Islamic finance roars again

“Abundance of money is a trial for a man,” according to an old Moroccan proverb. This saying summarises the challenge for the Islamic finance industry, which passed the $1000bn milestone during 2011. Sharia-compliant assets have surged from $894bn to $1086bn, reflecting yet another year of solid double-digit growth of 21.41%.

What is more impressive is that since The Banker's Top 500 Islamic Financial Institutions survey began in 2007, the rise in the industry’s sharia-compliant assets has maintained a persistent double-digit rate, averaging a compound annual growth rate (CAGR) of 18.82%. Perhaps more remarkable still is the fact that double-digit growth has continued in spite of the fact that last year’s concern was that the significant widespread statistical latency in the industry would show a greater impact of the financial crisis in the 2011 figures. Just under three-quarters (72%) of institutions reported a growth in assets, while 25% recorded a decline. Similarly, the vast majority (80%) of reporting institutions showed positive pre-tax profit growth.

Of the remaining 20% of institutions that showed a decline in profits, a high percentage of them were concentrated in the Gulf Co-operation Council. During 2011, 119 institutions increased their paid-up capital while 152 institutions increased their Tier 1 capital.  

Sharia-compliant increase

Overall, the number of institutions reporting sharia-compliant activity has increased from 221 in our 2007 survey to 348 in 2011. At the same time, the number of institutions registered to conduct sharia-compliant activities has risen from 525 in 2007 to 675 in 2011.

For comparison, all financial activity is converted to US dollars, which reduces or increases the growth rates as international currencies retreat or advance against the US dollar. In our five-year analysis of the data associated with the Top 500 Islamic Financial Institutions survey, we have factored these anomalies to make like-for-like comparisons. That said, the Islamic banking and finance industry is still a small fraction (just over 1%) of the global financial market.

The point is that as European and US bank regulators and monetary policy-makers continue to experience the wisdom of another old Arab proverb – misfortune is easier to bear if you share it with many others – the Islamic finance industry experiences another growth spurt.

In The Banker's 2010 Top 500 Islamic Financial Institutions survey, we identified a decline in year-on-year growth rate for the Islamic finance industry; this was recorded as a mere 8% growth, and we attributed this slower-than-before growth rate to the initial impact of the global financial crisis. But wonders never cease, and any decline in 2010 was reversed in 2011, as Islamic financial institutions felt a wave of capital as investors sought out safer havens in the emerging markets. Across the industry, the momentum of Islamic finance continues to defy the economic crisis as all regions have experienced solid double-digit CAGR.

One could argue that the financial crisis has heightened awareness of the industry among investors seeking safer, perhaps more modest returns. But this alone does not explain the full picture. Several factors have worked in favour of the Islamic finance industry’s growth; Middle East and north African (MENA) economies have not had the same economic corrections as Western markets, and banks in the MENA region acted to increase their capital adequacy ratios in many cases before the crisis. For example, Jordan’s minimum capital adequacy was set to 18% – well ahead of Basel II requirements, which set the tone for conventional and sharia-compliant banks alike.

The Western market drag

Early in 2011, the UK government decided not to issue a sovereign sukuk (denominated in pounds) which had been in discussion since April 2007. This retreat by the UK government sent a message that perhaps London’s role as Europe’s Islamic financial hub was losing momentum as slowing economic conditions continue to plague the conventional financial markets. Disappointingly, HSBC Amanah was unable to provide its sharia-compliant activities in time for this year’s survey, which acted to limit the growth of Islamic finance in the UK market to 0.49%.

Overall, the global Islamic finance industry is faring better than its conventional counterparts. This is not to say that sharia-compliant banks have been not affected by the financial turmoil of Western markets. Islamic institutions in the Middle East with exposures in real estate have experienced difficulties as property values experienced corrections in various domestic markets. However, as Western markets continue a cycle of risk avoidance and investor pessimism, sharia-compliant bankers are seeing new opportunities for the development of Islamic funds and other financial instruments that have been lacking behind conventional banks. Islamic investors are seeking new investments, asset classes and mechanisms for greater risk diversification.

Not waiting for the West

Islamic financial institutions are not waiting to see if a new economic world order will emerge from the West. Rather, they have adopted an attitude that the vast number of underserved Muslim populations can keep the industry moving forward. Early in 2011, the Central Bank of Nigeria introduced new regulations designed to enable Islamic banking, which resulted in Jaiz Bank International becoming the first sharia-compliant bank in Nigeria.

The industry continues to see new sharia-compliant institutions starting in Australia, Azerbaijan, Iraq, Mauritius, Nigeria, Oman, Pakistan, Qatar, Russia and Yemen. Also in 2011, Pakistan announced new plans to use Islamic finance as a mechanism for its financial inclusion and growth-setting targets, such as encouraging Islamic banks to open 20% of all new branches in rural communities.

Growth is predicated on infrastructure as Islamic finance continues to aggressively adopt new banking standards, increase transparency and harmonise sharia-compliancy standards. Industry activities must have sufficient financial infrastructure to function efficiently. To facilitate markets, several financial centres have emerged as leaders in the race to provide gateways to Muslim customers and act as a bridge to conventional markets. As the world’s second largest location to domicile funds, Luxembourg has been found to be the location of choice for Islamic funds in the West, with Mauritius attempting to achieve the same status in the East.

Sudan, with 31.10% growth, surged ahead of Bangladesh for 10th place in the country rankings, even though asset growth in Bangladesh rose by 24.68% to $11.7bn. Other moves on the country ranking saw Indonesia and Syria push Egypt down to 14th place, from 12th in 2010. 

