By Paul Wouters
Worldwide, the Islamic finance industry is developing rapidly. While it makes sense for the Islamic financial institutions to foster growth and to regularly compare themselves against the financial market as a whole, sometimes it is also worthwhile to keep an eye on developments in different countries.

It is easy to talk about “market shares” and “deposits”, but what do these terms really mean? And what can be expected in the near future? For a better idea, we will examine the Islamic banking system in some countries: Turkey, Indonesia and Pakistan.

Turkey and Indonesia are secular republics where Muslims form the majority of the population, but Islamic finance developed differently in the two nations. With a population that is roughly slightly over half that of both countries combined; the Islamic Republic of Pakistan is used as an outside comparator. To put all that into better perspective, the writer has included some data from Malaysia as benchmark.

Total Islamic Finance Assets – US$ mill
(Turkey, Indonesia, Pakistan and Malaysia)

Malaysia Turkey Indonesia Pakistan
Assets (US$ mill) 34,543 12,902 3,267 2,231
# of Islamic Banks 11 4 3 6
First licensed Islamic bank Bank Islam Malaysia (1983) Albaraka Turk
(1985) Muamalat Indonesia (1994) Meezan Bank
(1997-2002)
Branches (Islamic/
Participation bank, and brnchs of conventional bnks) 2,000 + 378
188
173

Potential market (ppn) 26.6 mill
60% Muslim 74.3 mill
97% Muslim 232 mill
85% Muslim 161 mill
96% Mulsim
Market share assets (%) 13% 3.25% 1.7% 3.2%

Source: Paul Wouters, Bener, Istanbul Turkey

Turkey

From the very start in 1985 with Albaraka Türk, the Turkish participation banks (before called Special Finance Houses) were poised to aim at the Turkish market as a whole. Therefore they did not really target the small niche of the “convinced” Muslim population in particular. This of course influenced marketing and product development.

Partly as a consequence of this strategy (and compared to Indonesia), the Turkish participation banks were able to flourish, and now they hold roughly 3.5 % of total assets in the country’s banking industry. It has outperformed its conventional counterpart for eight consecutive years now.

The collapse of Ihlas Finance House (2001 – alleged fraudulent insolvency) meant the loss of 40 % of the deposits held by the sector at that time and the subsequent stampede on the other Special Finance Houses (now participation banks) meant another 35 % loss.

Because of their ties to the “real economy”, the Special Finance Houses were not hit by the big financial crisis that hit Turkey in 2001 and they recovered fast. Their deposits now have been taken into the guarantee fund of the banks (to avoid other shock withdrawals) and the sector has acquired bank status.

Other differences to note: There is no specific government aid to the sector and nor is there (government or corporate) Islamic bond, although th eissuance of a government sukuk could be in the making, so it has been rumored for some time now. The talks on the projected rent (Ijarah) certificate are progressing slowly, due to inactive local financial markets, cheap conventional international funding and political factors.

Neither is there access to money markets, so we can hardly talk about a level playing field, as compared to conventional banking.

As there are no Islamic windows, foreign players can only enter the market via shareholdings in existing participation banks (or have to start their own participation bank from scratch.) A well thought off strategy of decentralization – for instance using techno / tax incentives and privatizations – created upcoming of several bigger conglomerates throughout the country.

Indonesia

In the world’s most populous Muslim nation, with its first established Bank Muamalat Indonesia (together with Bank Syariah Mandiri still today front runner), the situation differs profoundly. From the start, products and marketing were targeted at that very same group of “convinced” Muslim (market share of roughly 1.5 %).

Whilst the current impressive government initiatives aim to broaden that base (a potential “floating market” of approx. 75 % of the population would be within reach), Bank Muamalat confirms to adhere to its strict policies and target market. This means the other Islamic finance market players could see greater potential for growth.

The need to mobilize internal capital and attract foreign investments require special measures, and so Bank Indonesia announced in July 2007 that, subject to full implementation of the “blue print for development of the Indonesian Shari’ah Banking system”, total assets of the Islamic banks (and Islamic business units) are expected to triple by the end of 2008 (growth of approx. USD 6 billion) to reach an overall volume of 5% on the total Indonesian banking assets. When deposits/ loans follow same development, it will be clear that opportunities are at hand (growth potential of approx. USD 5 billion).

Foreign banks have yet to make their presence felt in the Indonesian Islamic finance market. HSBC was the first big international institution to establish a Shariah head office in Jakarta. The projected growth potential is enormous: HSBC calculated that roughly half of their clients would be willing to use the products if priced competitive. Recently, Albaraka Group announced the intention of expanding its a branch there.

The first government Sukuk (plans to raise up to USD 1 billion have been announced) is in the pipeline. Actual issuance could however be postponed till the fourth quarter of 2007 or even the first quarter of 2008, pending parliamentary approval. Indonesia alreday recognizes corporate Ijarah and Mudharabah Shari’ah Bonds.

Conventional banks that want a piece of the “Islamic pie” need to dedicate 5% of their assets to such venture. This commitment, together with other incentives, will be instrumental to the rapid growth over the next two years.

Pakistan

From the late 70s onwards, Pakistan has had a protracted history of Islamic banking. Beginning 1st July, 1985 all commercial banking in Pakistani rupees became interest free. The sudden conversion (and lack of preparedness) posed difficulties for the implementation of this practice.

However, from 2001 an evolutionary process was in place in order to nurture acceptability and development in a more structural approach. The first “Islamic bank license” was awarded to Meezan Bank back in 2002 (founded 1997).

