Islamic financial instruments in Dubai offer safe haven for capital

The financial services industry in Dubai is a major economic driver for the emirate, and the Islamic segment is no exception. In addition to the emirate’s Islamic banks and takaful (Islamic insurance) providers, since July 2015 it is also the largest centre for sukuk (Islamic bond) issuance in the world, with $36.7bn in sukuk listed on Dubai’s exchange. The drop in crude oil prices in 2015 may constrain growth, but Dubai is expected to continue adding breadth and depth to its sharia-compliant capital markets, and to carry on its leadership in boosting standards and governance. “Dubai is leading the game in terms of product range in Islamic financial services. Moreover, a lot of facilities are available for Islamic finance liquidity management. The emirate can use all these products and facilities to further promote the sector,” Hussain Al Qemzi, group chief executive at Noor Bank, told OBG.

IFS In Focus

Dubai Islamic Bank (DIB) was established in 1975 and was the first commercial sharia-compliant lender in the world. There is a renewed emphasis on Islamic financial services, as the emirate has ambitions to become the capital of the global Islamic economy, a goal set in 2013. Dubai now produces an annual “State of the Global Islamic Economy Report” and has implemented various initiatives, including new offerings and capacity-development programmes for Islamic financial services. The plan is to provide products, standards and systems that can be easily replicated worldwide, and in the process reduce the market fragmentation within sharia-compliant finance that limits cross-border investment and participation. For private investors in Dubai this manifests itself through a facilitative approach from the government and a thirst for new products. One example is the first sharia-compliant real estate investment trust (REIT), Emirates REIT, which sold shares in an initial public offering in 2014. Popularity was so high that in October 2015 it announced plans for a second REIT, focused on residential properties. While outward-facing plans are helping to shape the agenda, within Dubai’s domestic market for sharia-compliant services there is spirited competition for customers and experimentation with new strategies and initiatives. In the broader sector – Islamic and conventional combined – several foreign competitors have sold their operations to local leaders in recent years. In one high-profile 2014 transaction Barclays Bank sold its UAE-wide operations to Abu Dhabi Islamic Bank, one of the largest lenders of any type in the UAE, for Dh650m ($176.9m).

Another new opportunity for sharia-compliant investment in the emirate has been presented by the end of economic sanctions on Iran. Currently all banking in Iran is sharia-compliant, and the lifting of sanctions has heralded the end of a freeze on Iranian assets abroad and the opening of its economy to foreign business. This is likely to mean greater activity for Dubai’s Islamic banks, takaful providers and sharia-compliant investment firms. In addition, the Dubai Smart City project will require a large number of buildings be retrofitted, which also means a need for financing partners. Etihad Energy Services signed a deal with the National Bonds Corporation in November 2015 for a sharia-compliant structure to fund energy efficiency projects at the Jebel Ali Free Zone.

Size & Scope 

Islamic banks and takaful companies are licensed to operate at the federal level. Islamic banks had Dh404bn ($110bn) in assets at the end of 2014, or a 17.5% share of the total sector, according to the Central Bank of the UAE (CBU). They also accounted for 19.2% of system lending. However, that figure does not account for the Islamic operations of conventional banks. Including these, the market share for sharia-compliant assets, as of late 2014, was closer to 28%, according to credit ratings agency Moody’s. Globally, Islamic finance assets were valued at $1.81trn in 2014, according to 2015-16 analysis by the Dubai Islamic Economy Development Centre (DIEDC). A breakdown of current assets by category shows Islamic banking accounted for $1.35trn of the total, with sukuk representing the second-largest segment at $295bn. Takaful companies held $33bn and sharia-compliant funds stood at $56bn. Banking and takaful growth rates were 12% and 10%, respectively, in 2014, followed by sukuk (6%) and funds (7%).

