When is a bond not a bond or, to be more specific, when is an Islamic bond (sukuk) not what everyone thinks it is?
It was a question in many investors’ minds in the summer of 2017 when UAE-based Dana Gas shocked the market with an announcement that a $700 million sukuk was no longer deemed to be Shariah-compliant and would be replaced by new debt with far lower yields.
At the time, investors had started to think they could treat sukuk just like a conventional bond but, as one investment adviser said at the time, the move by Dana had thrown that sense of comfort “up into the wind”. All of a sudden there was a new risk factor – religious approval – that simply did not exist with conventional debt. Some were scared off and a number of western pension funds were said to have stopped making any sukuk investments, concerned about their complexity.
A costly legal battle followed between Dana Gas and its investors, involving courts in the UAE and the UK, before a settlement was agreed in May 2018. Now industry figures insist there is nothing to be concerned about and the episode was simply a tale of a company unable or unwilling to pay its debts rather than something specific to Islamic finance. Certainly, it was no coincidence that, in May 2017, Dana Gas said it was facing cash flow problems.
“Reputationally, the industry in the Middle East took a short-term hit when the Dana Gas case first hit the headlines,” says Debashis Dey, a Dubai-based partner at White & Case. “However, as time went by, investors and the industry realized that the issue was not about Islamic finance but rather about whether a company – which could be any debtor, whether conventional or Islamic – was willing to pay its investors back.”
Such concerns do of course hit conventional institutions too, but it was still a shock to an industry that prides itself on being ethical, and no one can escape the fact that it was a Shariah-compliant instrument that Dana Gas attempted to use as leverage.
The episode was a setback for what has been one of the successes in the development of Islamic finance. According to the most recent Islamic Finance Development Report (IFDR) compiled by Thomson Reuters, sukuk is the second largest part of the Islamic finance industry, accounting for $426 billion of the industry’s total asset base of $2.4 trillion in 2017.
It is easily overshadowed by the Shariah-compliant banking sector, which has assets of $1.7 trillion, but is ahead of other areas such as Shariah-compliant funds ($110 billion) and insurance or takaful ($46 billion).
The development of the sukuk market did not happen overnight. Bashar Al Natoor, global head of Islamic finance at Fitch Ratings, worked at the Islamic Development Bank in 2003, when it issued the first Islamic bond backed by a pool of assets. (The five-year, fixed-rate $400 million Eurobond took Citigroup 22 months to arrange). He remembers a very different world to that of today.
“If you were talking to international investors and you said the word ‘sukuk’, you would just get questions,” he says. “Now you still have questions, but at least people understand the terminology.”
Building up trust and familiarity with novel financial products takes time, but that trust is fragile and the Dana Gas episode acted as a useful wake-up call for the industry, which has been trying to get its house in order since then.
“Just like any other emerging industry, Islamic finance has seen disputes and issues that have been resolved through negotiations or the legal system,” says Wasim Saifi, deputy chief executive, consumer banking and wealth management at Emirates Islamic Bank. “These incidents, however, have helped shape more robust policies and structures.”
Among recent initiatives, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) published a proposal on better sukuk governance in December.
“We believe this proposal can help minimize the risks of non-Shariah compliance after a transaction closes,” says Mohamed Damak, head of Islamic finance at S&P Global Ratings. “Standard Shariah requirements and legal documentation are the key to provide clarity for investors on the risks they are taking. This is still lacking.”
This goes to the heart of the difficulties with the Islamic finance industry, which has spent decades trying to develop workable standards everyone can agree on – a process that has taken place in the face of a fair amount of scepticism.
In the early days, Euromoney wondered how viable the idea of Shariah-compliant finance was, asking in April 1979 ‘Is an Islamic bank a contradiction in terms?’ That article examined some of the underlying religious principles – such as a prohibition on interest (riba) – before concluding: “Western financial institutions and methods now seem so firmly entrenched that they appear to be under little threat from this competition.”
Islamic finance has gone from being an exotic niche product to something considered throughout parts of Asia and the Middle East as a fairly normal way of financing- Debashis Dey, White & Case
Despite some of the scandals along the way – which have included a multi-million dollar fraud at Dubai Islamic Bank (DIB) in the late 1990s and a default by Kuwait’s Investment Dar on a $100 million sukuk in 2009 – the intervening years have not been kind to the conclusion of that 1979 article. Islamic banks are now the dominant form of banking in markets such as Saudi Arabia and, according to the IFDR, there are 1,389 Islamic finance institutions around the world.
The scale of today’s industry and the fact it has managed to carve out a sizeable niche for itself, is certainly a notable achievement.
