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Islamic Banking in the MENA RegionIslamic Banking in the MENA Region

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For your Queries Economic Research Department Marwan Mikhael Head of Research [email protected] Tel: +961 1 737 247 Fax: +961 1 737 414 Alexandre Mouradian Deputy Head of Research [email protected] Tel: +961 1 737 247 Ext: 1414 Fax: +961 1 737 414 Cynthia Zeilah Analyst [email protected] Tel: +961 1 737 247 Ext: 1413 Fax: +961 1 737 414 Rebecca Nakhoul Analyst [email protected] Tel: +961 1 737 247 Ext: 1418 Fax: +961 1 737 414 Yasmina Merhi Analyst [email protected] Tel: +961 1 737 247 Ext: 1410 Fax: +961 1 737 414 Jean-Claude Cherfane Analyst [email protected] Tel: +961 1 737 247 Ext: 1416 Fax: +961 1 737 414 Research Department [email protected] Tel: +961 1 737 247 +961 1 747 812 Fax: +961 1 737 414

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February 2009

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Table of Contents For your Queries ........................................................................................................................................................... 2

Table of Contents ......................................................................................................................................................... 4

Executive Summary ...................................................................................................................................................... 6

1. Global Islamic Banking Overview ............................................................................................................................ 7

1.1 Global Islamic Banking Regulatory Environment ........................................................................................................... 9 1.2 Islamic Banking during the Economic Crisis ................................................................................................................. 10 1.3 Growth Drivers for Islamic Banking ............................................................................................................................. 11

1.3.1 Large and Young Muslim population globally ......................................................................................................... 11 1.3.2 Low penetration in Muslim‐majority nations – for both conventional and Islamic products ............................... 11 1.3.3 Increasing wealth of Muslim nations, due to higher oil prices ............................................................................. 12 1.3.4 Spiritual attraction: a greater focus on Islamic identity ....................................................................................... 13 1.3.5 Government and regulatory support for the development and promotion of Islamic banking ............................ 13 1.3.6 Demand from non‐Muslims, wider acceptance of Islamic banking products ....................................................... 14 1.3.7 Participation of conventional banks in Islamic banking ........................................................................................ 14

2. Regional Islamic Banking Overview ........................................................................................................................ 15

2.1 Economic Overview ........................................................................................................................................................ 15 2.1.1 Comparative Economic Indicators and Ranking ..................................................................................................... 17

2.2 Regional Industry Overview – MENA .............................................................................................................................. 18 2.3 Competitive Landscape ................................................................................................................................................... 20

2.3.1 Metrics for listed banks in the region ....................................................................................................................... 20 2.3.2 Multiples Comparison .............................................................................................................................................. 21

2.4 Market Dynamics ........................................................................................................................................................... 22 2.4.1 Country‐wise regulatory frameworks for Islamic banking ...................................................................................... 22 2.4.2 Banking Laws and the growth of Islamic banking................................................................................................... 22 2.4.3 Availability of financial products ............................................................................................................................. 23 2.4.4 Availability of support services ................................................................................................................................ 23 2.4.5 Trends in Islamic banking ........................................................................................................................................ 24

2.5 Recent Developments ...................................................................................................................................................... 24 2.5.1 Impact of the Economic crisis in the MENA region ................................................................................................ 25

3 Critical Success Factors ...................................................................................................................................... 26

4. Opportunities and Challenges ................................................................................................................................. 28

4.1 Opportunities .............................................................................................................................................................. 28 4.1.1 Islamic Microfinance and Socially Responsible Investments ................................................................................. 28 4.1.2 Infrastructure and Project Financing .................................................................................................................... 28 4.1.3 The role of Islamic investment funds in promoting cross‐border Islamic investments ......................................... 29 4.1.4 Tapping the non‐Muslim market in times of a worldwide meltdown ................................................................... 29 4.1.5 Islamic insurance................................................................................................................................................... 30

