LONDON – The global Islamic banking industry enters its 38th year in 2013 in its contemporary phase with invigorated optimism, fueled partly by its continued proliferation in new markets especially in Oman and Arab Spring countries and partly by the impressive momentum of the sukuk market which in 2012 by its own standards enjoyed a record year with several new entrants to the market, especially from non-traditional issuers, and pioneering new structures. But the industry has a tendency to be beguiled by its own relative success largely because of a lack of independent evaluation of its performance and policy and architectural development. To put the industry in perspective, Islamic banking assets account for less than 1 percent of global banking assets, thus any euphoria about it being a game changer for the global financial industry even in the wake of the subprime scandal of 2008 and the subsequent credit crunch, financial crisis and Eurozone sovereign debt crisis, should be treated with a healthy dose of skepticism. This time next year (2014) the industry should be judged from three key angles – policy, regional development, and market and product dynamics. The crucial challenge remains that of policy. Banking legal and regulatory policy is at best erratic and piecemeal because of the absence of an Islamic Bank Authorization Standard which can be applied universally complete with stand alone enabling regulatory and legal framework. Other policy challenges are accounting and financial reporting framework, Shariah Governance Framework, corporate governance, compliance and consumer protection provisions, and enforcement and recourse to law. Policies and frameworks of course will have national and regional variations but at the core they must have a universal application as conventional banking has under the Basle accord. Policy also inculcates a political acceptance of Islamic banking as an alternative system of financial intermediation and not as a religious phenomenon per se being exploited by extremists. It would be honest (and better) for a member country of the Islamic Development Bank (IDB) to be upfront and stress that it does not accept or believe in Islamic finance as a viable system of financial intermediation rather than feign an ambivalent, tepid, expedient and hypocritical approach to Islamic banking. From a legislation point of view, once again all eyes will be centered on Kuala Lumpur as Malaysia formulates an upgraded legislation for Islamic banking and Takaful aimed at providing a conducive enabling environment for the next phase of development that will spur more risk-sharing transactions. “This new law for the industry,” said Dr Zeti Akhtar Aziz, Governor of Bank Negara Malaysia, the central bank, “is aimed at promoting certainty to the legal and regulatory treatment of Islamic financial transactions by providing legal recognition to the contractual requirements in accordance with the Shariah. This provides a comprehensive legal environment under which effective risk and profit sharing activities can take place, encompassing all aspects of Islamic financial transactions, from its prudential and business conduct requirements to the legal treatment of Islamic banking assets upon its resolution, to be fully consistent with the distinctive elements of the respective Shariah contracts employed in these transactions.” From a regional point of view, the industry will continue to develop as it has in the past three decades, based on the policy developments, underlying economic fundamentals and regional political and economic cooperation mechanisms in place. While Gulf Cooperation Council (GCC) countries, especially Saudi Arabia and Qatar, and Southeast Asia led by Malaysia will continue to drive the Islamic banking market, this may be tempered by dampener effects on key economic fundamentals especially GDP growth rates, stability of key commodity prices including crude oil, natural gas, palm oil, and the level of foreign direct investment (FDI) inflows. This dampener effect may impact the development of Islamic banking elsewhere especially if it is partly dependent on equity, FDI and liquidity inflows from the GCC and Southeast Asia. The World Bank Group estimate for real GDP growth for the Middle East and North Africa (MENA) region is a worrisome average of only 0.5 percent for 2012 - the figure is the lowest of all the regional groupings of the developing countries and the high income countries. This is in contrast to 7.2 percent for East Asia, 6.3 percent for South Asia, and 4.8 percent for Sub-Saharan Africa. It is also way below the 1.3 percent estimate for the industrialized economies. This trend continues for the forecast for 2013 and 2014 when the MENA region economies are projected to grow at an annual average of 1.9 percent and 3.4 percent respectively – still way behind the above peer regions except the industrialized economies. Similarly, the World Bank World Economic Outlook 2013 projects real GDP growth for MENA oil exporting countries in 2012 of 10.2 percent for Iraq; 6.3 percent for Kuwait and Qatar; and 6 percent for Saudi Arabia. The projections for 2013 decline sharply save that for Iraq which is expected to grow at a staggering14.7 percent, but Qatar is downgraded to 4.9 percent; 1.9 percent for Kuwait; and 4.2 percent for Saudi Arabia. One MENA country where Islamic Participation banking is expected to flourish even more is Turkey, which in 2012 issued its debut sovereign international ($1.5 billion) and domestic (TL1.6 billion) sukuk issuances. But even here there are important caveats. According to Ufuk Uyan, CEO of Kuveyt Turk Participation Bank, a subsidiary of Kuwait Finance House, who is also the Chairman of the Association of Participation Banks, the statutory Islamic banking industry body, “after the Turkish sovereign rating upgrade to an investment grade (Ba1 by Moody's Investors Service) after some 12 years, 2013 shall bring a different and challenging environment for Turkish Participation banks. As you are aware from the experience of those markets after a ratings upgrade (and especially if a second rating company upgrade follows as expected in 2013 for Turkey), interest rates come down, and due to flow of significant portfolio money, exchange rates are under suppression. Therefore, a lot of intervention from the Central Bank of Turkey (CBT) is expected in the market via open market operations or unique instruments developed lately by the CBT.” The main consequence of such a market environment for Participation banks is that there will be ample liquidity but rare financing