Qatar Central Bank ordered all conventional banks to close down their Islamic windows earlier this year

Qatar Central Bank ordered all conventional banks to close down their Islamic windows earlier this year

The Gulf's Islamic finance industry is on an upward growth trajectory as the sukuk market rebounds and new lines of business emerge. But there are growing calls for greater regulatory oversight to ensure the industry remains true to its values and improves transparency going forward.

For an industry less than 40 years old, the global financial crisis represents the first major challenge that Islamic finance has faced. The fact that it has emerged relatively unscathed when compared to conventional peers is testament to its sound underlying principles. In fact, the demand for Islamic banking services has gained momentum since the onset of the financial crisis as investors looked for a safe haven amid the collapse or struggles of conventional banking giants such as Lehman Brothers. 

As a result, predominantly Muslim countries have accumulated substantial liquidity in the region of billions of dollars over the past few years as Islamic investors seek to diversify away from a dependence on dollar-denominated instruments, which have become risky due to the high level of US debt. High oil prices this year have further helped increase liquidity in the system for countries throughout the Gulf.

Global sharia-compliant assets are estimated to have crossed the $1000bn mark in 2010, with about one-fifth invested in the Middle East. 

Bahrain's turmoil

The Islamic finance industry is expected to grow by between 15% and 20% a year over the next few years, according to a report published in November 2010 by professional services firm PricewaterhouseCoopers. But it is not simply a straightforward picture of growth. There have also been some dramatic changes to the Gulf’s Islamic finance landscape during the course of this year. 

Long regarded as the sharia banking hub of the region, Bahrain has been beset by political turmoil since February when its government responded to Shi'ite protests with violent crackdowns. The country's financial credentials have been badly shaken as a result. All three major credit rating agencies – Moody’s, Standard & Poor’s and Fitch – have downgraded Bahrain’s credit rating, as well as a number of financial institutions, and warned that further downgrades were possible.

“The cost of funding has gone up as it has become much more difficult for Bahraini banks to borrow money,” says Mohammed Chowdhury, head of Bahrain-based Arcapita Bank’s financial management group. “It has also resulted in a withdrawal of funds.”

The Bahrain Chamber of Commerce estimates that the losses incurred due to the political turmoil amount to about $2bn, although this figure is likely to increase as the country continues to feel the effects for some time.

“The events which took place in Bahrain between February and April this year have had an impact on all sectors of the economy. But the financial sector has been particularly affected,” says Mohammed Paracha, partner at the Bahrain office of international legal practice Norton Rose.

“Bahrain is now perceived as falling into a higher political risk category, which makes it more difficult for local corporates and banks to access the international financial markets. As a result, the confidence and appetite of investors and other industry players has lessened. The Islamic banking sector in Bahrain, which had been recovering well from the global financial crisis, has slowed considerably during the first half of 2011,” adds Mr Paracha. 

Oman's U-turn

The political unrest has diverted attention to neighbouring states, most notably Dubai in the United Arab Emirates, which can offer a stable alternative base, as well as sophisticated banking infrastructure.

However, new competition was introduced into the market in May this year when Sultan Qaboos bin Said Al Said issued a royal decree authorising sharia-compliant services in Oman. The decree approves the establishment of Oman’s first standalone Islamic bank, Bank Nizwa, which is expected to launch in early 2012 and entitles conventional lenders to open Islamic windows. 

Previously, Oman had been the only one of the six Gulf Co-operation Council (GCC) states that prohibited Islamic finance on the grounds that no distinction should be drawn between Islamic and conventional banks. Indeed, in 2007 the head of Oman’s central bank had said that “banks should be universal”.

The U-turn was prompted by the desire to curb the outflow of funds and grab a share of the rapidly growing industry. In green-lighting Islamic institutions, Oman hopes to tap the demand for sharia-compliant products and services, which is currently being met elsewhere in the Gulf.

