The market for Islamic banking is forecast to grow at double the rate that conventional wholesale banking will grow in the next five years. Unsurprisingly, banking centres around the world are scrambling to establish footprints in the market. Natasha de Terán investigates how London is positioned.

A recent McKinsey & Company study estimated that the Islamic banking industry would grow at a rate of at least 20% between now and 2012 – at least twice as fast as the rate for conventional wholesale banking. The statistics are promising but they are not the only ones that have been making Islamic finance business attractive to banking centres. According to Dealogic, the combined volume of Islamic bonds and loans issuance rose to the highest-ever yearly total of $20.8bn in 2006, compared with $15.6bn in 2005 – a 33% annual increase.

In the battle for Islamic purses, London has to compete not only with New York, but also with Bahrain, Dubai, Riyadh, Singapore and Kuala Lumpur. It has the advantage of politics and geography over New York. The UK government has put itself firmly behind London’s ambitions, while the US administration has yet to do the same, and London is better positioned to serve the overlapping time zones in the Gulf and Far East. London also has the advantage of neutrality over the Gulf and Far Eastern states: interpretations of sharia law vary widely from region to region – London can serve all neutrally.

London-based legal and banking experts have been quick to seize the opportunity. Law firms, including Clifford Shance, Linklaters, Allen & Overy and Norton Rose, have been making substantial inroads into the nascent market. At the same time, London-headquartered banks such as Barclays Capital, HSBC and Lloyds TSB have been building up Islamic expertise and product bases. The London arms of investment banks such as SG CIB, BNP Paribas, UBS and Deutsche Bank have also been hiring dedicated Islamic staff, as well as redeploying existing expertise.

Their endeavours, together with the UK government’s efforts to ensure London becomes the de facto Western centre for Islamic finance, have placed London firmly on the Islamic banking map. So much so, in fact, that many London practitioners believe the stage is already set for the UK capital to win the Islamic crown.

Shaun Wainstein, head of London equities and derivatives at BNP Paribas, says: “London is undoubtedly the main Western centre outside of the Middle East for Islamic finance. This is partly down to the geographical location and partly because the structuring experts within investment banks are based here.”

Andrew Roberts, the head of Islamic capital markets at Linklaters, believes that London is a major Islamic finance concern for much the same reason that it is the main centre for other forms of finance: “The accountants, lawyers and bankers who work on deals around the world are based here. Notably, the banks that have set up sharia operations still tend to run their structuring, origination and product development out of London – their sharia boards and customer-facing sales teams will be on the ground in Dubai or Bahrain or elsewhere, but their real product development activities have generally remained here.”

Geert Bossuyt, regional head of Middle East structuring at Deutsche Bank, says: “The environment, the appeal of the City [of London] itself and the recent political interest in furthering Islamic finance here are some of the factors. The ready availability of financial talent – and particularly the ability to re-engineer or refocus that talent on Islamic finance – are additional factors.”

Deutsche, BNPP and Linklaters have long housed a good proportion of their international expertise in London, so their expressed confidence in the capital is perhaps less remarkable than that demonstrated by some newer ventures. The European Islamic Investment Bank (EIIB) is one such example.

Owned by ranks of Gulf-based individuals and institutions, including a number of Islamic banks, the EIIB was established early last year, with the intention of becoming the first independent Islamic investment bank established and managed on a wholly sharia-compliant basis. It is not only headquartered in London, but is also regulated by the UK’s Financial Services Authority.

John Weguelin, managing director of the EIIB, explains why the UK capital was chosen to be the new bank’s headquarters: “London is obviously a major financial hub, a centre for deal flow and its regulatory environment is well established and widely respected. The capital also has a high concentration of very skilled people, and our strategy was always to bring in new talent from the conventional side of investment banking and to apply that skill set to the Islamic world.

“Another factor that influenced our decision to set up here was the government’s stance – it was very apparent from our early conversations with it that it already had in mind the idea of establishing London as a centre for Islamic finance. Finally, we wanted to list on the London Stock Exchange, so it made sense all round.”

