ISLAMIC FINANCE: MARKETING AND INVESTMENT
STELLA COX
Much of the short-term Islamic trade finance arranged through London by Citibank, Kleinwort Benson and ANZ Grindlays (amongst others) was, and is, for Western blue-chip end-users.
What is apparent is that the three institutions were all, because of their own business orientation and established Middle Eastern investor relationships, well-placed to deliver the specific services sought by Islamic institutions and investors during the initial phase of accelerated growth within the Islamic financial system.
Often, we read press articles and financial journals claiming London as the hub or centre of Islamic financial activity. Most would consider that such a comment, made on a stand-alone basis, is, at best, ill-informed nowadays, but there is probably greater justification for observing that a good percentage of trade-based activity has, to date, been arranged in London and regularly routed through the conventional banks.
To establish reasons for this and whether the bulk of investment has traditionally been directed towards Western, blue-chip corporates, we need to explore the evolution of the multi-billion dollar, London-based, trade finance sector of the Islamic financial system and the institutions’ motivation for developing corporate relationships in the West. We can then consider who is accessing Islamic finance facilities and why.
A Developing Financial System
During the late 1970s and early 1980s, the fledgling Islamic banks and finance houses were actively seeking outlets for the growing volume of liquidity under management. Those institutions seeking to diversify their asset-base and profitability through international investment had to address a number of issues:
Firstly, one needed to consider the development strategy of the institution itself in their nascent stage, the Islamic banks required a spread of opportunities that, first and foremost, conformed with the requirements of the Sharia jurisprudence committee but also represented a relatively low-risk investment with commensurate profitability.
With little or no recourse to liquidity in the absence of a viable alternative to the conventional money markets, it was essential for obligations to retail depositors to be met through the punctual repayment of the funds invested by the institution.
Secondly, there was the factor of external credibility. It is not easy for any financial institution to develop international relationships and there is often considerable reticence on the part of third parties to explore an emerging market capability. Attempting to promote that capability whilst simultaneously introducing unfamiliar techniques and terminology, in a mature and competitive conventional financing environment, was a challenge.
There was also an issue of internal resources. The developing Islamic institutions’ priority then was to consolidate their positions and represent serious competition for the domestic commercial banks. To do so they had to obtain a sizeable share of domestic retail deposits, and effort was focused towards marketing initiatives to identify suitable assets within those home markets.
As many of the developing institutions were operating with a limited number of personnel, this obviously imposed restrictions on the level of manpower available for concerted, international marketing efforts. Furthermore, the capability to identify, analyse and administer acceptable assets and liquid trade transactions offshore was not always present.
Establishing International Trading Partners.
With these considerations in mind, the Islamic financial institutions had two reasonable alternatives for developing international contacts and trading partners. Those larger houses with substantial resources often chose to forge direct bi-lateral relationships, relying on the marketability of their large-scale liquidity. The others approached conventional banks and appointed them as their “agents” for the purpose of identifying investment outlets.
There were a number of advantages for the emerging Islamic banks choosing the second course of action. The geographical coverage and distribution capability of large, international banks was extremely useful to investors without an international ground presence seeking introductions to new credits and country risks. Their involvement as agents enabled the Islamic banks to overcome some of the technical problems creating barriers to entering the Western markets too.
They rapidly identified the potential of the emerging Islamic financial system and understood that the first test any Islamic investor applies to a financing proposal is whether or not the transaction will satisfy the stipulations of its Sharia Committee. If it does not, then the deal will not be concluded, regardless of credit rating, pricing or any other commercial consideration.
Grasping this fundamental concept enabled them to work with the Islamic houses to ensure that the unfamiliar financing techniques could be presented favourably to Western, corporate end-users, whilst simultaneously taking due care that the Sharia requirements of the investor were fully incorporated into the structure.
Their established trading relationships ensured that those names with businesses that were ethically acceptable to the Islamic institution, as well as being able to satisfy commercial considerations (such as creditworthiness, status and dependable trade flow), were easily identifiable. This saved a great deal of time and preparative groundwork for the financier.