“There is a lot of demand, mainly in the retail sector, for sharia-compliant financial products which, in the absence of domestic institutions, resulted in a liquidity drain from Oman to other centres in the Gulf,” says Mr Paracha. “There has been a lot of Omani money placed with UAE Islamic institutions.” The decree is expected to prompt a reverse flow of capital from the UAE to Oman, which is triggering growing interest from banks.

“Based on discussions we have had, we are aware that most conventional banks [in Oman] are looking to set up an Islamic window,” says Ashar Nazim, executive director and Islamic financial services leader at professional services firm Ernst & Young. 

Ernst & Young forecasts that a successful roll-out of Islamic banking infrastructure could see the industry in Oman gaining up to $6bn in Islamic assets over the next few years. Total banking assets in Oman in 2010 were estimated to be $42bn.

Sukuk boom

The most significant industry trend to date this year, however, is the resurgence of the Islamic bond (sukuk) market. Global sukuk sales have climbed 24% to $7.8bn in the six months to the end of June 2011 over the same period last year. The Middle East and north Africa market has been particularly active, with three sukuk being issued in one week alone.

It is highly significant that the sukuk that re-opened the market this year was the $500m issuance by Dubai public joint-stock company Emaar Properties in January. This also represented the first corporate sukuk offering from Dubai since the state received a $20bn bailout from the Abu Dhabi government and the UAE’s central bank in 2009 in the wake of the Dubai World debt crisis.

“The Gulf sukuk market paradigm has definitely shifted in 2011,” says Mr Paracha. “In 2009 and 2010, sukuk activity in the GCC was hit by the global fiscal crisis and issuers found it difficult to raise money due to the prevailing uncertainty in the market. However, we have witnessed a comeback of sukuk in the region this year as the market recovers and confidence returns.”

The relatively successful restructuring of Dubai World’s $15bn tranche of debt in March this year has lifted a dark shadow that had been cast over the market ever since the government-owned conglomerate requested a six-month standstill on its $25bn debt in November 2009. 

HSBC landmark

According to Mohammed Dawood, managing director of global capital financing at HSBC Amanah, liquidity levels for sukuk are currently at the highest level they have been in four or five years. The bank says it is seeing mandates for sukuk issuance in 2011 above pre-crisis levels. 

In June this year, HSBC Middle East issued a benchmark $500m public sukuk, the first from an international bank, to help grow the group’s Islamic business. The issuance was oversubscribed by 3.5 times and shows continued demand with spreads for the sukuk now trading on the secondary market at 23 to 25 basis points inside the conventional bond. This illustrates that cheaper pricing can be achieved by issuing sukuk in the current market and, perhaps more significantly, it proves that conventional banks can issue sukuk successfully.

Sukuk issuance by country 1996 - 2010

“Our sukuk attracted capital from investors from the Middle East, Asia and the West,” says Mr Dawood. “Part of the reason for the attractiveness of the sukuk market right now is the investor base. New Islamic funds located in the Gulf and south Asia provide stable, long-term investors, which has the effect of smoothing out volatility.”

As a result, sukuk are becoming increasingly popular in the international market, particularly in the West, where investors are keen to avoid exposure to the eurozone debt crisis. 

Takaful growth

The Gulf’s appetite for Islamic insurance (takaful) is also helping drive the growth of the industry and generate a new profitable line of business. Takaful is one of the fastest growing segments of the regional insurance industry today, which is itself hugely untapped. GCC insurance penetration rates are generally less than 2% of gross domestic product, compared with closer to 10% in mature markets.

Takaful premiums expanded by 31% from $6.9bn in 2009 to $9.15bn in 2010, and are expected to touch $12bn this year, compared with growth of about 15% in the conventional insurance market. The Gulf accounts for the lion’s share of the global takaful market, with 70% of all premiums.

Noor Takaful, the sister company of Noor Islamic Bank, has quickly established itself as a leading takaful provider in the UAE and enjoys about 12% of the local market. “It has shown remarkable growth since its inception in 2009, despite increased competition and being launched at the height of the global economic crisis,” says Hussain Al-Qemzi, chief executive of Noor Islamic Bank. “Given the demand for sharia-compliant services and products in the region, it is not surprising that local, regional and international banks view takaful as a potential business opportunity.”

