The New Wave of Islamic Banking
Sutherland Banking Insights
May 2014
The New Wave of Islamic Banking Overview Islamic banking, a fast-growing industry, is giving a hard time to global financial systems due to its conservative and low-risk approach. Islamic finance adheres to Islamic law, or Shariah, which forbids Muslims from investing in businesses that contradict the Islamic principles of fairness and justness. The law also forbids taking or giving interest (Riba), which is the most essential feature of Islamic banking. Within limits, Islamic banking has developed profit sharing and fee-based financing approaches in compliance with the Shariah law. These special modes of financing are used in retail, private and commercial banking for debt and capital markets, insurance, asset management, structured and project financing, derivatives, etc. In a short span of time from 2004 -2013, the global Islamic banking market has grown at a CAGR of 35.9%, now exceeding USD1.4 Tn in assets, with 716 Islamic financial institutions spread over 61 countries. For 2014, Islamic finance assets are forecast to reach USD2.1 Tn and Islamic banking assets to reach USD1.8 Tn. Currently, Islamic banking assets contribute only 1% to the total global banking assets. The share is expected to increase with advancement of new products and services as well as opening up of new markets and jurisdictions. Islamic banks have also forayed into online and mobile banking. Though the adoption is slow compared to conventional banks in the coming years online Islamic banking is poised to take a big leap forward. This whitepaper covers the global Islamic banking industry, its geographical segmentation, challenges faced by the industry, and adoption of digital banking.
Islamic Finance According to Malaysian International Islamic Financial Centre (MIFC), the global Islamic financial industry sustained its remarkable growth of 16% y-o-y growth in 2013 to reach an estimated USD1.8 Tn in assets at the end of December 2013, witnessing a double-digit growth rate across all sectors of the Islamic financial industry. Riding on 2013’s growth, total Islamic financial assets achieve a CAGR of 17.07% during 2009-13. According to KFH Research Limited, by the end of 2014, the Islamic financial industry is expected to surpass the total assets of USD2 Tn. In 2013, Islamic banking represented the largest market share (79.8%) in the Islamic finance total assets. The industry has grown rapidly over the past few years and growth is expected to continue in the foreseeable future.
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Global Islamic Finance Assets by Segment (2013E) Funds 4.0%
Takaful 1.1%
Sukuk 15.0%
Banking 79.9%
Source: IFIS, Zawya, Bloomberg, KFH Research
Islamic Banking Industry In the early 2000s, Islamic banking was a niche market in most GCC countries with only a few institutions offering basic depository and financing instruments. It was restricted due to low awareness and weak demand for Islamic banking services, particularly in the Asia-Pacific and developed markets. Regulation was another area that was not fully formed in most jurisdictions until the mid-2000s, when various authorities began introducing and amending legislation to make it supportive of the Islamic banking industry’s growth. Such amendments served to regulate, accommodate and incentivize Shariahcompliant transactions in a number of markets across the globe.
Islamic Banking Assets Growth Trend 1,436
1,400
1273.6
1,200
1075.9
USD Bn
1,000
823
800
648
600
502 384
400 200
905
228 91
0 2004
2005
2006
2007
2008
2009
2010
2011
2012E
2013E
Source: Regulatory authorities, Bloomberg, Zawya, Central banks, Individual institutions, Corporate communications, The Banker, KFHR
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The Islamic banking industry charted a compound annual growth rate (CAGR) of 35.9% during 2004-13. Strong momentum was witnessed pre-2008 before a marked downturn in profitability and financing activity, particularly in the GCC region. Despite slower growth post-global financial crisis, the fundamentals of Islamic banks remain sound. Improving asset quality and a pickup in economic growth are expected to benefit the Islamic banking sector over the coming years. Although the Islamic banking assets currently constitute a meager 1.0% of the global banking assets, the share is expected to increase following development of new products and services, opening up of new markets, and jurisdictions in light of the industry's resilience during the global financial crisis.
Islamic Banking by Region Islamic banking assets are concentrated in the Middle East and Asia owing to the regions’ large Muslim population. Apart from Iran and Sudan, which support a fully Shariah-compliant financial system, selected GCC states, Bangladesh and Malaysia are the main markets where the market share of institutions offering Islamic financial services operating within the respective jurisdiction is increasing.
