The Surge is on
Islamic banking is one of the major contributing sectors to U.A.E.'s finance industry, factoring for around a fifth of all banking assets.
According to a report released by Standard & Poor's (S&P), the period of 2003 to 2008 saw a surge in GCC IFI assets, reaching $288.2 billion in 2008 (S&P 2010).
Drivers of growth of Islamic Banking in U.A.E and GCC Region
This surge could be attributed to several factors. The strong economic growth in the GCC, coupled with rising oil prices resulted in an influx of petrodollars.
U.A.E. in particular has benefited from positioning itself as a lively business hub in the Middle East.
Capitalizing on trade inflows, it saw a small economic boom driven largely by infrastructure related investments up till the recession.
As the government tweaked its policies to encourage economic activity, the accumulated wealth and rising per capita incomes in the GCC spurred the banking industry. The success in the Middle East was a highly publicized affair. Stories of professionals from all over the world, finding riches in GCC countries like Dubai became commonplace. There was an increase in privatization initiatives that accelerated project and structured finance activity. This coupled with rising sovereign ratings contributed to an overall increase in foreign direct investments (FDI) into the region (Dauphine 2007). All these factors point towards a flood of liquidity, which ultimately boosted both conventional and Islamic banking growth.
Rise of Islamic windows
Fully Islamic banks constitute the most visible portion of the Islamic banking sector. Unfortunately, they face a declining market share due to increased competition from Islamic windows. These Islamic windows accounted for 29% of the GCC Islamic banking assets in 2008 (S&P 2010).
According to an S&P report, demand for Shari'ah-compliant banking products has increased from retail consumers, private sector corporate and government institutions. To meet this demand, some banks are shifting towards Shari'ah compliance via transformational or diversification strategies. Islamic windows have experienced the largest growth within the Islamic banking industry.
(S&P 2010).
In research done by Infosys, it was found that Islamic banking had spread all over the world from Jeddah to Jakarta to Jordan (Infosys Finacle, 2009). In all, more than 280 banks operate within the Shari'ah space in more than 50 countries, with estimated assets of about $250 billion to $300 billion. Around 35 percent of these IFIs are located in the Middle East. Currently, Dubai has a very extensive network of Islamic banks; Emirates NBD, Dubai Islamic Bank, and Noor Islamic Bank are some of the major players in the region.
The crisis has changed the focus of Islamic banking towards resiliency.
Furthermore, the lack of exposure to the more risky and speculative assets, and the risk sharing model of Shari'ah has allowed IFIs to come out of the crisis relatively unscathed.
According to the International Islamic Finance Forum, bank holdings in the U.A.E are growing by more than 15 percent, a fair reflection of successful penetration strategies. The total Islamic banking loans base is also growing at around 15 percent a year (AMEinfo Press Release 2010).
Regardless, a large proportion of the world's Muslim population remains untapped. The distribution of Islamic assets, revenues and profits are held mostly within the GCC, which represents a low concentration of the world's Muslim population. We see a huge potential for the growth in Islamic assets outside the GCC area in the future, which will ultimately benefit Islamic activity in the Middle East region on a whole.
Standardization
Currently, the focus of the GCC region is to continue improving standards. Like conventional banking, Islamic banking performance is largely dependent on the regulatory structure. The lack of standardization of financial contracts and products across the various banks or institutions within the same country has been a key concern. The standards for Islamic banking operations continue to be fragmented. However, there has been an emergence in international initiatives taken by organizations like AAOIFI and IFSB to alleviate this problem. The rise of such institutions can help propel the growth of the industry.
In U.A.E., the standardization of policies follows IFRS. Conventional banking relies heavily on the contractual liability to recover funds invested in exchange for loans and deposits, along with an interest margin for the borrower or lender. On the other hand, Shari'ah-compliant banking requires a physical asset or trading transaction, akin to a profit sharing or an agency contract agreement. Though Islamic finance is primarily based on traditional practices, many of the recent product and service innovations are adapted from conventional counterparts. Due to this adaptive strategy, there is little difference between the imitative products from an accounting perspective.
As such, IFRS standards can be implemented with reasonable ease provided the product structure maintains its conventional similarities.
In the Arab world, where practices are largely driven by religion, there is a certain consensual approach to faith-based practices. It can be observed that the culture is inclined towards an industry-wide set of best practices when it comes to Shari'ah. This can be translated to a somewhat industry driven model, as compared to a regulatory driven model which is more prevalent in conventional banking.
An industry driven model has an added advantage of offering greater flexibility, largely due to retaining the bargaining power within industry players. Ultimately, this behavior benefits larger players who are able to exert more influence across the industry. One concern with such a model is the lack of control and the possibility for collusive behavior.
A large number of Islamic banks in the Middle East region have started moving towards IFRS standards. However, there are still a few countries like UAE and Bahrain, that follow the industry driven approach, preferring to maintain flexibility and expecting the industry to self-regulate.
Ethical standpoint
Under Shari'ah, riba is prohibited and investments are limited to assets deemed to be ethical and legitimate. The investment can only be within industries which are acceptable by religious standards. Vice industries, alcohol and tobacco are some of areas that do not comply with Shari'ah.
Additionally, funding is generally provided based on the investment potential and the strength of the business model, unlike conventional credit, which is largely governed by the creditworthiness of the borrower. Due to these regulations, Islamic banking is considered to be conservative, not speculative, as well as encourages entrepreneurship and promotes equitable distribution.
According to industry experts at the Abu Dhabi International Islamic Finance Forum, the industry is forecasted to climb to the $2 trillion mark in next seven to ten years.
The growth can be achieved with a strong base of ethical practices and banking values. The region's Islamic banks are placing more importance in maintaining good client relationships through the provision of efficient and friendly customer service. "The banking industry as a whole needs to revisit and restore the balance. Islamic banks using the foundation of Islam, should lead the way for an ethical banking structure. This will pave way for a profitable future and be an example to the conventional banking industry," said Afaq Khan, Chief Executive Officer, Standard Chartered SAADIQ.
Growth of sukuk
Analysts are optimistic about the increasing importance of the bond market. This is a crucial time for Islamic finance industry as sukuk demand in the GCC is expected to grow in the near future. Qatari sukuk as well as Saudi bonds are currently leading the market, with U.A.E. issued sukuk close behind. According to industry players, the recent rise of sukuk is largely due to the solid fundamentals and core values followed by the Islamic finance industry. These are the same factors that will continue to attract potential investors that follow strong ethical standards.
About the Authors
Luqman Hakim Ilham is currently pursuing his MBA at the SP Jain Center of Management, specializing in Consulting. He has experience in diverse disciplines from the military, to engineering, and has advisory and wealth management experience in financial services. He has also been in several client facing roles within corporate services and the non-profit industry.
© Business Islamica 2012
