JEDDAH - The pre-crisis moves toward developing the concept of Shariah-compliant investment banking (SCIB) were brought to a halt by the onset of the global financial crisis and severely undermined by the spectacular defaults of a few SCIBs mid-crisis, Moody’s Investors Service said in a special comment on GCC Islamic investment banks.
“The SCIBs’ unsound risk-management architecture is reflected by their concentration risks, poor sector allocation, imprudent liquidity management and imbalanced ALM,” it pointed out.
In addition, Moody’s have found that the public disclosure of these risk factors is usually incomplete and/or non-existent. For instance, TID (which defaulted in May 2009) did not disclose proper risk-management information. Furthermore, in 2007, most SCIBs only applied Basel I, which did not make it mandatory for them to adhere to Basel II’s Pillar 3 disclosure requirements.
Only in the 2008 financial reporting data (released during Q1 2009, i.e. quite late in the cycle given extreme circumstances at the time) did Moody’s glean a better view of the SCIBs’ approach to risk management, Basel II guidelines and requirements. Even then, not all the information was clearly and consistently released by the SCIBs, it added. However, since 2009, disclosure practices have been improving significantly.
The importance and growth of SCIBs was not directly due to their Islamic nature. The difficulties SCIBs are currently faced with mostly stem from risk-management failures, characterized by a very low degree of diversification, preference for illiquidity, and an absence of financial flexibility and imbalanced funding strategies, Moody’s said.
It noted that any recovery of the tarnished SCIB concept would require that lessons from the crisis - such as the need to improve risk management - be applied.
A potential rebirth of this subsector is likely to take a different form from the pre-crisis model. Specifically, Moody’s expects SCIBs to evolve away from being the preserve of boutique investment houses created by individual investment bankers.
Instead, Moody’s believes that the SCIB concept could re-emerge in the form of specialized business lines of larger Islamic banking groups seeking to diversify.
Islamic finance may be a relatively recent phenomenon, but the concept of Shariah-compliant investment banking (SCIB) is an even newer innovation. Just a decade ago, very few investors would have expected Gulf Finance House, Arcapita Bank, Unicorn Investment Bank or the Investment Dar to become major players in the Arabian Gulf’s financial landscape.
Some time before the crisis, these institutions were among the most profitable, innovative, dynamic and attractive wholesale institutions within the booming Islamic finance industry.
They diversified the sector by moving away from pure banking intermediation and into more sophisticated investment/merchant banking lines of business, like private equity, asset management, brokerage, infrastructure and structured real-estate finance, as well as advisory, corporate and project finance - thereby laying the groundwork for an SCIB sector.
These developments and innovations meant that - just before the crisis - Islamic finance was poised to enter a new era that would bring Islamic finance closer to the profit-and-loss sharing, asset-backed and real-economy financing ideals, which traditional Islamic universal banks had not previously been able to handle fully. Specifically, Islamic finance was on the cusp of moving beyond its sole focus on raising cheap Murabaha or Wakala deposits (so as to recycle them into safe, stable and expensive retail and corporate loans) - and to adopt a greater emphasis on risk-taking instead. However, the onset of the financial liquidity crisis prevented the dawning of this new era, and almost led to the collapse of the SCIB model.
Moody’s believes that the SCIB model still has the potential to re-emerge as a credible banking sub-sector, even though it has been tarnished by a succession of spectacular defaults. The SCIB concept looks set to evolve away from independent investment bankers setting up boutique investment houses toward the largest Islamic banking groups seeking business and geographic diversification. Indeed, the SCIB model is a useful vehicle to build up and boost business volumes at a time when basic banking intermediation is yielding incrementally lower margins and dominant Islamic banks are experiencing pressures in their home markets.
Moody’s does not currently rate any SCIBs.
Since mid-2009, Gulf Finance House (GFH), a leading Bahrain-based SCIB has been under negative market scrutiny. In 2009, it announced net loss of $728 million, against a $262 million profit in 2008.
However, by early 2010, it was on the verge of defaulting on a tranche of its $300 million Murabaha facility granted by West LB. It narrowly avoided default after arduous negotiations with the debt-holders.
In February 2010, the maturity of the tranche was extended until August 2010. This was eventually viewed as a selective default. GFH was then faced with the challenge of having to rapidly identify asset classes that could be sold within a six-month period in order to mitigate its liquidity issues.
