New horizons

Dr Samir Pradhan of the Gulf Research Centre gives an in-depth insight into the current trends shaping the global Islamic finance industry.

“The emergence of rival centres in the Gulf has fragmented the Islamic finance industry and resulted in very many small institutions being licensed which cannot benefit from economies of scale or scope”
-Dr Samir Pradhan

Over the last decade, Islamic finance (IF) has recorded spectacular growth and is currently poised to be a crucial ingredient of the global financial market. IF existed for more than three decades providing tailor made financial services to devout Muslims, yet its scope and coverage were largely restricted to commercial banking in the Middle East and Malaysia. However, in the last few years, innovative Islamic financial products and services, regulatory frameworks and increased linkages with the mainstream financial market have made IF as a rapidly growing segment with market presence in more than 75 countries and estimated total assets to the tune of US$800 billion dollars. With integration of Islamic financial services, Islamic banking and Islamic insurance into the global economy, IF has undergone huge expansion, partly driven by the oil‐driven financial liquidity in the Gulf, and the fast growing number of Muslims seeking more religiously sanctioned products.

Simultaneously, the spectacular growth of IF has also raised considerable concern in the world owing to its peculiar market characteristics, debate over the interpretation of shariah law and the apprehension of non‐Islamic western countries. However, in the current global economic environment, IF is increasingly being projected as a reliable source of global financing. Moreover, the competitive landscape is being redrawn, with more Islamic financial services institutions in the marketplace than ever before. Incumbent banks and new market entrants are facing vastly different market conditions and need to develop new sources of differentiation beyond compliance with shariah (Islamic law) to compete or remain successful in the future.

Current Trends

Buoyant economic growth coupled with a demographic surplus particularly, in predominantly Islamic countries, is the primary factor behind the phenomenal growth of Islamic finance over the years. As a result, Islamic assets have grown between 15 and 20 percent annually for the past five years, culminating in the current global Islamic assets of nearly 500 billion dollars, making Islamic banking one of the fastest‐growing sectors in the global financial services industry. As per other estimates, the total assets are around 800 billion dollars (Gulf One Investment Bank, December, 2008) and are expected to increase to 4 trillion dollars by 2015 (Moody's forecast). From a global financial industry perspective, IF still accounts for a small proportion of the market share of IF in world financial market assets accounting for less than one percent, although it increased from 0.2 percent in 2000 to 0.6 percent in 2007. Though, Islamic banking activities account for the bulk of worldwide shariah‐compliant assets, the scope of IF is expanding rapidly beyond retail and trade financing operations of Islamic banking to more sophisticated shariah‐compliant financial products. By 2009, the number of Islamic mutual funds have increased to 925-an increase of 28 percent within a decade. Simultaneously the Islamic capital market also saw growth with large-scale innovation of shariah compliant products. The most notable instrument (by volume) that has emerged is the sukuk, an Islamic financial vehicle similar to a bond. From 2004 to 2008, nearly $110 billion was raised through sukuk. 

More than half the global sukuk transactions in 2008 were based on the ijara mode of financing, followed by musharaka with 17.2 percent.  It is important to note that the global sukuk industry in 2008 witnessed a sharp downturn with a total value of sukuk issues of around US$16 billion, compared to nearly US$47 billion issues in 2007 due to the ongoing financial crisis. Also, Islamic funds such as Islamic private equity funds, hedge funds and real estate funds have experienced unprecedented growth in the last few years. Currently there are more than 700 Islamic funds globally. The first Shariah‐compliant fund was launched in 2007 by the international brokerage New Edge with seed investment by Saudi Arabia's NCB Capital. Since then many international financial players such as Deutsche Bank, HSBC and Barclays Capital have come up with a variety of funds in collaboration with their Islamic counterparts. Another important market segment is Islamic insurance or Takaful, largely dominated by GCC investors. The global Takaful industry is growing by 20% per annum and slowly expanding beyond the home markets to countries such as the Indian sub‐continent and Africa.

IF in the GCC

The growth of IF in the GCC region goes back to the 1970s when oil shocks resulted in huge influx of oil revenues and a massive surge of liquidity in the region. The earliest private Islamic banks of the region were the Dubai Islamic Bank and Al Baraka groups of the KSA and Kuwait Finance House. In its early stages, most governments in the GCC region were either hostile to, or at best ambivalent about, IF. As a result, it did not grew robustly in the region. However, demand for financial products allowed a number of local and western financial practitioners to create a small industry, using investment funds from the Gulf region especially Saudi Arabia. Bahrain and UAE also pursued IF as a niche segment in their overall economic diversification programme and now the region is home to the largest concentration of IF assets. Islamic banking assets in the GCC in 2008 stood at US$110 billion with Saudi Arabia accounting for the bulk (55 percent), followed by UAE (19 percent, Kuwait (16 percent), Bahrain (7 percent) and

Qatar (4 percent). The GCC Islamic banking sector is dominated by top three banks, Al‐Rajhi Bank of Saudi Arabia, Kuwait Finance House and Dubai Islamic Bank with combined assets of nearly 90 billion dollars.