“When you now look at the banking and finance landscape in the UAE and the wider region, people talk about Islamic banks and windows just as much as they may discuss conventional banks,” says Qasim Aslam, head of Islamic finance at law firm Dentons, which has been active in the UAE since the country’s earliest days.
“One may deploy an Islamic structure to a proposed financing as easily as one would consider using a conventional approach,” he says. “Parties might even use a mix of Islamic and conventional liquidity in the same transaction.”
Yet the industry has not entirely shaken off the doubters, and many of the problems that fuelled scepticism in the early years have still only been partially addressed.
est in Shariah products to launch their own” – but in general there remains a shortage of investable assets.
In a December 1982 profile of Dar al-Maal al-Islami – one of several Islamic finance institutions set up by Saudi Arabia’s pioneering prince Mohammed Al-Faisal Al-Saud – Euromoney pointed to a number of challenges. Beyond the ban on interest, these included the fact that some scholars also frowned on dealings in gold and other precious metals and Islamic banks had difficulty finding places to invest.
In addition, there was no real market in Islamic institutions’ shares: “So if any investor has second thoughts, there is not a great deal that can be done.”
Despite the difficulties, Antoine Zananiri, then secretary general of London’s Arab Bankers Association, told Euromoney at the time: “Islamic banking will be around for a long time.”
Some officials were still dubious however. A couple of years later Al Rajhi Bank was granted a banking licence by the Saudi Arabian Monetary Authority (Sama), becoming that country’s first licensed Islamic bank.
“Sama, which is reputedly doubtful about the widespread implementation of Islamic banking, nevertheless permitted Al Rajhi to go ahead,” Euromoney reported in ‘The first licensed Islamic bank’ in November 1984.
Al Rajhi is now the largest Islamic bank in the world, with assets of SR356 billion ($95 billion) as of September 2018.
The growth of the Saudi market has been the most important development for the industry in the Middle East, but similar trends are visible across the Gulf.
“In mid 2018, Islamic banking assets in the GCC [Gulf Cooperation Council] stood at around $800 billion, or almost 35% of total banking assets, compared with almost nothing 40 years ago,” says Damak. “The industry has become a major contributor to the financing of the GCC economies. Numerous Islamic banks in the GCC are considered as systemically important in their systems.”
Perhaps the greatest mark of success is that the industry has gained widespread acceptance as a normal way of doing business.
“There has always been some sort of Islamic finance in the countries where the population requires it, but much of it was small and very local,” says Dey. “It has gone from being an exotic niche product to something considered throughout parts of Asia and the Middle East as a fairly normal way of financing.”
However, senior industry figures know it has not yet achieved all it could.
Islamic banking needs to differentiate itself completely from conventional banking. It is not enough that the services provided by the Islamic banking are Shariah-compliant. They need to be genuinely innovative and align with the highest ethical principles- Adnan Yousif, Al Baraka Banking Group
“While Islamic banking has become globally acceptable, the challenge is to develop more products and services,” says Adnan Yousif, chief executive of Bahrain’s Al Baraka Banking Group. “Islamic banking needs to differentiate itself completely from conventional banking. It is not enough that the services provided by the Islamic banking are Shariah-compliant. They need to be genuinely innovative and align with the highest ethical principles.”
The fortunes of Middle East economies are closely tied to the price of oil. When times are tough – as they were in the late 1980s, when oil prices were often below $20 a barrel – banks suffer, and Islamic banks have some particular vulnerabilities, as Euromoney reported in October 1986.
“It’s not easy being a bank in Saudi Arabia,” we wrote in ‘Saudi bankers have their backs to the wall’. “Your customers are apt to stop paying interest on their loans. If you take them to court, you’re met with the intractability of Shariah law… which states that no interest should be given or taken on financial transactions. This means that you end up paying back all the interest you may have received – often more than the loan.”
Lack of integration
Other issues more specific to the sector have also been apparent from the early days.
By December 2001, the industry had grown into a $200 billion venture, but at the time Euromoney pointed out that regulatory and accounting standards were still weak, the quality of management was patchy, the product range was limited and the talent pool rather shallow.
These issues remain at play today and often feed off each other. Among the trickiest to deal with is standardization. A lack of agreement about what constitutes Shariah-compliance – highlighted so vividly in the Dana Gas case – is one reason why institutions find it hard to launch new products, for example.
That helps to explain why other potential areas of business, such as funds, have yet to really take off. There have been occasional signs of activity – in August 2008 Euromoney reported: “This could be the year when foreign institutions finally see enough interest in Shariah products to launch their own” – but in general there remains a shortage of investable assets.
