Spring forward: Consolidation and greater overall capacity will boost performance

As one of the world’s leading centres for Islamic finance, Bahrain hosts a wider variety of sharia-compliant financial services companies than perhaps anywhere else, and as in other areas in the Bahraini financial services industry these are aimed not only at the domestic economy but to customers from the region and beyond. As 2013 progressed, Islamic finance as a suite of products was enjoying asset growth and increased market penetration in existing strongholds, as well as eyeing new markets to expand on. For Bahrain’s Islamic lenders, takaful (insurance) providers, investment funds and others, the challenge looks to be converting assets into higher returns, and in a global economy different than the one they were formed in.

STRONG SUPPORT: In the kingdom there are also a growing number of support agencies, leadership groups and standard-setting bodies. Manama has become a magnet for specialists in sharia compliance at long-established organisations such as the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI), as well as in newer organisations created by conventional financial firms, information providers and consultancies – Ernst & Young and Thomson Reuters, for example, both have Islamic finance research and consultancy operations in the kingdom. Together, these groups have a range of services and intellectual infrastructure, researching and harmonising Islamic finance as the sector assesses lessons from its first economic downturn.

Bahrain has developed as a centre for sharia-compliant finance thanks to its history as a regional focal point for conventional finance. This has been a key part of the country’s economic diversification strategy and the tactic has been copied elsewhere in the GCC, creating a degree of competition. However, especially given the amount of capital generated in the region thanks to its petroleum riches, it is likely that more than one GCC city will end up a financial centre for the region – much in the way that Hong Kong and Singapore both maintain similar reputations despite their proximity. A degree of specialisation may characterise the future, and Islamic finance looks certain to be among those areas of expertise.

Bahrain has emerged as one of two international centres for Islamic finance along with Kuala Lumpur, where the Malaysian government’s top-down support for Islamic finance in the past two decades has driven the growth of a healthy and diversified market. These two cities are not necessarily where the most assets are – Saudi Arabia has the most sharia-compliant assets of any country – but where the talent, services, organisations and underpinning infrastructure have developed. Bahrain does rank as a major market in terms of assets, and was listed among seven key countries hosting sharia-compliant banking assets on Ernst & Young’s “World Islamic Banking Competitiveness Report 2012-13”, which was published in December 2012. The accountancy and advisory firm found that 55% of Islamic banking assets are concentrated among 20 banks domiciled in seven countries: Saudi Arabia, Kuwait, the UAE, Malaysia, Bahrain, Qatar and Turkey.

GROWTH PATTERN: Ernst & Young’s projections are certainly good news for Bahraini companies servicing the industry: global Islamic banking assets, which were pegged at $1.3trn in 2011, may surge to $1.8trn in 2013. That assets continue to pour in seems to indicate that Islamic finance as a group has survived the test provided by the global financial crisis: customers remain confident. The crisis was the first in which Islamic finance was a major option in the Gulf – and the sector fared much better than it had in Malaysia in 1997, for example. There is now more clarity about how assets are structured and what to expect, and other improvements are anticipated.

The sukuk, or Islamic bond, market is a good example: investment company Dubai World’s high-profile struggle to meet debt obligations in 2009 initially shook confidence, but eventually became a test case for restructuring. “There is more clarity now,” said Ijlal Ahmed Alvi, the CEO of the International Islamic Financial Market, a standardisation body specialising in capital markets. “People are more aware now of the risk in certain structures, and they have also seen now that it is possible to restructure.”

Islamic financial institutions have helped provide that clarity, but remain in the midst of a maturation process, however. “Islamic banks continue to grapple with multiple challenges relating to sub-scale operation, asset quality, negative operating income from core activities and a weak risk culture,” according to the Ernst & Young study’s conclusions. “The severity of performance challenge has prompted several institutions to initiate wide-ranging transformation programmes.”