A number of other factors determined the suitability of specific, conventional bank appointments as agents or arrangers, including: location, and those resident in London were particularly favoured because of their relative proximity to the Middle East; and their business focus and ability to deliver the investment opportunities that matched Islamic bank requirements at a time when trade and commodity investments were at a premium. They provided acceptable, shortterm outlets that involved the physical transfer of tangible assets and represented the main source of international investment for most of the market liquidity.
The London-based trading or merchant banks had the added advantage of direct involvement and penetration of a very mature trade finance market. Their existing exposure to large corporate and industrial end-users enabled them to act as a conduit for introductions, to comfort the Islamic bank by sharing in the risk of the credit, or even, perhaps more controversially, to provide support by guaranteeing the obligations of the names that they promoted. They also had the scale of in-house resources to handle all the necessary aspects of negotiation, documentation and administration, including the legal and taxation issues relating to individual structures.
For the reasons highlighted above, the London-based, conventionally managed banks, with developed trading credentials, were not only able to act as agents for their Islamic principals, they actually became regular end-users of Islamic finance to support their own in-house and subsidiary trade requirements. The additional benefit for them was also in being well-positioned to offer a greater, more diversified range of options to corporate clients and this was to take on greater significance as the system matured.
Initially, the comfort of a very low-risk investment strategy was of immense importance to the developing Islamic institutions. It is generally known that, in some instances, to protect their trade placements. Islamic institutions insisted that individual investments should bear the support of letters of credit and guarantees issued by international banks with an identifiable credit rating.
Whilst this supposedly ensured that obligations to depositors would be met promptly, it also incurred the displeasure of the Sharia advisors, who required their institutions to assume a full profit-and-loss sharing participation. Those investing with the trading subsidiaries of conventional merchant banks found that they were able to satisfy the regulatory concerns of central authorities, as well as the moral concerns of those who found the issue of guaranteed financial support fundamentally unacceptable.
We can therefore establish that, initially, conventional bank involvement assisted the Islamic bank to diversify and develop its asset and investment base and achieve an acceptable balance of sectoral and geographical risk and return. Certainly, in our instance (Kleinwort Benson), we were not approached to seek opportunities in the Middle East or Pakistan, where our clients have their own networks to generate business and have often been better placed to bring proposals to us.
As a British merchant bank, our mandate was to generate introductions and structure facilities within our core focus areas. We had extensive commercial activity in the physical trade and commodity markets and our subsidiaries included major exporters and companies trading physical commodities on regulated exchanges. Our primary regional focus was determined by our international ground presence and outside of the UK this included Continental Europe and the Far East.
Expanding the Corporate Client-Base
The increasing momentum of the Islamic trade financing capability helped it to gain acceptance in Western markets quite rapidly and considerable demand could be identified amongst UK and Western European trading companies independently active in the physical trade and commodity markets, as well as amongst the London-based subsidiaries of many of the giant Far Eastern trading companies.
Apart from the benefit of geographical location and relative proximity to the Middle East highlighted earlier, an added appeal of corporate beneficiaries based in London was their large on-going trade requirements and connections with the terminal exchanges. As the market expanded, there was an increasing appetite amongst investors for new investment outlets yielding a net profitability to the Islamic bank that would not be negatively impacted by the direct support of conventional institutions.
As the Islamic banks became more comfortable with the technicalities of the European trade and commodity markets and the performance of the credits involved, some sizeable, short-term, trade purchase facilities were delivered through direct principal relationships between financier and recipient. These have often endured to the present, albeit they sometimes originated at pricing levels the credit could not justify with conventional market sources.
The conventional bank intermediaries began to assume a different role and were required to provide more than agency or broker services and to justify a profit share. Third parties unable to add real value to a transaction started to disappear when significant contacts with London and European-based corporations were established. Rather than arranging and/or supporting the credit of the transaction directly, conventional banks were now required to share the risk of the facility with the Islamic financier through a joint disbursement of funds or an exposure to the credit on their own book.
