Islamic finance 2006: Local markets make it to the mainstream


Kate Luxford
Published on:

Euromoney reports on the innovations driving the market forward, and profiles the winners of latest Islamic finance awards.

Sukuk market breaks new ground             

The Islamic finance industry has witnessed phenomenal growth in recent years, and as long as institutions keep coming up with sound new products, there’s no end in sight for strong growth rates.              

Best Islamic bank in the Middle EastBest Islamic bank in Asia
Best sukuk houseOutstanding contribution to Islamic finance
Best general takaful providerBest life takaful provider
Best Islamic project finance houseBest Islamic private equity house
Best Islamic real estate finance houseBest Islamic advisory services
Best Islamic legal advisorMost innovative Islamic finance house
Islamic finance product of the yearIslamic finance deal of the year
Most improved bank in Islamic finance

Financial markets have always demonstrated an uncanny ability to take external factors as a cue for innovation and growth. Islamic finance, which has developed at a remarkable pace over the past five years, is no exception.

According to Badlisyah Abdul Ghani, CEO of Malaysian bank CIMB Islamic, which wins Euromoney’s 2006 award for best Islamic bank in Asia, this is because Muslims are refocusing on their local markets in the aftermath of the World Trade Center attacks and a resurgence of the Islamic faith. “We have seen a desire by a lot of Muslims to invest their wealth in shariah-compliant activities, particularly after 9/11 and the Gulf War. There’s a realization that they need to be investing in their own countries and in a shariah-compliant manner,” he says.

Geert Bossuyt, head of retail Islamic finance structuring at Deutsche Bank, winner of most innovative bank in Islamic finance and most improved bank in Islamic finance, adds that when Muslims invest locally, they are more likely to invest in a shariah-compliant manner than if they are investing offshore.

Looking at the Gulf specifically, Rahail Ali of Denton Wilde Sapte, Euromoney’s best Islamic legal advisor, notes: “The Gulf has been an absolute boom area for financing in all its forms.” Growth has been driven by high oil prices, huge amounts of liquidity, strong growth in construction and the associated liberalization of the real estate sector, and the encouragement by governments of Islamic finance as a means of retaining liquidity locally. Bossuyt agrees, pointing out that the industry’s growth, “goes hand in hand with a boom in local real estate and equity markets,” in which more money has being made locally and reinvested locally. A final factor, according to Badlisyah, is a greater awareness of Islamic financial products and services as they become more mainstream.

Indeed, the demand for Islamic financial products has been across the board: at retail and corporate banking levels; in project finance and real estate; from individual investors; and from governments looking to raise massive sums for project financing.

In such a booming market, Bossuyt argues: “The limitations to the shariah-compliant market are not on the demand side, but on the supply side.” There are shortages not only in products but also in skilled shariah advisers. Ali warns: “There is a significant shortage of shariah scholars in relation to the volume of transactions, and they’re absolutely inundated with work.” For now, the most eminent scholars sit on a number of institutions’ boards, which allows multiple institutions to sign off on new techniques at the same time. However, younger faces need to come through the ranks and gain the requisite experience. This challenge needs to be addressed, Ali argues, if new techniques and products are going to be approved in the longer term.


According to Asad Zafar, managing director of HSBC Amanah (Euromoney’s winner of best Islamic project finance house and best general Takaful provider), another challenge is to increase shariah standardization between the two biggest markets, the Gulf and southeast Asia. Ali notes that although the waraq technique (which uses commodities to engineer financing for a borrower that does not have an underlying asset to trade) is acceptable in Malaysia, “it doesn’t wash in the Gulf region”. It presents a possible reputational risk, because many see it as a prohibited transaction. So differences between what is acceptable in Asia and the Middle East are yet to be smoothed out. Despite this, Zafar says that there is already agreement on more than 95% of shariah issues.

“The limitations to the shariah-compliant market are not on the demand side, but on the supply side”
Geert Bossuyt, Deutsche Bank
Ultimately, the greatest challenge for Islamic finance concerns the shortage of shariah-compliant products. Mounzer Nasr of Arcapita, winner of the 2006 award for best Islamic private equity house, argues: “There is still a severe shortage of products for shariah-compliant investors, and that’s not going to change quickly.”