Legal & Regulatory 

Islamic financial services providers in Dubai are subject to the same laws governing conventional activities, and are regulated by the same entities – the CBU for banks, the Insurance Authority for takaful, and the Securities and Commodities Authority for capital markets. The emirate also has a purpose-built financial free zone, the Dubai International Financial Centre (DIFC). DIFC companies are governed by a bespoke legal regime created for the zone and regulated by a purpose-created body, the Dubai Financial Services Authority (DFSA). The DFSA’s regulatory regime for Islamic finance is based on the DIFC Law Regulating Islamic Financial Business of 2004, which requires firms be licensed as an Islamic financial institution or obtain an endorsement to operate an Islamic window in order to carry out financial services in accordance with sharia law. The DFSA Islamic Finance Rulebook requires sharia-compliant firms appoint a Sharia Supervisory Board, and establish and maintain systems and controls that will enable it to comply with applicable sharia requirements. The DFSA also has specific prudential requirements for Islamic financial institutions. In addition, the Collective Investment Law, the Investment Trust Law and the Collective Investment Rules contain provisions for Islamic funds.

Collaborative Effort

Whether in the local markets or the DIFC, the current trend in oversight of Islamic finance is a convergence of methods, and the push for standardisation in Dubai’s Global Islamic Economy initiative is echoed by other bodies internationally. In a 2015 research paper on Islamic banking, the IMF made several recommendations, including the use of Accounting and Auditing Organisation for Islamic Financial Institutions standards and the further development of a prudential framework.

The most significant development is the establishment of a sharia board at the federal level, which could reduce financial entities’ reliance on their own scholars for interpretations on sharia compliance. A UAE sharia board gained UAE Cabinet approval in May 2016. “Without standardisation in Islamic financial services there is no transparency. The announcement by the UAE Cabinet to approve the launch of the new Sharia Authority, will provide a unified, national regulator for the country and ensure the standardisation of Islamic finance products here. This will avoid a lot of unnecessary disagreements and through the implementation of this initiative, the UAE can serve as a benchmark for other countries to implement it globally,” Al Qemzi told OBG. The body would be created to approve or reject specific financial services products based on their sharia compliance. Other countries have established national-level sharia boards, but given Dubai’s global ambitions, the UAE’s version will be designed to provide international leadership on key issues where sharia interpretations vary. Khalid Al Janahi, advisor to DIEDC, told OBG, “The idea is to create a board with international credibility. Most sharia boards are geared to local markets.” Jamal bin Ghalaita, CEO of Emirates Islamic Bank said, “The decision by the UAE Cabinet to establish a unified sharia board for the UAE banking and finance industry is a significant step towards the development of Islamic banking and finance in the region. It will contribute to standardising laws and regulations within the sector, in line with the growth requirements of the Islamic economy, and help in the acceleration of growth of Islamic banks in the UAE. The decision reconfirms the UAE’s leading position on the global Islamic banking map, and consolidates its position as a developed Islamic economic model on a global scale.”

Banking 

The history of Islamic banking in the modern era stretches back to the 1970s, with Dubai playing a pivotal role. DIB was the first of its kind, though some other specialist sharia-compliant financial services firms preceded it. The UAE’s sharia-compliant lenders increased their financing by 22% in 2014 to Dh266bn ($72.4bn), according to the CBU’s annual report, bringing their market share in the lending segment to 22.2% at the end of the year, up from 20% at the end of 2013. The outlook for 2015 and 2016 is somewhat muted and based largely on subdued oil prices, which will result in less liquidity in the region. According to a forecast from Standard & Poor’s (S&P), earnings growth across the GCC is expected to be in the mid-single digits, down from an average of 12.7% in 2014. Sharia-compliant lenders can therefore expect lower growth in deposits, particularly from governments and government-related entities (GREs), and the value of their collateral assets could also decline. For Dubai banks especially, real estate assets are already seeing this type of drop, as property values and overall transaction volume are falling, meaning less income from fees. S&P forecasts credit growth of 8% in 2015 and 2016, down from 9.5% in 2014, but Dubai’s Islamic banks in particular can expect steady credit demand from government and GREs, especially those involved in projects to be built for Expo 2020, which Dubai will host. Tangential benefits should also filter through to banks from private investment in new hotels and other hospitality sectors gearing up to meet demand for the six-month event. While the number of banks in the UAE has declined in the past year, competition in the sharia-compliant sector is on the rise as conventional banks expand services through Islamic windows. Lenders such as Union National Bank and National Bank of Fujairah have grown in this direction, and in the DIFC several banks have opened Islamic windows, including Japan’s Bank of Tokyo-Mitsubishi UFJ, which received a licence from the DFSA in July 2015 to open one. Competition in Dubai’s retail market is also coming from non-bank financials. Dubai-based peer-to-peer lending operation Beehive has been declared sharia-compliant by Shariyah Review Bureau, a Bahrain-based consultancy providing services similar to those of sharia boards. Another player, Tawreeq Holdings opened its doors in 2015 as a sharia-compliant supply chain financier, and in September said it had extended a total of $55m in credit to small and medium-sized enterprises.