4.2 Challenges ................................................................................................................................................................... 30 4.2.1 Risk management ................................................................................................................................................. 30 4.2.2 Shariah interpretation ‐ differences among countries and regions ...................................................................... 31 4.2.3 Product innovation ................................................................................................................................................ 32 4.2.4 Regulatory issues .................................................................................................................................................. 32

5. Country‐wise Islamic banking overview ................................................................................................................. 33

5.1 Bahrain ....................................................................................................................................................................... 33

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5.2 Egypt ........................................................................................................................................................................... 34 5.3 Kuwait ......................................................................................................................................................................... 35 5.4 Jordan ......................................................................................................................................................................... 37 5.5 Qatar ........................................................................................................................................................................... 38 5.6 Saudi Arabia ................................................................................................................................................................ 39 5.7 UAE ............................................................................................................................................................................. 41 5.8 Oman and Lebanon ..................................................................................................................................................... 42

6. Future Outlook ...................................................................................................................................................... 43

7. Appendix ............................................................................................................................................................... 45

7.1 Appendix 1 ‐ Major Islamic Banking players in the region ............................................................................................... 45 7.1.1 Abu Dhabi Islamic Bank .......................................................................................................................................... 45 7.1.2 Al Rajhi Bank ......................................................................................................................................................... 46 7.1.3 Bank Al Bilad .......................................................................................................................................................... 47 7.1.4 Bank Al Jazira ......................................................................................................................................................... 48 7.1.5 Boubyan Bank ........................................................................................................................................................ 49 7.1.6 Dubai Islamic Bank ................................................................................................................................................. 50 7.1.7 Kuwait Finance House ............................................................................................................................................. 51 7.1.8 Masraf Al Rayan ...................................................................................................................................................... 52 7.1.9 Qatar International Islamic Bank ........................................................................................................................... 53 7.1.10 Qatar Islamic Bank ................................................................................................................................................ 54

7.2 Appendix 2 – Evolution of Islamic Banking .................................................................................................................. 55 7.2.1 Overview .................................................................................................................................................................. 55 7.2.2 Principles of Islamic banking ................................................................................................................................. 55 7.2.3 Classical Islamic banking ....................................................................................................................................... 55 7.2.4 Industry structure – Islamic Financial Services Industry ........................................................................................ 56 7.2.5 Evolution of Institutional framework .................................................................................................................... 56 7.2.6 Modern Islamic Banking ....................................................................................................................................... 57 7.2.7 Industry structure – Islamic banking ..................................................................................................................... 57 7.2.8 Product development over the years .................................................................................................................... 59 7.2.9 Product Trends ...................................................................................................................................................... 59 7.2.10 Comparative analysis of Islamic financing ........................................................................................................... 60 7.2.11 Islamic concepts applied to conventional banking products ................................................................................ 61 7.2.12 How does Islamic banking differ from conventional banking? ............................................................................ 62 7.2.13 Development of different asset classes in the Islamic fund .................................................................................. 63 7.2.14 Key Sukuks Announced in 2008 .............................................................................................................................. 64

7.3 Appendix 3 ‐ Mandatory Standards in Islamic Finance ................................................................................................ 65 7.4 Appendix 4 ‐ Regulatory Environment and Key Developments .................................................................................... 66 7.5 Appendix 5 ‐ Key Global Issues .................................................................................................................................... 67 7.6 Appendix 6 ‐ Acronyms ............................................................................................................................................... 68


