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Challenges on the horizon

Competition and cost will be just two areas in which the Islamic banking industry can expect future challenges. MUSHTAK PARKER looks at what 2013 has in store

Judging by the cornucopia of optimistic press releases, conference speeches and utterings, it is easy to get the impression that the global Islamic banking industry is the new “untouchable” – seemingly untouchable that is from the impact of the financial crisis, the ongoing economic recession, the eurozone debt crisis and even from the effects of the so-called Arab Spring.

The more discerning market practitioners, far less prone to chasing the surfeit of largely meaningless “industry awards” that have marked the industry over the last decade or so, have a more sober reflection of the state of the industry especially as it enters it 38th year of operations in its contemporary movement.

Revised upward estimates of the global assets under management of the Islamic finance industry reaching $1.8 trillion in 2012 are deceptive given that there is no single global independent industry statistical authority that compiles this data using recognised empirical methodology and the fact that the culture of disclosure and transparency in the industry is at best erratic with the Turkish and Malaysian markets the most open in terms of data and access to such information.

Mohamad Safri Shahul Hamid, deputy CEO of CIMB Islamic Bank of Malaysia

Mohamad Safri Shahul Hamid, deputy CEO of CIMB Islamic Bank of Malaysia

Transparency and disclosure is particularly important in better understanding the client’s credit. For instance, according to Mohamad Safri Shahul Hamid, deputy CEO of CIMB Islamic Bank of Malaysia, which has a branch presence in Bahrain, “to avoid more ‘bad apples’ in the Sukuk market, several preventive measures are needed. These include moving away from relying on the traditional ‘name lending’ basis; ensuring transparency through corporate governance and financial disclosure; regular dissemination of key information to investors and timely filings of necessary financial information; implementing credit rating of corporate issuances as a mandatory process; and implementing investment limits to minimise exposure.”

The headline figures aside, there remain huge policy, regulatory and structural, let alone market and product innovation and human capital development challenges for the industry as it enters the New Year.

Of course, the Islamic finance sector is just as beholden to the macro-economic conditions of the market as any other banking or economic sector. The latest World Investment and Political Risk Report 2012 published in December by the Multilateral Investment Guarantee Agency (MIGA), the political risk insurance agency of the World Bank Group, emphasised that global economic growth estimates for 2012 indicate a continuing fragile global recovery.

“The ongoing sovereign debt crisis and recession in the eurozone; curtailed bank lending and domestic leveraging; fluctuating but elevated commodity prices; and the ongoing political turmoil in the Middle East and North Africa have slowed the initial rebound that followed the 2008 global financial crisis. This slow progress has had an impact on developing countries, which initially fared well in terms of rebounding GDP growth rates, private capital flows and foreign direct investment (FDI),” MIGA reported.

Indeed, the World Bank Group estimates and forecast for real GDP growth for the MENA region specifically are sober and worrisome. At an estimated average of 0.5 per cent real GDP growth 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 per cent for East Asia; 6.3 per cent for South Asia; and 4.8 per cent for Sub-Saharan Africa. It is also way below the 1.3 per cent estimate for the industrialised 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 per cent and 3.4 per cent respectively – still way behind the above peer regions except the industrialised economies, which will continue to lag at 1.5 per cent and 2.2 per cent respectively.

This translates into a two-track development of Islamic finance over the next few years – an ongoing expansion of the industry in markets with high liquidity due to booming global commodity prices; and a much more subdued and uncertain development of the sector in markets weighed down by political uncertainty and the adverse effects of rising prices of oil, gas and other commodity imports.

The impact on FDI flows has also been marked, with the MENA region also badly affected. Global FDI inflows, according to MIGA, declined from $1.9 trillion in 2011 to $1.7 trillion in 2012. Any rebound in 2013 will depend on the pace of the global recovery, albeit there is evidence of greater South-South FDI flows, and the lessening of political risk whether through greater stability or a decline in expropriation of assets by beleagured governments.

In the MENA region, there has been a decline in FDI flows in 2012 to an estimated $14.3bn compared to $15.4bn in 2011. The Arab Spring countries were the most affected with FDI flows into Tunisia declining by 14 per cent in 2011, while Egypt experienced a net outflow of $483m of FDI. The good news is that investors, according to the MIGA-EIU Political Risk Survey 2012, which is incorporated into the Investment Report, have every intention to return to the MENA region because of increased market opportunities rather than political risk perceptions. Interestingly, increased access to financing – whether conventional or Islamic – was not a primary reason for investing or re-investing in the MENA region.

