Gaining critical mass

Spurred on by Islamic banking’s meteoric rise, Islamic trade finance is coming of age, write Nicholas Noe and Ali BouMelhem.


During the late 1990s the Islamic banking (IB) industry really began to take off as a result of a confluence of several factors.

First and foremost was the region’s pent up oil wealth and a growing recognition that such wealth should be invested closer to home. Second, the decade of the 1990s saw an increasing focus, indeed an out and out Islamic revival especially when it came to adhering to sharia (Islamic law) principles.

But perhaps the most important driver for the sector was the new breed of educated sharia experts deeply familiar with both Islam and modern banking structures.

“The industry started growing so fast because scholars [were] now connected,” says Jamil Jaroudi, deputy general manager at Lebanon’s Arab Finance House.

“Not to undermine previous scholars? but the previous ones may not have known, and would have ruled a certain instrument was haram (unlawful), perhaps because of a lack of knowledge. It was better for them to stay no than yes. The modern scholar, in contrast, goes and researches the fatwa (religious ruling), and says yes you can do this under this school of thought (there are four in all). This is what has pushed the industry forward in the past few years.”

By the numbers

Pushed forward might just be an understatement. Further buoyed by the post 9/11 environment which encouraged regional wealth to stay put, the General Council for Islamic Banks and Financial Institutions reported in early 2007 that worldwide assets for Islamic banks (IBs) and Islamic banking financial institutions (IBFI) as a whole stood at over US$260bn, with financial investments totaling more than US$400bn.

Year-on-year growth rates for the sector over the past seven years have averaged almost 15% helping to bring the total number of IBs and IBFIs to 267 in 2006, up from 176 in 1997.

One recent Standard & Poor’s (S&P) review provided particular fodder for market watchers: the sector could be worth as much as US$4tn. Indeed already, Islamic equity funds exceed US$300bn in value (growing an average of 25% annually over the past seven years), while Islamic sovereign and corporate sukuks (an instrument similar to bonds) have reached US$50bn.

According to one prominent IB, Al Baraka Bank, the Islamic share of banking activities specifically in the next decade is expected to rise to 50% of all bank activities in the Arab world.  That’s largely because, according to one recent conference presentation by Nasser Saidi, chief economist of the Dubai International Financial Centre, only about 20% of the Muslim population in the oil-rich Gulf Cooperation Council (GCC) countries buy sharia-compliant financial products currently.

According to S&P, the figure is even less, 10%, as far as the banking practices of the entire worldwide Muslim population is concerned. Which is to say nothing of the percentage of companies and wealthy individuals in the Middle East across to Southeast Asia who rely on conventional banking and finance instruments – or the fact that two thirds of all IB users in Malaysia, the main hub of the sector, are actually not even Muslim.

Western institutions pushing the sector

Of course, all of this points to a larger aspect underlying the rise of IBFIs. As regional Islamic finance experts and trade groups are the first to point out, the main driver for innovation and growth in the sector has come from some of the major institutions in the western world. At the same time, demand has recently been propelled by non-Muslim companies looking for some of the cost and risk advantages that sharia-compliant instruments can bring to the table.

As the Organization of Islamic Countries (OIC) puts it, Islamic institutions (and to a lesser degree investors in the Islamic world) have tended to be “inward-looking”. Given the growing demand from Islamic investors for financial products, it is the efficient and aggressive banks – whatever their origins – that are likely to win, the OIC adds.

And indeed, as the roster of high-profile names in the sector suggests, western banks are taking the lead in that competitive scramble – although, especially in the last year, major non-western institutions like Saudi Arabia’s Al Rajhi Banking and Investment Corporation (Arabic) and Kuwait Finance House (KFH), among others, have made significant gains in pushing new products to market.

Citibank, Dresdner Kleinwort Benson, HSBC and JPMorgan Chase all are now strongly involved in the IBFI sector and are variously wielding all types of sharia-compliant financing instruments, including even the more recent and controversial introduction of sharia-compliant derivatives and hedge funds.

In June 2006, Lloyds TSB announced that it would be offering Islamic financial services at all of its branches in the UK.

Deutsche Bank, too, has opened a dedicated pool of money for its Islamic business, headquartered in London. It acted as a joint bookrunner for a US$500mn sukuk for the Islamic Development Bank (IsDB) through a uniquely structured ‘trust certificate issuance programme’.

Dow Jones and the London FTSE also have well-trodden Islamic market indexes. In April 2006, Dow Jones and Citigroup Corporate and Investment Bank launched the Dow Jones Citigroup Sukuk Index that seeks to measure the global performance of sukuks in complying with Islamic investment guidelines.

