Raising the bar: Officials take steps to standardise sharia-compliant products

Throughout 2018 Dubai continued to strengthen its status as a global capital of the Islamic economy, with the last five years seeing the emirate emerge as a hub for sharia-compliant offerings and innovation in the commercial sphere. Financial services are a core aspect of that project, and the emirate has taken a leading role in hosting Islamic financial services (IFS) companies. Its government and government-related entities (GREs) were early sellers of sukuk (Islamic bonds), and the industry has become one of the world’s most active in takaful (Islamic insurance).

Dubai’s market is a two-track one; its onshore operations are complemented by an offshore element operated by the Dubai International Financial Centre (DIFC). The free zone is emerging as an international hub for market trading of sharia-compliant, risk-management tools and insurance syndicates, and soon will host its first offshore Islamic bank. Meanwhile, Nasdaq Dubai, which is located in the DIFC, is one of the leading sukuk-listing bourses in the world.

Structure & Oversight

The IFS sector in Dubai is governed and licensed at the federal level via laws set by the government of the UAE. Products and services under this categorisation can be provided by licensed banks and financial institutions that offer only sharia-compliant tools or by Islamic windows at conventional firms. In 2018 there were 51 local and foreign licensed entities offering banking and finance in the UAE, which included seven purely Islamic banks, one investment company and 12 takaful firms.

Oversight for IFS comes from the same authorities as their conventional counterparts: the Central Bank of the UAE (CBU) for onshore banking; the Securities and Commodities Authority of the UAE for securities; and the UAE Insurance Authority (IA) for takaful.

Performance

Dubai is positioning itself as the global capital of the Islamic economy, which accounts for 8% of the emirate’s GDP, with financial services being a major component. For reporting purposes, sharia-compliant economic activity in Dubai is grouped in with the other emirates. The UAE ranks as one of 12 systemically important countries in the global ecosystem. Of the $1.89trn in sharia-compliant assets recorded worldwide in 2017 by the IFS Board in its 2017 “IFS Industry Stability Report”, 78.9% were held in banking, 16.8% in sukuk, 3% in Islamic funds and 1.3% in takaful. According to the Dubai Islamic Economy Development Centre, sharia-compliant assets worldwide could grow to $3.3trn by 2021.

Regulatory Policy

At the financial institution level, sharia compliance is ensured by sharia boards, which typically consist of groups of three or more Islamic scholars who review a company’s products, accounts and governance practices. New in the UAE is a federal-level sharia board – the Higher Sharia Authority (HSA) – which was created by the CBUAE and met for the first time in February 2018.

While sharia compliance at the institutional level will remain a matter for sharia boards to determine and, ultimately, for customers to evaluate for themselves, the HSA will play a key role in providing guidance and promoting standardisation across the sector as a whole. As of 2017, 12 other countries with an IFS industry had established national sharia boards, including Pakistan, Malaysia and Bahrain.

Standardisation is one of the key issues of debate in Islamic finance. As these young and developing financial products have grown, the market has prized the ability to innovate, but this has also led to episodes that challenge the confidence of investors, in particular for sukuk, which is the asset class most likely to attract global institutional investors.

An example of a compliance issue was that of Dana Gas, an energy company based in Sharjah. The firm announced in 2017 that a sukuk it had sold was no longer considered sharia compliant, and that continuing to service the $700m debt would leave it in violation of religious principles. Dana Gas was able to successfully restructure the debt in May 2018, thereby resolving the issue without litigation. Such instances are rare, however, especially when compared to conventional bond defaults worldwide. Nonetheless, bodies such as the HSA are promoting standardisation across the industry as the market matures.

Scholarship

Sharia boards are at the heart of this debate, as Islamic finance depends in large part upon a group of well known and highly respected sharia scholars, who serve on an ongoing or contract basis. Younger scholars are now entering the scene and taking pressure off ageing elders, and standardisation is helping a great deal with decision-making. With standardisation could also come products that are more familiar, which may speed up the certification process and make it less expensive.

In the future, scholars will be expected to take on new topics, such as cryptocurrency. At issue with Bitcoin and other cryptocurrencies is whether their use is speculative in nature, or whether any exchange involving them must be immediate or can potentially be delayed. For his part, the Grand Mufti of Egypt, Sheikh Shawki Ibrahim Abdel-Karim Allam, has expressed concern about the use of cryptocurrencies for illicit activity. Such discussions have been a mainstay at recent Islamic finance conferences and gatherings.

According to the 2017 “Islamic Finance Development Report”, published by Thomson Reuters and the Islamic Development Bank, the UAE was home to 60 of the world’s 1075 scholars serving on the sharia board of an Islamic financial institution in 2016.

