The development of Islamic hedge funds and other complex instruments, as well as the provision of mortgages for a market hungry for property, shows how far the Islamic finance industry has come and where it is heading, write Mark Ford and Jon Marks.
As demand for Islamic financial services has rocketed in the six Gulf Co-operation Council (GCC) countries so the Islamic finance industry has evolved from being a quirky regional niche player to become a booming mainstream market. In response, Islamic bankers and the sharia scholars, who determine what is halal (allowed) and what is haram (forbidden) in Islamically-structured financial instruments, have been working hard to develop new products.
One quest has been to find sharia-compliant ways to mirror the risk-balancing properties of hedge funds. This is considered a big challenge in Islamic banking because selling something you do not own, undue risk and speculation for its own sake are prohibited under sharia law. This year, according to The Banker’s market soundings, several developers are poised to fill the gap in Islamic markets for instruments that mirror conventional hedging tools; they are building on the smattering of such funds that already claim to have satisfied the rigorous scrutiny of the sharia scholars.
Western banks are now committed to developing sharia-compliant asset classes. Deutsche Bank, for example, says it has developed a structure within which most conventional financial instruments can be mirrored by Islamic offerings, and it is offering its use to the still small but potentially substantial Islamic finance sector.
The industry has come a long way since 1997, when Kuwait-based specialist The International Investor (TII) launched its Al-Khawarizmi Market Neutral Fund. In the same year, Saudi Economic and Development Company (Sedco) in Jeddah and New York-based Permal Group launched the Al-Fanar Hedge Fund. But the appliance of the sort of rocket science that has made so many bulge bracket mathematicians multi-millionaires has proved elusive for the Islamic industry.
Product development
Now, there are signs of movement. In February, 2006, the Jersey Financial Services Commission approved a sharia-compliant hedge fund, Algo Al-Qayyim Fund, developed by Jersey-based Volaw. By August, reports emerged that a major Islamic player, Kuwait Finance House (KFH), had developed a scheme allowing investors to hedge foreign exchange exposure in compliance with Islamic law.
This year, several funds appear ready to pitch for a position in the sharia-compliant hedge fund market. Old Mutual Asset Management has said it will launch its Al-Saqr hedge fund, which aims to raise $500m. Wisconsin-based Stark Investments plans to market its Stark Al-Noor fund and London’s North of South Capital is launching the Al-Raed Emerging Markets fund. Other funds are waiting in the wings.
“At the moment, the industry is relatively small, and over-hyped,” says Geert Bossuyt, director of Deutsche Bank’s global markets structuring team. He is keen to promote the German bank’s product development capabilities, but says that more needs to be done if the Islamic finance industry is going to grow and remain sustainable.
Deutsche says it has overcome the obstacles to producing sharia-compliant products that have so far remained largely elusive. In a paper, ‘Pioneering Innovative Sharia Compliant Solutions’, the bank claims to have found sharia-complaint ways to offer investors access to several new asset classes, such as commodities, fixed income or hedge funds; different pay-offs, such as capital guarantees, range accruals; and liquidity transferable at market value.
Deutsche sees itself, and other international banks, “as product developers”, says Harris Irfan, director of its global markets structuring team. The bank’s role is to “structure, create and design” products and frameworks for new Islamic financing instruments.
Deutsche argues that this will help the Islamic sector to overcome a major barrier to growth: the industry’s lack of capacity to supply enough sharia-compliant products to meet demand.
“The Islamic share of the $11bn GCC and Malaysia investment banking revenue pool is estimated to be 10% to 20%,” Mr Bossuyt says. There are good reasons for the hype and excitement surrounding Islamic finance, he adds: “The number of Muslims in the world is growing at rapid pace [from 1.5bn now]… and by 2020 it is estimated there will be 2.5bn – comprising 30% of the world’s population.” Mr Bossuyt concludes: “It is expected that in eight to 10 years, Islamic banks will account for 40%-50% of total savings for the Muslim population.”
Standard & Poor’s estimates the potential market for Islamic financial services to be $4000bn.
Mortgage finance
Several new firms are latching on to the potentially lucrative market for sharia-compliant mortgages in the Gulf’s real estate construction boom.
