As an abundance of real estate, petrochemicals and refining developments are launched in the Middle East, the region’s top Islamic banks are gaining experience of taking on long-term project risk. With that comes a growing confidence in the use of complex structures that combine sharia-compliant and conventional products to finance capital investment.
Although large, long-term exposures are beyond the reach of many Islamic financial institutions, a clutch of top names do now have the expertise to handle them. “Kuwait Finance House (KFH) and Dubai Islamic bank are the main names in the field, although the latter is more Gulf-based whereas KFH is more international,” says one market watcher.
Another finance house with high ambitions is Noor Islamic Bank, in which Dubai’s ruling Al-Maktoum family is a key shareholder. Noor has stated its intention to become a world leader in the sector.
Banks such as these have brought useful extra capacity to the structured and project finance market, with impeccable timing. Without this extra capacity, the Gulf’s development ambitions, fuelled by high energy prices, could have fallen victim to the global credit squeeze. The supply of outside funds for projects has been constrained by the drying up of global liquidity, as nervous US and European banks cut back on commitments.
That makes the contribution that Islamic finance can bring all the more valuable.
The underlying principles behind capital project finance are well suited to the philo-sophy of Islamic banking, which is based upon the notion of taking a risk on the viability of a business and being rewarded for this through the profit that is earned.
Conventional banks see the risk of borrower default as one of the principle justifications for charging interest, alongside the cost of funds.
But from an Islamic perspective, finance is viewed as a form of investment in an enterprise or asset, and the potential profit is only justified by the fact that there is a real element of risk. Risk, provided it is properly assessed, is therefore viewed as a positive, indeed necessary, element.
Leading Gulf Islamic banks therefore have strong philosophical reasons to step up their financing of capital projects and major assets such as ships and aircraft. They also have a powerful market motivation: they need to meet the funding demands presented by their booming home region.
For example, Dubai Islamic Bank has a shipping finance fund and KFH is following suit. Noor Islamic Bank and Standard Chartered Saadiq, the Islamic arm of the international bank, have also agreed a $46m, eight-year ship financing for Stanford Charter, a subsidiary of oil and gas field services group GMMOS, to fund the acquisition of a dozen offshore service vessels.
Several conventional banks have also moved into the sharia-compliant sector, enhancing the capacity of the market. The scale of activity in the Gulf and the huge potential it offers have been powerful incentives for these big international banks with an interest in the Middle East to develop their own Islamic finance capacity. Big names such as Calyon, BNP Paribas and HSBC are increasingly active in the sector.
David Barzilai, a partner in the Islamic finance group at law firm Norton Rose, says conventional institutions now own about half of the sukuk (Islamic bond) paper that is being issued. “They are not taking big risks and they want to be seen in the Middle East to be doing these deals,” he says.
Even so, the Islamic finance market has not yet developed a capacity comparable with that on offer in the conventional arena. Estimates suggest there may be $500bn to $1 trillion in sharia-compliant finance in the world, a fraction of the global finance total.
This has led banks to bring together conventional and Islamic elements, says Barzilai. “There is a structure that combines Islamic and conventional financing for capital equipment purposes,” he says. “You have Islamic equity existing side by side with a conventional loan.”
Typically, 70 per cent of the cost of an asset or a project would be met with conventional bank financing, while 30 per cent of the funds would come from an Islamic tranche under an ijara lease agreement, with the owner or operator of the project making payments under the two arrangements. “This structure has been used for quite a few years in the transport and real estate sectors,” says Barzilai.
“It is not much used in manufacturing, but it is used often enough for power and petrochemicals plants.”
Although ijara leasing is more structurally complex than a loan, it also offers some technical advantages as a tool for financing capital investments, says Adnan Bahar, chairman and chief executive officer of The International Investor, a Kuwaiti Islamic finance house.
“Sometimes you find that the counterparts opt for leasing because it provides for more security, as it allows you to keep the asset in your name rather than taking a lien [a form of security] on the asset,” says Bahar.
If a problem arises and the financier needs to recover the asset, an ijara lease spares them the need to go to court, as they might have to do if they had taken a lien on it under a conventional arrangement.
Bahar also says it is easier to securitise a lease while remaining sharia-compliant than it would be to securitise a debt instrument. In the meantime, Islamic structures continue to be combined with conventional ones to produce the volumes of funding required for multi-billion-dollar projects. Such major investments can require credit terms of 20 or even 25 years.
But Barzilai says there is no basic structural obstacle to using Islamic finance for such long-term exposures. Instead of paying interest, the client pays a lease return – rent, in essence. This sum is variable and is supplemented by a margin. For the financing customer, therefore, it is not much different to conventional loan repayments.
Furthermore, ijara deals are generally structured to allow the client to eventually buy the asset outright if they wish, thus ending up as owner, as they would be under a conventional loan arrangement.
In broad terms, ijara are also cost competitive, says Barzilai. But some complications do have to be taken into account. “Because you are dealing with a lease structure, you have to deal with ownership issues,” he says. “For example, often you have to set up a special-purpose vehicle, which brings additional administrative costs.”
Meanwhile, when they are considering whether or not to get involved in capital project finance, Islamic banks are weighing up opportunities in the context of a regional economy where they are used to seeing huge returns in one particular sector: real estate.
“If there is any niche product that Islamic banking is involved with, it is real estate,” says Barzilai.
Although property clearly offers long-term risks, in the immediate future its pricing prospects in the Gulf look bright. Islamic investors would like, in theory, to take real asset risk, and they do this in real estate all the time.
But in today’s boom conditions, the danger of the property losing value is small, because property prices are continuing to rise strongly. So the returns are highly attractive when measured against the real level of risk that financiers face in this sector.
Islamic banks inevitably draw comparisons with the massive earnings to be found in funding real estate deals when financing ships, planes or petrochemical plants.
However, they are nevertheless active in other areas, and successfully too.“We know that they are being competitive or they would not be winning mandates,” says Barzilai.
At first glance, ships and planes as lease assets might appear condemned to unavoidable depreciation. And it is certainly true that financing such items has traditionally been the preserve of specialist conventional banks that understand how to forecast the likely depreciation trends and values.
But in today’s conditions of booming demand in emerging markets, the values of some ships and aircraft have been rising, offering further encouragement for Islamic banks to step up their activities in this field, as KFH is now doing.
Meanwhile, the development of standardised forms of derivative, such as sharia-compliant currency or ‘profit rate’ swaps, is in the pipeline. The latter is the Islamic equivalent of an interest rate swap. Many banks have developed their own versions of these products and as the market edges towards standardisation, they will become easier to trade.
The typical ratio of conventional to Islamic funds in project financing