The key responsibilities of the HSA are to develop a framework for sharia governance; introduce fit and proper criteria for sharia board members; launch new or adopt existing international sharia standards and documents for best practices; and issue rulings and opinions that will improve the legitimacy of products and institutions. The HSA also works with global bodies such as the Accounting and Auditing Organisation for Islamic and Financial Institutions (AAOIFI) to promote standardisation. The authority’s chairman is Sheikh Ahmad Abdul Aziz Al Haddad, the Grand Mufti of Dubai. Other members of the board of the HSA include Sheikh Essam Mohammed Ishaq, Aznan Hasan, Osaid Mohammed Adeeb Kilani and Jassim Ali Al Shamsi.

Banking

For the past decade Islamic banks in Dubai and the wider UAE have been consistently growing at a faster pace than conventional banks. Compound annual growth in financing and investment assets from 2014 to 2017 reached 10.9% at sharia-compliant banks, compared to 4.4% for conventional players. Islamic banks accounted for 20.4% of total assets at the close of 2017, up from 19.5% in 2016, and their respective shares in total bank deposits and outstanding credit was 23.6% and 22.4%.

Digging beneath the top-line figures reveals significant market segmentation between conventional and sharia-compliant institutions. Islamic banks’ financing to the private sector was steady in 2017, whereas for conventional banks it was a driver of growth, expanding by 2.8% year-on-year (y-o-y). Islamic banks held 30.6% of deposits from GREs, for example, but just 6.7% of non-resident deposits. Non-resident deposit growth among sharia-compliant lenders reached a two-year high in early 2018, increasing by Dh4.2bn ($1.1bn) over January and February to Dh17.1bn ($4.7bn). Officials said the performance reflected growing confidence in the sector.

Profit Increases

Dubai Islamic Bank (DIB) is the largest Islamic bank by assets in the emirate. It posted a 12% rise in net profits y-o-y over the first nine months of 2018 to Dh3.7bn ($1bn), a strong performance that was echoed by the majority of the emirate’s Islamic and conventional financial institutions. DIB reported a 21.1% jump in financing and investment-transaction income, and a 10% increase from fees, commissions and foreign exchange. Impairment charges fell by 7.9% y-o-y to Dh569.7m ($155.1m).

While the Islamic banking narrative in Dubai has thus far been dominated by its domestic market, the opening in March 2018 of the first home-grown Islamic investment bank in the DIFC could begin to change this. Arkan Bank, which has an initial paid-up capital of $100m and share capital of $500m, aims to be the first in the DIFC to offer wholesale sharia-compliant services for ultra-high-net-worth individuals, corporate and institutional clients. It plans to list its shares on Nasdaq Dubai within 12 months of starting operations, and will initially focus on the GCC region. The bank is backed by a consortium of investors led by Dubai Investments, a publicly traded conglomerate with assets in sectors that include real estate, finance, health care and education.

Financing

Trade finance is expected to be an area of large growth potential in the region’s IFS industry over the short term, according to research published by ratings agency Moody’s in March 2018. Sharia-compliant banks are also working to attract retail consumers in the real estate market with new mortgage products. For example, in March 2018 DIB launched a 15-year package at rates of 5-9%, with the option to include takaful protection. At the time, DIB told local media that most clients in need of mortgages were first-time buyers, with mortgage values ranging from Dh750,000 ($204,000) to Dh1.5m ($408,000). Mortgages can be underwritten for as long as 25 years in the UAE, but most customers reportedly settle them within seven or eight years. DIB has also paired with the Dubai Land Department to create an integrated online service for documentation, so customers will no longer need to visit the government office.

Asset quality at Islamic banks lags behind that of conventional banks, in part because of higher exposure to the real estate sector. However, the imposition of fees for late payments – of which a portion is donated to charity after recovery expenses are met – is working to keep quality high. Islamic banks remain well above the solvency standards set by the Basel Committee on Banking Supervision’s Basel III framework, with the average Tier-1 capital adequacy ratio at 16.6% at the end of 2017, according to the latest annual report from the CBUAE. This is more than double the minimum standard set by the Switzerland-based group, but slightly lower than that of conventional banks, which had a system-wide average of 17.6%. Tier-1 capital is defined in Basel III as a lender’s core equity capital in addition to debt instruments that can be converted to equity in the future.

Another global standard likely to impact UAE banks in 2019 is the ninth International Financial Reporting Standard, developed by the International Accounting Standards Board, and the AAOIFI’s Financial Accounting Standard 30, which applies to the Islamic market. Both frameworks will mandate stricter provisioning rules for loans that were restructured or are past due but not yet considered impaired. The banking sector’s transition to the new rules is likely to be a two-year process that will strengthen lending but exert downwards pressure on profitability.

Sukuk

Dubai has emerged as a global hub for both the issuance and over-the-counter trading of sukuk. The emirate, its GREs and its corporate leaders have all used Islamic bonds as an instrument for raising capital. In 2018 a total of 14 new sukuk listed in Dubai, bringing the total value of sukuk on the emirate’s markets to $60.4bn as of December that year, the largest amount of any market worldwide.