Islamic Banking Assets by Region, 2013 1% 2%
1%
6%
2% 3% 4%
37%
6% 7%
13%
18%
Iran Saudi Arabia Malaysia UAE Kuwait Qatar Turkey Bahrain Indonesia Sudan Pakistan Others
Source: Central Banks, KFH Research
In 2013, the top five countries excluding Iran captured 48% of the total global Islamic banking assets. The total assets, which include both pure-play Islamic banks and windows of conventional banks, are expected to increase by 16% compared to 2013 to reach at USD1.6 Tn in 2014. Saudi Arabia and Malaysia have increased their markets share from 13.7% and 9.8% in 2011 to 18% and 13% respectively in 2013 mainly due to the development of retail Islamic banks and diverse range of products and services.
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“It is banking with values, its core principles of trust, equity and fairness in dealings are shared equally by people of all faith, and we have seen adoption of Islamic banking by non Muslims in other parts of our market that include Malaysia, China and the United Kingdom,”
– Wasim Saifi, CEO & Global Head of Islamic Consumer Banking, Standard Chartered Malaysia
Islamic Banking in Malaysia Malaysia's Islamic finance industry has been in existence for over 30 years. The Islamic Banking Act 1983 enabled the country's first Islamic Bank to be established, and with liberalization of the Islamic financial system, more Islamic financial institutions followed. Excluding the Development Financial Institutions (DFIs), the Islamic banking assets in Malaysia are over USD132 Bn as at end November 2013. The Malaysian Islamic banking sector continues to outperform the conventional banking sector with average annual asset growth rate of 18.6% during 2008-12, in comparison to the conventional banking growth of 9.3% during the same period. Currently, Malaysian Islamic banking assets account for 13% of the total banking assets and the share is expected to reach 40% by the end of 2020. “Despite the challenging global environment, we are optimistic of double-digit growth in this sector. With the continuous double-digit growth momentum, and with the regulatory framework that Bank Negara has put in place, the target for Islamic assets is to make up 40% of Malaysia’s total financial market by 2020. This is easily achievable.”
– Wasim Saifi, CEO & Global Head of Islamic Consumer Banking, Standard Chartered Malaysia
"The government's seriousness in empowering and raising the standards of the Islamic financial system can been seen from various governing and legal initiatives."
– Datuk Seri Najib Razak, Prime Minister, Malaysia
Islamic Banking in the UK Although Islamic banks operate mainly in Muslim countries, but currently they are also operating outside these countries like the UK, which has become the most important location for Islamic financial activity outside the Muslim world. The UK is Europe’s chief centre for Islamic finance with total assets of USD19 Bn. At present, more than 20 international banks in the UK are providing Islamic finance. Six of these are fully Sharia-compliant, the largest number in all European countries. Islamic finance forayed into the UK market in the 1980s with the first commodity Murabaha transaction and the launch of the first UK Islamic bank, Al Barakara International in 1982. UK’s position in Islamic banking came to the fore in the early 2000s, when regulators and policymakers brought in reforms that eased the use of sharia-compliant products. In 2004, a first Islamic retail bank, Islamic Bank of Britain (IBB), was introduced. It is the UK’s only wholly Sharia-compliant retail bank.
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As the industry has developed and improved a breadth of products and services, it can now compete with the offerings of conventional financial institutions. In 2012, the UK was ranked the 9th largest country by Sharia-compliant assets with more than 20 institutions offering Islamic finance and six wholly Sharia-compliant banks.
