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Gulf Islamic banks climbing

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By Timucin Engin

Gulf Islamic banks continue to grow faster than their conventional peers, but profitability rates are converging, according to new S&P report


• GCC Islamic banks continued to capture market share and outgrow their conventional peers despite the 2008 crisis, and we expect them to continue to grow fast.

• Low interest rates and lower capital market-related gains than 2008 pre-crisis levels are impairing revenue growth for most Islamic banks in the region

• Strong government support is the key to the rapid growth of Islamic banking in the region.

• Qatari Islamic banks expected to grow especially fast because of the country's large infrastructure needs and investments, including the 2022 soccer World Cup.

• Operating environment over the next two years expected to remain supportive for Islamic banks' credit quality.

A recent report by Standard and Poor indicates that while Islamic banks in the GGG are likely to grow faster than their conventional counterparts, profititability rates for the two banking models are converging as Islamic banks take a hit from comparatively lower interest rates and non-core banking revenues. The report by Timucin Engin released before S&P's October "Developments in Islamic Finance" conference, is summarized below.

According to our analysis of some conventional and Islamic banks in the Gulf region, the GCC Islamic banks in S&P's sample of banks outgrew their conventional peers between 2009 and 2012. Their asset bases showed a compound average growth rate of 17.4 percent compared with conventional banks' 8.1 percent, while their net lending and customer deposits grew by an average of 18.2 percent and 19.9 percent compared with conventional banks' 8.1 percent and 10 percent.

The economies of the countries that make up the GCC are showing robust recovery after the 2008 economic crisis, with Qatar looking particularly strong. The region has one of the world's largest Islamic banking markets and the sector has healthy performance metrics.

Additional state support means S&P predicts that Islamic banking in the region will continue to increase its market share, and they expect the operating environment over the next two years to remain supportive for Islamic banks' business and credit quality.

How We Reached Our Conclusions

Strong government support is key to rapid growth of GCC Islamic Banking

S&P believes that GCC Islamic banks have grown very fast because of significant direct and indirect support from governments, ruling families, and authorities, and we expect this support to continue (see "Islamic Banking Has Reached Critical Mass In The Gulf After Sustained Growth, And Expansion Is Set To Continue," published on Dec. 4, 2009 on RatingsDirect).

For example, the granting of banking licenses is a discretionary power of the state authorities, and most of the new banks in the GCC region are Islamic. State authorities also control the system allowing conventional banks to change into Islamic ones; Bank of Kuwait & The Middle East in Kuwait, and Sharjah Islamic Bank and Dubai Bank in UAE have all done this. In addition, the authorities control the opening of dedicated business lines in Saudi Arabia, Qatar, and UAE, and the acquisition of Islamic banking subsidiaries, as happened when National Bank of Kuwait S.A.K. acquired a controlling stake in Boubyan Bank.

State authorities have had strong and direct involvement in the development of the Islamic banking sector by holding direct and indirect stakes in Islamic banks including Kuwait Finance House, Dubai Islamic Bank, Dubai Bank, and Al Rajhi Bank, and more recently, Alinma Bank, First Energy Bank, Al Hilal Bank and Barwa Bank. State involvement has been particularly strong in Qatar, where the Central Bank banned conventional banks from having "Islamic windows."

Differences in local credit conditions lead to divergent Islamic asset growth rates

S&P expects GCC Islamic banks' overall credit growth to remain strong over the medium term, with Saudi and Qatari Islamic banks accounting for a big chunk of the increase because of their planned infrastructure investments. We also think Abu Dhabi-based banks will show healthy growth, given their stronger balance sheets relative to their Dubai-based peers.

GCC banking system assets have risen by a compound average growth rate of 6.9 percent a year since 2009 to reach $1.6 trillion at the end of 2012, as the positive effects of strong oil prices offset the fragile global operating environment.

However, when we look at growth rates among individual countries using our sample of selected banks, we see quite a bit of divergence. The strongest compound average growth rate was in Qatar, where strong state support and a buoyant economy helped Islamic banks expand their loans by 32 percent compared with system-level domestic credit growth of 23.7 percent. The country's youngest Islamic bank, Barwa Bank, began operations after 2009. If we were to exclude Barwa Bank from our analysis, the lending growth for Islamic banks would still remain at 26 percent for the period.

Saudi Arabia was the second-fastest-growing Islamic banking market, with a average 22.3 percent growth rate in 2009-2012, as banks were able to capitalize on strong local economic conditions. Alinma Bank, the country's newest Islamic bank, began operations in 2008.

