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Monetary Policy and Oil Prices Buoy Islamic Banking

In part because of a prohibition against charging interest, Islamic financial products are drawing attention in the present low-interest-rate environment.

Islamic banking is gaining share within a market that is itself growing quickly, presenting potential opportunities to investors.

For millions of households in the Arab countries of the Persian Gulf, income and wealth on the back of the region’s oil and gas wealth are rising rapidly. The International Monetary Fund predicts gross domestic product growth of 4.2 percent this year in the six member states of the Gulf Cooperation Council: Bahrain, Kuwait, Oman, Qatar,Saudi Arabia and the United Arab Emirates.

There is, meanwhile, a structural trend of consumers in the region demanding Islamic banking, which differs from conventional banking in that, to comply with the principles of shari’a, Islam’s moral code, it forbids the charging of interest and investing in sectors deemed contrary to the religion’s teachings, such as pork and alcohol. Islamic banking also avoids investing in derivatives and risk transfers, as they are viewed as tantamount to gambling, also considered to be forbidden, or haram. Instead, Islamic banks share in borrowers’ profit and pass some of this on to lenders.

Bassel Khatoun, Dubai-based co-head, equity asset management, and portfolio manager of the $303 million Franklin Templeton MENA (Middle East and North Africa) Fund, sees huge promise within the banking sector as a whole in the region. He cites the high underlying economic growth and what he calls the “hugely underpenetrated” state of the banking market — with outstanding lending amounting to only about 40 percent of gross domestic product, a much lower figure than in many developed markets. “The rate of growth of Islamic banking in recent years has been faster than that of conventional banking, though it has grown from a very low base,” he adds. “In a region that is overwhelmingly Islamic in population, there is certainly some tremendous capacity for this subset of the banking sector to grow.”

London-headquartered professional services firm Ernst & Young estimates that 53 percent of banking assets in Saudi Arabia are shari’a-compliant, with 24 percent in Qatar and 17 percent in the U.A.E.

There are 17 Islamic commercial banks in the Gulf region with balance sheets of $5 billion or more, according to a recent report by Standard & Poor’s, the credit rating agency. Collectively, they have $317 billion in assets. Within the Gulf, the sector is dominated by Saudi Arabia’s $71 billion Al Rajhi Bank in Riyadh, up 7 percent on the year to June 4, to 67.64 Saudi riyals ($18.03) per share on the Tadawul, the Saudi Stock Exchange, and the $52 billion Kuwait Finance House in Kuwait City, up 13 percent on the year to June 4 on the Kuwait Stock Exchange at 810 Kuwaiti dinar ($2,872).

Islamic banking stocks enjoy another relative advantage, investors and analysts say. “Islamic banks are not as affected by interest rate movements as conventional banks,” says Afa Boran, manager of the 29.1 million Qatari riyal ($8 million) Qatar Gate Fund for Doha-based investment company Amwal. “This is something we find particularly attractive when interest rates globally are expected to rise, as Fed tapering continues.

That point is echoed by Jubin Jose, Doha-based research analyst at Qatar Insurance Co., which advises Qatar Investment Fund (QIF), a $245 million closed-end investment fund listed in London that’s invested primarily in the Qatari stock market. Jose says that the money Islamic banks pay to depositors in profit-sharing accounts, the Islamic equivalent of interest-bearing accounts, tends to rise or fall only to a limited extent when global interest rates change. Consequently, their funding costs should rise more gradually than those of conventional banks if and when global monetary tightening boosts interest rates, allowing them to make higher profits.

As an example. Jose cites Qatar Islamic Bank, which enjoyed the equivalent of 5 to 6 percent net interest margins (although the bank does not see its profit-sharing as a form of interest) in 2006–’07, when interest rates were high, compared with only 2 to 3 percent for conventional banks in the Gulf region. QIF has holdings in Qatar Islamic Bank, which is up 41 percent on the Qatar Exchange at 97.20 Qatari riyals in the year leading to June 4, and Masraf al-Rayan, another Qatari Islamic financial institution, which is up 119 percent on the year.

“We have a positive outlook on Islamic banks because they are gaining share in the local market and because they are relatively protected against a possible U.S. interest rate hike,” says Jose. The Qatar Gate Fund has invested in Qatar International Islamic Bank (a distinct financial entity from Qatar Islamic Bank). The bank is particularly attractive, in Boran’s view, because of its plans to develop its lending. Given its high levels of capital relative to assets, Boran sees QIIB on pace to accomplish this. The bank is up 59 percent on the year leading to June 4 on the Qatar Exchange at 85.50 Qatari riyals.

Analysts say that investors convinced of the potential of Islamic banking should invest in specialist Islamic banks rather than in stocks of conventional banks that also offer shari’a-compliant services. Among the latter group, Islamic banking rarely accounts for a high proportion of such financial institutions’ total revenues.

Analysts also mention, however, potential downsides to Islamic banking stocks. Paul Vrouwes, senior portfolio manager specializing in financials at €174 billion ($237 billion) ING Investment Management in the Hague, acknowledges the growth possibilities of the sector, noting, “I think it’s quite clear that, in the coming ten years, the global volume of Islamic banking products will grow faster than the volume of conventional banking products.”

This may, he says, reflect the time-consuming nature of offering Islamic banking products, given the extra hurdles imposed by Islamic regulation. Alternatively, it may reflect the fact that until recently, at least, volumes had not risen to the level at which they could absorb the costs of creating the complex systems needed to offer banking products.

If Islamic banking continues to grow, the volume problem will disappear. But are the costs of Islamic banking inherently higher, because of the extra moral hurdle? Some investors refer to the power of the supervisory boards set up by each bank, which reject haram products and deals that they deem not to be in compliance with Islamic teachings.

Farrukh Raza, Birmingham, U.K.–based managing director of Islamic Finance Advisory & Assurance Services, a provider of Islamic financial consulting and auditing services, thinks the rate of rejection by shari’a boards is on the decline, because both they and Islamic financial institutions are becoming more experienced in assessing what is suitable and what is not.

Raza does see other difficulties for Islamic banks, however. He points to the hurdles involved in shari’a-compliant hedging because of the implied interest rates in products and strategies used. Raza does not think that a shari’a-compliant way of hedging has been found, though some other Islamic banking experts disagree. Because of the difficulty in hedging, “in many cases the cost of capital rises because you will not have a product to manage risk,” he says. You’re not directly paying a lot of money for shari’a compliance or legal advice, but you end up having a product that is costing you more.”

Raza continues, “There is a revenue problem because Islamic banks will be able to offer many fewer products, and these products may not be the most profitable.” He points to the shari’a prohibition on overdrafts.

The return on equity for the 20 leading global Islamic banks was only 12.6 percent in 2012, compared with 15 percent for comparable conventional peers, according to Ernst & Young.

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