With the first Islamic banks forming in Oman, a new market is opening up for the sharia-compliant finance industry. Given the size of its economy and population – around 3 million people and a gross domestic product (GDP) of $56bn in 2010 – the potential in Oman may be relatively limited, but it means that the entire GCC now allows Islamic banks.

Our estimate is that there will be 100-150 new Islamic finance institutions being set up in the Mena region

Ashar Nazim, Ernst & Young

To date, two local banks, Al-Izz International Bank and Bank Nizwa, have been licensed, along with at least one investment banking advisory firm, the local Alpen Capital. Many more are expected to enter the market, either as standalone institutions or as Islamic windows run by conventional banks.

Islamic finance industry recovers  

It is a welcome new growth area for the industry, which has suffered from the tough economic times of recent years. Of the two main centres for the industry, the GCC and Malaysia, it is the Gulf countries that have suffered more, with Malaysia largely avoiding the worst affects of the global recession.

According to industry observers, growth should start to pick up again in the Middle East and North Africa (Mena) in the coming years. “We believe we’re just entering the next phase of growth,” says Ashar Nazim, the Bahrain-based head of the UK’s Ernst & Young’s Islamic Financial Services Group. “Our estimate is that there will be 100-150 new Islamic finance institutions being set up [in the Mena region] over the current decade.”

We think the GCC could aspire to be a leading region in terms of sukuk issuance in the long-term

Samira Mensah, Standard & Poor’s

Much of this is likely to happen in North Africa, with the political upheaval expected to prompt a move towards more diverse financial systems. Notwithstanding that, the GCC is likely to remain the heart of the regional Islamic finance industry. While the overall market share of Islamic banks in the Mena region is around 15 per cent, in the GCC it is now closer to 20 per cent according to Nazim.

“Crossing that 20 per cent threshold is a hugely symbolic milestone,” he says. “It means they are now catering for a share of the mainstream market and that’s very encouraging.” Globally, however, Malaysia remains the dominant force in Islamic finance, particularly when it comes to sukuk (Islamic bond) issuance. Between 1996 and 2010, it accounted for almost 63 per cent of all sukuk issued. The next most active market is the UAE, but with just a quarter of the volume.

It also holds a lead in other areas such as takaful, or sharia-compliant insurance. Contributions per takaful operator in Malaysia are currently at $115.8m, according to Ernst & Young. This is almost double the figure for the next largest market, the GCC, where it is $63.5m. Other areas of the world are far less developed, with the Indian subcontinent at $16m, Africa at $11.8m and the Levant at just $4.3m.

Malaysia has several advantages over the Gulf market, particularly in being a single country with one regulator that is able to impose common standards across the board. For the GCC, with six different regulatory codes, this is not so easy. The Gulf countries have also tended to insist on a more restrictive interpretation of what can be considered sharia-compliant.

Efforts being made by industry bodies based in Bahrain to agree on standard definitions are starting to have an impact, however. Institutions such as the Accounting & Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board have been working to create common interpretations of sharia principles.

AAOIFI, for example, has issued at least 86 standards covering various aspects of accounting, auditing, ethics and governance for Islamic finance institutions.

Growth restrictions to Islamic finance market

“For most of the GCC countries, the lack of uniformity in terms of interpretation of Islamic law has slowed down the globalisation of the Islamic finance market,” says Samira Mensah, a credit analyst and Islamic finance specialist at US credit ratings agency Standard & Poor’s (S&P). “Some [sharia] boards might approve something that another board would deem not sharia compliant.

“Malaysia is one country so it is easier there. What Bahrain is trying to do by setting up all these institutions is to have a single set of rules and guidelines for all Islamic institutions. But at the same time, each country in the GCC has its own adoption of Bahraini rules. It might be a while before we see some common ground reached by these countries.”

Some other familiar problems in the market continue to restrict growth, including the shortage of suitably qualified people to sit on sharia boards. This issue has been exacerbated by the differing standards between countries, so the move towards more consistent regulation may ease the problem to some extent.

Other weaknesses in the market are also being addressed, including the lack of short-term financial instruments, which banks can use to manage their liquidity needs. To date there has been a dearth of suitable alternatives to the products used by the conventional industry which, because they are interest-bearing, are off-limits to Islamic institutions.

