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DBS Group Research • April 2017DBS Asian Insights39 n

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SECTOR BRIEFING

Islamic Banking The Unconventional Banking Aspect

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DBS Asian Insights SECTOR BRIEFING 3902

Islamic Banking The Unconventional Banking Aspect

Produced by:Asian Insights Office • DBS Group Research

go.dbs.com/research @dbsinsights [email protected]

Goh Chien Yen Editor-in-ChiefJean Chua Managing EditorGeraldine Tan EditorMartin Tacchi Art Director

Lynette CHENG Equity Analyst AllianceDBS [email protected]

Sue Lin LIM Regional Banking and Finance Analyst DBS Group [email protected]

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Investment Summary

Malaysia’s Journey to Becoming the Global Hub for Islamic Finance

How Did Malaysia Get Here?

Unleashing the Potential

Two of a Kind

Deposits

Financing

Opportunities in Islamic Financing

Challenges

Industry Players at a Glance

Islamic Banking Proxies

Potential M&A candidates

Conclusion

slamic banking is based on the Islamic principle of transactions, under which sharing of profit (and loss) is a major feature, ensuring economic justice and equity. The financial relationships are deemed to be participatory in nature. Islamic banking technically bans the receipt and payment of interest in any of its operations. In the most basic way, this

rule sets Islamic banking apart from conventional banking. To realise the full potential of the demand for Islamic banking from sizeable Muslim populations, issues to address include non-uniformity in Shariah views, the need to establish an even playing field, and the bolstering of resources and awareness.

Malaysia, having acquired knowledge and expertise through actively pioneering initiatives and delivering solutions in the Islamic banking industry, is indisputably making inroads into becoming the global hub for Islamic finance. We expect growth of domestic Islamic financing to continue outpacing that of conventional loans – with a four-year compound annual growth rate (CAGR) of 12% over FY2015-2020F, compared to 2% for conventional loans. This is mainly underpinned by the efforts of Malaysian banks to fulfil Bank Negara Malaysia’s (BNM) target to have Islamic financing make up 40% of total system loans. Further upside could come from improvement in financial inclusion and regionalisation of Islamic finance. We believe that to achieve this, Islamic banks should differentiate themselves from their conventional peers through product innovation.

We like BIMB, the holding company of Bank Islam, for its deep-rooted expertise in the industry, which we believe will give it a strong competitive advantage as the likely leader in product innovation. Maybank Islamic, with its size and established regional presence, will give Malaysia’s Islamic banking industry a fillip and compete well on the global front. A new wave of merger and acquisition (M&A) activity in the Islamic banking space is plausible although the timing remains the key risk. Potential M&A candidates include Malaysia Building Society Bhd (whose appeal lies in its lucrative personal-finance business and sizeable Islamic-banking assets) and unlisted Bank Muamalat Malaysia (from a long-awaited pare-down in stake by its largest shareholder, DRB-HICOM). Albeit more indirectly, Bursa Malaysia is also an indirect proxy as transactions on its commodity trading platform are expected to increase in conjunction with the growth of Islamic financing.

Investment Summary

IProfit-sharing principle

Product innovation to be game-changer

BIMB, the proxy in Malaysia


Further upside could come from improvement in financial inclusion and regionalisation of Islamic finance

alaysia is the global leader in Islamic finance, with Saudi Arabia and Iran trailing just behind. Although Malaysia ranks third by Islamic banking assets, the country’s runaway success in the sukuk market boosted it to the top of the table in terms of financial assets Four Malaysian banks (Maybank Islamic,

Bank Rakyat, CIMB, and Bank Islam) are ranked among the 15 largest Islamic banks by assets. Success was not achieved without a great deal of effort. Malaysia’s competitive advantage in the sector was driven by strong government support, which brought about regulatory changes, tax incentives, and more educational resources.

To further enhance Malaysia’s footing in global Islamic banking, the country’s government has set the targets for the industry to achieve by 2020. This includes:

1. increasing Malaysia’s share of global Islamic banking assets from 8% in 2009 to 13% in 2020,

2. increasing Malaysia’s share of global takaful (insurance based on Islamic principles) contribution from 11% in 2009 to 20% in 2020,

3. increasing Islamic financing’s share of total financing in Malaysia from 29% in 2010 to 40% in 2020, and

4. propelling at least one Islamic financial institution to the list of top 10 global players by asset size by 2020.

The global leader

Targets for 2020

Malaysia’s Journey to Becoming the Global Hub for Islamic Finance

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Diagram 1. Global Islamic finance assets – Top 10 countries

Diagram 2. Global: Assets of major Islamic banks

Source: Thomson Reuters Islamic Finance Development Report 2015

Source: World Islamic Banking Conference Leaderboard


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Diagram 3. Malaysia: Assets of Islamic banks

Diagram 4. Global: Top Islamic economies

Source: Companies, DBS Bank, AllianceDBS


Country Islamic Finance Assets

Islamic Banking Assets

Islamic Financial

Institutions

Number of Islamic

Banks/ Windows

Takaful / Retakaful

Assets

Number of Takaful / Retakaful Operators

Other Financial

Institutions Assets

Number of Other Financial

Institutions

Value of Outstanding

Sukuk

Net Asset Value of Islamic Funds

USD mil USD mil USD mil USD mil USD mil USD mil

Global 1,814,086 1,345,891 1,143 436 33,390 308 83,916 399 295,094 55,794

Malaysia 415,418 173,956 77 38 8,205 21 48,204 18 167,256 17,797

Saudi Arabia 412,955 325,394 105 16 12,380 40 4,928 49 46,890 23,363

Iran 345,447 328,777 82 39 8,180 27 6,833 16 120 1,538

UAE 161,443 127,281 85 24 1,792 17 5,158 44 26,885 328

Kuwait 97,576 87,749 100 9 132 15 7,645 76 814 1,236

Qatar 86,524 71,620 38 8 323 19 756 11 13,566 259

Bahrain 72,825 68,367 59 32 450 10 415 17 3,585 9

Turkey 53,883 44,597 5 4 - - - 1 9,283 3

Indonesia 40,396 21,711 145 33 933 63 428 49 16,425 898

Bangladesh 23,150 22,471 42 26 608 15 71 1 - -

Pakistan 18,279 12,563 57 23 127 6 541 28 4,058 990

Egypt 13,487 12,869 26 9 - 8 377 9 - 242

Sudan 10,651 10,651 44 28 - 14 - 2 - -

Jordan 8,219 7,872 12 3 48 3 170 6 120 9

Switzerland 6,885 - 3 1 - - 6,879 2 - 6


How Did Malaysia Get Here?

The evolution of Islamic finance in Malaysia began as early as 1963 with the establishment of the Pilgrims Management and Fund Board (Lembaga Tabung Haji).

In 1980, a seminar on National Development from Islamic Perspective proposed the establishment of Bank Islam. Three years later, Bank Islam opened its doors for business once Malaysia passed the Islamic Banking Act. Takaful companies were incorporated under the Takaful Act 1984 subsequent to its enactment. In 1991, Bank Islam was listed on the stock market. The second Islamic bank, Bank Muamalat, was established in 1999.

Conventional financial institutions were then allowed to create Islamic “windows” that enabled them to offer Shariah-compliant banking products and services. This further facilitated the creation of a dual-financial system, in which Islamic finance operated alongside the conventional financial system. In 1993, the Islamic Interbank Money Market was launched, which continued to lend support to the Islamic banking industry. A Shariah Advisory Council was established in 1997 by BNM, to ensure the conformity of Islamic banking and takaful products to Shariah principles.

An important agreement was signed in 2001 by institutions in Bahrain, Indonesia, Sudan, Saudi Arabia, and Malaysia to create the International Islamic Financial Market (IIFM), which strived to develop an international secondary market for the trading of sukuk and other Islamic financial instruments. To facilitate liquidity management further, International Islamic Liquidity Management Corporation (IILM) was established in Malaysia in 2010 to create and issue short-term Shariah-compliant financial instruments.

The industry progressively liberalised, as licenses were granted to three foreign banks – Azerbaijan’s AFB, Saudi Arabia’s Al-Rajhi, and Kuwait Finance House – in 2003 to allow more foreign participation. Towards this end, the requirements imposed include a minimum capital of 300 million Malaysian ringgit as well as submission of a sound business plan and ownership structure to BNM.

