Over the past decade, the Islamic financial services (IFS) industry has grown 50% faster than the conventional financial sector. Worldwide IFS assets totalled $1.8trn in 2012, according to Ernst & Young’s (EY) “World Islamic Banking Competitiveness Report 2012-13”. By the end of 2014, IFS assets are projected to top the $2trn mark, and demand for sharia-compliant banking, investment and liquidity management tools in the predominately Muslim region is expected to continue to grow. Having already established a reputation as a leading regional financial centre with abundant liquidity, Dubai has emerged as a major beneficiary of the IFS growth story.
Sharia-compliant bond issuances have driven much of the growth in the UAE’s Islamic capital markets and propelled Dubai into the position of the third-largest market for sukuks, or Islamic bonds, in the world.
The takaful (Islamic insurance) segment has also flourished over the past decade, and the UAE is now home to 10 sharia-compliant insurers, according to the Emirates Insurance Authority.
In early 2013, Dubai announced plans to become the “global capital of the Islamic economy”, as part of a wide-ranging initiative targeting sharia-compliant financial services, Islamic contract arbitration and halal food production, among other areas. By doing so, the emirate’s government signalled to the world that it intends to make IFS a key pillar of its economic diversification strategy, despite increasing competition from London and Malaysia.
While Dubai is well placed to achieve this goal, the 2008-09 global financial crisis and its aftermath have laid bare certain structural issues undermining the long-term profitability of the IFS industry at both the global and local levels. Since announcing the Islamic economy initiative, Dubai has begun taking steps to address looming issues concerning standardisation of sharia-compliant financial services and a shortage of expertise in the IFS industry, but challenges relating to weak asset quality and profitability persist. While confronting these hurdles, Dubai’s IFS sector will have an abundance of opportunities to grow its market share, particularly in the key segments of takaful, retail banking and Islamic debt, as well as sharia-compliant trade, mortgage, project financing and fund management.
Like conventional banks, Islamic financial institutions (IFIs) are regulated by the Central Bank of the UAE (CBU). According to a 1985 law regulating IFS, IFIs are permitted to engage in commercial, industrial and trade activities, acquire real estate, receive deposits and invest in funds for their own account. They are also required to have an independent, supervisory board with sharia expertise that includes at least three members. The law also called for the creation of a “higher sharia authority” attached to the Ministry of Justice and the Ministry of Islamic Affairs, which has yet to be established.
A 2004 resolution issued by the CBU also includes rules governing IFIs, including a provision allowing them to “subscribe for shares and sukuk or finance an entity or person up to a maximum of 7% of its own capital unless the central bank gives approval to exceed this limit”. Meanwhile, IFIs headquartered in the Dubai International Financial Centre (DIFC) are subject to the laws set by the free zone’s independent regulatory body, the Dubai Financial Services Authority (DFSA). While full foreign ownership is permitted for banks headquartered at the DIFC, those with a category one licence are not allowed to do business with UAE nationals outside of the zone or collect deposits in dirhams.
In January 2013, as part of the government’s initiative to establish Dubai as a leading global centre for the issuance of sukuk, the emirate announced the creation of the Islamic Finance Council to regulate sharia-compliant equity and fixed-income products. NASDAQ Dubai, the emirate’s international exchange, where eight of the nine sukuks issued in 2013 were listed as of November, also released a draft of new listing standards for sharia-compliant bond offerings that were up for public consultation in January 2014.
In addition, the government has shared plans to open a centre in the second half of 2014 that will develop a set of Islamic corporate governance standards, Reuters reported in November 2013. Though these will not be compulsory, the centre will reportedly issue sharia-compliant certificates to banks, financial firms, and other companies that adopt them.