GFH is not the only SCIB to have undergone difficulties. The Investment Dar (TID), a Kuwaiti investment house, defaulted in May 2009, followed by Kuwait’s International Investment Group (IIG) which defaulted in both April and July 2010. Arcapita Bank and Unicorn Investment Bank (UIB), both based in Bahrain, have managed to avoid default, but their liquidity, financial performance and capital base were put under tremendous pressure.
While the Islamic financial industry seems to have been resilient to the current crisis relative to their conventional counterparts, it is far from being a risk-free segment. The most affected line of business within the industry was undoubtedly that of investment banking. And yet, until 2007, SCIBs were portrayed by market participants as having significant potential, benefiting from cheap funding, high liquidity, exceptional profits and robust capitalization.
At the time, the combination of these four factors led them to pursue investments in riskier markets and asset classes - such as private equity, infrastructure or real estate, mostly in emerging markets ranging from the Maghreb to Southeast Asia. Some business was also booked in the private equity markets in Europe and the US.
While GFH focused more on infrastructure, Arcapita invested heavily in private equity, and both were eager to improve their asset-management capabilities. Moreover, some other SCIBs were beginning to discover the merits of unfunded business lines.
For instance, UIB, Liquidity Management House (LMH, the investment banking subsidiary of leading Kuwait Finance House) and Al Rajhi Capital (ARC, that of Al Rajhi Bank) further enhanced their advisory and structuring services, until they eventually became significant players in the GCC’s debt and capital markets.
However, when the region’s economy started to fracture under the stresses of the global liquidity drought, the pro-cyclical nature of SCIBs became more pronounced. The illiquid nature of their investments contributed to rapid asset-value declines at a time when their wholesale and short-term funding features were rapidly damaging their liquidity profile. This structural feature of SCIBs’ asset-liability management - which was once a benefit when ample liquidity was chasing too few assets - started to turn negative when too many impaired assets were available to serve massive liquidity withdrawals. After all, it is the business of an investment bank to invest long-term and take risks; but when funding is short-term and stresses are mounting sharply and rapidly, simple, traditional contingency plans become largely ineffective, except when an SCIB is backed by a parent with a large and sticky retail-deposit base. In addition, the crisis revealed that SCIBs also had heavy concentrations across the board, by name, sector, geography and business lines.
The outlook for Islamic investment banking is not necessarily bleak. Firstly, demand for investment banking services in the GCC remains robust, especially for those that are Shariah-compliant.
The GCC economies still have an appetite for ambitious investments in infrastructure, and especially in the energy, logistics, communication and transport sectors.
Within the power industry for instance, the inception in 2008 of First Energy Bank in Bahrain, which complies with the rules of Islam and focuses on renewable energy, signalled appetite for further specialization in the SCIB universe.
Secondly, the future of SCIBs is deeply correlated to that of the whole Islamic financial industry, which continues its unabated growth despite global and regional turmoil.
Although the whole sector has been affected by the liquidity issue, investors in the Muslim world continue to value Shari’ah-compliant services, as shown by the ever-growing market share of Islamic finance in Muslim countries. As a proficient vector of innovation and sophistication, SCIBs remain vital components for the modernization of Islamic finance as a credible alternative to conventional solutions.
Moody’s “believes that the SCIB model will incrementally mutate into specialized business lines of larger groups rather than stagnate as a collection of more or less successful independent boutique investment houses.” To overcome extreme market volatility, Moody’s said, SCIBs will require stable funding, which can only be provided by an existing base of sticky (retail) deposits. As governments and regulators are unlikely to provide support to institutions without a retail franchise and with high risk appetite, the solution is twofold: SCIBs will either resort to long-term funding - which we do not envisage in the short term given recent events - or obtain backing from larger, more resilient and benevolent parents.
This is also likely to inform the strategies of the large Islamic commercial banks that are seeking to diversify their business lines away from pure traditional banking intermediation. KFH, the second-largest Islamic bank globally, created its own investment-banking arm LMH in 2007. Other banks have adopted similar strategies: Al Rajhi Bank with ARC, and Dubai Islamic Bank (DIB) with Millennium Capital (now renamed DIB Capital).
Thanks to the liquidity made available alongside the parent’s safer funding mix, these investment banking subsidiaries/business lines can more easily weather unexpected ruptures in the economic cycle.
This highlights that the Islamic financial industry is not yet mature enough to host standalone investment banks, regardless of the powerful shield of their commercial parents, Moody’s noted.
By going universal, Islamic banks can begin to think of themselves as diversified financial groups that are better equipped to explore new horizons beyond the natural borders of their home markets.
“Overall, we believe that the strategic move of SCIBs acquiring larger, more diversified and established commercial Islamic banks offers the most promising potential.” - QJM