Emerging sharia finance sector beats the downturn

25 September 2009

The central tenets of sharia finance stood Islamic banks in good stead during the global economic crisis over the past year, and the sector is now one of the fastest growing in the Middle East

The global financial crisis may have been characterised by the demise of some of the world’s most famous banks, but not a single Islamic institution has foundered in the past 18 months of banking turmoil.

Indeed, not only have sharia-compliant banks survived the credit crisis but, unlike many of their Western counterparts that have been saved through state intervention, none has required a substantial government bailout. Instead, the majority of Islamic banks have continued to expand their asset base.

According to MEED research, Saudi Arabia’s Al-Rajhi Bank, the Gulf’s largest Islamic lender by market value, heads the list of Gulf Islamic banks by assets. Al-Rajhi had total assets of $43.9bn at the end of June 2009, a 9.7 per cent increase from $40bn one year earlier. Meanwhile, the bank’s net profit grew by nearly 5 per cent over the same period, from $892.9m to $935.3m. Al-Rajhi’s growth is due to both a 14 per cent  increase in customer deposits to $33bn and the diversification of its income sources through the development of its investment and corporate banking business.

Kuwait Finance House ranks second with total assets of $37.7bn, a 5.3 per cent increase from $35.8bn at the end of June 2008, and Dubai Islamic Bank is in third position with total assets of $23.9bn.

Restricted lending

Abu Dhabi Islamic Bank (ADIB) ranks fourth after a 20.9 per cent annual growth in assets, to $15.5bn at the end of June 2009.

“Gulf Islamic banks that have fully-fledged retail operations have reported reasonably good results,” says Jawad Ali, a partner at US law firm King & Spalding’s Middle East & Islamic Finance Practice Group. “This is mainly due to the fact that they are heavy on liquid assets and lending has been restricted to the region.”

Islamic retail banks have performed better than sharia-compliant investment banks because their business models are built on high levels of liquidity and low-risk lending.

But while sharia-compliant banks have weathered the downturn better than their conventional counterparts, the economic slowdown has inevitably affected their performance. In particular, Islamic banks have high exposure to the real estate sector because, unlike conventional banks, their real estate loan portfolio is not restricted by the 20 per cent loan-to-deposit ratio imposed by most Gulf central banks.

Consequently, many sharia-compliant banks have been badly hit by the property market correction in the region. Dubai suffered the largest annual fall in house prices, at 47.3 per cent in the 12 months to June this year.

Property-related lending is estimated to account for an average of 30 per cent of the loan portfolios at Dubai’s three Islamic banks: Dubai Islamic Bank, Dubai Bank and Noor Islamic Bank. For example, about half of Dubai Islamic Bank’s loan portfolio is in the retail and real estate sectors and the high level of loan loss provisioning – setting aside funds in anticipation of lenders defaulting on loans – has eroded the bank’s asset quality and profitability.

The bank’s loan loss charges stood at $36.7m at the end of June, an increase of 208 per cent from the second quarter of 2008, contributing to a 40 per cent year-on-year fall in profits to $122.5m.

Exposure to real estate is substantially higher for Dubai’s two sharia-compliant mortgage lenders, Tamweel and Amlak Finance, with property mortgages representing 70-80 per cent of their debt exposures.

At the end of June 2009, Amlak’s total assets stood at $4bn compared with $3.8bn in June 2008. The real estate financier reported no income from real estate investment activity in the second quarter of 2009, compared with $28.2m in the same quarter last year.

Amlak announced in November last year that it had temporarily stopped granting home loans, and later that month the UAE Finance Ministry unveiled plans to merge Amlak and Tamweel into a single bank called Real Estate Bank.

“Sharia-compliant investment banks are wholesale funded with a concentrated deposit base and are highly exposed to cyclical and illiquid asset classes such as real estate, private equity and venture capital,” says Anouar Hassoune, vice-president and senior credit officer at ratings agency Moody’s Investors Service.

Most notably, in December last year, Kuwait’s Global Investment House defaulted on a $200m loan, while Kuwait’s The Investment Dar defaulted on a $100m sukuk (Islamic bond) in May.

