THE HEADLINE OF an article on Islamic banking in the Washington Post late in October was sanguine. "Steady in shaky times," it read. Proponents of the industry were reportedly promoting Islamic banking as "a cure for the global financial meltdown". The sector was gaining new confidence, the article said.
Fast-forward three months and industry insiders are less sure of themselves. Even by the summer of last year, for example, it was clear that in 2008 the Islamic bond, or sukuk, market would have far smaller growth rates than the 100% or more enjoyed in previous years. In the end, $38 billion of sukuk were issued in 2008: around half the amount for 2007, according to Islamic Finance Information Service (Ifis).
One reason for this was specific to Islamic finance and related to a dispute among scholars. The result of the controversy was that at the beginning of the year, one of the industry’s foremost regulatory bodies, the Bahrain-based Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), reinforced its criteria for what it would regard as a Shariah-compliant sukuk. This reduced the possibility of using popular structures of so-called musharaka and mudarabah sukuk. Without the ability to insert a clause guaranteeing returns in such sukuk, bankers are making more use of ijara or lease-back sukuk. But this makes it more difficult for entities with fewer tangible assets to raise capital through sukuk.
But the general consensus in the industry is that a more important cause of the decline in sukuk issuance is the extent to which the global crisis in the conventional market is also crippling such centres of Islamic finance as the Middle East and Malaysia, and, in turn, Islamic finance itself. In previous years, the majority of the buyers of Middle Eastern sukuk (by far the biggest sukuk market) were conventional investors from outside the region.
Despite the drop-off in sukuk issuance, bankers say supply of Islamic finance products overall is still growing, powered by the loan market, although there are doubts over how long this trend will last. Ifis data show that in 2008 Islamic syndicated loan issuance more than doubled to $70 billion.
This greater emphasis on Islamic loans-based financing to corporates and projects means that the Shariah market continued to grow in the GCC and Malaysia last year, even as issuance volumes for conventional products fell. For example, across the sukuk, Islamic syndicated loan and Islamic project finance markets, issuance rose from $158 billion in 2007 to $185 billion in 2008, according to Ifis. That is a much smaller rise than in previous years but is much better than the decline in issuance in conventional products in the GCC and Malaysia. Debt capital markets and syndicated loan issuance fell by more than 40% last year to $77 billion from $136 billion in 2007, according to Dealogic.
In September, however, the Gulf investment boom in particular suddenly slowed, while equity and general debt activity in the region’s primary markets froze. Therefore, this year will probably see an even more dramatic fall in overall issuance from the Middle East and Malaysia. And this will cause more declines in Islamic issuance: not only in sukuk, but also in syndicated loans and project financing.
Confidence has evaporated in many hydrocarbon-exporting countries since the oil price collapsed from last summer’s peak. In the fourth quarter of 2008, Middle Eastern banks, previously havens from the global crisis, were hit by a triple whammy. Apart from the confidence lost to the oil-price crash, the fallout from the bankruptcy of Lehman Brothers blasted away what liquidity remained in the international market. Closer to home, meanwhile, speculative funds betting on revaluation of currencies pegged to the dollar such as the UAE dirham and the Saudi riyal fled in droves over the summer as it became abundantly clear that such moves were not going to take place. Gulf banks had used the local windfall to lend more. But after the speculative funds exited, inter-bank rates rocketed. Three-month inter-bank rates in the UAE in September were double those in April. The country was hit by an exodus of capital, as much as $70 billion in September, according to some estimates, as global funds retreated after losing their currency bets.
According to Qudeer Latif of law firm Clifford Chance, last year the vast majority of Islamic syndicated lending, project financing as well as sukuk, happened in the first three quarters. "Based on the current state of the markets, the volume of Islamic deals in 2009 is likely to be closer to those volumes seen in 2006/07," he says.
