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WorldOctober 18 2013

Slower and steadier: the new stage of Islamic finance

The Banker's annual Top Islamic Financial Institutions ranking shows that growth has dropped into single digits for the first time since the ranking began. This, combined with the restructuring of sharia-compliant operations at major players such as HSBC, shows an industry that is entering a new phase of maturity; a phase that is, however, still rich with opportunity.
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World financial markets continue to test the interconnectedness of global and domestic banks to international economic and political agendas. Sharia-compliant banks, on the other hand, are demonstrating resilience as world events continue to reshape the landscape for global financial services. However, the test will be the way in which the Islamic finance industry prepares itself for the opportunities and challenges thrown up by the rapidly changing global economy.

Islamic finance

In our 2013 survey of sharia-compliant institutions, we see total assets rising for the seventh consecutive year since The Banker began collecting data in 2006, climbing from $1166bn in 2012 to $1267bn in 2013, representing 8.67% annual growth. While growth this year has recorded a slowdown from 20.7% in 2012 to 8.67%, the compound annual growth rate since 2006 still remains extremely healthy at 16.02%.

A slowing industry?

Furthermore, the statistics for the Islamic finance industry’s growth must be taken in context as the market redefines itself, adapting to changing economic environments, new demands from customers, increased regulatory requirements and pockets of market saturation for sharia-compliant services in some markets.

But while Islamic asset expansion has moved from double-digit growth during the past six years to single digit growth in 2013, the important thing is that the survey continues to illustrate that Islamic institutions remain consistent in growing their assets every year.

The number of institutions reporting sharia-compliant activity has also changed as conventional banks offering sharia-compliant windows re-thought their product offerings and restructured their business models. In 2013, the number of institutions reporting sharia-compliant assets grew to 349 from 307 institutions in 2012 – equating to a 13.68% growth in new institutions.

Another change to the ranking since 2011 is the exclusion of institutions that have not reported any financial activity since 2010, a move that helps increase the quality of the reporting. 

HSBC restructuring

In October 2012, following a strategic review of its global business, HSBC, the largest global player in Islamic finance, announced that it was restructuring its subsidiary HSBC Amanah, which with sharia-compliant assets of $16.7bn, had been the second largest Islamic window in the world. The restructuring will result in the closure of its Islamic finance operations in the UK, the United Arab Emirates, Bahrain, Bangladesh, Singapore and Mauritius.

Instead, it is going to focus its offering on customers in Malaysia, Indonesia and Saudi Arabia. The three countries together account for 83% of HSBC’s Islamic business revenues. Its global Islamic wholesale banking and sukuk capital markets operations, in which HSBC is the market leader, will still be offered through its subsidiary, HSBC Saudi Arabia, in which HSBC has a 49% stake.

HSBC’s change in strategy reflects a new level of maturity in the market for Islamic finance, with the provision of products and services having reached saturation point in several market segments. This also presents an opportunity for nimble local players with good customer knowledge and efficient cost structure.

A changing focus

Changing regulatory requirements, a greater need to accurately document sharia compliance and the growing sophistication of customers (corporate and retail) are challenging the business models within numerous institutions. At the same time, these same factors are providing new opportunities for sharia-compliant institutions to expand their product and service portfolios.

When reviewing the product and service offerings described in bank annual reports and websites, a clear topology of the industry emerges as the vast majority of institutions are focused on corporate financing, a smaller percentage on retail banking, and a small fraction of the financial institutions focusing on microfinance and servicing small and medium-sized enterprises (SMEs).

With less than 20% of Muslims globally having access to or using sharia-compliant banking products, the potential for banks to expand their portfolio is high. To achieve market growth, banks will need to innovate in three directions: products, services and internal processes, which need to be streamlined. Increased profitability will be a direct result of movement toward one or more of these objectives. The 2013 survey also indicates that a small group of institutions continue to make profits while the vast majority of institutions need to rethink their business models and or cost structure. 

Profitability aside, the figures comprising this year’s ranking show ongoing high growth in both the Gulf Co-operation Council (GCC) countries (27.73%) and Asia (19.24%). Meanwhile, growth in Africa continued to decline slightly (-3.42%). However, the biggest decline was in the Australia/Europe/America regional category (-60.33%) – essentially reflecting the impact of realigning HSBC’s sharia-compliant operations.

As the market continues to mature, sharia-compliant financial institutions are realising that integration with their conventional bank counterparts is vital to the economic development of the countries in which they provide services. However, this integration must be defined with a higher degree of clarity so customers and investors can best understand the extent to which Islamic finance interoperates with conventional capital markets.

A slowdown to sustainability

Market historians claim that double-digit growth is not sustainable in the long term. Yet when markets move from double-digit growth to single-digit growth, it is interpreted as a major problem. In the case of Islamic finance, it is fair to argue that this shift is a good thing, giving institutions a much-needed pause to realign their business models to accommodate the new realities of banking in the 21st century.

The market for Islamic finance is not actually declining; rather how the industry accounts for financial activities is redefining how to factor what is or is not the growth of an industry. The key message to emerge from reading through the annual reports, press releases and websites of sharia-compliant institutions is that the nature and composition of the next generation of market growth in Islamic finance will come from four different avenues: product growth, customer growth, product/customer density growth and market growth.

