Author: Anita Hawser
Players Vie for a Prime Slice of a Promising Market
Global and local banks are jostling for position in a rapidly growing and potentially lucrative market.

Islamic banking is more than 20 years old, but the terrorist attacks on the World Trade Center in New York and the Pentagon in Washington, DC, and rising oil prices—which means there are substantial liquidity reserves seeking suitable investments—are turning a little-known ‘ethical’ investment sector into a multi-billion dollar industry. Although it is difficult to gauge the exact size of the Islamic banking market, current estimates suggest it is between $270 billion and $500 billion and growing at rate of 15% to 20% a year.

“Rising oil prices generated significant liquidity in the market with a considerable portion being invested in the region and in many cases in a Shari’a compliant way,” says Omar Kamal, executive manager of Ernst & Young’s Bahrain-based Islamic Financial Services Group.

Ghazi Al-Hajeri, portfolio manager, alternative investments division at New York-based Wafra Investment Advisory Group—which is owned by the State of Kuwait’s Public Institution for Social Security and manages funds in the United States for Kuwaiti financial institutions and investors—says that governments in the Gulf Cooperation Council (GCC) countries increasingly are looking to invest in products that comply with Islamic law—or Shariah. “Governments in the region have requested Shariah-compliant funds, whether it is a pension system or the state allocating money to Islamic products,” he says.

There are approximately 300 Islamic banking institutions spanning more than 25 countries. More than 90% of assets are held in the Middle East, including countries such as Iran, Saudi Arabia, Kuwait, the United Arab Emirates, Egypt and Jordan. Non-Islamic financial institutions are also eager to get a slice of the action, with leading brand names such as Citigroup, HSBC and UBS establishing Islamic financing divisions.

But with approximately 1.5 billion Muslims in the world, the majority of whom still use conventional financing, the market for Shariah-compliant financial products remains largely untapped. In Malaysia, for example, which is home to 15 million Muslims and nine Islamic financial institutions, only 10% of total banking assets are held in Shariah-compliant accounts.

The initial focus of Islamic financing outside of the Middle East was in the home finance market. In the United Kingdom, HSBC Amanah, the Dubai-headquartered Islamic financial services division of the UK bank, was the first to launch Shariah-compliant mortgages in 2003. Amjid Ali, UK head of HSBC Amanah, says it has completed 2,000 Shariah-compliant home financing deals and manages in excess of 1,000 bank accounts. “We knew from Muslim umbrella organizations that there was a fairly large percentage of people who were prevented from entering the housing market because they didn’t want to have a conventional mortgage,” Ali explains. HSBC Amanah home finance typically services first-time buyers. Ali estimates there are 134,000 Muslims in the UK that still hold conventional mortgages.

Unlike conventional financing, Shariah law forbids the payment or receipt of interest (riba). Money is also viewed as a means of exchange instead of a commodity, so the idea that it can rise in value is not accepted. Common Islamic financing techniques include, ijara, a leasing contract in which, instead of lending money or earning interest, the bank charges rental on an asset leased to a customer. A murabaha financing structure means the bank buys the asset in question from a third party and resells it to the client at an agreed “mark-up” price, which is paid back in installments, thereby avoiding interest.
Banks Eye Bigger Targets
Ghazi Al-Hajeri: “There is a lot of money chasing few products”
Having gained a toehold in the home financing market, banks are now looking for richer potential markets, such as project finance, asset management, debt instruments, insurance and hedge and mutual funds. All of these products must comply with Shariah law, which outlaws speculation and permits investment only in certain stocks, excluding companies that earn income from the production of pork-related products, alcohol, conventional financial services, pornography, gambling, tobacco and arms.
Historically, most Islamic banking activity has been confined to commercial banking—corporate and retail—but Kamal believes that investment banking, asset management, equity capital markets, debt capital markets and private banking, will drive the next growth phase in Islamic banking, particularly with the development and opening up of capital markets in countries such as the UAE and Saudi Arabia, the increased liquid funds in the region and the high level of project finance activity in the GCC.
Acquisitions and investments by private sector companies in the Middle East, and the need for local banks to meet capital adequacy and liquidity requirements, are fostering the development of the Islamic bond, or sukuk, market. A sukuk is asset-backed and is leased to the client in order to yield a return. By the end of 2004, the sukuk market was valued at $6.7 billion. In the second quarter this year the market grew by 474% on the previous quarter, with 26 issues valued at $6.2 billion, according to the Islamic Finance Information Service (IFIS). Traditionally confined to sovereign issuance in Middle Eastern countries, the sukuk is being embraced by other markets and is attracting the participation of corporate, government and financial issuers. Mohsin Nathani, chief executive, Citi Islamic Investment Bank, a leading provider in the international sukuk market, says that there is a higher level of awareness among issuers. “One of the encouraging trends we are seeing is that issuers with large fund-raising requirements have a preference to go the Islamic route,” he says.
Some of the more notable issuances in the past 12 months include the World Bank’s (IBRD) $200 million Malaysian ringgit-denominated sukuk; ABC Islamic Bank’s Al Safeena sukuk, the first Islamic bond issued by the shipping sector; and the transaction that broke all records, the $2.35 billion raised for Saudi mobile telephone company Etihad Etisalat, billed as the largest debt transaction in the region and the biggest Islamic financing in the world.
In the area of structured products, BNP Paribas, which has some 20 years of experience in Islamic financing, has established a Shariah-compliant CPPI (portfolio insurance) or a more generic contract in which BNP Paribas guarantees to deliver a certain return for investors based onexposure to equity, mutual funds and other markets, in accordance with Islamic principles. David Choukroun, head of mutual fund derivatives, BNP Paribas, says these products reflect increasing demand for more sophisticated Islamic investment opportunities.
Other emerging areas in Islamic financing include hedge funds. Al-Hajeri of Wafra says banks in the US and UK have launched Islamic hedge funds, but very little is known about their structure and how they gained acceptance from Shariah boards. “There is still a lot of work to be done with hedge funds,” says Kamal of Ernst & Young.