Bonds and sukuk from the country, as well as from Saudi Arabia, Qatar, Bahrain and Kuwait, will be phased into three separate global bond indices between January and September 2019 because many investors worldwide build investment portfolios that mimic the weightings of these measures. The move will result in an estimated capital inflow of between $20bn and $60bn, of which slightly less than one-quarter will go to UAE securities. The group’s overall weighting on the indices will be 11.2%, with the UAE taking 2.6%.

Primary Market

This change sets up 2019 as a year in which secondary trading could take on a higher profile than the primary issuance market. Historically, the primary market has been the more active of the two, because many types of investors like to hold sukuk to maturity. This includes Islamic banks, which use them both as a liquidity management tool and for statutory reserve requirements for certain permissible sovereign issuances.

In 2017 the global sukuk market was dominated by sovereign issuers, providing roughly 70% of the $95bn in global issuance, according to a Moody’s report issued in December of that year. Sovereigns continued to drive issuances in 2018, although the recovery in oil prices and resulting increase in state revenues, particularly in the GCC region, dampened demand somewhat. In the first half of 2018 total global sukuk issuance fell by 15.3% y-o-y to $44.2bn and were expected to total $90bn-100bn for the year. According to Michael Grifferty, president of the Gulf Bond and Sukuk Association, a regional non-profit membership organisation, corporates may provide a greater share of primary sales going forward. “There is going to be a continuing need for refinancing, as existing sukuk reach maturity in 2019-20,” he told OBG.

While sukuk have become a global instrument, they have not been without controversy. Questions surrounding issuers’ ability to repay and the often complex structure of sukuk – which can make issuances expensive – have caused the most concern. There is no central authority in Islamic finance, and it is therefore up to issuers and buyers to gauge compliance for themselves. Issuers rely on sharia scholars for these opinions, while buyers often come to know and trust specific scholars. Talk of introducing standards that reduce the number of structuring options and enforce a consistent approach towards the asset class has been ongoing for years, and the AAOIFI has been finalising a standard for sukuk market participants to refer to. “If we have fewer and more understandable instruments to focus on, then a wider investor base will have an easier time,” Grifferty told OBG.

Islamic Funds

Islamic market instruments often require sharia boards to deem them sharia compliant – including funds comprised of equity shares issued by companies whose products or services already do not violate the religion’s principles. The universe of specific funds, investment vehicles and other market instruments remains a small element of the overall offering, at around 3% of total global assets.

Nasdaq Dubai has taken steps to increase market activity with a plan to permit retail investment in sukuk. This is expected in 2019, and will likely be a simplified product with smaller investment thresholds to accommodate the needs of personal portfolios.

Takaful

The takaful industry in the UAE, as well as in the wider world of IFS, remains a small part of the whole, accounting for 1.3% of global sharia-compliant assets, with 77.2% of that share coming from the GCC region. Takaful has a 44% stake in the GCC insurance market, with the figure sitting at approximately 15% in the UAE, according to the IA.

Performance in 2017 was positive, thanks to a regulation from the IA enforcing a minimum price for automotive coverage. In the past, insurers of any kind had opted to pursue growth in market share rather than underwriting profits, and were therefore willing to sell the coverage at low rates and look to their investment accounts to generate profits. But the new regulations boosted premiums between 15% and 20%. “Performance was mixed in 2018, but still at a level that allowed companies to make profits,” Emir Mujkic, lead analyst of insurance ratings at the Dubai office of S&P Global Ratings, told OBG. Another significant development in 2017 was Dubai-headquartered Takaful Emarat’s purchase of the takaful unit of Abu Dhabi’s Al Hilal Bank. The buyout created the largest takaful provider in the UAE.

The emirate’s takaful market has also seen increased take-up of financial technologies following the emergence in 2017 of online aggregators, which have the ability to challenge traditional distribution channels. Abu Dhabi-based National Takaful Company, known as Watania, has been working with those companies, using their data to boost its business and spot gaps in the market. Meanwhile, in Dubai’s offshore market, global interest in takaful appears to be building in the DIFC. Cameron Murray, head of MENA at Lloyds Banking Group, told local media in late 2017 that up to 10 of its insurance syndicates were in the process of becoming sharia compliant.

Outlook

With the emirate’s leadership continuing to prioritise the development of Islamic finance, and with new products on the way, the path for Dubai’s IFS sector is clear: leaders will continue their push for standardisation in the hope that the costs and complexity of products will drop. The AAOIFI – together with the HSA – has emerged as a provider of industry standards, against which companies can benchmark their products and grow their popularity as they become easier to understand, while new elements, such as cryptocurrency, are evaluated for inclusion.