Uncertainty for Islamic finance

The bullish performance of equity markets in the 1990s greatly benefited the growth of the Islamic finance industry, but a combination of market volatility and current events may have slowed the growth of the industry

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By  Massoud Derhally Published  May 19, 2002

|~||~||~|For much of the 1990s, the Islamic finance industry received unprecedented attention, with many financial institutions in the West getting on board what some saw as a lucrative bandwagon. The picture today for Islamic finance is not entirely the same. Much has happened in the first two years of the new millennium on both a regional and international level. The industry today seems fragmented and according to some bankers may have bottomed out.

The industry was growing at 20-30% per annum and, according to some bank officials, the estimated deposits in Islamic products were between US $ 150-250 billion. With the growing size of Islamic investments came the need to diversify, and as the industry grew so did the need for a larger range of products and services, even though, the pace of growth did not satisfy the liquidity needs of the industry. Access to liquidity is difficult especially in the absence of a money market on a comparable scale with conventional money markets in the US and this prompted those in the industry to look into ways to meet these shortcomings.

Bahrain, which is a regional hub in the Middle East for offshore banking and a pioneer in nurturing the Islamic banking industry, was selected as the location for Bahrain has signed a pact to establish an international Islamic financial market to help meet the needs of Islamic banks and financial institutions. The Governor of the Bahrain Monetary Agency (BMA), Sheikh Ahmed bin Mohammed al-Khalifa, signed the deal in Paris with Malaysia, Indonesia, Sudan and the Islamic Development Bank (IDB).

“The agreement aims at the setting up of an international Islamic Financial Market with its headquarters in Bahrain,” the BMA, the island state’s central bank, said. A council drawn from the four states and the Jeddah-based IDB as well as representatives of Islamic financial institutions would be formed to take the necessary steps to set up the money market, it said. To date, nothing has materialised since the announcement and the Islamic financial market is very much still an intangible concept.

On another front what was hailed almost a year ago as a groundbreaking deal between Dallah Al Baraka and The International Investor (TII) is now dead in the water. The US$ 300 million deal was supposed to merge the strength of DBG’s Islamic commercial and retail banking network with the investment banking expertise of TII. It would have been the second high profile cross-border consolidation after the merger of Gulf International Bank and Saudi International Bank two years ago and it would have answered the calling from industry analysts to have fewer banks in the Middle East and consolidate existing operations. However, very recently everything changed.
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In a surprise statement in April, TII said it regretted that following a request by Dallah DBG both parties were discussing the possibility of unwinding the merger transaction known as “Albaraka & The International Investor”. The TII statement said, “Although difficult and complicated at this stage, both parties will work together amicably to ensure that the unwinding process is carried out in a speedy, effective and friendly manner.” It then went on to say, “This is a disappointing development, given the extensive merger integration work that has been undertaken to date. However, TII still believes that the strategic goals of the merger are very valid, and plans to pursue these independently.”

Adnan Al Bahar, the vice chairman and CEO elect of what would have been known as ‘Al Baraka and The International Investor,’ did not respond to Arabian Business’s request for comment. However, speaking at the second conference for Kuwait Islamic financial institutions, Al Bahar said that the two parties “have not yet concluded that de-merging is the best solution, and we may very likely go ahead with the merger.” He added that both entities were “still committed to the merger if we can make it technically work. No matter what happens, our strategy to help develop a strong, viable and competitive regional Islamic financial services industry, remains both valid and pertinent.”

Al Bahar emphasized that consolidation is the way forward for the industry. Larger, regionally focused Islamic financial institutions are needed to compete with the growing competition from conventional banks and to offer an increasingly sophisticated customer base, a greater variety of products and enhanced levels of service.
“Consolidation in the Islamic banking industry can only be seen from the wider perspective of general economic developments in the MENA region. This is where the bulk of the industry is located, and these developments impact banking – both conventional and Islamic – in the same way,” said, Al Bahar.

“It would seem to me from the information presented, that they agreed on the valuations of each entity and how the company would be controlled, managed and run,” said one London based banker who is involved in the finance industry in the Gulf. “Based only on the information made public, I think it broke down, on the fact that TII needed money to fund the merger. They [TII] agreed that Dallah was much bigger and that TII would have to come to the table with more money if they wanted to play as equals. I assume they never managed to raise sufficient money and could therefore not accept the terms of the merger, which would effectively squeeze them out of control of the new entity,” added the banker.

The DBG and TII episode is certainly a drawback to the industry, especially when people are looking to integrate a fragmented market. “I think the industry could pull itself together and work together. What faces the industry today is the same as what faces this part of the world—a lack of cooperation and working together,” says Ramzi Abu Khadra, CEO of iHilal.com, an Islamic e-brokerage company.

“For the first time, you were going to see a true collaborative effort happening in the industry between DBG and TII and for some reason it fell through the cracks—I don’t know why that is the case—but that does not reflect well on the industry that is trying to work together,” added Abu Khadra.

