ISLAMIC BANKING

ISLAMIC BANKING

INTRODUCTION:

The evolution of Islamic banks from their modest ancestry in the early 1970s into a multi-billion dollar industry has been unprecedented in modern financial history.  Not only has Islamic banking been identified as a potentially lucrative business of rising importance in our primary markets, but the surge of interest in Islamically acceptable financial instruments has also encouraged conventional banks, including those in the west, to vigorously take part in the Islamic banking system.

Despite the significant expansion of the Islamic banking market, supported by the innovative financial engineering, to include almost all conventional banking products, which were adapted to comply with the Islamic law, there is still a huge pool of untapped assets in Muslim countries and among Muslim minorities in Europe, the Far East and the USA.

This study is intended to evaluate the expected benefits to the Arab Bank group via venturing into the Islamic Banking line of business in view of the strategic direction of the bank. 

THE MARKET:

The size of the global Islamic banking market, comprising the financial and capital market sectors, is now estimated between US$ 150 – 200 billion, with more than 200 Islamic financial institutions, managing funds about the same size, and spreading in over 50 countries.  For much of the past decade, this market has experienced a growth rate exceeding 15% p.a., outstripping that of the conventional banking industry.

The latest available official statistics on this market are as follows:

US$ Million

While the number of Islamic banks has increased by more than 76% between 1993 and 1997, their assets have increased by three folds.  The total deposits of Islamic banks are now valued at approximately US$ 150 million.  Deposits of the Islamic banks operating within the Gulf region do account for 10% of the total banking deposits.  In Kuwait, Islamic institutions have successfully managed to capture 20% of the domestic deposits market.

The Islamic banks’ consolidated net profit for 1996 stood at US$ 1.7 billion, a figure which excludes sizeable returns realized by Arab and western conventional banks that also invest in accordance with Islamic law.  This gave a return of 23% and 1.24% on capital and total assets in respective terms, which compares favourably with conventional banks.

Trade financing, which captured 32% of Islamic financing in 1997, continues to be the most popular sector due to the high volume of trade within countries of the region in addition to the relatively short term nature of this form of financing.  The real estate sector appears to be the sector gaining higher momentum and popularity.

The assets under the Islamic banks’ management are used in different ways.  While the bulk is still used in Murabaha (trade finance), which is attributed to the short tenor of the transaction, other activities are rapidly developing, such as Musharaka (equity participation).

BUSINESS LINES (PRODUCTS):

Although a whole range of Islamic products, that are comparable to those of the conventional banking system, is available, only few products have proved to be popular and are widely used by Islamic banks.  This can be attributed to the short term nature of deposits at the Islamic institutions in addition to some technical difficulties embodied into a number of Islamic modes of finance.  This in fact reflects very high potentials for the Islamic institutions that are capable of developing and structuring new Islamic banking products.

Some of the major Islamic products, available to Islamic institutions, can be outlined as follows:

³      Murabaha (mark up or cost plus financing).

³      Mudaraba (profit or loss sharing financing).

³      Musharaka (equity participation finance).

³      Ijara (leasing).

³      Istisna’.

³      Islamic funds.

³      Muqarada.

³      Commercial products (L/Cs, L/Gs, … etc.).

CLIENTS:

The potential client base for Islamic banking is any individual or institution, including corporates, with an interest in Islamic banking products.  High net worth individuals, who reside within the Gulf region and own approximately US$ 800 billion, do represent a targeted group of customers for the Islamic banks’ funds.  Retail clients, on the other hand, are gaining more magnitude and share of the Islamic banking customer base.  In all cases, some clients have a strong desire for Islamic banking products due to religious reasons, while others deal in such products for the purpose of diversifying their financial products and services and / or acquiring other indirect benefits; i.e., taxes … etc.

GEOGRAPHICAL DISTRIBUTION:

The Middle East and the Arabian Gulf region constitute more than two thirds of the Islamic banking market.  The assets growth rate of Islamic banks has outstripped that of the conventional counterparts during the 1990s in light of the booming demand for Islamic banking facilities, especially within the GCC states.

