The Islamic finance industry has seen rapid growth, with sharia-compliant banks often outpacing their conventional peers. However, the lack of standardisation and the complexity of adhering to multiple financial reporting systems could be holding the industry back
The Shariah-complaint finance sector has been growing strongly, but only in a few jurisdictions and with limited product diversity. As oil-derived liquidity flows dry up in its core markets in the Gulf, what can it do to fix its lack of international reach?
Sometime later this year Qatar International Islamic Bank is hoping to gain a licence in Morocco for a new bank that it is setting up in a joint venture with the local CIH Bank. It is just one small part in a wider story of Islamic banks gaining footholds and expanding. Among other recent converts to the cause is Oman, which began to issue Shariah-compliant banking licences in 2012.
It is not just a trend in Muslim-majority countries. In Europe, the Bank of England issued a consultation paper in February on the feasibility of establishing a Shariah-compliant liquidity facility. Such developments create the impression that Islamic banking is starting to make headway in the global banking system. However, the facts and a lot of industry opinion suggest otherwise.
Of the 1,143 Islamic finance institutions now in existence, the vast majority are in just a few regions. According to ICD Thomson Reuters, 627 of them are in the Middle East and North Africa and 241 are in southeast Asia, leaving just 275 institutions to cover the rest of the world.
This lack of geographic diversity is a challenge for the industry. It would like to have genuine global reach, but it has not yet managed to do so. The industry grew strongly in the first phase of its history, from the late 1970s when Dubai Islamic Bank opened its doors, but lost momentum in the 2007 and 2008 financial crisis and it has not recovered, according to some.
“The way we see the industry is the first phase of growth has gone quite well, in the sense that today you’ve got about 100 million customers across different markets,” says Ashar Nazim, a partner in the financial services advisory team at consultancy EY. “Since the 2007 and 2008 crisis, the industry has yet to take off on the next level of growth.”
He adds: “We do not see as many institutions being formed or new initiatives or ventures being launched as we saw pre-2007 and 2008. This decade, minus the sukuk innovation, can be called a lost decade for the Islamic finance industry, simply because we haven’t seen that aggression we saw in the 1990s or the early 2000s.”
Others take a slightly different view. Haitham Al Refaie, chief executive of Tawreeq Holdings, a UAE and Luxembourg-based firm that specializes in Shariah-compliant supply-chain finance, says the Islamic finance industry has “gained considerable expansion in the past years, with assets nearly reaching $2 trillion, about a 10-fold increase from a decade ago.”
Whichever opinion you prefer, the fact remains that Islamic finance still forms only a small fraction of the global market and is heavily concentrated. According to EY, around 93% of Islamic banking assets are held in just nine markets. Five of those are in the GCC, led by Saudi Arabia and including the UAE, Kuwait, Qatar and Bahrain. The other four are Malaysia, Turkey, Indonesia and Pakistan. Islamic banking still a niche-600
These figures exclude Iran. Other research suggests that if the Islamic Republic was included the situation would be pretty much the same. Data from ICD Thomson Reuters indicates that more than half of all Islamic finance assets are held by banks in just three countries: Malaysia, Saudi Arabia and Iran.
But even in these core markets, customers often prefer to bank with conventional lenders. EY reckons that only a third of banking assets in the GCC are Shariah-compliant. The proportion is largest in Saudi Arabia, where Islamic banks account for 51% of total bank assets, while in Kuwait it is a healthy 45%. The proportion falls off sharply after that however. In Qatar it is around 26%, while in the UAE it is just 22%.
In other parts of the Muslim-majority world, the situation is even worse. In Pakistan, Islamic banks have a market share of around 11%, according to Riaz Riazuddin, deputy governor of the State Bank of Pakistan. He says it should reach around 15% by 2018. The proportion is even smaller in countries such as Turkey and Indonesia, which manage 5.5% and 3.7% respectively.
If Islamic banks cannot persuade a majority of people even in Muslim-dominated societies to trust them with their money, then what are the chances that the Islamic finance sector will be able grow in other parts of the world?
One reason why Islamic finance institutions are not reaching more customers is their limited product range. The industry tends to focus on a small handful of product areas, such as basic banking, insurance (takaful) and bond (sukuk) issues. Islamic banking assets account for $1.35 trillion of the industry’s total assets of $1.8 trillion, according to ICD Thomson Reuters. The rest is made up of sukuk, $295 billion; Islamic funds, $56 billion; takaful, $33 billion; and $84 billion in other Islamic finance institutions. Islamic banking heavily concentrated-300
In banking, Shariah-compliant institutions often have less reach than their conventional counterparts. Typically, the largest sectors for Islamic banking loans are retail, real estate and construction. Conventional banks tend to have greater exposure to a wider range of industries, such as the financial sector and manufacturing, as well as to trade finance.
In Saudi Arabia for example, the three most important sectors for loans (retail, construction and services) account for 61% of all Islamic bank loans. The equivalent figure for the three biggest sectors served by conventional banks is 52%, according to data from Fitch Ratings. There is a similar pattern in Kuwait and the UAE.
In other countries the contrast with the conventional banking sector is even sharper. In Turkey, for example, the top three loan segments account for as much as 96% of all loans by Shariah-compliant institutions, compared to 85% for conventional banks.
