A sector with everything still to play for

12 July 1996

ISLAMIC banking is growing apace in the Middle East. The modern industry dates only from the oil price boom of the 1970s though its guiding principle - a ban on charging or accepting interest - has existed throughout Islamic history.

Most Islamic banks are still relatively small in asset terms, but one or two institutions are rising to the top of their domestic charts and the number and variety of products and services is growing steadily. Some big international banks are also taking an increasing interest in the possibilities of Islamic banking as a profitable niche marke.

Bankers say there are still billions of Muslim dollars on deposit with conventional banks which could be lured into Islamic investments. Estimates for the current size of the industry in asset terms range between $50,000 million-100,000 million: since this is a small portion of all the assets of Muslim investors world-wide, the industry could potentially grow a lot bigger.

However, there are obstacles which, if not overcome, may hold back this growth. These include a relative lack of standardisation in some areas of the industry, ambiguity about how Islamic banks should be regulated and the funding problems caused by their inability to borrow at interest on the interbank market.

In recent months, the most noticeable area of growth in the industry has been in investment banking, notably in the launch of a number of new equity and commodity funds. Conventional banks are also building up their Islamic operations in the Gulf

Modern Islamic banking got its kick-start from the rapid enrichment of the Gulf Arab states by oil. The oil price hikes of the 1970s brought unprecedented amounts of wealth to the Middle East, creating demand from devout Muslim investors for ways to place money without going against the Islamic prohibition on nba - an Arabic term usually understood to mean interest.

The growth of Islamic banking's deposit base is driven by economic development in Muslim countries. The coming of oil wealth to the Gulf spurred the initial development of the industry and the continuing infrastructure requirements of the region are today creating a need to mobilise private-sector funds. Economic growth in the Muslim states of south and South-East Asia is also providing a new and important area of demand for funds which Islamic banking can benefit from.

One high-profile advocate of Islamic banking notes the relationship between economic growth in general and the growth of the industry in particular countries. 'Islamic banking is bigger in the countries where middle-income groups are bigger,' says Adnan AI-Bahar. chairman of The International Investor (TII). a Kuwaiti investment company. 'Islamic banking in Indonesia, which has 180 million people and is 95 per cent Muslim, is smaller than in Malaysia. Or compare Saudi Arabia and Kuwait. It is bigger in Kuwait, where employees have to have a bank account.' The trend in Muslim countries is towards a steady reduction in the dominant role of the state in the national economy. The subsequent increase in assets that arc concentrated in private hands should help promote the growth of the industry, argues Duncan Smith, head of the Islamic Investment Banking Unit (IIBU) owned by London-based United Bank of Kuwait. 'The reasons why Islamic banking will grow in the Middle East are partly linked to privatisation,' says Smith. 'Money in private hands fuels Islamic banking because people go to hell and governments don't.'

Virtuous circle

Many bankers working in the industry argue that a Muslim investor will probably pick a Sharia-compatible investment over a comparable conventional one if the returns are the same. The growth of Islamic banking may create a virtuous circle - as the industry grows, competition will make it more attractive for Muslim investors who may now keep their deposits in conventional banks. 'Think of it as an arbitrage market,' AlBahar says. 'When costs approach those of the conventional market, it will attract maybe 80 per cent of Muslims. The growth is going to flatten out at one point - nothing, I believe, can stop it being 80 per cent. When that point is, I don't know.'

However, at this stage, the industry is fat short of becoming a fully-fledged competitor to conventional banking. 'There is a desire for an alternative financial system, but we don't have the liquidity,' says Stella Cox, who heads the Islamic banking division at London merchant bank Kleinwort Benson.

-'My view is that to achieve market liquidity you need a critical mass of big players with sizeable balance sheets.'

Most Islamic investments have historically been in short-term, trade-related business such as murabaha (see box, page 7), and only in recent years has more money gone into leasing and real estate. A recent study produced by Dresdner Bank, which owns Kleinwort Benson, estimated that in 1994 only 10 per cent of Islamic banks' assets had maturites of more than five years.

Such concentration in one area of business makes the field Islamic trade finance rather crowded. 'So many people have piled into murabaha. It drives margins down and becomes almost a clerical business of turning paper over,' says one Western banker. Pressure is growing to find new ways to place funds from investors who now expect higher returns than before. One business which has seen rapid growth is investment funds (see page 10).

Project finance is likely to become another growth area as Muslim states need to borrow for infrastructure and industrial expansion that was previously paid for in cash. The ANZ banking group arranged Islamic bridging finance for the Hub power project in Pakistan, which reached financial closure in 1995. More recently, Islamic commercial bank Kuwait Finance House arranged $200 million in finance for the Equate petrochemical project, while Al-Rajhi bank in Saudi Arabia was reported to be bidding to provide Islamic finance for a major power plant upgrade at Ghazlan. 'There are going to be billions of pounds in infrastructure financing requirements,' notes Richard Duncan of the Islamic finance division at ANZ International Merchant Bank.

