Keeping the Faith

Dramatic growth in the demand for Islamic financial services is prompting providers to offer ever more sophisticated products. It has also caught the eye of the global banking giants.

Dan Keeler

In the wake of the terrorist attacks of September 11, many banking observers were expecting the pall cast by the search for the terrorist money trail to fall on the Islamic banking sector. Some even predicted the industry, already reeling from soured investments in the struggling technology sector, could be quickly crippled as investors sought to distance themselves from all things Islamic.

It didn?t happen. If anything, the Islamic finance industry has emerged stronger, more visible, and with more determination to offer acceptable financial solutions to the world?s 1.2 billion Muslims?and anyone else who is interested. ?There is certainly more awareness of the Islamic finance industry as a result of September 11,? argues Ismail Dadabhoy, London-based executive director at UBS Warburg?s Islamic Finance Unit. ?It?s actually provided a boost to the industry.?

Islamic, or Shari?ah, law prohibits the use of such common Western tools such as charging interest, insists on the sharing of profits and losses, and prohibits speculative investments (see box, page 50). Typically a financial institution will have a panel of scholars who vet potential products and services to ensure they comply with the religious rules. Dadabhoy says that Islamic finance taps into a wider vein of sentiment toward investment. ?Think of it as more of an ethical product,? he says.

Not everyone involved in Islamic finance is convinced the industry will emerge from the aftermath of September 11 unscathed. ?There is still a very substantial fallout that has not settled down, and we don?t know when it will settle down,? says Abdulkader Thomas, a principal at financial consultant Strategic Guidance in Washington, DC. ?The very large private investors from the Arabian peninsula feel a strong desire to invest Islamically but fear they may be penalized for doing that [by having assets frozen]. There is more of a wait-and-see attitude.?

Rushdi Siddiqui, director, Islamic Index Group, at Dow Jones Indexes in New York, saw considerable anxiety among investors in the wake of the terrorist attacks: ?I got a call from someone concerned that if they invested in an Islamic fund that was SEC approved and registered that the assets would be frozen. In fact, after September 11 I thought I would have to update my résumé, but we have actually signed about five or six clients since then.?

That resilience stems from a number of sources, says Siddiqui. Some mainstream Muslims, for example, wish to demonstrate that Islamic institutions are not synonymous with extremism.

Investor Anxiety Rises
Islamic institutions? financial strength was largely unaffected by last year?s events, says Hank Calenti, Cyprus-based senior analyst at Moody?s rating agency. ?They managed to pull through pretty well, especially considering a certain amount of ?Islamophobia? took place,? he comments. ?We received a number of calls from potential investors, and we were able to reassure them about the institutions we rate in terms of how they screen their clients to make sure they?re not dealing with institutions that have tainted money.?

While the impact of September 11 on investors was less dramatic than many expected, many of the banks involved in the Islamic finance market have reconsidered their strategy. One London-based banker says: ?Some of the fringe players who had not committed themselves totally to Islamic financing have looked at the industry and decided not to be involved in it. They are deciding not to have a dedicated Islamic business model.?

This sentiment is echoed by the chief executive of an Islamic bank who on a recent trip to the United States complained that the big Western banks with which he was creating joint ventures were pulling out of the deals after September 11. With little capital invested in the deals, some decided it was easier to drop out than to face what might prove a dramatically changed marketplace.

?The large groups fall very tidily into a couple of different camps,? notes Strategic Guidance?s Thomas. ?Citibank and HSBC are historically deeply rooted in Islamic countries and have made a commitment that they are standing by totally. A number of others are not and are dropping Islamic banking. They are not willing to spend either the time or the money to get a competitive edge,? says Thomas.

Among banks based in the Middle East, however, the pressure is on to establish credible Islamic banking capabilities. ?Any bank that has a significant presence in Africa, western Asia, or south Asia has to take a solid look at this because it is the middle of the Islamic world?the non-extremists?who want this,? says one analyst. Ramzi Abu-Khadra, CEO of iHilal Financial Services, argues: ?There is a growing worldwide demand for Shari?ah-compliant investment products and services. And banks not offering Islamic financial services and solutions in the Middle East will face the risk of losing their customer base.?

Questions Remain Over Regulation
Confusion and uncertainty about the level and quality of regulation in the Islamic finance industry are at least partly responsible for the reluctance of many institutions to get involved. While Bahrain, Kuwait, and other Gulf nations are attempting to devise effective and reliable regulatory bodies, to Western eyes a shadow of doubt still hangs over the industry. Many Islamic institutions are attempting to combat this by asking their central banks effectively to certify them.