Islamic Financial Services Board (IFSB) started operations in Malaysia in 2003, serving as an international standard-setting body of regulatory and supervisory agencies. In 2006, the Malaysia International Islamic Financial Centre (MIFC) initiative was launched with the aim of providing a platform for participants in the industry to communicate with each other. International Centre for Education in Islamic Finance (INCEIF) was established in Malaysia to develop and nurture talent and experts for the global Islamic finance industry. Two new Islamic banking licences were offered in 2009, with the requirement of paid-up capital of at least US$1 billion. Finally, the Islamic Financial Service Act (IFSA) was passed by Parliament in 2013.

Dual financial system

Creation of sukuk market

Foreign Islamic banks


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Rising to the challenge

A giant leap

Diagram 5. Malaysia: Evolution of Islamic banking


Malaysia has successfully addressed the key issues confronting the Islamic banking sector. This includes establishing a separate regulatory framework that harmonised the Shariah principles, ensured a competitive playing field for Islamic banks and fostered an enabling environment to nurture more talent development.

Islamic banks found themselves at a regulatory crossroad when the Islamic Financial Services Act (IFSA) was implemented in 2013. This supersedes the Islamic Banking Act 1983 and the Takaful Act 1984, while incorporating elements of the Payment System Act 2003 and the Exchange Control Act 1953.

The IFSA enhanced requirements for Shariah governance by requiring Islamic banks to comply with Shariah law and operational standards issued by the BNM and the International Shariah Research Academy in all aspects of their business objectives and operations. By doing so, BNM aspired to elevate the operationalisation of Shariah contracts/concepts, as well as ensure higher compliance standards and global acceptability of Malaysian financial products.

Year Milestones

1963 Establishment of Lembaga Tabung Haji

1980 The Seminar on National Development from Islamic Perspective (1980) proposed the establishment of Bank Islam

1983 Malaysia passed the Islamic Banking Act

Bank Islam began operations in July 1, 1983

1984 Enactment of Takaful Act 1984

1991 Bank Islam was listed on the stock exchange

1993 Interbank Money Market was established

1997 BNM established Shariah Advisory Council

1999 Bank Muamalat, the second Islamic bank, was established

2001 Establishment of International Islamic Financial Market

2003 Islamic Financial Services Board (IFSB) started operations in Malaysia

2003 Licences were given to three foreign banks – AFB, Al-Rajhi and KFH

2006 The Malaysia International Islamic Financial Centre (MIFC) initiative was launched and International Centre For Education In Islamic Finance (INCEIF) was set up

2009 Two new Islamic banking licenses offered

2010 International Islamic Liquidity Management Corporation (IILM) was established

2013 Islamic Financial Service Act 2013 was passed by Parliament


The introduction of new standards remains an ongoing process. There have been 14 new standards issued since 2013. In our view, the enactment of the IFSA 2013 clearly illustrates BNM’s intention to encourage the industry to move to a risk-sharing model as opposed to a risk-transfer model. We believe this encourages more product innovation within the industry, thus allowing Islamic finance players to differentiate their products from conventional ones.

Source: BNM

Diagram 6. Malaysian Islamic banking: IFSA 2013

Ijarah Rahnu TawarruqTawarruq

Murabahah Mudharabah Wakalah Wadi'ah Mudharabah WakalahIstisna' Musharakah Kafalah Qard Musharakah

Investment Accounts (Other)

ASSETS LIABILITIESSales-Based Equity-Based Fee-Based Islamic Deposits Investment

Accounts (Equity)

Shariah Standards Operational Standards Oversight Functions Resolution

Islamic Finance:Islamic banks conduct financial intermediation functions using Shariah contracts

Distinct risk and reward profiles based on Shariah contracts

End-to-end Shariah compliance under the Islamic Financial Services Act 2013

Compliance with fundamental

requirements of respective Shariah

contracts

Codification of the role of the Shariah

committee and board of directors of financial institutions in ensuring

Shariah compliance

Priority of payment reflective of underlying

Shariah contracts

Strengthened risk management, governance,

transparency and disclosure, market conduct, and other

operational aspects of applying Shariah standards


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Source: BNM

Source: IMF Working Paper

Diagram 7. Malaysian Islamic banking: Shariah governance framework

Diagram 8. Malaysia: Islamic Finance tax neutrality

MANAGEMENT

Shariah Risk Management Control Function

Shariah Review FunctionShariah Research

FunctionShariah Audit Function

Identify, measure, monitor, report, and control risks of

Shariah non-compliance

Review business operations on a regular basis to ensure

Shariah compliance

Conduct in-depth Shariah research prior to submission to the

Shariah Committee

Provide independent assessment and objective

assurance designed to add value and improve IFI's compliance

with Shariah

Shariah as overarching principle in Islamic finance

BOARD

BOARD AUDIT COMMITTEESHARIAH COMMITTEEBOARD RISK

MANAGEMENT COMMITTEE

Oversight accountability on Shariah-related

matters

Provide necessary support to the Shariah Committee

Overall oversight of Shariah governance structure & Shariah

Compliance

Ensure execution of business and operations is in accordance

with Shariah principles

Shariah compliance and research functions

Tax neutrality

The equal footing provision in the Income Tax Act ensures that the Islamic financial transactions are not taxed differently from conventional financing transactions, regardless of the fundamental differences between the two. This means that, for tax purpose, profits received in Shariah-compliant transactions are treated in the same way as interest rate gains in conventional finance. Conversely, the payment of profits (equivalent to the payment of interest in conventional finance) by the borrower is treated as interest costs from a tax perspective.

Similarly, partnerships formed under the Shariah concept of a joint venture entailing the sharing of profits and/or losses are not recognised as partnerships from a tax perspective.

The equal footing provision in the Stamp Act ensures that Islamic banking and investment products, which require additional sales and purchases of the underlying assets due to the profit-and-loss sharing agreements, are as attractive and cost-efficient as their conventional counterparts. The provision ensures that where assets are required to be transferred (which would not otherwise be necessary under conventional financing schemes), the transferor is not subject to balancing adjustments on the sale/purchase and thus the transaction remains tax neutral. Similarly, partnerships formed under the Shariah concept of a joint venture entailing the sharing of profits and/or losses are not recognised as partnerships from a tax perspective.


The effort in developing strong regulations has resulted in Malaysia becoming one of the top countries in terms of governance. This is supported by a whopping number of Shariah scholars in the country (203) and an average disclosure index of 47 as at 2015.

BNM successfully addressed Islamic banks’ problem of lack of high-quality liquid assets by becoming the largest issuer of short-term sukuk (BNM switched to other instruments for liquidity management in 2015). To date, Malaysia remains one of the few countries with an active and liquid Islamic money market. Malaysian Islamic institutions have a higher percentage of liquid assets available for investing at 46% versus 35% and 12% for the Gulf Cooperation Council and other regions, respectively. Malaysia’s deep suite of products and instruments available in the domestic market also increases its institutions’ concentration of short-term assets, which make up more than half their total assets.

Governance index

Diagram 9. Islamic finance governance index – Top 10 countries


As evidenced by the competitive rates offered for Islamic banking products compared to conventional banking products, Islamic banks have levelled up in Malaysia. To enhance the attractiveness of Islamic banking products, on top of ensuring tax neutrality in Islamic financing transactions, regulators have introduced incentives. This includes granting tax exemptions to the industry in financing, sukuk, fund management, and stockbroking.


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Source: Thomson Reuters

Source: Thomson Reuters

Diagram 10. Average percentage of liquid assets available for investing (%)

Diagram 11. Average percentage of liquid assets available for investing (%)

A level playing field


Indeed, the Malaysian regulatory support in creating a level playing field, along with efforts in raising awareness of Islamic financing, has spurred the take-up of Islamic products by non-Muslim consumers. Malaysia has the highest number of conferences (24) and seminars (27) held on Islamic banking and is number 2 in terms of the amount of news on the topic (3,900; just behind the UAE with 3,944) – as at 2015. This has propelled Malaysia to the top of the league in terms of awareness of Islamic financing.

Source: IMF Working Paper

Diagram 12. Malaysia: Tax incentives for Islamic finance

Tax incentives

Tax exemption for profits derived from sukuk.

Ten-year tax exemption for Islamic banks and Islamic insurance companies on income derived from business conducted in foreign currencies, including transactions with Malaysian residents. This exemption was given to drive foreign participation in Malaysia’s Islamic finance and encourage Islamic financial institutions to transact internationally, with the aim of making Malaysia an international Islamic financial hub.