Amid all the activity, UK chancellor of the exchequer Gordon Brown in the summer of 2006 told the Muslim Council of Britain that he wanted to make the UK “the gateway to Islamic finance and trade”. The first standalone sharia-compliant bank in the UK, the Islamic Bank of Britain, was set up in 2004.

According to industry analysts, by 2007 an estimated US$20bn of specifically Islamic trade finance had been arranged through London annually, much of it for blue-chip multinationals and regional corporations.

This is still small globally in comparison to conventional financial counterparts however.

In fact, partially because major western players have seen the boundary-pushing Islamic project finance (IPF) arena as both more profitable and higher profile (involving the use of options and derivatives), some institutions which nevertheless engage in substantial ITF activity tend not to want to highlight such activities.

As one major German-based financial institution says: “We only take a reactive approach to such [trade-based] transactions as opposed to a proactive one.”

In other words: if a trade deal comes, then we might just take it. But we don’t go out looking for them.

Do such responses mean that some of the majors might be missing the boat when it comes to the Islamic trade finance market?

Perhaps. But for IBFIs that are through-and-through sharia-compliant – ie, not just with an Islamic window or a segregated branch – ITF is critically important, and should be even more so in the future.

“There is a massive amount of short-term liquidity in Islamic institutions that needs to be invested in something,” explains Michael Gassner, managing director of Michael Gassner Consultancy. “It is either trade or [project finance] in companies. Trade finance, by its short-terms nature, meets this need perfectly? It involves real assets not nominal ones (one key for being sharia-compliant) so this can really be done well.”

Islamic trade finance instruments

Doing sharia-compliant trade finance well, however, generally involves costs and operations above and beyond traditional trade finance – which means that Islamic trade finance is both more complicated and potentially less profitable.

Thus, although many of the risk mitigation tools used in both structured trade and project finance have strong similarities with various structures that have evolved in Islamic finance, the supply side, or the instruments made available by IBFIs, tend to be supported more by a desire on the part of institutions to propose Islamic financing to clients which can then translate into a competitive edge overall.

On the demand side, according to one 2006 UN Trade and Development report, “those that are able to tap into Islamic financing markets can obtain relatively low-cost capital”.

Of course, this is not always true. But more than a relative cost saving, a growing number of clients simply want to ensure a sharia-compliant transaction.

In that case, several instruments are available for structuring trade deals. All must, however, fall in line with a number of basic Islamic precepts that fundamentally revolve around the necessity of taking and sharing risk through the possession of real assets.

Although interest taking is therefore prohibited first and foremost in favour of asset-backed, partnership arrangements, this particular element is not the only one that makes a deal sharia-compliant.

Islam also prohibits trading excessive financial risk (gharar), with such activities regarded as gambling. Additionally sharia prohibits investing in businesses that are considered haram – those that sell alcohol or pork, or businesses that are engaged in gambling or produce un-Islamic media.

As a result, it is generally accepted (generally, because there is no single interpretation of what is permitted, and, in any case, each IBFI has its own sharia board), that deals are only undertaken with a business whose interest income is less than 9% of total income and/or who holds a ratio of debt to total assets lower than 33% of total assets.

With these prohibitions and benchmarks as a basic foundation, four instruments for financing trade are employed in the Islamic market: murabaha, bai al salam, musharaka, and istisna. According to a recent book by World Bank official Zamir Iqbal and IMF executive director Abbas Mirakhor – An Introduction to Islamic Finance: Theory and Practice – close to 90% of all Islamic trade financing is currently based on murabaha, with more than half of the assets of some Islamic banks invested in murabaha transactions.

As a result, murabaha deals have received a special focus and refinement over the years. Under the simplest construction, murabaha is a cost-plus-profit sales contract, whereby a financier purchases a product or raw material for an entrepreneur who lacks the capital to do so. The banker and the entrepreneur agree on a profit margin, often referred to as a mark-up, which is then added to the cost of the product. The goods are purchased by the bank, via the borrower, who is appointed as the bank’s agent, and then resold to the borrower. The payment for the transaction is delayed for a specified period of time.

In general, murabahas are used in conjunction with letters of credit (although the equivalent to ‘cash against documents’s is also used) and normal documentary credit collections, with the banks also charging a fee in the process.

Although the bank is supposed to, and sometimes does, literally take possession of the goods (in Sudan, for example, agent arrangements are not allowed), the borrower, as the appointed agent, can also be used as the sole holder from purchase point.

The critical issue, however, is that of the mark-up, which is a function of the time between the moment that the bank buys the good and the moment(s) the buyer pays the bank. According to one UN report, “Although to Islamic scholars, this is not an interest rate, most banks will actually determine the mark-up on the basis of the interest rates prevailing in international markets – after all, Islamic banks do not operate in a vacuum but have to compete with interest-charging banks, both to attract depositors and to attract borrowers.”

