The Middle East’s Islamic banking institutions are on the hunt for new business opportunities. Big names, including Kuwait Finance House (KFH), are seeking to develop a larger international presence and diversify an asset base that is still heavily rooted in its home market.

KFH has Bahrain, Malaysia, Saudi Arabia and Turkey on its growth list, and following earlier property plays in Jordan and Malaysia, it recently announced a $275m real estate investment in China, part of a wider strategic move to increase its Asian exposure.

As one of the largest Islamic banks in the Gulf, KFH is a trendsetter and its expansionary moves are likely to be emulated by others. Although the Gulf economies are booming, most are still relatively small markets and there are signs of increasing competition in the Islamic finance arena. Moreover, there are also significant risks, thanks to rising inflation and some Gulf property markets sitting in a bubble.

So it makes sense to diversify and look further afield. Asian property markets offer a useful opportunity for highly liquid Gulf institutions to do just that. As with private equity in Europe and the US, real estate offers Islamic institutions a useful route to profits through investment rather than lending.

Investor appeal

The financial sector itself is also attracting the Islamic banks’ interest, particularly in Malaysia. Al-Rajhi Bank, KFH and Qatar Islamic Bank - the latter through a consortium arrangement - have all moved into the market. Tax incentives bolster the investor appeal of the Malaysian Islamic finance business.

Such international expansion is just one facet of the Arab Islamic financial institutions’ drive to diversify and spread risk. In their desire to do this, they are no different from other banks and investment houses. But the relative youth and limited size of the sharia-compliant finance industry limits the options that are available to them at home, even though the choice of opportunities is growing.

“Risk management as a science is the same whatever the nature of the investor or institution,” says Adnan al-Bahar, chairman and managing director of The International Investor (TII), a leading Kuwaiti Islamic finance house. “I do not think there is a specific way that Islamic investment banks or institutions seek to manage risk. What is different is that their management do not have all the tools available.”

He explains that because the Islamic finance sector is still at an emerging stage of development, it has not yet generated a range of instruments that can match the breadth of what is on offer in the conventional finance arena. The choice of products available to hedge Kuwaiti dinar or Saudi riyal positions cannot yet match the number of dollar hedging tools that are available. “It is not Wall Street or London,” says Al-Bahar.

This means that Islamic institutions must sometimes pay more to protect themselves against risk than conventional counterparts would pay for the same level of security. Alternatively, says Al-Bahar, sharia-compliant banks or investment houses “sometimes have to be prepared to live with a slightly higher level of risk” than would apply to conventional institutions in a similar position.

Risk management

Having formerly held senior posts at both KFH and Al-Rajhi Company for Islamic investments, before leaving to set up TII in 1992, Al-Bahar has watched the modern Islamic finance sector develop since its early days and sees today’s limitations in perspective, taking a broadly positive view of its long-term development. “The range of tools is getting wider and it is starting to become an interesting market,” he says.

The fact that the Islamic finance sector is less developed brings advantages too. “The regular [conventional] market is larger, but it is much more competitive,” says Al-Bahar.

Islamic banking is growing in response to demand that is not fully served at present, so there is scope for growth. In particular, there is room for mid-market niche operators to expand. Where new instruments for risk management are being developed, it is in response to customer needs. As in any market, the presence of new products is not ultimately decided by the flow of ideas from those who design them, but by the level of demand from those who use them, says Al-Bahar.

Although the range of financial instruments and the options for investing them is widening, the process is gradual. For example, the secondary market in sukuk is still relatively small. In this context, the Gulf’s Islamic finance institutions have sought to broaden their investment portfolios and asset bases by putting money into other areas of business, of which real estate and private equity are among the most important. Both offer the scope to invest without actually making loans, thus avoiding any possible conflict with the sharia prohibition on interest-bearing credit.

KFH’s new Chinese property play is one of the largest such investment moves. The group has signed a deal with Nan Hai Corporation under which it will invest $275m in the Chinese company’s $3bn Peninsula project. In the summer, the Kuwaiti bank took an 80 per cent stake in a 20-storey office building in Kuala Lumpur, Malaysia, for KD20m, while its Bahrain offshoot took a $34m stake in Deera Investment & Real Estate Development Company in Jordan. At the time, Ali al-Ghannam, manager of KFH’s real estate department, said its Asian property portfolio was delivering 15 per cent annual returns.