Islamic banks, the biggest of which are based in oil-exporting countries, are becoming more deeply integrated into the global and Gulf-wide crisis, even as demand for their services is growing. In any case, Islamic banks use the same central banks as conventional financial institutions, and there is no Shariah-compliant lender of last resort.
"We didn’t attempt to create an alternative market. We have tried to be a player in the existing market, on our own terms"
Many Islamic lease-type transactions involve the use of conventional debt to facilitate the Islamic structure, and project financing is a particular area in which Islamic finance partly depends on the conventional market for its growth. As in last year’s $1.76 billion Islamic syndicated loan to Saudi mining firm Ma’aden, Shariah-compliant funding of mega projects usually comes as a tranche in a package that is predominantly conventional. Islamic banks have neither the ability nor the will to take on such projects in their entirety.
With Islamic banks prohibited from investing in the kind of toxic assets that triggered the global downturn, they appeared up to about six months ago to have followed a less punishing path. They suffered none of the write-downs some of their conventional rivals had to take on such assets. But more worrying now is the extent to which some Islamic banks, especially in the Middle East, are more exposed than local conventional lenders to the downturn in equity markets, and above all in real estate.
Shariah restrictions and the kind of asset-backed finance Islamic scholars encourage at present breeds an inherently high exposure to real estate. Lending collateralized by equity as well as a decline in brokerage income thanks to the Gulf-wide stock-market crash has already weighed heavily on Islamic lenders.
But now, as the property bubble in Dubai bursts, Islamic banks’ reliance on direct and indirect real estate risk is coming to the fore. In the UAE, for example, precisely because of their Shariah restrictions, Islamic banks are exempted from the regulatory 20% maximum exposure to real estate to which conventional banks in the country must adhere. Indeed, the local property investment portfolio of Dubai Islamic Bank, one of the biggest Islamic banks, includes ownership of a local real estate developer as well as ownership of a market-leading mortgage company.
Some Islamic banks have been more conservative in taking property-related risk than others. Abu Dhabi Islamic Bank, for example, only began developing a more aggressive real-estate product portfolio last year.
Raj Madha, banking analyst at Egyptian investment bank EFG Hermes, says: "Many Islamic banks go through a phase when they move from simply focusing on religious constraints to becoming much more commercially focused and expanding their product portfolio into higher-risk areas, shifting from focusing on what they can’t do to expanding what they can do."
Late developers in this respect may now be rewarded. They could provide some support to their more adventurous rivals and to the industry as a whole. But the question is whether they will want to, and whether it would be prudent for them to do so when commodity, equity and real estate values are being subjected to such negative sentiment, and when global investors are keeping money only in the safest securities.
Around the world, governments, sometimes in desperate need of things that will ease a dire situation, are joining those who have put into practice a stated eagerness to encourage Islamic finance. French finance minister Christine Lagarde, for example, promised to make legal and regulatory amendments to help the industry in France. In Asia, meanwhile, the Monetary Authority of Singapore invited banks to help it issue Islamic debt, while the first Islamic sovereign bonds from Indonesia were launched in the domestic market in the summer, and Pakistan issued its first local-currency sukuk.
In 2008 there was a flowering of new or reinvigorated Islamic banks, especially in the Middle East, which helped to maintain the growth of the industry. Dubai’s Noor Islamic Bank started operations by becoming involved, for example, in the $1 billion dirham equivalent sukuk for Abu Dhabi developer Sorouh. In Saudi Arabia, Alinma Bank’s $2.8 billion IPO in April gave that start-up one of the largest market capitalizations of Islamic banks worldwide.
Still, with a tightened Shariah regulatory environment and finance everywhere in paralysis, if Islamic finance is to continue thriving it must be even more innovative in designing effective structures. Syndications have to extend beyond the public markets. Extra attention has to be paid to elements in the industry’s development, such as Islamic risk management and the creation of such products as profit rate swaps.
For now, the years of easy and rapid growth in Islamic banking are past. The hope is that the crisis might make this youthful industry better equipped and ready for bigger, more stable growth in the future.