Gulf banks benefit from sharia rules

05 October 2010

The Gulf’s Islamic banks have been tested by the global financial crisis, but most have fared better than their conventional peers. Challenges still need to be faced, but the future is looking positive

Islamic banks in numbers

$2.05bn: Combined net profit of the GCC’s 20 largest Islamic banks

$149.9bn: Combined customer deposits of GCC’s 20 largest Islamic banks

$525bn: Total global assets of Islamic banks by end of 2010

Source: MEED

For an industry less than 40 years old, the global financial crisis represents the first major challenge the Islamic banking sector has had to confront.

Yet despite its early stage of development, the industry has withstood the tremors of the past two years reasonably well, and in most cases, better than its conventional peers.

The industry has withstood the tremors reasonably well, and in most cases, better than its conventional peers

Analysts credit the industry’s ethical foundations as a key reason why it escaped the full force of the economic turmoil.

The industry has benefited hugely from the central tenets of sharia, most notably the prohibition of charging interest (riba), and selling debt and speculative trading, which has stopped banks from playing on the derivatives market.

Islamic banks take cautious approach

The fact that risk and reward are shared between parties has meant Islamic banks have been more inclined to take a measured approach to protect their own investments.

Total global assets of Islamic banks grew at close to 18 per cent during 2009 to reach $478bn, according to US ratings agency Moody’s. Research by MEED shows that Gulf Islamic banks have continued to record growth in 2010, albeit at a much slower pace. 

Islamic banks usually have exposures to the property market of between 25-50 per cent of their total assets

Anouar Hassoune, Moody’s

The combined assets of the GCC’s 20 largest Islamic banks grew about 3 per cent in the twelve months to 30 June this year to stand at $219bn, compared with $211.8bn at the end of the first half of 2009.

Their combined net profit stood at $2.05bn at the end of June this year, while total customer deposits reached $149.9bn.

Arguably, the best-preserved segment has been that of Islamic retail banking, which has a business model built on high levels of liquidity and low-risk lending.

Such banks have also been aided by the fact that on the asset side of the balance sheet, retail offerings span credit cards, personal loans, mortgage lending and car loans, and in this way are more diversified than corporate and investment portfolios.

But, like every industry across the globe, Islamic banks have suffered at the hands of the crisis; profitability has fallen compared with previous years, liquidity measures have deteriorated and capital ratios have shown signs of incremental decline.  

We are increasingly finding ourselves doing new transactions for clients, both here in the GCC and further afield

Neil Miller, Norton Rose

Just as the West’s banking market has seen the demise of some of its most famous institutions, most notably the US’ Lehman Brothers in September 2008, sharia-compliant banking has had its share of casualties.

“Before the global financial crisis erupted, Gulf Islamic banks thought they would be relatively immune because they hadn’t invested in subprime assets and toxic instruments,” says Neil Miller, partner and global head of Islamic finance at the Dubai office of international law firm Norton Rose.

“But when Lehman’s went down, and we saw the general collapse in property and company valuations globally, then those banks that were exposed to real estate and private equity were caught out.”

Global downturn for Islamic investment banks

Islamic investment banks have undoubtedly been the hardest hit within the industry, a reflection of the fact that investment houses have also been one of the worst affected across the Gulf in general terms.  

Prior to the downturn, investment banks were benefiting from cheap funding and high liquidity, which led them to pursue investments in riskier emerging markets, from the Maghreb to Southeast Asia, and in asset classes, such as private equity, infrastructure or real estate.

Bahrain’s Gulf Finance House (GFH), formerly a leading investment bank in the country, was the highest-profile casualty. The bank announced a net loss of $728m in 2009, following a $262m profit in 2008.   

In early 2010, it narrowly avoided defaulting on a tranche of its $300m loan from Germany’s WestLB. GFH paid off $200m and extended the maturity of the remaining $100m tranche until August, at which point it secured last minute approval to push out the maturity by another two years.

It is now looking to sell off around $420m of assets in order to ensure its survival, and in May, sold its stake in the real estate project Bahrain Financial Harbour.

Two prominent Kuwaiti investment banks, The Investment Dar (TID) and International Investment Group (IIG), also grabbed the headlines for defaulting on loans. TID defaulted on a $100m sukuk in May 2009, while IIG defaulted in both April and July 2010.

Property slump impact on Islamic banks

The performance of Islamic banks in the GCC has been impacted in particular by their high exposure to the region’s real-estate sector – their loan portfolio is not restricted to the 20 per cent loan-to-deposit ratio imposed by most Gulf central banks on non-Islamic institutions.

The property market correction over the past two years, especially the bursting of Dubai’s bubble – which has seen values decline by more than 50 per cent from their peak in August 2008 – has resulted in a fast deterioration in credit quality.