Ten-year exemption from income taxes for domestic and foreign fund managers who manage Islamic funds for foreign investors.

Three-year exemption from stamp duties of 20% on instruments related to Islamic financing.

Tax deductions on expenses incurred in establishing an Islamic stockbroking firm

Tax exemption on profits paid by licensed Islamic banks in Malaysia to non-resident customers

Raising awareness

Diagram 13. Islamic finance awareness indicator – Top 10 countries




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Diagram 14. Islamic finance knowledge indicator – Top 10 countries

Discrepancy still a hurdle

Shortage of talent is one of the most frequently mentioned challenges within the Islamic banking industry. To address this, the government has lent strong support to the provision of education on Islamic finance. In 2005, BNM set up the International Centre for Education in Islamic Finance (INCEIF) to offer postgraduate studies in Islamic finance. The intensive focus on providing quality education and research has led to Malaysian institutions – including International Islamic University, University Sains Islam Malaysia, International Shariah Research Academy for Islamic Finance, and Insaniyah University College – becoming some of the best in education and research in the field. Unsurprisingly, Thomson Reuters ranked Malaysia as the top country under its knowledge indicator, attributable to the vast number of degrees and courses (30 and 16, respectively) as well as published research papers (522) on Islamic finance– as at 2015.

Nevertheless, a key challenge to the industry in Malaysia is the lack of uniformity in Shariah views among religious scholars. For instance, commodity murabahah is widely used – particularly in Malaysia – but its compliance with Shariah remains debatable. To this end, a call to establish a global Shariah body – which can address the issue of inconsistency in practices across the region – has been made. While the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and Islamic Financial Services Board (IFSB) have provided some Shariah standards and governance guidelines, compliance to these standards differs across the region. Regulators in Bahrain, Qatar, Sudan, and Syria have made the AAOIFI standards mandatory for Islamic financial institutions while other countries have considered these standards only recommendations.


e expect growth of domestic Islamic financing to continue outpacing growth of conventional banking loans, driven by the regulatory push to fortify domestic Islamic banking entities and enhance global competitiveness. To that end, we envisage Islamic finance to grow at a four-year CAGR of

12% from FY2016–FY2020F, compared to 2% for conventional banking loans. This is underpinned by the assumption that system loan growth stands at 5% (four-year CAGR) and the proportion of Islamic financing to the total system grows from 29% currently to 37% in 2020F; Note that BNM’s target is 40%.

Source: BNM, DBS Bank, AllianceDBS

Unleashing the Potential

WDiagram 15. Malaysia: Asset growth in conventional and Islamic banking

Given that seven out of the eight major banks in Malaysia have yet to reach BNM’s target of having Islamic financing make up 40% of total loans, we believe there is still room for growth of Islamic financing to continue outpacing that of conventional loans. However, we feel that an increase in financial inclusion would have to materialise.


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Source: Companies, BNM, DBS Bank, AllianceDBS

Diagram 16. Malaysia: Financing growth in conventional and Islamic banking

Diagram 17. Malaysia: Proportion of conventional and Islamic banking financing

Limited room to grow

What does this mean to the players in the industry? We view Islamic product offerings as complementary to the product suite of a bank, especially in Muslim-majority countries such as Malaysia. Banks without Islamic product offerings risk forfeiting the portion of the market that has a natural bias towards Islamic products. Malaysian banks appear to be well aware of this risk, as evidenced by the availability of Islamic offerings across all banks.

According to the Global Findex by the World Bank, while the percentage of the Malaysian population that owns an account in financial institutions stands at 81%, only 20% of the Malaysian population has borrowed from a financial institution in 2014. We believe that improving access to borrowing is challenging, as the current product offering may not be entirely suitable for the unserved population. However, product innovation could act as the game-changer as new offerings could increasingly meet the different risk-and-return requirements of this dissimilar segment of consumers.

Currently, Islamic products largely mirror their conventional equivalents, translating into minimal product differentiation between the two. However, since the implementation of IFSA 2013 which encouraged a move towards a risk-sharing model (from a risk-transfer model), we have seen some developments in product innovation. For example, a new guideline on distinguishing Islamic deposits and investment accounts from the conventional counterparts was introduced in early 2013. Consequently, Islamic banks have started offering investment accounts as an additional alternative to a typical current account, savings account. and term deposit products.


Diagram 18. Malaysia: Major banks’ proportion of Islamic financing to total domestic loans (%)

Source: Companies, BNM, DBS Bank, AllianceDBS

Product innovation

Differentiation

Customers who haven’t been informed about the differences in product offerings may find it difficult to accept new products. In the case of investment accounts, despite higher returns to compensate for the higher risks, differences such as the absence of a principal guarantee, loss of insurance deposit coverage, and the additional disclosure requirements and terminologies could spur a customer exodus back to more familiar conventional products. Nonetheless, in our view, it is crucial for Islamic banks to take this risk to enable differentiation from conventional banks. Hence, the ability of Islamic banks to execute this is the critical success factor of the industry. We expect the industry’s ability to offer a wider range of products to meet risk and return requirements of consumers to serve as a stepping-stone in producing “real growth” (as opposed to merely displacing conventional loans. Hence, we advise investors to keep a lookout for developments in this space.

Digital disruption has indeed intensified in the past few years, with services such as crowdfunding and peer-to-peer lending gradually creeping into the banking industry. Notably, these alternatives are based on a risk-sharing model, which overlaps with the premise of Islamic banking. In peer-to-peer lending and crowdfunding, lenders are matched directly to borrowers. To that end, we think these new digital innovations have opened up more opportunities for the Islamic banks, especially in product innovation and the aligning of their products and services to the true spirit of Islamic banking.

We have seen Islamic banks ride the digital wave through the launch of the Investment Account Platform (IAP). The IAP is akin to a crowdfunding platform, where investors can participate in the funding of ventures or projects by making monetary contributions to projects. The key factor distinguishing IAP from other technology-based fund-raising platforms lies in the intermediation roles played by the Islamic banks (e.g., due diligence, performance monitoring, suitability assessment, and investment management). While other fund-raising platforms largely feature ventures by small- and medium-sized enterprises (SMEs) and start-ups, the IAP also includes ventures by listed companies and multinational corporations. Independent ratings are also provided to facilitate users’ investment decisions.

There are four sponsoring banks (Maybank Islamic, Affin Islamic, Bank Islam, and Bank Muamalat) involved in the IAP, but to date, only three projects have been listed on the platform since its launch in February 2016. Nevertheless, we expect this platform to gain traction in the near future as participating banks have expressed keen interest in improving the flow of project listing.

Another growth lever for Islamic finance is the ability of Islamic banks to leverage the strong support from domestic authorities to extend their presence regionally to countries where the Islamic finance industry remains under-developed and banking penetration remains low. Consistently, we still expect the aforementioned product innovation to be the key success factor in driving substantial traction within the region.


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Consumer education

Digital disruption or enabler?

IAP yet to gain traction


The closest market for the Malaysian Islamic banks to explore is Indonesia. With 209.1 million Muslims, or 13% of the world’s total, as at 2010, Indonesia is the world’s most populous Muslim nation. Banking penetration – both conventional and Islamic – is low; 13% of the country’s population have borrowed from a financial institution and 5% of total banking assets are Islamic, implying ample room for growth.

Islamic banking has yet to take off in a meaningful way in Indonesia. Based on the Otoritas Jasa Keuangan’s (OJK) observations, challenges in developing Islamic banking in Indonesia include

1. the lack of coordination between the government and authorities responsible for developing Islamic banking,

2. the inability to establish a level playing field, causing the industry to be dragged by inadequate scale and efficiency, high cost of funds as well as insufficient depth in product offerings,

3. shortage of resources (human resource and information technology) to support growth,

Diagram 19. Countries with the largest Muslim populations, 2010 and 2050

Source: The Future of World Religion by Pew Research Centre

Case in point: Indonesia

Country 2010 population

(mil)

% of world's Muslim

Country Projected 2050 population

(mil)

% of world's Muslim

Indonesia 209.1 13.1 India 310.7 11.2

India 176.2 11.0 Pakistan 273.1 9.9

Pakistan 167.4 10.5 Indonesia 256.8 9.3

Bangladesh 134.4 8.4 Nigeria 230.7 8.4

Nigeria 77.3 4.8 Bangladesh 182.4 6.6

Egypt 77.0 4.8 Egypt 119.5 4.3

Iran 73.6 4.6 Turkey 89.3 3.2

Turkey 71.3 4.5 Iran 86.2 3.1

Algeria 34.7 2.2 Iraq 80.2 2.9

Morocco 31.9 2.0 Afghanistan 72.2 2.6

Subtotal 1,053.0 65.8 Subtotal 1,701.1 61.6

Subtotal for rest of world

546.7 34.2 Subtotal for rest of world

1,060.4 38.4

World total 1,599.7 100.0 World total 2,761.5 100.0

4. low consumer awareness, and

5. sub-optimal level of regulation and supervision within the industry.

