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Middle EastFebruary 1 2010

Gulf Islamic banks gear up for a change

Majid Al-Refai, CEO of sharia-compliant Bahrain-based Unicorn Investment BankAfter a turbulent year bookended by the near default on a large Dubai sukuk, the Middle East's Islamic banking community is taking stock. Writer James Gavin
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Gulf Islamic banks gear up for a change

The Gulf Co-operation Council's (GCC's) regional sharia-compliant financial institutions have emerged in somewhat better condition from the global financial crisis than their conventional peers, but they have still been marked by the experience and some of the lessons will be learned the hard way in 2010.

There are a number of positives that will boost confidence levels among the region's Islamic banking fraternity. Boasting strong liquidity, fat profit margins and generally conservative leveraging, Gulf Islamic banks have a strong growth story to tell. Growth rates have generally held up well across the Islamic finance industry, with banking assets showing double-digit growth in 2009, while conventional bank growth stagnated.

Assets held by fully sharia-compliant banks or Islamic banking windows of conventional banks rose by 28.6% to $822bn, from $639bn in 2008, according to The Banker's Top 500 Islamic Financial Institutions rankings.

Gulf-based banks have seen some of the strongest growth of the world's Islamic institutions, on the back of robust consumer demand and healthy oil revenues recycled into the financial system. Many of the region's Islamic banks are effectively state-owned and therefore more highly capitalised than their competitors. Kuwait Finance House, the region's second largest Islamic financial institution by assets, is 44% owned by the Kuwait Investment Authority, a sovereign wealth fund.

Throughout the financial crisis, Islamic banks have focused on boosting market penetration, driven by rampant consumer demand for all things sharia-compliant.

Saudi Arabia, the largest Gulf state, now has four fully sharia-compliant banks - Al-Rajhi Bank, Bank al-Jazira, Bank Albilad, and Alimna Bank. Moody's estimates that more than 80% of Saudi Arabia's consumer lending is structured along sharia lines, and it is a similar picture across the region; in Bahrain, a rash of new Islamic retail banks has pulled in deposits, in pursuit of better rates of return on profit-sharing accounts.

Some Gulf banks are extending their overseas footprints. Al-Rajhi, the largest Islamic bank in terms of assets, has set up a unit in Malaysia, the Gulf's main rival as an Islamic financial centre.

"Despite the crisis, the sharia-compliant banking industry has been expanding. In a situation of stress it has still grown by 20% - and just imagine how much more it will grow once the situation stabilises and liquidity returns," says Anouar Hassoune, Moody's vice-president of Middle East banking.

Robust economic conditions have played to the advantage of Islamic banks. A large chunk of the Gulf's oil bonanza has been recycled via government spending in the form of salaries and in investments into a number of sectors, which have ended up on Islamic banks' balance sheets.

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Razi Fakih, UAE-based deputy CEO of HSBC Amanah

Shockwave from Dubai

Still, Gulf Islamic banks have had to deal with some shocks to the system, starting with the sukuk problems involving Dubai World and its affiliate, Nakheel. Dubai real estate developer Nakheel requested postponement of a $3.4bn sukuk repayment due in early December, eventually paid by Dubai World after Abu Dhabi extended a $10bn loan to Dubai in mid-December. Dubai World has asked for a standstill on further debts of about $22bn.

The shockwaves are still being felt. Coming on top of the default of Kuwait's Investment Dar and the default problems at the two Saudi conglomerates and major borrowers, the Algosaibi and Saad groups, Islamic financial institutions have not fully escaped the collateral damage. Qatar Islamic Bank has announced an exposure of QR54m ($14.83m) to the Dubai World and Nakheel debt standstill.

"Dubai World has hurt us all very badly and it is destroying the reputation of the Gulf - there's no nice way to put it," says Majid Al-Refai, CEO of sharia-compliant Bahrain-based Unicorn Investment Bank.

Unicorn had planned a $425m sukuk for the fourth quarter of 2009, having launched two sukuk worth a total $1.6bn in 2007, but Mr Al-Refai says it will most likely postpone the issue to the second quarter of this year.

Sukuk issuance had surged in the period up to the Dubai World crisis, with total global sukuk issuance rising more than 40% in the first 10 months of 2009 compared with the same period in 2008, according to Moody's, largely due to Gulf sovereigns returning to the market.

But the financial crisis could also afford opportunities for Islamic institutions to learn some important lessons that will better prepare them for long-term growth. According to Razi Fakih, UAE-based deputy CEO of HSBC Amanah, this is the first real crisis that Islamic banking finance has suffered since its inception. "It is a very new industry and we've gone through various recessionary cycles, but they were limited to certain markets. As with other industries, by taking appropriate measures, we can come through this one in stronger shape," he says.