The client base of Islamic banks is not confined to Muslim countries alone, but is spread all over Europe, the Far East and the USA, evidenced by the geographical distribution of these institutions.

P.S.: Pakistan & Iran are included in the S. asia & M.E. groupings respectively.

ISLAMIC BANKS IN THE GCC:

The following section will cover Islamic banks in each country within the GCC market, their activities and the future prospects of the Islamic banking industry in this area.  This section has been incorporated since Islamic banks operating in the GCC region have currently the fastest growth rates among other financial institutions with the highest profitability ratios.

1)        Bahrain:

Islamic Banks:

Bahrain is rapidly developing into a major hub for Islamic banks in the region.  Within this context, Bahrain Monetary agency (BMA) has been encouraging finance houses to set up subsidiaries to undertake their non-conventional banking activities.  Accordingly, Bahrain currently plays host to 18 Islamic banks and financial institutions, of which two are commercial banks, while the rest are mainly investment banks.  Most of the banks are medium sized, capitalized at between US$ 70 – 200 million.

Gulf Finance House and Al Khaleej are the latest Islamic institutions being granted license to operate in Bahrain.  However, consolidation is expected in this sector as many of the working Islamic banks are small compartments, which need to merge in order to strengthen their lending capabilities and compete in a difficult and challenging environment.  An example of this is the emergence of the Shamil Bank of Bahrain, which emerged as the fruit of the union of Faysal Islamic Bank of Bahrain and Islamic Investment Company of the Gulf and is already in negotiations for a further merger with Bahrain Islamic Bank.

Going forward, and in an effort to strengthen Bahrain’s position as a major center for Islamic banks, BMA has been closely coordinating with major Islamic banks in the region, including Islamic Development Bank, to find convenient solutions to overcome the problems that are facing this industry and hampering its potentials for further development.  Islamic inter-bank money market, liquid tradable financial and short-term instruments, and unified accounting standards that are acceptable to different Sharia boards are some of the serious problems currently encountered by Islamic banks.  Accordingly, BMA, in collaboration with the Accounting & Auditing Organization for Islamic Financial Institutions, have been working to formulate new regulations for Islamic banks so that they may comfortably fit into the global financial system.

In addition, BMA is planning to start issuing Islamic government bonds and treasury bills that will be commodity backed, either by aluminum or oil.  The purpose of these bonds is to absorb Islamic banks’ surplus liquidity by developing active and liquid secondary market that will help Islamic banks manage their assets efficiently on one hand, and meet the government requirements on the other.

Characteristics:

Islamic banks in Bahrain can be divided into local banks, subsidiaries of foreign or regional banks, and specialized divisions within offshore foreign banks.  They all focus on corporate finance and investment banking services in order to tap the deposits of high net worth individuals in addition to Islamic mutual funds.  First Islamic Investment Bank focuses on private equity deals in the USA, while others, like ABC Islamic & Citi Islamic investment Bank, concentrate on structured transactions and project finance deals.  The money, raised by the last group of banks through their Islamic funds, is usually channeled to large investment groups, which manage this money on the banks’ behalf. 

Surprisingly, retail banking, which usually provides attractive returns has not been tapped by many Islamic banks.  This could be attributed to the youthful nature of the Bahraini population, whose financing needs have been met by the various kinds of loans offered by conventional banks.  However, there is a plenty of room for this business to prosper if proper marketing and promotion strategies could be formulated.

Major Players:

ABC Islamic, Citi Islamic Investment Bank, Al Baraka Holding Co., Shamil Bank (outcome of the merger between Faysal Islamic Bank of Bahrain & Islamic Investment Co. of the Gulf) and Bahrain Islamic Bank.  United Bank of Kuwait (UBK) has extended its Islamic Investment Unit in UK and establish an Islamic joint venture enterprise early 2001 in Bahrain.