Under the roadmap for Indonesian Islamic banking, the OJK has expressed willingness to address the issues. From 2015 to 2019, the OJK wants to implement seven policy directives and 41 priority programmes to develop the industry in Indonesia. The measures include involving Islamic investment banks in financing government projects, establishing a research and development centre of Islamic banking, raising Islamic finance financial literacy, as well as introducing an incentive framework to encourage the expansion of productive financing in infrastructure and the corporate sector to improve its funding structure.

Indeed, developments in the Islamic banking industry in Indonesia may take time, as financial inclusion sits higher on the priority list for OJK. That said, we believe the Malaysian Islamic banks are well-positioned to make inroads in the industry, as they are able to leverage their home market’s rich expertise and deep-rooted knowledge in Islamic banking. For instance, Maybank has successfully rolled out Islamic financial services in Singapore and Indonesia in the past three years, with the support of its Shariah Centre of Excellence in Malaysia.

The OJK stated that it would not grant new permits to foreign banks to open branches. However, it will allow existing branches to operate. Going forward, a foreign entity can only penetrate the Indonesian banking industry through ownership in a limited liability (PT/perseroan terbatas) legal entity. While there is no cap on foreign ownership, a single entity is prohibited from holding more than 40% of a bank, although this will be subject to further approval by the OJK. The regulation was effective after 2012 and was not applied retroactively. Maybank and CIMB have the upper hand, given their existing presence in Indonesia through Maybank Indonesia and CIMB Niaga, respectively.


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Country 2010 population

(mil)

% of world's Muslim

Country Projected 2050 population

(mil)

% of world's Muslim

Indonesia 209.1 13.1 India 310.7 11.2

India 176.2 11.0 Pakistan 273.1 9.9

Pakistan 167.4 10.5 Indonesia 256.8 9.3

Bangladesh 134.4 8.4 Nigeria 230.7 8.4

Nigeria 77.3 4.8 Bangladesh 182.4 6.6

Egypt 77.0 4.8 Egypt 119.5 4.3

Iran 73.6 4.6 Turkey 89.3 3.2

Turkey 71.3 4.5 Iran 86.2 3.1

Algeria 34.7 2.2 Iraq 80.2 2.9

Morocco 31.9 2.0 Afghanistan 72.2 2.6

Subtotal 1,053.0 65.8 Subtotal 1,701.1 61.6

Subtotal for rest of world

546.7 34.2 Subtotal for rest of world

1,060.4 38.4

World total 1,599.7 100.0 World total 2,761.5 100.0

Support from the home market

The Malaysian Islamic banks are in a better position to make inroads in the industry


slamic finance refers to the provision of financial services according to Islamic jurisprudence (Shariah). Islamic finance differs from conventional banking model, due to the prohibition of:

1. Interest or Riba, as it represents an increase in wealth that is not related to engaging in any productive activity,

2. Excessive uncertainty or Gharar, to honour principles of fair treatment and the sanctity of contracts by reducing information asymmetry (e.g., contract ambiguity or elusiveness of payoff),

3. Short-selling, based on the principle of ownership under which one should not “sell what one does not own”, and

4. Financing activities considered harmful to the society (e.g., gambling).

To ensure a link between finance and real economic activity, return on capital is legitimised by risk-taking. Return is then determined ex post, based on asset performance or project productivity. Asset-based financing establishes the link between finance and real activity, overcoming the issue of prohibition of short-selling.

How is this executed? Islamic finance products are contract-based and can be classified into three broad categories:

1. Profit-and-loss-sharing (PLS) financingPLS financing is based on the core principles of equity and participation, making it closest to the spirit of Islamic finance. Examples of PLS financing include musharakah (equity-like financing of projects and with pure profit-and-loss sharing) and mudarabah (profits shared, but losses borne by financier).

2. Debt-like financingRefers to contracts of exchange. The four debt-like financing instruments include:

• Murabahah: Cost-plus agreement with buyers making deferred payments

• Salam: Forward agreement under which the Islamic financial institution acts as the buyer of goods on behalf of the customer, with deferred delivery of the products

What makes Islamic banking different?

The banking model

Two of a Kind

I

• Istisna: Forward agreement under which the Islamic financial institution acts as the buyer of a project on behalf of the customer, with the completion and delivery of the project at a later date

• Ijarah: Lease contract with the sale of the right to use an asset for a period of time

3. Fee-based productsRefers to contracts of safety and security, such as Wadiah (safe-keeping contracts) and Wakalah (agency contracts)

The underlying principles of the two models of banking are vastly different, and deliberately so. However, consumers should not equate the seemingly higher level of intricacy in Islamic finance to higher costs, as regulatory support in Malaysia has ensured neutrality in treatment of conventional and Islamic products. This is further supported by the similar returns offered by conventional and Islamic products in Malaysia.


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Neutral treatment

CONVENTIONAL MODEL ISLAMIC MODEL

Lender and borrower Custodian, entrepreneur, financier

Interest-based deposits Safe custody, investment

Interest-based financing Debt financing, equity financing

Functions and operating models based on man-made principles (theory of capitalism )

Functions and operating models based on Shariah law

Governance as per conventional model

Governance inclusive of Shariah Governance Framework requirements

Financial Services Act Islamic Financial Services Act

Lenders/Investors are guaranteed a predetermined rate of interest or returns

Profit/Risk is shared between capital provider (investor) and user of funds (entrepreneur)

Profit is made by charging interest on capital (based on time)

Profit is made by trading goods or charging for a service

Source: Alliance Islamic Bank, AllianceDBS

Diagram 20. Differences between banking models

Deposits

Typically, Islamic deposits apply the safekeeping or Wadiah contract. While term deposit rates vary according to promotional rates, we see minimal difference in the rates between conventional and Islamic deposit products across most banks, as exemplified by the rates offered by Alliance Bank (see table below). Nonetheless, documentation-wise, a declaration form appointing the bank as an agent to sell and purchase commodities needs to be signed, for deposits under commodity murabahah.

Investment accounts are specific to Islamic banks, and differ from the usual Islamic deposit accounts on the type of Shariah contract involved, the guarantee of principal, and the availability of Malaysia Deposit Insurance Corporation (PIDM) protection (see Diagram 23). The introduction of investment accounts stemmed from BNM’s initiative to enhance the


Diagram 21. Islamic banking: Types of Shariah contracts being applied to products

Source: Bank Islam, IMF, BNM, DBS Bank, AllianceDBS

No rate differential


25

legal clarity on the application of Shariah contracts. The investment account is further separated into two types, i.e. the unrestricted investment account (URIA) and the restricted investment account (RIA). The key difference between the two is the mandate; the account holder of URIA allows the bank to make the ultimate investment decision without posing any restrictions or conditions while that of the RIA provides a specific investment mandate (i.e. purpose, asset class, economic sector, period of investment).

Indicative returns for investment accounts are typically higher, which are commensurate with the higher risk to consumers (no principal guarantee and deposit insurance protection). Consumers should also bear in mind that the indicative returns shown at inception is not guaranteed, as profit rates are determined ex post, based on the performance of the asset or project tagged to the account. The financing rate is also dependent on the pre-agreed profit-sharing ratio. Thus, while profits are distributed according to the pre-agreed ratio, the same applies to losses incurred by the asset or project.

While retail investors can ask about investment accounts through the branches of Islamic banks, an alternative way to participate in restricted investment accounts is via the IAP. Here, individual investors register themselves as an IAP user through the designated website and select their preferred venture to invest in. First- time users are given a suitability assessment to ensure they are choosing ventures that are within their risk tolerance. The suitability assessment is a requirement by BNM to evaluate individual investors’ financial capabilities, investment needs and appetite, and investment knowledge and experience. Institutional investors are not required to take the suitability assessment as they are deemed to have sufficient resources to make informed investment decisions.

