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M&A in Islamic Finance
Islamic Banks and Financial institutions can face vulnerabilities specific to their nature and locations. Mujtaba Khalid, Head of the Islamic Finance Centre, BIBF explains where some of these concerns arise and how M&A’s can help to strengthen the sector
Mujtaba Khalid, Head of the Islamic Finance Centre, Bahrain Institute of Banking & Finance (BIBF)
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The terms merger and acquisition (M&A) although often used as though they were synonymous, mean slightly different things. A merger implies the combination of two companies into one larger company for some economic or other strategic reasons. Acquisition is gaining effective control over the management and ownership of another company, from a legal point of view, the target company ceases to exist.
Given the current circumstances as well as the coming global financial condition, we can build a case for two or more Islamic banks or financial entities to merge and form a more robust Shariah compliant financial institution as was seen in the merger of Al Salam Bank Bahrain’s merger with BMI a few years back. Similarly, we can also build an equally appealing case for a conventional bank to acquire an Islamic bank, as was seen in the recent acquisition by The National Bank of Bahrain (NBB)’s of Bahrain Islamic Bank (BIsB).
Spurred by Commodities
Before moving on to the mergers and acquisitions, we need to zoom out and look at the Islamic finance industry as a whole and its prospects – the Islamic finance industry in the past has seen considerable growth. Over the past decade, it has averaged double digit growth. However, we did see this growth slow down to single digit in the past two or so years. Going forward, according to different reports including the Islamic Finance Development Report 2020, the industry is poised to grow by at least 50% in the next 5 years. I believe that there is a case for the Islamic finance industry to see more than 100% growth over the next 5 years - The last time the Islamic Finance industry was at its peak was around 2009, just at the culmination of last the global commodity super-cycle. Many countries the feed the growth of Islamic finance are dependent on commodities - be it the GCC with crude oil, Malaysia with Palm oil or countries like Pakistan and Indonesia with agriculture. There has always been a strong correlation between commodity prices and the growth of the Islamic finance industry. Some can argue that the correlation might not be as strong, non the less, it is very much there. Given the COVID19 pandemic, once nations start to vaccinate and economic activity starts (as has started in some countries), there will be a huge demand in commodities and raw material just to get back to the previous normal. This I strongly believe will result in a significant increase in the prices of commodities, thereby having a positive spillover onto the Islamic finance industry. If we look at the YTD increase of the S&P Commodities index, it will show that the prices of commodities have already increased significantly in 2020.
The Case for Mergers and Acquisitions
From an operational perspective, there are certain challenges faced especially by Islamic banks in the region that could act as a catalyst for increased merger activity –
As a response to the COVID situation, all regional regulators responded to lessen the impact on the public. There were many stimulus packages announced, Regulatory Capital requirements were reduced, and financial consumers were allowed to reschedule their interest/profit payments. This was a well-received measure from the perspective of bank customers, however, it leaves the challenge of uncertainty for banks. Even though many banks have increased their loan provisioning ratios, there is no sure way for banks to know the level of Non-Performing Loans (NPLs) on their books. This will be apparent once customers start making their interest/ profit payments. Coupled with the fact that Islamic banks will not be able to “benefit” from late payment charges (as all such fees have to be written off to charity), Islamic banks do face uphill operational challenges.
There is also an issue of the quality of financing assets on the books of Islamic banks in the region; if we assess the books of Islamic banks, we see that there is an over exposure of real estate financing – this can be in the form of Musharakah (equity) investments, Sukuks etc. mostly in residential projects or shopping Malls.
The success of these projects is very much dependent on the number of expatriates that enter the region or rather that do not leave. The past year has seen a considerable exodus of expatriates as can be seen from the latest report by Oxford Economics:
This deterioration of assets will have an added negative spillover – the calculation of Expected Credit Loss (ECL) under IFRS 9. This deterioration might see assets move to Stage 2 or Stage 3 impaired assets. The definition of both stages and their treatment are:
Stage 2 – If a loan’s credit risk has increased significantly since initial recognition and is not considered low, lifetime ECLs are recognized. The calculation of interest revenue is the same as for Stage 1.
Stage 3 – If the loan’s credit risk increases to the point where it is considered credit-impaired, interest revenue is calculated based on the loan’s amortized cost (that is, the gross carrying amount less the loss allowance). Lifetime ECLs are recognized, as in Stage 2.
Given these issues, a merger between Islamic financial entities to help shore up capital adequacy as well as consolidate resources to have sufficient buffers to weather storm. Bigger entities could potentially serve a larger client base (especially cross border regional mergers) diversifying country exposure of certain Islamic banks.
The region and many other parts of the world are experiencing a big shift towards digitalization and FinTech. There are many potential benefits that can be reaped by a first mover advantage. Many Islamic banks, partly due to the reasons mentioned above might not have the luxury to afford expensive capital expenditures in this space. Through mergers and consolidating resources, Islamic banks can reach out to younger more tech-oriented consumers. This can also potentially be a case for conventional banks acquiring Islamic banks – given most Islamic banks are undervalued given the upcoming challenges, conventional banks who want access to a new set of Shariah adherent customer base, can potentially acquire an Islamic bank.
GCC: Potential peak-to-trough declines in population
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Bahrain Kuwait Oman Qatar
Source: Oxford Economics Saudi Arabia UAE