In Malaysia, there is a more even match between the two sides of the banking system. Both conventional and Islamic banks make 72% of their loans to the top three sectors.
Such concentration is not necessarily a problem when things are going well, but at a time when many of these economies are struggling with low oil revenues, the calculations need to change.
Nishit Lakhotia, head of research at Securities & Investment Company, a Shariah-complaint wholesale bank based in Bahrain, says that this could be addressed by encouraging consolidation in the industry. “The Islamic finance industry faces challenges, and the lack of scale and diversity is one of the challenges,” he says. “Larger institutions benefit from the economies of scale, from a greater ability to expand their financial products and innovate.”
Lakhotia thinks such consolidation could benefit both industry participants and regulators alike, although he acknowledges that too much consolidation could of course hamper competition.
“Regulatory bodies and central banks should strengthen their governance of the sector, find places in which consolidation is more beneficial for Islamic finance entities to be better able to grow, especially in countries where we have a saturation of small Islamic finance entities,” he says. “The reduction in the number of financial institutions through consolidation will surely have a positive impact on bank supervision. With a reduced number of institutions, the regulators’ interaction with these banks would be better managed, which could enhance the effectiveness of compliance.
Fixing the problem of a lack of diversity also involves dealing with other issues. A lack of standardization is one of the biggest problems restricting the industry. While some progress is being made, it is proving to be slow. Industry analysts say there is less regulatory arbitrage going on these days, but standards still vary widely.
There are several different schools of Islamic thought and the notion of what is or is not Shariah-compliant can hinge on the personal views of specific experts. The two main schools are, broadly speaking, in the Gulf and Malaysia. But there are other variations, not least in Iran.
Even within a country there can be differences of opinion, depending on the views of the experts that sit on the Shariah boards of institutions. Centralized Shariah boards can help by setting basic standards for all institutions within a country, but the problem is harder to deal with on an international basis. The mosaic of regulations can make it difficult for a bank to expand across borders as the products it is used to selling may not be suitable in the new market without substantial modification.
“There is some common understanding now, but I don’t think we will be reaching the stage of international standardization soon,” says Bashar Al Natoor, global head of Islamic finance at Fitch Ratings. “In a few years, if there is a concerted effort, we could reach harmonization and then move to standardization. It’s evolving and developing, but we’re not yet there.”
“While new countries tap the Islamic finance industry, it will indeed take time to develop the right infrastructure for their new Islamic finance ecosystems,” adds Lakhotia.
Opportunities for expansion
If the Islamic finance industry can overcome these issues, there are many opportunities for expansion. Areas like retirement and pension plans remain largely untapped by the industry. The same can be said for wealth management, endowments (known as awqaf in the industry), and savings and finance products aimed at the mass market of lower middle-class customers.
In terms of bigger ticket items, areas like trade finance and infrastructure investment are other potentially lucrative avenues for exploration. Islamic banks need to start imitating the best of their conventional peers by going where the greatest opportunities lie.
“Islamic finance institutions have lagged behind their conventional counterparts in innovating the right financing solutions that match the rapid change in market requirements,” says Al Refaie of Tawreeq Holdings. “With competition in their local markets rising, the major names are starting to expand regionally and globally into new markets to preserve long-term sustainability and growth. Their ability to respond to market requirements and provide innovative and needed solutions will determine the extent of their growth over the coming years. Innovation is of the essence for the expansion of the industry, focusing on serving the needs of businesses and investors.”
Another problem holding back the industry is a lack of liquidity and in particular Islamic banks having enough places to put their money in search of a return. “Liquidity and capital management are critical problems for the Islamic finance industry,” says Al Refaie.
At the heart of the problem is the fact that Islamic banks often have a very limited range of instruments they can use. Buying sovereign sukuk has been one obvious option in the past, but that sector has been quiet in recent years. According to Thomson Reuters, the number of sukuk deals dropped from 834 in 2013 to 809 in 2014, with only 513 issues in the first nine months of last year. The value of this issuance fell from $137 billion in 2012 to $117 billion in 2013, $102 billion in 2014 and just $49 billion in the first three quarters of last year.
Part of the reason for the low rate of issuance in 2015 was the decision by Bank Negara, Malaysia’s central bank, to stop using sukuk as a liquidity management tool for its Islamic banking sector. Instead this year it has started issuing short-term T-bills aimed at the Shariah-complaint banks. Globally, the shortage of viable options means Islamic banks are often forced into partnering with their conventional peers.
“I was in a six-hour think-tank session with the Central Bank of Bahrain [recently], where the discussion was around how Islamic banks are mobilizing deposits from Shariah-sensitive customers,” says EY’s Nazim.
“Effectively, through inter-bank placement, they are parking this liquidity with conventional institutions. This amounts to about $500 billion globally. The idea of Islamic finance is that you should be able to deploy this Shariah-sensitive liquidity into purposeful economic activity, instead of passing it on to conventional banks and acting as a glorified broker. We’ve got to move to the next step where we’re not just passing on this liquidity to the conventional system. We [need to] have the market infrastructure, the instruments and the direction to deploy these in more purposeful economic activity.” “
The difference between conventional and Islamic banking can also work against the latter in some instances. Not only are most customers far more familiar with the concepts involved in conventional banking, but the processes involved in buying or using a conventional banking product or service are also more straightforward sometimes. And as every business knows, complexity equals cost. That also makes the job of signing up customers in countries where Islamic finance is a relative novelty even harder.