The success of the merger would have been viewed as a sign of a maturing and stable Islamic finance market. But the absence of consolidation in the market will only serve as an additional setback to a weak performing Islamic equity sector. Like the majority of mutual funds, Islamic equity funds, which were hailed as a new breed of investment instruments, were not spared in 2001. In mid 2001, there were about 102 Islamic equity funds worldwide, targeting about 1.3 billion Muslims.
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But, according to the American-Kuwaiti consultancy, Failaka International Inc., Islamic funds and indices were not spared when the technology bubble burst, wiping out $3 trillion of the nominal value of America’s stock markets, one third of the country’s GDP.
“Equity funds in general have all gone down. The entire market has gone down. 2001 was a horrific year and how to decouple the Islamic effect from the other general market conditions is tough,” said Abu Khadra. Failaka estimates that the Dow Jones Islamic Market Index, a global Islamic index, has declined 33.1% over the past two years compared to the MSCI World Index, which is down 29.1% over the same period.

In 2000, the Islamic equity sector was valued at US$ 4.9 billion, according to Failaka. In July 2001, when Arabian Business reported on the sector, there were 102 Islamic equity funds. Compared to the previous year the number of new funds in 2001 has been miniscule and total assets have come down to US $3.3 billion. In its observations on the current state of the industry, Failaka maintains that growth in the Islamic equity sector has peaked and the days of 50% growth from the period of 1996 to 2000 have stopped.

“Even though there were 23 new funds launched in 2000 and 11 in 2001, there were also funds that closed or were liquidated. The total industry shrank 34% in terms of assets over the last two years,” says Failaka. The consultancy attributes the contraction to “a decline in world equity markets and investors’ flight to safety.”

Failaka maintains that investor portfolios were largely affected because of their exposure to technology and have moved away to less volatile stocks in healthcare and energy. “Islamic funds have bottomed out with the tech sector and now look good for growth, as their low leverage makes them attractive in a recessionary market,” Failaka’s Tarek Al Rifai told Arabian Business.
According to Failaka, the best performing funds in terms of return and sector in 2001, were Oasis Crescent Global -1.6%, the Alfanar US Value 7.6%, AlSukoor European Equity -15.3%, Futuregrowth Pure Equity 57.3%, and the Al-Ahli (NCB) Small Cap -4%.

In addition to the influence of the waning tech sector on Islamic equity funds, some industry insiders maintain that the events of September 11 have also had a negative impact on the Islamic finance industry. While various news reports indicate that a good portion of an estimated US $1.3 trillion of investments in the United States has come back to the region, an actual figure is difficult to come by.
Commenting on the likelihood of a negative effect, Abu Khadra said, “I don’t think it has, if anything it has ironically had a positive effect.” One indication that supports Abu Khadra’s inference is that Lebanon’s secular banking system, according to Reuters, had attracted an estimated US$ 800 million of Gulf money since September 11, and that Lebanese monetary authorities are trying to encourage Islamic banks to set up in the country.

That’s not surprising to one chief executive who requested to stay anonymous, because “Clearing firms and brokerage houses have been asked to do much more due diligence work by the IRS and the US Treasury department in the Middle East.” “That has had two effects; it has made investors wary of putting money in US equities and it has also made potential companies interested in offering US equity trading rethink strategy,” explained the chief executive.
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“There is definitely a tendency for US companies now to scrutinize more Middle Eastern institutions absolutely, there is no doubt about that,” says Abu Khadra “That does not mean that the industry has shrunk because of that—people will still invest but through other channels. A lot of money also goes through Swiss banks and they all operate on a highly confidential basis. US companies or brokers do not know who the ultimate client is—they have no idea. The client can still access the US market in a very easy way. It is up to the Swiss to know who the guy is,” explained Abu Khadra.

Rushdi Siddiqui, director of the Dow Jones Islamic Market Index says “some of the funds being offered by Western financial institutions have become gun shy on promotions and there is concern by some of the fund shareholders that their assets may be frozen.”
While talking to Reuters, Sheikh Ebrahim bin Khalifa, board of trustees chairman of the Accounting and Auditing Organisation for Islamic Financial Institutions in Bahrain, says there is really nothing to worry about. “The system [Islamic banking] cannot be used to fund terror at all because it is completely transparent by nature,” he told Reuters.

The ongoing changes in regulation and monitoring of Middle Eastern and Islamic funds post September 11, may very well be a blessing in disguise to bankers who complain of lack of liquidity in the region. That said however, the repatriation of hundreds of millions of dollars will have a positive side effect, only if the Islamic finance industry is nurtured and innovative Islamic products and financial instruments are made available to investors who have traditionally invested overseas.

“People in the region must believe in their own economies, whether it is by conventional or Islamic finance,” says Eric le Blan, director of Menafin.com, and who formerly with the Saudi Arabian Monetary Agency (SAMA). “Now that you have a net inflow of capital into the region, it would be best if money is spent on businesses that need it — whether the investment is conventional or Islamic does not matter as long as people are going to invest in the local market, which is not what is happening today. What is currently lacking in the region is the proper infrastructure for local investors to invest in the local economies. The region, as a whole, needs to work together.” Massoud Derhally

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