Key concepts in Islamic banking
The rapidly developing Islamic banking sector was stunned by the recent revelation that one of its oldest and most respected commercial institutions, Dubai Islamic Bank, had run into what was described officially as “financial difficulties”. The bank only survived because of a capital injection by the central bank of the United Arab Emirates (UAE) and the emirate of Dubai.
The authorities are tight-lipped about the cause and scale of the bank’s difficulties. But the Gulf was immediately awash with unconfirmed rumours of fraud, that the losses totalled more than $50 million and the problem had been caused by the actions of one or two figures in Dubai Islamic Bank. There was an immediate run on the bank as depositors started to withdraw deposits. A nervous 24 hours passed before calm returned and it became clear the bank would not fail.
The shock was all the greater because Dubai Islamic Bank, which was set up in 1975, was seen as one of the most conservatively run of the Islamic institutions. It was also regarded as being up to international accounting standards: Ernst & Young had signed off the 1997 accounts earlier this year. Nor had there been any question marks about a bank which, with assets of more than $2 million at the end of last year, was the third largest Islamic commercial bank in the Gulf and one of the leading banks of all types in the UAE.
It was a measure of the embarrassment felt by Islamic bankers in the region that some were hoping the loss had been caused by fraud. “If it was malpractice by one or more individuals then it can be seen as the type of problem that all banks are vulnerable to and from which several have suffered all over the world in recent years,” says one Bahrain Islamic banker. “If the losses were caused by bad banking practice, there would inevitably have been questions about the credibility of Islamic banking.”
Samir Shaikh, secretary general of the Jeddah-based International Association of Islamic Banks, thinks the problems are a one-off. “For a short period we were concerned, mainly because there was a lack of real information about the real problems,” he says. “I have now been informed that the reason was the misbehaviour of a few people. As such we were relieved because that can happen in any bank.”
The consensus view is that the events have been more damaging to the reputation of the UAE regulatory authorities than to Islamic banking. Since his appointment in 1991, central bank governor Sultan bin Nasser al-Suwaidi has made considerable strides to re-establish the credibility of a shaky sector which has seen a series of bank mergers born from financial collapses. The central bank, which is a federal institution, has faced considerable delays in getting government approval for a new stricter banking act and has difficulty imposing its authority on individual emirates.
Although Dubai Islamic Bank is now officially “under control”, the episode has turned the focus on a growth area of banking in the region. Islamic banking is becoming increasingly popular with both retail and corporate customers and is described by one Gulf central banker as “the last frontier for further significant financial innovation”. The challenge now is to provide a proper regulatory framework and sufficiently qualified senior staff to ensure that the Islamic sector, which operates in a very different way to conventional banking, can develop in an orderly way.
According to Shaikh Ebrahim bin Khalifa al-Khalifa, chairman of the board of trustees at the Accounting and Auditing Organization for Islamic Financial Institutions, it “has developed into a multi-billion dollar industry. It is no longer an experiment but has become a significant segment of the international financial market. The impressive growth rates experienced by Islamic banking in recent years have brought about significant challenges as well as opportunities.”
The number of players in the sector is growing rapidly. There are now more than 200 Islamic banks. In addition, some multinational financial institutions, including Citibank and Arab Banking Corporation, are setting up subsidiaries. A raft of others, including Gulf International Bank and ANZ Grindlays, have set up specialist divisions.
Calculating the exact size of the Islamic sector is difficult. Pakistan, for example, defines all of its financial institutions as Islamic though western bankers say that many of the transactions are still effectively conventional banking. Saudi Arabia does not formally admit the distinction between conventional and Islamic banking. However, some such as National Commercial Bank have Islamic “windows” and Alrajhi Banking & Investment Corporation is acknowledged as operating in a mode that is not contrary to Shari’a law.
According to Samir Shaikh, Islamic banks “have a total capital of more than $7.3 billion, assets of more than $137 billion and deposits of more than $100 billion. The Middle East accounts for 56% of the capital, 49% of the assets and 54% of the deposits. It is also significant that 31% of Islamic financing goes into trading, 18% into industry, 13% to the service sector and 11% into property”.
A western banker comes up with a slightly different estimate. “There are now $70 billion to $80 billion invested in Islamic funds and that figure is growing by 12% a year,” he says. “Most business has been channelled at Turkey and Pakistan. Now there is a move away from these areas and a desire to spread the risk. There is a diversification towards the United States and the Asian republics. There was rapidly growing business in the Far East, particularly Malaysia although that has inevitably been hard hit by the crash there.”