One way in which banks have been addressing clients’ demand has been by creating new products that replicate conventional ones. Deutsche Bank’s mission statement declares that clients have a right to expect “the quality of the product and service at a level equal to the conventional market.” In theory, says Bossuyt, they can structure almost everything in a shariah-compliant manner. The only limitations are reputational (whereby a deal might be possible involving something that is popularly deemed un-Islamic and, therefore, would not attract clients) and uncertainty (whereby the transaction must not be a zero-sum game, such as gambling).   

There is debate, however, as to whether it is enough simply to replicate existing conventional products. Although Badlisyah agrees that such replication is possible, he remains sceptical: when CIMB came up with its concept of Islamic profit rate swap (Euromoney’s Islamic finance product of the year), he says, “the intention was to be able to mitigate the risk involved in doing Islamic finance. Whether we come up with a product from scratch or replicate a conventional product, as long as we mitigate the risks it’s acceptable.” He adds that there is a drive in Malaysia to come up with new ideas that are not based on conventional products and that would allow, “innovations in Islamic finance to be followed by conventional bankers.”

Ali also argues against Islamic finance seeking solely to replicate conventional transactions. “Islamic finance is not equipped to do that,” he says, adding that the long-term goal should be “to come to true risk-reward financing structures”, of which Musharaka or partnerships are the purest form. “This has to be the ultimate goal,” he says. “Then Islamic finance will be qualitatively different from conventional finance.”

Cutting costs

Beyond innovation, Islamic financial institutions have been working towards increasing their competitiveness via conventional institutions. “The challenge is that in a competitive situation, European sellers and lenders would prefer a conventional structure in place of a more complicated and less familiar Islamic structure,” says Nasr.

Cost is also a factor. He notes: “Deal costs can be higher because finding shariah-compliant structures that work in different jurisdictions requires significant investment, as well as structuring skill and experience. On the other hand, this skill and experience constitutes a competitive barrier to entry that helps Arcapita maintain its leadership position in the under-served Islamic private equity market.” Furthermore, as Islamic deals increase in number, familiarity increases and costs fall: previously used and proven structures can be applied to new situations.

While conceding that shariah-compliant transactions are more expensive because of additional restraints such as the need to transfer an underlying asset, Bossuyt says that such costs are minor on a big transaction and should not disadvantage Islamic financial institutions. “Our mission is to bring the products at the same price,” he says, which may involve cutting margins relative to conventional transactions. In a similar vein, HSBC’s Zafar confirms: “We’re not pricing Islamic packages to be more expensive than conventional packages.”

Badlisyah also questions the assumption that Islamic deals necessarily cost more: “The costs of doing Islamic transactions in Malaysia are the same as conventional transactions. The volume means that you can’t charge a premium”, because an existing structure is being replicated. The idea that Islamic finance is inherently more complicated and, therefore, costly is a myth fostered by advisors wanting to charge more for their work, in his view. “My experience is that the parties involved in transactions sometimes take advantage of the perceived complications of something that’s new, and they try to push up the price of their services,” he says.

Ali is also keen to dismiss perceptions of complication, noting that Denton Wilde Sapte, “is conscious of the need to simplify documentation and put it in plain English.”

The secret of success?

While business may be booming, Islamic financial institutions clearly have work to do: product innovation is vital to meeting strong demand, yet banks also need to increase the volume of transactions in order to create industry standards and cut both costs and the perception of Islamic finance as inherently complicated.

Badlisyah sees success in Islamic finance as the result of a number of factors: “The ability to be innovative; the ability to act fast to meet the changing needs of clients; the ability of banks to retain skilled staff because there are not enough Islamic bankers; and the ability of banks to manage costs in light of competition from global banks that have economies of scale.” CIMB Islamic has relied on making use of the existing infrastructure of the larger CIMB group to keep its costs under control. It has also worked hard to retain its workforce, despite outside attempts to poach employees.

For HSBC Amanah, Zafar argues that the key to success, among others, is “our global reach and our global expertise”. However, the bank also boasts the ability to deal with local issues, particularly on the legal front, having done deals almost everywhere. On Deutsche Bank’s part, Bossuyt identifies two clear strengths. The first is financial expertise: “Local people [in the Islamic world] know a lot about shariah, but may lack financial expertise... so you need to start with experts in conventional finance.” It is on this basis that the bank has built its knowledge of shariah-compliant finance. He adds: “Deutsche Bank has been able to establish excellent relations with shariah scholars.”

