Islamic banking - dynamics of growth

Mushtak Parker continues his report on the growth of Islamic banking in a post-9/11 international financial environment

Recently, 10 new Islamic banks have been established in countries ranging from the UK to Saudi Arabia to Malaysia.

Islamic financial products such as capital market instruments, including bonds and securities, are now attracting attention even in the West, following the recent successful closure of the 100m euros debut Sukuk or Islamic bond issued by Saxony-Anhalt, the German state. There are reports that Italy may be the next sovereign to launch a sizeable Islamic bond. One arranger is also structuring a debut Sukuk for a US corporate.

Yet, with all this rapid growth, especially in a Gulf Co-operation Council (GCC) market awash with liquidity, thanks to the high price of crude oil over the last year, no-one knows the real market size of global Islamic banking and finance. Estimates vary according to the pundits - US$200bn or US$300bn - supposedly growing at an annual rate of between 15% to 20%. Yet the actual figures quoted have remained static over the last decade or so despite the annual growth.

If one considers the rapid growth of private wealth management and the impact of the oil price bonanza on private wealth, the funds under management in global Islamic finance could be much nearer the US$500bn mark or even higher. The standard estimates of Islamic finance market size often ignore private banking funds because institutions are coy about revealing the size of their private wealth management book business.

The poor statistical representation of the market growth dynamics of global Islamic finance perhaps betrays an under-developed culture of disclosure, transparency, research and development (R&D), and regulation and supervision. Transparency, says Mahmood Al-Sheahabi, relationships officer for Islamic Financial Institutions first at Chase Manhattan bank and then at Asian Capital Partners, is a scarce commodity in Islamic banks. This is primarily because they are generally afraid that, if they become open about their business, the public might view it as nothing but semantics.

Although Islamic banks report to central banks in their countries, this information is in most cases aggregated with the conventional banking statistics, with no attempt or desire to separate the two reporting systems. Only Malaysia and Turkey, and to a lesser extent Bahrain, publish separate and regular statistics on their Islamic banking systems.

However, there are some interesting global indicators which underline the dynamism (albeit erratic) of the current Islamic finance market.

In the West, many of the banking majors including HSBC, Merrill Lynch, Citigroup, Morgan Stanley, Société Générale and Standard Chartered traditionally have had a long association with Islamic banking, primarily driven by the requirements of their Middle East clientele.

But with the Muslim population in North America and Europe on the increase, the market potential for Islamic finance is similarly increasing. The EU-wide Muslim population, for instance, is about 12m and growing, of which about 2m are in the UK with an estimated savings, according to the Financial Services Authority (FSA), in excess of £1,000m in 2002.

The UK figure however can rise to 2.5m during the summer months due to a transient population of tourists and visitors from many Muslim countries, especially the Gulf states and Malaysia, some of whom own investment or holiday properties in the UK. The estimated spending power of Muslim visitors to the UK in 2002 totalled over £600m.

UK first

In August 2004, the FSA authorised the Islamic Bank of Britain (IBB) to accept deposits, making it Britain's first stand-alone Islamic bank. But, as the experience in Malaysia has shown, Islamic banking is not only for Muslims but for anyone interested in ethical or profit-and-loss-sharing banking. In Malaysia, for instance, non-Muslim Chinese customers account for over 70% of the uptake of OCBC's Islamic banking products.

Indeed, Lord George, former governor of the Bank of England and a major supporter of Islamic banking in the UK, stresses that the FSA authorisation, 'will enable the Islamic Bank of Britain to offer a wide range of Shariah-compliant banking services in the country, which will provide real comfort to the many Muslim members of our society. At the same time it will usefully extend the range of financial products available to us all.'

The IBB model is already being studied by other EU central banks. Sources in the Netherlands stress that the Dutch Central Bank, DNB, has already met representatives of Muslim business organisations to discuss the feasibility of the introduction of Islamic financial products in the Netherlands.

In the US, the Chicago-based community bank, Devon Bank, recently started introducing Islamic home financing and consumer finance products to cater for sections of its 'culturally diverse customer base'.

The acid test, however, for the likes of IBB will be to what extent the bank can persuade Muslims and others to take up its products and services, if necessary by switching from their existing high street banks. In the UK, for instance, HSBC Amanah, Bristol & West, Bank of Ireland, West Bromwich Building Society and Royal Bank of Scotland are now all offering Islamic mortgages and savings accounts. It would be revealing to see how many ordinary Muslims in the UK subscribe to the IPO (initial public offering) launched in September 2004 by IBB to raise some £40m in additional capital.

If the West is an example of peripheral growth dynamism of Islamic finance, then the Middle East, especially the GCC States, is the core growth area. Simply because it has the largest pool of finance. Bahrain, which sees itself as a major international Islamic finance centre, reported that the total foreign assets of the Islamic financial institutions regulated by the Bahrain Monetary Agency (BMA) at US$2,458m at the end of August 2002, a mere 2.4% of total banking assets. The total domestic assets of these institutions totalled US$1,161.5m.

In neighbouring Kuwait, the total market capitalisation of 10 Islamic financial institutions at the end of July 2004 amounted to US$7.5bn. Kuwait has recently issued three licences under its new Islamic banking law, which will push up the market size even further.

In Turkey, Islamic banking accounted for just under 3% of market share of the total banking sector. But Ufuk Uyan, CEO of Kuwait Turk Evkaf Finance House, the largest Islamic bank in the country, is confident that, given the current growth and demand trends in the market, the Turkish Islamic banking sector can capture a 10% market share of the total banking sector 'within five to 10 years'.

By far the single largest market for Islamic finance in the world is oil-and-cash-rich Saudi Arabia, where Al-Bilad is the latest bank to be licensed by the Saudi Arabian Monetary Agency (SAMA). Although there is no Islamic banking law in the Kingdom, Al-Bilad is operating exclusively under Islamic financial principles.