BOOSTING PROFITS: Beyond that process, Islamic banks and takaful providers alike intend to tackle profitability issues to ensure healthy returns on assets. Both tend to lag conventional peers in this regard because typically the costs are higher for sharia-compliant alternatives to conventional products. The Islamic banking industry’s global average return on equity in 2011 was 12%, for example, which compares unfavourably with the 15% of the conventional banking industry in the same year, according to Ernst & Young’s study.

The post-crisis conditions and challenges for Islamic finance beyond Bahrain have led to some notable withdrawals from the market, including HSBC’s decision to end its offerings in all but a few key markets. Allianz Takaful sold 75% of its business in the Bahraini and Qatari markets to Medgulf, a local conventional insurer. Regional instability has put off plans for expansion in takaful in Mahgreb countries.

Meanwhile, in Bahrain, Islamic financial executives remain steadfastly focused on updating their business models to reflect current conditions. Consolidation is a hot topic – the Central Bank of Bahrain (CBB) has not forced mergers and acquisitions on licensees, but it has taken leading position in advocating for them (see analysis).

VARIED ROLES: Of the 54 licensed Islamic financial institutions in Bahrain, 26 are banks. Among that group are six retailers, which operate according to the typical universal banking model, and 20 wholesale banks. These operate in an offshore role, in which they are prevented from holding the deposits of locals, save for those in investment accounts of at least BD7m ($18.42m). In total, sharia-compliant financial services firms are licensed in 11 categories in Bahrain and comprise about 13% of licensees. They include the various types of banks; takaful providers local and offshore; nine investment firms in two separate licence categories; three financing companies; a bank representative office; an investment firm representative office; a microinsurer; and a licensed advisor on sharia matters.

The CBB is the sole regulator of all financial activity in the kingdom, which includes Islamic entities. A notable feature of regulation in the kingdom is the CBB’s allowance of conventional banks operating Islamic windows, an openness increasingly hard to find elsewhere. In non-licensed roles are organisations such as AAOIFI, whose main standards focus on sharia and accounting; the International Islamic Financial Market, which researches and develops global standards for common Islamic products such as sukuks in order to promote harmonisation and trading opportunities; the Liquidity Management Centre, which aims to make the financial firms cash flow and secondary trading in sukuks easier by securitising banks’ liquid assets into short-term sukuks; the International Islamic Rating Agency, which acts as a common rating agency but adds sharia compliance issues to the task; and the General Council for Islamic Banks & Financial Institutions, which is affiliated with the Organisation of Islamic Cooperation.

Sharia-compliant banking assets have surged in Bahrain from $1.9bn in 2000 to $25.4bn as of August 2012, according to CBB figures. That corresponds to a market-share increase from 1.8% of total banking assets in the country to 13.3% over that period. Banking is generally considered to be the most mature segment of the Islamic industry when compared with takaful companies, investment firms and other capital-markets vehicles. That means that the banking sector has control over a greater share of assets, however, there are other areas where growth from a small base remains possible.

DIVERSIFIED APPROACH: The outlook for the Islamic banking sector mirrors that of the conventional one in Bahrain. That means that retail banks are moving forward with steady progress and awaiting more economic growth to bring new customers to fuel loan growth, whereas wholesale banks, particularly those focused on investing rather than lending, are in some cases still suffering a drag on their balance sheets from the global financial crisis.

Underperforming real estate is the chief source, pulling down returns on assets. This has happened because wholesale Islamic banks, many of them created within the past decade, had responded to the strong demand for investment opportunities in the 2000s as oil prices rose. Investors looking for returns led to a wave of building accross the Arabian Peninsula, and Islamic banks found these investments to be well suited to their needs: sharia compliance requires that every transaction be based on an underlying asset. As a result, real estate made for a, seemingly, suitable sector to invest in.

Many, but not all, banks were overexposed. As a result, the focus now is on a return to a more diversified approach in IFS investing. Diversity means looking at other prospective sectors, such as health care, education and consumer goods, but also examining geography – Islamic banks are now looking toward promising Muslim markets such as Turkey, Indonesia and Kazakhstan, and further into the future, North African countries such as Egypt.