In terms of market capitalisation of the GCC IF sector, Saudi Arabia is the dominant player followed by Kuwait, UAE, Qatar and Bahrain. However, despite the tremendous progress, IF accounts for a small share (15 percent) in the region's total market capitalisation. Moreover, another important fact is that the growth of IF in the GCC is largely confined to a few economic sectors such as real estate followed by financial services largely in the form of consumer loans. This implies that the sector is slowly emerging from a low‐base with huge potentials in the future. With the liquidity crunch due to the financial crisis, Islamic syndicated lending acted as a cushion against the drop in sukuk issuance for project financing in the GCC. As the Sukuk market contracted with increasing LIBOR rates, investors switched to syndications as a better alternative.

In project finance, IF accounted for nearly 10 percent of the region's total project financing.

Legislation, Regulatory issues and Shariah compliance

Despite the growth and potential for IF in the GCC, there are critical issues that need to be addressed for making the sector more competitive., Unlike Iran, there are no mandatory legislations or law for making all internal financial dealings to be shariah compliant in the GCC countries. Kuwait adopted legislation in 1976 to allow the establishment of Kuwait Finance House, for many years its only Islamic bank, but this legislation was superseded in 2004 by an amendment to the Central Bank Law 32 of 1968 allowing Islamic financial institutions to function alongside conventional banks, but with no special privileges for the former. The law does however provide a framework for Islamic financial governance, especially articles 86, 87, 93 and 96, including a stipulation that each institution should have a shariah board with at least three members. Besides, there is no similar legislative provision in any other GCC state, where Islamic finance is dealt with at the regulatory level only, with Bahrain having the most detailed rulebook. Importantly, standards for shariah compliance are not harmonised in the GCC where each institution has its own shariah board but apart from in Bahrain, there are no national boards. Consequently there are conflicting fatwa reflecting different interpretations of shariah. Furthermore all those appointed to the shariah boards of the banks have to apply to the Central Bank and obtain accreditation.

Bahrain has functioned as a regional financial centre since 1976, keeping its market open to foreign banks, while Saudi Arabia and Kuwait only licensed majority locally owned institutions.

Bahrain has more than 30 Islamic financial institutions, including banks and takaful insurance companies, most of which serve the regional rather than the local market. It is very dependent on Saudi business however, and as the latter opens up its financial sector, there are competitive challenges to Bahrain, including in Islamic banking. Qatar also has a financial centre, with a detailed rulebook covering Islamic finance, including criteria for shariah supervision. A higher proportion of bank deposits are shariah compliant in Qatar than in any other GCC state. The Dubai Financial Centre has the highest international profile in the region, but Islamic finance is somewhat marginal to its interests.

Competition can of course be helpful to financial development, but the emergence of rival centres in the Gulf have  fragmented the Islamic finance industry and resulted in very many small institutions being licensed which cannot benefit from economies of scale or scope. None of the Islamic banks in the Gulf are in the top 100 world banks in terms of assets, and as a consequence it is the major international banks such as HSBC, Deutsche Bank and Citibank that have moved into Islamic finance to fill the void, especially in investment banking, where capacity and capability are of critical importance. Although HSBC has based much of its Islamic banking operations in Dubai, the other investment banks conduct their Islamic finance business from London, where it is easier to recruit skilled professionals, rather than the GCC. 

Conclusion

The Islamic financial industry has continued to flourish and is set to play an increasing role in the global financial system with the GCC region playing a pivotal role. Despite a belated start, IF in the GCC is on the upswing with tremendous future potential. The GCC countries are pursuing a strategy of integrated development of financial and real estate sectors on the premise that the two can reinforce each other. However, with increasing competition and market growth, a pragmatic strategy focusing on enabling policy regime is required to make the sector a niche economic segment. With regional financial integration in the GCC, this becomes imperative. Moreover, for GCC private players handicapped by the small market size, other emerging investment locations such as parts of Africa and the Indian subcontinent looks promising. But before venturing out, these regional players need to demonstrate domestic entrepreneurial success as role models, which aptly call for governments to play an enabling role in this regard.