Massoud Janekeh, director and head of Islamic capital markets at the Bank of London and the Middle East (BLME)

Massoud Janekeh, director and head of Islamic capital markets at the Bank of London and the Middle East (BLME)

Despite the proliferation of Islamic financial institutions (IFIs) globally, including recent new markets such as Oman, Islamic banking, warns Massoud Janekeh, director and head of Islamic capital markets at the Bank of London and the Middle East (BLME), “has to brace itself for more competition. Not just from conventional banks that are slowly enjoying more liquidity, but also from other Islamic banking economies such as the African nations, Indonesia and Turkey”.

Similarly, treasury costs are still lower in conventional banks, and loan documentation are still cheaper. To be more competitive, he advises, Islamic banking cannot afford to continue with a cost disadvantage.

To Islamic bankers such as Janekeh, there are three other major challenges for 2013. These include expanding wealth management; generating more short-term assets; and product and asset class diversification. In Islamic wealth and estate management, the main chance is now. “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” says Mr Janekeh.

The industry has also been criticised in recent years for its heavy exposure to the real estate sector, which continues to persist for most Islamic banks today. Islamic bankers would like to see a much greater diversification into real economy sectors such as transportation, energy and healthcare, where there are good opportunities especially for Ijarah financing.

“Most Shariah-compliant income funds face the same problem of shortage of quality assets to invest. Sukuk issuance is recovering but is 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 maintains.

With the proliferation of Sukuk (with an estimated total of just under $130bn of issuances in 2012 at the time of writing), it is not surprising that some bankers predict that Sukuk will increasingly replace Murabaha (cost-plus financing) and Tawarruq (commodity-based Murabaha) as tools for raising short-term financing and as cash management for retail customers.

However, in most of the MENA region, for example, this will depend on the emergence and presence of a domestic sovereign Sukuk market for liquidity management, reserve capital management and other uses. Currently, only Bahrain has a robust domestic sovereign Sukuk issuance programme based on Sukuk Al Salam and Sukuk Al-Ijarah.

The Turkish treasury in October issued the country’s first domestic sovereign Sukuk – a two-year TL1.6bn Sukuk Al Ijarah (lease-based trust certificates) offering that was oversubscribed to the tune of TL3.28bn, and may pave the way for regular future such issuances as part of the government’s overall domestic bond issuance programme. The Sukuk will pay a rental return of 3.7 per cent to be paid every six months.

Ufuk Uyan, CEO of Kuveyt Turk Participation Bank

Ufuk Uyan, CEO of Kuveyt Turk Participation Bank

“More Turkish lira Sukuk issuance by the Turkish Treasury,” confirms Ufuk Uyan, CEO of Kuveyt Turk Participation Bank  (KTPB), in which Kuwait Finance House has a controlling equity stake, “might enable us to develop alternative liquidity management tools to replace Murabaha and Tawarruq for Participation Banks (the Turkish euphemism for Islamic banks), through the Istanbul Stock Exchange and Turkish Central Bank open-market instruments.”

Uyan, who is also the chairman of the Association of Participation Banks of Turkey, the statutory industry professional body, also revealed that the association has been working to get the legislation relating to the Turkish Capital Market and Turkish Central Bank Laws amended to include Sukuk as a security to sell and buy back and as a guarantee. Hopefully this, he adds, will yield new eligible products.

However, others maintain that Murabaha and Islamic trade finance will continue to dominate the direction of Islamic finance over the next few years as it has done for the past three decades, when short-term Murabaha has accounted for up to 80 per cent of financing in the global Islamic finance industry, albeit it has declined to about 65 per cent currently.

“It is easier to match fund a 90-day trade finance deal than five-year property financing. 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. In my view, development of trade finance remains an untapped area of Islamic finance and one vital to its growth and competitiveness,” contends BLME’s Massoud Janekeh.

