Egypt became home to the world’s first modern Islamic bank in 1963, with the formation of a savings bank in the town of Mit Ghamr on the Nile Delta. But Egypt, like most countries of the Maghreb and Levant, has a small Islamic finance sector. 

Apart from Sudan, the region’s most dev-eloped Islamic finance market, where 72 per cent of financial products are sharia-compliant, few countries outside the Arabian Peninsula have developed a significant Islamic banking industry.

But in the past five years, Western institutions have begun to arrive in the region offering Islamic banking services, and Gulf-backed Islamic finance houses have spread beyond the GCC’s borders, promising to increase the provision of sharia-compliant financial services in the non-Gulf Arab states.

Although Gulf banks are eager to seek out new customers and investment opportunities in this market, demand has lagged behind that in the GCC states. This is partly due to the undeveloped financial services sector in many countries, both in terms of the number of banks and the number of products on offer.

In Syria, for example, there are only 19 banks, equivalent to one branch for every 49,500 people. By comparison, neighbouring Lebanon has one branch for every 5,000 people.

Limited options

Egypt, with a population of 81 million, has only four takaful (Islamic insurance) operators. Saudi Arabia, the largest market for Islamic finance products, but with a population of only 22 million, has 37.

The opening up of many of these markets over the past five years, catalysed by the flood of Gulf oil revenues and the accompanying foreign direct investment, is starting to change Arab states’ perceptions of the Islamic finance industry.

In the Maghreb, with its secular, French-speaking business elite, there has traditionally been a cultural resistance to Islamic finance. However, regulatory authorities are starting to wake up to the sector’s potential to contribute to economic development.

“Islamic finance can build bridges within the region,” says Anouar Hassoune, senior credit officer at ratings agency Moody’s Investors Service. “Those with the know-how and capital, typically GCC-based Islamic banks, are to a large extent constrained by the size of their own economies, while the emerging economies in the region have the customer base and a growing appetite for Islamic finance.”

Gulf Islamic financial institutions, like their conventional banking counterparts, see their domestic markets as too small to continue to grow their assets at the annual average rate of 15 per cent achieved in recent years.

In early 2009, Dubai Islamic Bank bought a majority stake in Jordan’s Industrial Development Bank and relaunched it as Jordan Dubai Islamic Bank.

The largest Islamic bank in the country, Jordan Islamic Bank (JIB), was established in 1978 and is a subsidiary of Bahrain-based Al-Baraka Banking Group. Al-Baraka has had branches in other Middle East and North African countries, including Egypt and Lebanon, since 1980.

Last year in Algeria, Gulf investors established Al-Salam Bank, which was capitalised at $100m, offering competition to the only existing Islamic institution in the country, Banque al-Baraka d’Algerie.

In Egypt, Abu Dhabi Islamic Bank acquired 49 per cent of the National Bank for Development in April 2007, with the aim of turning it into a fully sharia-compliant institution.

Qatari investors launched Syria’s largest Islamic bank, Syria Islamic International Bank (SIIB), in 2006.

“What is interesting here is that despite the slowdown in oil prices and drop in liquidity, there is still interest in foreign developments by Gulf Islamic banks,” says Hassoune.

Under pressure to respond to this interest from both consumers and outside investors, the regulatory work needed to develop the Islamic finance sector beyond the GCC is slowly being carried out.

In Iraq, where seven of the 42 licensed commercial banks are Islamic institutions, the central bank, which regulates the sector, is considering legislation that would ease the criteria needed for establishing sharia-com-pliant banks, such as reducing capital adequacy ratios, a measure of a bank’s ability to absorb losses, to less than the current 15 per cent.

Not all are convinced of the need to give special status to sharia-compliant institutions. In Lebanon, the region’s most developed banking sector, Banque du Liban, the central bank, has adopted a neutral approach to Islamic banking, treating it the same as conventional banking.

Some regulators, previously resistant to Islamic banking, appear to be warming to it. Morocco’s central bank, Bank al-Maghrib, authorised the offering of sharia-compliant services only in 2007. “Now it is keen to see more Islamic finance because it has seen there is a market for it,” says Hassoune.

Morocco now allows conventional banks to offer ijara (leasing) products, murabaha (cost-plus) contracts to buy and resell an underlying asset and musharaka (co-ownership) financing structures. But more work is needed to balance the taxation of conventional and Islamic products in Morocco.

