Islamic Banking

The global market for sukuk (Sharia-compliant bonds) has grown tremendously in recent years. Total outstanding sukuk rose from $8 billion in 2003 to around $100 billion in 2008. Sukuk provides companies and governments with access to financing and liquidity and offer a much needed Sharia-compliant instrument to investors. While the growth of the fixed income market in the Kingdom has been dwarfed by that of the equity market, we think that conditions are in place for strong growth in sukuk issuance and trading.

An important step was the launch by Tadawul of an automated order-driven secondary market for sukuk in mid-June. Previously, sukuk transactions were in an over-the-counter market, meaning that they were executed through bank treasuries and settled by Tadawul. Liquidity was very low, as most sukuk issues were held until maturity. The introduction of the new platform is intended to encourage investors to more actively trade sukuk. With the new system, investors can buy and sell sukuk through their brokers.

With the new trading platform in place, we think the following factors will stimulate supply from issuers and demand from investors in Saudi Arabia:

* Predictability and portfolio diversification: The collapse in the stock market last year has encouraged investor interest in more predictable assets such as sukuk. Given the very limited investment channels open to investors in the Kingdom, sukuk could also play in important role in portfolio diversification.
* Problems raising finance from traditional sources: Companies needing to raise finance have generally used a combination of bank loans and IPOs. With banks reluctant to lend and low valuations making IPOs unattractive, sukuk issuance should emerge as an important source of funding.
* Balance sheet mismatches: Little long-term bank lending is available, meaning that companies borrowing to finance long-term projects face an asset-liability mismatch on their balance sheets. Long-term sukuk would ease this problem.
* Healthy sukuk pipeline: Following two successful sukuk issues earlier this year, other local companies have announced their intention to issue sukuk, in addition to some GCC governments.

Notwithstanding the bright future for sukuk, there are still formidable challenges may impede growth. Liquidity is very low; there were only 50 transactions in the first two months of trading on the sukuk market. In addition, the local market lacks breadth and depth (there are only five listed sukuk) and there are no indications that the government will begin actively issuing sukuk (government support is generally a key factor in the development of debt markets). Furthermore, the lack of skilled human resources, Sharia-compliance standardization and innovative product development remain serious issues.

Background

The use of sukuk has become increasingly popular in recent years both for governments and companies. In part this has stemmed from the dramatic growth in Islamic banking that has been the result of the large inflows of liquidity (primarily oil revenues) into the Islamic world and a greater appetite among businesses and individuals to conduct their finances in a Sharia-complaint way. As the take up of Islamic financial services grew, demand from issuers for a product that performs a similar function to a bond leapt. Demand from investors has also surged as growing wealth within the Islamic world has made regional credit risk more attractive and greater understanding of the instrument and clarity of documentation, supported by credit ratings from international agencies, has enhanced investor comfort with sukuk.

Malaysia accounts for around 47 percent of global sukuk issuance by market value, followed by the GCC, which is the source of a further 46 percent. Sukuk issuance is not limited to Islamic countries and there have been issues from institutions in Singapore, Sri Lanka, Canada, Thailand, the UK and US. Recently, the second largest bank in Russia, VTB, indicated that it is considering a sukuk. The growing interest in sukuk worldwide reflects the spread of Islamic banking and the desire of foreign issuers to tap the liquidity within the GCC. As it is the structure of the instrument that has to be Sharia-compliant, rather than the issuer or the purchaser, the supply and demand for sukuk is set to grow in nontraditional markets.

Sukuk are generally built around one of six main contracts: Ijara, Mudaraba, Musharaka, Murabaha, Istisina and Istithmar. Ijara accounts for around 32 percent of global sukuk issuance followed by Musharaka and Mudaraba. The Saudi sukuk market is dominated by the Istithmar. The variation in the dominance of structures is explained by the lack of Sharia-compliance standardization. It is the responsibility of Sharia boards to determine what structures are Sharia-compliant and given that there are no universally agreed standards, boards across countries exercise considerable discretion in arriving at their opinions. Some countries adopt a conservative interpretation of Sharia, while others are more flexible, leading to an inconsistency about what is considered Sharia complaint. For instance, most Ijara structures that have been issued in other countries do not meet Sharia-compliance requirements in Saudi Arabia. This lack of Sharia standardization poses a great challenge to growth of sukuk.

Source

RIYADH, 15 March 2008 — Sheikh Saud Al-Shuraim, imam of the Grand Mosque in Makkah and a member of the teaching staff at Umm Al-Qura University, has called for the establishment of an Islamic common market.

Delivering his Juma sermon at the Grand Mosque yesterday, the imam said the proposed market should follow the teachings of the Shariah, keeping away from interest-based financial dealings.

Many international financial organizations have started adopting Islamic financing systems after the latter proved successful in terms of achieving substantial profits, Al-Shuraim said, adding that the Qur’an and Sunnah have explained the basic principles for financial transactions.

