The start of 2017 hailed a welcome development for the Islamic finance industry, with Morocco’s central bank, Bank Al-Maghrib, announcing on 2 January that five groups had been given the go-ahead to open sharia-compliant banks.
Morocco was one of the few countries in the Middle East and North Africa region where sharia-compliant banking had yet to take off and the roll-call of partners involved indicates how keen international banks have been to enter this untapped market. Among them are Qatar International Islamic Bank, which is partnering with the local CIH Bank; the Saudi/Bahraini-based Dallah Albaraka, which is working with BMCE Bank; and the Saudi group Guidance, which has linked up with Banque Centrale Populaire.
The number of Gulf banks involved in the nascent Moroccan scene also offers an insight into where Islamic finance is strongest. There are 1,329 Islamic financial institutions around the world, with a collective £2trn in assets, according to data from ICD Thomson Reuters. But the industry is heavily concentrated in the Gulf and south-east Asia. The three largest markets of Saudi Arabia, Iran and Malaysia together account for $1.3trn of all assets.
According to the Islamic Financial Services Board (IFSB), a Malaysian-based body that sets prudential standards for the industry, Islamic banking is systemically important in just 11 countries. Even in countries where Islamic banking is relatively strong, it usually still accounts for a minority of the overall market.
Other than places like Sudan and Iran – where all banks are sharia-compliant – it is only in Saudi Arabia where sharia-compliant banks hold a majority market share, with 51%. In other countries, the figure ranges from 45% in Kuwait, to 22% in the UAE, 21% in Malaysia and 10% in Pakistan, according to consultancy firm EY.
Of course, the Islamic finance industry extends beyond banking to encompass products such as sharia-complaint insurance (takaful) and Islamic bonds (sukuk). However, banking remains by far the most important segment. According to ICD Thomson Reuters, total Islamic banking assets were $1.45trn in 2015.
There is clearly plenty of scope for further growth. Gordon Bennie, MENA financial services leader at EY, points out that around the world more than two billion adults do not have a bank account and some 200 million small businesses don’t have access to the financing they need.
“The demand for a responsible, sharia-compliant financial system is huge,” he says.
Many of these unbanked people and businesses are obvious targets for the Islamic finance industry as they are in countries with large Muslim populations, running in a line from Morocco in the west, through parts of Africa and the Middle East and into south and south-east Asia. Many of them are expected to be among the fastest-growing economies in the world in the next few years, including the likes of Côte d’Ivoire, Niger and Yemen.
There have also been interesting opportunities in Western markets. In 2014, the UK and Luxembourg governments issued sovereign sukuk and the following year KT Bank was set up in Germany as the first Islamic bank in the eurozone.
In all, 35 countries have developed some form of Islamic finance regulations to date, but the industry’s reach is far wider than that and ICD Thomson Reuters includes 124 countries in its Islamic Finance Development Indicator rankings. Among the countries that have been moving up the table over the past year are South Africa, Morocco and Tanzania.
“Africa in general is at a stage where there is a need to broaden the source of funds required to support its large infrastructure deficit and plug its revenue shortfall caused by the global commodity slump,” said Khaled Al-Aboodi, chief executive officer of ICD, at the launch of the latest report in December. “Islamic finance can be the solution.”
Overall, though, the most significant markets are not expected to change rapidly. According to EY, total assets in the nine leading markets it tracks (which doesn’t include Iran) could reach $1.8trn by 2020, on the basis of an average growth of 14% from 2015-2020. Saudi Arabia is expected to retain a clear lead, followed by the UAE and Malaysia.
Across these markets there are some key principles underlying the industry. Perhaps the best known is the prohibition on earning interest on money (known as riba). Others include the requirement for profit and loss sharing and a ban on involvement in gambling, alcohol or other “haram” (forbidden) products. Such rules offer some benefits – for example, the emphasis on shared risk and the need for physical assets can reduce the chances of dangerously speculative activity. But there are difficulties too.
The regulatory environment for Islamic banks varies considerably from country to country, despite long-running efforts to standardise the rules and regulations. One of the main areas of divergence is whether to treat Islamic banks as part of the overall banking system – as happens in the Gulf – or to set up a separate system of oversight, as there is in Malaysia.
In addition, some regulators have brought in national sharia compliance boards to ensure a consistent approach in their territory. Malaysia, Pakistan and Sudan have done this and Bahrain, Morocco and Nigeria are expected to follow suit. Elsewhere, it is down to individual institutions to set up their own sharia boards. Opinions and advice will inevitably vary. There are 1,432 sharia scholars working with Islamic financial institutions, according to ICD Thomson Reuters, and they are bound to differ in their interpretation of what is permissible.
“I don’t think sharia boards have brought about much harmonisation, partly because sharia councils can operate at different levels,” says Professor Jason Chuah of City, University of London. “I don’t know whether they really do contribute significantly to consistency of reporting.” This is an important issue for financial institutions. In a worst case scenario, if a bank markets itself as being Islamic and then finds that it is not in compliance with some Islamic principles it could fail.