Today we are largely at par in terms of product offering as compared to conventional banking- Rehan Shaikh, Standard Chartered
Damak says: “The lack of integration between the different components of the Islamic finance industry has prevented the industry from experiencing stronger growth over the last decade.
“The fund industry and the takaful industry remain small and mainly exposed to real estate and the equity markets. Higher sukuk issuance from the GCC could have helped them to grow stronger by offering less risky investable assets.”
Some other areas of activity have barely been tapped at all.
“The one area where the industry as a whole hasn’t had enough focus is private equity,” says Usman Ahmed, chief executive of Citi Islamic Bank. “This is an inherent alignment between the principles of Islamic finance and private equity and yet we see that most of the Islamic liquidity is still with banks. Risk taking is quite conservative, but private equity investment on a Shariah-compliant basis, with Shariah-compliant debt, is an attractive avenue for growth in the industry.”
Despite such shortcomings, industry executives insist they provide a full spectrum of products these days. Citi Islamic has a Shariah-compliant FX platform and others point to factoring products, digital services and more.
“Today we are largely at par in terms of product offering as compared to conventional banking,” says Rehan Shaikh, chief executive Islamic banking at Standard Chartered. “It is ultimately the client’s choice to make. We’re here to promote banking which serves the needs of all our clients, regardless of their faith.”
Agreeing common rules for some of those products remains a key challenge, but there has been progress due to the contribution over the years of organizations such as AAOIFI, the International Islamic Finance Market and the Islamic Financial Services Board. However, enforcing their standards is also an issue. Some governments and regulators take the idea seriously – the UAE, for example, is forcing its Islamic banks to follow AAOIFI standards – but overall, adoption is sporadic.
“The issue is not having these standards, the issue continues to be in adoption,” says Al Natoor at Fitch. “We are not yet seeing strict implementation and enforceability of these regulations and standards.”
The UAE is also one of a small number of countries – along with Bahrain and Malaysia – that have set up national Shariah boards to provide greater consistency. But, perhaps perversely, some warn against too much standardization.
“Islam has a personal dimension to it,” says one industry veteran. “It is up to the individual to learn about Islam and form their own views. Islamic finance shouldn’t stray to a position where it becomes overly dogmatic, imposing the will of one body over everybody.”
Today, there is usually still more paperwork involved in Shariah-compliant products than conventional ones and extra complexity inevitably leads to higher costs. The situation varies from country to country, however.
In Malaysia, issuing a sukuk is as smooth and easy a process as issuing a conventional bond, helped by standardized documentation. The same is not said about the Gulf, where the battle to gain parity continues.
“The transaction cost is the same, it is the administrative costs which might be higher,” says Shaikh at StanChart. “However, as the industry is maturing, that’s an area where the whole market has worked aggressively and quite rigorously to ensure that the costs are more or less the same.”
The situation varies between issuers as much as regions.
“Initially sukuk was criticized for being more expensive and less liquid,” says Ahmed at Citi. “This is less of a concern today, particularly for frequent issuers. The cost of documentation has also reduced significantly. There is of course still some difference because of the extra structuring involved, but documenting a sukuk is not as prohibitively expensive as it used to be. The sukuk premium is more pronounced for issuers that don’t have a very strong historical or core affinity with Islamic investors. But for frequent issuers who maintain regular access to the Islamic market, the premium is minimal or non-existent.”
However, this is an area where change is constant.
“These standards are not static but are subject to revision whenever applications show the need to address a problem or to resolve a dilemma in line with Shariah principles and laws,” says Shaikh Abdul Latif Al-Mahmood, vice-chairman of Al Baraka Banking Group’s unified Shariah supervisory board.
Despite the significant global growth of Islamic finance in the recent years, there are still challenges due to shifting global economic and political landscapes, geopolitical conflicts and the continued low oil price environment- Adnan Chilwan, DIB
Some other problems have also persisted, including the shortage of liquidity and meagre secondary trading. As Euromoney pointed out in 2006: “The growth potential of the sukuk market remains stunted because of a lack of depth and sophistication”.
To some extent this is a result of wider shortcomings in the capital markets – something that holds back conventional, as much as Shariah-compliant, issuance.
“Complexity and the lack of understanding or standardization continue to be big issues, and we think that is still holding back the industry, particularly for international investors” says Al Natoor at Fitch. “But the main issue holding back the industry, particularly if you’re talking about sukuk or takaful, is the status and development of the capital market in these countries. The capital market is still at an early stage of development.
“A few years back there was no issuance from sovereigns like Saudi Arabia. That has changed and there is issuance, there is a yield curve, but we are not yet at a point where you have many corporates tapping the market. Corporates continue to be mainly funded by banks.”