“The road to start with is not going to be easy,” said Hamood Sangour al Zadjai, executive president of the Central Bank of Oman, speaking at the World Islamic Banking Conference in Bahrain’s capital of Manama in December last year. “Borrowing from conventional banks is easier, with less formalities and processes.”
The industry is also short of expertise and experience in many areas. According to a survey by consultancy firm Middle East Global Advisors, 64% of the industry executives questioned think that the availability of suitably qualified staff for the Islamic finance industry is limited. A further 18% think such people are very scarce. Only 18% think there is adequate or abundant properly trained staff available. Inevitably, that is a brake on growth.
Islamic banks also need to be more realistic about their business plans. Many have set their sights on conquering mature markets in Europe or North America, while more obvious targets for expansion are overlooked. Nazim says there ought to be more concentration on other Muslim-majority countries, such as the 56 countries that make up the membership of the Organisation of Islamic Cooperation (OIC).
“The industry at times gets carried away talking about entry into more mature, much bigger, more competitive markets like the UK and the US,” he says. “But there are 56 countries within the OIC that one would expect to be the natural home for Islamic finance. If you’ve got to establish your credibility this has to be your first stop.” Bashar al Natoor-160x186 Bashar Al Natoor, Fitch Ratings
Others agree that the most promising markets are Muslim majority ones, where there is a ready pool of potential customers to go after. “I expect Islamic finance will continue to be a minor part of the financing story in non-Muslim countries, rather than a major part,” says Al Natoor of Fitch Ratings. “However, we could see growth more in countries like Turkey and Indonesia, where there is a push from the government and real demand in the economy.
A further problem is the risk-averse nature of the industry. Steeve Bono, a Dubai-based partner at consultancy firm NBA Partners UK, says: “Banks at the moment are afraid of risk. In the Islamic framework, equity financing should really be the mainstream way of financing business. That’s not how it works in practice. In practice, when you take a look at most Islamic banks, they do something very similar to what conventional banks are doing. The Islamic banking world should be completely different. The whole idea is really to work closely with the entrepreneur and really find the key to recycle all these idle cash balances out there into productive projects. It’s really critical that this equity financing is there.”
There are some defences against this charge. Sultan Choudhury, chief executive of Al Rayan Bank, the UK subsidiary of Qatari bank Masraf Al Rayan, says the low-risk policies adopted by Islamic banks are a natural consequence of their wider business model.
“The majority of our deposits are retail deposits. People are putting their money in, typically their life savings, on a low-risk basis. That is the objective of depositors by and large,” he says. “That governs the risk appetite of the bank. I’ve taken deposits from ordinary consumers. I’ve then got to put it in relatively safe investments, which is typically going to be the equivalent of residential mortgages, or home purchase plans as we call it, or if in the commercial space, an asset-backed investment, typically real estate.”
He acknowledges that “there’s a big gap for start-up and entrepreneurial capital,” but adds that “looking to banks to fill that gap is not necessarily going to happen any time soon because of the way they’re structured to do safe investments.”
Choudhury can however point to one area in which his bank has managed to break down barriers and expand in ways that few of his peers have managed. He says the majority of Al Rayan Bank’s long-term depositors in the UK are non-Muslims.
Persuading more people in more countries to use Shariah-compliant banks is, more than anything else, a marketing challenge and one that may require some novel thinking. Given the political climate in many western countries, some industry executives suggest the term Islamic is itself problematic and that the industry would be better off replacing it with another phrase, such as ‘ethical banking’. That would echo the existing situation in some countries such as Turkey where Shariah-compliant institutions are generally known as participation banks.
“There has been some talk that the name could be better as ethical finance or fair finance, because that is what describes it,” says Ahmed al Mutawa, chairman of Gulf Finance House. “I would say with current events [the name] does cast a shadow on it. If you don’t change it, you have to explain it, so the task becomes even bigger.”
Despite the gloom, Islamic banks have been posting very healthy growth levels in recent years, often surpassing that of their conventional peers. For example, Islamic banks outpaced their conventional rivals in terms of asset growth in 2014 in Saudi Arabia, Malaysia, Kuwait, Qatar, Indonesia and Pakistan, according to EY. The compound annual growth rate for Islamic banks for the period from 2010 to 2014 was 20% or higher in five of the nine big Islamic finance markets: Saudi Arabia, Qatar, Turkey, Indonesia and Pakistan.
Thomson Reuters expects Islamic finance assets to reach $3.2 trillion by 2020, compared with $1.8 trillion now. EY thinks the total is already close to that figure, if you include items not usually incorporated, such as the Shariah-compliant assets held by high net-worth individuals and family offices.
Profitability has also been relatively good. EY estimates that the combined profits of Islamic banks in the nine core markets for the industry were around $13 billion in 2015. That figure could triple within four years, according to Nazim of EY, as more banks reach critical mass.
However, for those forecasts to prove accurate, the economies of the main markets will need to continue to perform relatively well. In recent years most observers have been cutting their growth predictions for the Gulf countries because of low oil prices. That is having a knock-on effect on the banking sector. On March 31, Standard & Poor’s cut its rating for five Saudi banks, including the world’s largest Islamic bank, Al Rajhi Bank.
- Sidebar: One size fits?