options. As such, Uyan warns that Participation banks in 2013 have to develop new products to meet customer needs, especially sukuk. Market and product development challenges are not unique to Turkey but pervasive across the global industry. “We expect the Turkish Treasury to issue more TL sukuk in 2013. They have already announced their intention to issue a domestic sukuk in February 2013, but have not yet disclosed the amount and tenor. So, Participation banks with their high liquidity shall be investing again in Turkish Treasury Sukuk in 2013,” he explained. An encouraging sign is that Kuwait Turk expects to issue its debut domestic sukuk also in 2013. Thus far it has issued two sukuk in the international market. Turkish lira denominated sukuk, contends Uyan, will also enable Participation banks to develop alternative liquidity management tools to replace short-term Murabaha and Tawarruq and listed and traded on the Istanbul Stock Exchange and through Turkish Central Bank open market instruments. Elsewhere, Turkish participation banks which are major users of syndicated murabaha also plan to improve their export financing abilities with the launch of new products. While most industry players project another bumper year for sukuk in 2013 for manifold reasons, they harbor several other wider expectations and concerns for the industry going forward. The global sukuk market, for instance, said Mohamad Safri Shahul Hamid, Deputy CEO of CIMB Islamic Bank of Malaysia, is anticipated to grow tremendously in 2013 because of interest from new markets, issuers tapping non-traditional market, the return of previous issuers, the emergence of non-traditional issuers from markets such as Saudi Arabia, the continuation of Malaysia as the leading sukuk hub globally, the increasing number of foreign corporates and governments choosing to sell their sukuk outside their home countries, spending established and mature markets, and the huge infrastructure spend in the MENA and ASEAN and East Asia regions. Other Islamic bankers such as Massoud Janekeh, Director and Head of Islamic Capital Markets at the Bank of London & the Middle East (BLME), said 2013 will be a continuing theme of 2012 highlighted by new entrants to the market especially in Africa and Central Asia, more debut sukuk issuances by new issuers and more sukuk with higher volumes to deal with refinancing. A pleasant surprise will be the emergence of a truly international Islamic bank and a UK debut sovereign sukuk issuance. To Janekeh, the potential for Islamic wealth and estate management is huge. “Islamic private banking needs more wealth management products to grow. In the current market of low yield fixed income returns, the opportunity for good performing Islamic funds is endless. Most Shariah-compliant income funds face the same problem of shortage of quality assets to invest. Sukuk issuance is recovering but still not meeting the fund management sector's demands. There is scope for widening access to local currency issues with an appropriate [dollar] swap structure,” he noted. As far as murabaha and tawarruq continuing to dominate the Islamic finance landscape, Janekeh said “most Islamic banks prefer to use instruments such as murabaha/ tawarruq and ijara for their financing, and I cannot see that changing in the short term. Contracts such as musharaka and mudaraba do not fit in with general bank financing regulations in most tax regimes.” Murabaha and tawarruq, on the other hand, according to CIMB Islamic's Mohamad Safri Shahul Hamid, “allow jurisdictions which have yet to or while ‘developing' their Islamic finance infrastructure, in particular to amend their existing legal, regulatory and tax frameworks to become more ‘accommodative' with other Islamic structures, to have a ‘feel' of the enormous potentials of Islamic finance. Secondly, it gives the opportunity to potential issuers that don't possess any assets to issue sukuk by ‘utilizing' Shariah-compliant assets from a third party.” Syndicated murabaha will continue to have its following especially outside of Malaysia, ie in the Middle East, Turkey etc. In Malaysia, sukuk will continue to dominate. However, both market players and regulators are keen to see some movement of Islamic financing structures away from the traditional and dominating debt-based instruments to more participatory risk-sharing structures. Bank Negara Governor Dr Zeti in a recent speech warned that “while Islamic finance has all the ingredients and the potential to meet the needs of the global economy, the channeling of funds to productive activities in Islamic finance today is still largely being carried out through non-participatory contracts, that include the mark-up sale (murabaha) and the lease-based (ijarah) structures, which continue to remain essential to cater for financing trade and the purchase of assets.” Such contracts, she added, are similar to lending instruments which expose the Islamic financial institutions mostly to credit risk elements. While non-risk-sharing contracts will continue to contribute to the future growth of Islamic finance, Dr Zeti contended that the wider use of risk-sharing transactions and undertakings under participatory finance models have significant scope in evolving a broader representation of Islamic financial products that will spur the next phase of industry growth and development. This includes participatory or equity-based contracts such as mudarabah and musharakah that support ventures involving entrepreneurship endeavors. “Greater use of equity-based models in Islamic financial solutions has been observed in the more recent period. This has been most evident in the sukuk segment, with Shariah structures evolving from predominantly Ijarah and murabaha structures to musharakah partnerships as well as convertible and exchangeable trusts,” she said. To most Islamic bankers, however, the main challenges for the Islamic finance industry in 2013 include: i) Islamic banking bracing itself for more competition; ii) The industry reducing costs. Treasury costs are still lower in conventional banks, and loan documentations are still cheaper; iii) Generating more short term assets. It is easier to match fund a 90-day trade finance deal than 5-year property financing. As such, the development of trade finance remains an untapped area of Islamic finance and one vital to its growth and competitiveness; and iv) Diversification. Exposure to the real estate sector remains the highest exposure for most Islamic banks. There is potential to diversify in other sectors such as transportation, energy and healthcare.