Upon completion of the suitability assessment, the results are compared against the chosen venture. Investors who have chosen ventures beyond their risk tolerance will be alerted and asked to seek additional consultation at dedicated branches of participating Islamic banks. Once the investor declares an understanding of the risk involved and agrees to proceed with the investment, the Islamic bank creates the investment account for the investor and sends periodical reports on the venture.

The banks provide better returns to the customers under the investment accounts; the benefits to the bank comes in the form of

1. savings from the non-payment of the PIDM premium,

2. more effective capital management as tagged assets are excluded from the calculation of the capital adequacy ratio, and

3. reduced regulatory cost as investment accounts are excluded from the Eligible Liabilities base for the computation of the statutory reserve requirement.

Investment Account Platform

Impact on the banks


Source: Alliance Islamic Bank, DBS Bank, AllianceDBS

Source: BIMB, DBS Bank, AllianceDBS

Source: BIMB, DBS Bank, AllianceDBS

Diagram 22. AFG deposits: Key features similar for conventional and Islamic products

Diagram 23. Comparison of investment accounts and conventional Islamic deposit accounts

Diagram 24. Comparison of unrestricted and restricted investment accounts

Product Name Type Initial/ Minimum deposit

Tenure Profit/Interest rate

Basic savings Conventional RM20 N/A 0.25% - 1.00%

Basic savings Islamic RM20 N/A 0.25% - 1.00%

Term deposits Conventional RM500 12 months 3.15%

Term deposits Islamic RM500 12 months 3.15%

Conventional products Islamic products

Conventional deposit Islamic deposit Investment account

Nature of deposit Sum of money accepted or paid not in accordance with Shariah

Sum of money accepted or paid in accordance with Shariah

Money is paid and accepted for the purpose of investment in accordance with Shariah

Shariah contracts None Wadiah, Tawarruq, Bai' 'Inah

Mudarabah, Musharakah, Wakalah

Principal guarantee Will be repaid in full on maturity and/or on demand

Will be repaid in full on maturity and/or on demand

No expressed or implied obligation to repay the money in full and/or on demand (Principal and/or profit)

Deposit insurance protection

Yes Yes No

Unrestricted Investment Account Restricted Investment Account

Mandate General mandate (allows the bank to make ultimate investment decision without restriction or any conditions)

Specific Investment Mandate/Asset Class

Withdrawal Unlimited Fixed tenure

Maturity Mismatch Redemption upon maturity of assets; or redemption only upon realisation of underlying assets to a third party; or redemption only upon finding replacement of funds from other Investment Account Holder (other than the Bank)

Yes Yes

Balance Sheet treatment

On-balance sheet (subject to compliance with principles of FRS 10)

Off-balance sheet


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Financing

Islamic banks use the Base Rate (BR) and Base Financing Rate (BFR; conventional banks equivalent of Base Lending Rate or BLR) as the reference rates in pricing their financing products. Typically, banks with both conventional and Islamic units use the same rate for the Base Rate and the Base Financing Rate/Base Lending Rate.

In principle, Islamic financing offers a rebate (also known as Ibra) on early settlement, termination or maturity of an account. Islamic financing also places a ceiling on the financing rate, protecting consumers from paying high interest rates in the event of a steep increase in the Base Rate. In accordance with BNM’s guidelines, Islamic banks can impose late-payment charges, but the amount recognised as income is limited to the administrative cost incurred to manage the late payment. The remaining portion must be channelled to charitable organisations.

Mortgages under Islamic principles similarly offer rates that are competitive with those of conventional loans.

On top of the salient features mentioned above, additional incentives for mortgages under Islamic principles come in the form of the discounts on stamp-duty charges. There is a 20% discount for consumers taking a new or top-up loan, as well as a full discount for switching to an Islamic loan.

To enjoy these benefits, customers are merely required to complete two additional documents (versus conventional loans) for mortgage financing based on Bai’ Bithaman Ajil (BBA or sale contract based on deferred payment at a certain price), i.e. Asset Purchase Agreement (APA) and Asset Sale Agreement (ASA) in the solicitor’s office.

For mortgage loans under a Tawarruq (or commodity murabahah) contract, the process is similar to an application for a conventional mortgage loan, except that the document would contain an additional agency agreement (appointing the bank as an agent to sell and purchase commodities). Meanwhile, the application for car financing requires customers to submit two agreements – the Al-Ijarah Contract (hiring agreement) and the Al-Bai’ Contract (purchasing agreement) – as opposed to just one HP agreement under conventional loans.

Similar reference rate

Unique features

Mortgage loans

Additional incentives for mortgages under Islamic principles come in the form of the discounts

on stamp-duty charges


Diagram 25. AFG mortgage loans: Key features similar for conventional and Islamic products; stamp duty more advantageous in Islamic product

Diagram 26. Mortgage loans under BBA: Two additional documents required under Islamic financing

Diagram 27. AFG hire-purchase loans: Key features similar for conventional and Islamic products

Feature i-Wish Home Financing-I (Islamic) Home Loan (Conventional)

Stamp Duty 1. New & Top Up: 20% discount Full

2. Refinancing: Waived (100% discount) for refinancing cases (i.e. Conventional loans from other financial institutions to Islamic financing)

Full

Margin of Finance 90% + 5% MRTT and/or Financing Entry Cost

90% + 5% MRTA and/or Financing Entry Cost

Tenure 35 years/70 years of age 35 years/70 years of age

Islamic Conventional

1. Product Disclosure Sheet (PDS) Sales/Branch Staff 1. Product Disclosure Sheet (PDS)

2. Application Form 2. Application Form

3. Letter of Offer (LO) 3. Letter of Offer (LO)

4. Sales and Purchase Agreement (SPA) Customer 4. Sales and Purchase Agreement (SPA)

5. Asset Purchase Agreement (APA) Solicitors Office 5. N/A

6. Asset Sale Agreement (ASA) 6. N/A

7. Facility Agreement (FA) 7. Facility Agreement (FA)

8. Other Documents 8. Other Documents

Islamic Hire purchase Conventional Hire Purchase

Margin of finance 90% of total value of car 90% of total value of car

Tenure Max 9 years Max 9 years



The documents MUST be executed in the particular order above at different intervals i.e. the time must not be the sameSource: Alliance Islamic Bank, DBS Bank, AllianceDBS


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While the terms of business loans are negotiated on a case-by-case basis between the bank and customer, we understand that banks generally do not practice price discrimination, regardless of the status of the loans ( i.e. conventional or Islamic). However, listed companies seeking to attain Shariah-compliant status should apply for lines under Islamic banks. The status is granted to listed companies provided that

(1) the contribution of Shariah non-compliant activities to overall revenue and profit before tax is below the 5% benchmark (20% for activities such as hotels and resorts, stockbroking and share trading), (2) the company’s ratio of cash (placed in conventional accounts and instruments) over total assets does not exceed 33%, and

(3) the company’s ratio of debt (under conventional financing) to total assets does not exceed 33%. Listed companies are generally inclined to seek Shariah-compliant status in order to attract a larger pool of investors. Other incentives offered include waiver of commitment fees for the unutilised portion of the facility limit and full exemption of stamp duty for switching from a conventional financing facility to an Islamic one.

Shariah-compliant status

Listed companies are inclined to seek Shariah- compliant status to attract a larger pool of investors


anking penetration (defined as percentage of adults with an account at a formal financial institution) remains low among the member-countries of the Organisation of Islamic Cooperation (OIC) and the Muslim population as a whole, averaging around 32% and 29%, versus the global average of 62%. According to findings

by the World Bank, the low banking penetration rate is attributable to the low sums of money people have (i.e. no necessity for accounts); the expensiveness of financial services is the second most cited barrier. Only 7% of adults in OIC countries cited religious reasons for resisting financial services. Hence, we believe Muslims do not reject conventional finance solely due to religious reasons. Nonetheless, in an environment of homogeneous pricing (between conventional and Islamic banking products), in our opinion, Muslims will have a natural bias towards Islamic banking products given the products’ ability to help them fulfil their religious duties concurrently.