An idea gaining momentum in Islamic finance is that of centralised Shariah boards to deal with the chronic lack of standardization, a problem that can lead to confusion among customers and, some say, is holding back the industry. However, they are not without problems of their own.
Malaysia has been one of the earliest movers. In 1997 its central bank, Bank Negara Malaysia, set up a Shariah advisory council to act as the highest Islamic finance authority in the country. Others with similar systems in place include Indonesia, Pakistan and Sudan.
More recently, the idea has been spreading to the Gulf. Oman set up its High Shariah Supervisory Authority in 2015, while Bahrain has said it will launch its version in the near future. The UAE is expected to follow suit before long.
It is a development that is welcomed by analysts.
“It is set to become the industry standard going forward,” says Ashar Nazim, partner in the financial services advisory team at EY. “Once you’ve got the critical mass, it’s always good to have national alignment on strategic issues. At the national level, a Shariah board will ensure strategic alignment on the overall direction of the industry. I think that’s a very good thing.”
There are some notable differences in the approaches being taken. Some use them as a high-level layer of regulatory oversight, without allowing the boards to get too involved in specific products, while other countries use them to set out rules and regulations for particular instruments and transactions.
“The extent of a central Shariah board can differ by country,” explains Bashar Al Natoor, global head of Islamic finance at Fitch. “It can go all the way to product standardization and approval or it can be a supervisory, higher-level board. Malaysia has more product standardisation. In Bahrain, Oman and the UAE I’d expect to see a supervisory structure evolving, at least in the initial stages, and then they will assess whether it is beneficial for them to standardise transactions and products or do something in between.”
Whichever system a country adopts, there are likely to be teething problems for at least some of the institutions they regulate and advise. Centralised boards can prove more conservative or more liberal in their interpretations than the banks they oversee. In either case, if a bank finds that it has taken a different approach to the regulator there needs to be a period of realignment.
While the trend is generally viewed as positive, it doesn’t address a more fundamental problem for the industry, which is the lack of global standardisation. Some industry executives see that as the target for the future.
“Further to a country-wide centralised Shariah board, a global reference should be adopted to clear some of the variant interpretations and complexity that is slowing growth,” says Haitham Al Refaie, chief executive of Tawreeq Holdings.
The sukuk market is going through a tough time at the moment, with a steady fall in both the number and value of instruments issued in recent years. With 2016 now upon us, the question for the industry is whether that trend will continue or if something will happen to turn its fortunes around.
According to a Thomson Reuters report published in early December, the number of sukuk issuances fell from 834 in 2013 to 809 in 2014. The full-year figures for 2015 are not yet available but the decline appeared to be accelerating, with only 513 issues in the first nine months of the year. The trend has been even more pronounced in terms of the amount being raised via these issuances, with the figure falling from $137 billion in 2012 to $117 billion in 2013, $102 billion in 2014 and just $49 billion in the first nine months of 2015.
“It’s a big slowdown [in 2015]. The big fall in issuance is really the story,” said Mark Smyth, chief investment officer of Luxembourg-based Tawreeq Holdings, speaking at the World Islamic Banking Conference in Bahrain in early December.
One big factor in the slowdown has been the decision earlier in 2015 by the Malaysian central bank to move away from sukuk as a liquidity management tool for the country’s Islamic banking sector. But the sector has also been affected by a variety of other factors, including the performance of the bond market more generally.
“Some issues are specific to the global Islamic finance industry, others are quite clearly tied to the general bond market,” says Smyth. “I think most bankers would agree that it’s a particularly tricky read these days–the financial markets, geopolitical tensions–all these things play into tough trading for bond markets and fixed income.”
There are a few reasons why the dynamic might change over the course of 2016, however. Among them is the fact that banks need to raise capital to comply with Basel III regulations.
In addition, a lot of oil-producing governments need to cover their ever-widening budget deficits. Both these factors mean that the sukuk market could be far healthier, although it is not clear to what extent issuers might favour conventional bonds over sukuk.
Another positive development is greater clarity on interest rates. One thing holding issuers back last year was uncertainty over what action the US Federal Reserve might take on interest rates. That has now been lifted to some extent, following the mid-December decision by the Fed to raise interest rates by 0.25 per cent, its first rise since 2006. The likes of Saudi Arabia, Bahrain and Kuwait all raised their interest rates in response, to maintain their currency pegs to the US dollar. Further rate rises may follow, but the direction of travel is at least clearer.
In the longer term, the sukuk market needs to expand into new areas if it is to thrive. Mohammad Farrukh Raza, managing director of IFAAS, an Islamic finance advisory firm, says there are several promising areas that have yet to be explored properly, but which would help to the sector to develop and mature.
“I think there are two pools that are seriously under-tapped in this market,” he says. “First of all, the corporate sector, and also retail sukuk. There is a lot of opportunity out there, but due to the lack of awareness among corporates, it’s simply not happening. The retail sukuk is another area that is almost completely ignored … The GCC markets need to investigate this more and develop structures that are geared towards the sukuk market and that will bring a lot of new liquidity into the market.”
Khalid Hamad Abdul-Rahman Hamad, executive director of banking supervision at the Central Bank of Bahrain, agrees that more needs to be done in this regard.
“We should encourage more innovation in sukuk structure and call for more issuances of sukuk by Islamic financial institutions, corporates, sovereigns and multilateral development banks,” he says.
