CONVENTIONAL BANKS AND THE DEVELOPMENT OF ISLAMIC FINANCIAL PRODUCTS AND SERVICES
STELLA COX
The Market of the 1970s and 1980s
Conventionally managed institutions have undertaken various roles in the Islamic banking sector for the best part of twenty years. Much of the focus to date has been centred on creating diversified, international investment opportunities for the Islamic institutions and, whereas there is certainly no lack of product offerers, arguably, until quite recently, there has been a lack of diversified product.
Trade and Commodity Investment
T h e original role for the conventional, international institution was to identify and arrange wholesale investment opportunities for the outlet of Islamic institutional funds. During the late 1970s and for much of the 1980s, the liquidity of Islamic institutions was mobilised for short-term investment in a wide range of permitted trade- and commoditybased transactions. The London-based banks, in particular, proved to be really quite good at this because of their proprietary trading activities and direct access to physical commodity exchanges. Additionally, their international credit standing rendered them a low-risk counterparty for the developing Islamic banks, and both the conventional houses and their trading subsidiaries were able to benefit from a diversified source of funding.
In addition to utilising Islamic finance directly, the mainstream banks acted as intermediaries, brokering introductions between their global, corporate relationships and the Islamic banks. Many of the early facility recipients were international trading groups based in the UK, Europe and the Far East. Trade and commodity financings were arranged to match the trade purchase requirements of those organisations, thereby providing an alternative solution to conventional financing structures. Th e creditworthiness of these corporate counterparties, plus their enormous ongoing funding requirement, generated repetitive investment opportunities. These were able to accommodate most of the short-date liquidity circulating in the Islamic banking system and could be adapted to comply with the Sharia stipulations of individual banks and investors.
Profitability, particularly when impacted by the cost of conventional bank support, was not particularly attractive but, at the time, the focus was to establish a low-risk, international asset base. Annually increasing liquidity, lack of market competition and a high rate of return for US dollar-based investments during the early 1980s did little to encourage asset diversification and institutions such as Kleinwort Benson and Citibank, with established global trade flows, had a major role to play in structuring appropriate investment opportunities.
Re-positioning the Focus
During the second half of the 1980s, a number of new Islamic institutions were established, competition for depositors’ funds grew and accordingly the requirement for enhanced performance rose quite sharply. T h e resulting effect for conventionally managed organisations meant that:
(i) There was cause for a considerable degree of restructuring and upward review of short-term investment rates; and
(ii) They were required to actively endorse commercial risk through joint investment with Islamic clients. This ensured that the Islamic institution continued to receive analytical support. Simultaneously, it generated added comfort that its conventional partners applied prudent guidelines for their own risk assumption and sought returns that equalled those achievable through the extension of conventional structured finance.
Although possibly one of the most demanding early development periods for the Islamic banking sector and one marked by some ill-advised investment decisions that were, at times, attributable to conventional, third-party arrangers, it did focus Islamic banks’ senior executives’ minds on product development and in-house capability. Most importantly, it exposed those conventional third parties that had little to contribute to either the market or its participants.
The Market of the 1990s
After the first stage of repetitive commodity and trade investment structures, the Islamic market started to seek additional products that would both enhance profitability, extend investment tenure and satisfy the requirements of increasingly discerning depositors. Th e situation was exacerbated by the downward yield curve of the US dollar at the beginning of the 1990s, which impacted significantly on the trade financing returns available to the Islamic banks.
Asset Finance – Leasing
As a result, during the past five or six years, the Islamic institutions’ focus has moved towards financing a far greater percentage of non-trade assets. Ijara, or leasing, has increasingly become the preferred structure for extending longer-term funding and Islamic institutions have provided lease finance for assets ranging from aircraft, ships and motor vehicles, to office and medical equipment, to commercial and residential property. Again, the expertise of conventional banks has been channelled into identifying and structuring these investments on behalf of Islamic clients and some large-ticket transactions have been concluded. From a commercial and marketing perspective, the similarities between Islamically and conventionally structured leases provide considerable incentive to a Western user of Islamic funds.