Government momentum

It has doubtless been with one eye on the UK’s urgent need to forge relations with Muslim communities at home and abroad, and another on the wider economic opportunity, that the Labour government now aims to makes the UK “a global centre for Islamic finance and trade, as well as a strong partner for financial markets in the Middle East, north Africa and other Muslim countries around the world”. The present government started shaping the tax and regulatory framework to allow for the development of Islamic finance products back in 2003. Through the Finance Act 2003, the UK government removed the double stamp duty land tax charge on murabaha and ijara-based mortgages and, in 2005, it legislated to bring Islamic mortgages within the existing mortgage regime. At the same time, it addressed the issue of both mudaraba and murabaha transactions, facilitating the creation of a fuller service retail banking sector (see page 78 for definitions).

Then UK chancellor Gordon Brown (now prime minister) and his economic secretary, Ed Balls, showed particular interest in establishing London as one of the global centres for Islamic finance. Mr Brown, now prime minister, has spoken on the matter on repeated occasions. But, from his appointment to economic secretary in May 2006, Mr Balls (who has been secretary of state for children, schools and families since June this year) led the Islamic finance charge – so much so that one of his first tasks as minister was to get legislation through to enable sharia-compliant borrowing for UK businesses.

Islamic hub credentials

Speaking at an Islamic finance summit in London in January, Mr Balls laid out the UK’s credentials as the pre-eminent Islamic finance centre. He noted how the largest sukuk to date, a $3.5bn convertible issue by DP World, had been written out of London; how mainstream banks such as HSBC and Lloyds TSB had started offering sharia-compliant products in all their branches; how regional building societies, such as the West Bromwich Building Society, were offering sharia-compliant products; and how the UK now has a fully sharia-compliant retail bank, the Islamic Bank of Britain. He related how UK-based law firms were playing prominent roles in the Islamic market, and how organisations like Ansar Finance in Manchester were providing loans and investment opportunities for local Muslim communities.

There is much more besides. London has been credited for driving much of the recent innovations in the sharia finance market. Bankers here have developed Islamic indices, structured products, currency hedging devices and – more recently – come up with ways for hedge funds to short securities in an Islamic-compliant way. Most of the structured product deals have been aimed at the buoyant private banking market and have been shrouded in secrecy. Back in 2005, SG CIB developed real estate and commodity structures as well as some interest rate-like pay-offs, the bank describes as being “quite simple but proprietary”. Similarly, Citigroup pioneered and successfully marketed the first Islamic-compliant credit derivative offering, the details of which it will not disclose.

Sukuk issues

London’s role in the public sukuk issues has been no less prominent. For instance, in January 2006 Barclays Capital lead managed a $3.5bn sukuk pre-IPO bond for DP World, the largest ever sukuk. And when Tabreed issued the first rated corporate sukuk in the Middle East in June last year, Linklaters was appointed to act for the firm.

Allen & Overy, meanwhile, advised the deal’s lead managers HSBC Bank and Dresdner Bank. Allen & Overy again advised HSBC when the UK bank acted as arranger and dealer on a December 2006 $5bn Trust Certificate Issuance Programme established by Abu Dhabi Islamic Bank. That programme broke new ground, being the first sukuk programme to be established in the United Arab Emirates and the largest programme (whether conventional or Islamic) to be established in the region. It was also the first sukuk programme to be listed on the London Stock Exchange.

Even more important, perhaps, has been the more recent emergence of London as the centre for secondary market trading in Islamic instruments. The UK capital is a natural centre for secondary market trading: it houses not only many of the originating banks, but also many of the hedge fund and real money investors that have recently bought into Islamic bonds.

The same, however, could also be said for New York, so it will have been particularly gratifying for London’s advocates that a New York firm, the interdealer brokerage GFI Group, chose to establish the first-ever secondary market brokerage desk in London. Having decided in mid-2005 that there was sufficient interest in secondary market trading in Islamic assets to warrant opening a dedicated Islamic brokerage desk, GFI staff cast around to decide where to house it. In July last year, the firm chose to base it in London.

GFI’s five person-strong Islamic banking and finance broking desk typically matches Middle Eastern banks’ trading interest in sukuks with London-based counterparts. Chris Steer, head of the desk, says that secondary market activity remains “quite low”, but he insists that London was a “natural choice”, notes how the market there has been growing “exponentially” and points to recent estimates of monthly secondary market volumes of about $2bn.

