RESEARCH AND DEVELOPMENT FOR ISLAMIC BANKS
STELLA COX
Since the emergence of Islamic banking in the Middle East in the mid-1970s, we have witnessed the development of a financial system that now reaches, at least to some extent, into most areas of the world. It remains difficult to assess the extent of the market accurately, although there is a general consensus of opinion that it will amount to more than US$100 billion by the turn of the century.
Emphasising profit share related to risk assumption, and the total prohibition of trade in interest-based instruments, the system encompasses over 150 Islamic banks and investment companies, including: an ever-increasing number of conventional banks providing Islamic investment services to clients, corporates of the region that have realigned financing and investment criteria and a rapidly growing group of families and individuals.
During the 1970s and, indeed, for much of the 1980s, the liquidity of Islamic institutions and investors was mobilised for short-term (by this I mean less than one year) investment in a wide range of permitted trade and commodity-based transactions. In reality, the average life span of such investments was probably closer to one month in duration than one year.
Much of the initial trade investment flow was engineered by conventional. Western banks who identified the Islamic investors’ need to access a regular, reliable flow of investment opportunity that would generate a profit, and be flexible enough to accommodate the ever-growing volume of funds and the very short-term investment profile of the business.
It is true to say that several of the larger Islamic houses chose to forge their own relationships with international corporates. For the remainder, constraints on manpower and the lack of analytical support facilities led to approaches to conventional banks and requests to research and develop deal flows that would enable funds to be deployed into structures with approved Sharia compatibility.
Conventional banks, including Kleinwort, reviewed the concepts that were explained to them and, with advice and Sharia guidance from their Muslim clients, shaped the investment structures. At this stage, the Murabaha contract was dominant and it could be readily tailored to provide a satisfactory alternative to the short-term funding options of a conventional corporate client base.
Many of the initial facility recipients were international trading groups, particularly in Europe and the Far East. Th e undoubted creditworthiness of these counterparties, plus enormous on-going requirements for trade purchase support, generated repetitive investment opportunities. These were able to accommodate the growing short-date liquidity in the system and could be adapted to comply with the Sharia stipulations of individual banks and investors. Furthermore, during the 1980s, the rates of return for these short-term, primarily US-DoIlar-based investments generated a profitability that could only encourage substantial annual increases in the total volume of funds circulating the sector.
The interest-based financial system has faced many well-publicised difficulties during its maturing process and these have been addressed with varying degrees of success to achieve its current position.
To break into new relationships, direct, bilateral facilities were sometimes extended to international corporates on terms that gave Islamic financiers vastly inferior returns to those enjoyed by conventional bank relationships. In some respects, the legacy of this has prevailed to the present day, and we regularly meet corporates professing to enjoy very established facilities from Islamic institutions that are far more competitively priced than the credit rating justifies.
It then becomes almost impossible to make fresh introductions and develop new relationships, as the perception of the corporate’s Treasurer is that Islamic funds are “cheap”. Any competitively priced arrangement offered by a new Islamic relationship is considered unattractive and perhaps directly jeopardising the pricing of his existing lines.
In some instances, the promotion of general and specific products development for banks in the sector was not enhanced by the involvement of a number of conventional agents and brokers (banks or otherwise) appointed to research and identify suitable investment opportunities. As competition for depositors’ funds grew between the Islamic institutions in the second half of the 1980s, the requirement for enhanced profitability and return rose sharply. Furthermore, ill-advised credit decisions were taken by investors who had, historically, chosen to focus on Sharia application.
The beginning of the 1990s heralded an acknowledged drive for progress and development amongst the banks of the Islamic financial sector that can be attributed to several motivating factors. Firstly, and primarily, the downward yield curve of the US Dollar impacted substantially on the returns achieved by the Islamic banks. After incorporating the cost of any security or credit enhancement and the obligations of the institutions, we moved to the boundaries of negative returns for secure, short-term investment.
Then, poorly performing assets, some loss-making investment assets, and the cost of the passive involvement of a number of conventional institutions, re-focused attention on the development of Islamic financial products and the technical capability and foresight of individuals working in the financial market. The banks now had an urgent requirement to achieve an acceptable return for an increasingly discerning depositor base and that could not be satisfactorily accomplished by matched investments with a very short-term profile.
A feature of the 1990s has been the large-ticket, asset-based leases and several innovative funds devised by Islamic and conventional banks in joint venture. In just a couple of instances, conventional banks reacting to the demands of their own Islamic clients have been willing to commit to the expense of researching and developing fund-type products themselves.
The services of conventional banks are still employed by their Islamic counterparts, and it is apparent to all of us with long-term involvement that we must contribute more than just fee-based broking or introductory services and that add-on value is a pre-requisite. The Western banks that maintain continual presence and commitment are all able to add that value, whether by reciprocal participation on a risk-and profit-sharing basis; by fund management techniques supported with underwriting and seed capital; or by product engineering enhanced by the provision of professional and educational research.