Future growth assured

While some banks have done better than others, there appears to be more than enough business to go around. Bossuyt observes that the standard belief is that the market will continue to grow at about 15% to 20%, with the main constraint being supply. This is based on the assumption that 20% of the market wants only Islamic banking products; 20% wants only conventional products; and 60% is undecided. However, he believes these predictions are underestimates, arguing that as more types of transactions become possible, and Islamic and conventional banking become equal in terms of quality and cost, more conventional clients will decide to bank Islamically. In fact, he believes: “The conventional market and the shariah-compliant market will grow into each other.”

Ali also challenges predictions of 15% growth, arguing that for the next two years, at least, growth of 30% or more is likely. A major cause will be the entrance of new players into the market, he says, bringing with them “significant skills and expertise, which will augur well” for the industry. Zafar agrees. “Larger conventional financial organizations operating in the Middle East and southeast Asia see that it’s possible to get into Islamic finance,” he says. These new entrants will help push up overall growth rates.

To some, this may seem counter-intuitive: shouldn’t new entrants mean increased competition for the existing players? No, says Aref Kooheji, DIB’s executive vice-president of investment and corporate banking, because local and international banks can work together to do more business. Local banks have natural talents for sourcing and structuring sukuk, but international banks bring international distribution networks. Gulf and Asian banks are also able to participate in deals sourced by international banks in Europe, where they tend not to have good networks.

Thus, concludes Kooheji: “It’s not competition but complementary.” He adds that there will also be more business for Islamic banks to go after. The Gulf region alone is expected to witness around $200 billion worth of projects in the next five years that will need a range of financing solutions.

“My experience is that the parties involved in transactions sometimes take advantage of the perceived complications of something that’s new, and they try and push up the price of their services”
Badlisyah Abdul Ghani, CIMB Islamic
Beyond growth in the rate of transactions, Bossuyt notes that the Muslim community is itself growing at a remarkable rate: Islam is the fastest-growing religion in the world. It has a high proportion of young people within the overall population and the wealth of the community is growing fast. Thus the future of Islamic finance looks bright, “if you combine these demographics with favourable market conditions,” he says.

In such conditions, will there be a trend towards Islamic finance as the mainstream in existing markets? In terms of project financing, Kooheji believes so. “A few years ago, Islamic financing was the second choice as a tranche of the deal. Today, if the deal isn’t done 50/50 [conventional/Islamic], then Islamic is the first choice.” Project owners realize that if the deal is conventional, then Islamic banks will not be able to participate; if it’s done in a shariah-compliant manner, however, the deal attracts wider participation, which means lower costs.

Wider world

Banks that offer both conventional and Islamic products and services may have some big decisions ahead of them. Bossuyt notes that Deutsche Bank has discussed the possibility of offering only shariah-compliant products in the region, if it can offer them at the same price and quality as conventional products. “For people who care about banking Islamically, then they have what they want. For those who don’t care, it doesn’t matter”, Bossuyet says, because the same products will be available, at the same cost, but in a shariah-compliant manner.

“There is a realization that [shariah-compliant] products are being demanded in the Gulf region,” says Zafar of HSBC. Such a realization has also occurred at Saudi Arabia’s National Commercial Bank, which has spurred into converting to shariah-compliance in all its operations. Such developments in Saudi Arabia will undoubtedly affect the Gulf region as a whole and the wider world of Islamic finance.

RankManagerAmount $mIssues% share
1Dubai Islamic Bank2800.00149.91
3HSBC Amanah433.6627.73
4=Alliance Merchant Bank Bhd192.9813.44
4=RHB Sakura Merchant Bhd192.9813.44
6=Atlas Investment Group100.0011.78
6=Emirates Financial Services100.0011.78
7=Muthanna Investment Company33.3310.59
7=Kuwait Finance House33.3310.59
7=Liquidity Management Centre33.3310.59
RankManagerAmount $mIssues% share
2HSBC Amanah1304.591013.41
3AmMerchant Bank Berhad883.76109.09
5RHB Sakura Merchant Bhd442.3134.55
6Dubai Islamic Bank383.3323.94
8Standard Bank270.0022.78
9Bank Muamalat267.5542.75
10Deutsche Bank250.0012.57
Source: IFIS


Best Islamic bank in the Middle EastBest Islamic bank in AsiaBest sukuk house
Outstanding contribution to Islamic financeBest general takaful providerBest life takaful provider
Best Islamic project finance houseBest Islamic private equity houseBest Islamic real estate finance house
Best Islamic advisory servicesBest Islamic legal advisorMost innovative Islamic finance house
Islamic finance product of the yearIslamic finance deal of the yearMost improved bank in Islamic finance