2)        Kuwait:

Islamic Banks:

The prominent players in the Islamic field in Kuwait can be narrowed to include two names only: Kuwait Finance House (KFH) and The International Investor (TII).  Both names are large and well established in terms of human and financial resources, and do control a major share of the local market.  Also, KFH & TII have both extended their presence to neighboring markets by establishing various subsidiaries in Bahrain, Qatar and UAE, whereas TII has extended its presence further to Switzerland. The two players are active in retail banking as well as regional structured transactions and funds.

Characteristics:

KFH & TII have been regarded as two of the most innovative wholesale and investment banks in the region.  KFH provides a full spectrum of retail products ranging from car loans with different schemes to more complex mutual funds with various integrated instruments.  Additionally, KFH is an active player in the syndicated market and has helped in raising funds for various corporate borrowers in the region.

TII is considered more advanced than KFH in the fields of structured finance and advisory services.  Within this context, TII is responsible for restructuring the diverse banking activities of Dallah al Baraka group.  Besides, TII has been one of the only two institutions in the world to launch an Islamic equity index.  Arab Bank, as a new venturer into this market, can liaise with either KFH or TII in introducing any of the Islamic products and/or benefit from their experience.

Major Players: KFH & TII

3)        Oman:

Islamic Banks:

Practically speaking, Islamic banking institutions do not exist in Oman.  All previous Islamic deals that were undertaken within the Omani market were mainly initiated by Citi Islamic Investment Bank.

Islamic products do have a market in Oman and can be marketed with relative ease to both individual and corporate customers, whom we should concentrate on through Arab Bank Oman.  The consumer market, on the other hand, is saturated and faces fierce competition, and therefore should be avoided.

4)        Qatar:

Islamic Banks:

The Islamic banking system in Qatar is represented by Qatar Int’l Islamic Bank (QIIB) and Qatar Islamic Bank (QIB).  It is believed that these two banks are not well developed when compared to their peers in other GCC states as most of their assets are held in trade financing (Morabaha), government investments or its various local entities as well as in real estate. 

Both banks are minor players in the regional Islamic banking industry and their names are rarely heard in syndicated Islamic transactions.  The idea of introducing Arab Bank in the local market of Qatar for the purpose of providing Islamic products needs careful and thorough evaluation of the legal system, related regulations, and the size of the market.

5)  Saudi Arabia:

Islamic banks:

Islamic banks in Saudi Arabia can be categorized into the following: Islamic banks with commercial banking Iicensing like Al Rajhi; Islamic banks that are owned by several governments like Islamic Development Bank (IDB); and Islamic banks that conduct their activities with no formal existence like Faisal Islamic Bank.

Saudi Arabia is the largest as well as the wealthiest Islamic country in the Middle East. According to estimates, there are 200,000 high net worth individuals in the GCC who own about US$ 800 billion of liquid assets, of which Saudi Arabia’s share is US$ 500 billion.  Based on this, Islamic products are smoothly marketed in the wealthy kingdom.

Local banks have established specialized Islamic divisions to meet the accelerating demand for and growth of Islamic products market.  These divisions have succeeded in introducing many mutual funds and using new techniques and instruments in reducing investment risks to investors.  Some of the innovative tools were the launching of capital guaranteed funds Launched by National Commercial Bank and Life Insurance funds by Bank Al Jazira.

Moreover, the Islamic divisions of local banks have strated to concentrate their efforts and resources on Islamic retail products that are gaining momentum in the local market; i.e., car loans and real estate loans. Investment bankers also found a great potentiality in routing many of their funds to Saudi citizens, and eventually channeling money raised into the global financial system .

Offshore banks, especially in Bahrain, have successfully managed to get a good slice of the cake by pooling for Islamic banks’ excess liquidity at a cost lower than those predominant within the money markets through Murabaha transactions.  Foreign banks as well have secured a place for themselves in this giant market by either structuring a fund and/or dealing for local banks or investing directly in the domestic market.  In summary, the Saudi market is quite big allowing for easy absorbtion of all the possible products and services launched.