Most bankers agree that wholesale banking will see the strongest growth in the next few years. 'In the next few years we will see the biggest growth in institutions which are focused on the corporate and wholesale sectors of Islamic finance,' says Omar All, chief executive of the Dar Al-Maal Al-Islami Group (DMI). The group, which is based in Geneva, controls a worldwide network of Islamic banks. 'Most of the growth will take place in the value-added new products area of structured finance, capital markets and corporate tinance.'

'Corporate and project finance is a growing area,' adds Al-Bahar of TII. 'This will stimulate growth in securitisation of assets and a secondary market trading in those assets. We're also seeing more international investment products like equity funds.'

At the moment there is nothing like a secondary market for Islamic securities in the Middle East. 'The problem is not Islamic banking as such,' argues Al-Bahar. 'It's the fault of banking in developing countries without proper capital markets. You don't have liquid instruments. The problem is to create more assets to trade, but this isn't the task of retail banks.'

Some bankers say that Malaysia might serve as an example for the Middle East. The Malaysian government has taken a more hands-on approach - it passed a law on licensing and regulation of Islamic banking as long ago as 1983, though the country still has only one dedicated Islamic bank. But Malaysia has a powerful need for investment and thus for capital markets that run smoothly - this makes the attitude of the authorities towards Islamic banking less conservative than in the Gulf.

Not all bankers think the future expansion of the industry will be confined to the Muslim world. 'The area where Islamic banking will grow is outside the Islamic world. This can be achieved when the corporate sector there has a closer look at Islamic banking products and realises that they can be quite competitive on technical terms alone,' says Abdel-Hak Elkafsi of Arab Banking Corporation (ABC), a conventional bank which is currently upgrading its Islamic business into a bank with a separate capital base (see below).

Bankers' optimism about the future is qualified by awareness of several significant obstacles. The first is the religious barrier that keeps Islamic banks out of the interbank market. Because Islamic banks cannot borrow at interest from other banks or hedge against interest rate risks through derivatives, it is harder for them to match assets and liabilities for fear that they will be unable to meet demand from customers to withdraw deposits. They also suffer from lack of day-to-day liquidity. The industry has an ambiguous relationship with regulators in some Muslim countries which means that Islamic banks usually do not have a lender of last resort.

There are ways round the liquidity problem. A bank can buy shares in a highlytraded company which it knows can be liquidated in a hurry. Several conventional banks provide this kind of service to Islamic commercial banks. Another route is to securitise assets such as those owned by banks and leased out - while Islamic securities cannot pay interest, they can give a return linked to the earnings on the underlying asset.

How far and how fast these kinds of developments will go will be partly determined by the attitudes of Sharia boards in Islamic banks, which assess the religious acceptability of a business. A key difference between the way in which Islamic banking has developed in Malaysia and in the Gulf is that the Malaysian government has laid out a single set of regulations for Islamic banking. In the Gulf there is no single authority, but a proliferation of Sharia boards, one to each bank.

Given the important role of the Sharia boards within Islamic banks, it is important that board members have an understanding of business if they are to help rather than hinder the introduction of new products and services. 'We notice strongly at the moment that a number of Sharia advisers are now scholars who do have some exposure to commercial business,' says Kleinwort Benson's Cox. 'If advisers can relate Sharia stipulations to business experience, things will move on.'

Islamic subsidiaries

Three conventional banks with global networks are preparing for growth in Islamic banking by gathering their various activities in the sector into new subsidiaries based in the Gulf. In the case of Citibank and ABC, these will be fully-fledged investment banks with their own capital bases. However, they will both be quite small, with capital of $20 million and $35 million respectively. Dutch bank ABN AMRO, by contrast, is adding a dedicated Islamic banking division to its offshore unit in Bahrain.

The reaction from indigenous Islamic banks in the Middle East has been mixed, with both optimism and unease expressed at the prospect of institutions with much larger assets and worldwide networks expanding their operations.

A decade or so ago Middle Eastern Islamic banks were principally deposit-takers, which were highly dependent on Western banks for investment expertise and access to international markets. This is no longer the case, at least for the bigger Islamic institutions, and as they try to expand their investment banking activities they may not welcome an increase in competition from conventional banks.

On the plus side, the greater participation of conventional banks with a high global profile may add credibility to the industry as a whole. 'We believe that the new entrants to the Islamic banking scene are creating competitive space for Islamic finance as a sector,' says Omar Ali of DMI. 'Our investment banking and wholesale franchises in Babrain and other parts of the world are well-positioned to benefit from the creation of this additional space.'

Islamic banking looks set to go on expanding as it has done for over two decades, with southeast Asia providing a focus of attention alongside the Gulf. There are complex areas still to be negotiated which might define the shape of that growth, such as the need for standardisation and the problem of creating functioning Islamic money and capital markets. But with only a small part of all the assets of Muslim investors actually invested in Islamic banks, there is still everything to play for.

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