“Islamic banks in the GCC usually have direct and indirect exposures to the property market of anywhere between 25-50 per cent of their total assets,” says Anouar Hassoune, vice-president and senior credit officer at Moody’s. “This has required large amounts of extra provisioning, which, in many cases, has become systemic and eaten up a large chunk of operating income. This in turn has driven down profitability, sometimes into negative territory.”

This has been the case for the UAE’s Dubai Bank and Kuwait’s Boubyan Bank.

As an asset-backed type of finance, property has always been the preferred collateral for Islamic banks’ transactions. 

But when liquidity dries up, real-estate prices tend to decline fast, so too the economic value of Islamic banks’ collateral, and the quality of their exposure deteriorates. As a result, non-performing loan (NPL) ratios at most Islamic banks worsened last year.

Banks are still having to set aside provisions for NPLs today and will have to continue to do so for some time, according to Hassoune. “Banks will keep on provisioning further credits in 2010, and the trend is expected to continue in 2011,” he says. “We view current provisioning levels at some banks as insufficient.”

According to Moody’s, coverage of 60 per cent – which assumes a recovery rate of 40 per cent – is the lower limit for adequate provisioning. Fortunately, only a few Islamic banks are now below this line. 

However, Dubai’s Islamic mortgage specialists Tamweel and Amlak were severely impacted by the crisis. With property mortgages representing 70-80 per cent of their debt exposures, the two lenders have haemorrhaged substantial amounts of money in the past couple of years.

In November 2008, trading in the lenders’ shares was suspended as the UAE Finance Ministry unveiled plans to merge the two rivals into a single bank called Real Estate Bank. Neither lender has traded since nor issued any new mortgages.

But on 26 September this year, Dubai Islamic Bank, the UAE’s largest Islamic lender, announced it had raised its stake in Tamweel to 57.33 per cent from its current 21 per cent. 

It is now unclear as to whether the long-touted merger will be implemented. Amlak’s future also remains uncertain – it posted a loss of AED597,000 ($162,533) in the three months to June this year.

A sustainable recovery for the Islamic banking sector will require improved risk management, especially within the investment area. Yet, according to some industry insiders, banks are already starting to heed the lessons from the crisis.

Solid opportunities

“What we’ve seen in the last year is a mature re-appraisal by investment banks of their business models,” says Richard Thomas, chief executive of UK-headquartered Gatehouse Bank, an Islamic wholesale investment bank whose target clients include Gulf-based corporates and financial institutions.     

“They are showing more interest in going back to trade-related activities and productive business lines, such as manufacturing, which provide more solid income-producing opportunities, rather than quick spectacular returns. We recognised that speculative markets were not where we should be and it has turned us from a loss-making to a profit-making organisation over the last year.”   

While Islamic banking has clearly been tested by the crisis, the GCC’s expansionary fiscal budgets and concurrent diversification plans are helping to revive the industry.

Increased activity in GCC

“We’ve been seeing a significant pick-up in activity levels over the last few months,” says Norton Rose’s Miller. “We’re doing our fair share of refinancing of previous transactions that have been under stress, but we are increasingly finding ourselves doing new transactions for clients, both here in the GCC and further afield. We’re also getting a lot more requests for proposals (RFPs) across our desks from a fairly wide spectrum of sectors.”

As the industry begins to recoup its losses, banks can look forward with renewed optimism at a positive growth trajectory. Moody’s forecasts that Islamic banks’ total global assets will grow by 10 per cent during 2010 to reach $525bn. However, the industry faces many challenges as it continues to evolve. Foremost among these challenges is its fragmentation, a result of the fact that Islamic banks are still maturing and that differing interpretations of sharia law have resulted in a lack of integration for Islamic financial products.

However, in the case of the GCC, it is not so much regulatory standardisation that is at stake, but the need for Islamic banks to start thinking on a regional as opposed to a national scale.    

“You cannot ask a collection of regulators in a region to apply the same rules, but you can ask them to open up their borders more actively,” says Hassoune. “However, most Gulf Islamic banks do not have a license to operate in neighbouring countries, which is very surprising in a region that plans a single currency during the current decade. This is where the issue of standardisation is important.”

International strategy for the Gulf’s Islamic banks

Indeed, despite being the world’s largest Islamic bank, Saudi Arabia’s Al-Rajhi only has a foreign presence in Malaysia, while Kuwait Finance House, which was established in 1977 and is the second-largest Islamic bank globally, currently has a regional subsidiary only in Bahrain. Bahrain’s Al-Baraka Banking Group is active in 11 countries, none of which is in the GCC.

In the long-term, if the Gulf’s Islamic banks want to grow their market share and compete globally, then they need to build a robust domestic platform from which an ambitious international strategy can be drawn and executed.

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