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Opportunity in crisis?

Islamic banking in the United Arab Emirates (UAE) sits within a country that, arguably, is 'over-banked', with some 52 banks in the UAE serving a population of 5.3 million through 808 branches. Yet Islamic banking appears to be growing in importance. Robin Amlot reviews the outlook for Shari'ah-compliant institutions in the UAE
The key issue facing all banks in the UAE are those facing many banks around the world a crisis of confidence caused by a combination of the downturn in real estate values, leading to questions about asset quality combined with pressure on investment portfolios due to global equity and credit market stresses. A small recovery in global market values since the end of the first quarter notwithstanding; these issues dominate the short and medium-term outlook.

Within the UAE banking sector there are 24 local banks. In a recent research note Al Mal Capital suggested that not only is there room for consolidation to create what the firm's financial analysts called "scalable entities which will have funding advantages (post the current liquidity crisis), economies of scale, and diversified revenue and income streams."

About 14 per cent of the UAE banking market measured by loans and advances is Shari'ah- compliant. The sector is growing by as much as 20 per cent a year, compared with growth of 10-12 per cent in the conventional market. Many observers have been suggesting for some time that banking in the UAE is ripe for consolidation. However, Al Mal believes that Islamic banks in particular are "prime for some sort of consolidation, either from within the Islamic banking sector or with a conventional bank."

Al Mal bases this view on three factors:
Some conventional banks conduct Islamic banking via windows or via newly launched subsidiaries;
Competition in the Islamic banking landscape has increased with the launch of new entities;
Recent stresses in loan quality have impacted collateral quality at Islamic banks.

Yet there is a fourth factor at play which could militate against any merger activity nearly all the domestic banks in the country have close ties to the Emirate they are based in with sizeable majority shareholder concentration. Prime Holding underlines this point, noting that, "The majority of banks within the UAE enjoy strategic, and often large, holdings by either government or quasi-government entities. Associated ownership structures are reflective of support and high credit ratings assigned to the banking institutions, in turn facilitating favorable borrowing terms, (specifically relevant in the current international crunch), and also provide for an important source of both funding (FY08 - 48 per cent) and risk free lending opportunities (FY08 - 16 per cent) for the sector."

Thus, says Al Mal , "In addition to business logic there needs to be political willingness for mergers to occur."

Recent years have witnessed explosive growth in Islamic banking assets in the UAE - estimated at 48 per cent compound annual growth rate (CAGR) during 2004-2007 by Prime Holding. In response to this, a number of new banking licenses have been issued, notably to three new majority government-owned Islamic institutions: Noor Islamic Bank (2007), Ajman Bank (2008) and Al Hilal (2008). At the same time several conventional banking institutions established Islamic subsidiaries or banking 'windows'. The ongoing talks between Islamic mortgage providers Amlak and Tamweel , which serve more than 50 per cent of the UAE mortgage market, could also result in a merged institution that may be granted a full banking license by the Central Bank of the UAE.

The market for Islamic finance
The UAE led the way in modern Islamic finance with the establishment of the first modern commercial Islamic bank, Dubai Islamic Bank (DIB) in 1975. The bank is the largest Islamic lender in the UAE with a market share of 45 per cent in the domestic Islamic banking market. Abu Dhabi Islamic Bank (ADIB) was created in 1997. There are now eight local fully Shari'ah-compliant banks including DIB , ADIB , Dubai Bank , Sharjah Islamic Bank , Al Hilal , Ajman Bank , Noor Islamic Bank and Emirates Islamic Bank .

HC Brokerage notes that the UAE's Islamic banks are backed by the government and that the UAE central bank has been lenient with Islamic banks regarding the 20 per cent loans/deposit cap of real estate loans, as investment opportunities are limited for the industry. The firm adds, "On the funding side, the central bank gave Islamic banks the option to issue repo's against their holdings of Sukuk. As for the AED 70 billion ($19.1 billion) pumped by the Ministry of Finance, they were given through Wakala deposits."

The UAE's Islamic banks were not allowed in the past to engage in interbank activity, however, via Shari'ah-compliant structured products, they may now both borrow and lend in the interbank market.

HC reports that DIB management claims that Islamic banks have been able to attain higher deposit rates of up to 60 basis points over prevailing interest rates provided by conventional banks. This has allowed Islamic institutions to be more aggressive than conventional banks in securing funds. Furthermore, Islamic banks have, so far, been net lenders in the interbank market since they have a better liquidity position. In fact, according to HC Islamic banks in the UAE have lower loan/deposit ratios averaging at about 80 per cent.

"However, deposit growth in 2008 was slow, due, says HC , to cut-throat competition between banks to attract deposits, especially among conventional banks. Since Islamic banks offer flexible rates and are dependant on profit and loss schemes, customers abandoned them and rushed to banks offering more attractive deposits. We believe that this should stimulate Islamic banks to offer new retail and corporate structured products and higher rates to regain their clients. Nevertheless, Islamic banks were able to lend at lower utilization rates than their counterparts. In addition, their conservative approach towards avoiding investments in debt securities and toxic assets will allow Islamic banks to weather the current storm much better than other banks," the brokerage said.

Islamic windows in the UAE
Major international conventional players with significant Islamic presence in the UAE include HSBC ( HSBC Amanah ) and Standard Chartered ( Standard Chartered Saadiq). Many local players have got involved in the Islamic banking space for two reasons: to gain market shares in servicing the local Sukuk issuance market; and to create a fully-fledged Islamic retail banking capability.