Opportunities in Islamic Financing

Diagram 28. Banking penetration

Source: World Bank, Global Findex database

Natural bias B

Given that Muslims make up more than 20% of the global population and banking penetration is low within the OIC countries, we opine that attending to the needs of the underserved Muslim population is the low-hanging fruit for Islamic banking. The Muslim population is also projected (by Pew Research Center) to be the fastest-growing religious group up to year 2050. The proportion of Muslims to the global population is expected to hit 30% in 2050, closing the gap with the Christian population, which stands at 31%.

The key drivers underpinning the strong growth in the Muslim population include the higher-than-average fertility rate (3.1 children per woman versus the global average of 2.5) and comparatively high concentration of children as of end-2010 (34% for Muslims versus global average of 27%). Populations that begin with a larger proportion of people who are in or will soon enter their prime childbearing years are expected to grow faster than populations that begin with a larger proportion of people who are past their prime reproductive years. The Pew Research Centre also accounts for other factors such as life expectancy, religious conversion, and migration in its growth projections. Caveats to the findings of the Pew Research Centre include changes in current trends that could alter the trajectories.


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Muslim population

Diagram 29. Size and projected growth of major religious groups

2010 population (mil)

% of world Projected 2050 population (mil)

% of world

Christians 2,168.3 31.4 2,918.1 31.4

Muslims 1,599.7 23.2 2,761.5 29.7

Unaffiliated 1,131.2 16.4 1,230.3 13.2

Hindus 1,032.2 15.0 1,384.4 14.9

Buddhists 487.8 7.1 486.3 5.2

Folk religions 404.7 5.9 449.1 4.8

Other religions 58.2 0.8 61.5 0.7

Jews 13.9 0.2 16.1 0.2

World total 6,895.9 100.0 9,307.2 100.0


Diagram 30. Fertility rate by religion

Diagram 31. Age distribution by religious group in 2010



Despite forecasts that the proportion of under-60s in the global population will shrink, the Muslim population’s equivalent is expected to remain higher than the global average (84% versus 78%). The Muslims’ relatively younger demographic is beneficial to the banks as the financing needs of this group of consumers have yet to peak, implying room for banks to grow further in the long term.

Although Islamic banking is based on Islamic teachings, many of these values may also appeal to non-Muslims, given the risk-sharing feature and ethical nature of the business model. In our view, two factors – pricing and awareness – remain the key determinants of favourable take-up by the non-Muslim market. Given the slight incentives offered by Islamic products (lower late payment charges and ceiling rates), we believe that with sufficient education on Islamic banking products, non-Muslim consumers would be agreeable to adopting these products.

At US$6.9 trillion, the combined GDP of the 57 mostly Muslim-majority member-countries of the OIC in 2014 represented 9.5% of the global GDP. Although growth prospects of several OIC economies have dimmed due to lower oil prices, these economies remain a significant portion of global GDP. Note that nine out of the top 15 oil-exporting countries are members of the OIC. Notwithstanding the correction experienced by the sukuk market in 2015 (caused by BNM’s decision to stop the issuance of short-term sukuk and switch to other instruments for liquidity management for Islamic financial institutions), the sukuk market


33

Young demographic

Attracting the non-Muslim market

Sizeable Islamic economies

Diagram 32. Projected age distribution by religious group in 2050



has experienced strong growth, thanks to the rise of infrastructure projects and the need for large corporate exercises to seek funding from investors in the Gulf States and other Islamic countries – which require the products to be Shariah-compliant.

Diagram 33. Global sukuk issuance

Source: International Islamic Financial Market

Note: OIC members highlightedSource: The World Factbook

Diagram 34. Size and projected growth of major religious groups

Country bbl/day % of world

Saudi Arabia 7,658,000 17.3

Russia 4,594,000 10.4

Canada 2,900,000 6.6

United Arab Emirates 2,500,000 5.7

Nigeria 2,411,000 5.5

Iraq 2,390,000 5.4

Kuwait 1,824,000 4.1

Angola 1,815,000 4.1

Kazakhstan 1,365,000 3.1

Venezuela 1,358,000 3.1

Iran 1,322,000 3.0

Qatar 1,232,000 2.8

Mexico 1,220,000 2.8

Norway 1,218,000 2.8

Algeria 1,158,000 2.6

The clear drive to develop intra-OIC trade is also facilitating the development of Islamic economic sectors. Intra-OIC trade has grown from 13% in 2005 to 19.9% in 2014, close to the OIC’s 2015 target of 20%. Under the OIC’s ten-year programme of action leading up to 2025, the target for intra-OIC trade is to hit 6% north of 2015 levels.


35

Intra-OIC trade


xisting legal and regulatory frameworks should take into consideration the value propositions of Shariah. For instance, the legal definition of banking and financial services in certain jurisdictions does not recognise Islamic financial transactions, which leads to potential conflict and adverse legal effects. The government should

also be supportive in granting neutral tax treatment for Islamic financial transactions to ensure that Islamic banking products are cost-efficient.

To avoid an exodus back to conventional finance, there is a need for Islamic products, at the very least, to be on par with conventional products in terms of diversity, cost effectiveness, ability to meet the risk and return requirement of investors as well as the standard of service, while remaining Shariah-compliant. To get a one-up on conventional banking, these Islamic products are expected to be superior to their conventional peers in these aspects.

Liquidity problems exist in the Islamic capital market because of a lack of derivatives and an organised secondary market for dealing with Islamic instruments. Without an effective secondary market where financial instruments are easily tradable, an early exit may be difficult or costly for an investor. In addition, most central banks have not been very active in issuing short-term sukuk, limiting the availability of high-quality liquid assets in Islamic finance.

Despite the strong presence of Islamic finance in the Gulf Cooperation Council (five out of the six member-countries are among the top 10 Islamic economies), findings by PWC show that residents in this region lack familiarity with Islamic banking. 56% of Muslim respondents believe that they are familiar with Islamic banking while 64% of non-Muslims cited insufficient knowledge of Islamic financial products as the reason for not using Islamic financial services.

The Islamic financial industry requires a specific set of competencies and skills, such as Shariah understanding and market insight. The shortage of talent, especially experts such as Shariah scholars, may impede the growth of Islamic finance, as the views of these scholars are highly valuable in product development and innovation. In an extreme case, scarcity in talent may also cause inflated salaries and lead to a drag on the cost structure of Islamic banks. Hence, the abundance of educational institutions focusing on Islamic banking is crucial for the development of the industry.

Different interpretations of Shariah lead to different practices and uses of concepts across jurisdictions. Certain products may be accepted in some jurisdictions but not in others,

Challenges

Regulatory gap

An even playing field

Liquidity management

Lack of awareness

Talent shortage

Shariah views

E

impeding the growth and internationalisation of Islamic finance. Differences in opinion among religious scholars regarding Shariah compliance of specific financial arrangements can expose Islamic banks to the risk of non-compliance with Shariah principles, which may have serious implications on the industry. Harmonising differences in the compliance of different instruments would reduce uncertainty and foster industry growth. It also ensures that Islamic banks are able to capture opportunities in the entire Muslim market, instead of being sidelined by a portion who perceive that Islamic banks do not adhere to Shariah values. By the same token, the AAOIFI and IFSB have provided some Shariah standards and governance guidelines.