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Executive Summary The global economic crisis that took center stage in 2008 shows no signs of abating as the world enters the new year. The MENA region on account of its abundant natural hydrocarbon reserves has gained prominence on the world’s geopolitical map particularly during the last year which saw oil prices soaring to all-time highs. The liquidity and surplus built during the first half of 2008 has triggered a spate of development and infrastructure activity in the region. Extensive reforms undertaken by the regional governments and a strategy of actively diversifying the economies from oil is pumping capital to develop other sectors like manufacturing and financial services. The strong cash flows into the region provide opportunities for long‐term growth and trade development within the region. These are the major drivers of a thriving banking industry coupled with strong banking regulation compared to other Western counterparts. GDP growth for the region is forecasted between 5 and 6% and is expected to remain healthy despite the dampening effect of recent low oil prices and the global economic slowdown. The economic fallout has had two primary effects. On one side, the crisis has led to banks questioning the approach to evaluating assets and the process of measuring, recording and tracking mark-to-market value vs. the underlying risk. On the other, it has brought to limelight segments and sectors that have weathered the impact relatively better than the less fortunate ones. Islamic Banking is one such area that has caught the attention of banking experts and industry analysts worldwide. The system is relatively new and still evolving compared to conventional banking. Regardless of the type of system, the region is aware of the need for world class banking supervision. Dubai, Bahrain and Qatar’s continued focus on developing adequate financial infrastructure and regulation are clear instances of this thought and practice.

Islamic Banking has come a long way since it was introduced as a parallel system specifically targeting devout Muslims desirous of complying with their religious principles. Naturally, the MENA region with a majority population following Islam was and continues to be the nerve center for the evolution of this banking system. However, it is another Muslim country Malaysia, which has strongly furthered the cause of Islamic Banking by establishing it along side conventional banking. This report focuses on the industry’s structure and landscape within the MENA region and attempts to draw comparisons and inferences from examples like Malaysia where Islamic Banking has grown and developed much faster. The success in European countries and the growing interest in Americas about the tenets of Islamic Banking are testimony to the interest and the potential opportunity that is just starting to unfold.

As the world looks at the overall vulnerability of conventional banking systems, it perceives Islamic Banking as a potentially safer and more controlled approach to managing financial assets. If the industry has to grow holistically, there will be a need for all-inclusive participation going beyond boundaries of religion. In that direction, the system will need to address the key challenges that impede growth today and devise a way to make itself available as an alternative banking model. The aversion to interest and the idea of Profit and Loss Sharing (PLS) that form the backbone of Islamic Finance fundamentals are ideas that are orthogonal to conventional banking and will take a while to be adopted by the mainstream.

The Shariah law was laid down in historic times and within the law, there are multiple schools of thought. Like any other theological principle, it is important to derive appropriate adaptations and interpretations of how these principles apply to a changed context of the modern world. The multiple interpretations however, have impeded the emergence of a standardized regulatory system or a common governance mechanism that can apply to both Muslim and non-Muslim countries. The varied and non-standard nature is the foremost challenge the industry needs to address to facilitate product innovation and extension of this banking methodology to non-Islamic markets. Islamic banking has a natural direct market – the large Islam-practising population. However this population will act as both an impetus and a constraint unless the thoughts and processes driving Islamic banking are able to learn and adapt and bring in modern views and progress into its fold.

The time is ripe. There is a cry for change in the financial systems across the world and the Islamic world in the MENA region has the necessary financial resources. Although human resources and technological platforms may be a temporary hindrance, Islamic banking is well poised to develop into an attractive banking model with a whole new approach to managing risk vs. return.

Is there a need for rapid growth at breakneck speed for Islamic Banking to be successful? The world around us today tells us clearly that is not required. Any era or period of unnatural growth has brought with it corrections and painful adjustments. Though Islamic banking is not a paradigm shift in the financial system, the growth will still need time and the right approach that is controlled and all-inclusive.

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1. Global Islamic Banking Overview Islamic banking is one of the fastest-growing sectors across the global banking industry. While estimates about the size of the industry differ, the IMF puts the total assets of Islamic banking at USD 250 bn, expected to reach USD 1 trillion by 2016. Of this, the GCC countries account for nearly 56% of the total Islamic banking assets, a majority of which in turn are accounted by the top-three Islamic banks alone (Al Rajhi bank, Kuwait Finance House and Dubai Islamic bank). Currently, there are more than 390 Islamic banks and institutions spread across 75 countries, which are expected to grow at over 10-15% during 2009. Notwithstanding the encouraging data, the fact is that the industry is too small compared to the size of its potential market. An estimated population of 1.6 bn Muslim across the world implies a huge untapped opportunity. Globally, Islamic banking assets have been growing at a faster pace than the overall banking system. The pace of growth has increased dramatically over the past decade driven by increased awareness and demand, as well as easier access to Islamic banking services. However, Islamic financial products remain a small part of the global banking sector. The industry’s promising benefits and returns have attracted the conventional banks that otherwise might never have considered offering such products. The “ethical banking” concept has helped generate interest in Islamic finance from both Muslims and non-Muslims.

