this, some sector players predict that there will not be any major changes to the banking system, as the law is still evolving and regulators do not want to cause disruption.

Performance

Despite a challenging economic environment, banks have managed to grow their balance sheets in recent years. Between 2014 and 2018 aggregate deposits increased at a compound annual growth rate (CAGR) of around 7% to reach $60bn. Although growth slowed in 2015 and 2016 due to falling oil prices, which reduced the volume of government deposits, it has picked up again in 2018 with annual growth of 8%.

Demand for credit has remained robust, with a CAGR of 9% between 2014 and 2018. This solid performance can partly be attributed to government spending in an effort to diversify and expand the economy in the absence of oil income. Government spending continues to drive high-quality loan growth, as do major ongoing projects, such as oil and gas developments, the Duqm refinery and the construction of hotels and tourism infrastructure. However, as the growth of credit has exceeded that of deposits there has been a gradual tightening of liquidity, which heightened in the first nine months of 2019 due to falling oil prices. In this period loans grew by 4.2%, while the deposit base contracted by 3.3%, raising the loan-to-deposit ratio from 108% at the end of 2018 to 112% in September 2019.

Therefore, the main challenge for the banking sector is combatting deposit growth and tight liquidity. Profits have improved slightly due to steady economic growth, high-quality assets and an increase in loans. Banks have also introduced a number of measures to boost efficiency and speed up processes through automation and digitisation.

Nevertheless, slower lending growth has contributed to a difficult environment for individual banks, with profit growth remaining sluggish at around 3-4%. More than 70% of government revenue is generated by oil and gas, meaning that lower oil prices have a significant effect on the banking sector and the economy as a whole. In addition, interest rates continue to rise and net interest margins are under pressure, partly due to tight liquidity. The rate increases in recent years have led to a rise in funding costs, while retail loans are capped at a maximum rate of 6%, resulting in compressed interest margins for the sultanate’s banking sector.

Islamic Banks & Windows

The Islamic banking segment has expanded rapidly since its introduction in 2012, experiencing annual growth of 15% in 2018 and 9% growth between January and September 2019, when assets totalled $12.5bn. There are two full-service Islamic banks in Oman – Bank Nizwa and Alizz Islamic Bank. Additionally, there are six Islamic windows that are owned by conventional banks. However, this structure is expected to change in the coming years with the upcoming merger of Alizz Islamic Bank and Oman Arab Bank.

The majority of windows are operated as entirely separate operations with their own balance sheets. Nonetheless, they are still able to benefit from the existing infrastructure of a conventional bank, such as established systems and administrative support. Islamic windows are also subject to some of the regulatory limits of their conventional owners.

“Islamic banks and windows are both performing relatively well and continue to increase their market share,” Sohail Niazi, chief executive of Maisarah Islamic Bank, told OBG. “This is a net positive for the banking sector as a whole, as customers now have additional options; this is good for consumers, financial inclusion and increasing banking penetration.”

There are some key differences between conventional and Islamic banks, which have helped the latter to expand in recent years. Islamic banks generally have low non-performing loans compared to conventional banks, partly because the majority of financing is asset backed. Additionally, Islamic windows are able to share resources with their conventional owners, enabling them to share costs.

However, Islamic banks usually have narrower interest margins as their cost of funds is higher. They also have a new concentrated deposit base with more wholesale funding. As a broader deposit base is built, the cost of funds is likely to fall.

Like the conventional sector, Islamic banking benefits from conservative regulations. “The CBO’s Islamic banking framework is excellent,” R Narasimhan, general manager of Islamic banking at Bank Nizwa, told OBG.

“ The sector is now widely accepted and continues to expand further. It has penetrated both the retail and wholesale banking segments, and new branches are being opened across the country.”

Each Islamic bank and window has its own sharia board, which consists of scholars approved by the CBO. The segment is also overseen by the High Sharia Supervisory Authority of the CBO, which has been in place since 2014. This model has made the process of approving Islamic products easier and faster, allowing the segment to develop rapidly in recent years. Nevertheless, efforts are still being made to expand Islamic banking further. Bankers have called for short-term liquidity instruments for Islamic banks, which would offer more options when they are holding surplus cash.

Many of the factors influencing the conventional banking sector – such as funding costs, oil prices and wider economic conditions – also affect the Islamic banking segment. However, other challenges are specific to the sharia-compliant sector. For example, education is a critical part of expanding Islamic banking. It is necessary for banks to clearly explain Islamic finance, its risks and benefits, and the range of products available to potential customers.

The definition of sharia compliance is becoming more well-defined, despite some obstacles. Globally, there have been challenges in terms of creating effective regulatory frameworks and compliance measures, as well as standardising certain financial products, although the segment continues to develop. There are also limitations on the products that Islamic banks can offer, due to restrictions on sectors such as gambling and securitisation. Nonetheless, Islamic finance is still able to address most customer finance requirements. Therefore, building on its past success, the outlook for sharia-compliant banks is considered broadly positive. “The Islamic banking sector is expected to continue to expand,” Niazi told OBG. “The regulatory environment has been supportive, we are building the right ecosystem and the demographics are favourable.”

Islamic Financial Services

The Capital Market Authority (CMA) has been responsible for implementing the legal and regulatory framework to support Islamic financial services (IFS) since 2011. In recent years the authority has become increasingly active as the sector has expanded. “Since 2016 there has been a large amount of interest in Islamic financial services,” Kemal Arbi, advisor at the CMA, told OBG. “We have been focusing on educating the market, as Omanis are generally more familiar with conventional banking products and often expect Islamic finance to be more expensive or require more capital, which is incorrect.”