On paper the period of fastest growth in Islamic banking came in the 1980s when the sector grew by 30% a year compared with an annual 5% to 7% in this decade. But the 1980s figures were distorted by the decisions in Sudan, Iran and Pakistan to move to an entirely Islamic system. In terms of services, the most dramatic change in approach has come in the past five years. Until recently, Islamic institutions were seen merely as a place for those with strong Islamic convictions to place their money. Now senior managers of Islamic banks believe they must compete on commercial grounds by offering a more cost-effective financial package to non-Islamic as well as Islamic customers.
“The idea is not to sell Islamic products to Moslems, it is to sell our products on the basis of their inherent advantages to Moslems and non-Moslems,” says Abdelhaq el Kafsi, executive director of ABC Islamic Bank, the Islamic banking arm of Arab Banking Corporation.
El Kafsi says that ABC is “focusing on structured and project finance, selling Islamic finance on the basis of the advantages they offer for the balance sheet. Most of the products can be done in such a way as they can appear off balance sheet. Also, as they are not interest based, this can be a benefit in a number of countries from a tax point of view”.
Great potential
Tahir Chaudhary, manager of Islamic finance at ANZ Grindlays in Bahrain is equally enthusiastic. “A few years ago very few people knew about these matters,” he says. “It was thought to be solely to do with religion and buyers and sellers had to be Islamic. Now many European-based companies doing business in the Middle East and the Islamic world are considering Islamic funding. Every day we get inquiries from them as to whether financing can be structured Islamically. The level of awareness has risen considerably. The potential is great.”
The activities of the Islamic banks tend to reflect the conditions of the country in which they are based. There are strong retail operations in Iran (though they have played comparatively little role in international markets) and Saudi Arabia. Alrajhi Bank has 350 branches in Saudi Arabia through which it delivers conventional banking services such as current accounts, credit cards, credit transfers and mortgages. “The difference is that any transaction has a formula for meeting the Shari’a requirements,” says Ibrahim al Ghofaily, the bank’s deputy general manager.
Alrajhi has led the financing of major projects in Saudi Arabia, including one of $1.3 billion to build 400 schools for the government. It has provided Islamic finance for the kingdom’s petrochemical and electricity companies. It is also establishing an Islamic sharing fund with Chase Manhattan. Investors can participate in the fund, which will finance long-term projects. “Each partner will share in the profit and loss,” says al Ghofaily.
In the more secular societies of northern Africa, Islamic banks compete on the quality of their products, not their religious acceptability. In Tunisia, Best Bank, a joint venture between Al Barakah Bank of Saudi Arabia and the Tunisian government, offers its products on the grounds that they are commercially more attractive.
“It is an extremely competitive form of finance for all the people we do business with,” says Mahfoudh Barouni, deputy general manager of Best, which has a capital base of $50 million and assets of $170 million.
In Kuwait, well-established institutions such as the Kuwait Finance House have been involved in substantial financing for the petroleum sector and Islamic finance institution the International Investor raised $500 million for Kuwait Airways to buy new jets. Its banks are also strong on real-estate investment. But there is concern that Islamic banking will not play a more significant role until new legislation has passed through the national assembly.
In the UAE the emphasis is on trade finance. Meanwhile, in Bahrain, which has enjoyed some success in marketing itself as the region’s Islamic financial centre because of its internationally respected regulatory system, there is a greater emphasis on investment banking. “Those customers who are looking for equity investment and fund management come to Bahrain”, says Mohammed Tariq, head of asset management and capital markets at Faysal Islamic Bank of Bahrain. “Here they can do seven-year financing. In contrast, in Saudi Arabia, they specialize in retail and trade finance.”
The competition in Bahrain is getting more intense with both of the two leading offshore banks, Gulf International Bank and Arab Banking Corporation, offering a range of services. At ABC, el Kafsi says: “We have succeeded by focusing on liquidity management. Until ABC devised an overnight scheme for a float and investment fund, there was nothing that was Shari’a compatible. We have only scratched the surface because there are a lot of liquid funds in the market that can still be tapped on an institutional basis. If we develop our size and asset base we can afford to market more aggressively.”
The most interesting struggle is likely to be between, on the one hand, local institutions and, on the other, the international banks, including HongkongBank, ABN Amro and Standard Chartered, which are making a new pitch for Islamic funds. “There is a gradual change as more Islamic institutions become aware of the opportunities. They are no longer looking at providing funding but they also want to take a senior role in the transactions”, says one western banker
Short-term schemes
Some of the best-placed western banks in Bahrain are those which have a successful track record. ANZ Grindlays has an Islamic finance unit which is part of its investment bank in Bahrain. It was set up in 1989 and has done “across-the-board financing” of $3 billion.
