Ernst & Young's World Islamic Banking Competitiveness Report 2013 notes that global Islamic banking assets held by commercial banks are set to cross US$1.8 trillion this year, up from the US$1.55 trillion in 2012.This is significantly higher than some of the earlier industry estimates.
Globally, the Islamic banking industry continues to record robust growth, with the leading top 20 Islamic banks registering a growth of 16% in the last three years and Saudi Arabia emerging as the largest international market for Islamic assets (excluding Iran's banking industry, which has major limitations on international participants).
The top 20 Islamic banks hold 57% of the total global Islamic banking assets (excluding banks in Iran) and are concentrated in the seven core markets for Islamic banking, which include Saudi Arabia, Malaysia, Kuwait, the UAE, Bahrain, Qatar and Turkey.
The Islamic banking industry in Saudi Arabia with an estimated US$207 billion of assets was ranked first in 2011. Malaysia was ranked second with total assets of US$106 billion and the UAE third with US$75 billion.
In the new markets, Egypt has been actively pursuing the issues of sovereign sukuk as well as the development of a new regulatory framework for Islamic banks where several banks are expected to launch syariah-compliant products. Iraq is studying Islamic banking legislation while Libya is preparing to implement its Islamic banking framework.
A number of both established and new banks are considering introducing Islamic banking operations in these markets, highlighting the continued growth and development of Islamic banking throughout the Middle East North Africa (MENA) region.
Ten of the world's 25 rapid growth markets (RGMs) have large Muslim populations and present significant growth prospects for Islamic banking. The fast-growth economies now form almost half of the global GDP and remain the main contributors to overall global growth. The outlook for Islamic banking in these markets is bright.
Profitability still an issue
Despite the projected asset growth and the introduction of new Islamic initiatives in a number of countries, the profitability of Islamic banking continues to lag behind that of conventional banking in the same markets. Between 2008 and 2011, the leading ROE for Islamic banking was only 11.6% against 15.3% for conventional banking.
Islamic banks continue to face a number of issues that affect the profitability of the industry. These include subscale operations, very basic risk culture, incomplete market segmentation, low engagement with clients and an absence of technologically oriented value propositions.
In several markets, Islamic banks are significantly overexposed to the real estate sector. On average, almost one-fourth of their balance sheet is concentrated in real estate compared with 16% for conventional banks in the same markets.
During the years prior to the global financial crisis, Islamic banks were able to ride the boom in the real estate sector to generate high profitability. This performance hid many of the operating inefficiencies in those institutions, especially with regard to their core business.
The severity of performance challenge has prompted a wide-ranging transformation of business practices at several Islamic financial institutions, which is a welcome development. We believe this will see the industry take the next step in its evolution from being a niche market to a profitable, service-orientated industry attracting customers with its product innovation and value-added services. Discussions with management and boards of leading Islamic banks suggest that major transformation is happening around regulations, risk and retail banking (the 3 Rs).
These 3 Rs of transformation are geared towards capital planning, risk modelling, mitigating syariah risk and building customer-centric organisations. There are also meaningful developments on the regulatory front, although a lot more needs to be done to create the right enabling environment for Islamic banks to implement the reform agenda.
A well-executed transformation programme could take two to three years to be implemented and could improve Islamic banks' profitability by about 25%. Ernst & Young's estimate suggests that this would potentially improve returns to Islamic bank equity holders by an additional US$9 billion by 2015. But at the same time, there is a general consensus that a partial implementation will lead to complete failure.
Critics argue that no Islamic bank today can claim to have a truly international brand either in terms of market coverage or service excellence. However, there are 13 Islamic banks that have built up significant financial muscle, each with equity of more than US$1 billion, and they will decisively influence the future trajectory of the industry.
High potential international markets — each in different stages of development and therefore requiring different penetration strategies — include Saudi Arabia, Malaysia, Qatar, Turkey and Indonesia.
Mustafa Adil is a manager with Ernst & Young's Middle East and North Africa Islamic Financial Services in Bahrain. The views expressed are the author's and do not necessarily reflect the views of the global Ernst & Young organisation or its member firms. This is the third of a four-part series.
This story first appeared in The Edge weekly edition of Jan 7-13, 2013.