In October 2010, a group of 11 central banks along with the Islamic Development Bank and the Islamic Corporation for the Development of the Private Sector set up the International Islamic Liquidity Management Corporation (IILMC). Once up and running, it will be able to issue short-term, sharia-compliant instruments for Islamic banks. Such facilities are vital for the longer-term health of the industry, according to observers.

Modern tools for Islamic finance institutions

“The Islamic finance industry definitely needs some modern tools for institutions to perform better,” says Mensah. “At some point their profitability could come under pressure as they continue to hold a large amount of liquid assets at central banks with very low yields.”

The new body has its headquarters in the Malaysian capital Kuala Lumpur, further affirming the country’s central position in the industry, but the membership of the new body hints at the expanding international nature of the sector. The founding members include countries with well-established Islamic finance sectors such as Iran, Qatar, Saudi Arabia and the UAE, but also involved are Turkey, Luxembourg and Nigeria.

Expansion in the years ahead is likely to take place on a number of fronts, with observers pointing to other areas of West Africa, such as Senegal and East African countries, including Uganda, Kenya and Tanzania as areas of potential growth. Among southeast Asian countries, Indonesia, which has the largest Muslim population in the world with more than 200 million adherents, has the potential to emulate its neighbour Malaysia.

The characteristics of the industry in these emerging markets is likely to be different to the more established ones of the GCC and Malaysia – both in terms of the size of institutions and the sort of products they offer to customers.

“In frontier markets vanilla products will suffice for now,” says Nazim. “But in more mature markets there’s a clear demand for more innovative products, especially when it comes to wealth management. There’s a serious dearth of investment products. In frontier markets, we’ll continue to see smaller, greenfield institutions emerging. In mature markets we’re seeing significant consolidation.”

Among the merger deals that have taken place so far, in October 2010, Pakistan’s Emirates Global Islamic Bank joined forces with Al-Baraka Islamic Bank, the local arm of Bahrain’s Al-Baraka Banking Group, to create an operation with assets of more than $578m. More recently, Bahrain Islamic Bank and Al-Salam Bank Bahrain announced on 10 August that they were in merger talks. If the deal goes ahead, the combined entity will have assets of some BD1.7bn ($4.5bn), making it the country’s third largest domestic bank.

Such consolidation will certainly help to address the fragmented nature of the Islamic banking market that currently prevails. However, this issue of having myriad small, and thus relatively weak institutions, is not just a problem for the banking sector. According to statistics compiled by US-based research firm Dinar Standard and the Islamic International Rating Agency, there were 504 Islamic mutual funds as of June 2010 with total assets under management of $31bn – but 80 per cent of them have assets of less than $50m.

The mergers among banks hint at the strong role that Bahrain plays in the Islamic finance market. With 26 Islamic banks and 19 takaful operators, it is the leading centre in the Gulf. The political unrest in the country this year has led some conventional banks to pull out of the country, such as France’s Credit Agricole, but its position in the Islamic finance sector appears more robust. The strong track record of the central bank as a regulator, the presence of international institutions such as AAOFI and the depth of skills there should limit the number of institutions looking for an alternative home, as long as unrest remains limited.

Bahrain’s Islamic finance niche

“Bahrain has created a niche for itself in Islamic banking globally,” says one senior banker based in the country. “Each market has its own distinct advantages and each can continue to develop. I don’t think what Bahrain has built up will just fall away.”

If more Bahraini institutions can press ahead with cross-border mergers and takeovers, it may yet be able to strengthen its position in the global market. The infrastructure investments being planned by other Gulf countries such as Qatar could lead to those markets becoming more important too, according to Mensah.

“We think the GCC could aspire to be a leading region in terms of sukuk issuance in the long-term, but Malaysia will likely remain the strong player in the near future,” she says. “Qatar and Saudi Arabia have strong infrastructure projects and they’ll need to finance them, so this will enable them to issue sukuk and increase liquidity in their national market.”

Globally, the value of Islamic finance assets has stayed fairly static at around $1-1.2 trillion since 2009, according to S&P, with the GCC accounting for perhaps a third of that. While Malaysia remains the dominant player, the growth plans of the GCC markets for the coming years means they could start to close the gap.