Islamic banking can no longer claim immunity from the global financial crisis now that it is hitting the industry’s main source of funding and property values in the Gulf Arab region.

The industry escaped the immediate fallout from the crisis as its ban on interest and its lack of structured products prevented it from investing in the assets that turned toxic for conventional banks.

In a report issued last week, debt rating agency Moody’s said Islamic financial institutions in the Gulf showed strong resilience during the global financial turmoil, but that they are not risk-immune due to a shortage of liquid instruments and the lack of an Islamic interbank market.

The ratings agency expects growth in Islamic banking assets to slow sharply in 2009, to around 10 to 15 per cent from a range of 20 to 30 per cent this year.


Islamic banks now stand in the same firing line as their non-Islamic counterparts, facing a slump in equities valuations and a slump in Gulf real estate, to which they are heavily exposed.

Even though Islamic banks avoided the speculative investments and complex financial instruments that derailed Western banks, their balance sheets still show a mismatch between assets and liabilities, and they depend more on short-term maturity liabilities than conventional banks.

At the end of 2007, only 10 per cent of Gulf Arab Islamic banks’ liabilities were bonds and other long-term liabilities, compared with 23 per cent at conventional banks, according to McKinsey & Company. “There is a need to diversify our funding sources, we still typically depend on retail deposits,” said David Pace, chief financial officer at Bahrain-based Unicorn Investment Bank.

As liquidity has dried up in a region spoiled by high oil revenues, Islamic banks need to diversify their products and better manage the cash they have on their balance sheets.

Islamic hedging products, derivatives, liquidity- and risk-management tools are all in early stages of development. But developing new products is an arduous process, as Islamic scholars need to approve their compliance with Sharia.

Just as the biggest financial crisis since the 1930s has hit banks worldwide, the industry is soul-searching in a key segment, Islamic bonds, or sukuk.

Sukuk issuance this year has dropped 60 per cent from 2007, as a debate over whether some types of sukuks are compliant with Sharia has added to the liquidity drain.

Testing time

Although the industry has been viewed as more crisis-proof due to the asset-backed nature of its transactions, that theory is increasingly being tested by economic and legal realities. There are also structural impediments.

Islamic property lenders, under the ijara and diminishing mudaraba deal structures, acquire formal ownership of the property serving as loan collateral and then lease it to the customer. While the ijara deal is a simple leasing structure, property ownership under the diminishing mudaraba deal is gradually transferred to the customer over a fixed period.

“Do you have a legal protection from the authorities [in an ijara deal] that in case of a default you simply go there and say, ‘Mr. So and So, get out!’, or do you still have to go through lengthy procedures to enforce the right [as with a conventional mortgage]?,” said Jamal Abbas Zaidi, chief executive officer of the Islamic International Rating Agency. “I have not seen this tested at any of my customers as yet. It has to be tested in the courts to see how it functions,” he said.

Unicorn’s Pace said that very few sukuks have actually reached maturity yet.

“It worries me that there’s billions of dollars worth of sukuk, which are due to mature in the next 12 to 18 months. I have doubts about the ability of all borrowers to either repay those or to refinance them,” he added.