Despite being relatively young as a global industry with the first modern Islamic banks only emerging in the 1970s, Islamic banking nonetheless has not only taken root in the Gulf Cooperation Council (GCC) countries but also in certain Asian countries – primarily in Malaysia. Though Islamic banking in East Asia is slowly developing, however, it needs more action by regulators to establish legal and regulatory frameworks if it is to emerge as a significant segment across the region, said Moody's Investors Service in its recent report entitled “Islamic Banking in East Asia - Growing but not without Challenges.” Its growing importance is also evidenced by the segment's relatively high market penetration in Brunei and rapid asset growth in Indonesia. Moreover, announcements from some of the most important financial centers in the Asia Pacific, such as Singapore, Tokyo and Hong Kong that they are to increase their participation in the segment also underlines the emergence of Islamic finance. The report noted that aside from Malaysia, where the industry's assets now account for 15.4 percent (about $62 billion) of the country's banking system assets, its market penetration across the region has been somewhat patchy. For instance, while Islamic banking has achieved relatively high market penetration in Brunei and asset growth in Indonesia has been rapid (though off a low base), Islamic banking services available in the Philippines, Singapore and Thailand and remain very small in terms of asset size. Islamic banking market share in Indonesia was about 1.58 percent as of the end of 2006 in terms of assets. The 2007 data is not yet available, but Moody's forecast its market share should remain below 2 percent as of the end of 2007. “There exists a natural business potential for Islamic banking services in Malaysia as approximately 60 percent of its population is Muslim, but it is government reforms during the past 20 to 30 years which have really helped develop the necessary legal and regulatory framework and institutions for the industry to flourish,” said Christine Kuo, a Moody's analyst and author of the report. “The adoption of various incentives, including tax breaks, has also proven critical to nourishing the business. “We believe the Malaysian experience over the last three decades demonstrates how instrumental regulators can and need to be in order to grow the Islamic banking sector,” she added. As Malaysia's experience has illustrated, government involvement is critical in laying the groundwork and ensuring that the development of the Islamic banking sector is sustainable, Moody's report said. “As a result of efforts of market participants and regulators, we believe Islamic banking assets in several East Asian countries will continue to grow quickly. However, as Islamic banks expand they will need to deal with the twin challenges of managing their rapid growth and competing against conventional banks.” The report pointed out that a large Muslim population is not an assurance of fast development of Islamic banking, as evidenced in Indonesia and some Gulf countries. In Indonesia, for example, the segment's market share is less than 2 percent ($3 billion, and the Philippines, Singapore and Thailand each have just one small Islamic bank. In Brunei, although Islamic banks' shares of total assets have already reached 36 percent, “their absolute size is small” at only $4 billion. Development of Islamic banking has been slower in Indonesia partly because the country's banking system was badly hit during the Asian financial crisis and party because the government has had many other competing priorities, it said. Nonetheless, a few important legal and regulatory changes seem to be gathering momentum. These changes, if successfully implemented, could lead to a gradual increase in penetration of Islamic banking, the report added. “Rather, the driving force behind the development is a very proactive government. Malaysia established its first Islamic bank in 1983. During the past two to three decades, the country's regulator has developed the necessary legal and regulatory framework and institutions, while also providing various incentives critical to nourish the business.” The report further said that while conventional banking dominates the region and is expected to continue to do so, the major financial centers of Hong Kong, Singapore and Tokyo have all announced their interest in developing their Islamic banking segments and facilitate capital flow of Islamic funds similar to the strategy adopted by London. The interest reflects the recognition of the growing importance of Islamic finance, and the reality that capturing international flows of Islamic asset management and capital market businesses will further cement their positions as financial hubs. The increasing interest among financial centers, the report pointed out, will not only facilitate product offerings to bridge regional and international financial linkages but increase acceptance of Islamic assets as an alternative asset class. Moody's said a “proactive government is needed” to cultivate the necessary operating environment to encourage the growth of an Islamic banking sector, which includes establishing the legal, Shariah and regulatory frameworks to support a diverse range of market players and products. The capital market also needs to be developed and supported by an adequate secondary market. In Malaysia, separate Islamic legislation and banking regulations exist side-by-side with the conventional banking system as a result of a series of government measures focusing on institutional development in the 1980s and 1990s, the report said. Today Malaysia has an active Sukuk market with ringgit-denominated sukuk representing 66 percent of global sukuk outstandings as of Dec. 31, 2007. Islamic banking services in Malaysia are offered through three types of governance structures: (1) stand-alone Islamic banks; (2) Islamic banking windows within conventional banks; and (3) Islamic banking subsidiaries of conventional banks. As Islamic banking businesses grow, some banks have chosen to incorporate their Islamic banking businesses. With a separate legal entity, it is easier to form strategic alliances with potential partners who are interested only in forming partnerships with other Islamic banking businesses. Also, a separate Islamic banking subsidiary gives an impression of a stricter segregation of Islamic funds, which appeals