Islamic Banks stepping businsess models in face of increasing competition in the banking sector

  Islamic banks in the GCC have been stepping up their business models in the face of increasing competition in the banking sector, in a bid to stay ahead of the market. According to a comparative analysis of Islamic banks in the GCC by Moody’s Investors Service, the region’s Islamic banks are developing mortgage and financial services to diversify their incomes and hold on to clients of Shariah-compliant products. “Competition has been heating up, forcing Islamic banks to enhance their commercial entrenchment, develop relevant business models, strengthen their brands and reputation and provide innovative solutions to a growing number of clients attracted by the concept of interest-free banking,” said Moody’s analysts and authors of the report, Anouar Hassoune and Adel Satel. Islamic banking in the GCC has been expanding at double-digit annual growth rates over the past decade and presently controls a market share close to 15 per cent of the region’s banking assets.

 The study analysed 23 leading Islamic banks operating in the GCC, which account for total assets in excess of $125 billion (Dh458bn) – or 25 per cent of Shariah-compliant assets globally.

 “Although commercial banking in the Islamic financial industry is expected to remain dominant, specialised investment houses will continue to grow, as the financing and investment needs of regional clients are getting more specific,” the report added.

 According to the ratings agency, newcomers to the banking industry are also set to intensify the competition, forcing established players to seek opportunities in non-traditional businesses and to expand outside their home markets.

 “On the one hand, Shariah-compliant investment banking and products have grown as a viable, profitable and successful way to manage alternative Islamic asset classes,” said Hassoune.

 “On the other hand, specialised financial institutions focusing on mortgage, housing and consumer banking have been providing financing solutions to households facing unprecedented needs in terms of accession to consumption and property,” he added.

 According to the report, Saudi Arabia’s Bank Al Jazira has diversified into brokerage, margin lending, and leveraged finance on behalf of customers to keep pace with rising competition, a move which brought the lender very large revenues in 2006.

 Dubai Islamic Bank has also “dramatically enhanced” its Islamic investment banking  business through its Millennium brand, which is established under a separate legal entity handling advisory, listing, private equity, and fund and asset management.

 The firm added that Kuwait Finance House, Qatar Islamic Bank and Saudi Arabia’s Al Rajhi Bank have already explored new territories by establishing operations in Malaysia to tap into a wider client base in a larger part of Muslim Asia.

 And several GCC-based financiers are also sponsoring the recent foray of Islamic finance in the United Kingdom.

  Asset quality

 However, Moody’s added that portfolios of Islamic banks in the Gulf tend to be concentrated, with very few exceptions such as Al Rajhi, Kuwait Finance House and Dubai Islamic Bank.

 Most Islamic banks in the region are domestic players, with only very few holding operations outside their home country, and this limited geographic reach often leads to cropping up of concentration risk, the report said. It added Islamic banks in the GCC also face concentration by name and sector.

 “Given the lack of economic diversification of their operating environments,

Islamic banks also face the drawback of being exposed to a limited number of borrowing industries. Only business diversification out of pure lending is improving, although its sustainability remains questionable,” Moody’s said.

 According to the report, concentration and potential volatility in the credit quality of portfolios have meant Islamic banks must maintain strong capitalisation, despite rapid growth. “This has in turn put pressure on dividend payouts, and sometimes also on shareholders to inject fresh capital despite spectacular returns on their investments.”

  Sustainable profits?

 The net income of Islamic banks in the Gulf, despite being “very strong”, may be beyond the long-term potential of the industry, according to the Moody’s report. The firm said that past provisioning charges might not be good indicators of future write-downs and of the banks’ overall profitability.

 “Not only are fees and commissions, as well as investment income, expected to slow down going forward, but a large portion of current exposures have never also been tested by a sharp economic downturn,” the ratings agency said.

 However, net income for the 23 Islamic banks under review by the firm – in excess of $5.6bn – was 6.7 per cent of risk-weighted assets in 2006, which Moody’s said it considered to be “very strong”. “The size of non-intermediation revenues, although unsustainable in the long-term, reflects a positive development in that Islamic banks are no longer pure commercial banks,” the firm said.

 “Notwithstanding the necessary caveats attached to any analysis of the 2006 figures, Islamic banks in the GCC are structurally profitable, and their business model robust enough to weather credit cycles.”

 The report added sources of income from investment banking, brokerage, and fund and asset management might represent about half of gross operating income – as opposed to the inflated two-thirds recorded in 2006 – if growing business diversification by Islamic banks into these services is sustained.

  Challenges

 According to the Moody’s report, Islamic banks in the region face a number of constraints in terms of risk management, including the entanglement of credit, market and operational risk in each contract type used in their daily operations.

 “Absent a wide pool of Shariah-compliant, sufficiently liquid investment vehicles, Islamic banks [also] find it difficult to manage their balance sheet from an asset-liability management perspective, especially liquidity and margin-rate risk,” the firm said.

 It added Islamic banks’ funding mix also tends to be imbalanced, with the dominance of deposits, PSIAs (profit-sharing investment accounts) and equity making their funding profile predominantly short-term, while the maturity of their asset classes is widening. 

 Some Islamic banks have started issuing medium-term sukuk (Islamic bonds) to lengthen the maturity profile of their funding in an effort to ease this problem. However Moody’s said sukuk accounted for only 1.6 per cent of total liabilities (excluding equity) at the end of 2006.

 The ratings agency said expectations of likely external support help to uplift the ratings for GCC-based Islamic banks, with government ownership a critical rating driver for the lenders.

 “Government shareholding provides us with additional comfort that support would be made available to those institutions should the need arise,” the report said.

“Islamic banks’ ratings in the Gulf are usually driven by robust financial fundamentals, and benefit from high levels of external support.”

  ISLAMIC BANKS IN THE UAE

 A new study by the Dubai Chamber of Commerce and Industry released earlier this week revealed Islamic banks in the UAE are set to eat into the business of conventional lenders.

 The report said Shariah-compliant banks in the Emirates would continue the trend to capture a sizeable share of business – in the form of real loans and real deposits – from conventional and foreign banks in the coming years, as interest in Islamic financial products “looks promising”.

 Quoting results of surveys by McKinsey Consultants, Dubai Chamber said that 25 per cent of investors are “strongly committed” to seeking out and using financial services fully compatible with Shariah principles.

 The report added another 50 per cent of investors say they prefer to put their money into Islamic funds where possible, “as long as they do not have poorer returns or service compared with conventional products”.

 According to the findings, the growth of real assets and real loans of Islamic banks was larger than conventional banks during the 2001-2005 period.