Islamic Banking in GCC – Resilience in the Financial Crisis

The global financial crisis has prompted calls to return to basics and emphasise sound fundamentals. While most of the formerly fashionable financial innovations – such as credit-default swaps, mortgage-backed bonds and single-tranche collateralised debt obligations – took a beating, one segment exhibited remarkable resilience: Islamic banking.

Modern Islamic financial services have been around for more than three decades, but they gained widespread attention only recently, as rising prosperity in the GCC and South-east Asia fuelled demand for financial instruments that avoided inclusion of interest payments, which are forbidden by Islamic law.

Islamic banks, as well as traditional banks that offer Islamic services, have been a part of RAK’s financial scene from the outset. Major regional players such as Abu Dhabi Islamic Bank, Dubai Bank, Dubai Islamic Bank (DIB) and Noor Islamic Bank have active branches in RAK, and the home-grown National Bank of RAK received a licence from the UAE Central Bank to offer sharia-compliant services in 2007. DIB has been especially active, opening a fourth branch in RAK in late 2009 and becoming the official escrow agent for real estate deals via an agreement with RAK Investment Authority.

While the financial sector as a whole recorded historic drops in activity and profit over the last two years, a WTO report on trade levels predicted aggregate asset growth of Islamic banks to reach an impressive 15-20% in 2009 – down from the optimistic 20-30% predicted in 2008, but far from disappointing. Yet despite their strong showing, some analysts warn that Islamic banking, like so many of the financial vehicles that enjoyed soaring popularity over the past decade, is attracting investors with false impressions of lower risk.

Islamic banking is commonly seen to have two advantages over conventional banking. The first is a perception that Islamic banks are bound to a higher moral standard: they will not take on irresponsible amounts of risk or pay outsize bonuses to their top bankers. The second is that earnings come from identifiable assets, not opaque combinations of derivatives and securities. Because Islamic banks cannot make money through interest, they rely on ties to tangible assets such as real estate and equity, charging “rent” instead of interest.

Until recently, this was seen as a strength of the sector. However, the relative volatility of the real estate and equity markets, especially in the UAE, has created challenges for Islamic banks. The near-default of Dubai World’s Nakheel sukuk was only the most high-profile in a series of events that called into question the supposed safety of Islamic financial products.

An assessment of Islamic financial services may lead the investor to question their viability. The changes needed to make funds sharia-compliant – who buys what, who rents what – lead to a proliferation of transactions, each with its own cost. The frequent reliance on real estate as an underlying asset subjects Islamic financial products to the unpredictable swings of the real estate market. And, in the absence of any overriding regulatory body, the exact definition of sharia-compliant is difficult to pin down. Perhaps most importantly, a standard course of action in the case of a default has not been established.

Yet despite these risks, public and private investors are still creating high demand for Islamic financial services. RAK’s government unveiled a $2bn sukuk programme in 2008, with a preliminary issue of Dh1bn ($272m) in May 2008 and a heavily subscribed Dh1.47bn ($400m) issue in the summer of 2009. The strong investor response indicates the RAK government’s credibility among international investors is solid. And while historically sukuk issues have attracted the most attention within the GCC region, over half the stakeholders in the 2009 issue are from outside the region: 34% of investors are in Asia and 19% in Europe.

While many of the most well established Islamic banks are based in the UAE, continued demand shows that there is still space for new players in the market. Greater competition should stimulate efficiency and growth in 2010 and beyond, marking the rise of Islamic banking as no fleeting fashion. For the sake of investors, it is to be hoped that Islamic banking regulation rises along with it.
source : GAN