Effectively, the agent was now expected to assume the full role of Mudarib and, additionally, the onus of credit analysis of individual corporate end-users often stayed with them, as did the responsibility for the more onerous aspects of the negotiation process. This suited many of the institutions, as they retained the added comfort of an agent with a physical presence in the London market to actively monitor the business and ensure that both the religious and commercial stipulations of the investor were at all times rigorously enforced. The conventional bank, on the other hand, was able to secure the continuity of its own relationship with its Islamic principal.
Developing the Corporate Facility
The Islamic banks and investment companies have continued to target the London market in search of fluid, dependable, low-risk investments and have often specified a desire to penetrate the European, blue-chip names with track-records of dependable performance. I should emphasise that our own international corporate clients also approach us to arrange introductions and deliver Islamically-provided facilities to them.
Each Islamic investor has certain specific and individual Sharia and commercial criteria to adhere to, but the motivating factors for Western, blue-chip-corporations assessing the viability of Islamically-provided finance have remained fairly standard. If the following commercial criteria of the end-user can be satisfied, most are responsive to admitting Islamic institutions to their funding group.
First and foremost, corporate facility-users are motivated by the all-in cost of an Islamic facility compared to that of conventional finance. Western end-users have recourse to a range of financing options and the short-term Islamic facility must compete against the conventional alternatives that include bills of exchange, commercial paper programmes and cash loans; and unfamiliar concepts can sometimes present difficulty, although this is not usually, in our experience, insurmountable.
Many of the London-based companies that Kleinwort works with find that, once they have overcome those initial reservations about terminology and application, the Islamic facility is a valuable resource. Interestingly, much of Islamic trade finance’s Western acceptance has been due to the success of the much-maligned Murabaha trade finance contract.
It is a powerful and competitive product when employed as it should be, and that is to promote the physical flow of trade through principal-to-principal purchase and onward sale with immediate delivery on deferred settlement terms. The concept fits quite naturally into the trade purchase mechanisms of many western corporates, and presents a diversification from the other funding sources available.
Also, we now find that if a facility is appropriately structured, the sheer scale of liquidity in the market means that funding is usually available; the length of time needed to complete the full approval process has, however, sometimes been regarded as onerous.
This can be addressed by a conventional bank intermediary being willing to commit its own resources to research and development with investors before approaching potential end-users, and ensuring that facility recipients are aware of the Islamic institutions’ two-tier approval structure requiring ratification by both commercial credit and sharia committees; once comfortable with the Islamic bank’s ability to provide the facility, one must consider the degree of flexibility afforded by the structure.
A significant dis-incentive to the end-user has been the very short-term nature of the facilities made available (often no more than one month deferred settlement granted). There is little motivation for an investment-grade corporate to commit its own resources to negotiating facilities with inflexible terms and maturities.
Whilst sharia considerations will call for firm structural guidelines with a set definition of commodity or asset category, storage or shipment technicalities and delivery and usage of goods, the net effect of these restrictions can often be offset against a degree of flexibility in other key areas.
The majority of Western companies accessing direct trade finance facilities are large, often world-renowned names of undoubted creditworthiness. They have identifiable physical trading capability in oil, sugar, base metals, textiles and a range of soft commodities or a requirement to finance the purchase of specific assets and they have been well-positioned to reap the benefit of dependable, short-term facilities with a stable cost of funds.
Most of the original facilities extended to European, blue-chip names are still in place and the innovation and structure of Islamic trade finance facilities ensures that, at the short-date end of the market (i.e., up to 12 months), they are an attractive and regularly utilised alternative to conventional, competitor products provided by international banks.
Structuring for the Islamic Investor
Nowadays, most of the trade facilities that we are requested to arrange enable the investor to assume clean, corporate risk, often in conjunction with KB. Many of our Islamic clients still have an ongoing requirement to expand bi-lateral, corporate sector relationships in OECD markets that generate investment-grade comparable opportunities.
