Islamic trade finance banks are going mainstream, looking to offer conventional banks and corporates a new source of liquidity, writes Rebecca Spong.

“Islamic trade finance can be an integral part of global trade finance – there is no reason for it to sit outside international trade finance,” comments Massoud Janekeh, director, corporate banking at Bank of London and the Middle East (BLME).

Janekeh is one of many London-based Islamic finance bankers keen to see shariah-compliant trade financing instruments become more mainstream, acceptable to conventional banks and corporates, as well Islamic businesses.

Indeed, he believes that the current market conditions offer the ideal environment in which to really accelerate the expansion of Islamic trade finance.

With liquidity still relatively constrained, the Islamic banks are positioning themselves to provide that additional injection of cash.
“As other banks deleverage, this helps accelerate growth in Islamic finance, as it is a new source of liquidity,” comments Akbar Ahsan, head of origination at European Finance House (EFH) in London.

Ehsaan Ahmed, head of global transaction banking (GTS) at Noor Islamic Bank in Dubai remarks: “Larger corporate players have lines with multiple conventional banks, but these might not be enough given the current climate.

“But there are now more Islamic banks in the market than a few years ago, and these corporates may be approaching these banks in addition to conventional banks.

“So I believe there is an increased appetite for Islamic finance on the trade side.”

BLME’s Janekeh adds: “The liquidity situation in the market has not softened significantly and there are a lot of corporates looking for diversification. Most client meetings are looking at how to diversify funding sources.

“Islamic finance is an untapped funding source for them – a source they’ve heard about, but they don’t know how to access it.”
Indeed, the appeal of Islamic finance in general was demonstrated at the end of 2009 when GE was the first US corporate to float a sukuk bond on the Malaysian bursa, and the US$500mn issue was twice oversubscribed.

However, it is London that is striving to be the centre for Islamic finance, being the only European country with five licensed Islamic banks (Gatehouse Bank, Bank of London and the Middle East, European Finance House, European Islamic Investment Bank and Islamic Bank of Britain) and having implemented tax regulations that support the growth of this sector.

As Richard Thomas, CEO at the shariah-compliant Gatehouse Bank in London comments: “It is good to see the market returning to Islamic finance, and I believe London will be the centre for intermediating access to this type of finance.”

Providing liquidity

The Islamic banks are keen to promote their trade finance business to a whole spectrum of borrowers. Bankers remark to GTR that there should be no problem for large trading companies such as Trafigura or Glencore to raise some of their financing through Islamic instruments.

Equally, there are opportunities to support the small and medium-sized markets (SMEs), those borrowers potentially overlooked by the conventional banking sector.

Understanding Islamic trade finance should come easy to those already familiar with conventional trade finance, argues BLME’s Janekeh.

“Islamic finance fits well with trade finance. The trade finance contract is a very Islamic contract. It is a trade, you buy and then sell at a higher value, and that is essentially what Islamic finance is under a murabaha sale.

Islamic trade finance comes in many forms, but one of the more familiar structures is the murabaha instrument.

Also known as cost-plus financing, a murabaha is a contract for the sale of goods on deferred payment at a price which includes a profit margin agreed by both parties. The goods are sold, and the title immediately passes to the client with a fixed mark-up profit.
Deferred payment, usually in instalments, is specified in the contract, and the increase in the sale price is not allowed even in the case of late or non-payment.

Typically, instruments such as murabahas are short-term, like traditional trade finance, and do not allow for speculation, something prohibited by Islamic principles.

At BLME, Janekeh explains that there are many ways the bank can work with conventional banks and corporates. He is able to issue letters of credit under UCP 600 as well as accept deferred payments from conventional banks.

The bank can also co-fund trade deals with conventional banks where there is an underlying trade taking place.
Islamic banks can also participate in large-scale financings where the deal includes an Islamic tranche.

Non-Islamic banks are also able to join a shariah-compliant finance transaction. “There is nothing stopping conventional banks in participating in Islamic finance,” Janekeh asserts.

“Our role is to integrate Islamic financing into a wider trade finance market.”