At the same time, the increasing interest from Western banks is encouraging tighter regulation. According to Samuel Hayes, a professor of investment banking at Harvard Business School, these changes are prompting mixed reactions among the Islamic banking community: ?The Islamic banks are proud to see the growth and the legitimacy of the sector enhanced by the entry of the Western banks. At the same time many of them don?t welcome regulation. Others feel that it is only through regulation that they will see their market sector grow.?

A Big Market ? but Just How Big?
Having so far concentrated on the high-net-worth sector, the big banks are now eyeing the consumer market. With the value of the funds already invested in Islamic banking a subject of heated discussion, few participants feel ready to gauge the size of the potential market.

Figures of between $150 billion and $250 billion are commonly cited for the existing market size?as is an annual growth rate of around 15%. Dow Jones? Siddiqui dismisses such figures: ?There is no scientific way to quantify that number. I?ve been hearing this same figure since about 1997. So if the market was $150 billion then and growing at 15% per annum, why is it still $150 billion now? It should be at least $400 billion by now.?

Hayes points out that assessing the market size is near impossible because the information is scattered and hidden. ?A good bit of the money that is being managed for Islamic investors is off-balance sheet. There is also a good amount?one relatively reliable estimate is $50 billion?that is hidden in Switzerland that is also managed Islamically. Whatever figure you could get by adding up the assets of the Islamic banks?would understate the amount that is being handled Islamically,? he says.

Siddiqui?s suggestion that the total market size far exceeds the prevailing consensus is supported by Bashir Ahmed, president of Kettering, Ohio-based Islamic financial services company Samad Group. ?The market in the United States alone is thought to be between $45 billion and $100 billion,? he says. ?Islam is not only the fastest growing religion; it is the second largest religion in America, and the US Muslim community is the richest in the world, with an income of between $100 billion and $150 billion a year.?

Siddiqui adds that the target market size of 1.2 billion Muslims is also misleading; at most 5% of that number would be in a position to invest, he says. Yet many bankers are building business plans on the assumption that a significant proportion of Muslims do want to invest in Islamic products. A senior London-based banker cites the 3 million Muslims in the United Kingdom and the 8 million in the United States as a potential client base. ?If I can get just 10,000 investors giving £7,000, that?s £70 million, or $100 million.?

In developing the retail market, however, Dadabhoy believes there is an urgent need for more mature products. ?We don?t have a global bond market yet,? he points out. ?Most investments are equity or short-term or illiquid products. We as an industry must develop and offer the full risk spectrum to the investor together with transparency and liquidity.? Dadabhoy admits the industry is stuck in a chicken-and-egg situation: ?You have to start somewhere. Somebody has to bet and do something.?

Laying precisely that bet, HSBC is on the verge of launching a suite of three Islamic retail banking products in the United States: an interest-free charge card, an interest-free checking account, and a home-finance solution (see box, page 49 for home-finance products).

Struggle for Supremacy
Observers of the industry believe that the big Western banks? extensive experience in marketing will allow them to outpace the Islamic banks in developing both their retail and commercial business. ?The Western institutions with Islamic windows and the Arab banks with Islamic windows are more aggressive than the Islamic banks, so they are already taking over the market.? says Siddiqui. ?With their big balance sheets the Western banks can afford to be more innovative.?

The result of the turf war with the Western giants is by no means a foregone conclusion. According to one insider, Islamic banks are increasingly turning to Western-trained bankers to help them grow their business: ?With the newer generation you will see aggressive bankers no different than the conventional bankers marketing themselves and producing products that the market wants?not what they think the market wants.?

HOME FINANCE PRODUCTS
The American dream is built on home ownership, and Islamic bankers are working hard to ensure that Muslims don?t miss out on their stake in that dream. Tariq Al-Rifai, vice president of Islamic banking at HSBC in New York, says the bank is developing a home-finance product that gets around the need to charge interest on the loan by employing a technique known as Murabaha. ?We purchase the house on the customer?s behalf, place a mark-up on it, and then resell it to the customer,? he explains. The bank will make a similar profit on this as they would on an equivalent conventional product.

McLean, Virginia-based home-finance group Freddie Mac is also launching an Islamic home-finance product. Freddie Mac?s product will work on a leaseback basis, where the finance company will buy the house and then lease it to the customer. Essentially, the customer buys a home by paying extra on top of the ?rent.? Saber Salam, a Freddie Mac vice president, believes there are between 1.5 million and 2.5 million households in the United States that would be looking for Islamically acceptable ways to finance their home purchase. ?Our expectation is to do between $3 billion and $5 billion in the next three to four years,? he says.

UBS Warburg?s Ismail Dadabhoy says similar moves are being planned in the United Kingdom, but local taxation rules mean homebuyers could face double taxation on their investment. Bankers are now trying to devise a leaseback structure that would circumvent the taxation issue.