Such diversification appears to be well regarded by the ratings agencies. Capital Intelligence recently upgraded its assessment of KFH to A+ for long-term foreign currency risk and A1 for short-term foreign exchange exposure.

In parallel with direct investment, KFH spreads its risk exposure by the choices it makes about which clients to fund. For example, it has agreed a $300m package of funding for a fellow Kuwaiti institution, First Investment Company, which plans to expand in the Saudi financial and real estate sectors, and in the UAE and Oman. The bank has approved a $100m murabaha (Islamic financing) facility, to be followed by a $200m sukuk (Islamic bond).

Financing arrangement

Meanwhile, private equity also has attractions for Islamic institutions, allowing them to take stakes indirectly in companies, thus generating income in a clearly sharia-compliant way. In moving into this area, they are following the lead already set by other Gulf institutions such as Investcorp, says Al-Bahar.

Another area of diversification could soon be Saudi housing finance, which can be structured in ways that meet Islamic criteria. Up to now, homes finance in the kingdom has posed risk problems, because Saudi law does not allow a house or flat to be used as effective collateral for financing, whereas this is precisely the form of security upon which mortgage finance is based. Saudi laws do not allow a financial institution to force a private individual to surrender their home if they fail to keep up payments on the financing arrangement they used to purchase it in the first place.

However, one leading Islamic finance spec-ialist in Saudi Arabia says a new law is in prep-aration that will allow homes to be used as collateral. This should give banks, both Islamic and conventional, the confidence to provide mortgages. The mortgage law has been approved by the Majlis al-Shura (Consultative Council) and is awaiting final ministerial approval. It is expected that the law will be on the statute book within a few months, thus opening the way for finance institutions to move into the housing finance market in a big way.

Such product diversification within the region is important because, despite the expansion into international markets, Gulf Islamic banks remain primarily focused on their home region. “The main growth comes from the credit portfolios in the country,” says one Saudi-based Islamic finance specialist. “There is a lot of activity in the Saudi investment banking area.”

It is not uncommon for the financing structures of major industrial projects to include a sharia-compliant component. Petro-Rabigh’s funding package included a $600m Islamic component of the $5.8bn total package. For participating financiers - such as Riyad Bank, Sabb and Gulf International Bank - such arrangements provide a useful form of sectoral diversification in their risk portfolio.

Some years earlier, Abu Dhabi Islamic Bank led a $250m Islamic facility that complemented the main $985m syndicated bank credit for the Shuweihat power project in the UAE. At the time, this was a relatively unusual move for sharia-compliant Gulf financiers, but it both broadened their risk exposure and gave them experience of involvement with a project with a genuinely long-term timescale.

Companies active in the takaful (Islamic insurance) field also face the challenge of risk management. Last year, Salama Islamic Arab Insurance Company, one of the leading players, shifted its strategy to increase the proportion of its portfolio placed in marketable and private equities.

In its latest assessment of the firm, issued in August, ratings agency AM Best gives its approval to this new approach, which it says is still reassuringly conservative. The agency has maintained its strong A- and a- grades for Salama - which had been uprated in January 2008 from B++ and b+++ - and says the company’s risk-weighted capitalisation is holding steady this year.
One important facet of Salama’s risk management is business growth and diversification, extending its geographical reach and introducing new life products. It has expanded beyond Arabia into Egypt, Algeria, Tunisia and Senegal.

The value of assets and income flows in these economies, with their strong links to Europe - Senegal’s currency is tied to the euro - helps to balance the group’s heavy involvement in the dollar-pegged markets of the Gulf. Not that performance in these home markets is weak - AM Best expects Salama to generate post-tax profits of $40-50m a year.

Risk diversification through product and portfolio diversification is nothing new in the banking world, but as Islamic banks tool up to be able to manage risk better, it will be interesting to track how much their approach differs to that of the mainstream banks.

Key fact

$275m - The value of Kuwait Finance House's real estate investment in China