Amid the gloom, it is worth pointing out that sukuk is still the second-largest segment of the global Islamic finance market, making up 16 percent of the industry’s total asset base in 2014, according to the Thomson Reuters report. Since 2012, the total amount of outstanding sukuk has grown by an average of 8.3 percent a year, more than twice the rate for the industry as a whole.
However, its relative strength within the industry highlights the lack of diversity in Islamic finance more than any particular strength in terms of sukuk. If the sukuk market does manage to grow this year, it could lead the way for expansion of the industry more generally.
New regulations could help Bahrain maintain its strong position in the Islamic banking market, but there are plenty of headwinds for the industry.
The Central Bank of Bahrain (CBB) says it will launch a central sharia board for Islamic banks early in 2016. Previous reports had suggested that the board would be in place before the turn of the year and it is not clear what has caused the delays.
Nonetheless, the move could provide a useful fillip to the local Islamic banking sector at a time when the economy is having to face up to a tougher regional environment, with low oil prices and reduced state spending.
The new board will oversee product development and compliance by Islamic financial institutions in the country, provide guidance to the CBB when it is setting new regulations, and to the courts in legal cases involving Islamic finance. This should help to ensure there is greater clarity in the way that sharia principles are applied - an important issue given that a lack of standardisation is often blamed for holding back the growth of the Islamic finance industry. But there are many other issues that are hobbling the industry and Bahrain will have to continue to innovate if it is to maintain its position as a regional Islamic finance hub.
The central sharia board initiative is being supported by the Accounting & Auditing Organisation for Islamic Financial Institutions (AAOIFI), which is based in Bahrain and which is one of several organisations around the world that sets standards for the industry.
“We have had a lot of discussions with the Central Bank of Bahrain regarding the central sharia board,” says Khairul Nizam, deputy secretary general of AAOIFI. “It could help us in getting a stronger adoption of our standards. In Malaysia, for example, they have a central sharia board and that board uses our standards as the basis of their work. Having a central sharia board can definitely help to promote the adoption of standards.”
However, he notes that the initiative is not bound to succeed. “When it comes to central sharia boards, there’s no one size fits all model,” he adds. “It has worked in some jurisdictions and hopefully it will work in Bahrain, but it may not be a suitable model in some other jurisdictions.”
Bahrain is already home to 25 Islamic banks, including six retail banks and 19 wholesale banks. The most recent to be granted a licence was Sudan’s Bank of Khartoum, which officially launched its presence in the country in early December.
Some of the local banks appear to be doing very well. Recent research by consultancy firm Middle East Global Advisors (MEGA) named Bahrain Islamic Bank as the best performing Islamic institution globally in terms of return on average equity and return on average assets - both key indicators of a banks’ performance and its ability to create shareholder value.
Such metrics are not a reflection of size, however, and most sharia-complaint institutions remain very small. Speaking at the World Islamic Banking Conference (WIBC) in Manama in early December, CBB governor Rasheed al Maraj suggested this was a problem.
“The Central Bank of Bahrain continues to strongly encourage Islamic banks to merge or acquire other institutions,” he said. “Given a tougher regulatory environment, challenges to their business model and increased competition from Islamic as well as conventional competitors, the preferred path, particularly for Islamic investment banks, is to merge in order to create institutions of size. Not only will this increase their chances of survival by enabling them to participate in larger deals but also help them attract the right human resources.”
Overall, Bahrain punches well above its weight in Islamic finance. The country has the seventh largest Islamic finance market in the world, with assets of around $73 billion, according to Thomson Reuters. It is not far behind Qatar and Kuwait, which have Islamic finance assets of $87 billion and $98 billion respectively, despite having far larger economies. Bahrain also easily outpaces the likes of Turkey, Indonesia and Egypt in this regard.
However, the performance of the Islamic finance sector more generally has been rather muted of late. Sukuk issuance has been falling for the past few years, for example. According to a report published by Thomson Reuters in early December, the number of sukuk issuances fell from 834 in 2013 to 809 in 2014 and there were only 513 issues in the first nine months of 2015. The amount raised via these sharia-compliant bonds has been dropping at an even more alarming rate, from $137 billion in 2012 to $117 billion in 2013, $102 billion in 2014 and just $49 billion between January and September 2015.
In addition, the industry is struggling to break out from a narrow base. Around 74 per cent of all Islamic finance assets are held by banks, with a further 16 in the form of sukuk, according to Thomson Reuters. That leaves other areas like Islamic insurance and funds particularly small. In geographic terms, Islamic finance has also made little headway. As it stands, 65 per cent of the industry’s assets are in just three countries - Malaysia, Saudi Arabia and Iran. Such failings are widely recognised in the industry, not least in Bahrain.
“Islamic finance is full of good principles and fair practices. However, the industry has failed in publically communicating them,” said Khalid Hamad Abdul-Rahman Hamad, executive director of banking supervision at the CBB while speaking at the WIBC.
Local banking executives agree. “The potential of Islamic finance is more than what has happened already,” says Ahmed al Mutawa, chairman of the local Gulf Finance House (GFH). “There is a need to create greater awareness of Islamic finance, even in Islamic countries. A lack of awareness, a lack of understanding, limits the areas in which Islamic finance can operate and that’s why we see this [geographic] concentration. Once there is a better understanding I think it will reach broader areas and more economies around the world.”
