Sharia compliance: Banks hit by a shortage of products

While Islamic banking has expanded rapidly in the Gulf, its usefulness as a single source of finance has been curbed by a shortage of products that sharia-compliant institutions can buy and sell.

Assets under management at Islamic banks have grown at a tremendous pace over the past decade, but the industry has struggled to create enough financial tools to help manage short-term liquidity.

Unlike in more developed markets, such as Malaysia, the sukuk market in the Gulf is still in its early stages of formation and cannot yet support the short-term cash management needs of the banks.

To tackle the dearth in short-maturity products, both governments and investment banks have a role to play as assets under management are forecast to double to $990bn by 2015 from $416bn in 2010, according to Ernst & Young. “The market requires much more short-dated product in order to enable Islamic banks to effectively manage their liquidity,” says Yavar Moini, an executive director at Morgan Stanley in Dubai.

Commodity murabaha – Islam’s version of interbank short-term lending and syndicated loans – that generate funds through the buying and selling of products, such as precious metals, have become the tool of choice. However, their popularity has drawn the ire of Islamic scholars who criticise the structure, saying that it is not in reality backed by assets.

Efforts to develop Islamic short-term liquidity products have been multifaceted. Solutions have run from deepening the sukuk market to creating more complex structured products that are taking time to catch on. With a more liquid Islamic bond market, participants can trade longer-dated maturities in short timeframes, so allowing them to earn a return on their cash.

In recent years the central banks of Bahrain and the United Arab Emirates have introduced short-term liquidity management tools, such as Islamic certificates of deposits and short-dated sukuk, to support their banks. In Qatar, which has separated its Islamic banks from its conventional lenders, the government sold billions of dollars in Islamic debt to help lenders. The split between the two types of banks is forcing sharia-compliant institutions to pay more attention to the management of their funds.

Saudi Arabia recently sold its first sovereign-guaranteed Islamic bond, another step towards developing the local market that also took advantage of low borrowing costs.

However, because of the unfavourable profit rates of these low-risk tools, there is still a gap in the market for investment banks to create new products.

“There’s a lot of work being done on the investment banking side to come up with more ways to manage short-term liquidity rather than to place it with the central bank,” says Muhammad Farhan, head of Islamic finance for HSBC in Saudi Arabia. “This may not be as swift as we want it to be, but we see a lot of momentum.”

The sukuk market in Saudi Arabia, the Arab world’s largest economy and home to the world’s largest Islamic bank, may have an advantage over some of its other Gulf counterparts, thanks to a strong institutional investment sector. Some bankers complain Islamic lenders are slow on the uptake when it comes to new products, even when they have been crafted to meet their needs. With many western banks retrenching from the sharia-compliant industry in the region there has been less of a focus on innovation.

While much of the discussion focuses on how Islamic banks can put their cash to work, HSBC says its sharia-compliant structuring business in the region is dominated by liquidity creation as opposed to investment tools.

Although many Islamic banks remain highly liquid in local currency, they are facing the need to generate more short-term dollar-based funding, creating opportunities for investment banks. Commodity murabaha remains the dominant product for short-term liquidity management, while there has been a rise in short-term repurchase activity, says Mr Moini. Repurchase agreements, known as repos, allow banks to lend out an asset to a counterparty and get a return on the transaction.

Still, neither of these has provided the perfect short-term liquidity management solution for Islamic banks, analysts say. Some lenders remain cautious and slow in using such tools. Both tools have also been criticised by the more conservative elements of the industry, which see the products as a means of mimicking conventional ones.

Despite some progress, bankers agree that Islamic lenders have limited options when it comes to raising short-term funds or putting to work short-term money.

“It’s still an issue,” says Afaq Khan, chief executive of Standard Chartered’s Islamic banking arm in Dubai. “There is a sense of urgency to address this. A lot more needs to be done, we’ve not seen much.”