Stifling Innovation
Mohsin Nathani: “Issuers have a preference to go the Islamic route”
One of the problems for banks in the Islamic financial services sector is keeping pace with investor demand for new and innovative products. In countries such as Kuwait, Al-Hajeri says that traditional banks have only just started selling Shariah-compliant products—and only on a small scale. “There is a lot of money chasing few products,” he says. In terms of customer acceptance, Kamal says being Islamic is not enough. “The banks need to focus on competitive products and services and benchmark against the best conventional banks.”

Ali of HSBC Amanah in the UK says not only do Islamic financing products need to be competitive in terms of pricing, but customers also need to have faith in the Shariah supervisory councils that most banks are required to maintain in order to gain approval before launching products. “Customers look to see whether the source of funds the product is based on are Shariah compliant and what scholars we have on our board,” Ali says. Shariah boards are made up of esteemed scholars conversant in Islam, economics and finance.

Gaining the acceptance of Shariah scholars takes time, and Shariah councils in different parts of the world do not always agree on what is compliant and what isn’t. “The need to achieve certification of the Shariah board does add complexity,” says BNP Paribas’ Choukroun. “You may have to modify your contract or part of the deal and then take it back to the Shariah board, which is time consuming.” Some believe the process of gaining approval can hinder the development of new products. “It is hard to be innovative,” says Al-Hajeri. “The Shariah board has to [approve] the product, which means they are putting their reputations on the line.”

Kamal believes the main reason for the slow pace of innovation in Islamic financing is the lack of human capital. “Getting talented and high calibre people experienced in Islamic financing is difficult,” he explains.

Shariah scholars also need to agree on interpretations of structures for financial products, Kamal says. “Financial products approved by Shari’a scholars for a certain set of banks may not be approved by Shari’a scholars advising certain other banks resulting in varied product offerings by banks and lack of uniformity.” Citi’s Nathani agrees that differences of interpretation mean products approved by a Shariah board in one region might not receive the same seal of approval in another. “It is a challenge the industry is working to address, but it will not happen in the next six months,” he says.
Global Muscle, Local Knowledge
In an increasingly globalized world, Islamic financial institutions are also struggling against competition from larger and better-capitalized western banks. Most Islamic banks have assets of $25 million or less, which limits their ability to compete in the primary and secondary markets. Despite their dominant size, the larger, more sophisticated western banks believe there is room for both Islamic and non-Islamic banking providers to flourish. “We have the structuring, global distribution, trading and asset management capabilities, as well as local knowledge” says Shaun Wainstein, head of London Structuring & Exotics Group, BNP Paribas. “We also work with Islamic banks who are established in the region.” Kamal believes competition from global banks is essential for the development of the Islamic financial services industry, but calls for the development of a well-capitalized wholesale Islamic bank to lead the Islamic financing industry.

Regulation is also needed. Most countries do not have specific regulations in place for Islamic banks, although organizations such as the Islamic Financial Services Board and the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions are developing capital adequacy, risk management, accounting, auditing and ethical standards. “We have a number of enablers,” Kamal says. “The question is, Are they able to influence the outcome of what they are doing with Islamic banks? They need the support of the banks.”

Anita Hawser