THE star that is Islamic banking has continued to rise and shine ever brighter in 1999. New banks have been launched, some as subsidiaries of established institutions and others as independent entities, and there is no sign that momentum for the further growth of the sector is slowing. Islamic project finance has also become more conspicuous this year and Islamic investment banks are becoming increasingly active in the private equity markets. There is confidence within the Islamic banking community that it has a firm foothold and is braced to play an ever greater role in the financial activities of the region.

Bahrain lays fair claim to be the regional centre of Islamic banking with 16 institutions licensed to operate by the Bahrain Monetary Agency (BMA - central bank). Two recent additions to the fold are indicative of the nature of the sector's expansion. Bank of Bahrain & Kuwait (BBK) staged the soft launch for its Islamic banking subsidiary, Al-Khaleej Islamic Bank, in early August, and Gulf Finance House (GFH) received an operating licence a week later.

Al-Khaleej Islamic, 65 per cent owned by BBK, is a joint venture with Kuwait's The International Investor (TII), which holds the remaining 35 per cent. Although a small operation - Al-Khaleej Islamic has paid-in capital of $12.5 million - it is already involved in two corporate finance transactions.

The decision by BBK to enter the Islamic banking sector through a subsidiary follows a tried and tested path. Arab Banking Corporation spun off its Islamic banking operations to form ABC Islamic Bank in 1998 and Jordan- based Arab Bank set up Islamic International Arab Bank the year before.

Al-Khaleej Islamic will initially focus on investment banking, not least to make the best use of TII's experience in this area, and to this end a service agreement has been signed with TII which will be responsible for the bank's management. 'However, as time passes, Al-Khaleej Islamic will seek to diversify into other areas,' says BBK chief executive officer Murad Ali Murad. 'In the same way, the bank will initially focus on its Bahraini market but it will later aim to establish operations in other Arab and Islamic markets.'

GFH comes from a different stock to Al-Khaleej Islamic, and appears to be more closely modelled on First Islamic Investment Bank (FIIB), which was set up in Bahrain in 1997. Both are owned by a comparatively broad cross-section of shareholders from the Gulf, are of a similar size, and focus on investment banking.

Kuwait-based Gulf Investment House was the driving force behind the establishment of GFH and has provided $10 million of the bank's $62 million paid-in capital. Existing Islamic banks are prominent among the other shareholders with Bahrain Islamic Bank, Qatar Islamic Bank and Kuwait Finance House (KFH) each holding 8 per cent stakes and a seat on the board. A sure sign of the continued momentum for the growth of the sector was the fierce competition among those bidding for stakes in the new bank.

'GFH will concentrate on private equity transactions,' says Esam Janahi, GFH's chief executive officer who was formerly with FIIB. He adds that the bank will concentrate on deals in the US and Western Europe - markets in which a number of Islamic banks have been increasingly active.

Private equity deals

FIIB completed the largest private equity deal conducted by an Islamic bank this year with the $175 million acquisition of a controlling stake in US-based telecommunications company Computer Generation. The deal was partly financed by a $60 million ijara wa iktina facility, which is a leasing programme, ending in ownership. FIIB chief executive Atif Abdulmalik is not resting on his laurels. He told MEED in July that the bank is close to closing two more major buy-outs in the US: the first will be a technology company, worth about $60 million-70 million, and the second a manufacturing operation, worth about $70 million-80 million. Analysts agree that private equity deals, particularly in the US, are increasingly a happy hunting ground for Islamic investment banks, and the number of deals completed is expected to rise.

To finance these deals and strengthen its capital base, FIIB has had to tap the Islamic capital market, and a $50 million facility is in the final stages of syndication. Counterparty relationships in the Islamic banking community can be strengthened by family ties. The facility for FIIB is being lead arranged by ABC Islamic Bank, whose chairman is Adnan Yousif, one of Atif Abdulmalik's many banking brothers. Another, Abdul Rahman Abdulmalik, in April took up position as chief executive of Abu Dhabi Islamic Bank (ADIB), which is understood to have participated in the syndication of the FIIB facility. While the Islamic banking community might be becoming increasingly competitive, Atif Abdulmalik says that at least communication remains good.

