Islamic finance in search of the mainstream

Published in MEED, 6 December 2015

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

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.

Militancy fallout

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.”