In August, the UAE-based Islamic home loan company Amlak reported that its losses had widened to AED52.2m ($14.2m) for the second quarter of the year, from about AED0.6m a year earlier.

The company closed for new business in 2008 as Dubai’s property bubble burst leaving it holding a huge collection of bad loans. It has since struggled to turn itself around, and a seemingly aborted government attempt to merge it with a better-performing rival has left its future unclear, although Dubai Islamic Bank has upped its stake to 57.3 per cent.

Amlak has continued to struggle on, toying with the possibility of restructuring, and other Islamic banks in the region have been forced to deal with similar issues, although on a smaller scale.

Continued struggle for Islamic banks in the Gulf

For the top 20 Islamic banks in the GCC, 2010 was a disappointing year. Profit at the banks was flat on 2009, as cuts in the interest rate hit income and the region continued to struggle with the impact of having relied on real estate for much of the past decade.

Saudi Arabia’s Al-Rajhi Bank remains the largest Islamic bank in the region by assets, with nearly $50bn on its books. The bank is also far more profitable than any of its peers, although it failed to increase profits in 2010 as provisions weighed on its income.

Islamic banks have struggled to increase profitability … because of … provisioning for real-estate exposures

Across the top 20 banks, the story is the same. While assets have continued to grow, the Islamic banks have struggled to increase profitability. Analysts say this is largely the impact of provisioning for real-estate exposures eating into profit figures.

Dubai Islamic Bank, the region’s third-largest Islamic bank, with assets of $24.5bn, also reported a decline in profits in 2010. It reported profit of $262m in 2010, down from $330m in 2009 largely because of building up provisions. Its performance has started to improve in the first half of 2011, with profit up 10 per cent, compared with the first half of 2010.

“Provisions have been picking up at Dubai Islamic Bank and that is impacting profits, although the bank remains liquid with a loan-to-deposit ratio at the low end for most regional banks,” says Shabbir Malik, a banking analyst at Egypt-based investment house EFG Hermes.

The same is true for most of the Islamic banks. Combined, the top 20 banks recorded profits of $3.84bn in 2010, hardly improving from $3.81bn in 2009. Their total assets rose by 14 per cent to $246bn, from $216bn. Deposits in the banking system also increased by 14 per cent to $149.5bn. Total loans rose at a much faster rate of nearly 23 per cent to hit $117bn, from $95bn at the end of 2009.

Compared with conventional banks, the figures show that Islamic banks have generally performed better. The assets of the top 20 banks in the region (including Islamic ones) rose by just 6.6 per cent in 2010, while total loans increased by just 4 per cent. Conventional banks reported faster profit growth, however, of 8 per cent, largely because they started provisioning earlier than the Islamic banks.

Greater liquidity at Islamic banks

The figures also show that, in general, Islamic banks have much greater liquidity than their conventional counterparts. Most Islamic banks tend to have significantly more in deposits than they have outlayed in loans.

In contrast, most conventional banks in the region went into the financial crisis massively overextended, leaving them unable to make new loans, while they concentrate on building their deposits books more in line with loan books.

The same is true for the Islamic banks that also offer retail banking services. Those institutions tend to have a strong and often wealthy customer base in the region, providing them with a secure source of deposits.

Many Islamic investment banks remain troubled, however. Kuwait’s The Investment Dar had about $4.5bn in assets in 2008, which would have made it one of the top 20 Islamic banks in the region by assets. Since then, it has been mired in a protracted restructuring of $3.6bn of debt and has not reported the actual value of its assets. It finally came under Kuwait’s Financial Stability Law in July 2011, enabling it to start making progress on its debt problems, but the current state of its assets remains unclear. It is likely they are worth significantly less than when they were last accounted.

Debt restructuring

Other Islamic banks face similar issues and sharia compliance adds further complexity to the legal wrangling involved in a debt restructuring. “It is difficult enough to achieve consensus with a group of banks on a conventional debt restructuring, to add in sharia scholars representing several different banks only makes it more complicated,” says one banker working on the restructuring of an Islamic bank.

