Islamic Finance: Opportunities for Growth and Innovation
Furqan Ahmad, Head of Product Development and Segmentation
ADCB Meethaq-Islamic Banking (Abu Dhabi)
The recent global financial crisis has shown us the critical importance of having equity participation, risk sharing and fair dealings in all banking and financial services. Internationally, trillions of dollars in wealth was wiped out in the crisis.
Since the commotion in 2008, customers are increasingly looking at alternative ways of banking. Islamic banking institutions are well placed to cater to the needs of such clients, especially those who want to avoid risks which have been rampant in the international conventional financial sector revolving around sub-prime lending, the American market meltdown, toxic assets, mismanagement of leveraged products, speculation, hedge funds, interest rate options, unethical practices, federal bailouts, short selling, mortgaged debts and derivatives.
High-Net-Worth Individual Market Opportunity
The total wealth of high-net-worth (HNW) individuals in the GCC has suffered in the recent crisis with a decrease of 14% to US$900 billion in investible assets, according to market surveys conducted in 2009 and 2010. On the other hand, Islamic HNW wealth is estimated to be approximately 10% to 15% of total assets, between US$90 billion and US$135 billion. Nevertheless, the opportunity for Islamic wealth management is at hand.
Market studies have shown that there is a definite opportunity in the UAE market for launching Islamic banking HNW propositions by Islamic banks and Islamic windows of conventional banks.
In this article, we will be looking at opportunities for growth, primarily for Islamic banks and secondarily for the Islamic banking windows of conventional banks, with particular focus on the UAE market.
Leading Islamic banks in the UAE have seen this opportunity and are opening up focused banking boutiques to serve the HNW segment clients. For Islamic windows of conventional banks, it is also a good idea to have high-quality branded wealth management banking initiatives embedded in their regular wealth management segment (initially mirroring the conventional HNW products, documentation and processes for quick launch) with the well-positioned and distinct unique selling proposition of Shariah compliancy, quality of service and competitive returns. For both, HNW offerings should reverberate across the bank's collaterals and in their brand awareness initiatives.
What is So Unique About Islamic Finance?
The basic Islamic financial model works on the basis of mutual risk and reward sharing while avoiding payment and receipt of interest. Any Islamic banking institution is not permitted to finance or borrow from customers and other banks on interest.
Both the customer and the bank share the risk of investments on agreed terms, and divide profits or losses between them. In addition, investments should only support practices that are not forbidden; for example, trades in alcohol, pork, betting, pornography and such.
While Islamic financial institutions (IFIs) have not managed to emerge unharmed from the current financial crisis, the extent of impact has been limited as compared to their conventional banking counterparts.
This has largely been due to Islam's ban on interest, which prohibits these institutions from investing in collateralised debt instruments (CDOs), complex hedging instruments and derivatives, when their primary objective is to mimic underlying securities and seek only the economic benefits with miniscule risk exposure.
Since Islamic banks distanced themselves from derivatives; they kept relatively safe. However, IFIs have faced other risks. The concentration of their exposure remained high in real estate, which was also impacted by the international downturn.
Business Opportunity in Ethical Finance
Studies by McKinsey & Company have shown that the UAE's total banking assets at the end of 2008 were in the range of US$393.7 billion, registering 10% growth from 2007, when banking assets totalled US$357 billion. Islamic banks have shown modest growth in their share of total bank assets, from 8.8% at the end of 2002 to 13% at the end of 2008. Islamic banking assets were estimated to be US$53.7 billion at the end of 2008.
The financial crisis has been a blessing in disguise for banking institutions offering Shariah-compliant solutions, providing numerous business opportunities to them. Islamic banking institutions can now target a fresh HNW client base. Reversion to more ethical investments by non-Muslims can offer Islamic institutions significant opportunities for expansion. The institutions which can take advantage of this shift in customer preferences during the current great recession should be in a position to become leaders in the future.
Islamic law prohibits investing in businesses that are considered haram in Islamic ethical code. Islamic ethical investment structures avoid businesses that deal in gambling, alcoholic liquor, nightclubs, pornography, pork and such.
Islamic investments rely on tangible asset-backed transactions and avoid sub-prime securities and financial leverage from hybrid products, derivatives and associated creative accounting practices.