37

Different interpretations of Shariah lead to different practices and uses of concepts across jurisdictions

Diagram 35. OIC members: Selected economic data points

Country GDP Banking penetration

Population Density

Total population

Ages 0-14 Ages 15-64 Ages 65+ Account at fin inst

Borrowed from fin inst

UnitUSD per capita

% per sq km mil % of Total % of Total % of Total % of Total % of Total

Afghanistan 668 10 50 32.5 44 53.5 2.5 10 3.6

Albania 4,634 38 105 2.9 18.6 69.1 12.4 38 10.2

Algeria 5,484 50.5 17 39.7 28.5 65.5 5.9 50.5 2.2

Azerbaijan 7,884 29.2 117 9.7 21.9 72.5 5.6 29.2 18.9

Bahrain 24,854 81.9 1,940 1.4 21.5 76.1 2.4 81.9 21.3

Bangladesh 1,088 29.1 1,237 161 29.5 65.6 5 29.1 9.9

Benin 903 16 98 10.9 42.2 55 2.9 16 7.6

Brunei 40,979 N/A 80 0.4 23.1 72.5 4.4 N/A N/A

Burkina Faso 725 13.4 66 18.1 45.6 52 2.4 13.4 5

Cameroon 1,407 11.4 49 23.3 42.5 54.3 3.2 11.4 1.9

Chad 941 7.7 11 14 47.7 49.8 2.5 7.7 2.4

Comoros 841 21.7 424 0.8 40.3 56.9 2.8 21.7 7.2

Cote d'Ivoire 1,546 15.1 71 22.7 42.5 54.5 3 N/A 2.3

Djibouti 1,814 N/A 38 0.9 32.7 63.1 4.2 12.3 4.5

Egypt 3,151 N/A 92 91.5 33.2 61.6 5.2 13.7 6.3

Gabon 10,317 30.2 7 1.7 37.1 57.8 5.1 30.2 4.3

Gambia 441 N/A 199 2 46.2 51.5 2.3 N/A N/A

Guinea 536 6.2 51 12.6 42.5 54.4 3.1 6.2 2

Guinea-Bissau 672 N/A 66 1.8 40.8 56 3.2 N/A N/A

cont


Note: Percentage of adults with accounts in financial institutions is used as a proxy for banking penetration Source: OIC, Global Findex 2014

Guyana 4,040 N/A 4 0.8 28.8 66.2 5 N/A N/A

Indonesia 3,492 35.9 142 257.6 27.7 67.1 5.2 35.9 13.1

Iran 5,443 N/A 49 79.1 23.6 71.3 5.1 92.2 31.6

Iraq 6,475 11 83 36.4 41 56 3.1 11 4.2

Jordan 5,423 24.6 86 7.6 35.5 60.7 3.8 24.6 13.6

Kazakhstan 12,496 53.9 7 17.5 26.7 66.6 6.7 53.9 16.5

Kuwait 43,600 72.9 218 3.9 22.3 75.7 2 72.9 14.1

Kyrgyzstan 1,269 N/A 31 6 31.4 64.4 4.2 18.5 13.5

Lebanon 10,916 46.9 572 5.9 24 67.9 8.1 46.9 15.6

Libya 6,602 N/A 4 6.3 29.8 65.6 4.5 N/A N/A

Malaysia 10,934 80.7 92 30.3 25 69.1 5.9 80.7 19.5

Maldives 8,484 N/A 1,364 0.4 27.5 67.8 4.7 N/A N/A

Mali 701 13.3 14 17.6 47.5 50 2.5 13.3 2.7

Mauritania 1,283 20.4 4 4.1 40 56.8 3.2 20.4 7.7

Morocco 3,243 39.1 48 34.4 27.2 66.6 6.2 39.1 4.3

Mozambique 628 N/A 36 28 45.3 51.4 3.4 N/A N/A

Niger 427 3.5 16 19.9 50.5 47 2.6 3.5 1.4

Nigeria 3,203 44.2 200 182.2 44 53.3 2.7 44.2 5.3

Oman 19,310 73.6 15 4.5 20.5 76.9 2.6 73.6 9.2

Pakistan 1,358 8.7 245 188.9 35 60.5 4.5 8.7 1.5

Palestine 2,972 N/A 735 4.4 40.2 56.8 3 N/A N/A

Qatar 97,519 65.9 193 2.2 15.5 83.3 1.2 65.9 12.6

Saudi Arabia 24,362 69.4 15 31.5 28.6 68.6 2.9 69.4 12.2

Senegal 1,067 11.9 79 15.1 43.8 53.3 2.9 11.9 3.5

Sierra Leone 775 14.1 90 6.5 42.4 55 2.7 14.1 4

Somalia 131 7.9 17 10.8 46.7 50.5 2.8 7.9 2

Sudan 2,081 15.3 17 40.2 40.5 56.2 3.3 15.3 4.2

Suriname 9,680 N/A 3 0.5 26.8 66.3 6.9 N/A N/A

Syria 9,680 N/A 101 18.5 37.1 58.8 4.1 23.3 13.1

Tajikistan 1,114 11.5 61 8.5 34.8 62.2 3 11.5 3.8

Togo 643 17.6 134 7.3 42.2 55 2.8 17.6 3.7

Tunisia 4,313 27.3 72 11.1 23.4 69.1 7.6 27.3 8

Turkey 10,515 56.5 102 78.7 25.7 66.8 7.5 56.5 20

Turkmenistan 9,032 1.8 11 5.4 28.2 67.6 4.2 1.8 2.2

Uganda 727 27.8 198 39 48.1 49.4 2.5 27.8 15.7

UAE 43,963 83.2 110 9.2 13.9 84.9 1.1 83.2 15.4

Uzbekistan 2,049 40.7 74 31.3 28.5 66.8 4.7 40.7 1.3

Yemen 1,418 N/A 51 26.8 40.3 57 2.8 6.4 0.4

OIC 4,012 31.9 10,009 1,726.30 34 61.9 4 31.7 8.4


39

he key players in the industry can be segregated into three broad categories, i.e. full Islamic banks, subsidiaries of Islamic banks, and development banks or financial institutions that offer Shariah-compliant products (see table below for banks under the respective categories). A comparison of the financials of the

key players in the industry can be found in the Appendix. We used numbers in the latest published financial year for all key players. Apart from BIMB, for which we have used numbers of the financial holding company, the numbers of the entities reflect the Islamic banking unit individually. In our analysis, we included only one development bank, Bank Rakyat, which boasts a sizeable market share.

Diagram 36. Malaysia: Key players in the industry

Type Bank

Full Islamic banks Bank IslamBank Muamalat

Asian Finance BankAl Rajhi Bank

Kuwait Finance House

Islamic bank subsidiaries Maybank IslamicAmIslamic

AffinIslamic Alliance Islamic Bank

CIMB IslamicPublic Islamic

Hong Leong IslamicStandard Chartered Saadiq

HSBC AmanahRHB Islamic

OCBC Al-Amin

Development banks/financial institutions that offer Shariah-compliant products

Bank RakyatAgro Bank

Bank Simpanan NasionalSME BankEXIM Bank

Bank Pembangunan MalaysiaMalaysia Building Society


Industry Players at a Glance

T


Maybank Islamic stands head and shoulders above peers. Similar to its positioning in conventional banking, Maybank Islamic leads the market in terms of assets. In fact, Maybank Islamic, Bank Rakyat, and Bank Islam are among the top global Islamic banks by assets. While Maybank Islamic and Bank Rakyat remain at the top of the table when ranked by loans and deposits, CIMB Islamic is the third-largest in these aspects. Meanwhile, foreign Islamic banks, which constrained by operational restrictions such as the number of branches and ATM installations, are typically on the other end of the spectrum.

Due to their relatively small balance sheet and operational restrictions, Middle Eastern Islamic banks struggle in building scale, which reflects their growth (lower-than-average loan growth) and profitability (higher-than-average cost-to-income). BIMB has the highest return-on-equity (ROE) in the industry, thanks to its higher-yielding loans and strong current and savings account (CASA) ratio. Similarly, Malaysia Building Society and Bank Rakyat enjoy high net interest margins (NIMs) as their portfolios are skewed towards personal financing. However, the CASA ratios of Malaysia Building Society and Bank Rakyat are lower than that of the industry as exempt finance companies are restricted from accepting demand deposits (current accounts). Banks that are heavier on mortgage financing (e.g. Maybank Islamic, Hong Leong Islamic) tend to have NIMs below 2%. Financing-to-deposit ratio is highest at SC Saadiq (more than 200%) as it is able to tap interbank funding from its parent through its profit-sharing investment accounts (PSIA). Inclusive of the PSIA placements, the ratio would be lower.

Diagram 37. Malaysia: Assets of Islamic banks


Paltry earnings


41

Banks with strong credit culture (Public Bank and Hong Leong Bank) congruently have low non-performing-loan ratios for their Islamic banking arm. Malaysia Building Society’s impaired financing ratio increased due to its impairment programme. Kuwait Finance House’s asset quality is impacted by high impaired financing in the manufacturing sector. Kuwait Finance House and Malaysia Building Society booked high credit costs, in line with its high impaired financing ratios. All Islamic banks are sufficiently capitalised, with the Middle Eastern Islamic banks registering higher capital ratios than peers.