How to grow?

A major constraint of the Gulf’s retail Islamic finance market, however, is the small population of most of the GCC states, which limits domestic demand. With a population of 25.7 million, Saudi Arabia is an exception in this respect and much of the future growth of Islamic banking is expected to originate from there. 

At the same time, hydrocarbon resources in the region generate a great concentration of free capital that local governments are looking to put to use. 

Given the fact the local economies have been affected by the global financial crisis and more recently by political turmoil, it is now more difficult for Gulf sharia institutions to find high-return investment opportunities locally. This is one reason why banks are increasingly looking beyond the region to emerging economies for new growth.

“We are establishing our presence in Turkey by structuring, managing and leading sizable corporate finance deals,” says Mr Al-Qemzi. “To date, we have participated in deals valued at approximately $1.1bn and are joint leading, arranging and book-running deals valued at about $600m. We will leverage this expertise into opportunities that emerge across Asia. It used to be that Far Eastern investors came to the Middle East. However, I foresee the reverse taking place as Asia grows and proves its resilience.”

Aside from its strong economic growth, the other obvious attraction of Asia is that it is home to the majority, or 62%, of the world’s 1.6 billion Muslim population, which is increasingly demanding sharia-compliant banking products. As the world’s most populous Muslim nation – 85% of its 238 million population is Muslim – Indonesia is proving to be a particularly popular market. 

In February this year, Doha’s largest lender Qatar National Bank completed its acquisition of an 82.4% stake in Indonesia’s Bank Kesawan. Both Qatar Islamic Bank and Bahrain’s Al Baraka are eyeing acquisition targets in Indonesia to tap demand for Islamic banking in Asia.

Concerns raised

Amid industry efforts to pursue new avenues of growth, sharia scholars are increasingly voicing concerns over the future direction of the industry. “The most common complaint is that the differentiation between Islamic and conventional banking isn’t very visible,” says Ernst & Young's Mr Nazim. “They point to the fact that the industry doesn’t seem to be moving beyond synthetic product structures.” Indeed, the scarcity of data and underinvestment in analytical tools means the focus of Islamic banks remains limited to a handful of asset classes. 

“The unique selling point of Islamic banking is the claim that it is a more fair and ethical form of financing,” says Mr Nazim. “If Islamic products are simply replications of conventional products then it calls into question the credibility of the existing system. The downturn has been a major catalyst for Islamic finance to put its house in order.”

Mr Nazim’s viewpoint is representative of a broader industry stance that Islamic banking is entering a period of housecleaning, with central banks looking to revise their sharia governance frameworks to properly audit the operations of financial institutions.

The desire to clean up existing frameworks was brought to the fore by the directive issued by the Qatar Central Bank in February this year ordering all conventional banks to close down their Islamic windows by the end of 2011 amid worries over the co-mingling of funds. The directive will result in a field of 12 competing institutions being pared back to just four wholly Islamic banks.

“We are certainly seeing a trend towards greater regulatory scrutiny of Islamic financial institutions,” says Mr Paracha. “I think this is a good thing, which will foster confidence and transparency in the sector. However, the [Qatar Central Bank] directive seems to be a bit of an extreme manifestation of this more profound trend.”

A lack of standardisation?

Qatar’s directive is unlikely to set a precedent that could spread to other Gulf countries, but it has sparked considerable debate about the ongoing development of the industry and its lack of standardisation.

The United Sharia Board was established in the UAE in 2009 with the aim of achieving a centralised sharia board for the Gulf’s Islamic finance market. It now has two scholars from Saudi Arabia and one scholar each from Kuwait and Qatar. In the long term it hopes to boost corporate governance within the industry and limit the number of boards that individual sharia scholars can sit on.

“I believe there is a growing consensus that, in order for the region’s Islamic market to fulfil its potential, there is a need for the industry to sit together to develop products and structures that are acceptable to us all,” says Mr Al-Qemzi.

“More and more people are coming around to the view that, only by leveraging our collective expertise, can we push the regional boundaries of understanding closer towards each other.”

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