Others such as CIMB Islamic Bank’s Mohamad Safri Shahul Hamid, emphasise that Syndicated Murabaha especially will continue to thrive in markets outside of Malaysia, especially in the MENA region. This is because the Sukuk market infrastructure is more developed in the south east Asian country than in its MENA counterparts. Malaysia currently accounts for just under 70 per cent of global Sukuk market issuances in terms of volume.

In addition, Murabaha and Tawarruq, he adds, “allow jurisdictions that have yet to  ‘develop’ their Islamic finance infrastructure the breathing space to amend their existing legal, regulatory and tax frameworks to become more ‘accommodative’ with other Islamic structures, and to have a ‘feel’ of the enormous potentials of Islamic finance. It also gives the opportunity to potential issuers that don’t possess any assets to issue Sukuk by ‘utilising’ Shariah-compliant assets from a third party”.

Kuveyt Turk head office

Kuveyt Turk head office

Turkey and the GCC countries, especially Saudi Arabia, Bahrain and the UAE, are the most active markets for Syndicated Murabaha, usually a short-term fund-raising instrument for both banks and corporates.

Syndicated Murabaha transactions over the last four months suggest robust demand for such deals, and, according to MENA bankers, this trend will continue through 2013. Al Baraka Turk Participation Bank (ABTPB), a subsidiary of the Bahrain-incorporated Al Baraka Banking Group, for instance, in September closed its third dual-currency Murabaha Syndication facility – worth $450m – which is the largest to be completed for a Turkish corporate.

The fact that the $450m facility, which comprised a $293.2m tranche and a EUR124.5m tranche for a total US dollar equivalent of $450m, was lead arranged by Bank Islam Brunei Berhad Darussalam and the UAE’s Al Hilal Bank, and attracted the participation of 32 banks from 16 countries, underlines the global reach of the Murabaha instrument; its attractiveness as a safe short-term financing instrument; and the continued appetite for Turkish participation bank risk.

So far this year two Turkish banks had already raised funds through dual currency syndicated Murabaha facilities. They include Asya Katilim Bankasi (Bank Asya’s) $325m dual-currency syndicated Murabaha facility, which carried a profit rate of 200 basis points over the relevant benchmark; and Turkiye Finans’s $350m facility which had a profit rate of six-months LIBOR/EURIBOR plus two per cent.

And it is not just the Participation Banking sector that has got the Syndicated Murabaha blues. Turkish real estate investment trust Is Gayrimenkul Yatirim Ortakligi A.S. (Is REIT) recently closed a debut two-year $50m Syndicated Murabaha facility with a profit rate of LIBOR +250 basis points, which was lead arranged by Qatar Islamic Bank (QIB) and co-arranged by Barwa Bank, First Gulf Bank and Mashreq Bank.

According to Turgay Tanes, chief executive officer of Is REIT, “a Murabaha facility is the most suitable form of financing for our business as it is one of the most widely used instruments used by banks within Islamic finance. This type of instrument offers relevant cost and payment terms for our current and future investments”.

Elsewhere, in Saudi Arabia, Sahara Petrochemical Company closed a three-year SR500m Commodity Murabaha Tawarruq standby medium term revolving facility, which was arranged by Riyad Bank. The purpose of the facility, according to a statement by Sahara Petrochemical Company, is “to provide standby support for the company’s financial requirements with respect to working capital and the needs of the company’s projects and future investments”.

Similarly, another Saudi firm, Fawaz Abdulaziz AlHokair Company, signed a SR717m Syndicated Murabaha facility, which was arranged by SAMBA Financial Group, Saudi Hollandi Bank and Gulf International Bank. The proceeds from the facility are being used to finance the acquisition of NESK Commercial Projects Co (Al Jedaie).

However, there is no doubt that the general optimism of the industry participants is based on the perception of an even greater proliferation of the global Sukuk market in 2013. At the time of writing, FWU AG Group (FWU), the Munich-based financial services company with a special interest in Takaful (Islamic insurance), had just issued Europe’s fourth Sukuk to date – worth $55m.

This was the first ever issuance by a German corporate and the largest corporate Sukuk from a European entity to date. According to FWU, the issuance is also the first Sukuk to utilise a computer software programme and intellectual property rights under an Ijarah (leasing) structure.