The deterioration in the GCC’s macro-economic environment has meant that Islamic banks’ investments in the corporate sector have also suffered. For example, ADIB, the fourth biggest Islamic bank in the MEED ranking, has a $66.7m exposure to troubled Saudi conglomerate Saad Group. ADIB made the loan to Saad in 2007 to finance an investment in an Abu Dhabi warehousing company that never became operational.

ADIB’s net profit for the first half of 2009 stood at $125.7m, down 11.2 per cent over the first half of 2008 due to credit loss provisions amounting to $46.6m in the second quarter of this year.

Islamic banks’ prohibition from selling debt and speculative trading has prevented them from playing on the derivatives market and spared them the associated huge losses. 

Meanwhile, the concept of shared risk and reward, whereby risk and reward are spread between parties, has meant that Islamic banks have been more inclined to take a measured approach to protect their own investments.

“In this way, the fundamental principles of sharia-compliant banking ensure that there is self-imposed restraint,” says Ali. 

Growing popularity

The benefits that have resulted from adhering to these ethical and more conservative aspects of the Islamic finance sector have led many analysts to predict a surge in popularity for the industry. Since November 2008, 11 new Islamic banks have been established around the globe.

This includes Ajman Bank, the UAE emirate’s first Islamic commercial bank, which was set up in February this year with a paid-up capital of $271.7m.

There is also evidence of the industry’s growing popularity as customers switch their savings from conventional banks to Islamic banks. Islamic banks in the UAE, Kuwait and Bahrain have all reported an increased flow of deposits, with the latest figures for these banks showing an increase of 34.37 per cent in their combined third-quarter 2008 deposit base over the previous year.

“We have seen that there has been money flowing into Islamic banks, especially earlier in the year because, unlike conventional regional banks, they don’t hold sub-prime debt and are therefore perceived to be safer,” says Isam Salah, a senior finance partner at King & Spalding’s New York and Dubai offices, who also heads up the firm’s Middle East & Islamic Finance Practice Group. “By contrast, other Gulf banks loaded up on a lot of toxic instruments [assets that have exposed their holders to large losses] and have been badly hurt by them.”

According to the Islamic Financial Services Board, total assets held by Islamic banks globally amounted to $840bn at the end of 2008 and the industry is still growing at an average rate of 15 per cent a year.

However, there are issues that need to be addressed to ensure the healthy evolution of the Islamic banking industry. The GCC’s Islamic banks are still small in size and centred on serving their home markets. As a result, analysts have frequently noted that the industry is fragmented. “Islamic banks are still maturing,” says Majid al-Sayed Bader al-Refai, managing director and chief executive officer of Bahrain’s Unicorn Investment Bank. “And one of the biggest hurdles we have in the industry is a lack of strategy. There is a nurturing and educational process that needs to take place and I would like to see that being focused on.”

The need for greater standardisation across the industry is an ongoing issue and is considered the main impediment to growth.

“A big issue with Islamic banks is that there is an incomplete and developing regu-latory regime,” says Salah. “Bahrain has the most comprehensive regulations for Islamic banks, but if you go to other jurisdictions, the regulations tend to be patchy, and that is an ongoing problem.”

A lack of innovation in product development has been highlighted as another impediment to the industry’s future health. This is a particular problem in the GCC, where newcomers to the market often prefer to take a conventional product and replicate it on a sharia-compliant basis.

“A lot of the young GCC banks don’t want to pay for research and development, so they try to replicate products,” says Ali. “There is far more genuine new product development outside the Middle East, and as a result, the deals closed in Europe and the US are much more innovative.” 

However, until the global economy recovers, Islamic financial institutions around the globe will be focused on safeguarding revenues.

“Our strategy is to break even in 2009 and 2010,” says Al-Refai. “I think our financial performance in 2009 will be similar to this year.”

Given the industry’s infancy, the fact that most Islamic banks have bucked the general trend of stagnating economic performance is commendable. The resilience they have shown to date means Islamic finance remains one of the fastest growing sectors in the global financial industry.

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