Although results for the first half of 2011 indicate the sector is [improving], real-estate exposure remains a concern

Bahrain’s Arcapita, an Islamic investment bank with significant interests in North America, reported a sharp drop in the value of its assets in 2010, falling to $3.4bn from $4.3bn in 2009. Things improved slightly in the first six months of 2011, with its assets now valued at $3.7bn and the bank making a profit again after losses in 2009 and 2010.

Although results for the first half of 2011 indicate the sector is starting to improve, real-estate exposure remains a concern and growth prospects do not seem as strong as over the past few years.

Then the region was benefiting from a high oil price and a boom in infrastructure investment. Islamic finance was an attractive prospect and differentiator for the region. Even conventional investors were happy to become involved in Islamic instruments to give them exposure to the Middle East.

That may be different now. Analysts worry that Dubai’s real-estate sector, which most Islamic banks are exposed to in some way, is still under pressure as new supply comes to the market. State spending in Abu Dhabi is failing to materialise, meaning the local banks there will not have that as an opportunity to boost their business. In Saudi Arabia, the banking industry remains extremely cautious about new loans and Riyadh’s $135bn in spending pledges risks elbowing out the private sector, diminishing the need for more lending.

Positive predictions for the Islamic finance industry

Dubai Bank was taken over by the government of Dubai in May in order to “ensure all depositors’ interests are safe”, and another Dubai-government owned bank, Noor Islamic Bank, has had to put foreign expansion plans on hold because of the financial crisis.

Islamic banks will … grow over the next 12-18 months, but the pace of industry growth will start to slow down

Dubai-based banking analyst

Some positive predictions for the industry remain though. A July report from the Dubai Chamber of Commerce and Industry found that assets of UAE Islamic banks rose by 11 per cent during 2010. It also said that globally Islamic banking turnover is set to rise from AED3.7 trillion in 2010 to AED9.9 trillion in 2015.

“The Islamic banks will probably continue to grow over the next 12-18 months, but the pace of growth for the industry will start to slow down, particularly as a lot of regional trade flows, real-estate development and investment is much slower now that it was at the start at the 2000s,” says one banking analyst based in Dubai.

The list of the top 20 GCC Islamic Banks shows that fragmentation remains one of the key challenges for the industry. The two largest banks make up nearly 40 per cent of the total assets of all 20 banks. This means the Islamic banking sector in the GCC largely comprises small institutions, many of which struggle to compete with the Islamic banking windows of large international banks.

Coupled with concerns about keeping Islamic banking ‘pure’, this has led Qatar to ban conventional banks from operating Islamic banking arms.

Despite some significant growth rates over the past few years (globally Islamic finance assets have been growing at more than 30 per cent a year) Islamic finance assets still only make up about 1 per cent of global financial assets, according to estimates by US-headquartered consultancy firm Oliver Wyman.

With oil prices for most of this year at well above $100 a barrel, the prospects for the GCC Islamic finance sector look good. Much of the demand in the region for Islamic finance is led by the state and state-owned investment vehicles, which prefer to invest and borrow through sharia-compliant structures.

Necessary consolidation for some Islamic banks

The Arab uprisings have led many Islamic banks (and conventional ones) to put foreign expansion plans on hold, while they wait to see the outcome of revolutions in places such as Egypt and Libya. Both countries had been prime expansion targets for regional banks. Reaching out to the rest of the Muslim world will be essential for GCC Islamic banks if they are to further strengthen their deposit base and grow in size. Consolidation is also necessary to create banks large enough to compete with Islamic banks based in other parts of the world and to achieve the economies of scale necessary to take on their conventional rivals.

Extending the reach of the franchise of Islamic banks is essential, but with the global economy still looking fragile, now may not be the time for aggressive expansion. It seems more likely that consolidation will continue to be forced on the region’s Islamic banks because of emerging problems, rather than as a result of strong players trying to capture more of the market.