After a decade of growth that transformed Islamic finance from an obscure niche into a mainstream alternative, the industry has suffered its first major setback. The market for sukuk, or Islamic bonds, tanked last year, as the global economic slowdown hit the Gulf region hard and forced governments to bail out many lenders, including Islamic financial institutions.
These problems, although very real, haven’t diminished bankers’ enthusiasm about the sector’s long-term prospects. Indonesia and Bahrain have issued major new sukuk in recent weeks, raising hopes for an imminent rebound in issuance. Islamic banks and mutual funds are expected to continue to grow at a rapid rate in the Gulf, driven largely by increasing customer demand and the region’s expanding wealth. And new initiatives, such as efforts to develop Islamic mortgages for home ownership in Saudi Arabia, promise to broaden the industry and enable banks to diversify their income streams.
Perhaps just as important, bankers say, the global financial crisis promises to boost the Islamic sector by prompting investors to look for alternatives to now-tarnished conventional Western banking products and institutions.
“The financial crisis has challenged the assumption that conventional financial solutions are the most desirable,” says Hussein Hassan, head of structuring MENA for Deutsche Bank. “Many experts in the conventional space are looking seriously at alternative approaches. The principles of Islamic finance look very strong.”
Spurred by the Middle East’s oil-fueled economic growth and fast-rising wealth, the trickle of money into Islamic finance products has become a flood. Bankers at State Street Corp. estimate that the industry has grown at a compound annual rate of about 15 percent over the past five years, with total assets under management at Islamic institutions now exceeding $600 billion. Before the 2008 slump in the sukuk market, issuance had grown more than sixfold in recent years, from $5 billion in 2004 to $33 billion in 2007, according to Moody’s Investors Service.
The Gulf has also witnessed an explosion in the number of Islamic banks, whose assets totaled a combined $60 billion at the end of last year. The United Arab Emirates, which had only two Islamic banks as of 2002, Dubai Islamic Bank and Abu Dhabi Islamic Bank, now boasts six after the launches of Al Hilal Bank, Emirates Islamic Bank, Noor Islamic Bank and Sharjah Islamic Bank. In Saudi Arabia — the largest market for Islamic products after Iran — the National Commercial Bank, the country’s largest lender with 250 billion riyals ($67 billion) in assets, started out as a conventional bank in 1953 but has expanded its retail Islamic banking services aggressively in recent years.
The industry has tapped into genuine demand for products that adhere to shari’a, the Islamic law that prohibits the payment of interest and bars investment in companies that are involved with alcohol, tobacco, gambling, pornography or speculation. Islamic finance can’t escape the laws of economics, though. Much of the industry is based on real estate, and values in the Gulf have suffered from the global recession and the bursting of local property bubbles.
The impact on the sukuk market has been particularly severe. Global issuance of sukuk fell by more than 50 percent last year, to $15 billion, reports Moody’s, and the supply of new paper slowed dramatically in the first half of 2009. There were only four sukuk issues, worth a total of $5.4 billion, in the first six months of this year, according to data provider Dealogic. In addition, spreads on outstanding issues have widened dramatically. Spreads over LIBOR on the HSBC/DIFX sukuk index increased to a peak of more than 1,200 basis points in February; although those spreads came down to less than 800 basis points in May, they are still three times as high as a year ago.
At the heart of the problem is the dependence of sukuks on the regional real estate market, which has been hurt by overbuilding and the fallout from the global credit crunch. “The majority of sovereign and corporate ijaras were backed by real estate assets to finance the construction boom in countries like the UAE, so at the heart of the widening spreads and fall-off in demand for sukuks was the stark correction in these markets,” explains Mariam Boulbol, an Islamic fund specialist at HSBC Global Asset Management in London. An ijara is a commonly used sukuk structure that resembles a lease agreement and can be used to finance property or equipment.
The collapse of the sukuk market was followed by the first major default in May, when Investment Dar Co., an Islamic financial institution that is one of Kuwait’s largest asset managers, failed to make payments on its $100 million global sukuk. The company, which recently completed the £479 million ($790 million) acquisition of U.K. performance car company Aston Martin, is still in talks with bankers and investors regarding Investment Dar’s restructuring. It was the region’s first default of a large public Islamic instrument.
