The past year has seen a number of firsts in the Islamic finance industry, including the first sovereign sukuk from the West. This represents a huge step forward for an industry previously considered niche. Islamic players now must consolidate on these gains by broadening their product offerings, expanding their customer bases and targeting new levels of interoperability with global markets.

During 2013, new market dynamics in Islamic finance continued to develop as institutions providing financial services invested in infrastructure, expanded their product portfolios and moved to service new customers. Numerous financial institutions have started to focus on expanding their product line to reflect the needs of customers, while other institutions have concentrated on enlarging their customer base by targeting new demographic groups.

The way in which Islamic finance is maturing brings to mind an old Arab proverb: “Aspiration is not a defect for youngsters.” Many banks now share a common aspiration to provide sharia-compliant services to greater numbers of people in domestic markets. Over the past decade, the lion’s share of development in Islamic finance was concentrated in four key areas: infrastructure development, corporate finance, wealth management and takaful.

Now, financial institutions offering retail banking are broadening their reach by expanding their products to customers in the bottom two-thirds of the economic pyramid. Corporate services in many institutions are now offering services to small and medium-sized enterprises (SMEs), though there is significant room to develop in this space.

Regional asset growth

Global growth

The Banker survey data for 2014 indicates a change in the composition of the market for sharia-compliant finance as total assets for the industry continued to rise for the eighth straight year, from $1267bn in 2013 to $1391bn, representing 9.81% growth. More importantly, total assets have increased every year from 2007 to 2014, representing an impressive compound annual growth rate of 15.73%.

The sharia-compliant finance industry reached a new level of maturity in 2014, as government and corporate sukuk issuance continued to grow in terms of both volume and product offerings. The Banker’s survey indicates that banks and other financial institutions are changing their business models to adapt to the new market conditions. In 2014, 360 institutions reported sharia-compliant activities, compared with 349 institutions in 2013. This may be because institutions are changing the way that they are reporting sharia-based activities and how they are responding to The Banker's survey.

Growth in the industry was positive across all geographical markets. The Gulf Co-operation Council (GCC) saw total sharia-compliant assets grow by 11.16%, non-GCC Middle East and north Africa (Mena) saw 9.67% growth, Asia recorded a 4.38% rise, Australia, Europe and America enjoyed a 8.43% increase, and Africa recovered from its 2013 decline to report a 1.88% growth.

The 2014 survey reflects the emergence of two distinct operating models in Islamic finance. Of the 360 institutions registered globally as offering sharia-compliant in financial services, 250 are wholly sharia-compliant organisations, and 110 are conventional banks operating sharia windows. A further categorisation of the institutions in the ranking reveals that 214 institutions are commercial banks, 55 are foreign-owned subsidiaries and 91 are insurance companies.

As with the 2013 survey, several small adjustments were made to method of data collection, based on refinements in reporting requirements that will increase the quality of reporting.

Cost concerns

In this year’s survey, 78.33% of institutions reporting financial activity disclosed a rise in assets, while only 21.66% of institutions reported declines. Reviewing the profitability of the industry, 292 institutions (81.38%) saw their profits grow on the previous year, while 62 institutions saw them decline. For 171 institutions, pre-tax profits demonstrated positive growth compared with the previous year, while 94 institutions recorded a decline in this metric. 

Higher costs and a changing regulatory environment have characterised the banking landscape in 2013 to 2014. On average, the cost-to-income ratios of wholly sharia-compliant institutions were typically higher than at subsidiaries of conventional banks, and conventional banks with Islamic windows. This is not a completely new trend, but it is worth noting. It can be attributed to a number of factors. Indeed, discussions with bankers in the Middle East and south Asia suggest that conventional institutions have a slight cost advantage because of their ability to leverage technology investments by gaining access to critical infrastructure. 

In 2014, 168 institutions increased their Tier 1 capital while only 36 reduced their core capital.

Market maturity

Several banks in the Chinese and Indian markets have expressed interest in partnering with sharia-compliant banks to explore how these products can be used by both Muslim and non-Muslim investors in their domestic markets. One key issue identified by these institutions was the lack of awareness among customers as to how sharia-compliant products functioned.

Adding to their concerns were gaps in their internal operations, which made it hard to accurately market, brand and sell these products. Many institutions noted that significant investments would have to be made to educate their salesforces and this was pegged as the next challenge in the bid to bringing Islamic finance to domestic markets.

The next step in market maturity is achieving greater access, which will require interoperability with global capital markets. It will also require the continued development of standards and the ability to partner with foreign regulators, conventional banks, market makers, legal firms and other Islamic financial institutions. To achieve greater integration with conventional markets, sharia-compliant institutions need to make substantial investments in technological infrastructure.

