“Asset growth for the seven leading GCC Islamic banks [in the first three quarters 2008] goes something like this. Abu Dhabi Islamic Bank plus 12%. Al Rajhi Bank plus 31%. Bank Al Jazeera plus 9%. Boubyan Bank plus 27%. Dubai Bank plus 61%. Dubai Islamic Bank plus 4%. Kuwait Finance House plus 23%,” said Moody’s analyst Anouar Hassoune. These numbers paint a picture of growth for the Islamic finance industry in an otherwise gloomy global economic environment. And although Dubai Islamic Bank posted growth of just four percent, this low figure can be chalked up to a couple of extenuating factors. For starters, one of the bank’s former vice presidents was held by police this summer as part of a bribery investigation. It is more likely, however, that the low posting derives from DIB’s failure to make use of the United Arab Emirates Central Bank facility for refinancing in the face of the ongoing financial difficulties in the UAE. Even with minor hiccups like these in the industry, the Islamic banking sector is on track for asset growth of 27% for 2008, a repeat performance of 2007.
The formerly niche market of Islamic finance has quickly moved into the main stream in recent years, boasting over 390 Islamic financial institutions in 75 different countries. Studies suggest that the assets under management of these institutions will exceed $600 billion by the end of 2008. It is further predicted that 80% of GCC banks will be sharia compliant by 2015. But this rush to become sharia compliant should not be conflated with a uniform strategy in the sector. Evolution within the GCC Islamic banking sector in 2008 has highlighted the differences between countries. While the Islamic banking sector in most Gulf countries has moved towards a more commercial approach, Saudi Arabia’s sector has a comparatively conservative costumer base and no competition from conventional banks, which will likely promote stasis in the austere kingdom’s banking scene. Meanwhile, the Central Bank of Qatar has opened the door to competition within its Islamic banking sector by making licenses more available, in turn driving their Islamic financial institutions to compete more earnestly on the commercial level with their conventional banking competition. This development has been followed to its logical conclusion in the UAE where Islamic banks and commercial banks are virtually indistinguishable. Meanwhile, Kuwait’s Islamic banks have settled into mode of functioning like investment vehicles. They take funds from depositor accounts and invest them into ventures such as real estate projects. Profit from the project is then paid back to the depositor at their arranged rate of return.
Despite the different approaches of the region’s Islamic banks, there is one common thread among them: real estate. As Islamic finance prefers physical asset backed investments, Islamic banks have become heavily involved in the GCC’s spicy property markets in recent years. Some analysts have expressed concern about the fact that those institutions tend to be even more exposed to the region’s property markets than conventional lenders. It seems the deciding factor would be the amount of value lost. “A 10-to-15% decline in property value in Dubai might not have a big impact,” said Hassoune of Moody’s. “But a 30% decline in the property market starts to become a crisis.” Given the current state of the world’s economy, it is extremely difficult to predict what may happen to real estate markets in the Gulf. It is, however, expected by many analysts that the market will drop by at least 10%. Islamic bankers throughout the region will be holding their breath and hoping it doesn’t go much lower than that. Yet if even if their fears are realized, there may still be hope. Moody’s stress tests, which simulate worse case scenarios, suggest that even if there were a 50% fall in real estate prices most Islamic banks would survive the resulting substantial equity losses, while smaller banks would likely need to be bailed out. While most sharia compliant banks may survive the expected real estate turmoil, some Islamic mortgage providers have already begun to suffer. In late November, two of the UAE’s largest Islamic mortgage providers merged under pressure. Amlak Finance and Tamweel united under the banner of the Real Estate Bank (REB). REB is a government entity and the move was perceived by analysts as direct intervention by the UAE government to save troubled assets. This was the first time the federal government had rescued a company. Time will tell who will be the second.
Growth for 2009?
Even if Islamic mortgage providers are braving rough waters these days, the Islamic banking sector as a whole is set to grow for 2009. Yet it is unlikely that the industry will see the same 27% growth rate that it enjoyed for both 2007 and 2008. “The Islamic financial system is facing some structural weaknesses, which need to be overcome for the Islamic banking industry to keep growing. First is capital. To keep growing at 27% you need equity to maintain the same capitalization… [and] internal capital generation is not enough,” said Hassoune. While some investors, like governments, are willing to put money into the Islamic banking industry, non-sovereign investors have been constrained. So the key variable will be sovereign spending — sovereigns will need to spend next year in order to make their economy grow.
Another issue facing Islamic financial institutions in the Gulf is liquidity. “Liquidity needs to be there for you to keep on growing and liquidity management is very difficult,” Hassoune asserted. And managers have been “providing incentives not to grow the credit portfolio excessively. So liquidity is a structural constraint. Especially at times when liquidity is disappearing out of the money markets and out of the credit market anyway,” he concluded.
Given these constraints, it is not surprising that Islamic banking is expected to grow by only half of what was seen in 2007 and 2008. But even if the percentage of growth is in the mid-teens, that is still higher than the global market. And Islamic banks are still on pace to reach 20% of market share by the end of the decade.
Sukuk
In 2007, sukuk issuance grew by 90% on the previous year to hit the $47 billion mark. In 2008, however, it is expected that issuance will only have reached $20 billion, which is a 40% decrease. There are several reasons that sukuk issuance has declined. First, the spreads on sukuk have widened due to perceived higher systemic risk in the global banking system. Second, the liquidity needed to make the sukuk market run has dried up. Third, the initial spread on sukuk was too low because demand for sukuk was significantly higher than supply. Finally, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) has cast doubt as to the sharia compliance of previously issued sukuk. Recent AAOIFI fatwa’s on the issue have, in part, prompted a shift toward one particular type of sukuk known as ijara. Even though ijara have buy back agreements, they are still sharia compliant, explained Moody’s Hassoune.
“AAOIFI scholars have said that a repurchase agreement is not incompliant with sharia. What is incompliant with sharia is to say five years ahead of the maturity of the sukuk that we will repurchase underlying assets at a given price, except for ijara. Ijara is leased assets, so because they are leased the assets are still the property of the originator. The repurchase agreement is just the originator saying to himself that he will buy back the asset at the price that is his price. At the end of the day the sukuk holders are not buying the underlying asset, they are buying the usufruct of these assets,” Hassoune explained.
Other developments in the sukuk industry include a shift away from the US dollar as the dominant issuing currency. Many issuers these days are using their own local currencies for ease of use rather than out of fear of an unstable dollar. The geographic distribution of sukuk is also widening. Senegal has considering issuing, while the Gambia and Sudan have both issued non-rated sukuk recently. It is likely that 2009 will see further shifts, including one away from corporate issuance (currently 75% of the market) and towards sovereign issuance (now just 25% of the market). These percentages will probably shift to half and half by the end of the year.
In conclusion, the sukuk market will slow in 2009. “Two thousand nine will probably resemble the second half of 2008, which is to say limited sukuk issuances, except for in domestic markets,” said Hassoune. Yet even with this decline, surely there are bankers in the West peering into the sukuk market with envy when compared to the mess they see brewing at home.
