Sanctions on Russia over the crisis with Ukraine are leading banks to call for the development of Islamic finance as they seek alternatives to European and U.S. pools of funding.

The expansion of the Shariah-compliant industry would let the country attract fresh capital from the Middle East and Asia, the Association of Russian Banks said this week in response to an inquiry from the state bank. The Bank of Russia should develop rules for Islamic banking, the association said.

Global Islamic financial assets are growing at 17 percent a year and are set to reach $2.7 trillion by 2017, according to PricewaterhouseCoopers LLP. Expansion of the industry in Russia could help lenders such as state-backed OAO Sberbank and VTB Group manage being mostly shut out of U.S. and European capital markets amid penalties over Russia’s role in supporting separatists in eastern Ukraine.

“Necessity will create innovation,” Rizwan Kanji, a Dubai-based partner at King & Spalding LLP, a law firm that has advised on Shariah-compliant transactions in Russia since 2012, said by phone on Aug. 7. “Russia may be at the cusp of transition. The opportunity for Islamic finance is mouth-watering.”

Rare Deals

The average yield on Russian dollar-denominated debt climbed to 6.03 percent yesterday, 126 basis points higher than Feb. 28, the day before the country’s incursion into Ukraine’s Crimea, according to data compiled by Bloomberg. That compares with a 21 basis-point decline to 4.16 percent in the average yield of Middle East sukuk, according to JPMorgan Chase & Co. indexes.

The European Union added Russia’s three largest lenders, including Sberbank and VTB, to a sanctions list over President Vladimir Putin’s stance on Ukraine on July 31. The measures, which followed U.S. penalties, restrict the lenders from selling bonds or shares in the EU.

A spokeswoman for VTB declined to comment by phone yesterday. The press office at Sberbank didn’t immediately respond to a phone call and an e-mail seeking comment.

“The Kremlin should move quickly into the Islamic finance market as a way forward,” Theodore Karasik, director of research and consultancy at the Institute for Near East and Gulf Military Analysis in Dubai, said by phone Aug. 11. “Centers of Islamic finance in the Middle East and Asia” have a good relationship with Moscow, he said.

Islamic financial transactions in Russia are rare. Tatarstan, an oil-rich predominantly Muslim federal republic in south-eastern Russia, has led Islamic finance development in the country. Kazan-based AK Bars Bank, in which the government of Tatarstan is a shareholder, closed Russia’s first Murabahah transaction in 2011. In a Murabahah contract, goods are bought and then resold with a pre-agreed mark-up to allow lenders to cater for customers that want to lock in payments in the future. Tatarstan’s plans to sell a sukuk have been delayed by technical difficulties, according to Linar Yakupov, head of the Tatarstan Investment Development Agency.

U.S. Sanctions

The absence of legal infrastructure and a lack of high-level government backing have been a key barrier to the growth of Islamic finance in Russia. Sergey Shvetsov, the first deputy chairman of Bank of Russia, said last month he didn’t see a huge demand for Islamic banking products in Russia, and was “tolerant” of it, according to state news agency, Interfax.

“The lack of specialized regulation of Islamic finance in Russia makes full-fledged development of the industry through banking institutions impossible,” Madina Kalimullina, Moscow-based director of the economics department at the Mufti Council of Russia, said by e-mail on Aug. 11. When sukuk and other Islamic instruments are regulated and become competitive they’ll be a good platform to attract investments, she said.

The Association of Russian Banks, a non-governmental organization, proposed introducing a draft law that would spur the full development of Islamic banking in Russia, spelling out legislative and tax frameworks and introducing a shariah board to oversee issuance.

Tatarstan still plans to sell a $200 million sukuk, according to TIDA’s Yakupov.

Attracting Arab and Muslim capital should be on Russia’s agenda, he said by phone yesterday. “It makes sense to examine these instruments more seriously as an alternative.”

*This article was originally published on Bloomberg Businessweek on 13 August 2014. Read the original article here.