Muhammad Hammad

1.0 Growth and Resilience of the Islamic Financial Services Industry

1.1 Global Macro Financial Environment

Global financial conditions in 2025 remained accommodative despite weakening growth and elevated risks. Equity valuations and credit spreads are near record highs, while growth is slowing. Islamic financial institutions, mostly in emerging markets, face challenges from tight macro financial conditions, debt sustainability, and limited fiscal space.

1.2 Growth and Market Development Trends

The global Islamic financial services industry reached $4.4 trillion in assets in 2025, with growth in banking, capital markets, and insurance sectors. Islamic banking remains dominant, but non-banking segments are growing faster. The industry is concentrated in GCC and EAP regions (75% of assets). Sukuk markets expanded to $1.10 trillion, with strong growth in sustainability and climate-related issuances. Islamic insurance grew double-digit, driven by emerging markets and mandatory insurance requirements.

1.3 Banking

Islamic banks’ asset quality shows signs of deterioration in some jurisdictions, with high non-performing financing ratios in Bangladesh and Kenya. Capital adequacy remains resilient, but hybrid financing models and concentrated exposures to commercial real estate and retail segments pose risks. Funding and liquidity risks are contained, but structural vulnerabilities exist, such as limited high-quality liquid assets and reliance on commodity Murabaha transactions. Profit-sharing investment accounts (PSIAs) also pose risks, as banks may absorb displaced commercial risk, compressing retained earnings. Overall, Islamic banks face emerging pockets of vulnerability, requiring continued supervisory attention.

1.4 Insurance

Islamic insurance operators face weakening profitability due to margin compression, with rising claims costs outpacing contribution growth. Solvency ratios remain above minimum but have narrowed in several markets. Operators increased Sukuk allocations, supporting income but increasing exposure to repricing risks. Structural constraints, like long-term Sukuk scarcity, limit the sector’s capacity to absorb large-scale losses, such as climate-related events exceeding $100 billion in insured claims globally. The growing bancassurance linkage increases interconnectedness with Islamic banking, amplifying potential risks.

1.5 Capital Markets

The Sukuk market saw strong growth in 2025, with issuances reaching $234.5 billion, driven by core markets like Malaysia and Saudi Arabia. However, structural constraints persist, including a narrow investor base, overreliance on sovereign issuers, and limited corporate participation. Domestic issuance contracted, while international issuance expanded, introducing currency mismatch risks. Islamic funds recovered in 2025 but remain small and geographically concentrated, constraining capital market development and financial stability.

1.6 Financial Stability Outlook

Global financial stability risks are elevated due to the Middle East conflict, energy price volatility, and rising inflation, which may tighten financial conditions and trigger market volatility. Islamic financial systems, concentrated in affected regions, face transmission risks through sovereign debt, capital markets, and corporate sectors. Islamic banks, though well-capitalized, may face asset quality and funding pressures. Supervisors should monitor risks closely and manage exposures.

1.7 Policy Recommendations

A coordinated policy response is needed to address vulnerabilities in the Islamic financial services industry, balancing market development with prudential safeguards. Key priorities include strengthening governance, risk management, and supervisory frameworks; developing liquidity management options for Islamic banks; improving insurance business models and capital frameworks; expanding Islamic reinsurance capacity; and enhancing Islamic capital markets.

Developing local currency Sukuk markets and diversifying the investor base can strengthen resilience. Strengthening crisis management frameworks and implementing robust regulatory standards are also crucial. Supervisors should monitor risks closely and take proactive actions to mitigate vulnerabilities.

2.0 Hybrid Risks and Financial Stability Implications

2.1 Market Trends and Drivers

Hybrid instruments dominate Islamic banking in many jurisdictions, shaping financing and funding patterns. They are used for interbank funding and liquidity management, often due to structural constraints like limited high-quality liquid assets and shallow Islamic money markets. Commercial pressures and regulatory considerations also drive away their adoption, allowing banks to manage short-term liquidity and balance sheet volatility. Their prominence varies across jurisdictions, reflecting local market conditions and institutional practices.

2.2 Financial Stability Implications

The growing reliance on hybrid instruments in Islamic banking poses financial stability risks at both institutional and system-wide levels. These risks include increased balance sheet elasticity, leverage build-up, operational complexities, and liquidity pressures. System-wide, hybrid models may synchronize credit expansion, amplify feedback loops between credit growth and asset prices, and propagate liquidity stress through interbank markets. Structural constraints, such as limited high-quality liquid assets and shallow Islamic markets, may exacerbate these vulnerabilities.

2.3 Micro Prudential Implications

Hybrid banking models pose micro-prudential vulnerabilities, including amplified credit and leverage dynamics, reduced loss-absorption capacity, funding vulnerabilities, and non-financial risks. They can facilitate rapid credit growth, increase balance sheet elasticity, and concentrate on risk in similar asset classes. Hybrid instruments may also lead to reputational, legal, and Sharīʻah-compliance risks, undermining confidence in Islamic banking. Regulatory arbitrage in dual banking systems can further obscure risk profiles and weaken prudential measures. These factors may increase the likelihood of credit booms and amplify financial stress during downturns.

2.4 Macro Prudential Implications

The widespread use of hybrid banking models can amplify system-level risks, including correlated credit and leverage cycles, and liquidity fragility. Hybrid models can fuel rapid credit growth, increasing system-wide leverage, and exacerbate credit deterioration during downturns. Interconnectedness through hybrid instruments can propagate stress across institutions, while shared market infrastructure creates operational vulnerabilities. This interconnectedness may also transmit external shocks, amplifying financial instability in Islamic banking systems.

2.5 Policy Recommendations

Hybrid banking models require adapted supervisory and regulatory frameworks to address unique risks. Key priorities include ensuring capital frameworks capture hybrid instrument risks, monitoring balance sheet growth, and addressing liquidity vulnerabilities. Supervisors should track hybrid exposure concentrations, conduct relevant stress tests, and integrate macroprudential buffers. Strengthening infrastructure, like Sukuk markets and liquidity instruments, is also crucial. Aligning business models with prudential frameworks and developing Islamic finance infrastructure can support resilience and sustainable growth.