“If the Islamic financial industry is to be successful at each stage of any economic cycle, the sector’s players need to implement and demonstrate diversity in their asset portfolios,” said Rasheed Al Maraj, the governor of the CBB, in December 2012, addressing the industry at the 2012 World Islamic Banking Conference, which was held in Bahrain. He added, “This, in turn, needs to be coupled with investment in a much wider range of economic sectors.”

Whilst the current economic climate is surely a more difficult one in which to turn profits for any financial company, a closer look at Islamic banks in Bahrain reveals that the group was always more than simply a collection of identical players chasing after the same types of opportunities. An example is Venture Capital, a sharia-compliant investment bank that has been focused on investments in the regional food sector. Elaf Bank specialises in the sukuk trade. First Leasing Bank was a targeted bank financing, renting and otherwise investing in petroleum extraction equipment, until it merged with Ithmaar Bank, of which it was previously a unit. A recent example of investment diversification beyond real estate is Bank Al Khair’s teaming up with Venture Capital to acquire 65% of Turkish juice and fruit concentrate producer Goknur Gida.

OLD MODEL: Perhaps the bigger adjustment – more than expanding away from real estate – has been an abandonment of what banks in Bahrain refer to as the upfront-mark-up model, which lenders, Islamic or conventional, used for investment during the economic boom. They were seeking out investments on behalf of clients and selling stakes to them at a premium to the bank’s investment and transaction costs. This gave the bank some profit at the start, which made liquidity easier to manage, and mandated big returns, so investments could still provide meaty returns in the end. The model also did not require banks to take an equity stake in any particular investment, which reduced its own risk. Investors are more cautious now, however, and in the current global economic climate investments with potentially large enough returns to fit the upfront-mark-up model are harder to come by.

According to Ernst &Young’s global study on Islamic finance, sharia-compliant banks, regardless of geography, could improve their performance and find returns easier in tougher markets if they boost capacity in three main categories: regulatory transformation, including better management of balance sheets and liquidity; risk transformation, such as more detailed risk modelling; and strengthened retail banking operations to adapt a customer-centric model and deploy new technologies. Diversification, new business models and increased operational capacity will not directly help banks attract more capital, which many of them see as a crucial step forward. Most Bahraini Islamic banks are still working with fairly small amounts of capital to deploy – of the world’s 13 Islamic banks with an equity base of more than $1bn, only one is Bahraini, according to Ernst & Young. Mergers and acquisitions make sense across the banking sector, and are beginning to happen more regularly, in particular among Islamic banks (see analysis). “There are simply too many small- to medium-sized Islamic financial institutions,” Maraj said in his December 2012 speech at the World Islamic Banking Conference. “The risks inherent in that scenario are clear – Islamic banks cannot play with the big boys. Smaller banks will find it very difficult to combine the increased capital requirements with the ability to participate in the market.”

CAPITAL MARKETS: An option for raising money other than consolidation is through capital markets, which are developing sharia-compliant solutions alongside the other Islamic financial classes. Sukuk, the sharia-compliant alternative to bonds, could be a suitable vehicle. Since the financial crisis focused more attention on risk, corporate issuers are no longer the driving force behind the global sukuk market, and sovereign sukuk are now getting more attention. However, an innovative sukuk structure that enables debt to be treated like equity means that sukuk funds can count as Tier 1 bank capital under the coming Basel III banking rules, and that makes this type of sukuk another option for banks. Abu Dhabi Islamic Bank was the pioneer with a $1bn issue in 2012. Dubai Islamic Bank announced a similar plan in March 2013, for example.

“We expect increasing Tier 1 issuance in 2013 by UAE and other GCC banks,” according to a Fitch Ratings November 2012 report on the topic. “In our view, relatively high levels of capital are necessary for GCC banks due to the difficult operating environment and the concentration of single names and sectors, particularly of real estate and government-related entities, in the loan portfolios. Any pick-up in loan growth by the banks would need to be supported by additional capital.”

