While a no-deal Brexit could have a significant negative impact on U.K.-based Islamic banks' asset quality, it is unlikely to cause major disruption to their funding, according to a report published today by S&P Global Ratings titled "Countdown To Brexit: Implications Of A No-Deal Brexit For Islamic Finance."
The U.K. is home to five fully fledged Islamic banks (all unrated) 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," said S&P Global Ratings' Global Head of Islamic Finance, Mohamed Damak.
The potentially damaging effect of a no-deal Brexit on the U.K. economy and asset prices, particularly in real estate where most activity of Islamic banks 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," Mr. Damak said.
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 of 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.