The main disadvantage of short-term, investment-grade risk is always the level of net profitability for, whilst triple A-rated assets provide a solid base on an institution’s balance sheet, the profit margins available from some of the structured facilities provided to blue-chip names are very thin.
Islamic institutions are obliged to exercise due care in ensuring that their investment funds are used for the benefit of society and in accordance with the ethical principles of the Muslim faith.
We should not forget that they are also required to produce an acceptable return for depositors and shareholders. Generally, the low-risk segment of the trade portfolio is now complemented by a layer of performance driven investment to enhance overall profitability.
Re-aligning the risk profile of investments to comply more precisely with the fundamental profit-and-loss-sharing principles of the financial system by assuming a direct risk position in the transaction has certainly helped enhance the investor’s net profitability in short-term sector of market.
Rather more recently, however. Islamic banks have been able to provide added value to their corporate counter parties through the investor’s own appetite for specific crossborder risks, particularly for those countries with majority Muslim populations.
London-and European-based companies exporting to the Middle East, Africa and Asia have identified a capacity amongst the Islamic institutions to assist with their export programmes through the extension of deferred payment facilities to ultimate, overseas purchasers.
In doing so, they are providing a valuable service to corporates that is not always available from the conventional banks, who might have significantly less country capacity for some of the more difficult credits. This can reduce the level of receivables on a corporate balance sheet and has the added attraction of assisting the company to penetrate some of its more challenging export markets and access new ones.
The trade transactions that we have focused on with our clients in the past year have supported exports of trade from the UK, and further afield, to purchasers outside of the European markets. By example, this includes the purchase of nickel cathodes from the UK markets for export and delivei7 to a South African entity for stainless steel production and oil procured from a Middle Eastern supplier on behalf of an African end-user.
In conjunction with Islamic institutions, we are arranging project financing for Pakistan, part of which facilitates exports to Pakistan by Western suppliers. European based business has included the provision of a trade purchase facility to a German corporate, but with a second tier to the arrangement that facilitates exports to global industrial counterparts of that same company.
Conventional banks publish few statistics or detailed information of specific investment structures, and again the only indications of volume and distribution are based on our own activities, but I can confirm that in our instance the total volume of trade transactions structured for and in conjunction with Islamic clients comfortably exceeds US$5 billion annually.
Currently, short-term funds invested with, or through, ourselves in short-term trade finance total around US$1 billion. Of this total, approximately 40% has been made available to corporates and organisations in the UK and Europe, 35% is directed to the Asian market, 15% to the Middle East and the balancing 10% to African recipients.
Investment Today Through the Conventional Banks
So, can we establish that the majority of short-term Islamic trade finance made available today through the conventional banks in London is still delivered to Western corporations?
It is certainly very difficult to ascertain the percentages of geographical distribution overall. But public notification of transactions delivered by others has seen facilities arranged for entities in Saudi Arabia, Turkey, Pakistan and India as well as the European and US markets. It is not unreasonable to assume that their product development and distribution is also concentrated on their own areas of sectoral and geographical expertise and is not necessarily confined to meeting the requirements of blue-chip. Western European names but driven by substantial investor demand.
Although financiers’ and investors’ Western and European relationships have always been important, they were often initiated at a time when the volume of liquidity in the Islamic financial system exceeded appropriate investment outlets. I see no indication that these contacts are of any less importance as, in our experience, Islamic banking remains relationship-based and the building of trust and comfort from the initial point of contact is vital.
It is the alternatives available to the Islamic investor that have increased and diversified and those initial provisions of Islamically-structured finance to Western, blue-chip corporations has developed into a more sophisticated capability. Latterly, it is the development of cross-border, flexible financing solutions, rather than the arrangement of direct, one-off transactions that has moved the boundaries of the London market.
The funding techniques employed more recently have certainly enabled Western end-users to access an expanding range of products to provide solutions to their own requirements.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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