Gulf and Asian Centers Battle Over Islamic Finance

In the aftermath of the global financial crisis, the prospects for Islamic finance appear brighter than ever. The industry boasts an estimated $1 trillion in assets, and Islamic banking — untouched by subprime-mortgage-backed securities and other toxic assets that devastated many Western institutions — continues to grow at a rate of about 20 percent a year. Financial centers from Bahrain and Dubai in the Persian Gulf to Malaysia and Singapore in Asia are moving to improve their regulatory frameworks in a bid to win a bigger piece of the pie.

Yet much of the industry’s potential remains untapped. And the competition itself may be part of the reason, bankers and analysts say.

A lack of consistency in the interpretation of Islamic law by scholars who decide if a product complies with shari’a principles is holding back the development of a vibrant capital market and asset management business. The industry must resolve differences between the secular element of contracts frequently based on English common law and a shari’a board’s interpretation of the same contract if conventional money managers are to see long-term value in Islamic finance, an essential element for future growth. Among other things, shari’a bans the charging of interest and requires that loans be structured on a profit-sharing basis.

“There is a need for standardization and uniformity,” says Arul Kandasamy, head of investment banking at Abu Dhabi Commercial Bank. “We cannot rely on shari’a scholars, as they have a vested interest in retaining the status quo. Governments and regulators have primary responsibility for resolving this situation.” Similar concerns temper the optimism of Mohieddine Kronfol, managing director of Algebra Capital in Dubai. “Shari’a-compliant assets are more than $1 trillion, but legal and market infrastructure as well as corporate governance standards are current and very relevant challenges facing Islamic finance,” he says.

The Islamic fund management business has total assets of just $52 billion, a fraction of the $22 trillion handled by conventional money managers, according to a recent report by accountants Ernst & Young. Most of the funds have less than $100 million under management, the threshold needed to achieve profitability, the firm says. The small size of the funds also limits their ability to match the variety and quality of conventional investment funds, it adds.

The market for sukuk, or Islamic bonds, shows signs of recovering from the blow dealt by Dubai’s near default last year, but the market remains a fraction of the size of the conventional fixed-income market. Sukuk issuance totaled $5.6 billion in the first five months of this year, up slightly from $5.3 billion in the same period of 2009.

The Dubai property developer Nakheel came close to defaulting on its $3.52 billion sukuk — the largest ever — before Abu Dhabi stepped in to bail out Dubai. The company’s debt problems raised doubts among investors about the ability of sukuk holders to seize control of assets backing the bonds in the event of a default — doubts that have yet to be resolved, bankers and analysts say. The region’s credit problems continue to weigh on the sukuk market. Gulf corporations are facing a wall of debt coming due, with $145 billion outstanding and $28 billion scheduled to mature in 2012, the bulk of it for companies in the United Arab Emirates, according to Moody’s Investors Service. It’s little surprise, then, that Malaysian entities are dominating the sukuk market, accounting for slightly more than half of global issuance this year through May.

“The cost of structuring and issuing sukuk remain high relative to conventional” bonds, says Nasser Saidi, chief economist of the Dubai International Financial Centre. “The lack of uniformity and certainty is also curbing and inhibiting innovation.”

Notwithstanding the problems, countries across the Gulf region and Southeast Asia are targeting the industry for growth and hoping to establish themselves as major centers for Islamic finance. “From our perspective, the exciting thing is, so many countries are focused on Islamic finance,” says Afaq Khan, the Dubai-based CEO of Standard Chartered Saadiq, the Islamic banking subsidiary of Standard Chartered Bank. “That can only be positive for industry growth.”

For many years, Bahrain has led the Gulf region by devising supportive Islamic and tax regulations that have boosted its reputation as a leading banking center. Bahrain has 28 Islamic financial institutions, the largest such concentration of any country, according to Kamal Ahmed, chief operating officer of the Bahrain Economic Development Board. Total assets in Bahrain’s Islamic banking sector jumped by nearly 50 percent last year, to $24.5 billion. As recently as 2000, assets totaled just $1.9 billion. Bahrain is also home to 47 Islamic investment funds with total assets of $2.15 billion, according to Ernst & Young.

The country regards a strong regulatory environment as a competitive advantage. The highly regarded Central Bank of Bahrain regulates the sector; its forerunner, the Bahrain Monetary Agency, was the first central bank in the world to develop and issue sukuk. The central bank has also moved to address the shortage of trained professionals in the industry by establishing the Waqf Fund for Research, Education and Training in 2006. The Bahrain Institute for Banking and Finance recently launched a master’s program in Islamic finance in conjunction with DePaul University.

“Bahrain is an important regional financial center and offers a well-established legal and regulatory framework and good ancillary services to support the financial services sector,” says Ikbal Daredia, who heads capital markets, institutional banking and the Malaysian arm of Unicorn Investment Bank in Bahrain.

Bahrain officials say they are eager to work with other financial centers to establish common standards and help overcome the fragmentation that is holding back the growth of Islamic finance. Fund managers in particular identify the lack of connectivity and a transparent screen-based trading platform as significant barriers to the growth of the Islamic fund business.

“We need to work with other countries to get appropriate regulatory structures for Islamic finance in place,” says the Economic Development Board’s Ahmed. “We are working with others, of which Malaysia is a big player, to develop the Islamic banking equivalent of Basel II.”