In any event, banks have to take some risk of loss on the assets in order for the murabaha to be valid.

“It is a little bit more risky than conventional trade finance,” says Yakub Bobat, global head of commercial banking at HSBC Amanah, one of the first international banks to introduce Islamic trade finance services for the commercial market in 1998. “But there are mitigants – such as an immediate transfer of the assets from the banks to the customer. Plus you have the promise of purchase, and if you are financing oil, you have insurance which mitigates these things from a credit perspective.”

“The other way to look at it,” he adds, “is that ownership of the underlying asset makes the deal more structured and more secure from the perspective of you owning the underlying asset in theory and through the contract.”

In practice, sharia courts have also allowed banks to restrict the possible extent of any possible losses by putting a maximum value on damages, and limiting the possible sources and time period of loss through disclaimers.

But here too, questions remain, since in most cases, sharia courts have not permitted a bank to exact extra fees because of a delay in payment – although they are permitted to exact such a fee if the entire amount is then transferred to a charity.

In Pakistan, however, banks have introduced a mark-down, thus giving time-limited rebates as an incentive for early payments. Courts there have allowed for an extra mark-up for delays – which essentially comes to resemble interest charges for late payment.

Perhaps not surprisingly then, it was Pakistan that took the lead in mitigating another risk – time – through what is known as an istijrar. Introduced in the late 1990s, this allows the bank’s return to depend on the various prices of the goods during an agreed upon period between the delivery of the goods to the buyer and the maturity date of the istijrar.

In this sense then, as the UN report points out, “istijrar can be compared to the rather complex ‘knock-in’s options used in some financial markets. In effect, both bank and buyer have the option to fix prices at a set level (the same for both of them, and equal to the price that the bank would have charged under a murabaha transaction), but this option only becomes active once prices have moved outside of certain agreed boundaries.”

The second ITF instrument commonly employed is bai al salam. Essentially, salam is a simple pre-paid forward sale used especially for seasonal agricultural purchases. However, it can also be used to support commodity purchases where the seller needs working capital before he can deliver or even, produce. The instrument differs from the limited recourse prepayments common in the west since the bank, and not the trader is making the prepayment.

Interestingly, salam has proven especially useful to project finance in addition to trade finance since it can involve items which do not yet exist. When combined with other Islamic financing techniques, it becomes possible to enter into a kind of futures trading permissible under sharia.

The final two instruments used by IBFIs to far lesser degrees are musharaka and istisna. In the former case, the activity resembles venture capital: to compensate the high risks it is taking, the bank requires a relatively higher share of the profits and becomes, in effect, much more of a managing partner. Musharaka can also be used for financing imports under an LC, with deferred payment terms for the importer, but with the bank retaining a far higher mark-up ratio and greater involvement in the entire operation.

With istisna, the instrument employed by banks is similar to salam, in that it constitutes a simple pre-paid forward sale. However, while salam is used for commodity trade, istisna applies to goods that need to be manufactured. And while salam requires a full upfront payment, in istisna, payment can normally be made at various stages of the process. Moreover, the time for delivery of the product need not be fixed in advance. As such, istisna can be used as a form of pre-export finance, with the bank buying all the goods for which an export contract has been established.

Challenges and horizons

All four instruments pose challenges to both IBFIs as well as conventional FIs who wish to enter the Islamic trade finance marketplace.

One particular problem native to all four instruments is that the mere presence of sufficient collateral is not sufficient for a transaction. In contrast, an extensive evaluation of a borrower’s business is required, which, as the UN report points out, “can slow down financing decisions, and disqualify borrowers without much of a track record, thereby stifling economic growth”.

Added to this is the problem of how to give the flexibility of variable interest rates, since financing is generally made on a basis equivalent to fixed interest rates. As one industry report recently says: “It is not clear whether borrowers can swap out of such a position, but if not, fixed interest rates (in an environment where most companies have the possibility to actively influence the rates they are paying) may seem at times somewhat unattractive.”

Nevertheless, “Islamic trade finance is our bread and butter,” says HSBC’s Bobat. “It is an efficient contributor to our overall Islamic finance activities and it is a key driver of the Islamic banking pie as a whole.”

While that appears to be the general sentiment among those involved in ITF, the truth is that the sector will only become an indispensable driver of growth if it is matched up with the far more ambitious tools now being pioneered by Islamic project finance.

“Frankly,” adds Bobat, “the industry needs to move away from commodity murabaha? Historically there has been a lack of a comprehensive product suite, but this is fast developing [and now] you have rollouts across markets.”

“You will see,” he predicts, “the industry gaining critical mass.”