After more than three decades of modern Islamic finance, the time has come to review the past and examine the future of this fast-growing industry. By Emmanuel Volland, Standard & Poor’s.
Double-digit growth rates for Sharia-compliant assets over the past decade have naturally driven Islamic financiers to look beyond historical boundaries to explore new territories, both within and outside the Arab world. In response to the increasing competitive pressure stemming from the entrance of new players into the market, existing Islamic banks have started to leverage on their natural competitive advantages, which include customer loyalty, sensitivity to religious practices, and stable bases of cheap deposits.
Even conventional banks have moved to open Islamic branches, create Sharia-compliant subsidiaries, or undergo complete conversions to become fully Sharia-compliant. The retail market, the key profit driver of banking in the Gulf, is attracted by what Islamic banking can offer. The size of global Sharia-compliant assets is estimated today at up to US$400bn, whereas Standard & Poor's Ratings Services believes the potential market for Islamic financial services to be closer to US$4trn, meaning that Islamic finance currently has only a 10% market share among the Muslim community globally and still a long way to go.
Islamic banks in the Gulf have displayed, and should continue to show, strong profitability, so long as oil revenues pour into the Gulf economies, maintaining economic momentum through a powerful multiplier effect. It is important, however, that the Islamic banking industry does not become complacent.
A number of issues need to be tackled, among which size and concentration risks are some of the most important. And the realisation of a common conceptual framework that unites the approaches of the two historical centres of Islamic banking – the Gulf and South-East Asia – would go a long way to enabling the Islamic banking industry to expand and diversify.
The market for Sharia-compliant notes, also known as sukuk, is set to expand rapidly. Standard & Poor's currently rates more than US$5bn of the US$10bn market for listed sukuk, which is expected to grow to more than US$20bn by the end of the decade. In the Gulf, investing in sukuk has become part of mainstream asset allocation and diversification, with Islamic banks in particular seeing these instruments as an important tool in managing their assets and liabilities, and recycling liquidity.
Islamic banking is expanding
In Arab and non-Arab Muslim countries, Islamic finance is currently being expanded beyond its historical borders of the Gulf region, where it began to emerge domestically in the 1970s as a result of the oil boom. Other Arab and non-Arab Muslim countries, particularly in Asia, are increasingly attracted by the principles of Islamic finance.
For the first time in the industry's history, several Islamic banks headquartered in the Gulf have recently set up business operations in Malaysia, while making clear that on the radar are Indonesia and China – large and deep markets only a short hop away from the Malaysian platform.
New horizons are also emerging for Islamic finance within the Arab universe: Lebanon, Syria, Egypt, Turkey, and – to a lesser extent – North Africa, have been identified as potential engines for unlocking franchise value.
Beyond the natural borders of the Muslim world, the advanced markets of both Europe and North America promise niche segments in which Islamic finance can profitably gain momentum, as shown by the financial community's bullish welcoming of both the Islamic Bank of Britain and its investment banking counterpart, the European Islamic Investment Bank. This is internationalisation, but not yet globalisation, for which some challenges remain.
Leveraging on natural advantages
The current market positions of existing Islamic banks are subject to significant competitive pressure. Although historical Islamic financial institutions – such as Al Rajhi Bank (A/Stable/A-1), Kuwait Finance House (A–/Positive/A-2), Albaraka Banking Group (not rated), and Dubai Islamic Bank (A/Stable/A-1) – still have bright prospects within their own marketplaces, new entrants are looming.
Sharia-compliant investment banks – such as Gulf Finance House (BBB–/Stable/A-3), Arcapita Bank (BBB/Stable/A-2), and Unicorn Investment Bank (not rated) – are shaking the old rules of Islamic finance with more aggressive (and so far very successful) business models.
In addition, new heavyweight contenders are making their debut, pushed by the proactive ambitions of Gulf entrepreneurs and governments. Al Rayyan Bank, Al Masref, Boubyan Bank and Bank Albilad are examples of institutions that could reshape the entire industry, given the relatively large size of their capital bases by regional standards and very focused strategies.
Even deeply entrenched conventional financial institutions have found it relevant, if not necessary, to make inroads into the promising territory of Islamic finance, although strategic approaches vary. Some have opted for the route of opening Islamic branches (particularly in Saudi Arabia and Qatar), some for creating fully fledged Sharia-compliant subsidiaries (such as Emirates Bank International PJSC {A/Positive/A-1} and Mashreqbank {BBBpi}), and others for complete conversion to Sharia compliancy.
This last alternative – taken up by Sharjah Islamic Bank (BBB/Stable/A-2), Kuwait Real Estate Bank (not rated), Emirates Islamic Bank (not rated), and Dubai Bank (not rated) – is the most radical, and has so far been the strategy of choice for smaller entities that have found themselves with their backs against the wall and faced with the alternatives of merge, specialise, or disappear. While the first option is obviously difficult, the second, specialisation, is a challenging opportunity.
The Islamic identity tends to provide a bank with an immediate and true element of differentiation, which helps in building barriers to entry at a time when domestic, regional, and foreign competition in the Gulf is becoming more intense by the day. It is difficult for a conventional competitor to replicate the natural reputation an Islamic financial institution has with retail clients, who are far more sensitive to religious considerations than are corporations – which care more about service and price. This intangible but powerful asset bodes extremely well, as the key profit driver of Gulf banking today is the retail market, which displays the most attractive risk-return trade-off.
