Adapting to change

Islamic banking is growing at 20-30% per annum with US $150-250B in deposits, but the business environment is changing, competition intensifying and to compete Islamic banks must change

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By  Massoud Derhally Published  December 4, 2002

|~||~||~|With the growing size of Islamic investments comes the need to diversify, and as the industry grows so does the need for a larger range of products and services. That was one of the underlying messages of the ninth World Islamic banking conference held in Bahrain in November, which brought together Islamic bankers and financial institutions from all over the world and concluded with a call to consolidate Islamic banks and the financial industry.

But to consolidate, the industry must take into account a number of external and internal factors, such as the lawsuit filed in the US by relatives of the victims of the Sept. 11 attacks, regulatory aspects, and other local or internal elements, like reforming existing business models of Islamic banks.

Islamic financial institutions and banks received negative publicity in the West as a result of the Sept. 11 attacks. A US $116 trillion lawsuit filed by the families of hundreds of victims of the 9/11 attacks alledges that seven international banks, eight Islamic foundations and charities, the government of Sudan and a number of individuals helped fund terrorist activities.

Observors do not appear too concerned about the suit, however. “It will have some ramifications but taking somebody to court does not mean you are going to win,” says Adnan Al Bahar, of the Kuwait based International Investor. “I think the major impact of September 11 has been on people being careful on what charitable organisations they donate to.” Arab governments have been proactive in the past 15 months. Regulations that may have been lax before Sept. 11 are being tightened.

The government in Bahrain has traditionaly been a heavyweight on regulation. While the Kingdom was among the first to recognise the importance of Islamic finance and gathered a shore of Islamic institutions over the years, it made sure that regulating the industry was a top priority. “There has to be a regulatory framework and a structured environment, which allows the industry to experience sustainable growth that strengthens investor and customer confidence. Much of this is already the case with the supervisory role of the Bahrain Monetary Agency [BMA],” Sheikh Ahmed Bin Mohammed Al Khalifa, governor of the BMA, told Arabian Business.

“A forum like this will create the awareness that Islamic financial institutions don’t work in isolation of international practices or the rule of law, but are based on the rule of law,” says Abdulla Hassan Saif, Bahrain’s Minister of Finance. “We are fully engaged with those responsible for the international financial architecture in preventing and combating both money laundering and terrorist financing. These are challenges, which are faced by both conventional and Islamic financial institutions, and their regulators, across the world,” added Saif.

That was certainly the message that Sheikh Saleh Kamel wanted to get out, in what was considered a significant speech, as Al Baraka Group, of which he is chairman, is one of the companies being sued in the US. Kamel, who is also chairman of the General Council for Islamic Banks and Financial Institutions, rejected the accusations waged against Islamic banks in the US lawsuit.

“We explicitly condemned...and expressly disowned these shameful incidents and their executors, because they should not have been done by a true Muslim who believes in Allah and the essence of Islam,” Kamel told an audience of 500. “At the same time, we should make clear, in our defence, the actions of Islamic banks and institutes..., [which] are operating under the control and regulation of Central Banks and international regulatory agencies,” he added. ||**|||~||~||~|
There are other basic challenges that Islamic banks have to address and they will require a fundamental change in the way Islamic banks do their business. Leo Puri, principal at the management consulting firm McKinsey, told an audience of Islamic bankers and businessmen, “most Islamic banks and financial institutions don’t have a business model that is scaleable, that will allow them to succeed in terms of allowing them to capture opportunities that Islamic banking actually offers.”

Islamic banks are organised in terms of providing project financing and deposits. Over 90% of loans go to corporations and 90% of deposits come from the personal side of the business. This, Puri says is “a highly imbalanced business model.”

Islamic banks need to enhance their offering to effectively serve new customer segments, and this Puri says, will require a boost in the level of service and quality of the overall offering. “They will have to cope with increased competitive intensity from conventional players, achieve sufficient scale to compete efficiently and overcome current limitations in the business model,” says Puri.

The transformation of Islamic banks has to be supported by a new approach to performance management, says Puri. As foreign conventional banks set up windows to tap wealth in a Sharia compliant manner, Islamic banks and institutions need to redefine their strategy. There should be a clear focus around large corporates, and small to medium sized enterprises on the commercial side, while focusing on high net-worth clients. This will require broadening the consumer finance product suite.