Investors in Islamic investments have an implicit right of information on the use of their funds and the nature and performance of underlying assets. The comfort level of investors through this transparent guarantee on the proper utilisation of their funds is a clear advantage in Islamic banking. Non-Muslim scholars at the Anderson Graduate School of Management, University of California, have pointed out that, "Islamic finance will be less prone to inflation and less vulnerable to gambling-like speculation, both of which are fuelled by the presence of huge quantities of debt instruments and derivatives." Islamic banking, if comprehensively implemented in its original form, can be an ethical solution for preventing future financial crises.
Many western social investments and green funds are based on promotion of environmentally friendly businesses. Islamic finance does not allow financing anti-social and unethical businesses dealing in gambling, alcoholic liquor, and nightclubs. In this respect, it is clearly ahead of the recent surge in ethical finance and socially responsible finance.
Islamic financial institutions, because of their knowledge of the nature of their clients’ businesses, are in a better position to detect and prevent the channelling of depositors’ money for financing highly risky anti-social activities. The financing it provides is mostly asset-based, whereby the Islamic bank knows the actual utilisation of funds due to the very nature of its transparently structured modes of finance.
The global market for Islamic banking services continues to expand and the sector has perhaps the best potential for growth of any sector in international finance today. Products that are compliant with Shariah law are gaining wider understanding and acceptance and are making their way into the international mainstream of financial products.
The Islamic finance industry, with the help of leading bankers, product development managers, lawyers, regulators and investors, are contributing to new product innovations and expanding the market in breadth and depth.
Islamic finance is steadily making its mark across the world not only in regions with predominant Muslim populations but also in the Western countries such as the UK, France and Germany where a sizeable expatriate Muslim population resides and is increasingly keen to avail Shariah-compliant investment and financing facilities. Asset growth has been particularly pronounced in the GCC countries.
Internationally, Islamic banks grew quicker than conventional banks, maintaining double-digit asset growth over the period 2005-2008. Banking assets account for the majority of global Islamic finance assets worldwide. Total Islamic assets amounted to US$$700 billion in 2007. According to most estimates and industry consensus, these Islamic assets rose to US$1 trillion in 2008, of which banking assets are estimated to total US$785 billion.
Focused HNW Segmentation
The challenge for Islamic banks is to have high-quality service with leading edge innovative products, while at the same time, maintaining credible Shariah compliance. This applies to various retail, investment and corporate products.
At present, most Islamic banks lack a segmented focus and implement a "one-size-fits all strategy". Thus, they must adopt a focused and differentiated, customer centric strategy to grow quickly in a relatively small but highly competitive HNW market.
Target Market Focus
Market studies by Ernst & Young have shown that Emiratis, GCC nationals and Iranians in the UAE have the greatest propensity to consume Islamic products. The fact that these segments have higher average monthly household incomes suggests potentially profitable focus segments for the Islamic banks.
Easy to Pick Fruit
The Islamic bank's liability deposits have historically been concentrated in Emirati and GCC national communities. Though relatively smaller in numbers, the wealthy segments bring considerably more revenue per customer than the mass segments. This should be a lucrative focus for a premier Islamic HNW banking proposition.
Therefore, refocusing the product strategy of an Islamic bank on the wealthy HNW segment of the UAE national and other Shariah-compliant segments of the UAE resident population should be the main source of differentiation for increasing the customer base in the overall HNW segment of the bank.
The following characteristics are generally observed in Islamic banking HNW clients:
Prefer frequent visits from a trustworthy HNW relationship manager
Prefer to deal with established banks. Track record, ethical banking standards, and sound financial qualifications are important for selection.
Preference for local income generating, high net return products
Preference for asset classes with competitive risk/return profiles
About half of all ultra HNW clients, having greater than US$30 million in investible funds, have a preference for Shariah-compliant products, while the other 50% of these HNW clients are indifferent and rate shoppers.
According to industry sources, over two-thirds of HNW investors with a preference for Shariah-compliant products have re-entered the investment markets in late 2009.
HNW Strategic Marketing
Industry experts have mentioned that:
The UAE demographics indicate a positive future outlook for the HNW banking sector. As income levels increase, demand for credit versus investment products changes as does product sophistication requirements.