One concern expressed by some sharia scholars is that tighter integration with global capital markets might be considered as synonymous with mixing non-interest-based funds with interest-based funds. However, establishing higher levels of integration in the form of 'market pathways' enables sharia-compliant institutions to have greater access to global investors without compromising fundamental sharia principles.

In June 2014, the UK became the first Western country to issue a sovereign sukuk, attracting more than £2bn ($3.2bn) in orders from global investors. This was followed with issuances of sukuk by Hong Kong, Luxembourg and South Africa.

The issuance of the UK sukuk marked another milestone in the progress of the financial infrastructure required for the next phase of the industry’s development. It also signified the growing level of competition among international financial centres, as they seek to develop closer ties with the Islamic world. As such, the factors driving these transactions are as much about strategic and policy objectives as they are about the pure financial rationale for issuing.

A year of firsts

Global investors are looking at investments in Islamic finance as a new way to diversify their portfolios. This process is having profound implications on the global Islamic finance industry, as an increasing number of these investors are looking to gain exposure to the growth stories of the Gulf countries and Malaysia. Encouragingly, levels of US dollar-denominated sukuk are increasing, being driven by the dollar-pegged economies of the Gulf, which is stimulating greater demand from those investors that wish to avoid local currency risk.

In another positive trend, there have been an increasing number of first-time corporate issuances in the sukuk market, both in terms of geography and sector. Notable transactions include the Bank of Tokyo-Mitsubishi UFJ Malaysia’s yen-denominated issuance, as well as Qatari telecoms provider Ooredoo, which issued a sukuk using airtime as the underlying asset.

The long-term implications of these transactions are significant. A first-time entry into the sukuk market, particularly for non-Islamic issuers, requires careful preparation. It is also banking on an untested market response. Accordingly, as a number of new corporates begin to tap the market, their transactions are acting as a ‘proof of concept’ for their peers to follow. In the case of sovereign transactions, they play a vital role in setting a benchmark for corporate entities to base their issuances on.

Significant contributions to the sukuk market are also expected to emerge from Islamic banks in the coming years. With a faster growth rate than their conventional peers, sharia-compliant lenders need to support this asset growth with more frequent sukuk issuances. Moreover, the expected Basel III capital requirements are also likely to drive greater levels of sukuk transactions, as has already been seen from a number of Gulf issuers hitting the market with additional Tier 1 capital (and Basel III-compliant) sukuk.

Opening up access

It is estimated that, globally, 80% of Muslims have no access to sharia-compliant banking. A vast majority of banks in The Banker's survey provide little or no services to customers in the lower half of their domestic economies, and do not provide microfinance or SME lending. During 2013, a number of banks started experimenting with various banking models in order to enter these markets, but no clear model emerged as a regional solution.

Recent research conducted by the International Finance Corporation points to the huge opportunity presented to Islamic banks by SMEs in the Mena region. Estimates indicate that SMEs require about $13.2bn in sharia-compliant finance and are currently underserved by the market. Yet, before Islamic banks can meet this market potential, they must address a number of challenges. Notably, considerable product innovation is required in order to develop the kind of operational capacity needed to deal with SMEs.

While this work is ongoing, it will take time to mature. However, it is important to recognise that a lack of Islamic products and services is not solely to blame for this lending deficiency. Both conventional and Islamic banks are faced with an increased risk profile when dealing with SMEs, and most prefer to deal with established corporate entities.

Examining the microfinance industry, less than 3% of all sharia-compliant microfinance is offered by commercial banks, while village banks, non-government organisations and other lenders make up 97% of the market.

An analysis of the survey data indicates that when compared with their conventional counterparts, the return on equity and liquidity performance (net loans-to-total assets ratio) lag behind. This is a matter that requires and will continue to require vigilant attention by senior management teams. That said, the net loans-to-deposit ratio performs slightly better than their conventional counterparts as well as having better performance in equity-to-asset ratio and the equity-to-net loan ratio.

Future strategies

Industry growth is a continued theme for sharia-compliant banking. Islamic financial institutions are expanding their product portfolios, attracting new customers, achieving new levels of interoperation with global markets and exploring opportunities by seeking partnerships with institutions in new markets. This growth needs to be matched by more insight and innovation on the part of senior managers in the industry. The future lies with them.   

Senior managers of sharia-compliant institutions are refining their strategic initiatives to broaden their offerings and improve customer service gaps. On the strategy radar screen for 2015, financial services executives must continue to address rising costs, gaps in customer services and the broadening of customer segments to make sharia-compliant finance more inclusive and to move in a cost-effective manner down the economic pyramid.

A number of institutions have their product offerings to the SME sector while others have chosen to enter the market for microfinance. Similar to their conventional counterparts, sharia-compliant banks must deliver profitable results in their expansion into other market segment. During 2015, institutions will work to refine their business models to offset additional costs brought on by additional reporting requirements and documentation.