FIIB might be well served by the Abdulmalik family but it is not alone in seeking substantial Islamic financing. A number of Islamically-structured facilities have been arranged this year and, significantly, Islamic institutions have been joined in the market by conventional banks.

Bahrain-based Investcorp - one of the best-known investment banks in the region due to its high-profile acquisitions of Gucci, Tiffany's and Saks Fifth Avenue - made its debut in the Islamic capital market in June. The $75 million facility, the largest non-project Islamic financing of the year to date, was arranged by Islamic Investment Company of the Gulf (IICG). 'Investcorp has opened its investor base, it has tapped a whole new market,' says Mohammed Buqais, vice-president of ABC Islamic which was involved in underwriting the facility.

Buqais says Islamic financing for the region's conventional banks is likely to increase in the months and years ahead. 'The determining factor is liquidity: recently there hasn't been any serious squeeze, but liquidity is in decline within the region and this will force a greater number of conventional banks to seek Islamic funding,' he says. Buqais cites the loans taken this year by Emirates Bank International, Commercial Bank of Kuwait, National Bank of Egypt and Commercial Bank of Egypt as evidence of a growing need for financing. 'If levels of liquidity in the region decline much further, balance sheets will get saturated and there will be an accelerating move towards Islamic financing for conventional institutions,' he says. ABC Islamic is itself working on three Islamic financing deals, all of which are for more than $50 million.

Islamically-structured project finance made an auspicious start with the seminal $200 million part-financing of the Equate petrochemicals complex by KFH in early 1996. Hopes that a flood of similar-sized deals would follow have not been fulfilled but activity, limited in 1997-98, has picked up with a number of significant deals this year. The most sizeable was a $100 million Islamic component of the $600 million package for Thuraya Satellite Telecommunications Company. Signed in July, the six-and-a-half- year facility was arranged by ADIB and KFH. Sharjah Electricity & Water Authority secured a $56 million, five-year ijara wa iktina facility from ABC Islamic earlier in the year. A further $55 million ijara wa iktina facility was lead arranged by IICG for Trenergy, a Malaysian shipping company, in August. Analysts agree that this run of deals is likely to breed further activity.

The number of Islamic banks elsewhere in the Middle East is steadily increasing, mirroring developments in Bahrain. Al-Aqsa Islamic Bank has started operations on the West Bank, International Leasing & Investment Company has been established in Kuwait and United Bank of Kuwait is developing plans to spin off its Islamic banking unit as a London-based independent entity, possibly before the end of the year (see page 15-16).

While there is no doubt that the sector is developing rapidly, some are beginning to voice concern that some areas are on the cusp of becoming over-banked.

'There are already too many Islamic investment banks chasing a limited supply of funds,' says Buqais. 'Islamic financing is already over-banked, and with a growing number of conventional banks offering Islamic facilities, the market is increasingly becoming squeezed.' He adds that the number of banks is growing faster than the range of products. 'There aren't enough good new vehicles that are worth placing money in and there is often no added advantage in Islamic funds over conventional ones,' he says. While no reliable figures are available, it is generally agreed that a growing proportion of deposits made at Islamic banks are subsequently being placed at conventional institutions.

Despite the pressures, it seems that the proliferation of Islamic banks is set to continue. All of the major Islamic banks report steady or growing levels of customer deposits, and some, such as Al-Rajhi Banking & Investment Corporation and KFH, saw customer deposits grow considerably faster than the GCC average in the first half of the year. That new Islamic institutions continue to be launched successfully in such a climate suggests that client appetite remains strong and that funds are, at present, continuing to be diverted from conventional banks.

The sustainability of this trend will be determined by the ability of the Islamic sector to generate impressive returns. Most analysts agree that the limited nature of investment vehicles, particularly long-term vehicles, dictates that the need for continuing innovation remains strong.