Monday, August 02, 2010

Islamic banking no longer flying high

A couple of years ago, Islamic banking - that is, banking according to the principles of Islamic Sharia law - was booming. Major multinational banks were jumping on the bandwagon, and respected financial companies were hiring imams to ensure compliance.

That enthusiasm seems to have been dimming. Although initially "sukuk" bonds were touted as having lower risk, they started defaulting last year during the economic downturn just as other investments were. 

Now, things seem to be getting worse. From Arabian Business:

The lure of Islamic bonds appears to be wearing off for conventional borrowers in the Gulf, even as the global industry grows, with high-profile defaults and rising costs souring their appeal.

On a global scale, Malaysia continues to dominate the Islamic finance market, which is based on financial principles from the Koran, and has led sukuk issues so far this year.

A Reuters poll in July estimates global sukuk sales at $23-25bn, similar to 2009, but down from earlier estimates.

"Dealing with sukuk defaults, standardising sharia interpretation, and increasing sukuk liquidity, we believe, are at the root of issues that could curb future growth," said Mohamed Damak, analyst for Standard & Poors in a recent report.

No conventional borrowers have sold sukuk this year, and those in the pipeline, such as that of Qatar Islamic Bank, have not been able to come to market.

"There are likely to be various reasons for borrowers having held back from issuing sukuk, such as debates over sukuk structures, documentation issues," said Chavan Bhogaita, head of credit research at National Bank of Abu Dhabi (NBAD).

Islamic finance had been seen as a hot market in the region, and foreign investors saw sukuk as a way to tap into abundant liquidity in the Middle East.

International demand was high, particularly from European and U.S. hedge funds, for perceived high-quality issues, such as the Dubai government's $2.5 billion sukuk sale in October.

But the near-default in December of the dollar-denominated sukuk from Dubai property developer Nakheel sounded alarm bells.

Kuwait's International Investment Group has defaulted on two sukuk payments this year, and The Investment Dar, which owns half of British carmaker Aston Martin, defaulted on a sukuk in May last year.

The effect has been not just reputational damage to the industry but also a stronger focus on structuring, costs, compliance, and the legal ramifications of default.

Islamic bankers say a number of mandated sukuk issuances are now being pulled from the market in the region, or are in the process of being restructured as conventional bonds.

Sukuk structures are usually more expensive due to the costs associated with sharia board approval, extra legal fees, and fees associated with the often complex structures.

While Islamic institutions accept the extra costs, other issuers need a good reason to opt for what is typically a longer, more expensive process.