WITH credit rating downgrades raising the interest rates that have to be paid on bonds, banks should look at Islamic financing to meet the added capital requirements of new regulations, professional services company Ernst & Young recommended in a report released last week.

According to Ernst & Young’s World Islamic Banking Competitiveness Report 2013, Islamic banking assets held by commercial banks worldwide are expected to exceed $1.8-trillion this year, a 38% increase compared with $1.3-trillion in 2011.

This was a sign that the need by clients to get sharia-compliant offerings was increasing.

Unlike other forms of lending, which attract interest on deposits or loans, Islamic finance operates under the principles of sharia law, which prohibits the charging of interest. For example, if an Islamic bank arranges financing for a home loan, it does not charge interest but buys the asset from the seller and then sells it to the buyer at a profit. The bank retains the asset until the debt is settled.

"Capital requirements are onerous and sukuks (Islamic bonds) are an opportunity for banks to raise capital," said Merisha Kassie, a director in financial services at Ernst & Young.

Islamic banking is relatively small in South Africa. Out of a population of 51.7-million, it is estimated that the South African Muslim community does not exceed 2%, Ms Kassie said.

However, she said that Islamic finance presented an attractive market in Africa as a whole, where the Muslim population numbers more than 400-million, with the majority unbanked.

Ernst & Young noted that South Africa had made progress in the inclusion of Islamic finance into tax legislation and there were some amendments expected this year.

South Africa’s largest unsecured lender, African Bank, said it did not offer Islamic banking products. But Markus Borner, the executive for balance sheet management, said: "We would, however, not discount the possibility of issuing listed or unlisted bonds that comply with certain requirements as set by Islamic investors should these bonds meet our funding requirements."

Capitec spokesman Charl Nel said the bank, for risk management reasons, was not a buyer of Islamic bonds. "Islamic banking in South Africa requires very specific processes, which would require significant investment in alternate systems, which is not part of our current strategy."

Last year, banking group Absa said it was looking to expand its Islamic banking franchise in South Africa and the rest of the continent, in countries such as Egypt, Tanzania, Uganda, Ghana and Zambia. Absa has also bought an Islamic insurance company (Takafol), which is a provider of sharia-compliant insurance products. It also launched a "sharia forward exchange" contract. The bank has appointed a new MD of Islamic banking, Afzal Seedat.

However, the Ernst & Young report noted that the profitability of Islamic banking lagged behind that of conventional banking, prompting institutions to initiate a number of transformation programmes.