Recently, not only have conventional and Islamic banks worked in unison, but in some asset categories, including aircraft financing for flag carriers, there has been a healthy degree of competition. Consider, for example, the earlier success of Th e International Investor of Kuwait in arranging a US$ 450 m leasing package for the fleet modernisation of Kuwait Airways.
Structured Trade Finance
The geographical coverage and distribution capability of large international banks means that there is still a role for conventional houses to play in introducing Islamic institutions to new credits and country risks, particularly when the arrange r is able to actively demonstrate its own risk appetite for the credit.
Although high-volume commodity trades are still transacted, Islamic banks are now delivering structured, trade-finance solutions to new international markets and this often prompts a role for local institutions. Individual focuses of different banks bring a depth to the trade finance market and increasingly. Islamic trade investment has global penetration. In addition to the traditional Islamic bank strongholds of the Gulf, North Africa and Asia, there are now strong relationships with corporations in South Africa, Europe and the USA. Dresdner Kleinwort Benson has been very active during the past 3 years in bringing its South African corporate relationships to the market, structuring and participating in Islamic trade financings aggregating more than US$ 150 million. Simultaneously, we have been able to take full advantage of being a key part of the Dresdner Bank Group by accelerating the level of our own risk participation in financings arranged by banks such as Faysal Islamic and Islamic Investment Company of the Gulf (Bahrain). The reciprocity in such relationships allows us to venture into new territories and markets in which we might not have been principally active but which are core strategy for the large Islamic banks.
Murabaha is still a much-used contract for the provision of Islamic trade finance. Although it has been criticised for hindering development of new products and for being little more than a manipulated conventional, financing seized upon by the international banks, arguably, it has done more to promote the capability of the Islamic market globally than any other Islamic funding technique. Dresdner Kleinwort Benson, Citibank, ANZ Grindlays, ABN Amro and United Bank of Kuwait are all conventional houses who structure and participate in billions of dollars of trade investments annually for Islamic institutional customers, and there are still others seeking an involvement. Facility structures have, nevertheless, developed and pre-production trade-financing made available through techniques of Istisna and Salam complement the well-established Murabaha and syndicated Mudaraba deferred-settlement concepts.
Islamic Investment Funds
Although the Islamic institutions have delivered some very sizeable bilateral and syndicated financings, one of the constraints to the development of the Islamic financial sector has been the insufficient depth of the asset base and another has been the lack of market recourse to liquidity. Although I shall consider market liquidity later on in this article, the lack of diversified investment products prompted several conventionally operating banks to address the demand for enhanced-performance, liquid investment and, in the second half of the 1980s, a number of funds were launched, including UBS and Kleinwort Benson’s Islamic global equity products.
Investment Fund Development
Although the early investment funds, particularly those focusing on quoted equity, met with mixed reception, they motivated a shift in the focus of the market. In the past few years there have been several new initiatives by London-based banks to develop investment funds encompassing different asset categories, such as the Oasis Global Equity Fund launched by Robert Fleming and the US Leasing Fund launched by the United Bank of Kuwait. The combinations of NCB and Wellington in offering their Islamic Global Equity product, and ANZ and the IFC in the more recent launch of leasing focused FAIM, also demonstrates the market commitment and confidence of Islamic divisions and segregated units of conventional banks. These have developed their own strategic alliances to deliver new products to their Islamic clients. Not only do these serve to increase the choice and diversification available to investors, they also address previous criticism that conventional institutions were reluctant to commit funds and resources to developing innovative and previously untested products for the Islamic market.
There is a growing precedent for conventional organisations to launch funds in conjunction with Islamic institutional partners. One example is the Ibn Majid Emerging Market Equity Fund offered by The International Investor with Swiss Bank Corp as investment advisor. Focusing on an entirely different asset category, Dresdner Kleinwort Benson launched a physically-traded base metals fund with the co-sponsorship of IICG (Bahrain). Not only do joint ventures of this type serve to expand the focus of specific product sectors, these partnerships can obviously be quite complementary too, blending joint structuring skills with Sharia credibility, fund management capability and global distribution.