Most note worthy is the present Islamic Banking Policy (December 2001), under which Islamic banking is promoted parallel to conventional banking. Implementation of set by the Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI) and Islamic Financial Services Board (IFSB) is under way.

Image: Meezan Bank ’07 Annual Report

Besides a draft for the new Government Securities Bill, Draft Risk Management and Draft Shari’ah Compliance guidelines have been published.

A growth of 40% per annum is expected and a % 15 market share is targeted. Conventional banks are allowed to operate Islamic bank subsidiaries or even “standalone Islamic banking branches” along-side full-fledged Islamic bank. A vast concentration of Islamic banking in the cities (Karachi and Lahore) is evident. There are government and corporate Sukuk on the market.

In 2007 ABN AMRO opened an Islamic branch, Emirates Global Islamic Bank has started a dedicated Islamic commercial bank and QATAR Islamic bank has confirmed plans to setup a Shari’ah compliant banking unit soon. Citibank was another big foreign entry.

Malaysia

Starting off with Bank Islam Malaysia in 1983, Malaysia now has separate Islamic legislation and banking regulations that co-exist with those for the conventional banking system.

In order to create an efficient, progressive and comprehensive Islamic financial system, Bank Negara Malaysia recognized the need to attract a large number of global players; develop a variety of instruments and, install comprehensive financial infrastructure.

Image: Bank Islam ’07 Annual Report

Malaysian banks currently offer more than 100 of Islamic financial products and services that use various Islamic concepts – such as Mudharabah, Musharakah, Murabahah, Bai’ Bithaman Ajil (Bai’ Muajjal), Ijarah, Qard, Istisna’ and Ijarah Thumma Bai’ — alongside the Islamic Interbank Money Market.

Probably subject to pressure from the Dubai International Financial Center, Malaysia recently opened up regulations to allow sukuk issuance in foreign currencies and is competing with Singapore to be the prime Islamic finance hub in the Asian region. Hong Kong has decided to join the race as well.

Observations

First of all, it has to be noted that real entrance of foreign investments in Turkey, Indonesia and Pakistan still bounces on inadequate tax regimes.

Though it is difficult to distract far-reaching conclusions from the accompanying table, at first glance, it is clear that both Malaysia and Turkey share the following characteristics: relative big concentration of the population in bigger cities, lower portion of population working in agriculture and a lower weight of that sector in the overall economy. The GDP per capita (calculated in relative purchase power – not in hard dollars) in Malaysia and Turkey also is two to four times higher then in Indonesia and Pakistan.

Also in Indonesia and Pakistan, Islamic finance flourishes first in the big cities and then branches out to smaller concentrations of the population while the rural areas (probably due to lack of cash) appear to be dependent on micro finance.

In both countries, the agriculture sector appears to attract socially important (statistically less so for the total economy) “rural Islamic banks” targeting micro finance. There is no such sector in Turkey (neither conventional or Islamic.) Only recently, initiatives from the United Nations Development Program have been undertaken to introduce microfinance on a sustainable basis there.

Neither the percentage of the Muslim population (in Indonesia, Turkey, or Pakistan), nor the respective governments’ zeal to promote Islamic banking (in Indonesia, Pakistan) appears to be a determinant for success so far.

A marketing strategy of the Indonesian Islamic banks proved to be successful for the loyal but small niche of the “convinced” Muslim population, but did not succeed to appeal to the “public at large.

Admittedly, Turkish participation banks are at a serious disadvantage because of the above mentioned differences from the conventional system (lack of sukuk and money markets, limited products, no government incentives and no Islamic windows.) Nevertheless, they prospered thanks to the neutral banking approach focusing on financial advantages, with slight emphasis on ethical merits.

Looking at the mix of relevant measures applicable to the different countries, perhaps the following can serve as guidelines in contributing to the success of Islamic banking:

dedicate sufficient means to Islamic rural banking / micro finance for agricultural areas
create a level playing field in order for Islamic banks to compete with conventional banks (for instance, access to Sukuk and the money markets), without any specific need to issue prime conditions (that also distort the market)
open up markets for international institutions (this attracts financial power and innovation)
ensure possibilities for all financial institutions to create Islamic windows and/or branches (better product awareness and overall acceptance of Islamic banking would benefit the dedicated Islamic banks)
ensure conventional banks that want access to the market commit sufficient means from the start (the need to dedicate assets enhances market growth)
promote diversification of products (diversity is one of the handicaps of Islamic finance vis-à-vis the very mature conventional counterpart)
try to spread wealth from existing bigger cities to smaller ones but do not focus on the existing metropolises
try to create sufficient liquid financial markets and stock exchanges, if necessary through strategic alliances
give sufficient attention to international accounting standards, (corporate) governance, transparency and accountability
build strong prudential controls
give bank status and deposit protection
without loosing sight on the underlying Islamic principals, focus on market competition, quality of products and pricing thereof.
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The author, Mr. Paul Wouters is a lawyer at the Antwerp Bar Association (Belgium) and consults BENER Danısmanlık A.S., Yapı Kredi Plaza, C Blok, Kat:1, 34330 Levent-Istanbul, Turkey;
Tel +90(0)212 325 02 32 / ext 127; Fax +90(0) 325 10
66; Mobile +90(0) 535 656 23 24; Email: Paul.wouters@bener.com.tr.

The article first appeared in IslamicFinanceNews.com. Reproduced with Permission of Author.