A dispute about the legitimacy of certain sukuk structures has also undermined confidence in the market. In February 2008 the religious board of the Accounting and Auditing Organization for Islamic Financial Institutions, a Bahrain-based shari’a standards setter, ruled that two sukuk structures — musharaka and mudaraba — violated shari’a principles because they contained repurchase guarantees. Such guarantees are deemed contrary to the Koranic principle that investors should share in the profits or losses of any venture they back, rather than make money through usury.
The ruling shook confidence in the sukuk at a time when the market was already reeling from the impact of the global credit crisis and economic slowdown. “Suddenly, people are talking about shari’a risk — the risk that the product you thought was shari’a-compliant may turn out not to be,” explains Rushdi Siddiqui, global head of Islamic finance at Thomson Reuters in New York.
Data show the extent of the damage. Issuance of musharaka , a type of profit-sharing joint venture that was the most popular sukuk structure, with more than $12 billion of new offerings in 2007 — declined by 83 percent in 2008, and issuance of mudaraba , another type of profit-sharing, dropped 68 percent, according to Moody’s.
Disagreements about what constitutes an Islamic product are likely to persist because of the decentralized nature of Islam. Judgments about shari’a compliance are typically made by a board of at least three religious scholars employed by the issuer. Such judgments about how to apply the Koran are always open to debate.
In the six-nation Gulf Cooperation Council — which includes Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the United Arab Emirates — countries impose an almost universal ban on short-selling, revolving credit cards and overdraft facilities. However, those products are permitted in Malaysia, where a more relaxed interpretation of shari’a prevails. In some instances variations exist even within the GCC. Total-return swaps are well established in the UAE and Bahrain, but when several banks tried to introduce the product in Saudi Arabia in 2007, shari’a boards there refused to approve it. Although the boards deemed the swap structure itself to be legitimate, they ruled that the basket of stocks from which a swap derived its return was not screened for shari’a compliance.
Notwithstanding these differences, the industry is making progress in developing common standards. The AAOIFI and the Islamic Financial Services Board, based in Kuala Lumpur, have helped reconcile accounting and regulatory standards across different jurisdictions and worked to develop international best practices. AAOIFI’s sukuk standards are now accepted by Bahrain, Jordan and Sudan, with Qatar and Pakistan likely to sign up soon. In Malaysia, Asia’s largest market for Islamic products, the government has centralized the process of certifying that products are shari’a-compliant.
“There has been considerable progress around the standard language used over sukuks,” notes Mukhtar Hussain, CEO of Dubai-headquartered HSBC Amanah, the Islamic subsidiary of HSBC Holdings. “Banks, scholars and regulatory bodies are pulling together so that over the next year, I think, we’ll see real strides toward a common standard.”
Bankers hope the two recent sukuk offerings by Indonesia and Bahrain signal a broader recovery in the market. In April the Indonesian government raised $650 million with its first dollar-denominated sukuk, a five-year offering that was priced to yield about 720 basis points over U.S. Treasuries. Book runners Barclays Capital, HSBC and Standard Chartered Bank claimed that the offering was well oversubscribed, with orders totaling $4.7 billion. In June, Bahrain issued $750 million of five-year sukuk priced at 340 basis points over Treasuries. Investor subscriptions for the offering totaled $4 billion, according to HSBC Amanah, which managed the issue along with Calyon and Deutsche Bank.
Sovereign issues are likely to continue to dominate the flow of issuance, bankers say.
GCC governments have committed to spending some $1.3 trillion on infrastructure over the next five years, according to Moody’s, and they will look to finance a chunk of that with sukuk. Many bankers, including HSBC’s Boulbol, believe that issuance during the second half of this year will exceed total 2008 volume.
Anticipating the resurgence of these markets and a continued narrowing of spreads, leading Western banks are looking to launch sukuk funds. In July, HSBC Global Asset Management launched a $100 million closed-end sukuk fund for UAE and Saudi investors.
The market for Islamic equity mutual funds also continues to grow strongly. Consulting firm Booz & Co. predicts that 925 Islamic mutual funds will exist worldwide by the end of this year, more than double the number in 2006.