Equity Investment
Despite recent volatility in the markets, investment in equity remains in focus, with City Islamic Investment Bank announcing the launch of its own Islamic global equity fund earlier this month, blending the skills of its Islamic banking subsidiary with those of its regular fund managers. In addition to adopting a joint venture approach, a number of Islamic institutions have appointed mainstream organisations as fund managers with a mandate solely to provide the portfolio management expertise for products developed, branded and distributed by the Islamic institution itself.
Whatever the preference, it seems that a top-tier asset manager has a continuing role to play and we should take a couple of minutes to explore this rationale. Although approaches vary, a fund manager needs to be especially pro-active with an Islamic portfolio. A conventional bank launching its own Islamic investment fund will obviously need to be willing and able to operate in strict accordance with the stipulations of its Sharia advisors. Without the endorsement of a recognised and esteemed panel of Sharia scholars, it will not succeed. It must also contribute to the entire initiative and if they are sufficiently committed, large institutions can really add value through the application of extensive resources. The research capabilities of global groups can greatly contribute to the stock-screening procedure and whilst there is still not universal Sharia endorsement of Islamic investment in international equity markets, the volume of new products has sewed to promote greater standardisation of stock-selection procedures.
Research and Development for the Future Market
Having looked at some of the services offered previously and currently by international institutions actively participating in the Islamic market, it is important to consider some of the sector’s outstanding requirements and the role that those same institutions might play in assisting with the development and subsequent implementation of new products.
Islamic Interbank Liquidity Market
The fact that conventional banks are actively assuming risk alongside Islamic institutions has already been mentioned. Not only do they provide joint venture investment, but also valuable reciprocal liquidity for many of the Islamic banks. The impact of the limited recourse to liquidity by the Islamic banks is certainly not a new topic. For the Islamic institutions of the Gulf, North Africa, Turkey and the Near East, there is no alternative to the regular money-market and recourse to liquidity is often provided through the extension of bilateral, Sharia endorsed financing facilities by other banks, particularly those from the conventional sector. These facilities go some way towards injecting essential liquidity, thereby enabling the Islamic banks to mismatch a small percentage of the balance sheet whilst still upholding obligations to depositors and meeting liquidity ratios established by central regulatory authorities. Although valuable, such a fragmented funding solution is obviously inadequate and lack of recourse to market liquidity is generally perceived as one of, if not the major hindrance to the development of a fully integrated Islamic financial system outside of Malaysia.
ABC Investment & Services Co. has developed overnight and short-term asset-backed, liquidity facilities to plug the gap and I believe this was the first initiative of its kind to have been implemented. Issues such as lack of a Sharia consensus and common rules for the establishment of market practice and systems are still to be resolved. Other barriers, such as standardisation of financial reporting and accounting standards by the Islamic financial institutions are being rigorously addressed by the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) in Bahrain. Th e presence of recognised, international rating agencies in the region is another relatively new, but essential, ingredient. To formalise a recognised market, the next stage of development calls for the critical mass of players to ensure its effectiveness. There is arguably a very large role for conventional Western institutions to play in delivering this, not least because of the extensive balance sheet capability and recognised credit ratings that will enable both placement and utilisation of funds.
Long-term Investment and the Islamic Capital Market
Earlier we looked at non-trade asset finance and concluded that the greater percentage of longer-term assets tends to have been assumed through lease-based structures. Although this has been an important development in expanding the penetration of the Islamic financial sector, the investment of substantial capital for longer periods still rests uncomfortably with some of the smaller Islamic banks.
In Malaysia, the Islamic financial system functions through the liquidity available within the Islamic Interbank market and its infant Islamic capital markets have begun to generate finance for numerous, sizeable infrastructure projects.
Presently, Islamic institutions elsewhere are not consistently able to trade long-term assets and it is clear that the barriers to establishing the Islamic, institutional liquidity market similarly apply to the implementation of a fully functional capital market for financing and trading those long-term assets. Again, the potential benefits of developing the Islamic capital market are numerous. Consider, for example, the rapidly escalating requirement for infrastructure investment and development in the Middle East. It has been estimated that over US$ 33bn of project-related funding has recently been invested in Islamic countries with just a fraction of this total underwritten by the Islamic banks. Admittedly, conventional arrangers of project finance have also sought access to Islamic investment companies and high-net-worth individuals in the knowledge that illiquidity is less of a constraint.