Reassessment across the industry is still needed, says Mr Fakih: "Certain players have tended to look at risk purely in terms of simple credit and default payment risk, but there's much more to it than that. There's now a far greater willingness to go deeper."

Commercial success

Not all Islamic financial entitles have been affected equally by the crisis and those banks funded by 'sticky' local deposits have minimised funding vulnerabilities. Commercial Islamic banks enjoy access to a large pool of retail deposits, which has enabled them to cope better in the crisis by granting them a stable source of liabilities on which to build strategy for growth. But the Gulf's Islamic investment banks lack such a robust domestic platform.

"Most investment banks in the GCC are wholesale funded, so when liquidity dries up, it can be a nightmare. Either you raise money which costs you your shirt, or you simply cannot fund your business," says Mr Hassoune.

Unicorn's Mr Al-Refai is cautious about the outlook for 2010. "We think the market is going to be as bad or worse this year; that's our bottom line," he says. "Of course, there are fantastic opportunities in the market despite our gloomy outlook. We are still very interested in making acquisitions, getting our strategic acquisition fund for financial institutions moving more aggressively. But the challenge is still in the market - the sentiment is negative, confidence is low and you cannot get acquisition financing - the basics just are not there."

While some Gulf Islamic banks were caught up by their exposures to troubled real estate assets, Unicorn at least had only limited exposure to the property market.

"We hardly have any real estate - we only have three baby pieces, secondly we had no listed shares, no Dubai exposure and our debt-to-equity ratio when the crisis hit was 39% - so we are a real oddball in that sense," says Mr Al-Refai.

Others have also minimised their exposures to the troubled sectors such as real estate. The Bahrain-based Albaraka Banking Group, which reported a 10% rise in assets to $12.2bn in the first nine months of 2009, registered real estate financing receivables at the end of September 2009 of just 1% to 2% of total financing, a significant source of insulation at a time of plummeting property prices.

Diversification will help banks to weather the storm. Unicorn's business model is based on six core business lines. "Our diversified business model saved us. Our commitment to diversification and to building a diversified financial services group shielded us from the worst of the crisis, otherwise we would have been clobbered a long time ago," says Mr Al-Refai.

Other Islamic investment banks are less fortunate. Bahrain-based Gulf Finance House completely wrote off its exposure to its Dubai Land project, taking provisions of $300m during the fourth quarter of 2009.

Investment banking risk

Despite the conceptual innovation offered by Islamic investment banks, their business model looks riskier in the current climate and analysts predict there will be moves by these institutions to secure the backing of larger and more stable retail-entrenched Islamic commercial banks.

In December 2009, Ithmaar Bank announced a major restructuring aimed at shifting the focus from investment banking to retail banking in an effort to stem the bank's decline in operating income. Ithmaar will merge its wholly owned retail banking subsidiary, Shamil Bank, into the parent company.

Consolidation may emerge as a strong theme in the Gulf Islamic financial sector this year. Islamic banks are still mainly small and overly focused on their domestic markets. The strongest players are those with a truly diversified offering and a broader reach.

"The Middle East, and the Gulf in particular, still offer huge potential and a real opportunity. To be able to capture the opportunity, we have developed a full suite of products and services. We focus on value-added products and services, and on quality rather than quantity," says Mr Fakih.

There are still formidable challenges confronting the region's Islamic financial institutions. They lack a breadth of instruments for managing excess liquidity and asset-liability mismatches persist. Until a comprehensive range of sharia-compliant instruments is developed, banks will be constrained in finding ways to manage asset-liability mismatches effectively.

"The Islamic finance industry is asset-deficient. Historically we've been long on liabilities and short on assets, the consequence of which is that when Islamic securities and debt capital market instruments come onto the market, they are taken on the balance sheet and not traded, " says Mr Fakih.

Until such a time as deeper sharia-compliant capital markets emerge, Islamic banks will struggle for volumes on the secondary market. But Gulf banks will take comfort from their durability during an unprecedented global financial crisis. They can also draw strength from robust consumer demand seen across the region, which has led numerous conventional banks to open Islamic windows.

"Islamic finance is customer driven. It is not something pushed by banks or regulators or by the edict of a king. And consumer behaviour has essentially changed the behaviour of the corporate world," says Mr Fakih.

The result is that banks are expanding product lines, even as they grapple with major structural challenges. "The size of the pie is growing, while the shape of pie is shifting in line with the greater penetration rates of Islamic finance. But there is enough room available for everybody to have their share of that market," says Mr Fakih.

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Read more about:  Banking strategies , Islamic Finance , Middle East