Public issuance of sukuks in Bahrain is conducted through the CBB – the kingdom was actually the first country in the world to have its central bank sell this type of security. There are now three types of sukuks on offer on a regular basis. The shortest term is 91 days. These are called the Al Salam sukuks, and are denominated in dinars. The CBB sells BD18m ($47.36m) in Al Salam sukuks in a monthly auction. There is also a short-term sukuk structured as an ijara, or Islamic leasing bond, issued monthly at BD20m ($52.6m) at a time and maturing in 182 days. Longer-term ijara, generally for periods of three to 10 years for maturity, are sold on an ad hoc basis and either denominated in dinars or US dollars.

A new sharia-compliant securities option available in Bahrain now is a securitisation service from the Bahrain Financial Exchange (BFX), a bourse that opened up in 2011 and is offering trading in derivatives and plans to expand in other asset classes. The BFX’s Islamic service is called Bait Al Bursa, and it is intended as a way for Islamic financial companies to manage their liquidity.

This is typically done through murabaha, a type of sharia-compliant transaction in which a financial intermediary buys something, often a commodity, and sells to another financial institution for a higher price. Payment is deferred for an agreed-upon period, giving the buyer – typically the financial institution – the liquidity it requires and its partner some profit from the transaction. The BFX proposes to play an intermediary role – once the two sides have agreed on terms, they can use the BFX’s platform to securitise the asset and complete the sale. This makes Bahrain one of two places worldwide in which a murabaha transaction can be funnelled through a formal securities exchange, instead of relying on interbank money markets or creating sharia-compliant ones. The other is in Kuala Lumpur, where on Bursa Malaysia palm oil futures are used to promote a similar product, which was launched in 2007.

TAKAFUL: Sharia-compliant insurance is a less developed segment of Islamic financial services, but following generally the same patterns worldwide as Islamic banks: growth thanks to the popularity of the products on offer, but struggling to maximise returns. Ernst & Young’s global study found returns on equity for takaful trailing those of conventional insurers in both the GCC and in Malaysia. Global takaful growth has come slower than anticipated, according to the report, but that is because of legislative holdups to making medical insurance compulsory in the UAE, on which projections of $9.1bn in assets by 2011 were based. The actual figure was $8.3m.

The CBB is expecting takaful growth to continue, predicting global assets of $20bn by 2017. It has been updating and expanding its relevant rules. In Bahrain, takaful accounted for 19% of total gross premiums in 2011, the latest year for which full-year statistics are available from the CBB. That amounted to BD40.2m ($105.7m), up 4% from 2010. Total assets increased 3% to BD114.78m ($302.03m). Liabilities jumped 20%, however, to BD70.36m ($185.14m). There were, as of the end of February 2013, eight locally incorporated takaful firms.

Takaful operators have been suffering a similar problem to conventional insurers in the GCC – a highly competitive market in which penetration rates are low and profit margins thin. This was not a problem in the 2000s, when returns on investment accounts were growing at a point that made concerns about risk-based underwriting miniscule.

Insurers became used to writing policies at almost any cost to gain market share and on the assumption that any losses would be more than made up for by gains in investment accounts. In today’s global economic climate, however, insurers and takaful operators alike are looking to boost their capacity for risk-based underwriting, in hopes of reducing claim ratios and boosting profitability.

OUTLOOK: Islamic finance is now battle-tested; having made it through the global financial crisis, players in the sector have learned how to manage risk accross the economic cycle. Asset growth continues in the post-crisis global economy, indicating that the products are popular enough with retail investors and institutions alike. There is still room for growth from a small base in takaful in particular, on the assumption that those willing to try Islamic banking will also use takaful. Ernst & Young calculations show sharia-compliant finance’s market share in the GCC at 25% and in Malaysia at 22%, whereas takaful has just 15% and 10%, respectively. From here, the challenges appear to be to build upon the extended growth period to firm up operational capacity and risk management, find new, sustainable lines of business, develop human resources and boost overall capacity in preparation for a more competitive future.