Such comments suggest that the industry’s problems are principally down to a lack of decent marketing. Certainly that is a factor, but there are more technical issues at stake too. In his speech Hamad noted that the industry is weak in a number of important areas, citing the lack of an active and efficient capital market or well-developed money and credit markets. He also noted that there are skills shortages in many key areas of the industry, including sharia auditing and chief executives and chief finance officers who are well acquainted with Islamic finance.
As with standardisation, the need to develop skills and talent is an issue facing the industry around the world. Some claim that Bahrain is in a better position than most in terms of its skills base, at least within the Gulf region. The central bank says that Bahrainis account for 77 per cent of the workforce in banks and around 68 per cent of all staff in its wider financial sector.
“Although there are many centres of Islamic finance now in the GCC that might compete with Bahrain, at the level of human resources Bahrain is still the best,” says Al Mutawa of GFH. “It’s a more indigenous workforce in Islamic finance rather than an expatriate one. That’s their strength. This is not true in the other GCC countries.”
Another shortcoming of the global industry that is frequently noted is the lack of liquidity management tools, something which makes life harder than it otherwise would be for sharia-compliant banks.
“Liquidity management is quite limited and varies from country to country,” said Riaz Riazuddin, deputy governor of the State Bank of Pakistan, the country’s central bank. “Concerted efforts are required to address this issue. Limited liquidity management instruments have been among the key issues faced by Islamic banks in most jurisdictions.”
The Bahrain authorities have been making efforts to tackle this issue over the past year. In April 2015 the CBB launched a sharia-compliant liquidity management tool, called wakalah. This is aimed at absorbing the excess liquidity of local Islamic retail banks by allowing them to place their spare funds with the central bank. The instrument lasts a week at a time and is made available to the banks every Tuesday. Any money deposited with the central bank is invested on behalf of the retail banks in a sukuk portfolio.
The market would also be helped by the issue of more sukuk by the government. But although there is a clear need for states across the GCC to fund their growing budget deficits, there is an expectation that the Manama government favours conventional bond issues over sukuk these days.
Najla al Shirawi, chief executive of SICO, a Bahraini wholesale bank, says she expects Bahrain to concentrate on conventional issues in the short term. “For Bahrain we will see more conventional issues. For other countries it will mostly depend on the local appetite. Saudi will see just straightforward conventional issues. In the UAE it will be a combination.”
In the meantime, it is not clear at this stage how popular the wakalah facility has been with local banks. But such initiatives, along with the forthcoming central sharia board, do at least help the country to maintain a reputation within the Islamic finance industry as an important hub.
“Any jurisdiction that has thought of Islamic finance will always come to Bahrain to learn from their experience,” says Nizam.
“Bahrain as a jurisdiction has provided the top leadership for Islamic finance for a long time, and I’m not just saying that to be nice.”
Islamic bonds are expected to play a greater role in propping up government finances and government-related issuers are expected to have the upper hand in the market.
There is no getting away from the fact that the sukuk (Islamic bond) market is going through a tough time. Globally, the value of issuances dropped sharply in 2015, according to data from US/Canada-based Thomson Reuters. In the first nine months of the year, sukuk issuance totalled about $48.8bn, compared with $79.5bn in the same period in 2014.
Part of that fall stems from the decision by the Central Bank of Malaysia to move away from using sukuk as a liquidity management tool for the country’s Islamic banks. Just as important, however, was the fact that no one else came to the market to pick up the slack. Uncertainty over US interest rates has been among the factors that seem to be holding some issuers back.
This trend is certainly visible in the Gulf. The GCC is the second-most important market for sukuk after Malaysia, with a total market share of between 20 and 30 per cent in recent years. However, issuance in the main Gulf markets has been on the slide.
In Saudi Arabia, the value of sukuk issuance has dropped from $15.2bn in 2013 to $12.1bn in 2014 and $5.4bn in the first nine months of this year. Issuance in the UAE fell from $7.1bn to $5.7bn and then $4.7bn over the same period.
However, there is some hope that sovereign issuance may start to turn things around. GCC governments need to raise finance to deal with their ballooning budget deficits and the bond market is an obvious place to turn, whether in terms of conventional or sharia-compliant finance.
“In the GCC and more generally as well, the funding requirements of sovereigns are lending a bit of a new lease of life to the sukuk market,” says Jarmo Kotilaine, chief economist at Bahrain’s Economic Development Board.
When making a decision on what type of bond to issue in the past, Gulf governments have more often than not opted for conventional bonds over sukuk. One consequence of this is that Islamic banks have plenty of liquidity available that could be used to invest in any sukuk that are launched.
“A lot of the Islamic institutions have more liquidity than the conventional institutions,” says Najla al-Shirawi, CEO of Securities & Investment Company (SICO), a Bahraini wholesale bank. “Most of the conventional institutions were buying the conventional issues from the government. So that sucked up a lot of their liquidity. The Islamic institutions have not seen the same pace of Islamic issues from the governments, so the liquidity remained intact.”
Given that banks are the dominant buyers of sukuk, that is a position that will be welcomed by many Gulf finance ministries as they try to put their fiscal house in order. Oil prices are expected to rise only slowly at best over the coming years, which means deficit management is likely to be one of the most important issues facing governments for some time to come.