Need for clarity

Market confidence is built on a basic understanding of how the market works, how corporations behave and the rules under which they operate. As the Islamic finance markets continue to grow and mature, the need for clarity on sharia compliance becomes more acute. Organisations such as the Islamic Financial Services Board, Labuan IBFC, Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the central banks of Bahrain, Malaysia, Qatar and the United Arab Emirates have all taken proactive steps to increase the harmonisation of sharia interpretations. In fact, one of AAOIFI’s mandates is to achieve harmonisation and convergence among sharia supervisory boards to avoid contradiction or inconsistency between the fatwas and applications.

That said, sharia harmonisation is a double-edged sword. On the one hand, the harmonisation of sharia standards and practices will enable Islamic finance to move to a properly integrated international market. On the other hand, the dynamic interpretive nature of sharia as it is applied by scholars is an inherent strength of Islamic finance, and any attempt to increase transparency and integration will have an impact on the industry’s regulatory framework.

Another aspect of sharia harmonisation is the transitory change in meaning as the market continues to refine itself. In a number of contexts, sharia harmonisation is used to describe the codification of juristic interpretations, categorisation of sharia principles, fatwa and rulings by scholars relating to interpretations of transactions and activities. In other contexts, sharia harmonisation is used to describe the process of integrating sharia and civil law; the latter is the case in Malaysia, Pakistan and Nigeria, where Kaduna State proposed the harmonisation of sharia penal and criminal procedures.

Confusion reigns

In some cases, the lack of clarity spills over into the area of Islamic banking, where customers (Muslim and non-Muslim) may not be clear as to what constitutes compliance to sharia principle by banks. This confusion has prompted some regulators to institute change to how banks are reporting their activities, informing their customers and marketing their products to customers.

In the case of Qatar, the lack of clarity led to the passing of new regulatory guidelines which prohibit conventional banks from offering sharia-compliant services by the end of 2011. As a result of this measure, banks such as HSBC Amanah announced that it will cease Islamic banking operations in Qatar, while other institutions have opted to sell their customer base to domestic Islamic banks. This was the case of the International Bank of Qatar, which promptly sold its Al-Yusr operations to Barwa Bank in August 2011.

In contrast, Malaysia’s Labuan Islamic Financial Services and Securities Act 2010 sets in motion the constructs for a one-stop and seamless regulatory framework for sharia-compliant financial and business activities, establishing new corporate mechanisms such as a Labuan Islamic limited partnership and a Labuan Islamic limited liability partnership.

Continued growing pains

As the market for Islamic finance continues to grow, it is only inevitable that there will be a rise in mergers and acquisitions (M&A) as the industry reacts to changes in the global financial environment. As assets rise and banks seek opportunities, they look for banks offering complementary services, access to a new client base or entry into a new geographic market.

Islamic finance is not immune to this behaviour; banks such as Burj Bank emerged from Dawood Islamic Bank in Pakistan, while Al Khaleej Islamic Investment Bank, formerly a subsidiary of Bank of Bahrain and Kuwait, became known as Capinnova Investment Bank in Bahrain. Crédit Agricole of Egypt merged with Egyptian American Bank, and RBS Pakistan merged with Faysal Bank earlier this year.

As the industry redefines and positions itself for long-term growth, one emerging trend is a development of the sharia-compliant bank brand identity that is reflected in the recent M&A activity. New institutions are opting to use more generic identity, dropping the word 'Islamic' from their name in favour of a brand that will resonate with Muslims and non-Muslims alike. 

Risk of overbanking

Industry pundits have stated that perhaps the Islamic finance market is overbanked. They suggest this because conventional banks have been opening sharia-compliant operations in more and more countries. One could argue that in some states this is true, and the end result is that M&A activity became catalysed during 2011. However, one could also argue that with less than 12% of the global Muslim population banked, there is still significant room for improvement in the retail banking business, as banks expand their operations to be more inclusive of small and medium-sized enterprises and consumers in the bottom three-quarters of the global economy.

A review of banking activities sees sharp increases in Islamic institutions facilitating trade finance and remittances, two services vital in emerging market development. Another market activity worth watching is the expansion of Islamic banking to new geographies, both in Muslim and non-Muslim countries. Banks are developing clearer strategies to expand beyond their traditional geographic confines by either establishing a joint venture with an existing Islamic or conventional bank, white-labelling their products through a partner bank, and/or simply setting up 'de novo' operations.

Looking ahead

Moving into 2012, the Islamic finance industry continues to face acute problems. These include, but are not limited to, branding, product depth, financial literacy, transparency, liquidity management, regulatory issues, taxation, talent availability, the development of a secondary market, and interbank mechanisms. The industry still needs to develop comprehensive interbank liquidity management mechanisms among institutions operating transnationally and central banks.

However, in spite of all its shortcomings, in the broader context of competition with conventional banks in Europe and the US, Islamic financial institutions have demonstrated consistent asset and revenue growth with numerous institutions maintaining double-digit growth over a five-year term. What the global financial crisis has made clear is that asymmetric economic shocks from industrialised countries do travel to the emerging markets, but with surprising, often unpredictable impact levels.

Yes, several regions experienced a contraction in their real estate markets, changes in trade flows and a reduction in foreign direct investment. Nevertheless, it is also true that the economic aftershocks reflected in oil price changes and increased volatility in commodity and equity markets provided Islamic banks with a roadmap for offering alternatives to conventional financial markets.

Joseph DiVanna is the CEO of Maris Strategies, and author of numerous books and articles on banking and finance.