According to an IMF working paper released in 2010, the UAE had a 13.5% market share of the global Islamic banking industry in 2008, and between 2001 and 2008 national Islamic banking (IB) assets grew by nearly 60%, as compared to just over 38% for conventional banking assets. IB assets in the UAE totalled $75bn in 2011, making it the third-largest market in the GCC region for sharia-compliant lending, after Saudi Arabia and Kuwait, according to the EY report. In 2011, Islamic banks in the UAE claimed a 16.7% share of the national banking market.
Dubai Islamic Bank
With 1.4m subscribers, 85 branches in the UAE, and assets valued at $29.23bn as of third-quarter 2013, Dubai Islamic Bank (DIB) is the fourth-largest sharia-compliant lender in the world and the largest Islamic bank in the UAE, with an estimated market share of more than 5%. The government of Dubai owns around 29% of the UAE’s first Islamic bank, the federal pension fund controls over 3%, and the remaining shares are publicly traded.
For the past five years, the core of DIB’s strategy has been the expansion of its retail window, while consolidating its wholesale and commercial real estate business. Since 2008, retail’s share of DIB’s financing portfolio has grown from 14% to more than 42% in 2012. According to Adnan Chilwan, CEO of DIB, retail banking now generates more than half of the bank’s annual revenues and DIB is the market leader in Islamic credit cards and auto finance. The Islamic bank is also a leading provider of sharia-compliant mortgages, a position bolstered by its acquisition of an additional 28% stake in regional real estate financing firm Tamweel in 2013, bringing the bank’s total ownership share in the firm to 87%.
Wholesale banking comprised nearly 60% of DIB’s financing portfolio in 2012 and 57.6% as of the first half of 2013, according to DIB’s figures. DIB also offers sharia-compliant derivative solutions, fixed-income products and other Treasury offerings. Like much of the UAE’s banking sector, both conventional and Islamic. DIB was also exposed to the commercial real estate sector in the early days of the crisis. Since then, the bank has significantly reduced the same from 37% at the time to under 28% today. DIB also returned to growth with the significant improvement in asset quality, exposure diversification, enhanced capitalization, a strong liquidity ratio of under 75% and net profitability up 34% as of the third quarter of 2013.
Abu Dhabi Islamic Bank (ADIB) is the secondlargest sharia-compliant lender in the UAE, with assets totalling Dh96.38bn ($26.23bn) – a 12.4% increase over Dh85.7bn ($23.3bn) at the end of 2012 – and liabilities amounting to Dh834.44bn ($227.13bn) as of late 2013. ADIB was the first sharia-compliant lender to issue a perpetual, $1bn, Tier 1 sukuk to raise capital in November 2012, and its Tier 1 capital ratio has risen from 13.7% in September 2012 to 19.3% in 2013. As one of the oldest players in the UAE’s IFS industry, the bank was incorporated in 1997 and by 2000 it had listed on the Abu Dhabi Securities Exchange. In 2008 ADIB put together a new management team and created a new strategy for growth based on three main points. The bank is working to establish itself as a market leader in the emirates by developing its customer service sector; creating an integrated financial services group and capitalising on synergies; and pursuing opportunities for growth outside of its home market, such as the purchase of a 49% stake in Egypt’s National Bank for Development.
Another leading Islamic bank headquartered in Dubai, Emirates Islamic (EI) also followed ADIB’s lead by issuing its own Dh1.5bn ($408.3m) perpetual sukuk to create a capital buffer against the bad loans it held on its books at the start of 2013. EI is a subsidiary of the largest bank in the UAE, Emirates NBD, and has 49 branches, making it the sixth-largest lender in the country by footprint, according to the bank’s 2012 annual report.
After suffering a net loss of Dh448m ($121.95m) in 2011, EI returned to profitability in 2012, reporting a net profit of Dh81m ($22.05m) in its annual report. EI’s operating income rose 61% y-o-y to Dh538m ($146.44m) in 2012. The bank’s assets stood at Dh37.26bn ($10.14bn) in 2012, up from Dh22.74bn ($6.19bn) in 2011, while liabilities totalled Dh34.64bn ($9.97bn) and Dh20.26bn ($5.51n), respectively.