to more religious clients. The regulator has actively encouraged conversion of Islamic windows to Islamic subsidiaries with the result that all Islamic banking windows within domestic banking groups will have converted to Islamic subsidiaries by the end of 2008. This will bring the total number of licensed Islamic banks in the country to 16 and includes four new Islamic subsidiaries which will or have already commenced operations in 2008. The challenge for Islamic institutions is to provide not just Shariah-compliant products but also competitive returns. Malaysia, Moody's said, is a case in point. Based on discussions with several industry players, Moody's report noted that a significant portion of Islamic banking customers are non-Muslims. Even most Muslim customers compare pricing and services offered by Islamic banks with those of conventional banks. These two phenomena suggest that Islamic finance is increasingly viewed as an alternative means of financing and investment and, more importantly, Islamic banks are competing directly with their conventional banking peers. Moody's said assuming that a third to a quarter of Islamic banking assets are contributed by non-Muslim customers, “this would suggest that more than 80 percent of the Muslim population in Malaysia still bank with conventional banks.” However, converting conventional banking assets into Islamic ones poses challenges, according to the report. Firstly, not all Muslims seek Islamic banking. In the Gulf countries where the population is almost entirely Muslim, the market shares of Islamic banks are still not high even though they are fast growing in several markets, Moody's said. Moreover, while customers may initially choose a bank based on faith, continued business growth and client retention will hinge on Islamic banks' ability to provide competitive pricing if their customers are rate sensitive, the report noted. A study on movements of Islamic rate of returns and conventional interest rates showed that in the interbank market, the profit rates in the Islamic money market have been generally slightly lower than those in the conventional money market. Notwithstanding, movements in the Islamic profit-sharing rates closely follow changes in conventional money market interest rates. In addition, the base financing rate of two major Islamic banks in Malaysia (Bank Islam and Bank Muamalat) are shown to move fairly closely with the base lending rates of conventional banks. It was also noted that most banking groups offer similar pricing for conventional and Islamic banking products because their customers will engage in arbitrage if this is not so. “It becomes clear that as Islamic finance modernizes, customers are keen not only on the Islamic nature of the financial instruments offered, but also on the returns offered and how they compare with other financial products. The significant business contribution from non-Muslim population in Malaysia makes pricing even more important for Islamic banks to retain their clients,” the report said. The challenge for Islamic institutions is therefore to provide not just Shariah-compliant products but also competitive returns, it added. According to BNM's Financial Stability and Payment Systems Report 2007, Islamic banking assets have expanded at an annual average rate of 19.3 percent since 2003 to constitute 15.4 percent of assets of the total banking system as of December 2007. The growth rate is somewhat higher than the conventional banking sector, as the entire commercial banking sector (including Islamic banks) has grown at 16 percent during the same period. The growth momentum in this sector is expected to continue with the commencement of operations by wholly-owned foreign Islamic banking institutions and an increasing number of Islamic subsidiaries of domestic banking groups. A further study on the profitability of nine Islamic banks showed that their profitability is generally less favorable and more volatile than the sector average that includes Islamic banking windows of conventional banks, the report said. “This suggests the Islamic window is a better business model in terms of profit,” it said, since conventional banking parents help absorb some cost of their Islamic window operations, and also that a separate legal entity necessarily involves extra cost. In light of the keen competition from conventional banks and the need to continue to invest, Moody's said Islamic banks will still lag behind with conventional banks in terms of profitability in the next couple of years. BNM's financial sector master plan envisions that the Islamic banking landscape will evolve in parallel to conventional banking, constituting 20 percent of the banking market share by 2010, making an effective contribution to the financial sector of the Malaysian economy. So far, the growth of Islamic banking assets have outpaced that of conventional banks, leading to impressive and constant rise in their combined market shares, from 6.9 percent in 2000 to 15.4 percent as at the end of 2007. “If this trend continues, the country will be well on its way to reach the 20 percent market share target in years to come, if not by 2010,” Moody's said. “We believe that the incentives provided by the regulator will remain necessary if the growth of the sector is to continue. The growing population will also help.” Another more daunting challenge for Islamic banks is to manage growth. Like any company experiencing rapid growth, these banks will need to cope with issues such as system and infrastructure upgrades and talent cultivation and retention. Competition for talent has been particularly intense in the field of Islamic finance in recent years, it said. Additionally, they need to address risk issues specific to Islamic financial institutions. “These issues include investment concentration as a result of the limited scope of eligible asset classes, higher costs for managing liquidity (as Murabahah contracts make it necessary for commodity brokers to be involved), concentration of liabilities (due to a limited range of possible funding sources and imbalanced funding continuums), displaced commercial risk, and other non-financial risks. Moody's believed Islamic banks in Malaysia can deal with these challenges as long as they are not under too much pressure to pursue aggressive asset growth, as it would take time to develop risk professionals within their institutions and appropriate tools to manage risk. __