Banque Nationale de Paris has developed eight Islamic investment schemes, worth $1 billion, which it has marketed to institutions since the late 1980s. “In general, Islamic institutions require liquidity, which means they favour short-term schemes.” explains Jean-Christophe Durand, deputy general manager at BNP’s Bahrain office. “These transactions tend to have underlying commodities.”
One area that at least 15 banks have been examining is the equity market. With the exception of Saudi Arabia’s National Commercial Bank, whose large retail base has enabled it to raise $200 million for an equity fund, the others have raised only between $5 million and $15 million each, a figure one banker described as “disappointing”.
Part of the explanation may lie in the varying interpretations of Shari’a law by Islamic courts. Some experts say that there should be no investment in equities at all. Even those who approve equity holdings say stakes must only be in companies which are in accordance with Islamic precepts. “For example, you cannot invest in banking, alcohol or gambling,” says one banker. “You can invest in airlines which sell alcohol but should go through a cleansing of the profit. You must pay a comparable proportion to charity.”
Tariq accepts that equity participation contracts have not played a significant role in Islamic finance but he says it is his “fervent hope that as the system develops further, this situation could change”.
One factor which could be crucial in the competition for business is structure. There is a growing number of independently established Islamic banks, many set up in Bahrain by Saudi shareholders. “The advantage of doing this is that you can have clearly separate Islamic deposits and liabilities which is difficult for a unit,” says one banker. This also guarantees that the Islamic funds will remain separate from conventional funds.
Some of the largest banks, such as Citibank and ABC, operate subsidiaries which are wholly owned but run quite separately on Islamic lines. “The dilemma is whether you go for a full bank or a lower-capitalized subsidiary”, says Faysal Islamic Bank’s Tariq.
El Kafsi says that there is enough business to justify a separate operation. “The economics of the Islamic business in ABC have been successful to the point where it made sense to set up an Islamic bank,” he says. “The reason for this was not just this success but the market’s appetite for assets as well as liabilities. So we have a wholly owned subsidiary with a paid-up capital base of $42.5 million. We thought we could better serve the market by being a separate legal entity”.
In contrast Gulf International Bank has set up a division of the bank to carry out its Islamic operations. Its thinking appears to be that the division would have more authority and be better able to serve its clients if it was backed by the strength of the bank. Some bankers are also sceptical whether a separately capitalized subsidiary gives any real advantage over a specialist division.
The issue that all Islamic banks have to address is size. The reality is that many of the specialist institutions are extremely small and cannot remain serious players in the Islamic market as it continues to expand and attract large international banks. “Islamic banks have to realize that the world is changing and there is a trend towards globalization,” says one banker. “As international markets open up, they have to reach mutual understandings to merge or cooperate. The alternative is to be very small fry.”
They also have to take fundamental strategic decisions about the type of banks they wish to become. According to Samir Shaikh: “The areas of development might well be in specialization. In Africa it might be on particular industries like agriculture. In Asia, it might be more industrial and service sector while there might be a great focus on trade. I am sure we will see Islamic industrial and trade banks.”
Islamic finance may even have a role to play in underpinning the stability of the international economy. Faysal Islamic Bank’s Tariq argues that Islamic finance, such as secured debts in the form of leasing, could have reduced the impact of the south-east Asian slump or prevented it from happening at all. “Under an Islamic financing system, finance or investment will need to be targeted to the specific needs of an entity,” says Tariq. “For instance, financiers or investors will need to satisfy themselves as to the reliability of a project, their lease rentals or the return promised in the murabaha [cost-plus financing] deals. There is little scope for raising a variety of unsecured debts which may or may not be targeted to the specific needs of the borrower.”
He believes conventional financing lacks a corrective mechanism to stop companies borrowing beyond their means. In good times, it is too easy to raise and in bad times it costs so much that the risks are further increased. “Under Islamic finance these excesses will not occur,” says Tariq. “To be successful, investors and financiers have to exercise due diligence and careful monitoring of their investments. The key point is that the amount of total borrowing under a conventional system is several times more than would be possible under an Islamic system, because in the case of the latter, financing is to be directly linked to a specific economic project.”
But taking on world markets is a long-term ambition. Before then Islamic institutions have to define uniform and consistent accounting and auditing standards and ensure proper regulation. Many observers believe that the differences in interpretation are holding up the development of the sector and that standardization is desperately needed.