In October 2011, EI took over Dubai Bank, the troubled lender that was co-owned by Dubai Holding (70%) and Emaar Properties (30%), after it incurred significant losses in 2009 from the collapse of the UAE’s property market. Dubai Bank had Dh4.72bn ($1.28bn) in assets and Dh7.6bn ($2.06bn) in liabilities at the time of acquisition, EI’s 2012 annual report states. However, EI also inherited Dh752.16m ($204.74m) in its subsidiaries’ off-balance sheet liabilities.
The final stand-alone Islamic bank in the UAE is Noor Bank, which is co-owned by the government’s Emirates Investment Authority and the Noor Investment Group. Noor’s assets rose from Dh16.88bn ($4.59bn) in 2011 to Dh17.95bn ($4.89bn) at the close of 2012, while profits jumped from Dh49.15m ($13.38m) to Dh75.58m ($20.57m) during the same period. Noor reported total assets rising by Dh3.3bn ($898.2m), or 18.3%, in the first half of 2013, while net profit grew to Dh100m ($27.2m) in the same period. First established in Dubai in 2008, the bank has expanded and now has locations in Abu Dhabi and Sharjah. The bank also launched a sharia-compliant banking service, Noor Trade, in June 2013.
The initiative is targeted at increasing lending to small and medium-sized enterprises to Dh5bn ($1.3bn) over the next five years. Several conventional banks, including Mashreq and Commercial Bank of Dubai, have established Islamic divisions as well. International players, such as Standard Chartered Bank, have also set up Islamic lines.
Despite the impressive recent growth in Islamic banking assets both in the UAE and around the world, the global financial crisis exposed some of the underlying challenges the sector faces, particularly in its bid to compete internationally. “Islamic banks continue to grapple with multiple challenges relating to sub-scale operation, asset quality, negative operating income from core activities and a weak risk culture. The severity of performance challenge has prompted several institutions to initiate wide-ranging transformation programmes,” the EY report stated.
Islamic banks in the GCC region have for the most part disposed of underperforming assets and stabilised their return-on-asset ratios to an average of 1.5%, according to EY, but operating expenses as a proportion of assets remain an average of 50% higher for Islamic banks compared to their conventional counterparts. The IFS industry’s average return on equity (RoE) at the peak of the crisis in 2011 was 12%, compared to 15% for the conventional financial services sector. Part of this is certainly due to increased provisioning levels adopted by all banks in the GCC during the international financial crisis. Both Islamic and conventional banks in the region increased their provisioning levels between 2008 and 2011 from 15% to 22% and 13% to 19%, respectively.
Much of the disparity in profitability between Islamic and conventional banks, however, has to do with high operating costs and other unresolved structural issues in the IB model. Between 2008 and 2011, GCC Islamic banks saw the ratio of operating costs to income rise from 33% to 42% during the same period, while conventional banks saw this ratio drop from 39% to 32%, the EY report said.
During this period borrowing costs also increased gradually for Islamic banks in the region, eroding their traditional access to lower-cost funds. In 2008, Islamic banks in the GCC region borrowed at a rate of 2.8%, compared to 3.5% for conventional banks, while rates dropped to 1.6% and 1.2%, respectively, as of 2011.
These issues are particularly noticeable in the retail segment of the market, a fact underscored by HSBC’s announcement in 2012 that its Islamic arm, HSBC Amanah, would cease operations in six markets, including the UAE. Although the bank has not disclosed performance figures for its Islamic banking window, the move has been widely interpreted as a sign of the difficulty sharia-compliant retail banking operations have had in achieving profitability. UK-based Barclays and Germany’s Deutsche Bank have also scaled back their own Islamic banking arms in Dubai since 2012.