Islamic Banking Proxies

BIMB, the Islamic banking champAs the nation’s longest-standing Islamic bank, BIMB’s (the holding company of Bank Islam and Syarikat Takaful) expertise in the industry is indisputable. With its experience and expertise in Islamic finance, BIMB would be able to step in to meet the growing demand for Islamic finance (domestic and/or abroad). This could be through strategic partnerships or technical collaborations. A strategic partnership could involve taking a strategic stake in a bank in the host country or a merger or acquisition. For example, Bank Islam assisted in setting up the first Islamic bank in Sri Lanka, Amana Bank Ltd, and acquired a strategic interest in the bank in February 2011. Such initiatives strengthen Bank Islam’s size and market share, driving growth further. While Bank Islam’s attempt to pursue a controlling stake in PT Bank Muamalat in Indonesia was to no avail, we would not discount the possibility of another pursuit in the longer term, given that Indonesia, as the world’s most populous Muslim nation, continues to pack vast potential for Islamic financing.

Maybank Islamic is well-positioned to lead in the international-isation of Islamic financeMaybank Islamic is the nation’s biggest bank (both Islamic and conventional), with the most extensive regional reach. In 2011, Maybank Islam rolled out its “Islamic First” strategy in Malaysia, where customers were offered Islamic banking products as the first choice. Their efforts came to fruition as Maybank Islamic’s proportion of financing to the group surpassed the 50% mark in FY2015 (from 39% in FY2013). The bank replicated the “Islamic First” strategy in Indonesia in 2014. This – along with initiatives such as increasing the awareness of Shariah products and services, revamping Shariah offerings, and expanding the bank’s distribution network (through converting conventional-only branches to dual branches that

Weak asset quality

Due to their relatively small balance sheet and operational restrictions, Middle Eastern Islamic

banks struggle in building scale


also offer Shariah products) – improved Bank Maybank Indonesia’s unit Usaha Syariah’s industry ranking from 12th in FY2013 to 5th in FY2015, in terms of assets. Over in Singapore, Maybank Islamic pioneered several products in the market such as a special savings account for the Hajj pilgrimage, Islamic Auto Finance, Malaysia residential property financing and Malaysia commercial & industrial property financing in 2013, and Islamic Business Term Financing and Islamic trade facilities and foreign-currency deposits in 2014.

Diagram 38. Maybank Islamic: Proportion of Maybank’s domestic financing

Source: Company, DBS Bank, AllianceDBS

Source: Bloomberg L.P Finance

Diagram 39. Global sukuk league table

2015 2016

Bank Amount (US$ m) Market share (%) Amount (US$ m) Market share (%)

CIMB 5,234.7 15.0 5,329.5 12.8

Maybank 2,959.8 8.5 4,602.4 11.0

Standard Chartered Bank 2,255.0 6.5 3,878.4 9.3

RHB 3,300.1 9.5 3,037.5 7.3

HSBC 4,453.0 12.8 2,905.4 7.0

Dubai Islamic Bank 1,302.6 3.7 2,636.2 6.3

AmInvestment Bank Bhd 1,914.3 5.5 2,633.9 6.3

JP Morgan 1,483.0 4.3 1,464.8 3.5

National Bank of Abu Dhabi

1,181.9 3.4 1,463.7 3.5

Emirates NBD PJSC 664.8 1.9 1,389.8 3.3


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Potential M&A candidates

Banks to watch in the M&A space include Malaysia Building Society and Bank Muamalat. In our view, Malaysia Building Society remains an attractive M&A target, thanks to its lucrative personal-finance business and sizeable Islamic banking assets. Furthermore, Malaysia Building Society’s commitment to “closing the gap” between it and the banks would further elevate its attractiveness, as it lowers the hurdle to integration. Based on current fundamentals, we believe the current valuation is rich, given its weak ROE traction of sub-5% in the near term (FY2016- FY2017). Nonetheless, in the event of M&A (which, in our view, will be increasingly imminent in FY2018), we believe MBSB can fetch a higher valuation of 1.1x book value.

Bank Muamalat, a long-awaited M&A playWhile Bank Muamalat is a relatively small entity, M&A talks have surfaced several times as its largest shareholder, DRB-HICOM ), had been required by BNM to pare down its stake from 70% to 40%. Alternatively, the reduction in shareholding could take the route of an initial public offering. In that case, we expect the bank to fetch a valuation that is comparable to that of Affin’s (the most similar in terms of ROE profile). At a conservative valuation of 0.5x book value, Bank Muamalat could be listed with a market capitalisation of close to 1 billion ringgit. BIMB (2011), Affin (2013) and Malaysia Building Society (2016) had tried acquiring Bank Muamalat, but no firm development has materialised to date.

Talk of a mega Islamic bank surfaced as early as 2010, when the central bank was said to be issuing two mega Islamic bank licences to foreign players that have at least 1 billion ringgit in paid-up capital. M&A spin-offs in the Islamic banking space are plausible, in our view, potentially setting off a new wave of M&A activity in the Islamic banking space. In 2014, Malaysia Building Society was in talks to merge with CIMB and RHB. The merged entity was expected to displace Maybank from its #1 ranking in Malaysia (by assets). More interestingly, Malaysia Building Society was slated to remain listed and act as a vehicle for any proposed mega Islamic bank, i.e. the banking operations of CIMB Islamic and RHB Islamic would be injected into Malaysia Building Society if the three-way merger were to succeed.

The next mega Islamic bank?

M&A spin-offs in the Islamic banking space are plausible, potentially setting off a new wave of

M&A activity

2015 2016

Bank Amount (US$ m) Market share (%) Amount (US$ m) Market share (%)

CIMB 5,234.7 15.0 5,329.5 12.8

Maybank 2,959.8 8.5 4,602.4 11.0

Standard Chartered Bank 2,255.0 6.5 3,878.4 9.3

RHB 3,300.1 9.5 3,037.5 7.3

HSBC 4,453.0 12.8 2,905.4 7.0

Dubai Islamic Bank 1,302.6 3.7 2,636.2 6.3

AmInvestment Bank Bhd 1,914.3 5.5 2,633.9 6.3

JP Morgan 1,483.0 4.3 1,464.8 3.5

National Bank of Abu Dhabi

1,181.9 3.4 1,463.7 3.5

Emirates NBD PJSC 664.8 1.9 1,389.8 3.3


he path to success is a long and winding one. In our view, Islamic banking remains a nascent industry which still has plenty of hurdles to clear. There is indeed sufficient demand from the large and fast-growing Muslim population and sizeable Islamic economies to justify the need for Islamic banking, but for the industry to be

attractive as a growth industry, its foundations need to be strengthened. The challenges the industry must address include harmonising differences in Shariah compliance across jurisdictions, establishing an even playing field, strengthening resources (human capital, technology, and liquidity management tools), and promoting Islamic banking literacy to the public.

Undeniably, Malaysia has pioneered plenty of Islamic banking initiatives on the global stage, which has deepened the country’s knowledge and expertise. The country is a natural candidate to lead the industry to the next stage, especially given the strong support of regulators. Product innovation will be the transformative factor for the industry, in our view, as it enables Islamic banks to step up their game against their conventional counterparts. We believe it is crucial to monitor developments in this space when identifying the next growth cycle for the industry.

We like BIMB for its rich experience in the industry, which we believe forms a powerful competitive advantage for it to lead the avant-garde movement in product innovation given its superior knowledge in Islamic banking. MAY ISL complements the Islamic banking scene for its size and established regional presence which will work to its advantage in competing on the global front. MAY ISL and CIMB ISL are also global sukuk players.

A new wave of M&A activities in the Islamic banking space is plausible, although timing remains the key risk. Potential M&A candidates include MBSB (whose appeal lies in its lucrative personal financing business and sizeable Islamic banking assets) and unlisted MUAMALAT (from a long awaited pare down in ownership by its largest shareholder, DRB). Albeit indirect, Bursa is also a proxy to growth in Islamic banking as transactions on its commodity trading platform, Bursa Suq al-Sila (BSAS), are expected to increase in conjunction with Islamic financing growth.

Malaysia is in a unique position as the country

is at the forefront of the industry

BIMB could lead way

Islamic banking remains a nascent industry which still has plenty of hurdles to clear

Conclusion

T


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The information herein is published by DBS Bank Ltd (the “Company”). It is based on information obtained from sources believed to be reliable, but the Company does not make any representation or warranty, express or implied, as to its accuracy, completeness, timeliness or correctness for any particular purpose. Opinions expressed are subject to change without notice. Any recommendation contained herein does not have regard to the specific investment objectives, financial situation and the particular needs of any specific addressee.

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