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Rising to the challenge
of phenomenal growth
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The Islamic finance
industry is growing fast and needs to rise to the multiple challenges of
competitive performance, greater transparency and good governance amongst other
key requirements, says Atif Abdulmalik, CEO of Arcapita, till recently
the First Islamic Investment Bank |
As Islamic banking grows in size
and significance, reliable statistics on the size of the industry are hard to
come by, but Islamically managed assets are estimated to run into several
hundred billion dollars and rising. A recent study we undertook on the deposits
of Islamic banks in the Gulf Cooperation Council (GCC) countries estimated
these to be approximately $60 billion at the end of 2003. If the current growth
rates continue, these deposits may reach $110 billion by 2010.
As an
investment bank focused on alternative investments, what is more relevant for
us is the amount of funds available for alternative investment. According to
Merrill Lynch, the total high net worth wealth of the Middle East is around
$1.3 trillion, with the GCC accounting for about 70% or $910 billion. Up to 10%
of these funds, or $100 billion, could be allocated towards alternative
investments. A significant amount of these funds may be available solely for
investment in Sharia compliant investments.
Bank numbers on the rise
Not only
have we witnessed an increase in deposits but also an increase in the number of
Islamic banks. In Saudi Arabia, a $400 million IPO for the Al Bilad Bank is
currently under way and the largest Saudi bank, National Commercial Bank, is
going though a re-branding process where its retail operations will focus
mainly on Islamic banking. In Kuwait, a new $300 million Islamic bank, Boubyan
Bank, is being established and in the UAE, a number of financial institutions
are switching over their operations to become Sharia-compliant.
Increasing deposits from Muslim customers who do not wish to place
funds with conventional banks is attracting new players into the industry. New
entrants are also attracted by the success of incumbents. We expect this trend
to continue. A competitive landscape is good for our industry. We need
diversity and focus on achieving measured growth. The successful financial
institutions around the world have been those which have followed a focused
strategy where they concentrate on their core competencies.
Speculative investing
With soaring
oil prices, the GCC has been experiencing an investment boom, with the prices
of quoted stocks and real estate doubling in most GCC markets over the last two
years. Although Dubai grabs most of the headlines, important developments are
taking place throughout the GCC. According to some estimates, by the end of
2005, some $9 billion will be raised through several IPOs in the GCC.
However, we have to be careful that investment decisions are based on
economic fundamentals rather than speculation. For the recent IPO in the UAE,
the subscriptions exceeded the entire banking deposits of the UAE, and bankers
estimate that 80% of the subscription funds were from bank loans.
As we
saw with the technology bubble in the late 1990s, we need to maintain our
investment discipline and ensure that we educate our investors and provide them
with a diversified portfolio of assets. As an institution, our view of asset
allocation is that investors should invest up to 80% of the funds allocated
towards equity and real estate investments in the OECD countries, and invest up
to 20% in the emerging market economies like the Middle East.
The
Middle East is still a maturing market and there are limited viable investment
opportunities. Major industrial sectors are dominated either by governments or
concentrated among a few families, and investors have to be aware of the lower
levels of transparency and legal protection compared to more developed
economies. The capital markets are still developing and there is lack of depth
in Middle East stock markets.
North America and Europe will remain
important markets for Islamic banks. Although together they account for only
11% of the world population, North America and Europe account for two thirds of
the world's GDP. The US remains an attractive market to invest in. As most of
the investors in the Middle East, particularly in the GCC, are US dollar based,
by investing in the US, GCC investors can avoid currency risk.
Although
the strengthening of the euro against the dollar in the past few years has led
some investors to shy away from investing in Europe, the EU competes with the
US in economic size, growth and population, and there are greater avenues to
diversify geographically and in terms of currency. We believe the EU will
provide attractive investment opportunities, especially in countries which have
recently joined the EU.
We also have to consider Asia. Japan is the
second largest economy in the world, and China and India are set to become the
economic superpowers of the 21st century.