There is significant variance between the different estimates of Islamic banking industry’s size as it stands today. According to a recent McKinsey study titled ‘The World Islamic Banking Competitiveness Report 2007/08: Capturing the Trillion Dollar Opportunity’, the value of Islamic banking assets and assets under management is expected to reach USD 1 trillion by 2010. Whereas, the Euromoney Islamic Finance Review for 2007/08 stated that the estimated Islamic financial market’s size ranked between USD 700 bn to USD 750 bn, with an annual growth rate of 15%. According to Financial Insights, Islamic finance has been growing at 20-30% per year over the past decade, while Ernst & Young is even more optimistic in its forecast suggesting that Islamic financial assets will hit USD 2 trillion by 2010. This rapid growth has been fuelled by surging demand for Shariah-compliant products not only from financiers in the Middle East and other Muslim countries, but also by investors globally, thus making it a global phenomenon. Besides its vast geographical expanse, Islamic banking is witnessing rapid expansion across the whole spectrum of financial activities including retail banking, insurance and capital market investments.

According to IMF, the continued growth in the Islamic banking industry is attributable to three factors: increasing demand from a large number of Muslims (including Muslim immigrants to western countries); rising oil wealth in Dubai and other UAE countries; and the growing attractiveness of Shariah-compliant financial services to non- Muslim investors seeking “ethical” investments and banking practices.

Islamic vs conventional banking asset growth

0

10

20

30

40

50

60

70

Pakist an UAE Qat ar Bahrain Indonesia Kuwait SaudiArabia

Malaysia Egypt Jordan

%

Islamic Banks Assets

System Assets

Source: Country wise Central Banks, M.S & Blominvest

Global Islamic Assets (USD Bn )

140

750

1000

0

200

400

600

800

1000

1995 2007 2010

Source: Standard & Poor’s, McKinsey Company, Euromoney & Blominvest


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After leading conventional banks such as Citibank and HSBC started offering Islamic financing products on a basic level in the Middle East, other leading conventional banks followed suit. Recently, the Islamic finance institutions are focusing on expanding their international footprint. Countries in Europe, North America and parts of Asia have also witnessed the commencement of Islamic

banking operations. These services are offered either through Islamic windows created at existing banks or through newly established entities. The regulatory bodies in these countries have facilitated a conducive market environment for Islamic products.

Malaysia is widely acknowledged to be at the forefront of Islamic finance. The industry’s success in Malaysia underscores the importance of strong government/regulatory support, building scale and engaging conventional banks, and adopting a flexible, holistic approach and establishing supporting financial infrastructure/institutions.

UK has emerged as the epicenter for Shariah-compliant finance outside the Muslim world. In the Islamic Bank of Britain, for instance, one in five applicants for some of the products is a non-Muslim (source: Money UK website, August 2006). During 2004, when HSBC Group offered Islamic equivalent mortgages (more like leases), more than half the customers were non-Muslim. According to the bank officials, what drew these customers was the “competitive pricing” compared to that of traditional interest-based financing. The evolution started with a few banks from the Middle East and South-Eastern Asia offering simplistic and limited product offerings. The situation however has changed since 2000, with the offering of more competitive products and development of specific Islamic financial regulations enabled the dynamic growth of the industry. Today, more than 26 banks in the UK offer Shariah-compliant products. Financial institutions such as Citibank, Deutsche Bank and HSBC, which after several years of running Islamic windows in the Middle East have initiated the same in UK, are enhancing coverage by providing new and innovative products. The Islamic Bank of Britain is the first fully Islamic retail bank in a non-Islamic country. The British Financial Services Authority has authorized the first investment bank as well as the European Islamic Investment Bank. While the main products are current accounts and mortgages, the British government is planning to issue its first Sukuk.