In the first half of 2013, the UAE saw $1.4bn of sukuk issuances. That puts the country two places behind Malaysia, which had $18.4bn in publicly listed sukuks during the period, and Saudi Arabia with $4.5bn, according to figures from the Malaysia International Financial Centre (MIFC). The three countries accounted for 91% of the primary sukuk market in 2013. Dubai’s sukuk market has also benefitted from a global run on emerging market debt over the past few years due to record low conventional bond yields in Western markets, and sukuks emerged as the preferred tool to meet the UAE’s corporate refinancing needs in the wake of the 2009-11 credit crisis.
The hunt for higher yields pushed global sukuk sales to a high of $46.3bn in 2012, surpassing the 2011 record of $36.7bn, according to Bloomberg. The GCC saw the value of sharia-compliant bond offerings triple in 2012 to $21bn. By November 2013, the total value of listed sukuks in Dubai reached $12.58bn, the third-highest amount among global financial markets. The nine new sharia-compliant bonds issued in Dubai during the first 11 months of 2013 accounted for nearly half of this value ($6.15bn). Eight of these were listed on NASDAQ Dubai, bringing the total number of sukuks listed on the exchange to 13, compared to five on the Dubai Financial Market.
Global sukuk issuances during the first nine months of 2013 totalled $79bn, according to Reuters, over a quarter less than $109bn in the same period of 2012. Some issues are believed to have been put on hold as the prospect of the US Federal Reserve tapering its stimulus programme weighed heavily on spreads.
Dubai bucked this trend in the third quarter of 2013 to become the best-performing sovereign dollar sukuk market of the 33 sharia-compliant sovereign bonds tracked by Bloomberg. The emirate boasted seven of the 10 best-performing sovereign sukuks among the group, and the return on Dubai’s $650m of notes due May 2022 was 5.3%, the highest of all 33 monitored – the average was 1.3%. The UAE was also the only sukuk market worldwide that did not see a decline in US dollar issuances in 2013, according to the MIFC.
In its Islamic banking report, EY stated, “Demand for sukuk instruments will continue to grow, outpacing supply and providing opportunities for banks to establish their fixed- income advisory platforms.”
Based on current global growth forecasts, IFIs will require at least $400bn in short-term, credible, liquid securities for liquidity and capital management purposes by 2015. Therefore, the challenge for Dubai will be to continue innovating and coming up with new sharia-compliant short- and long-term liquidity management tools to meet the growing demand.
Islamic Money Market Transactions
In May 2013 Noor Bank also participated in the first transaction on a new sharia-compliant trading platform created by the Dubai Multi-Commodities Centre (DMCC). The platform is meant to closely track asset transfers in one of the most common, yet controversial trade financing tools used to manage short-term liquidity, the commodity murabaha. Islamic banks are forbidden to use conventional inter-bank money markets as Islam bans interest. As a result, the commodity murabaha allows one party to buy an asset from another party at an agreed-upon mark-up.
Noor Bank signed a $13.6m loan facility with the Commercial Bank of Dubai, using oil products and copper cables sourced from the Emirates National Oil Company and Ducab as the underlying assets. The commodity murabaha has also been criticised by some Muslim scholars as it is difficult to monitor whether an underlying asset has actually changed hands or whether the transaction is just an exchange of paper. Commodity murabaha was even banned in Oman in December 2012, and is also banned by the sharia advisory boards of certain IFS firms based in the UAE. The DMCC’s platform, called Tradeflow, aims to rectify this by using a system that gives parties assurance that a true asset sale has taken place.
Most Islamic banks in the GCC region structure commodity murabaha transactions using products from the London Metal Exchange, the global centre for industrial metals trading, and the DMCC aims to win a share of this market through Tradeflow.
The UAE’s sharia-compliant insurance market has proliferated in recent years and takaful firms in the country saw gross written premiums (GWP) increase by more than 15% during 2012, according to a research note published by international ratings agency Standard & Poor’s (S&P) in January 2013.