Among the conventional institutions making headway in the Islamic space, Emirates NBD (ENBD) through its wholly-owned Emirates Islamic Bank ), First Gulf Bank (FGB) and Union National Bank (UNB) have outperformed, in terms of expanding Islamic financing services with Islamic loans accounting for a growing shares of their aggregate lending portfolios.

ENBD 's 2008 results were boosted by activity at Emirates Islamic Bank with total Islamic loans of AED 21 billion ($5.72 billion), up 44 per cent on year-ago levels with associated net financing revenue of AED 425 million ($115.8 million). UNB launched Al Wifaq Finance Company in June 2006, with a paid up capital of AED 500 million ($136.2 million), taking a 79.6 per cent stake. The Islamic unit contributed net interest income of AED 250 million ($68.1million) on associated Islamic financing of AED 6 billion ($1.63 billion, 12 per cent of total loans) in 2008. FGB 's 2008 results show income from Islamic financing rising from AED 124 million in 2007 to AED 296 million ($80.7 million) in 2008.

Among the UAE's other major conventional institutions, National Bank of Abu Dhabi (NBAD launched Abu Dhabi National Islamic Finance (ADNIF) in March 2008, planning to offer a full range of banking services, with its initial focus on corporate and retail finance; and Abu Dhabi Commercial Bank (ADCB) established its Islamic subsidiary, Meethaq in August 2008.

Prime Holding expects ENBD to develop a lead through its subsidiary Emirates Islamic Bank but also believes that UNB and FGB are well placed, expecting them to see 21 per cent and 22 per cent associated average loan growth, respectively, over the coming three years. ADCB 's Meethaq is expected to grow rapidly on the back of an aggressive retail strategy armed with market experience derived from the bank's 25 per cent equity stake in Malaysia's RHB Capital (RHB 's Islamic banking subsidiary is ranked the sixth largest in Asia). As of the end of 2008, Meethaq had a negligible loan book but already built up a deposit base of AED 2.1 billion ($572.2 million, 2.5 per cent of total deposits).

Other local conventional banks with Islamic windows or subsidiaries include Mashreq ( Badr Al-Islami ), National Bank of Umm Al Qaiwan (Al Tayseer) and Commercial Bank of Dubai (Attijari Al Islami). More than half of Commercial Bank of Dubai's (CBD) branch network is concentrated in Dubai. CBD launched its first comprehensive Islamic financing services, Attijari Al Islami, last September.

Al Tayseer from National Bank of Umm Al Qaiwan (NBQ) is an "Organised Tawaruq" and, says the bank, is designed for customers who wish to repent and get rid of "Riba". It is approved by the Shari'ah Board of National Commercial Bank , Saudi Arabia.

Badr Al-Islami is an independently managed business comprising Badr Al-Islami Finance and Badr Al-Islami Banking. Badr Al-Islami Finance, which is majority owned by Mashreq , is a private joint stock Islamic Finance Company and Badr-Al Islami Banking is the Islamic Banking Division of Mashreq . The banking unit was established in early 2006. Badr Al-Islami Finance was formed in 2007 with Mashreq investing AED 500 million in the equity of the finance company. The company is subject to the supervision of UAE Central Bank and an independent accounting firm, as well as the Shari'ah Supervisory Board.

Outlook for Islamic finance
Islamic banks enjoy a higher potential of lending and balance sheet growth than their conventional counterparts given their lower loan/deposit ratios. However, a note of caution should be injected as a result of the bursting of the real estate bubble. Exposure reaches as high as 37 per cent in the case of DIB and up to 50 per cent for FGB if indirect exposure is included. ADIB discloses only a 7.5 per cent exposure to real estate but analysts believe that a substantial proportion of its retail lending (58 per cent of total lending) may be directed towards real estate as well.

All the key products structured for Islamic finance, including Murabaha, Mudaraba, Musharaka, Ijarah and Istisna'a, are asset-backed. In most cases that asset, in recent years, will have been property or a joint venture entity involved in property development. It is not yet clear just how much damage the real estate bust will actually do to the banks' balance sheets.

Nevertheless, growth opportunities do exist. Dubai Banking Group (DBG) and Noor Investment Group (NIG) both subsidiaries of Dubai Group have plans to increase their banks' profiles outside the UAE. Dubai Bank , a wholly-owned subsidiary of DBG is reported to be increasing its branch network and looking at potential acquisitions in the Gulf Cooperation Council, Asia and Africa. The bank is also said to be considering entry into other GCC markets, notably Saudi Arabia.

In July 2008 NIG's Noor Islamic Bank has turned to the Maldives, entering into a joint venture with the Government of the Maldives and the Islamic Development Bank to create Noor Maldives Islamic Bank, the nation's first Islamic bank.

The UAE economy is still expected to grow in 2009 as a whole, just! The International Monetary Fund is forecasting growth of 1.5 per cent. In global terms this will remain something of an achievement but within the domestic economy it still represents a crunching slowdown from the growth rates of recent years. The short-term focus is likely to be on government infrastructure spending and limited project financing/ refinancing.

The banks that will be successful as the economy emerges from its current tightness will be those which focus in strengthening risk management systems, manager their investment portfolios diligently, reduce bad debts and restrict margin pressures.

© Islamic Business and Finance 2009