“There is a pool of Islamic liquidity that is available and will play an important role in bridging these [fiscal] deficits,” says Nitish Bhojangarwala, assistant vice-president of the financial institutions group at Moody’s Investors Service, a US ratings agency.
The banks are, however, being adversely affected by other aspects of the current fiscal climate. Along with issuing more debt, governments have also been drawing down some of their savings to help cover their spending needs. In some cases they have done this by selling off assets held by their sovereign wealth funds, but they have also been drawing down their bank deposits.
Across the region, the authorities play a critical role in providing deposits for both conventional and sharia-compliant banks and, while their withdrawals have been relatively limited so far, the potential consequences of this are far-reaching. Even at the current rate of withdrawals, there has been an notable impact, with banks having less money to lend or to invest in bonds or sukuk.
“A lot of liquidity in the GCC environment is driven by the government deposits within the system,” says Bhojangarwala. “In 2015, we started seeing a sharp reduction in the deposit growth, which then means on the asset side banks will scale back as well. That is what we are seeing on the sukuk side. Credit appetite in general has come down, primarily driven by the reduction in deposit growth.”
All this creates a rather uncertain picture for the sovereign sukuk market in the region and there are mixed views on the likely extent of sovereign issues in the future. Bahrain is expected to concentrate on conventional issues in the short term, but others such as the UAE and Saudi Arabia could see a mix of both conventional and Islamic issues. The Kuwaiti government is also thought to be looking at a sukuk listing, possibly in 2016, according to Bhojangarwala.
In Oman, the recent sukuk issue by the government could lead to further activity, according to Hamood al-Zadjali, executive president of the Central Bank of Oman.
“The government of Oman has issued its first sovereign sukuk with a successful initial offering,” he said, speaking at the World Islamic Banking Conference in Bahrain in early December. “This is expected to help to some extent liquidity management issues in the Islamic banking sector and also to have a positive impact on Oman’s capital market in general and the sharia-compliant financial market in particular. The successful launch of this first sovereign issue will pave the way for future issuances.”
The best outcome is probably slow and steady growth in sovereign issues in the near term, so that other potential issuers are not crowded out of the market. If governments become too enthusiastic with sukuk issues, they could take up too much of the available liquidity, meaning the region’s large corporates might find it difficult to sell any sukuk issues of their own.
As it is, the tough market conditions look likely to continue for many issuers in the short term, but government-related issuers are expected to have the upper hand.
“There is liquidity there, but it is for specific players,” says Mohammad Farrukh Raza, managing director of IFAAS (Islamic Finance Advisory & Assurance Services), a consultancy specialising in Islamic finance and based in the UK.
“Not everyone will be able to tap the market in the near future. Historically we have seen a lot of players come to tap the market periodically; now we will see a few players tap the market regularly in the near future. I think the market at the moment is ‘wait and see’. [Investors] will only touch good, government-related entities that have issued in the past as well. That’s where the funding will go in the near future.”
Sharia-compliant banking has been expanding quickly, but the industry seems impatient for even faster growth.
At the World Islamic Banking Conference in Bahrain in early December, the delegates were asked a simple question at the start of the first day: what did they think of the performance of the industry over the previous 40 years? The answer they gave was rather stark. A clear majority, 58 per cent, said it had been disappointing.
Other, more in-depth, research has also found there is a sizeable pool of unimpressed Islamic finance professionals. A survey by UAE-based consultancy Middle East Global Advisors, the results of which were launched at the conference, found that about 33 per cent of industry executives think the financial performance of Islamic banks has been below or far below their expectations over the past five years.
You would not know it from all this evidence of gloom, but the sector is actually growing at a fairly healthy clip these days. It is just that the growth rate does not seem to be enough for some market participants.
A third of banking assets in the GCC are now sharia-compliant, according to UK consultancy EY, and globally the industry now controls at least $2 trillion in assets. Ashar Nazim, financial services customer leader in the Middle East and North Africa (Mena) region for EY, says his firm expects the industry to expand its asset base by an average of 14-15 per cent a year in the next few years, matching the rate it has enjoyed over recent years.
Most other corners of the global banking industry would be very happy with such a performance. Indeed, Islamic lenders have been outpacing conventional banks in many of their core markets. In Saudi Arabia, for example, Islamic lenders grew their asset base by 18 per cent in 2014, compared with growth of 7 per cent by conventional banks, according to EY.
It was a similar story in Kuwait, where the respective growth rates were 13 per cent for Islamic financiers and 4 per cent for conventional banks. In Bahrain, conventional lenders suffered a 1 per cent fall in assets last year, while Islamic banks posted a 7 per cent rise. Across the main GCC markets, only the UAE saw conventional financiers outpacing their Islamic peers, although there was little to distinguish between them, with 18 per cent for sharia-compliant institutions compared with 19 per cent for the others.
For anyone who wants to strike a more pessimistic tone, however, there are plenty of industry weaknesses they can point to. One major shortcoming has been the industry’s narrow reach, both in terms of the range of products it offers and where its customers are located. According to EY, about 93 per cent of Islamic banking assets are held in just nine countries and the top three markets – Saudi Arabia, Malaysia and the UAE – account for almost 64 per cent of the total. The remaining core markets include three in the GCC – Kuwait, Qatar and Bahrain – and three outside the region – Turkey, Indonesia and Pakistan.