Liquidity 

Another concern for Islamic banks is liquidity management, as most of the short-term instruments available are interest-bearing and thus forbidden. “Islamic banks are usually forced to maintain higher liquidity than conventional banks, in view of the dearth of investment opportunities with a short-term tenor that offer the prospect of a return,” a 2015 research paper from the IMF said.

In 2014 the CBU stepped in with a programme to allow overnight borrowing using eligible securities as collateral, providing an option to address the problem. For the long term, federal authorities are committed to a state debt issuance programme that will further develop a yield curve, making borrowing easier and provide more short-term instruments that banks can invest in. “Deepening the financial market through the issuance of government debt will expedite our plan to implement Basel III requirements,” CBU chairman Khalifa Mohammed Al Kindi wrote in the central bank’s 2014 annual report. In December 2015 Abu Dhabi-based daily The National reported that the central bank had started the process of implementing Basel III liquidity requirements. These have been implemented in the DIFC by the DFSA since January 2015. Others noted the value of a slow approach to reform. “Regarding the Basel III liquidity coverage ratio, implementation is staggered until 2018, so it will be gradual,” Adnan Chilwan, group CEO at DIB, told OBG. “This will help ensure that high-quality liquid asset criteria are met by Islamic banks.”

Established in 1975, DIB is one of the top players in the global Islamic financial services industry. The bank returned to international capital markets in March 2016 with the successful issuance of a $500m five-year sukuk, its first since November 2015. DIB expects that increased sovereign debt issuance within the region will have an important impact on sukuk. Chilwan told OBG that with Islamic capital markets, particularly sukuk, growing at such a phenomenal rate, a variety of different structures have already been introduced, including the Tier-1 hybrid sukuk. He cited Hong Kong as an example of the growing popularity of the instrument as governments push for more sukuk issuance. He added, “Within a decade, sukuk has become a household name with global marketability. In fact, they have become the preferred mechanism for fundraising compared to conventional bonds, with a much wider investor base not just in home markets, but larger non-Islamic financial centres around the world. The governments and sovereigns pushing for more sukuk issuance have definitely played a major role in this area, which has already led to significant sophistication.”

Branding is another element in the competitive Dubai market. Islamic lenders looking to expand their customer bases are contemplating the merits of having the word “Islamic” in their brand name and are increasingly opting to remove it. In January 2015 Noor Islamic Bank rebranded itself as Noor Bank, for example. Abu Dhabi Islamic Bank has branded its operations in other countries as Abu Dhabi International Bank. The idea is to appeal to non-Muslims, but also to fit with nomenclature in established Islamic finance markets where the terminology differs. These include Turkey, Saudi Arabia, Algeria and others. Islamic banks can be called “participation banks” instead, for example. Noor Bank, which was established in January 2008, has grown rapidly and provides a comprehensive range of products and services in personal and corporate banking, wealth management, insurance and trading. It is supervised by a sharia board and a team of scholars who ensure sharia compliance on all legal, financial and banking matters. The bank was launched under the specific instruction of the government of Dubai, with the shareholders and the board of directors also selected and nominated directly by the government.