More to be done

For all the confidence in London’s Islamic credentials, both existing players and those in government admit that there is still more to be done if London is to see off its many rivals for the Islamic capital crown. In his January speech, Mr Balls said: “We are aware that there is more for us to do. We are currently looking at the how the tax system interacts with the sukuk market – what barriers there are to establishing a secondary market in the UK; what barriers are in the way of UK issuance and how UK holders are taxed.”

The UK government will be addressing some, if not all of these issues this year. The 2007 budget, for instance, set out what the tax framework for sukuk will look like and HM Revenue and Customs (HMRC), the UK’s tax authority, has published guidance on the tax treatment of takaful products and on how diminishing musharaka products will be treated for capital gains and capital allowances. Islamic finance is meanwhile set to become a “key priority” of the work of the chancellor’s High-Level Group, a joint working group between the UK government and the City.

“The objective of all our work is to enable the market to develop and flourish, to help the Islamic finance industry to go from strength to strength, to cement London as one of the global centres for Islamic finance,” said Mr Balls.

Mr Weguelin seems pleased with the commitments. “What HMRC is trying to do is to create a truly level playing field between Islamic and conventional finance, thus making it a real alternative for issuers and investors.”

Room for innovation

Whether London will continue to be prominent in the business thanks to its ranks of clever structuring experts is, however, still open to doubt. Mr Roberts believes there is still “a lot of room” for innovation. He says that the universe of assets that has been used to generate sharia-compliant profit is still limited and there is huge scope to expand it – for instance his firm is now working to put together the first-ever aircraft sukuk.

“Also, while a lot of sharia-compliant or sukuk securitisations have been put into place, these have so far been relatively basic,” says Mr Roberts. “The credit ratings have tended to look back to the credit of the transferor and there has been no attempt to use the credit of the underlying asset to improve the rating. Soon, I believe, we will start to see more ‘real’ securitisations.”

Mr Wainstein is similarly confident of the scope for innovation. “There is a massive amount of potential for this market,” he says. “So far we have mainly been working on equity-linked structured baskets, in which the stocks are specifically selected to be sharia-compliant, and we have also looked at developing some similar commodity-based products. But we have also done a lot of recent work on sharia ‘wrappers’, which allow for a lot more flexibility in product development and we expect increased demand for such products in the future.”

Deutsche Bank’s Mr Bossuyt disagrees, however. He says the market may already be at a turning point with innovation: “Structuring techniques are now sufficiently developed that they can be applied to develop almost any sort of product.”

Although there has been a lot of self-congratulatory talk about recent innovations in Islamic finance, Mr Bossuyt argues that there has been relatively little recent conceptual innovation. “There is a real distinction to be made between the emergence of conceptually new innovations and earlier innovations being adopted more widely,” he says. “What has been happening of late is more the latter – for instance, the profit trade swaps, sukuk and wakala deals of last year. None of these were new; they simply became more widespread in 2006. Thus, I think this trend will continue; we will see existing products being more widely applied and sold, and far less conceptual innovation occurring.”

The good news for London is that Mr Bossuyt believes this is no bad thing for the City and its structuring experts. “We welcome this, because it will allow the market to expand exponentially. The market is far from saturated and we believe that overall growth is more important than market share at this stage.”

The landscape ahead

Following the lead of the many conventional investors that have been buying into public sukuk deals in the past few years, bankers believe that more and more Western investors will now look to buy into Islamic products as a way of gaining Middle Eastern exposure. This, too, bodes well for London because many of the conventional investors are based there.

Mr Bossuyt believes that there are two more factors that will help towards London’s continued success. First, he says that more and more Western corporates and governments will seek to follow the lead of the German state of Saxony-Anhalt, which issued a €100m sukuk in 2004, by doing more and more of their financial activity in a sharia-compliant way. Second, he says that Islamic companies will start to hedge out their risks in a sharia-compliant way. In both cases, the London ranks of origination, distribution, debt and derivatives experts are likely to prosper.

Government support: in 2003 Gordon Brown (right) and Ed Balls (left) showed particular interest in establishing London as a global centre for Islamic finance.

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