Currently, outside of Malaysia, Islamic institutional participation in non-recourse project-financing has been largely restricted to providing sizeable financing facilities for start-up development and the acquisition of individual assets within a project. One of the earliest and most cited examples of a segregated Islamic financing within a large-scale project was A1 Rajhi Banking and Investment Corporation’s provision of a US$ 92m Istisna pre-production facility for the Hub River Project in Pakistan, arranged by ANZ Grindlays. Although such investments are valuable to infrastructure development, the Islamic banks are keen to take a longer view, but again the inherent risks and absence of cash flow in the long development phase of a project remains prohibitive to significant participation.
There are a few notable exceptions to the strategy of incorporating Islamic short-term working capital facilities within large-scale financings, one being the financing segment of the Equate project arranged by Kuwait Finance House and The International Investor. The US$ 200m Islamic tranche of the US$ I billion-plus Equate project was encouraging in that its two Ijara components had 8 and 10-year maturities. It seems likely that another Islamic institution will play a major role in arranging a segment of the US$ 2.3bn 10.5-year project financing for the Saudi Yanbu Petrochemical Company.
The appetite of the banks would be substantially increased by the ability to take a long-term view through investment in capital market issues with undoubted liquidity. Development and co-ordination of a capital market would certainly add depth to the Islamic financial system by expanding its asset base and broadening the range of available investment opportunities. Again, a market environment can only be created by amassing efficient participants to underwrite and trade in the individual issues. Over to the large global banks again, as a conventional institution’s ability to underwrite a long-term, securitised issue would generate a certain level of comfort for an Islamic bank and would ensure that there was sufficient market liquidity for subsequent trading.
Sharia consensus for market practice is again essential, but other important commercial issues must be resolved as the typical capital market investor looks for a secure investment supported by centralised regulation, listing on an approved exchange and a credit rating from a recognised ratings agency. I believe that definite progress has been made in most of these areas during the past 18 months.
That said, we should be aware that the regional capital markets are, themselves, in relative infancy, having been constrained by local legislation, controls on capital flow and economic development. It is not unreasonable that the Islamic capital markets of the Arab world are following behind their conventional counterparts. Development cannot be forced, but should be cautious and properly researched, so as to meet both regional requirements and those of market participants comfortable with balancing market risks and rewards.
Conclusion
There are no doubt that Islamic and conventional banks have different motives for offering Islamic banking services. However, the mainstream banks, with continual presence and active involvement, have long since understood that added value is a pre-requisite, whether by reciprocal participation on a risk-and profit-sharing basis; through offering investment funds, supported with their own seed capital; or by equally balanced investment partnerships incorporating sophisticated product engineering. To support the development of technical capability, many also invite and welcome the participation of the Islamic bankers to their training programmes.
Lately, conventional banks have also been reviewing their past and present involvement (and, indeed, their likely contribution to the future development of the market and its participants), in order to position themselves accordingly. The results of these endeavours are apparent: Citibank has an established Islamic subsidiary; Arab Banking Corporation, through ABC Investment & Services Co., has announced a similar strategy and others are maintaining a watching brief through expanded segregated divisions, or dedicated Islamic banking teams. Furthermore, a large number of conventional institutions are now visibly offering niche investment products and services which complement their individual focuses and are considered appropriate by their Islamic clients.
In Britain, it is the Islamic divisions of conventional banks that are presently seeking to deliver, or are directly associated with Islamic financial services for the Muslim community. There may not be a licensed Islamic bank in the UK at the moment, but the requirement amongst British nationals for savings and credit products at retail level, structured in accordance with the Islamic Sharia, is accelerating.
In most instances, the Islamic banks claim that their conventional bank relationships do add value, and readily acknowledge that some of the world’s most reputable banks are utilizing their own resources and research and development allocations to present diversified proposals which can be considered subjectively. Islamic houses now expect that reciprocity and the aforementioned capital resources of mainstream bank counterparts should afford Islamic institutions important bilateral relationships. Increasingly, the extent of the reciprocity is used by the Islamic banks as a measure of commitment to the relationship and this will have a considerable role to play in successfully addressing the challenges of the future market.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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