Reef, a sharia-compliant real estate financing company based in Bahrain, started operations last April, and in January announced an agreement to offer mortgage packages to investors in The Lagoon Bahrain, a mixed-use commercial development backed by the deep pockets of Abu Dhabi Investment House. It offers several sharia-compliant ways to buy property, pointing to the wider opening up of this potentially important market:
- ijarah muntahia biltamleek (lease-to-own), in which customers can opt to own a property at the end of the lease period;
- musharaka (partnership finance): a profit and loss-sharing arrangement in which Reef commits itself as a partner in its clients’ financed project or property;
- musharaka mutanakisa (diminishing partnership finance): the fund takes a diminishing partnership, leaving the customer as sole owner at the end of the property or development financing;
- murabaha (cost-plus-finance), in which a profit rate is fixed throughout the finance period;
- and istisna’a (commissioned manufacture financing), which provides construction finance for a commercial development project or a residential home.
Home building funds
The Bahraini government wants to use Islamic finance in its campaign to build more homes for those on low incomes – amid an expected surge in housing demand during the next 15-20 years. However, as Fahmi Bin Ali Al-Jowder, the Bahraini minister of works and housing, points out, there are still some issues surrounding sharia-compliant mortgages that need to be resolved. He says: “We are working on setting the conditions for a secondary mortgage market based on Islamic finance.”
“The development of secondary mortgage market will be key to fostering the development of a vibrant housing finance market,” agrees the International Finance Corporation (IFC). The IFC has backed an innovative scheme in Saudi Arabia pioneered by Kingdom Installment Company (KIC) by providing credit enhancement of the mezzanine tranche of the mortgage-backed securities (MBS) to be issued by KIC. In this securitisation, KIC – the largest private housing finance company in Saudi Arabia and a regional Islamic housing finance pioneer – issues MBS paper backed by a pool of sharia-compliant housing finance contracts. The IFC’s facility takes the form of a stand-by murabaha facility.
The presence of the World Bank’s private sector affiliate in structuring new Islamic markets, like the interest of bulge bracket banks in developing sharia-compliant instruments, points to the global community’s perception of the sector as being among the most significant of emerging markets.
ISLAMIC TRADE AND PROJECT FINANCE
Including a substantial Islamic tranche in Gulf project finance structures has almost moved from being a fashion to the norm – and the numbers are starting to get dizzy. “The total sukuks [Islamic bonds] raised [in 2006] by Dubai Islamic Bank amounted to more than $15bn, an unprecedented amount in the history of Islamic banking across the world,” says Mohammed Khalfan Bin Khirbash, DIB chairman.
The Petro-Rabigh project in Saudi Arabia notched up what was, at the time, the region’s largest long-term Islamic project financing. Participants in the Islamic portion included Saudi state-controlled newcomer Bank Al-Bilad, established in November 2004, and the Jeddah-based Islamic Development Bank (IDB), which added depth to the pool of Gulf-based Islamic project financiers.
The old guard was there, too, with Bahrain-based Gulf International Bank (GIB) participating in both the Islamic and conventional portions of the financing for one of the biggest integrated refining and petrochemical complexes to be located on the Red Sea. Project capital of $9.8bn is split equally between Saudi Aramco and Japan’s Sumitomo Chemical.
Project finance is in some respects an easy way for Islamic investors to channel money into the regional construction boom that was worth about $146bn in 2006 and may generate $300bn of Islamic project financing business in the Middle East over the next decade.
Investing in infrastructure suits Islamic financiers because asset-backed financing makes sharia compliance relatively straightforward, while the use of Islamic finance to develop infrastructure that in turn leads to a combination of social or economic development appears in the spirit of ethical Islamic investments.
There are, however, obstacles for Islamic bankers, too. Margins on some of the region’s mega-projects have been slim – an experience shared by conventional project financiers – making it difficult for smaller Islamic financiers with relatively high borrowing costs to make money. One banker canvassed by The Banker suggests that project sponsors appear happy to pay over the odds for projects but then expect to access finance “on a shoestring”.
Another obstacle has been the inclination for Islamic investors to go for short-term instruments that may not fit large projects that can take 10 years to complete. Here there are signs of change: the $550m sukuk issued for Dubai Airport carries seven years maturity, and sukuks are getting bigger.
According to the World Islamic Banking Competitiveness McKinsey Report 2006, the two areas where Islamic banks have made significant inroads in wholesale banking are asset management and corporate activities, including corporate lending, corporate deposit and trade finance.
The world’s first fully-fledged Islamic bank, DIB, describes the routine business of opening and managing letters of credit as a “core function” of the bank’s trade finance division, while its letters of guarantee cover billions of dollars in key business. Trade services are well rooted in the Gulf’s established Islamic banks but, according to the Islamic Development Bank, there is plenty more to promote and facilitate intra-trade among Muslim countries using sharia-compliant instruments.
Deep pockets and a perceived need to offer the widest range of Islamic projects are leading public and private sector institutions to re-evaluate their products ranges, even in sectors such as trade finance, where the Islamic industry cut its teeth.