Global focus
Islamic financial institutions have
to transition from being regional players and evolve into global financial
institutions. We need to be able to compete with the global financial
institutions, and provide products and services as competitive as the
conventional alternatives.
We should not restrict ourselves to strict
Islamic customers. It does not make any sense to limit customer base and growth
potential. There is no reason why a Christian or Jew or Hindu or, for that
matter, an atheist or agnostic, should not deal with us as long as we can
provide a competitive product or service.
In February we launched our
new name, Arcapita, with the aim of operating under the same brand name in
North America, Europe and Middle East.
Most Islamic banks around the
world are based in less developed countries, where they do not have the market
discipline to ensure that there is sufficient disclosure and transparency to
allow market participants such as potential shareholders and investors to make
informed decisions. If the Islamic financial services industry is to be
successfully integrated as a viable and credible component of the global
financial system, it needs to develop an effective regulatory framework.
The establishment of the Islamic Financial Services Board (IFSB) by
several central banks and the IMF to issue prudential and supervisory standards
for the Islamic financial services industry is a very important development for
our industry. The IFSB combines aspects of the mission of the Basel Committee
on prudential matters and aspects of the UK Financial Services Authority on
financial services good practice matters.
The IFSB has started
developing prudential standards relating to (1) risk management (2) capital
adequacy and (3) corporate governance. These are issues which our industry has
to address as a priority.
When we are making investment decisions, we
need to focus on risk adjusted returns rather than absolute returns and use the
risk adjusted return on capital framework to allocate capital to different
business lines or investment transactions. However, risk management is more
than just implementing the risk adjusted return on capital framework or value
at risk methodologies. We need to implement risk management frameworks from the
board level down.
After complaining for years that Islamic banks are
too focused on low risk, low return murabaha products, we are seeing
Islamic banks being more creative and undertaking a wider range of investments
such as real estate development projects. However, these projects entail
significant execution and development risks that need to be managed carefully.
Capital adequacy, good governance
The risk in undertaking development projects in developing
markets, especially commercial projects, is amplified by the fact that many of
the Islamic financial institutions undertaking these projects are relatively
small with relatively small capital bases. As an industry trying to increase
our credibility, we have to ensure that these financial institutions have the
balance sheet strength and management experience to absorb the balance sheet
and fiduciary risks associated with large development projects, which in many
cases run into billions of dollars.
My advice to Islamic financial
institutions which are growing at a fast rate is to plan for measured and
steady growth and to build up a strong equity capital base by increasing
retained income or through rights or new share issues. This will not only
provide a cushion against unforeseen shocks but also allow banks to achieve
higher credit ratings and hence the benefit of lower financing costs.
In the post-Enron era, corporate governance has become an important
issue. For example, the Sarbanes-Oxley Act has put a lot of additional
responsibilities on the directors and officers of public companies in the
United States. We need to ensure that we appoint qualified non-executive
directors with relevant experience so that the board of directors of Islamic
financial institutions can play an effective role in monitoring the activities
and performance of executive management.
We also need to make executive
management including the CEO, accountable for its performance. We need to make
each employee accountable, and ensure that we reward people based strictly on
performance.
Islamic capital
market
A perennial issue for the Islamic banking industry has
been the underdeveloped interbank and money markets, which makes it more
difficult for Islamic banks to manage liquidity and risk.
In recent
years, the Governments of Bahrain, Malaysia and Qatar have issued several
tranches of Sharia-compliant government bonds using salam- and
ijara- based sukuks. One of the largest corporate sukuks
to date was the US$1.6 billion sukuks for the UAE Etisalat. The main
reasons why we have not seen more corporate sukuks is that they
generally have low credit rating and are usually small in size, which negative
consequences in terms of accessing international capital markets.
Further discussions on aspects of Islamic finance should lead to fresh
ideas for products and services.
This article is based on the paper
that Atif A Abdulmalik delivered at the Fourth Annual Islamic Finance Summit in
London. |
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Conscious of the concerns of Arab Banker readers and their desire to do
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