Islamic banking needs to break out

Published in Euromoney,  25 April 2016

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.”

Small fraction

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.

Risk-averse nature

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.

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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.