The compound average growth rate for the Islamic banks in our sample for the UAE over the same period was around 14.5 percent, but this falls to 9.3 percent if we exclude Al Hilal Bank, which began operations in 2011. Most of the growth was generated by Abu Dhabi-based banks and the contribution from Dubai-based banks was minimal as they had to focus on cleaning up their balance sheets due to real estate and government-related entity (GRE) lending exposures

In Kuwait, the compound average growth rate of 10.5 percent was largely driven by Kuwait Finance House, whose rise came mostly from overseas businesses, predominantly in Turkey. That's why Islamic banking growth was significantly above domestic credit growth.

Bahrain has experienced political and economic upheaval over the past two years, and central bank data show total assets for Islamic retail and wholesale banks unchanged at $25.5 billion from 2009-2012. Total Bahraini banking system assets contracted by about 16 percent between 2009 and 2012.

In Oman, the regulator approved Islamic banking from Jan. 1, 2013. The country's first Islamic bank, Bank Nizwa, opened in January 2013. Oman's biggest lender, Bank Muscat, has begun to sell Islamic banking products through an Islamic window. Despite this recent push, we do not expect the Islamic banking segment in Oman to represent a meaningful portion of the regional Islamic banking market because Oman's banking system, at around $37 billion at the end of 2012, is small.

Deposits are the main source of funding, and overseas borrowing is very limited

Most GCC banks have traditionally funded themselves through customer deposits, and the overall role of non-depository funding is limited. This is more visible with Islamic banks, where debt capital markets issuance has historically been very limited.

About 72 percent of Islamic banks' total assets were funded by customer deposits as of Dec. 31, 2012, and 14 percent were funded by shareholders' equity. Most GCC banks also have high levels of non-remunerated current accounts, and Islamic banks generally have stronger access. In addition, most Islamic banks in the region traditionally employ more capital than their conventional peers in funding their assets.

Given the larger equity base and current account deposits, Islamic banks' interest bearing liabilities to total liabilities are generally lower than their conventional peers.

The Gulf region's currencies, with the exception of Kuwait, as its currency is pegged to an undisclosed basket of currencies, are pegged to the U.S. dollar, so regional interest rates have tracked the decline in global interest rates over the last few years. Islamic banks are able to operate with strong net interest margins in a high interest rate environment because of their funding advantage. The impact of declining interest rates was therefore more obvious on their performances. Conventional banks were able to mitigate some of the pressure on their yields on earning assets as they were able to capitalize on the lower cost of funding opportunities in debt capital markets.

The corporate and infrastructure related nature of lending in the Gulf region means the average tenor of loans for most Islamic banks is substantially higher than a year. Furthermore, the average tenor for customer deposits is generally very short-term. This results in a contractual asset liability mismatch for Islamic banks similar to their conventional peers. Although these deposits have a very high roll-over rate, we believe that under the incoming Basel III regulations, the region's banks will be further incentivized to issue longer term paper. We therefore expect Islamic banks in the region to adopt a more active stance in debt capital markets.

Islamic banking returns are converging with their conventional peers

Unless we see a cycle of higher interest rates that would help Islamic banks to expand their net interest margins, we expect to continue to see convergence between conventional and Islamic banking returns in the GCC region over the next few years.

Islamic banks have continued to outgrow their conventional peers since the beginning of the crisis, but their margins have been eroding and their return on average assets converging with conventional banks. Between 2008 and 2012, Gulf Islamic banks' average return on average assets declined by around 100 basis points (bps), and operating revenues to average assets declined by 130bps. The main driver behind the lower revenue generation was the significant contraction in net interest margins, but this was also accompanied by a significant contraction in revenues some Islamic banks had traditionally generated from non-core banking activities. These factors mean that Islamic banks' revenue generation is now falling to their conventional counterparts' levels.

Conventional banks have been able to reduce their provisioning requirements substantially since NPL formation began to stabilize, as they entered the crisis with substantially higher loan loss reserve coverage. Islamic banks have continued to operate with higher levels of credit losses, which has also contributed to the convergence of Islamic and conventional banks' profitability.

As with asset quality, profitability depends significantly on country of operations, so banks in Qatar and Saudi Arabia are operating with better metrics than their peers in the UAE and Kuwait.

We believe the convergence of returns between the conventional and the Islamic banking models in the GCC region is here to stay. Islamic banks used to be able to rely on strong returns from non-banking activities such as capital markets and real estate owing to the inflationary asset valuation cycle in the region. After their recent credit losses we now expect them to have similar provisioning levels to their conventional peers.

(Courtesy: Zawya)
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