Challenges in the Islamic Banking Sector To keep pace with an ever-changing financial marketplace and match increasing customer expectations, the Islamic banking sector must invest adequately in technological advancements. Beyond the conventional risks, acquiring and implementing an Islamic banking system presents a number of unique challenges that banks need to address as part of the procurement and contracting process. A number of these challenges, and suggestions as to how they can be met, are outlined below. Absence of Standardization Absence of single interpretation of the Shariah law is the major recognized challenge in procuring the Islamic banking system. Generally, a bank’s Shariah supervisory board determines Shariah compliance, which leads to the absence of common standards across banking systems, making it difficult for a bank to procure an Islamic banking system with logical certainty that the system will comply with the Shariah law. Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB) have attempted to improve standardization, but such standards are neither mandatory nor universally accepted. This ambiguity over standards also leads to cases where vendors claim to offer systems that are “Shariah-compliant”, in the sense that they comply with an AAOIFI or IFSB standard, but such a system may not actually comply with the requirements of a bank’s Shariah supervisory board. Complexity of Products and Processes Islamic financial products are more complicated than conventional financial products as a result of the use of sale contracts, leasing arrangements, agency and profit-sharing arrangements, and other structures in place of straightforward interest-bearing loans, bank accounts and other conventional banking products (such as credit cards and insurance). This presents banks with two challenges: first, to ensure that Islamic banking system vendors fully understand the complexity of the bank’s products and second, to clarify in the system contract whether or not the vendor needs to support the relevant bank’s products to avoid contract disputes. Division of Conventional Banking and Islamic Banking Funds Conventional banks operating an Islamic banking window may fail to notice the need to isolate conventional banking funds and Islamic banking funds. Shariah compliance and local financial regulations requires the bank to keep conventional banking funds completely separate from Islamic banking funds. A bank may be required to operate parallel banking system infrastructures and processes, which may hike up the costs. Banks providing both conventional and Islamic banking services should note this risk when dealing with vendors who claim to provide a single system that can service both conventional and Islamic banking clients.
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Challenge to Innovate and Adapt Innovation has always been significantly pervasive in Islamic Banking. And the industry needs to further accelerate the innovation momentum to ensure that it achieves its objectives and aspirations. The challenge to innovate and adapt at the same time must be based on the core principles and values as well as the ethics of Islam. “For innovation to become an important driver of growth, a critical area that needs attention is addressing the shortage of skilled and experienced professionals in the industry. We need to build a pipeline of talents who have the ability and creativity to develop new ideas and the capacity to run ideas into achievable results.”
– Nor Mohamed Yakcop, Minister in the Prime Minister's Office, Malaysia
Islamic Banks’ Online and Mobile Adoption Conventional banks have invested in digital channels, which have changed the way the banks offer services to their customers. Emergence of internet banking and mobile banking has helped customers do financial and non-financial transactions online anytime and anywhere. In contrast, very few Islamic banks are offering services through online channels at present. Majority of their customers still seem to prefer the brick-and-mortar structure than any other channel. While basic services like account inquiry and transfers are offered online, interactive and advanced services are yet to find their way online. Internet and mobile penetration continues to rise, and so does banking on these channels. As the digital generation comprises a major chunk of the online banking population, it is essential for Islamic banks to provide a distinguished experience through online banking portals and mobile apps. Mobile Islamic banking adoption is very low. Recently, few banks have adopted mobile banking to provide secure anytime and anywhere banking. In 2014, alizz Islamic bank launched a new mobile banking application given increased smartphone adoption and rising customer demand. The mobile banking app is available on the Android as well as iOS platform. It will provide the bank’s customers, who have signed up for its online banking service, access to their accounts. With this app, users can access online banking services, including the facility to view balances, view transaction history, transfer between accounts, ATM and branch locator service and also quick dial to customer service. “alizz islamic bank is the first full-fledged Islamic bank to offer mobile banking application. We know our customers already access our digital channels. By launching the mobile banking app, we continue to expand our offerings to our customers and are responding to their needs. Ultimately, we are listening to our customers’ needs through their channel of choice. Android and iPhone applications are foundational for everything we want to build for our customers in the digital space. This is just the beginning of much more to come.”
– Saif al Yarubi, Acting Chief Executive Officer, alizz islamic Bank
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Conclusion The global Islamic banking industry has managed to sustain its impressive double-digit growth rates in 2013. It is expected to continue its robust performance, particularly with more jurisdictions jumping on the bandwagon. The growth will also be further supported by aggressive government spending on infrastructure projects and domestic consumptions in GCC countries and Asia. To take advantage of this growing demand, the Islamic banking sector must first ensure it invests adequately in technological advancements and makes the most of the growing digitization channel.
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