With an estimated market capitalization of US$100 billion, Islamic banks are barely scratching the surface of global banking. NAZNEEN HALIM speaks to industry players on how this can be remedied, and if consolidation is the future.

The math is simple. The more money a bank has; the wider its reach, and thus the more business it brings in. However, despite seeing the value of this, industry experts are still hesitant about the need for Islamic banks to consolidate their resources to create more competition within the Islamic banking realm, and eventually tap into the conventional banking space. Most believe that time is their biggest ally when it comes to consolidation, and also currently the enemy, seeing how nascent the Islamic market is.

As at 2009, Islamic banks in the Middle East displayed asset sizes far bigger than their Asian counterparts. In Malaysia, the region’s biggest (in terms of value) and most advanced Islamic finance market, the top five players — Maybank, Bank Islam Malaysia, CIMB Islamic, Public Bank and AmBank — held assets of US$18 billion, US$13 billion, US$10 billion, US$10 billion and US$8 billion, respectively. Across the continent, the top four Islamic banks in the Gulf were Al Rajhi with US$44 billion in assets, followed by Kuwait Finance House (US$40 billion), Dubai Islamic Bank (US$24 billion) and Abu Dhabi Islamic Bank (US$13 billion).

Most industry players believe that having more global Islamic financial institutions would help the Islamic finance industry secure a stronger international presence. And that volume and size will not only equip banks to significantly increase their financial capabilities — thus enabling them to take on more mega projects — but would also help them leverage on the various benefits, particularly when it comes to knowledge and expertise.

Organic vs Instant
“It is true that Asian Islamic banks are, by far, smaller than their Middle East counterparts. Nevertheless, looking at the region’s promising economic climate and growth, there is ample room for organic growth. In this part of the world, M&As (mergers and acquisitions) among the Islamic banks is not essential, more a possibility, but I don’t see it happening so soon.

“The primary focus now should be organic. It is true that having a regional champion in the Islamic finance industry would be helpful, but before that, we must have a national champion. We don’t want to have a champion by acquisition,” an investment banker revealed.

However, Mohamad Safri Shahul Hamid (caricature), deputy CEO of MIDF Amanah Investment Bank, disagrees. “As it is, I believe that Malaysia is currently over-banked. Almost every local bank has its own Islamic banking outfit, and I think the way forward is for these bank-backed institutions to expand regionally. For instance, CIMB has made it very clear that that Indonesia will be its single largest contributor by 2015.

“Organic expansion takes time, whereas M&As will produce much faster results. The biggest Malaysian banks — Maybank and CIMB — are still smaller in asset size compared to Singapore’s DBS bank, and in order to compete with the bigger banks even within Asia, such as India’s ICICI Bank and the Bank of China, you need a wider reach.”

Davide Barzilai, partner at London-based law firm Norton Rose, believes that from a legal perspective, consolidation may provide more resources for the research and development aspects of the industry which arguably are currently lacking. “This, together with the fact that there would be fewer small players in the market, may mean that greater standardization could be achieved,” he added.

In 2009, Malaysia’s central bank announced the offer of two international licenses to foreign Islamic banks with a minimum paid-up capital of US$1 billion, dubbed the “mega-bank project” by Malaysian market players. Safri of MIDF Amanah Investment believes the move is in the best interest of the Malaysian Islamic finance market.

“I am certain that Bank Negara had put a lot of thought into this before it came up with the US$1 billion cap, because banks, especially those with a foothold in commercial, corporate and investment banking, need capital to mobilize their business. Banks doing purely investment activities, on the other hand, do not need as much, hence Bank Negara’s US$500 million cap for these.”

However, Safri revealed that Islamic banks actually do not need much capital because of their ability to render their services on a non-balance sheet basis. Having said that though, he still believes in the importance of merging smaller Islamic financial institutions to establish a stronger foundation: “It really isn’t rocket science.”

The Middle Eastern dilemma
The shockwave felt throughout the Islamic markets during last year’s defaults have affected policies and governance, and cemented the need for more prudent and transparent business dealings. Industry analysts say this is not a problem among the larger banking outfits and global players, but signals a need for smaller institutions to revamp their business conduct.

“Although the defaults that happened had nothing to do with the size of the institutions, it shows that smaller institutions are perhaps more inclined to take up riskier business deals with higher returns as a survival reflex,” Safri stated. “It is only natural to be more aggressive in sealing deals if you are a smaller player because you have to fight the bigger boys for a piece of the business.

“Smaller institutions are also more inclined to be more lax in terms of repayment tenors, without thoroughly analyzing the risk. Bigger banks would not have done deals like Investment Dar.”

“In Malaysia, however, we are blessed to have a proper audit system in place implemented by both the central bank and the Securities Commission, which includes composite risk rating and the placement of internal rating models, thus minimizing the risk of such defaults,” he added. Those within the industry also admit that there have been some repercussions from the defaults that have affected investor habits. “There are currently a lot of deals in the pipeline, but people are not willing to issue papers because investors now demand premium pricing,” a lawyer revealed. “Instead of relying solely on implicit support, we need more information, documents and generally more transparency,” a lawyer said.

“A lot of businesses in the Middle East are family-owned and there is nothing wrong with that; in fact, some of these families are worth billions of dollars. However, because they are so rich, they are hesitant about disclosing too much information, which includes rating information, for fear of revealing their net worth and inviting unnecessary attention.”

All talk?
Merger talks among banks and institutions such as Amlak Finance and Tamweel have been ongoing since 2009, including the establishment of a mega Islamic bank, but nothing has materialized. However, the one merger to emerge from Dubai last year — that of Emirates Bank and the National Bank of Dubai — had made it one of the biggest banks in the Middle East, with the ability to rival industry giants like Al Rajhi Bank and Kuwait Finance House. “When you have a large presence, you can easily invest and expand without having to think twice, and this is especially crucial when you are planning to list,” Safri elucidated.

Why then has nothing much transpired? Barzilai believes that one of the weaknesses the industry faces is the relatively small balance sheets available for the financing needs of the Islamic world. “As a result, the debt markets (capital markets, syndicated and club) are critically important in order to deliver sufficient finance for many of the businesses and projects demanding sizeable facilities.

“As we have seen during the global banking crisis, these markets can seize up and as a result, availability of debt is severely restricted. One response to this has been to increase the size of the Islamic banks so that they can provide sizeable sums to their customer base on a bilateral basis.”

Government policies, which may be seen as a form of protectionism, could also pose a major challenge for cross-border M&A deals. Such as in Malaysia, where foreign companies are only allowed to take a minority stake in a local company, which could serve as a deterrent for international players considering M&A deals. As a result of the heavy market cap discount in the global corporate scene, it is evident that major Islamic banks are looking out for potential acquisitions. However, most usually demand a controlling stake and are not keen to be merely minority shareholders.

Barzilai affirmed this by stating that consolidation is difficult to achieve due to the fact that many of the Islamic financial institutions are currently privately owned. “As a result, there is no easy way to consolidate unless the shareholders are willing to sell.

“Those institutions that are publicly listed would be suitable targets but the banking crisis and almost global recession has meant that valuations of targets have become difficult, and any possible buyers have been very cautious following some of the high profile mergers in the conventional banking sector.”

However, as the banking sector emerges from the crisis, the industry could perhaps anticipate a greater willingness for buyers to take risks and expand through acquisition, as opposed to natural business expansions. This again, is subject to time.