While key Islamic banking players have done relatively well at capturing market share, challenges need to be dealt with, and if not addressed, will result in loss of market share to foreign or conventional banks, many of whom have already set up Islamic finance windows in the region and beyond. This is taking place because “most Islamic banks are still focused on financing corporates while personal finance and Islamic financial services are growing faster and are more profitable, attracting new players who are gradually building strong positions and increasing competitive intensity,” says Puri.

“The Islamic market is a very important business for us. We will never ever be as big or as sophisticated as an Islamic bank because that’s not our mission. What we do want to be able to do though is take some of the products and services that we have and customise them so that they are acceptable to Islamic investors,” says Jeffrey Culpepper, vice chairman of Deutsche Bank in London, which recently concluded some real estate transactions in Chicago and Sweden on behalf og Kuwait Finance House.

“The Islamic market is massive and much too important to ignore, so we are continuing to change a lot of the products that we use to modify them in order to meet the needs of the investors,” he adds.
Deutsche Bank is not the only foreign bank that has ventured into Islamic banking. The expansion of Islamic banking and the size of assets under management have also attracted other non-Islamic banks that want a piece of the pie. Citicorp has Citi Islamic Investment Bank in Bahrain that also caters to Islamic investors; HSBC has Amanah Finance in Dubai, Brown Brothers Harriman and Commerzbank, also conventional banks, have Islamic investment products.

Bahrain’s minister of finance, Abdullah Hassan Saif says, “Instead of saying competing why don’t we stress complementary to each other. I think both the conventional banking system and Islamic banking system have a role to play.”

He adds: “Competition should not be a factor that we shy away from. I think the potential for Islamic banking is great because it is developing very fast and will play an important role both on social and economic development, and not only in Arab countries but Islamic countries and other countries around the world. Conventional and international institutions are opening windows dealing in Islamic banking and finance. So it is not something that is confined to one country or region, it is becoming global.”
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But unless Islamic banks shift their focus towards the retail business, says Puri, competition is likely to get tougher and put a dent into the bottom line of pure play Islamic banks. “They need to gain greater scale to maintain an adequate level of investment and market presence and achieve sufficient efficiency in their operations,” says Puri.

Malaysia, says Puri, shows that there is a clear and present danger to Islamic banks today. There are 48 conventional commercial banks with Islamic value propositions in Malaysia next to 29 pure Islamic banks, but the “conventional banks control almost half of the market share of Islamic banking assets – after less than a decade,” says Puri.

To exploit possible opportunities in the future, Islamic banks will have to address four primary challenges, according to Puri. Banks will have to continue to develop their business model substantially by shifting from a product focus to a customer focus; they will need to enhance their product suite; address their limited consumer finance product suite and harness new skills, especially in distribution and credit. “The development of the right products and services to serve the region is important. The region’s needs are changing and therefore the requirements of financial institutions serving this region are changing as well,” says the governor of the BMA, Sheikh Ahmed Al Khalifa.

There is no doubt that Islamic banking and finance has become part of the mainstream banking environment, and that it will grow in importance as Muslim countries have substantial capital sufficiency. But in order to transform and meet the challenges, banks will have to change the way they think.

“The new challenges will necessitate a shift from product focus towards customer focus and a broadening of the consumer finance product suite and tailoring it to segment needs,” says Puri. “Banks will need to move from a product-centric to a customer-oriented approach to establish complete, segment specific offerings. They will need to establish the necessary product development and infrastructure to upgrade retail lending and investing and redesign the distribution network to deliver service quality at a par with conventional banks.”

Mohammed Toufic Kanafani, chief executive of Noriba, UBS’s newly established Islamic banking arm in Bahrain, says, “The more participants the better. The more providers there are working toward the same goal, the more we will be able to meet the requirements of the sophisticated Islamic investor. Similarly, the more we work together to expand the range of products available, the more growth and liquidity we will see in the market.”

Abdel Hamid Mamdouh, director at the trade and services division of the WTO says, “Growth will depend on the ability and desire of consumers to buy the products and interact with financial institutions.”

The challenges for Islamic banks today, some might argue is to rebuild consumer confidence and tighten the regulatory infrastructure while meeting the challenges posed by foreign and conventional banks that have entered the Islamic financial arena.
Ramzi Abu Khadra, chief executive of iHilal.com agrees.

“Islamic banks can and should become leaders in the industry. This will require reforms on managerial and regulatory levels, or the space will largely be taken by conventional or western banks, which are catering to the industry,” says Abu Khadra. “For Islamic banks to truly excel, there will also need to be more collaboration between them to overcome industry fragmentation and get economies of scale needed to reduce cost,” he added. Massoud A. Derhally||**||

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