The regulatory framework governing Oman’s IFS industry is influenced by more mature markets such as Bahrain and Malaysia. The CMA’s regulations are designed to be flexible and facilitative, with suitable parameters to keep the restrictions on the structure of Islamic financial products and services to a minimum. IFS are also designed to meet international standards and the limits set by the CBO, as well as approval from sharia boards.

Takaful

Since 2013 Takaful (Islamic insurance) has been available in Oman. There are two takaful companies in operation: Takaful Oman, which was established as a start-up in 2014, and Al Medina Takaful, which converted to an Islamic insurance provider in the same year. For the first two years the firms operated under the conventional insurance law, but in 2016 the Takaful Insurance Law was introduced. According to local media, updated regulations governing takaful activities were being finalised by the CMA in March 2019, which are expected to help support the fast-growing segment. “The takaful market is expanding,” Arbi told OBG. “While in the past takaful was largely focused on automotive insurance, the introduction of compulsory medical coverage has helped the segment to expand into new areas.” In 2018 takaful generated OR53.2m ($138.2m), representing 11.4% of total conventional and Islamic insurance premium.

Sukuk & Islamic Equities

Meanwhile, the sukuk (Islamic bond) segment has also expanded since regulations were first established in 2011 and the first bond was issued by the government in 2013. The first private sukuk issuance was made in 2014 by property development company Tilal. Since then, a number of companies, both private and listed, have issued sukuk in a variety of different structures. However, certain criteria must be met to ensure that issuances are sharia compliant. For example, sukuk regulations must be reviewed in order to obtain a fatwa (a decision issued by the Islamic oversight board) before they can be approved.

Nevertheless, the segment presents a significant opportunity for sharia-compliant banks to expand. “The creation of a local sukuk market is important, as Islamic banks need new investment avenues,” Arbi told OBG. To this end, new sukuk issuances are in the pipeline. In May 2019 Meethaq Islamic Banking, the Islamic arm of Bank Muscat, launched its second sukuk programme after the success of its first issuance in 2017. The OR45.6m ($118.4m) issuance is due in 2024 and form part of the bank’s plans to issue a total of OR100m ($259.7m) in sukuk.

In terms of Islamic equities, 31 out of 116 listed companies in Oman are sharia compliant, and 15 are part of the Muscat Securities Market Index, which was created in 2013. The constituents are reviewed and filtered at the end of every quarter.

The CMA is currently focused on expanding the supply side of Islamic investment, such as sukuk and sharia-compliant companies. Looking beyond the short term, the authority aims to build demand for investment by encouraging the creation of Islamic funds and fund managers. The existing framework governing sharia-compliant funds was established between 2013 and 2016, but improved guidelines are required to support the segment’s development.

Financial Technology

The banking sector is starting to push the use of financial technology (fintech), with support from the regulator. Banks are increasingly implementing digital payment options through cards and merchant payment systems, as well as alternative ATM channels, cash deposit machines and new payment options with utilities providers. To support this drive, the National Payments Systems Law was passed in February 2018 and came into force in July 2019. The new law is designed to enhance the infrastructure and systems in the financial sector and ensure safe and fast payments, providing a solid base for future technological advancements and innovation.

Currently, all fintech entities operate under the same licence issued by the CBO. However, in 2019 Tahir Al Amri, executive president of the CBO, told OBG that the central bank is planning to allow non-banking fintech entities to operate under a separate licence, making it easier for them to launch new products such as payment services. Some nonbank entities have already made headway in this area. For example, Thawani, a start-up that offers cashless mobile payment solutions, has worked with local utilities providers Haya Water Company and Oman Oil Company to develop automatic payment systems. At the moment, banks often outsource their technology and IT solutions to India. The new regulation should encourage the growth of the local fintech segment and help banks to digitise their services using Omani companies.

In June 2019 the CBO also established a task force to develop a new comprehensive fintech strategy to support the segment’s expansion by reducing the cost of doing business and increasing the accessibility of banking services. Upon announcing the task force, Qais Issa Mohammed Al Yahyai, executive vice-president of the CBO, highlighted the opportunities for fintech within the IFS segment. For example, the automation of contracts could speed up sharia-compliant transactions, which currently require a large amount of documentation.

Although there is some entrepreneurial development in progress with regards to fintech, banks need to be more open to work with tech companies in order to keep up with consumers’ changing needs and requirements. “Consumers are already educated in social media and willing to try and test different platforms,” Majid Al Amri, CEO of Thawani, told OBG. “Consumers are willing to take risks, but successful marketing is needed to convince them to use new products and become more familiar with fintech.”

Outlook

In recent years Oman’s financial sector has been supported by low interest rates, rapid adoption of IFS and higher demand for credit as a result of the growth of non-oil sectors. However, with rising interest rates, a slowdown in the growth of Islamic banking and relatively low oil prices, there may be challenges ahead. The CBO’s conservative regulatory framework should ensure that the sector is well positioned to withstand any potential strains, particularly as the sector has proved resilient against falling oil prices in recent years. Looking ahead, the updated banking law and new rules for fintech companies will provide further support and ensure that banks are able to keep up with technological advancements and changing consumer trends.