Businessweek : Islamic Finance Comes of Age

Islamic Finance Comes of Age

Amid rapid growth, Sharia-compliant banks are looking to expand beyond their traditional markets

From Standard & Poor's RatingsDirect

After more than three decades of modern Islamic finance, the industry's build-up continues at a rapid pace. Double-digit growth rates for assets compliant with Sharia—Islamic law based on the Koran—over the past decade, have naturally driven Islamic financiers to look beyond historical boundaries to explore new territories, both within and outside the Arab world.
In response to the increasing competitive pressure stemming from the entrance of new players into the market, existing Islamic banks have started to leverage their natural competitive advantages, which include customer loyalty, sensitivity to religious practices, and a stable base of cheap deposits.

POTENTIAL MARKET

Even conventional banks have moved to open Islamic branches, create Sharia-compliant subsidiaries, or undergo complete conversions to become fully Sharia compliant. The retail market, the key profit driver of banking in the Gulf, is attracted by what Islamic banking can offer.
The size of global Sharia-compliant assets is estimated today at up to $400 billion, whereas Standard & Poor's Ratings Services believes the potential market for Islamic financial services to be closer to $4 trillion, meaning that Islamic finance currently has only a 10% market share among the Muslim community globally and still has a long way to go.
Islamic banks in the Gulf have displayed, and should continue to show, strong profitability, so long as oil revenues pour into the Gulf economies, maintaining economic momentum through a powerful multiplier effect. It is important, however, that the Islamic banking industry does not become complacent.

GROWTH IN COMPLIANT NOTES

A number of issues must be tackled, among which size and concentration risks are two of the most important. And the realization of a common conceptual framework that unites the approaches of the two historical centers of Islamic banking—the Gulf and Southeast Asia—would go a long way to enabling the Islamic banking industry to expand and diversify.
The market for Sharia-compliant notes, also known as sukuks, is set to expand rapidly. Standard & Poor's currently rates more than $5 billion of the $10 billion market for listed sukuk, which is expected to grow to more than $20 billion by the end of the decade. In the Gulf, investing in sukuk has become part of mainstream asset allocation and diversification, with Islamic banks in particular seeing these instruments as an important tool in managing their assets and liabilities, and recycling liquidity.
Islamic finance is currently being expanded beyond its historical borders of the Gulf region, where it began to emerge domestically in the 1970s as a result of the oil boom. Other Arab and non-Arab Muslim countries, particularly in Asia, are increasingly attracted by the principles of Islamic finance.

NEW HORIZONS

For the first time in the industry's history, several Islamic banks headquartered in the Gulf have recently set up business operations in Malaysia, while making clear that on their radar screens are Indonesia and China—large and deep markets only a short hop away from the Malaysian platform.
New horizons are also emerging for Islamic finance within the Arab universe: Lebanon, Syria, Egypt, Turkey, and, to a lesser extent, North Africa, have been identified as potential engines for unlocking franchise value.
Beyond the natural borders of the Muslim world, the advanced markets of both Europe and the U.S. promise niche segments in which Islamic finance can profitably gain momentum, as shown by the financial community's bullish welcoming of both the Islamic Bank of Britain and its investment banking counterpart, the European Islamic Investment Bank. This is internationalization, but not yet globalization, to which some challenges remain.

BUSINESS MODEL SHAKE-UP

The current market positions of existing Islamic banks are subject to significant competitive pressure. Although "historical" Islamic financial institutions—such as Al Rajhi Bank (S&P credit rating, A), Kuwait Finance House (A-), Albaraka Banking Group (not rated), and Dubai Islamic Bank (A)—still have bright prospects within their own marketplaces, new entrants are looming.
Sharia-compliant investment banks such as Gulf Finance House (BBB-), Arcapita Bank (not rated), and Unicorn Investment Bank (not rated), are shaking the old rules of Islamic finance with more aggressive (and so far, very successful) business models.
Plus, new heavyweight contenders are making their debuts, pushed by the proactive ambitions of Gulf entrepreneurs and governments: Al Rayyan Bank, Al Masref, Boubyan Bank, and Bank Albilad are examples of institutions that could reshape the entire industry, given the relatively large size of their capital bases, by regional standards, and very focused strategies.

THE RADICAL APPROACH

Even deeply entrenched conventional financial institutions have found it relevant, if not necessary, to make inroads into the promising territory of Islamic finance, although strategic approaches vary. Some have opted for the route of opening Islamic branches (particularly in Saudi Arabia and Qatar), some for creating fully fledged Sharia-compliant subsidiaries (like Emirates Bank International (A) and Mashreqbank (BBBpi), and others) for complete conversion to Sharia compliancy.
This last alternative—taken up by Sharjah Islamic Bank (BBB), Kuwait Real Estate Bank (not rated), Emirates Islamic Bank (not rated), and Dubai Bank (not rated)—is the most radical, and has so far been the strategy of choice for smaller entities that have found themselves with their backs against the wall and faced with the alternatives of merge, specialize, or disappear. While the first option is obviously difficult, the second, specialization, is a challenging opportunity.
The Islamic identity tends to provide a bank with an immediate and true element of differentiation, which helps in building barriers to entry at a time when domestic, regional, and foreign competition in the Gulf is becoming more intense by the day.

LONG JOURNEY AHEAD

It is difficult for a conventional competitor to replicate the natural reputation an Islamic financial institution has with retail clients, who are far more sensitive to religious considerations than are corporations, which care more about service and price. This intangible but powerful asset bodes extremely well, as the key profit driver of Gulf banking today is the retail market, which displays the most attractive risk-return trade-off.
Islamic banks should not rest on their laurels, however, as they still have a long journey ahead to build stronger recognition, longer track records, and greater scale. Otherwise, they run the risk of being ghettoized amid increasingly globalized financial markets, at the expense of 30 years of progress. To keep on track, they must tackle certain issues.
Size is a serious a matter as are concentration risks. Even the largest Islamic banks remain small by international standards, and their portfolios continue to focus on a limited number of asset classes and market segments.

IMPROVEMENT WITH INTERACTION

Consolidation within the Islamic finance industry does not seem to be on the horizon, while the two historical centers of Islamic banking—the Gulf and Southeast Asia—have just started actively talking to each other. Intellectual competition and differing interpretations of the fundamental rules of Islamic finance have so far kept these two universes apart.
Greater interaction between them could eventually contribute to the emergence of a common conceptual framework for Islamic finance. This in turn could translate into improved accounting, governance, transparency, and management practices at Islamic banks—the sine qua non for their global aspirations.
Institutions such as the Accounting & Auditing Organization for Islamic Financial Institutions (AAOIFI), the Islamic Financial Services Board (IFSB), and the Islamic Development Bank (IDB; AAA/Stable/A-1+) would certainly be instrumental in achieving these goals. Ultimately, however, the marketplace itself, including all stakeholders of the Islamic banking community, should take responsibility for the sustainability of a business model that is about to come of age.
Standard & Poor's ratings analysts Anouar Hassoune and Emmanuel Volland contributed to this report

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