But it is not only the conventional banking market that can benefit from Islamic finance. BLME has worked closely with UK corporates and has, for example, provided a murahaba to a UK steel manufacturer. This involved the manufacturer acting as an agent for the bank in procuring raw material, which is delivered to the manufacturer and the supplier invoices the bank.

A deferred payment obligation is produced allowing the manufacturer to finance its stock requirement, giving it time to buy raw materials and produce finished goods.

Through this structure, BLME aims to provide its client with short-term financing that helped support its cashflow and working capital needs.

Raising liquidity

Islamic banks are also looking to boost their trade finance activities to increase their own supply of liquidity, with many banks looking to establish Islamic trade finance funds.

“Islamic banking needs trade finance as it has recognised it as a source of liquidity management. It is on the agenda of all Islamic banks to grow and develop this market,” observes BLME’s Janekeh.

One of the obstacles to the growth of the Islamic finance market as a whole is the limited number of liquidity sources the industry has access to. In contrast to conventional banks, Islamic banks do not have access to the money markets; they don’t deal in risk management tools such as derivatives, and there is no central public bank they can do a repo with.

Islamic institutions also have a significant exposure to property, often their preferred asset class, which are usually long-term assets and therefore the banks are not able to easily tap into this source of liquidity.

But as the Islamic finance industry grows, banks will require regular liquidity inflows to finance their expansion.

By building up a solid portfolio of trade finance transactions, the banks has the opportunity to create this supply of liquidity.

Trade finance is seen as a relatively safe means of raising money, promising regular returns of an investment. Due to the fact that each trade deal has its own credit features and underlying trade, the investor can be selective in terms of what it wishes to finance.
“If you wish, you can invest only in high investment assets. It allows you to select where your risk appetite is,” remarks BLME’s Massoud.

Some banks are also looking at creating funds dedicated to Islamic trade finance. BLME set up a dollar income fund last July, the largest shariah-compliant money market fund in Europe. It was initially set up to invest in diversified portfolio of Islamic instruments such as sukuks and Ijara (leasing of assets), but the bank has now created a mechanism to book trade finance assets within the dollar income fund that are investment grade-rated.

Following this, BLME is looking to create a fund dedicated to trade finance assets, potentially set to launch early next year.

Gatehouse Bank, another London-based shariah-compliant bank, is also investigating the possible launch of an Islamic structured trade finance fund. The fund is to be launched in conjunction with an Islamic market intermediary company DDCAP to invest capital in structured trade finance transactions. It is currently still in documentation stage.

Step back in time

Islamic trade finance banks are not only squeezing themselves back in the market as an additional provider of liquidity. They are also in the position to meet the growing need for safer, more secure and perhaps even more ethical forms of financing.

Richard Thomas, CEO at Gatehouse Bank comments: “What we are seeing in today’s market is a renewed focus on providing better trade finance rather than just cheap corporate lending. It is this trend that is allowing Islamic finance back in.”

In a post-crisis era there is much emphasis in trade finance markets in only financing true trade deals, meaning that there is an underlying contract or trade relating to each transaction.

The large unsecured syndicated debt facilities are now far rarer. Banks want to know what their money is being used for, and in the event of non-payment, what security they hold.

Islamic finance, with its focus on financing assets, arguably fits with this new approach.

Thomas elaborates: “People call Islamic finance more ethical, but what it is, is very practical. It is about doing real business. A trading company can get support to trade goods, the money goes in to buy and then sell something, a profit is made, and the money is recycled. You don’t get a lot of inflation.

“What Islamic finance does not like is when you start multiplying money though loans used for speculation not trade. Islamic finance keeps money in the real economy.”

Thomas began his career back in the late 1970s in merchant banking, and found himself moving into Islamic finance after becoming disillusioned with how the traditional markets were developing.

He saw Islamic finance as a closer fit to traditional trade than the new debt financing model moving into Europe from the US during the 1980s.

With huge cheap debt facilities being raised for corporates, traditional trade was being marginalised. “I didn’t like what I saw happening in my industry,” he remarks.

He adds that a lot of trade finance skill was lost during this era, and sees this current gap in expertise as something the Islamic finance industry can move into.

“Islamic trade finance is not a new thing, it is a return,” he concludes.