The general consensus is that 2013 will be a continuing theme of 2012 for the Sukuk market, which will be further highlighted by new entrants and more debut issues; and with longer tenors and higher Sukuk volumes to deal with refinancing.

What then are the drivers of the Sukuk market in 2013? According to CIMB Islamic Bank’s Mohamad Safri, who is one of the unsung experts of structuring Sukuk both in South East Asia and the MENA region, they include:

interest from new markets
issuers tapping non-traditional markets such as the Renminbi and Euro markets
the return of previous issuers such as sovereign Qatar, which issued a $4bn Sukuk in July after an absence of nine years from the Sukuk market;
  • the emergence of non-traditional issuers from market such as Saudi Arabia, for instance, the SR15bn Sukuk issued in 2012 by the  General Authority of Civil Aviation (GACA), which is the biggest ever Sukuk from Saudi Arabia and first government-backed Sukuk in the Kingdom, and by several other Saudi banks and corporates
  • the continuation of Malaysia as the leading Sukuk hub globally, including several foreign issuers especially from the GCC countries preferring to issue Sukuk in the Malaysian ringgit market
  • the huge proposed spending on infrastructure development in the GCC region, with an estimated $452bn earmarked for projects over the next decade or so, including the GCC Railway Project which links a 2,117 km long network and starts from Kuwait and ends in Saudi Arabia, and the additional infrastructure and sports facilities needed leading up to Qatar hosting the FIFA 2022 World Cup.

BKME’s Massoud Janekeh, however, maintains that Islamic banks will also continue to need long-term liabilities to match their funding gaps and there is still appetite for investment grade Sukuk by IFIs. These factors, he adds, will fuel the continued issuances by Sovereigns, Quasi Sovereigns and IFIs in 2013. Retail sukuk, amortising paper and more short-term paper is what the market wants.

“There are one or two exciting pipeline deals that carry these features and could set a new trend for Sukuk issuance.  I cannot see in the short term the return of Sukuk to refinance large-scale projects finance transactions,” he said.

But there are other country-specific and structural reasons for more Sukuk issuances. In Turkey for instance, the country’s sovereign rating was upgraded to investment grade by Moody’s Investors Service just prior to the launch of Turkey’s debut sovereign $1.5bn Sukuk Al-Ijarah last September. This upgrading is the first by any of the three major international rating agencies in 12 years. With the other two rating agencies, Standard & Poor’s and Fitch, imminently expected to follow suit, the year 2013, according to Kuveyt Turk’s Ufuk Uyan, will bring a different and challenging environment for Turkish Participation Banks.

“As you are also 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),” explains Uyan. “Interest rates come down, and due to the flow of significant portfolio money, exchange rates are suppressed. Therefore, a lot of intervention from the Central Bank of Turkey (CBT) is expected in the markets via open market operations or unique instruments developed lately by the TCB. The very consequences of this market environment for Participation Banks is that there will be ample liquidity but rare financing options. Therefore, Participation Banks in 2013 have to develop new products to meet customer needs.”

One of those products, not surprisingly, is Sukuk. With the success of the debut Turkish sovereign international and domestic issuances, Uyan, like other participation bankers in Istanbul, expect the Turkish Treasury to issue more Turkish lira (TL)-denominated Sukuk in 2013. Indeed, the treasury has already announced that it will have its next TL Sukuk auction in February 2013. This will give the Participation Banks with their high liquidity new-found opportunities to invest in Shariah-compliant Turkish Treasury papers.

While other Turkish participation banks such as Albaraka Turk and Asya Bank have recently confirmed their intention of raising longer-term funds from the international Sukuk market in 2013, a more revealing market development would be for local issuers also to issue Sukuk in the TL market.

Kuveyt Turk’s Ufuk Uyan, in fact, confirms that the bank may issue its debut TL Sukuk in 2013, “especially with the new opportunities availed by the new Leasing Law with regards to the formation of an underlying asset pool via a sale and lease mechanism.

“Provided the tax treatment is similar to that for Sukuk Al Ijarah, this will provide a huge potential and incentive for participation banks such as Kuveyt Turk, with its higher than investment grade rating, to conclude, Sukuk for blue-chip Turkish corporations with suitable assets. We are already working on getting mandates with our partner, the Liquidity Management House (LMH) from Kuwait, from two or three local corporations.”

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