Dubai had sought to challenge Bahrain’s leadership in the Gulf with a raft of sukuk issues in 2006 and 2007. Nasdaq Dubai is one of the world’s largest exchanges by listed value of sukuk, with 20 issues worth a total $16.3 billion. The emirate faces an uphill climb to regain momentum, however, following the recent debt crisis and the restructuring of Dubai World’s $23.5 billion in borrowings.

Giambattista Atzeni, corporate trust business manager for the Middle East and North Africa at Bank of New York Mellon Corp., notes that Dubai has focused on international sukuk issues, many dollar-denominated, while Bahrain has concentrated on local currency offerings “and has a great track record in government deals.”

The emirate still has some ways to go if it is to become a serious regional contender, says ADCB’s Kandasamy. Most of Dubai’s sukuk offerings have been real estate plays, and the emirate’s regulatory framework lags behind that of Bahrain, he says. “Bahrain has taken the right steps to close the gap with Malaysia, but its small domestic market will constrain further growth,” says Kandasamy.

There are 12 Islamic funds domiciled at the Dubai International Financial Centre, with combined assets of $580 million. High costs are one key barrier to growth, officials acknowledge. Late last year the Dubai Financial Services Authority issued a report on collective investment funds that raised eyebrows when it stated that the DIFC was the most expensive financial center in the world.

By many measures, Saudi Arabia is rapidly becoming the biggest Islamic financial center in the Middle East, although its market is almost entirely domestic in focus. The kingdom boasts 174 Islamic funds with a total of $22.7 billion in assets, according to Ernst & Young. There has been a major trend toward Islamic banking, which was virtually unheard-of in the country a decade ago, notes Paul Gamble, head of research at Jadwa Investment in Riyadh. “New banks launched in recent years are 100 percent Islamic, as are virtually all the local investment companies,” he says. Saudi entities are also beginning to wade into sukuk in a big way, a potentially significant development for that market. Saudi Electricity Co. raised $1.9 billion in May with a sukuk priced to yield 95 basis points over the Saudi interbank offered rate.

Notwithstanding the efforts of the Gulf countries, Malaysia continues to claim the world’s largest Islamic capital market. The country has integrated the Islamic sector into its broader financial system, providing institutions as well as intermediaries a deep market in shari’a-compliant equities, sukuk, exchange-traded funds, real estate investment trusts and derivatives. At the end of 2008 (the most recent figures available), Malaysia’s Islamic banking assets had reached $72.5 billion, according to the Malaysia International Islamic Financial Centre. The country boasts 184 Islamic funds with assets totaling $5.1 billion, according to Ernst & Young. Shari’a-compliant companies make up 63 percent of the Bursa Malaysia’s 1.06 trillion-ringgit market capitalization.

Malaysian entities accounted for 53.4 percent of global sukuk issuance in the first five months of this year, according to Dealogic. The government itself has led the way by issuing a $1.25 billion sukuk, the largest ever by a Malaysian borrower, in May.

“Local investors’ demand and established market infrastructure has supported issuance, while local players such as Petronas and Khazanah have successfully issued large cross-border sukuk, raising capital abroad,” says BNY Mellon’s Atzeni. Kandasamy of ADCB agrees that Malaysia’s depth and sophistication give it a firm lead over the Gulf centers. “Malaysia has the best capability due to its advanced regulatory environment, strong government support and large pool of educated professionals to support growth,” he says.

For the Gulf to match the depth of the Malaysian market, it will need to establish more common standards to increase trading activity and attract new investors, industry experts say. Adopting a benchmark index like LIBOR would immediately improve transparency and liquidity and create clarity for conventional investors. “There is a consensus among scholars and market practitioners that a conventional benchmark index such as LIBOR can be applied to Islamic finance operations,” says Mohamad Nedal Alchaar, secretary general of the Accounting and Auditing Organization for Islamic Financial Institutions, in Bahrain. “Nevertheless, in the long term it will benefit the Islamic finance sector to have its own benchmark index.”

Malaysia’s success is spurring imitation in Asia, most notably by neighboring Singapore. The city-state is targeting Islamic finance in a bid to expand its financial center. The Monetary Authority of Singapore is extending its existing regulatory framework to the shari’a-compliant sector. “Our approach is to treat conventional and Islamic financial products similarly, as long as they share similar risk characteristics,” a spokesperson for the central bank says.

Recent regulations by the MAS allow Singapore-based banks to enter into Istisna financing transactions, a shari’a-compliant method of financing construction projects. The move appears designed to allow the country’s banks to participate in an expected surge of financing for major infrastructure work in the Gulf Cooperation Council, a bloc that encompasses Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE. “The GCC are heavily investing in infrastructure, with $2 trillion of infrastructure investment over the coming five to seven years,” notes the DIFC’s Saidi.

Although Islamic finance is growing at an annual pace of about 20 percent, it remains a very small part of the overall market. Singapore has 13 Islamic funds managing a total of $760 million in assets, compared with $610 billion in assets run by conventional fund managers.

Elsewhere in Asia, Hong Kong has begun to look at Islamic finance with greater seriousness. It could be a shrewd move. The growing trade relationship between China and the GCC, particularly in energy, offers a rich possibility for Islamic finance projects. “Hong Kong has talked about strengthening its credentials as an Islamic financial center,” says Ben Simpfendorfer, chief China economist at Royal Bank of Scotland in Hong Kong. “This shouldn’t be interpreted as competing with Malaysia and Singapore. Hong Kong is hoping to profit from Islamic bond issuance by mainland Chinese corporates.”

With so much competition for leadership in Islamic finance, will there be enough business to go around? A little more cooperation to address some of the industry’s shortcomings could help grow the market for everyone.