Certain ethnic segments which show a higher predisposition to consume Islamic products must be targeted first.
Islamic banks must target those segments of the population which use competitiveness as key criteria for selection in addition to Shariah compliancy and quality.
The Blue Ocean strategy tells us that the purpose is not to outperform the competition in the existing Islamic banking industry but to create a new uncontested Shariah-compliant market space or a "blue ocean", thereby making the competition from other Islamic and conventional banks irrelevant.
Female HNW Segment
An interesting and increasingly visible tendency in the UAE HNW banking sector is the focus on the female bankable population. The Islamic bank should propose to have an HNW segmented proposition, especially for female clients with its branded Shariah-compliant products targeting the wealthy homemakers and businesswomen.
HNW – Islamic Mutual Funds and Stocks
Islamic funds have stayed away from high risk investments, which include derivatives and CDOs. This has led to outperformance against conventional benchmarks in the recent crisis. Islamic funds also shied away from investing in banks due to the Shariah ban on interest, which was also instrumental in safeguarding Islamic investors from the effects of the financial crisis to some degree.
In addition, Islamic law prohibits usury, the collection and payment of interest (riba); trading in financial risk (a form of gambling); and investing in businesses that are considered haram in Islamic ethical code (businesses that deal in alcohol, pornography or pork).
The downside exposure of Shariah-compliant stocks in the recent global meltdown was limited as compared to conventional stocks. This can be gauged by the performance of the S&P 500 Shariah Index which lost 42.1% of its total value from January 2008 to February 2009, while the S&P 500 fell by 50.1% over the same period.
The underlying reason for the relatively lower loss experienced by Shariah-compliant stocks compared to conventional (non-Shariah) ones is attributed to investment in less leveraged companies and being disallowed from investing in conventional financial sector, a rule which is embedded in the screening process for Shariah-compliant investments.
After eliminating companies that profit from unacceptable business activities, several financial and screening ratios are established by the Shariah board to exclude companies that have unacceptable levels of debt or impure interest income.
As per Shariah requirements, according to the financial ratios guidelines, each of the following amounts must be less than 33%:
Total debt divided by trailing 24-month average market capitalisation
The sum of a company’s cash and interest bearing securities divided by trailing 24-month average market capitalisation
Accounts receivables divided by trailing 24-month average market capitalisation
The Islamic banking product suite delivers Islamic funds and investments diversified across asset classes such as equities, sukuk, real estate and commodities. Depositors are treated as investors distributing profits or losses from ventures according to shared risk. As the foundation of Islamic banking is based on ownership in tangible assets, this creates incentives for making investments as highly profitable as possible.
Service Quality – The Weakest Link
Most Islamic banking customer surveys confirm a lack of Islamic product knowledge among frontline staff and an inability to respond promptly and convincingly to Islamic banking related questions. Thus, rigorous and continuous training is the key to strengthening Islamic banking knowledge in frontline relationship managers to achieve the full benefit of the Islamic HNW banking market opportunity.
In the case of Islamic windows of conventional banks, by combining the mutually exclusive strengths of both the conventional and Islamic banking teams, they must draw upon the collective core competencies of both teams in order to offer Islamic HNW solutions by means of the conventional bank's well-established brick and mortar distribution network.
In essence, Islamic finance product and sales training is crucial for best service quality delivery. Many face-to-face and online Islamic finance training solutions have emerged in the market recently and
are being used by leading banks to upgrade the skills of frontline staff to deliver a better Islamic banking service quality experience to their customers, and further build their confidence in the bank's product offerings.
HNW Business Essence for Future Growth
Finally, let us not forget that Islamic banking and finance globally constitutes only about 2% of the entire financial services industry. Ratio-wise, it is still small and the top priority in the future must be first to increase that ratio through best of breed HNW Islamic banking offerings with focused quality service as an innovative strategic growth initiative.
Furqan Ahmad is a senior Islamic banking expert with experience in various international Islamic financial institutions, covering product development, strategic management of client segments and business management of Islamic banking products.
This article first appeared in Islamic Finance News (23 February 2011, Volume 8 Issue 7, Page 22). For more details, please visit www.islamicfinancenews.com