The steady growth of sharia-compliant assets suggests banks believe in the future of the sector, but the dismantling of the largest cross-border Islamic window raises questions about whether global banking groups can make a success of the business.

The steady growth of Islamic assets that The Banker's Top Islamic Financial Institutions survey has recorded since 2007 is testimony to the confidence that banks have in the future of the sector, and their willingness to invest capital in expanding it. But growth does not guarantee profitability. For local banks in Muslim-majority countries such as the Gulf states and Malaysia, Islamic banking has cultural and political imperatives. By contrast, international banking groups are likely to take a more calculating stance driven entirely by the bottom line.

In that context, recent developments at HSBC, the largest global player in Islamic finance, are inauspicious. In October 2012, HSBC effectively shut down its subsidiary HSBC Amanah, which had been the second largest Islamic window in the world, with sharia-compliant assets of $16.7bn. The bank will continue providing universal sharia-compliant banking for clients in Malaysia, Indonesia, and in Saudi Arabia through Saudi British Bank, in which HSBC owns a 40% stake. Global Islamic wholesale banking and sukuk capital markets, in which HSBC is the market leader, will still be offered through 49% subsidiary HSBC Saudi Arabia. HSBC will retain 83% of Islamic finance revenues at group level.

This means the bank has shut its Islamic finance operations in the UK, the United Arab Emirates, Bahrain, Bangladesh, Singapore and Mauritius. HSBC Amanah had already closed in Qatar following regulatory changes that effectively banned Islamic windows. HSBC’s move is reminiscent of the decision by Swiss banking giant UBS to fold its somewhat smaller Islamic window Noriba back into the bank in 2006.

HSBC has long been coy about the financial performance of HSBC Amanah, never providing separate pre-tax profit figures for the unit to our survey. Similarly, Standard Chartered Saadiq, the other leading global Islamic window, provided no consolidated data at all, with asset and profit figures available only in countries such as Pakistan and Malaysia that require individual regulatory reporting.                              

Islamic banking return on assets differential

Underperformance worries

Despite the paucity of data from foreign-owned subsidiaries, The Banker has set itself the task of trying to assess whether cross-border Islamic banking has much of a future following the closure of its largest proponent. The first challenge in calculating the profitability of Islamic finance is that sharia-compliant windows – the Islamic subsidiaries of conventional banks – rarely break out their pre-tax profit data separately from the group.

As a result, a detailed study of return on sharia-compliant assets must make use only of fully sharia-compliant banks. For many countries, this does not have a significant impact on the total assets The Banker is analysing. In Iran and Sudan, all banks must be sharia-compliant, while Qatar does not allow conventional banks to run Islamic subsidiaries. In other countries, such as Kuwait, the UAE and Thailand, the difference is less than 15%. But in countries such as Malaysia, Saudi Arabia and Pakistan, the difference is much more substantial. Incorporating Islamic windows doubles the total assets in Saudi Arabia and Pakistan, and more than triples them in Malaysia.

While this means our sample from those countries is less comprehensive, we assume it is still representative of the performance of the Islamic banking sector as a whole. The Banker has calculated return on assets (ROA) for all the 100% sharia-compliant banks in each country, and compared these with ROA for the whole banking sector, including conventional banks.

On this basis, there does appear to be logic behind HSBC’s decision to maintain universal Islamic banking only in Saudi Arabia and Malaysia. Aside from Qatar, where conventional banks such as HSBC can no longer operate an Islamic window, these are the only major markets where Islamic banking has a higher ROA than its conventional peers.

By contrast, Islamic banking in HSBC’s other surviving market, Indonesia, is the worst performer in our sample relative to conventional banking, falling 182 basis points short on its ROA. But this partly reflects the remarkable performance of the country's conventional banking sector, which was the third most profitable in the world in 2011. Since Islamic assets are still only 6% of the total banking system, it would be understandable if HSBC expects the performance of Islamic banking to begin catching up to the conventional sector, and Indonesia is also a growing market for sukuk issuance.

Foreign subsidiary share of Islamic bank assets

Newer markets

The two top-performing Islamic finance markets are Iraq and Egypt. Both are underdeveloped in terms of sharia-compliant assets (less than 10% of total assets), and in Iraq’s case the conventional banking sector itself is also still at a very early stage of reconstruction. Iraq’s conventional banking has an impressive ROA of 2.27%, with a startling 3.85% for Islamic finance. Egypt’s conventional banking sector is rather less impressive, with an ROA of 0.85%, whereas Islamic banking manages a more respectable 1.29%.

Overall, there is no clear pattern indicating that the maturity of Islamic banking leads to reduced profitability. Islamic banking outperformers Brunei, Malaysia and Saudi Arabia are all well-established markets where sharia-compliant assets are a substantial part of the system. But so too are underperformers Bangladesh (60% of total assets), Kuwait (41%), Bahrain (49%) and UAE (23%). Turkey is an underperformer where sharia-compliant assets remain very small, at 6.3% of the banking sector. Like Indonesia, this differential partly reflects a very profitable conventional banking sector.

A more consistent indicator is that Islamic banks attempting to cater for Muslim minorities in majority non-Muslim countries are facing strong headwinds. Thailand is one of the worst relative performers, while Islamic banking in the UK and Switzerland lost money on aggregate in 2011.

Foreign or local?

For HSBC, Islamic banking was about choosing the right markets, and the bank remains committed to the concept. But the more profound question would be whether foreign banks can provide a sharia-compliant offering that competes successfully with local players. In answering this question, The Banker's sample shrinks much further, and many countries in our ranking have only one or two foreign-owned Islamic banks.

Our ranking includes 49 foreign-owned subsidiaries, with sharia-compliant assets totalling $64.2bn. Eliminating the Islamic windows for which profit figures are not available leaves just 31 fully sharia-compliant foreign-owned subsidiaries, with total assets of $53.2bn. A rather small sample, but unambiguously an underperforming one. Aggregate ROA for these 31 subsidiaries is just 0.72%, about half the aggregate ROA for fully sharia-compliant bank holding companies in our ranking.

While lacking pre-tax profit figures, it is possible to build some kind of performance indicators for Islamic windows using net operating income data, which is more widely available. For 78 sharia-compliant windows with assets totalling $113.3bn that have separate net operating income data, income from Islamic operations is 12.56% of the holding companies’ total net operating income. By contrast, the sharia-compliant assets of these windows constitute 14.77% of the holding companies’ total assets. The implication of this is that as a sector, Islamic windows are less profitable than their parents’ conventional operations.

However, one type of Islamic subsidiary could still be very profitable for global banks – investment or wholesale banking and sukuk origination, which HSBC intends to maintain. Citi is the only global bank to break out the results for its Islamic investment bank, based in Bahrain. Although the bank is very small, it reported 21% ROA in 2011, the best-performing foreign-owned subsidiary in the ranking. But Islamic investment banks are not necessarily any better than their conventional counterparts at avoiding earnings volatility. In fact, of the 24 fully sharia-compliant wholesale and investment banks in our ranking, with assets totalling $14.65bn, almost half were loss-making in 2011.


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