A stamp duty imposed on mortgages has penalised borrowers under the murabaha system, meaning customers using Islamic finance are effectively forced to pay double the tax imposed on interest-bearing mortgages.

In neighbouring Algeria, the banking community is also pushing strongly for sharia-compliant financial services. But some tax issues have yet to be addressed. Uncertainty surrounding the taxation of Islamic financial services is understood to have dissuaded some French banks from launching Islamic divisions within conventional banks in Algeria.

Opening up

The banking sector in Tunisia is also opening up to Islamic finance. In March, a new sharia-compliant institution, Zitouna Bank, controlled by the son in law of Tunisian President Zine el-Abidine Ben Ali, became the North African state’s second Islamic institution,  alongside Bank Ettamwil Tounsi Saoudi.

In the region’s largest potential market for Islamic finance, Egypt, just three Islamic banks operate: NBD, Egyptian-Saudi Finance Bank and Faisal Islamic Bank. Cairo is well behind the curve, despite Egypt’s claim to be the home of modern Islamic banking.

“Islamic finance has been pushed out of the front door but is coming back in through the window,” says Hassoune. “There is an appetite there but the government is keeping it as a niche and not as mainstream business.”

For the largest players, Egypt will remain off the map, due to a regulatory climate that has yet to fully prioritise sharia-compliant financial services.

“Expansion is at the forefront of our thinking, but it needs to expand first of all in the places where it will be most straightforward to do so and where local regimes are most favourable for it,” says Tim Harrison, head of corporate communications at HSBC Amanah, the world’s tenth largest Islamic bank by asset size. “There is a huge difference in legal and regulatory frameworks in every country, which means you have to adopt a country-by-country approach. Egypt would not be in the first rank because of regulatory restrictions there.” 

Syria is in the early stages of developing a commercial banking system, but Islamic franchises are starting to make much of the running. With Damascus’s commercial banking system barely five years old, Islamic institutions enjoy a level playing field, and one where their sharia-compliant offering stands a better chance of getting money out from under the mattresses of Syria’s 90 per cent Muslim population of 19 million.

Islamic finance also enjoys stronger support from the regulatory authorities in Syria than the Maghreb or Egypt. “Syria’s a big one because it has a large population but one that is still ill-equipped in terms of financial services,” says Hassoune. “That is why the central bank is very keen to see Gulf and Lebanese banks joining in with sharia-compliant offerings.”

In the summer, SIIB introduced four new Islamic products: ijara, musharaka moutanakissa (diminishing musharaka), qard al-hassan (interest-free loans) and istisna (manufacturing contracts). It is part of a wider plan under which SIIB aims to provide a range of sharia-compliant products and services, through a countrywide network of nine branches.

SIIB’s early success has led its main shareholder, Qatar International Islamic Bank, to float an idea for a joint Syrian-Turkish Islamic banking operation, tapping into the growing cross-border trade and investment between the two countries.

Jordan, though much smaller than Syria, has three Islamic banks. The Central Bank of Jordan has proved supportive of sharia-compliant financial services, adopting the standards of the Bahrain-based Accounting & Auditing Organisation for Islamic Financial Institutions. JIB recorded a 3 per cent increase in net profits in the first half of 2009 compared with the same period the previous year, to JD20.7m ($29.8m), thanks to strong growth in Islamic banking services.

JIB also operates a subsidiary in Palestine, Al-Aqsa Bank, which operates alongside two other Islamic institutions: Arab Islamic Bank and Palestine Islamic Bank. Palestinian appetite for sharia-compliant services is strong but the volumes of business in the West Bank and Gaza are small.

The wider geographical picture underlines the potential of a region where the appetite for alternative forms of finance is growing in line with economic development.

But it is in countries where the potential is biggest, such as Egypt, that the regulatory advance has also been the weakest.

It will take time for the Islamic finance industry to grow to a significant size in the non-Gulf Arab states, but a successful template has been created by the Gulf states and by the banking sector in Malaysia.

Wholesale transactions at the sovereign level, such as large sukuk issues, can have a trickle-down effect encouraging growth in both corporate and retail Islamic finance.

The challenge now is to lay the regulatory foundations that will allow meaningful growth in the region. Once that is in place, the banks’ range of sharia-compliant service offerings will grow as well.

“Every country has to be taken on its merits but we remain confident of growth in the [sharia-compliant banking] industry as we have seen a lot of countries change their regulatory and legal system to enable Islamic financing to come in on a level playing field,” says Harrison.