Financial reporting is another important area of divergence. In some countries, such as Malaysia, Islamic banks follow International Financial Reporting Standards (IFRS), set by the International Accounting Standards Board (IASB). Elsewhere, banks follow those of the Bahrain-based Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI). The latter are more clearly structured around Islamic finance, although the IFRS perhaps offer more support in the form of implementation guidance and illustrative examples.
How to treat sharia-compliant business when it comes to financial reporting has long been recognised as a problem. Indeed, in 2011 the IASB launched a consultation to examine the issues involved with sharia-compliant instruments and transactions, but differences remain. All this has created “an unnecessarily uneven playing field upon which the industry grows”, according to Hatim El-Tahir, director of Deloitte’s Islamic Finance Knowledge Center.
The extent to which this hinders the sector’s growth is unclear, however. Nik Shahrizal Sulaiman, a partner at PwC Malaysia, says the impact of sharia compliance rules on financial reporting varies by country, but is manageable. “The interpretation of religious rules differ, as such there will be some differences with regards to sharia compliance rules between different regions,” he says. “However we do not think this is a significant obstacle in the context of the industry’s growth.”
There are a number of other issues arguably holding back Islamic finance. One is the fractured nature of the market. Islamic banks are often small and find it hard to take advantage of the potential that is out there, particularly beyond their home market; just a few have real scale, with only 22 having more than $1bn in shareholder equity.
The largest Islamic bank in the world is Saudi Arabia’s Al Rajhi Bank, although a plan by local rival National Commercial Bank to convert to full sharia compliance means it could soon take the top spot. There have been other moves towards consolidation. A merger of three Qatari banks – Masraf Al Rayan, International Bank of Qatar and Barwa Bank – was announced in December. If it goes ahead it will be one of the world’s largest sharia-compliant financial institutions, with assets worth more than QR160bn ($44bn).
Another problem has been the limited range of sharia-compliant investment options, meaning spare liquidity is often deployed in short-term placements with other banks. A more active sukuk market would be one obvious solution, but the prospects for that are not bright. In 2016, global sukuk issuance was flat and ratings agency Standard & Poor’s thinks it will remain subdued this year, not least because of the complexity involved in sukuk issuance – a problem which extends to other Islamic finance products.
“We forecast a stabilisation of total issuance in 2017 at around $60bn-$65bn,” says Mohamed Damak, S&P’s global head of Islamic finance.
“The complexity of sukuk issuance will continue to weigh on issuance volumes, unless counterbalanced by tangible results on standardisation or the establishment of large issuance programmes.”
Another issue facing many banks is the weak macroeconomic conditions in their home markets. This has been a problem for GCC banks in particular over the past few years, as a result of low oil prices.
Despite such hurdles, Islamic banks have often been posting stronger growth than their conventional peers in some key markets in recent years, including in Qatar, the UAE and Malaysia. If that is to continue, sharia-compliant institutions should arguably do more to embrace the potential from new technology. They also need to expand their range of products from the small handful of sectors and products they now focus on. Islamic banks tend to be heavily concentrated in certain sectors of the economy, such as retail, real estate and construction, and to focus on basic banking, insurance and bond issuance; they have largely ignored the areas of pensions, wealth management and endowments.
Some countries’ authorities are keen to encourage more innovation. In Bahrain, the Economic Development Board (EDB), the country’s inward-investment agency, says it wants to see more experimentation. It is looking to set up an accelerator to encourage new ideas and businesses, with a focus on Islamic finance among other things, including finding ways to connect with potential customers who are currently unbanked.
“We’re trying to encourage banks to be disruptive,” says David Parker, executive director for financial services and business development at the EDB. “We’re looking to turn Bahrain into a test bed.”
As well as being open to change, banks also need to be more open with their own books. There is a significant transparency gap in the industry. ICD Thomson Reuters gives an average financial disclosure score across the industry of just 29 points out of a possible 70 on its Financial Reporting Disclosure Index, based on things like timely reporting of results and breakdowns of deposits. Bahrain, Pakistan and Malaysia score above average, while Sudan, Kuwait and Egypt are among those trailing.
The IFSB has been trying to encourage better disclosure, holding a roundtable discussion on the topic in November in Kuala Lumpur. Such efforts have been welcomed by observers but they are only part of what is needed.
“We think the current governance framework shows room for improvement and believe the industry stands to benefit from increased disclosure, as well as clear, standardised sharia principles and interpretation,” says S&P’s Damak. “Well-defined standards could also help the industry become more integrated, thereby unlocking new growth opportunities.”
The chances of all the regulatory issues being resolved any time soon, especially when it comes to financial reporting, appear rather slim. For one thing, if the different approaches are to be reconciled and compromises reached then regulators will have to acknowledge that, to some extent at least, they had taken the wrong approach to sharia compliance up to that point.
“There’s a lot of talk about standardisation, but I’m not entirely convinced all the talk is going to lead somewhere,” says Chuah. “The more established countries like Saudi Arabia and Malaysia have already gone their own way and I cannot see them reconciling their differences. There may be some gradual harmonisation over technical stuff, like what should be considered on or off balance sheet; I can see a convergence there, but I don’t think they will shift very much on IFRS or AAOIFI. And they will also not shift on whether they will have a unified system or a separate system. The regulatory approaches in the Gulf and in Malaysia will remain as they are.”