The geographical coverage and distribution capability of large, international banks means that there is a continuing role to play in introducing the Islamic institutions to new credits and country risks – no longer, it should be said, at the expense of the Islamic investor, but to identify investment opportunities that will enable the Islamic bank to diversify and develop its asset and investment base and achieve an acceptable balance of sectoral and geographical risk and return.
During the past few years. Islamic banks have been able to develop bilateral relationships with a range of prominent global corporates, and a good percentage have been engineered by conventional banks who can actively demonstrate their own risk appetite for the credit.
For the banks’ development to reach a new plateau and the financial market to progress from its newly post-nascent stage, a movement from the aforementioned one-off financings that have accounted for a reasonable percentage of the Islamic banks’ efforts of the 1990s must be an objective.
Much of the impetus needed to spearhead Islamic banking’s evolution from niche market to parallel financial system could be generated through increased uniformity. The mismatching difficulties that previously tied Islamic investors to the short-term have not been universally addressed. The result is a bias towards short-term, secured, low-return but liquid investments and a lesser percentage of predominantly illiquid, medium-term assets with quite limited options that provide any degree of flexibility in between.
Without a general consensus of investment criteria, trading practices and a system of settlement, how will a functional Islamic capital market be implemented? How will we find a commonly acceptable solution to the currently fragmented answers we have for raising short-term liquidity and applying acceptable protection against currency exposure?
If the Sharia stipulations for equity investment can be satisfactorily addressed, this is one area that will assist in filling the gap. Many await the launch of the new style, screened equity fund products that are now in final development and promised before the end of the year.
Others have addressed the situation directly and are involved in managing their own portfolios, traded with Western investment banks and utilising the economic indicators and equity research that their analysts provide. A few Islamic banks have already moved into the developed and emerging market IPO opportunities, demonstrating the in-house capability to handle the analytical aspects that facilitate a technically complex investment.
Project Finance is surely another area that will benefit from new research and developing initiatives. There is some evidence of an increasing desire for Islamic involvement in Project Finance, particularly in the Middle and Far East, where there are a growing number of high-profile, new projects emerging. There has certainly been a degree of Islamic institutional and private sector involvement in this area, but there is scope for so much, and the financing of individual segments and assets can be superseded by the involvement of Islamic institutions as equity investors and in prominent management roles.
As a major project financing house, Kleinwort is only too aware of the enormous amount of commitment and capital outlay needed to research and provide a package that will support the development of a greenfield project. The necessity to provide a package commitment of funding a significant period in advance, the (initially) insubstantial income stream and the negotiation of the intercreditor issues that would be generated by a multi-sourced financing all prove challenging. It is to be hoped that the Islamic compatibility of this type of investment will encourage allocation of resources and a desire to investigate and tackle the issues with vigour.
The emergence of the Islamic investment banks has brought an added dimension to the market. Their product focus has and will continue to enhance, expand and further develop the range of business in which Islamic institutions have involvement and continue to promote the transition from niche to fully-fledged market.
This is already in evidence from the extensive research that is being undertaken by several institutions to find acceptable solutions to the question of commonly acceptable equity participation. It is to be hoped that it will lead to the emergence of a new range of products to pave the way to establishing the elusive secondary market.
During the past five years, we have witnessed a considerable crossover of executives, in some recent cases in very senior positions, from conventional banks to the Islamic sector There is obviously a direct relationship between the development, capability and reputation of a bank and the calibre of its employees.
This flow of human resources has, and will, continue to escalate the engineering abilities of individuals and institutions as technical and structural know-how is imparted to others. An added benefit is derived from the international business experience and the corporate and institutional contacts that these executives bring to their employers from a mature market environment; not to mention their ability to modify and apply, sophisticated Western financing techniques to Islamic jurisprudence.
We have witnessed growing evidence of this during the past few years and just one example is the Islamic banks’ positioning to compete directly against commercial banking counterparts for mandates to provide financing of commercial aircraft for flag-carriers throughout the world, not only in the Muslim countries. This endorses the need for all Islamic bankers with direct client responsibility to attain professional presentation and marketing skills that will serve them equally well when dealing with participants of both financial systems.
Education of graduates and other personnel entering the Islamic financial market is also more readily available. A number of Islamic banks and organisations have sponsored Islamic finance departments at universities in the Middle East. Undergraduate opportunities to study the Islamic financial system, either as a speciality or a major component of a business degree, are available at a number of European universities.
The distance-learning Diploma Course made available by the Institute of Islamic Banking and Insurance fills another gap, as it is targeted not only at Islamic financiers, but, importantly, is available to other individuals working in Western markets and workplaces seeking knowledge of, and involvement in, the Islamic banking system. It is quite evident that these avenues of education will, in time, benefit the banks and the system as a whole and will enable those involved to educate potential customers, Muslims or otherwise.
Opportunities for private and institutional research have improved significantly of late. Whilst some might question the validity of the number and frequency of Islamic Banking conferences in the Middle East, Far East and UK (and admittedly with lesser frequency elsewhere), the benefit is usually derived from the opportunity to meet and talk with colleagues at first hand. Gatherings such as these also promote discussion and debate, generate new business contacts and, ideally, lead to business development.