Senior managers must continue to work towards the following:

  • Increasing human capital and educating their customers, both in face-to-face branch contact and through new media including social media and web-based ventures;
  • Developing cross-national networks to build effective relationships with stakeholders;
  • Developing innovative products that reflect their unique systems, structures and regulatory and philosophical frameworks; 
  • Improving the quality of their services, and investing in new infrastructure;
  • Refining the growth agenda to set directions for effectiveness and efficiency across borders.

On the numbers

As The Banker survey of the top Islamic financial institutions reaches its eighth year of measuring the industry’s performance, we must acknowledge a striking improvement in the data provided by institutions. During the past eight years, The Banker’s survey of Top Islamic Financial Institutions has set the baseline for measuring the Islamic finance industry. The survey strives for reporting excellence in the compilation and consolidation of the financial data supplied by banks, central banks and other financial institutions; our statistics depend on this. In our estimation, the industry will continue to mature bringing into focus a greater need for data by financial institutions as they enter into a new realm of competition. Our intent has been, and will continue to be, to provide data that can be used to drive strategic decision making by financial institutions.

Joseph DiVanna is the managing director of Maris Strategies and has been co-author of The Banker’s survey of Islamic finance since 2007. James King is the Middle East editor of The Banker.

Methodology

The Banker’s Top Islamic Financial Institutions ranking was created in 2006 to serve as a barometer of the health and growth of the global Islamic banking and finance industry. Since its creation, the ranking has built a solid reputation as one of the most credible sources for measuring the development of the global Islamic financial industry.

The methodology employed in the Top Islamic Financial Institutions ranking has since evolved to keep pace with the rapidly growing industry.

Data collection and verification

Institutions providing sharia-compliant financial services and products are identified from various sources including central banks, government financial supervisors, and other public and private agencies providing accounting and auditing services for Islamic financial services institutions. Once institutions are identified, The Banker’s research team contacts these institutions to request their latest audited financial reports.

The financial data used in the ranking is based on publicly available annual data, which is typically verified by independent auditors and sharia supervisory boards before publication. The audited annual financial information is used in the ranking in order to maintain the stability of the ranking data and key performance indicators for growth and profitability.

The latest financial data collected from individual institutions is verified with data sets sourced from other organisations including central banks, stock exchanges and regulators. This is a process developed to produce the highest quality information from an industry experiencing rapid growth and a constantly changing competitive landscape, with continually evolving products and services.

The ranking criteria

The Top Islamic Financial Institutions uses sharia-compliant assets as the main financial indicator for compiling the ranking.

The Banker acknowledges that definitions of sharia-compliant financial operations is subjective and varies among different countries. This means that there could be question marks over the meaning of sharia-compliant financial activities because what might be considered as sharia-compliant financial activities by the financial regulator in one country could be regarded as non-sharia compliant by a similar authority in another.

As the prime objective of the ranking is to illustrate the size and diversity of the market, The Banker respects each country’s practices in defining sharia-compliant financial activities.

The Banker believes that it is necessary to have a baseline for comparison to examine the development of the entire industry and sharia-compliant assets can serve this purpose despite its limits. The ranking also uses pre-tax profits as a base measure of an institution’s performance.

Institutions that have not reported data since 2010 have been removed from the ranking in order to represent the structural changes in the industry more clearly. To minimise any complications caused by currency conversions, the ranking uses the annualised foreign exchange rates from the International Monetary Fund’s Government Financial Statistics Yearbook when converting local currencies to US dollars.

New aspects

While we continue to use sharia-compliant assets as our key financial indicator in the ranking for measuring the size and growth of the industry, the methodology has made a number of adjustments to ensure the statistical soundness of the survey since 2012.

One new addition to the methodology this year is the use of the net operating income of Islamic windows. Our previously used indicator for institutional performance – pre-tax profit – does not reflect the performance of the windows. Net operating income is defined as income after total impairment charges and provisions and before administrative and operating costs, including staff expenses.

Another significant change recently made to the survey is the use of data from the highest level of institutional consolidation. If a parent company or holding company issues a consolidated set of figures indicating total sharia-compliant activities, the foreign-owned and domestic subsidiaries are not included separately in the calculation of total global sharia-compliant assets, as they will have been already included in the figures of their holding companies. If a higher level holding company does not report sharia-compliant assets, its subsidiaries are included in the ranking individually. However, the rankings section for individual countries continues to include foreign-owned subsidiaries in the countries they operate.

Key data point definitions and glossary

The Banker’s ranking for the Top Islamic Financial Institutions include the following key data points and abbreviations:

DOS: Domestically owned subsidiary
FOS: Foreign-owned subsidiary
HC: Holding company

NBF: Non-bank financials
S: Standalone sharia-compliant bank
W: Sharia-compliant window of a conventional bank

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