Maintaining standards

Published in The Gulf, 1 January 2016

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.”