Further opportunities now exist for cross-training, with conventional banks welcoming the participation of Islamic bankers in their formal, technical and marketing training programmes and, but as yet probably to a lesser extent, Western bankers having the opportunity to accept exchanges to Islamic banks in the Gulf.
Education and formalised training are a necessity, but it is often bypassed and perceived as non-essential, not just by Islamic banks, because of the cost and the inconvenience of the absence, albeit temporary, of personnel.
The dynamic approach of some CEOs who have risen to assume control of a number of Islamic institutions and investment companies shows that the system is able to attract ambitious new entrants and, in such circumstances, is more than capable of nurturing its own stars.
There are, of course, other research and development issues that need to be directly addressed by the Islamic banks and their scholars. A barrier to greater global participation in the Islamic banking sector is the lack of standardisation of products, as mentioned earlier, and documentation. Although many would call on an organisation such as the International Association of Islamic Banks to inaugurate a committee to approve the implementation of market standards, there needs to be a common willingness amongst all institutions in the sector to support and, importantly, finance the initiatives.
For almost twenty years, the structures and the facilities that we have worked with have evolved around the individual Sharia interpretations of individual institutions. At this stage it appears unlikely that uniform opinion will be achieved in the foreseeable future, but the result of this is a series of isolated transactions, with individual banks specialising in specific contract opportunities rather than the development of market-accessible products.
This is obviously a serious disincentive to corporates and organisations, who become reluctant to seek new relationships in the Islamic system if they are unable to obtain definitive product information and have no access to standardised trading mechanisms or facility documentation. The lack of standardisation would also hinder the implementation of an alternative pricing benchmark.
Although I appreciate the desire to progress from an interest-linked LIBOR base, this is often the only benchmark that a new recipient may have to compare against other facilities and the familiar pricing terminology can motivate a desire to grasp new concepts. Unfortunately, many Western corporates do look to their existing Western bank relationships to explain Islamic financing structures and techniques.
The final implementation of a uniform set of accounting practices for Islamic banks will also be a welcome development and the research efforts of organisations such as the FAOIBFI are to be applauded. Lack of common accounting standards does not assist the banks’ endeavours to establish reciprocal relationships with others. Islamic financial institutions’ accounts must be comprehensive to outside users so that an Islamic bank’s performance over a set period of time can be subjectively judged against that of another and, moreover, consistent, to generate confidence in the banks’ themselves, both within the Islamic market and externally.
In the past, most of KB’s activities and products have been arranged and developed for a predominantly commercial banking environment servicing its own retail customer base, and, apart from demonstrating reciprocity in transactions, these relationships have not always been as developed as we might have wished. Although there has been a very real desire on our clients’ part to develop new ideas and structures, in some instances there has been considerably less enthusiasm to provide the financial resources and manpower that such endeavours undoubtedly require.
During the past couple of years, however, we have discovered Islamic contacts with whom we can undertake joint research and development initiatives and who have actively been assisting us with the development of our own business in geographical locations that are new to us. For example, we are actively involved with an Islamic institution in an advisory capacity for corporate finance in Asia.
Conversely, we have brought our relationships to our own global IPO activities. This indeed demonstrates that banks can integrate activities to provide the most appropriate and complimentary blend of conventional and Islamic financier capabilities and jointly bear the (sometimes unattractive) costs of development and start-up.
A London-based journalist once commented that in researching his article he had been amazed to discover two extreme viewpoints amongst market participants. Half of those he approached said that the Islamic market was stagnant and that nothing was happening. The other half were extremely buoyant and looking forward to the future.
To those who claim that nothing is happening we should refer to the trade syndications totalling over US$2 billion arranged and provided, primarily for Pakistani enterprises, by Faisal Islamic Bank of Bahrain; to the wholesale Istisna and international lease financings provided by Al Rajhi; the structured, multi-asset range of investment funds launched by the Al Baraka Group companies and the structured finance facilities for emerging markets arranged and provided by the Islamic Investment Company of the Gulf. These are most definitely “happenings” and I apologise for omitting many other noteworthy transactions.
Although Kleinwort has, and will continue, to maintain a segregated team to safeguard the interest of Islamic client relationships, we identified a requirement amongst our customers for direct access to a growing number of the specialised product skills of executives working in the mainstream system. As a result of this, senior executives have been appointed within our Financial and Advisory, Equity, Investment Management and Treasury Divisions to research and develop new business with the team and, importantly, directly with its clients.
To conclude, the very rapid expansion of Islamic banking has surprised many. It is now on the verge of further advancement that should make it well-placed to compete and prosper as an efficient market, as we move towards the 2Ist century. The effort needed to ensure that the research and development aspects that we have considered generate results, must derive from the system’s growing international profile and the increased demand for detailed information of structure, application and practise, delivered by professional spokespeople who are central to the market.
Edited By Asma Siddiqi
Institute Of Islamic Banking And Insurance London
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