In some senses this is the sort of problem the industry would like to be faced with, so that rather than having unique problems that mark it out as different and strange, the Shariah-compliant industry is now seen as part of the wider financial services sector and dealing with the same issues.
“Despite the significant global growth of Islamic finance in the recent years, there are still challenges due to shifting global economic and political landscapes, geopolitical conflicts and the continued low oil price environment,” says Adnan Chilwan, group chief executive of DIB. “So, in general, factors that affect the advancement of Islamic finance globally are pretty much the same as those affecting the conventional banking sector.”
However, it is still not the whole story, as Chilwan acknowledges.
“That said, there are obviously some regulatory regime changes that need to come about in potential markets around the world, which would help expedite the spread of this model,” he says. “Currently, many countries with huge potential – India being a case in point – have a framework which is not fully conducive to the establishment and development of Islamic banking and finance.”
A shortage of talent is another restriction that points to the difficulty the industry might have in sustaining itself in the future. It is a big problem, according to industry insiders, although there are initiatives to address it.
“As the market is growing, the availability of suitably qualified staff for the Islamic finance industry still remains a challenge,” says StanChart’s Shaikh. “The gaps are across the board. Training programmes within the organizations are helping to create more talent in the market and we’re also seeing a rise in university-level programmes in Islamic finance.”
“The industry does require more talent,” agrees Citi’s Ahmed. “There has been a dearth of experienced banking professionals and Shariah scholars. But it’s not an insurmountable challenge. We are seeing more and more training institutions that offer Islamic banking courses. And of course, as the number of banks and players in this industry increase, more on-the-job learning opportunities are available.”
Attracting more talent is one thing, attracting more customers is another. For all its ambitions to remodel global finance, Islamic banking remains largely a story of Gulf and Far East markets. While there may be Shariah-compliant institutions in many corners of the world, according to the IFDR, just a handful of markets are really important: Saudi Arabia, Malaysia and, to a lesser extent, the UAE.
“Islamic banking and finance assets represent 2% of global assets,” says John Iossifidis, chief executive of Dubai-based Noor Bank. “We need more to increase the industry’s appeal as a real and robust alternative to conventional banking and finance.”
There have been attempts to expand into the wider world, but they have had limited success and even some Arab countries have been slow to get involved. Oman only put comprehensive Islamic finance regulations in place in 2012, and Morocco in 2016.
And beyond a few notable exceptions, Islamic banking remains a niche even in most Muslim countries. In the UAE, for example, only seven of the 51 licensed banks are fully fledged Islamic banks, according to the Emirates Institute for Banking and Financial Studies (EIBFS). Together with Islamic windows of conventional banks, the industry accounts for around 20% of UAE banking operations, according to Jamal Al-Jassmi, EIBFS general manager.
In the search for new markets, many are now focusing on Africa, where there is a large population of Muslims and where a new middle class is emerging.
“Africa is a region in which Islamic finance could and, indeed, should thrive,” says Yousif at Al Baraka. “The continent has a Muslim population of approximately 636 million [and it] is projected to grow by nearly 60% from 2010 to 2030. Furthermore, a vast infrastructure development deficit creates financing needs.”
Even so, it makes sense to be selective about which markets to focus on. DIB, for example, is concentrating on the eastern part of the continent.
Islamic banking and finance assets represent 2% of global assets... We need more to increase the industry’s appeal as a real and robust alternative to conventional banking and finance- John Iossifidis, Noor Bank
“Our international expansion is focused primarily on the PIK region of Pakistan, Indonesia and Kenya,” says Chilwan, “allowing us to connect the dots from the Far East to south Asia to the Middle East to Africa. Our operations in Kenya will allow us to tap into the growing market in eastern Africa.”
However, most of the industry remains focused on existing core markets, partly because of the inherent difficulties in trying to expand into virgin territory.
“Investors do see the benefits of diversification and they do have a desire to expand their geographic horizons,” says Ahmed. “It’s very often a function of whether the local legal and regulatory environment in new markets provides a level playing field for Islamic finance, or if it is too difficult and expensive. Another factor is scale. Sometimes we see a few investors interested in a frontier Islamic finance market, but there still isn’t enough appetite to deliver scale from an issuer standpoint.”
Even in markets where Islamic finance is relatively strong, there is more to be done to tackle outstanding issues and build up credibility and loyalty. That was made clear in the recent Dana Gas case and it is something the industry cannot really rush. It takes time to build up credibility and loyalty.
“International investor confidence is something that needs to be built,” says Fitch's Al Natoor.