In contrast to the risk-transfer business model used by the conventional insurance industry, the takaful system common to the GCC in general and the UAE in particular relies on the shared distribution of risks between fund members. The intense price competition that the UAE’s 61 insurers engage in to gain market share often leads to rampant underpricing of risk, especially among relatively new players. Deficits stemming from underpriced premiums can only be recouped by increasing the contributions paid by fund members under this model. While the UAE’s relatively low insurance penetration rate of 1.9% represents a major growth opportunity, takaful insurers have found it difficult to remain profitable in a market that S&P has characterised as “over-populated”.
According to a review of second-half 2013 financial statements from the 29 listed national insurance companies in the UAE – seven of which are takaful firms – published by the firm Taha Actuaries and Consultants, the net profit earned by takaful companies in the first half of 2013 was Dh6m ($1.63m), compared to Dh785m ($213.68m) for their conventional counterparts. The return on assets, share capital and equity for takaful firms during the period was 0% across the board, the report said, which is an improvement from first-quarter 2013, when all returns were negative. While conventional insurers saw GWPs increase 10% during first-half 2013 to Dh6.3bn ($1.71bn), takaful companies saw their GWPs drop by 20% to Dh1.3bn ($353.86m).
According to S&P, in the first quarter of 2013, takaful fund deficits in the UAE rose over 70% from December 31, 2012. In 2012, S&P noted that those same companies saw their fund deficits increase by almost 40% y-o-y. While total shareholder funds grew by some 5% in 2012 before any new capital injections in the country’s conventional insurance sector, takaful companies recorded zero growth in shareholder funds. “Why is the takaful sector underperforming?” S&P’s statement asked. “The key reason, in our view, is that it must compete directly with conventional insurance companies that benefit from established economies of scale, have longer service track records and have more established distribution mechanisms to the marketplace – on balance the conventional insurance sector companies are less intermediary dependent for their revenue streams.”
Between 2011 and 2012, the takaful combined ratio – the loss ratio plus the wakala, or management fee expense ratio – in the country rose from 109% to 115%, and deteriorated further in the first quarter of 2013 to reach 143%, according to figures from S&P. Since takaful net claims costs are “not so out of line with the market norms” in the conventional sector, S&P attributed the poor performance to an increase in wakala fees charged on takaful funds, which have risen from 13% of gross contributions in 2011 to 22% in the first quarter of 2013.
“Despite the aforementioned shortcomings, we still consider the core GCC takaful insurance model to be sound,” S&P concluded in its statement. “However, the proliferation of insurance sector participants, coupled with robust competition for risks, is making it difficult for many of the takaful companies established in the past few years to deliver a sustainable level of performance. As the loss ratios being suffered are within market norms, it is the expense bases that need controlling, and to be matched to the operational scale,” S&P went on to note.
According to S&P, the $1trn global Islamic finance industry is set to double in size by 2015. The growth of the Muslim population and the demand for alternative asset classes in Western financial markets are expected to drive demand for the sharia-compliant financial products that Dubai, as a leading regional financial centre, is poised to capitalise on. The challenge for Dubai’s IFS industry in the years ahead will be to determine how best to develop specialised niches in untapped, attractive segments of the market, according to Ahmed Saad, the deputy CEO of Sharjah Islamic Bank. “The Islamic finance industry needs to work towards a system of greater liquidity to improve services and cost of services offered,” Saad told OBG.
“Trade finance remains a largely untapped sector of great opportunity. We do not have specialist Islamic banks that deal exclusively in trade finance, and in the coming years Islamic banks will surely take on a larger part of this segment,” he added.
Sharia-compliant project financing, asset management and pension products are other segments poised for growth in the coming years. To realise the full extent of this potential, however, developing a solid regulatory framework and pursuing harmonisation of sharia-compliance standards at the national, bilateral and global levels will be key for Dubai.
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