There is no doubt that demand for banking services, in particular products and services which are Shariah-compliant, is on the increase in the Kingdom and the GCC countries. David Hodgkinson, CEO of HSBC Middle East, which recently launched its dedicated Islamic finance brand, HSBC Amanah in Dubai, said there is strong potential growth of the sector, particularly due to growing demand from large corporations such as SABIC, Qatargas, Equate, Tabreed, Dubai Civil Aviation, Emirates, and Emaar Properties. Investor support for Islamic financial institutions could not be better illustrated by the IPO for Amlak Finance, the Islamic property finance arm of Emaar, the largest property developer in the UAE. The IPO was oversubscribed 33 times and received orders for AED13.7bn.

Rising access

A survey carried out earlier this year by UK polling company YouGov for the inaugural HSBC Middle East Business Confidence Index, for instance, showed that some 48% of companies with sales of more than US$100m from or operating in the Middle East expected to access more Islamic financial facilities over the next three years.

According to Hodgkinson in Saudi Arabia, for instance, 95% of all new borrowing (both corporate and consumer finance) in the first quarter of 2004 was reportedly done on an Islamic finance basis. Perhaps the most important indicator of demand for Islamic finance in the Kingdom is the decision by the National Commercial Bank (NCB) in Saudi Arabia, the largest bank in the Arab world, to convert its entire branch network and retail banking activities into a dedicated Islamic banking operation. NCB, with total assets at the end of March 2004 amounting to SR112.2bn, effectively is stopping short of fully converting into an Islamic bank, allowing it time to continue conventional activities which currently have no Islamic equivalents such as credit derivatives and other such debt products.

NCB is a pioneer in Islamic asset management. Its Ahli Saudi Riyal Trading Fund is the single largest Islamic fund with just under SR9bn under management. It has by far the largest family of Islamic funds, with a total under management in excess of US$7bn. And yet, NCB does not publish a separate Islamic banking balance sheet.

The market growth in Saudi Arabia would be even more phenomenal if the Government had a clear and transparent Islamic banking policy. At present it is ambivalent. The Government tolerates it but cannot officially endorse it through the adoption of a stand-alone Islamic banking law. The adoption of such a law would be a tacit acknowledgement that there is also riba or interest-based banking in the Kingdom, which technically is against the Saudi constitution, which in turn is supposedly based on the Shariah (Islamic canon law). In reality of course, most of the Saudi banks operate under interest-based banking rules. As such, Islamic banking is a highly sensitive political issue in the Kingdom.

In sharp contrast, Malaysia is by far the most transparent market where the regulator and the Government are both proactive enablers and drivers of Islamic banking through a world-class regulatory and supervisory regime complete with legal, compliance and enforcement infrastructure, and a host of policy incentives to market players.

Bank Negara publishes annually a comprehensive report on the Malaysian Islamic banking system comprising policy initiatives, market size, sources and direction of financing, asset quality, capital market activities, and even Islamic inter-bank money market data - the only one of its kind anywhere. To stimulate the market further, the Government has recently brought forward its financial market liberalisation plan as stipulated in the country's ambitious Financial Sector Master Plan by three years. It has already issued an Islamic banking licence to Kuwait Finance House, one of the largest Islamic banks in the world, and is evaluating two other applications by qualified foreign players. It has also just given two new Islamic banking licences to domestic players Commerce Bank and RHB Bank.

High market share

The market share of Islamic banking deposits of total deposits in the banking sector at the end of 2003 was 10.4%; total Islamic banking assets was 9.7%; and total Islamic financing was 10.3%. In monetary terms total Islamic banking assets at the end of 2003 were RM82,196m - up 20.8% on 2002. Total Islamic banking deposits were RM60,212m - up 13% on 2002; and total Islamic financing totalled RM48,615m - up 32.4% on 2002. The capital base of the Malaysian Islamic banking system increased to RM6.8bn in 2003 and recorded a strong risk-weighted capital adequacy ratio of 13.1% and a core capital ratio of 11.4% - both well above the Basel I minimum of 8%.

However, even in Malaysia, Islamic banking statistics can sometimes be beguiling. For the underlying rate of growth of the market share of Islamic banking deposits has decreased over the last few years, suggesting that either depositors are opportunistic, or that the Islamic banking market may be showing signs of overheating or is not competitive enough. This must throw some doubt over whether the Malaysian Islamic banking system can achieve a 20% banking deposits market share as targeted under the Financial Sector Master Plan by 2010.

There is no doubt that Malaysia is keen on promoting the globalisation of Islamic banking, and is encouraging its own Islamic banks and windows to do more cross-border financing and to seek more opportunities abroad, especially in the Middle East - in particular the cash-rich Gulf States. But in giving Islamic banking licences to qualified foreign players from the GCC, it is also trying to bridge the gap between the Gulf and south-east Asia. Domestically, Dr Zeti Akhtar Aziz, governor of Bank Negara, also sees the enhancing of the effectiveness and efficiency of the Islamic banking system 'as an enabler of economic growth and development'.

If these policies prove successful, and there is every chance that they could, they could be important drivers of global Islamic banking growth dynamics.

However, the biggest boost for market size and growth would be to educate ordinary Muslims and others about Islamic banking and to make them aware about the rationale, the products, the ethics, the flexibility, and competitiveness of the system. And, above all, to increase accessibility to such alternative modes of financing through the removal of barriers to entry such as: lack of relevant laws; financial market protectionism; lack of international accounting standards; a non-level playing field in taxation; poor marketing; and other enabling factors.

Mushtak Parker is editor of Islamic Banker.