Characteristics:

Due to the huge size of the Saudi market, the wealth of its people and the complexity of its banking system as well as its legal framework, no specific features can be linked to Islamic banks or those investing in their products.  Nonetheless, the growth and complexity of the market are accelerating rapidly allowing for the introduction of products that were unacceptable in the past.

The growing number of market players and the sophistication of products offered are indicative of the increasing appetite for Islamic banking.  The Saudi market is too big to ignore or overlook and there exist very high potentials in this market.

Major Players: Al Rajhi, IDB, National Commercial Bank, Saudi American Bank.

5)        United Arab Emirates:

Islamic Banks :

Abu Dhabi Islamic bank (ADIB) is head quartered in the emirate of Abu Dhabi, the capital and the wealthiest emirate among the UAE.  Dubai Islamic bank (DIB), on the other hand, is stationed in the trading center of UAE,Dubai.  The problems faced by DIB have negatively influenced the growth of the Islamic banking in the country as a whole and paved the way for foreign banks to step in and take hold of the existing opportunities.  The practice of Islamic banking in the UAE took advantage of the advanced foreign banks as ADIB & DIB are considered relatively small to their rivals in terms of experience and products range.

However, faced with the new competition, both ADIB & DIB have started to move in a different direction and focus on their activities. DIB  is upgrading its IT system and planning to offer internet services to its customers to enable them monitor their investments.  ADIB, which is more active than DIB in syndicated transactions particularly for Gulf borrowers, is now cooperating with DIB in setting up two insurance and real estate subsidiaries.

In addition, the bank is planning for future expansion, with targeted markets in India and other Gulf states.  Both ADIB and DIB are expected to play a greater role in the local market and control a higher share of domestic deposits and broaden the range of the Islamic products and instruments available to investors.

Characteristics :

The focus of Islamic banking in the UAE has been on trade finance, which is clearly demonstrated in the case of DIB, whose activities are mainly concentrated on Murabaha contracts.  ADIB, on the other hand, has been trying to build long-term assets in its balance sheet by participating in various Islamic syndicated transactions, especially for the GCC region.

However, efforts ADIB are constrained by small size of transactions and the limited number of Islamic syndicated transactions available. Both banks (ADIB & DIB) are rich in cash and highly liquid, whereas the basic channel for this excess liquidity is Murabaha, where returns are not highly attractive. 

Major Players: DIB, ADIB and foreign banks.

Ranking of Islamic Banks in the GCC:

Middle East Economic Digest (MEED) has recently published a ranking of banks in the GCC.  The following listing shows the ranking (by assets) of Islamic banks among the top 65 GCC banks:

US$ Million

CRITICAL SUCCESS FACTORS:

³      Ability to develop / structure genuine Islamic products.

³      Build strategic alliances (with users of funds outside the Arab World).

³      Focus on Investment Banking in the wholesale business and on Commercial Banking in the retail business.

³      Hire skilled and experienced staff since Islamic banking, in particular, is more sophisticated than conventional banking as it combines commercial and investment banking.  This puts more pressure on Islamic banks to have staff with better skills, competency and experience.

³      Sophisticated banking services and products require certain types of infrastructure, all of which require financial resources, which perhaps, are beyond the means of smaller entities.

³      Deep and thorough knowledge of the business.

CONCLUSION:

The Islamic banking industry is most definitely on the path of high growth, evidenced by the healthy growth rate of 15% p.a.  This occurrence has resulted due to the increasing demand for Islamic finance across all market segments, which include retail, high net worth individuals, corporate, industrial, institutional, and government entities.

Observers predict that the Islamic banking market will account for at least 50% of the total savings of Muslims by the end of this decade.  On the other hand, Islamic bankers, keeping pace with sophisticated techniques and latest developments, have evolved investment instruments that are not only profitable but re also ethically motivated.

In essence, major banks seeking opportunities in the Muslim world cannot afford to ignore or overlook this growing and lucrative market.  And if we are keen to be a major player serving the Arab people, Islamic banking should be vigorously ventured in light of the following:

³      It would be a valuable source of low-cost deposits.

³      It also goes well with other businesses, such as trade finance, project finance and assets management.