Many in the industry recognise the need to expand, both in terms of reaching new countries and serving more market segments. Riaz Riazuddin, deputy governor of the State Bank of Pakistan, the country’s central bank, points to several areas that he says Islamic banks could and should do more to target.
“The current practices of Islamic finance have been keeping in close proximity to conventional financial products,” says Riazuddin. “It blurs the [distinctiveness] of services offered by sharia-compliant institutions. There is a need for these institutions to explore new models and markets. Islamic banks need to reach out to strategic sectors such as agriculture, SMEs [small and medium-sized enterprises] and housing, especially low-cost housing.
“Most of the Muslim countries have agriculture as one of the main sectors contributing to GDP. Islamic banks need to capitalise on this opportunity. Similarly, SMEs remain of paramount importance for achieving growth objectives [and] most of the Muslim-dominated countries have a significant proportion of their populations having housing needs. Islamic financial institutions can contribute to the expansion of this sector.”
Others share some of these views. Hamood Sangour al-Zadjali, executive president of the Central Bank of Oman, made a similar point at the conference in Manama, saying the industry was unduly focused on a few areas, such as real estate. “We look forward to increased focus on the SME sector in particular,” he says.
However, the industry is not necessarily well placed to expand into new areas as fast as some might want, as it faces plenty of tricky hurdles. Efforts to standardise sharia-compliant methods and products has been a long-running and slow process, for example, and is still only making fitful progress. Some countries such as Bahrain are setting up national sharia compliance boards, which could help.
“The main purpose of the Central Sharia Board is to have more centralisation of the Islamic standards,” says Abdulrahman al-Baker, executive director of financial institutions supervision at the Central Bank of Bahrain. “This is important because that will grow the market more. It’s going to be implemented soon, possibly in 2016.”
As welcome as such a move is, it does nothing to address the broader challenge for an Islamic bank that might want to offer services in many different jurisdictions.
“The standardisation problem has existed for decades,” says Jinesh Patel, CEO of the Bahrain-based GFH Bank. “There is a confusion across jurisdictions, across sharia boards. Until we get these basic tenets right, it’s going to be very difficult to trickle this down to everybody who is not just Muslim but non-Muslim.”
Liquidity management issues are another factor. Here too there has been some progress, in the shape of sovereign sukuk (Islamic bond) issues, for example. However, the rather tepid market in sukuk at the moment suggests this does not yet represent a full fix for the industry and there is a shortage of alternatives.
“Some of the fundamental issues the industry has faced over the past couple of decades have unfortunately still not been addressed,” says Usman Ahmed, CEO of Citi Islamic Investment Bank, a wholly-owned subsidiary of US-based Citicorp Banking Corporation. “The biggest of those is how do you manage liquidity in the short term. The inter-bank Islamic market is not developed.”
Such problems are at least within the ability of the industry to deal with, even if doing so tends to happen at a slow place. There are other issues beyond the industry’s influence however, which are also having detrimental effects on the sector. Perhaps the most notable is the fall in oil prices over the past 18 months, which is hurting many of the economies where Islamic banking is most solidly established.
“The growth rate of Islamic finance in the near term will be tested by the fact that the global economy is in something of a soft spot,” says Jarmo Kotilaine, chief economist at the Economic Development Board in Bahrain. “The fact that there has been this period of commodity price weakness will have an impact, simply because a lot of the countries that have pioneered Islamic finance are more affected by this than other countries. Typically, when oil prices turn south then Islamic wealth creation globally tends to grow much more slowly.”
On top of that, the impact of the slowdown in China and other emerging markets is likely to be negative. The survey by Middle East Global Advisors found that 49 per cent of industry professionals think continued low oil prices are the most likely factor that could slow the growth of the Islamic banking sector in the year ahead, while 21 per cent cite interest rate volatility and 16 per cent say commodity price movements more generally. A further 9 per cent point to the slowdown in the Chinese economy as the most likely cause of any deceleration, while 4 per cent say a possible resumption of the European debt crisis is the greatest risk.
The main base for an Islamic bank is likely to determine which of these factors is the most important for them. As the survey highlights, some at least have close ties to Europe, where Islamic banking is still in its infancy. In markets such as the EU, there are some less technical issues the industry might also need to address if it is to make the most of its potential. Perhaps the thorniest nettle of all to grasp is the name of the sector itself.
As some industry executives recognise, the current political climate makes anything with the word ‘Islamic’ in the name a harder sell in some markets. “Unfortunately brand Islam is broken in the West,” says Nazim. “Therefore the sharia part has to be embedded in the proposition. You’ve got to show the economic and the business impact of Islamic finance, rather than just sharia compliance, if you want to go mainstream.”
Ahmed al-Mutawa, chairman of GFH, takes a similar view, suggesting that a name such as ‘ethical banking’ might be an easier proposition in some markets. However, he also points out the industry is still very young.
It is just 40 years since Dubai Islamic Bank effectively created the modern Islamic finance industry and Al-Mutawa suggests that people in the industry should bear that in mind and be realistic about how long change can take before they get too despondent about the industry’s potential.
“You still have to think of Islamic finance as a young industry,” he says. “Even in the Islamic world, traditional banking has the advantage of being here a lot longer. People have got used to it. To shift them from one banking style to the other will take time and effort.”