This is one product area that stands to reap clear benefits from the financial turmoil in the West. Islamic mutual funds screen out stocks that aren’t shari’a-compliant. Doing so means excluding stocks of Western financial institutions because they charge interest. The absence of such financial holdings is a major reason that the Dow Jones Islamic Market index, which consists of more than 2,500 stocks in 50 countries, has outperformed the Dow Jones world stock index over the past five years, declining 4 percent over the period compared with a loss of 8 percent for the conventional index. The tenets of Islamic investing — lower leverage, transparency, no speculation — are particularly attractive in the wake of the global meltdown.
“After the financial crisis we saw a lot of market makers and investors from the region repatriate assets to the GCC,” says Rossana Abueva, head of global conventional debt strategy and product management at Bank of New York Mellon in London.
Thanks to the surge in oil prices in recent years, the number of people in GCC countries with liquid assets in excess of $50,000 grew at a compound annual rate of 6 percent from 2003 to 2007, according to accounting firm Ernst & Young. And those individuals are allocating more wealth to the region. Consulting firm McKinsey & Co. reports that the percentage of the Gulf’s private wealth that is invested in the region, rather than in U.S. or European markets, say, has risen to 25 percent from 15 percent in 2002.
Islamic banks have also suffered from the credit crisis less than many of their conventional rivals. Shari’a prohibits Islamic institutions from investing in companies that charge interest or engage in significant leverage — typically defined as debt amounting to more than a third of the firm’s stock market value. Consequently, they have avoided investments in financial stocks and in such complex securities as collateralized debt obligations, which are at the heart of the global financial crisis.
Certainly, several Islamic banks have faced major problems, some requiring government bailouts. The most notable are Dubai’s two largest mortgage lenders, Amlak Finance and Tamweel. The two banks are in the process of being merged and restructured under the supervision of the UAE government. Other regional Islamic lenders, such as Bahrain-based Gulf Finance House, Emirates Islamic and Dubai Islamic, have continued to see significant losses this year because of investment hits and bad loans.
Bahrain-based Gulf International Bank has posted losses of $1.1 billion during the past two years because of exposure to U.S. banks and a large book of asset-backed securities. In March the bank sold $4.8 billion of toxic assets — roughly two thirds of its entire investment portfolio — to the six GCC governments that own it. Kuwait’s Gulf Investment Corp. and Bahrain-based Arab Banking Corp. have also suffered heavy losses from subprime investments.
The difficulties of such conventional Middle Eastern institutions help to bolster the image of Islamic banks and the wider Islamic finance industry, in the eyes of many local investors.
If the industry is to benefit, however, it needs to make considerable progress in managing market, liquidity and credit risk, bankers say. In particular, banks must develop an expanded range of shari’a-compliant risk management instruments such as derivatives, which are virtually nonexistent.
“Funding and liquidity risk are among the most critical issues for Islamic financial institutions now,” notes Rod Ringrow, head of State Street’s Doha, Qatar–based Islamic finance division.
Secondary markets for Islamic products are few, owing to a combination of shari’a limits on reselling and the relative scarcity of products like sukuk. In addition, Islamic banks typically aren’t allowed to invest in fixed-income instruments for Treasury management.
Islamic institutions also need to diversify their asset base to control credit risk. Most of these firms’ assets are highly concentrated in real estate, private equity and commodity investments. “Credit risk at Islamic institutions is still high. All products must be backed by tangible assets to be shari’a-compliant; for many banks that means real estate,” explains Emmanuel Volland, senior director of financial institutions ratings at Standard & Poor’s Paris office. “Dubai Islamic Bank, with over 30 percent of its assets in real estate, is not exceptional.”
Some hope for industry diversification comes from the prospect of mortgages being legalized in Saudi Arabia — currently the region’s second-largest market for Islamic products. The Saudi Consultative Council recently approved a draft of the long-awaited mortgage law that will allow banks to help finance homeownership for the first time. The Kuwait Financial Centre, an asset management and investment banking outfit, estimates that a Saudi mortgage law, if enacted, would increase demand for residential property by as much as 50 percent over the next five years.
The challenges are significant. But given the rapid growth of the past decade or so, most bankers are confident that the market will continue to expand.