Tax issues

However, there are some obstacles Islamic banks will face as they return to the market.

One issue highlighted by the main Islamic players is the lack of standardisation in terms of documentation across the industry.

Ahmed at Noor Islamic Bank elaborates: “One challenge facing the market is on the risk sell-down side. Master risk participation (MRP) agreements have been standardised for conventional banks, but this has not happened for Islamic finance banks.

“The reason for this is that shariah boards for each bank have differing views on how this MRP should be constructed. There is no standardisation across the sector.”

As yet, there have been fairly minimal efforts to bring standardisation to the market, but without a coordinated effort, potential clients are likely to be put off by this complicated and possibly more expensive financing.
Janekeh at BLME argues that the market has to work with the larger established banking players to improve products and standardise documentation procedures.

The market is also constrained by taxation regulations that are perceived to put Islamic finance at a disadvantage compared to conventional banking.

The UK has, however, been leading the way in tax reform, with the previous Labour government keen to establish London as the European gateway to the international Islamic finance market.

New regulations include measures that prevent murabaha transactions being penalised by corporation tax, allowing the trading profit (or financing charge) to be treated in terms of taxation the same as interest in a standard loan.

Despite such reforms, BLME’s Janekeh believes there is more work to be done in terms of VAT charges.

“The issue of VAT, which is under a EU directive, has not been specificall addressed.

“This means if an Islamic bank pays VAT on the purchase of goods in the UK, and for whatever reason is unable to fully recover the VAT on resell (for example on an export sale) then it is at a disadvantage over conventional finance.”

BLME is leading the lobbying efforts within the industry to ensure the UK government recognises these issues.

The early enthusiasm at government level in the UK does seem to have diminished.

There was talk of the country issuing a sterling sovereign sukuk, making it the first western country to do so. But plans were postponed in 2008.

Other nations are now keen to overtake the UK as a pioneer of Islamic finance, with France busily introducing tax changes and debating the possible issue of a sukuk. Asia is also pitching itself as a hub for Islamic finance.

International ambitions

The continued expansion of this market will to a certain extent depend of political backing of national governments, but it also relies on all the Islamic banks to work together to encourage more clients to turn to them as a source of trade financing.

As BLME’s Janekeh argues, there should be, “no fear or barrier in using Islamic finance. Customers should not think they are taking a risk on using Islamic finance”. GTR


New lows for Islamic finance

Islamic banks’ ambitious growth plans in shariah-compliant trade finance are developing against a backdrop of falling volumes of Islamic finance.

According to Dealogic, Islamic financing reached US$4.9bn in the first half of 2010, a drop of 17% from US$5.9bn in the first half of 2009.

Despite this drop in volume, the deal count has increased to 13 completed deals in the first half of this year, compared to nine in H1 2009. Although this total still falls far lower than the 26 deals signed in H1 2008.

The most recent loan including Islamic financing tranches was signed in June for the Saudi Aramco Total Refinery and Petrochemical Company. The US$6.9bn facility included Islamic loans totalling US$1.4bn. Proceeds of the loans are being used to support the construction of a 400,000 barrels per day export refinery in Jabail, Saudi Arabia.

HSBC was the top Islamic finance mandated lead arranger, taking a 19.8% market share. Standard Chartered closely following with an 18.3% share.

Data released by Bloomberg has also shown a slump in Islamic syndicated loans, citing a five-year low for the Europe, Middle East and Africa regions. This fall is in part due to the overexposure to the property sector by Islamic banks, with some real estate companies facing severe challenges when looking to refinance.

The Islamic finance industry itself has also had to grapple with the restructuring of the Nakheel bond in Dubai.

However, some banks believe the market will rebound in the coming 12 months. Jawaad Chawla, director of Islamic finance at Standard Bank, based in Dubai, predicts a recovery: “There are a number of potential issuers [of sukuks] coming to the market, in particular the market benchmarks will be set by a continued resurgence in sovereign/quasi-sovereign issues rather than those from corporates for next 6-12 months.

“One would expect to watch for sukuks this year, and then next year hope for the revival of the Islamic syndications market. The sukuk market should be the flag bearer of revival.”