Islamic finance: Size will matter in Islamic banking

By Chris Wright

THERE ARE 300 Islamic banks operating in the world today. But this statistic, ubiquitous in presentations about the growth of Islamic banking, is not an entirely positive number: it’s far too high. Islamic banking is enormously fragmented. At the top end, there are: Al Rajhi Bank, with $33.3 billion of total assets in 2007; Kuwait Finance House, with $32.1 billion; and Dubai Islamic Bank with $22.8 billion. But after that, there’s daylight, and you don’t have to go too far down the list to get to the minnows.

Numbers are notoriously tricky to pin down in this field, but in a January study the IMF put total Islamic banking assets at $250 billion, citing several other studies. That’s an average of less than $1 billion of assets for each bank, and with the best part of $100 billion accounted for by the top three alone, there are many banks with very little to their name. "They say that something like 65% to 70% of Islamic institutions are capitalized at less than $25 million," says Agil Natt, chief executive of Malaysia-based Islamic finance training organization Inceif, and formerly head of Aseambankers and deputy chairman of Maybank. "That’s nothing."

Natt continues: "Moving forward, not only do you need balance sheet, but you need reach and the power to distribute the various instruments that you come up with. My opinion is that there is a need for a few large Islamic financial institutions with global reach. But the industry has not reached that stage."

There are the earliest signs of consolidation. This year, Maybank bought a 20% stake in Pakistan’s MCB Bank for $686 million. However, MCB is not actually an Islamic bank: only eight of its 1,026 branches at the time of the acquisition were dedicated Islamic branches.

Consider also the full merger of National Bank of Dubai and Emirates Bank: although there is an Islamic entity in the group (Emirates Islamic Bank), and both banks sell Shariah-compliant mutual funds, this is again a merger of conventional entities that happens to have an impact on Islamic subsidiaries. Likewise Malaysia’s CIMB Islamic, which runs Islamic banking and asset management operations in Indonesia through Bank Niaga: a cross-border presence certainly, but one that sprang out of the 2002 purchase of one conventional institution by another, both banks happening to have Islamic subsidiaries or licences.

There have been signs of Islamic banks becoming more globally minded but they have tended to do this through organic expansion. The clearest example is Al Rajhi and Kuwait Finance House, which have taken advantage of Malaysia’s policy of opening its doors to foreign entrants to establish itself as the global hub for Islamic finance. KFH opened in February 2006, and Al Rajhi a year later. A third bank followed: Asian Finance Bank, which at the time of launch was owned 70% by Qatar Islamic Bank, 20% by Saudi Arabia’s RUSD Investment Bank, and 10% by Kuwait’s Global Investment House.

For KFH, the Malaysia expansion – which has been followed this year by the licensing of an Islamic asset management business – was in keeping with a long-standing and against-the-herd policy of global engagement. Until recently one could have argued that KFH was the only Islamic bank to have expanded cross-border. It holds a majority stake in Kuyevt Bank, an Islamic bank in Turkey, and has operations in Bahrain, Algeria, Saudi Arabia and Morocco and affiliates in the United Arab Emirates, Oman and Bangladesh. Its first participation in Malaysia came in 1995 when it set up a leasing joint venture with several Malaysian partners and the Islamic Development Bank; at the same time it applied for a full Islamic banking licence from Bank Indonesia, but the Asian financial crisis put that on ice.

But the fact is it could have been even more of a trailblazer if it had got its way last year, when it bid to buy a 33% stake in Malaysian financial services group Rashid Hussain. It got as far as striking a preliminary agreement with the seller, Utama Banking Group, and outlined plans to invest a total of M$12 billion ($3.3 billion) in the group and turn it into an Islamic banking powerhouse.

It didn’t happen: Utama opted instead for Malaysia’s key pension fund, the Employees Provident Fund. And so this is still the transaction Islamic banking is waiting for – a truly transformative, intercontinental acquisition to make a global Islamic banking leader. But it’s still possible that one will emerge, and when it comes it’s likely to be KFH that achieves it. The Malaysia managing director Dato’ K Salman Younis said last year that, in Indonesia, "we have identified some target banks where we know the owners desire to divest. There are four or five of them. Once we get the green signal from the parent company, we will be able to move."

KFH apart, though, most other Islamic banks are more sluggish. Al Rajhi’s expansion into Malaysia was all the more notable because it marked the first time it had ventured outside Saudi Arabia. Its behaviour in Malaysia suggests a more ambitious view of the world – it opened with 12 branches, quickly announced plans to get to 50 by 2010, and launched a blanket marketing campaign – but the bank looks less likely to expand by acquisition. Dubai Islamic Bank is growing with gusto – last year it said it aimed to open 70 branches in Pakistan – but again, it’s organic.

So why don’t mergers happen? There are several answers.

First, Islamic banks are just too busy. Most estimates (McKinsey is a frequently cited source) say that Islamic banking is growing by 15% to 20% a year. If you’re doing that, the challenge is finding enough people to run your own business. Why bother acquiring a whole other shop that would need integrating? With growth rates and margins like this, anyone new can set up a franchise from scratch without having to pay a premium for an acquisition.

This is an argument that relates to the maturity of the sector. For the moment, Islamic banks are opening branches and in some cases expanding overseas; the imperative isn’t, yet, to cut costs and improve profitability because margins have been so good. There has also been no need to look overseas when pickings have been so rich at home. But in time, that focus will undoubtedly shift, as the increasing competition from all these players starts to push margins down. That’s when mergers are likely to get more attention as an idea.

The second argument is regulatory, and this applies in particular to anything cross-border. Many Islamic countries have restrictions on foreign ownership, or limit the number of licences that can be awarded to foreign entities.

A third concerns Shariah interpretation. If KFH had succeeded in buying Rashid Hussain, there was much conjecture about how it would have integrated its assets. KFH is considered one of the most conservative institutions in the world in terms of Shariah compliance, and there are marked differences in interpretation between Malaysia and the Gulf, which makes cross-border acquisitions trickier.

For a long time there was a fourth argument: high equity valuations, particularly in the Gulf, made takeovers prohibitive. Still, that argument has gone out the window following the recent plunges in Gulf stock markets along with those everywhere else in the world.

Could the much tougher global environment be the catalyst for consolidation? Islamic banks by and large have come through the credit crunch in good shape, since many of the securities that triggered the sub-prime crisis in the first place are off limits to Shariah-compliant banks. But there’s no escaping the effects completely, and bank growth rates will surely slow. A 20% growth rate can’t last for ever anyway: it’s a function of starting from a low base, and maintaining that pace becomes more difficult with every passing year. Also, we have been in the midst of a period of asset transfer, as more funds have moved across from conventional to Islamic structures as awareness and regulation have permitted. That free kick to Islamic asset growth will be gone sooner or later, and asset gathering will have to come from other sources, perhaps acquisitions.

One possibility is that regulators will become agents for change rather than opponents of it. If they raise capital requirements, for example, or define a minimum scale for Islamic banks, they will drive consolidation; they can further enable it by being more accommodating to foreign buyers. Malaysia brought its domestic conventional banking sector down from more than 50 financial institutions to 10 banking groups in less than a decade.

Logically, mergers should come: this is how the conventional banking world has ended up and Islamic banking, when it reaches a greater degree of maturity, will likely do so too. "There are merits in growing organically, but that takes time," says Natt. "The future is for Islamic banks to look beyond their borders."