Product growth

The next generation of Islamic finance will require management teams in sharia-compliant institutions to manage growth in a new way. As the several markets reach saturation points where there are numerous banks offering the same services chasing the same clients, growth will have to come from two different directions.

Increasing the product portfolio will enable banks to expand the range of services and to develop specialised services that will cater to the emerging needs of Muslim customers and to some extent new needs from non-Muslim customers. Expanding the product portfolio must go beyond the host of corporate financing instruments and investment products offered to investors and customers in the upper third of the economy.

A wider product portfolio produces greater competition and more value for money to customers. Portfolio managers and marketing experts who want to grow their portfolio need to consider to what extent their products and offerings are unique – to the market as a whole, via distinctive channels, and/or to specific market segments.

Customer growth

Globally, almost 80% of the potential customer base for Islamic finance is still untapped. Sharia-compliant institutions need to reach a wider range of customers by expanding their market presence to more customer segments. The Banker's 2013 ranking shows that institutions offering retail banking services continue to expand in markets such as Malaysia, Indonesia and the Middle East.

However, market segmentation strategies are still for the most part focused on wealthy customers and middle-income consumers. In these segments, retail customer and investors are becoming more sophisticated, demanding more integrated, lower cost services and higher returns on investments. Several banks have started to move down the value chain to engage customers in the bottom half of the economy and expand into more services for SMEs.

Sharia-compliant microfinance and services designed to facilitate the changing need of small businesses are still a part of the market with room for significant growth. However, interviews with customers of Islamic financial institutions allude to a significant problem: as banks move services down the value chain, customer service performance deteriorates rapidly. Thus the challenge is twofold: to educate customer service staff in order to leverage technology investments, and to develop a greater awareness in the market for the banks’ products and services.

Product/customer density growth

In discussions with sharia-compliant institutions during 2013, banks revealed they have two fundamental problems that they share with their conventional banking counterparts that inversely impacts short-term performance and long-term growth. The first is a shortfall in product/customer density (often confused with the traditional cross-sell ratio) for financial products and banking services.

Product/customer density is the number of products per customers contrasted against the volume and value of transactions which reflects value of the bank’s ability to service customers. The cross-sell ratio in conventional banks in Europe is typically between 2.5 and 2.9 products/customer. A number of sharia-compliant banks have indicated that their ratio is 3.5 to 3.8; however, holding an account/product is different to actively using an account and executing a transaction.

Institutions have found it easier to sell products than to encourage customers to use them. When customers are queried on how to use sharia-compliant accounts/products to facilitate their day-to-day banking needs, it becomes evident that customers need much more education and understanding on Islamic finance.

The second challenge that banks have in achieving high product/customer density can be attributed to customer service personnel not being up to date with the bank’s product portfolio and the fundamentals of high-quality service. Complaints from customers have not focused on higher cost or lower profits, instead they have been on slowness of service and time-consuming procedures. In the increasingly competitive landscape, service quality will be the market differentiator. 

Market growth

As markets mature, the nature and trajectory of growth has been known to change. Institutions adapt their value proposition and their business models in an effort to provide more comprehensive services and generate profits. Sharia-compliant financial services continue to stay just ahead of the damage caused by global economic problems.

Although aggregate figures reflect slowdowns in several regions, Islamic asset growth in the GCC and Asia continues to record high double digits, as previously mentioned. Geographic expansion is increasingly becoming part of a bank’s growth strategy as many institutions look to enlarge their customer base in countries beyond the more traditional locations.

Discussions with Islamic bankers reveal that part of their growth strategy is to seek out institutions that are looking to supplement their product offerings. Related to this are new but growing inquires by Chinese financial institutions into establishing greater co-operation with Islamic institutions – a growth potential which remains vastly untapped.

Senior management agenda

In summary, the key issues that should be on the strategy radar of senior bankers in Islamic finance during 2014 can be classified into four key areas: building capabilities, improving competencies in human capital, leveraging technology investment, and developing international relationships with other institutions with complementary product portfolios. The following points should also be adhered to:

  • Refine the growth agenda – set directions and make strategic investments.
  • Educate customers – increase marketing and continue building a unique brand identity.
  • Increase human capital capacity – improve product knowledge and sharpen customer service skills.
  • Improve service quality – streamline customer-facing business processes to reduce lag times.
  • Develop new innovative products – create products that best reflect the changing financial needs of target customer segments.
  • Pro-active communication – inform government and industry stakeholders with greater frequency so as to manage expectations.
  • Develop a transnational network – build relationships with customers and other financial institutions as trade and commerce between nations continues to change.
  • Reduce costs – review sharia-compliance documentation and leverage technology investments to improve margins.

A few final thoughts on the numbers During the past seven years, The Banker’s survey of Top Islamic Financial Institutions offering sharia-compliant services has set the baseline for measuring the Islamic finance industry. We continue to strive towards reporting excellence in terms of the compilation and consolidation of the financial data supplied by banks, central banks and other financial institutions. 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 goal 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 author of numerous books and articles on banking and finance. Melissa Hancock is the Middle East and north Africa 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 contact 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 FX rates from the IMF’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

S: Standalone sharia-compliant bank

W: Sharia-compliant window of a conventional bank

Joseph DiVanna is the managing director of Maris Strategies. Dr Jay Jung is a senior researcher at Maris Strategies, specialising in African and Middle Eastern economics.

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