Takaful 

The main theme in the UAE’s takaful market, along with the insurance sector overall, is heavy competition. Return on equity in the sector is low in comparison with some others as a result – around 0.4%, compared with 6% in Saudi Arabia and 14% in Malaysia. While income through underwriting has always been a challenge, as young companies in the market seek to grow and attain economies of scale that would help cut costs, investment income is likely to be more of a challenge in the near future than it has been in the past. Relying on income from investments was possible and justified selling policies at low or negative margins when oil and real estate prices in Dubai were higher. With equities prices subdued on local exchanges due to the bear market for crude and real estate prices in Dubai also slumping in 2015, this looms as an added challenge.

Yet, for takaful providers that have been authorised to participate in the new and fast-growing health care sector, opportunities for profit are greater. Takaful Emarat, for example, posted a profit of Dh10.2m ($2.8m) in 2015, up from Dh7.18m ($1.95m) in 2014. The last two years have seen an end to a consecutive string of quarterly losses that stretched back to 2009, with 2014 being the first profitable year since the company was founded in 2008. The company also has approval to provide low-cost health insurance to workers whose employers are obliged to pay. In December 2015 the firm’s rights issue raised Dh50m ($13.6m) and was 36.5% oversubscribed. Despite the strong showing, it was a reminder that segment players remain in need of capital and face potential challenges in the years ahead. A new insurance law in the UAE is expected to affect takaful firms, because it mandates a round of solvency audits.

Sukuk 

The sharia-compliant alternative to bonds has been a crucial element of Dubai’s developing capital markets offering, for public and private issuers as well as for foreign and local investors. A strong government commitment to making Dubai a global leader in sukuk has resulted in the value of listed sukuk soaring from $7bn in 2013 to $42.6bn as of the end of April 2016. Growth in 2014 and 2015 made the emirate’s two securities exchanges the largest sukuk market in the world, ahead of Malaysia ($26.6bn traded on two bourses), the Irish Stock Exchange ($25.7bn) and the London Stock Exchange ($25.1bn). Of the two exchanges available to host sukuk listings in the emirate, Nasdaq Dubai has emerged as the most common choice and hosts 93.5% of the listed value. The bourse, located in the DIFC, was designed to attract international listings, and that international flavour is notable the sukuk market, as just 50.5% of Dubai’s listed sukuk are from UAE issuers. The biggest foreign issuers are Saudi investors, who account for 22%. In 2015 international sales were a strong growth element in Dubai, as foreign entities including the government of Indonesia listed sukuk on Nasdaq Dubai.

Crude Impact

Several factors suggest that growth in sukuk issuance could be muted or negative worldwide for 2016, starting with oil prices. The drop in crude oil’s value means less liquidity in the GCC region overall, and therefore possibly a drop in demand for sukuk. As an asset class it remains relatively young, gaining traction in a period that has coincided with strong energy prices. For sukuk investors, the current bear market for crude is a chance to determine how closely correlated prices are for these two assets.

Another factor is interest rates. Following the increase of the US Federal Reserve’s benchmark lending rate to 0.50% in December 2015, global stocks had a very challenging start to 2016. This was a particularly uncertain factor in Dubai, since the UAE dirham is pegged to the US dollar, but rate increases in the US were expected to signal an increase of equal size in the emirate, pushing up expected yields for sukuk.

Rating Effects 

January was a positive month for Dubai’s exchange, in spite of the rate increase, and there was potential for other asset classes to grow as defensive investors moved assets. Some of the growth in sukuk sales in 2014-15 can be attributed to the expectation of rising rates, said Anver Jalaldeen, senior vice-president and head of investment banking at Sharjah Islamic Bank.

“It was a big year for sukuk, because a lot of people wanted to lock in rates for the long term,” he told OBG. “They were expecting an interest rate increase from 2014 in the US.” In 2016 it is likely that some would-be issuers of sukuk that have refrained from doing so due to the lack of stability in crude prices and more general concerns over economic growth. “There is a backed up pipeline as well because the market has been volatile, so it is a difficult time to borrow,” said Khalid Howladar, global head of Islamic finance at Moody’s. “However, those issuers will eventually come to the market.”

Outlook 

While the UAE will continue to be a leading market for Islamic financial services, with the expected recovery in crude prices forecast to be gradual rather than sudden, the growth curve for Islamic financial services in the emirate is likely to be modest and steady in the near and medium term.