Tackling issues of size
Islamic banks should not rest on their laurels, however, as they still have a long journey ahead to build stronger recognition, longer track records, and greater scale. Otherwise, they run the risk of being ghetto-ised amid increasingly globalised financial markets, at the expense of 30 years of progress.
To keep on track, they must tackle several issues. Size is as serious a matter, as are concentration risks. Islamic banks, even the largest ones, remain small by international standards, and their portfolios continue to focus on a limited number of asset classes and market segments.
Consolidation within the Islamic finance industry does not seem to be on the horizon, while the two historical centres of Islamic banking – the Gulf and Southeast Asia – have just started actively talking to each other. Intellectual competition and differing interpretations of the fundamental rules of Islamic finance have so far kept these two universes apart.
Greater interaction between them could eventually contribute to the emergence of a common conceptual framework for Islamic finance. This, in turn, could translate into improved accounting, governance, transparency, and management practices at Islamic banks – the sine qua non for their global aspirations.
Institutions such as the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the Islamic Financial Services Board (IFSB) and the Islamic Development Bank (IDB; AAA/Stable/A-1+) would certainly be instrumental in achieving these goals. Ultimately, however, the marketplace itself – including all stakeholders of the Islamic banking community – should take responsibility for the sustainability of a business model that is about to come of age.
Increased attention
Any examination of Islamic finance requires an in-depth look at sukuk, the Sharia-compliant Islamic notes that are an alternative to conventional bonds. These debt securities are backed by a pool of assets originated, owned, and managed by their originator, the latter also being the issuer of the sukuk. As asset-backed financial instruments, sukuk are by nature in line with one of the key principles of Sharia as applicable to financial transactions – that any financing should relate to a tangible and identifiable underlying asset.
The sukuk market came under the spotlight in 2002 when the governments of both Bahrain and Malaysia issued Sharia-compliant notes, as a deliberate choice to provide more visibility, depth, and liquidity to what was at that time a dormant practice. At year-end 2002, the market for sukuk did not exceed US$1bn, in a period when enhancing the profile of Islamic finance was high on the agenda of governments as well as bankers in a large part of the Muslim world.
Less than four years later, the outstanding amount of listed sukuk has crossed the symbolic line of US$10bn. Of this amount, Standard & Poor's has assigned ratings ranging between AAA and CCC+ to sukuk totalling more than US$5bn. We expect the size of the market to expand fast over the medium to long term.
Although sovereigns have remained so far the largest issuers of sukuk, the market is now expanding to non-sovereign issuers. Sovereign sukuk have become a benchmark, not only in terms of pricing, but also as far as acceptable structures are concerned, from both a Sharia and financial perspective.
A number of corporate issuers have taken the sukuk route to raise funds from the cash-rich oil economies of the Gulf, where investing in sukuk has become part of mainstream asset allocation and diversification. Islamic banks in particular see in sukuk a way to replicate, on a Sharia-compliant basis, conventional banks' fixed-income portfolios for asset-liability management, and to recycle part of their excess liquidity stemming from large inflows of new deposits resulting from high oil prices.
While expanding, the sukuk market remains a buy-and-hold asset class. Although the primary market has been quite active over the past two years, as a whole it remains narrow, and still constitutes a niche segment even by regional standards. The secondary market for sukuk is virtually non-existent. A significant demand for investment, highly correlated with the prevailing liquidity in the Gulf region, is chasing a still-limited supply of Sharia-compliant vehicles, all the more so as some inconsistencies remain in the interpretation of what is and isn't lawful as far as sukuk are concerned.
For example, what might appear as a licit investment vehicle in more liberal Malaysia might not be considered so in more conservative Saudi Arabia. Notwithstanding such subtleties, the existing appetite for sukuk demonstrated by both institutional and individual investors in the Gulf has provided strong incentives for issuers outside the region to tap this formidable pool of liquidity:
Germany's State of Saxony-Anhalt (AA–/Stable/A-1+) raised €100m in the form of sukuk in 2004; and US-based companies such as Loehmann's Holdings Inc. (B/Stable) and East Cameron Gas Company (not rated) have also issued rated sukuk to exploit alternative sources of available funds. According to various sources, the government of Japan is itself considering issuing Sharia-compliant classes of bonds to better suit the needs of its investment constituencies in oil-rich Gulf states.
It is a surprising fact that until recently Islamic banks have not been active issuers of sukuk. In fact, in the Gulf region, no Islamic financial institution of material size had issued any sukuk by late 2006. The market had to wait until April 2007 for an Islamic bank to issue the first sizeable bank sukuk ever. The move came not from one of the larger Islamic banks in Saudi Arabia or Kuwait, but from a relatively smaller institution, Sharjah Islamic Bank (SIB), which became a fully Sharia-compliant bank only in 2002. The size of SIB's sukuk issuance is US$225m.
We expect the SIB sukuk to be the first of a series, however, as a number of prominent Gulf-based Islamic financial institutions are lining up to raise Sharia-compliant money through sukuk. Islamic banks face the same kinds of challenges as conventional peers. One of these is amending their funding mix by raising more long-term funds in order to better manage maturity mismatches at a time when asset tenors are increasing. Issuing sukuk is probably the most appropriate way to achieve this goal, as the regional economic environment is currently benign and pricing is attractive.