Ezzuddin Khoja, secretary-general of the Supreme Council of the Islamic Financial Banks, said Islamic banks in Arab and Muslim countries alone now handle more than $250 billion.

Islamic bank deposits in the Gulf rose by 29 percent to $58 billion in 2005 compared to the previous year. Islamic finances worldwide are estimated at about $450 billion, he explained.

Islamic and traditional banks apply different rules.

The Islamic banking system does not depend on loans and offers a variety of products such as murabaha, mudaraba, musharaka, ijara and istisna based on profit and loss sharing.

The Islamic banking system began in Saudi Arabia and Prince Muhammad Al-Faisal and Saleh Al-Kamil have played a pioneering role in promoting it, Khoja said.

Source: Abdul Rahman Al-Muafa, Arab News

Small-and-Medium Enterprises (SMEs), usually considered to be the backbone of an economy, are set to receive a major boost especially in the Islamic banking and finance sector. Countries such as Saudi Arabia and Malaysia are encouraging greater allocation of financing for SMEs by the banking sector in an effort to stimulate the private sector and to boost rural and inner city poverty alleviation policies.

In Malaysia, for instance, according to Bank Negara, the central bank, financing for SMEs by the Islamic banking sector continued to increase from RM3.5 billion in 2002 to RM6.2 billion in 2003 to RM8 billion in 2004. The year-on-year increase in 2004 was almost 30 percent. More encouragingly, the market share of Islamic banking financing out of total financing for SMEs in Malaysia almost doubled from 7.5 percent in 2003 to 13.9 percent in 2004.

However, the Islamic SME financing in Malaysia in 2004 is merely RM8 billion out of a total financing by the Islamic financial sector of RM57.882 billion, which suggests that there is a huge challenge and business opportunity for Islamic banking in Malaysia in respect of financing SMEs.

This trend is reflected elsewhere in member countries of the Islamic development Bank (IDB), as the role and contribution of the SMEs to GDP and economic activity assumes greater importance.

Saudi Arabia is also encouraging the financing of SMEs. The country’s largest bank, National Commercial Bank (NCB), which is owned 69.3 percent by the Saudi Public Investment Fund (SPIF), earlier this year launched a Shariah-compliant financing scheme aimed at small businesses and self-employed professionals.

The "Al-Ahli Program for Free Tradesmen" offers Shariah-compliant loans of up to SR1 million repayable over three years to small businesses and professionals such as consultant doctors, engineers, and accountants who own and manage their own activities.

This financing program, according to Al-Sharif Khalid Al-Ghalib, head of NCB’s customer management group at the time, was the first of its kind on the Saudi market, and offers financing without collateral to all qualifying business people whether they are NCB customers or not.

"The small business sector makes up 80 percent of the Saudi market", stressed Ibrahim Al-Buloushi, head of NCB’s small business group, "and the bank’s aim is to expand the national economic structure; provide additional support to increase sources of income; and activate the economy to create more jobs and investment opportunities."

Some Islamic bankers have criticized the sector’s over-concentration on corporate, institutional and high networth clients, and its slowness in targeting SMEs.

"The reasons why SME financing should be a natural niche for Islamic banking," stresses Dr. Adalet Djabiev, CEO of Badr-Forte Bank in Moscow, which is Russian sole Islamic bank, "is that it deals directly with the real economy; creates employment; involves the productive use of resources especially capital and finance; and contributes directly toward the alleviation of poverty."

The IDB offers lines of financing for onward financing of SMEs in member countries along with extension, in principle, of full delegation of authority to selected National Development Financial Institutions (NDFIs), which are also encouraged to use the IDB’s technical assistance facilities.

At the 29th annual meeting of the IDB board of governors in Tehran in September 2004, SME financing was high on the agenda with particular emphasis on the need for using modern banking products to help alleviate poverty by generating wealth in rural areas.

The biggest policy boost for SME financing has come from Malaysia in the last two years. Bank Negara in October 2004 embarked on a project to enhance the capabilities of its development financial institutions (DFIs) such as Bank Pembangunan; Bank Industri; EXIM Bank; MECIB; and Bank Pertanian Malaysia.

The Bank Negara SME policy thrust is part of Prime Minister Abdullah Badawi’s so-called "agro-revolution", whose priorities include reducing poverty significantly, especially among the hardcore poor; rooting out corruption; and reforming education.

Indeed of the 22 banking measures introduced by Bank Negara in 2003, some eight dealt with measures to improve access to financing and those promoting active consumerism.

Malaysian Second Finance Minister Tan Sri Nor Mohammed Yakcop last year rightly called on Islamic finance to impact more on the ordinary citizens and not just bring value to shareholders, and bonuses to senior executives.

For instance, in the context even of an Islamic Capital Market (ICM), he is suggesting greater use of equity-based and hybrid financial instruments, and more non-collateral-based Islamic financial products to promote entrepreneurial development.

Link