The Netherlands is another country which is actively promoting Islamic finance. According to a study conducted in 2007 by the Dutch Central Bank and AFM, there is a huge potential for Shariah-compliant mortgages and other services. The authorities have started discussing the introduction of the necessary regulatory changes which would make Islamic banking possible and more efficient. With respect to North America, until the development of a full Islamic bank, some “alternative products and services” currently offered by a limited number of companies and finance houses are home, auto and business financing; car and equipment leasing; interest free deposits and mutual funds management. Equity indices were created by Dow Jones for benchmarking Shariah-compliance investments. Meanwhile, Canada is looking into the licensing of its first Islamic investment bank.

Source: Islamic finance news & Blominvest

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February 2009

1.1 Global Islamic Banking Regulatory Environment Middle East and North Africa Bahrain: The Central bank of Bahrain provides a regulatory framework. Islamic Finance Institutions

(IFIs) are required to adhere to the standards set by the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). Kuwait: Fatwa Board of the Ministry of Awkaf and Islamic Affairs acts as a regulator. Standards issued by the Islamic Financial Services Board (IFSB) for Pillar 1, Basel II norms are mandatory Qatar: Qatar Financial Centre Regulatory Authority is a member of IFSB and AAOIFI and has issued rules to govern IFIs, as of 2005 Saudi Arabia: Saudi Arabian Monetary Agency acts as a regulator for all IFIs. The Islamic Development Bank (IDB) also plays an important role in promoting Islamic banking UAE: All IFIs must comply with Federal Law No. 6 of 1985 Iran: Since 1979, the entire banking system is strictly Islamic Oman: The Central Bank implemented various restrictive policies preventing the establishment and expansion of IFIs Lebanon: Islamic banking is relatively new as laws to establish Islamic banks with all their different instruments were passed only in February 2004 by Parliament under legislation No 575, giving the Central Bank of Lebanon (BdL) authority and supervision Syria: In 2005, the CBS also issued separate regulations for the creation and operation of Islamic banks. Another law was passed in May 2005, authorizing private investors to establish Islamic banks. The requirements were similar to those for traditional banks, except for the minimum required capital of USD 100 mn as opposed to USD 30 mn for traditional banks.

Asia

Malaysia: The Shariah Advisory Council (SAC) of the Central Bank, established in 1997, acts as the sole regulator for IFIs. Initiatives like tax deductions are adopted by the government to promote Islamic finance. All the IFIs have to comply with Islamic finance standards issued by IFSB by the end of 2010 Indonesia: The Shariah Bureau of the Bank of Indonesia acts as the regulator. The Government will need to amend laws (including taxation) on state debt securities or state treasury to promote growth in the sector Singapore: Changed its banking and tax laws to ensure that Islamic products are at par with conventional debt securities Japan: Tokyo is changing firewall regulations to allow financial institutions to engage in asset trading through subsidiaries Thailand: There is only one fully-fledged Islamic bank (the Islamic Bank of Thailand). However, the sector is starting to catch up with support from the Ministry of Finance and the Bank of Thailand China: Active member of IFSB India: No separate legislation by the Reserve Bank of India. No initiatives are undertaken to promote Islamic banking Pakistan: The State Bank of Pakistan acts as the regulator for Islamic banking Bangladesh: The Central Bank acts as a regulator and introduced reforms like lower Statutory Liquid Ratio to promote Islamic banking


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The ongoing turbulence in global financial markets highlights the importance of financial stability for broader economic developments. Islamic banking had relatively lesser impact immediately as its ban on interest and lack of structured products prevented it from investing in assets that turned toxic for conventional banks. However, the industry can no longer claim to be immune to the global financial crisis which has hit the industry’s sources of funding and property values in the Gulf Arab region. According to Moody’s, Islamic financial institutions in the Gulf showed strong resilience during the financial turmoil, but are not risk-immune due to a shortage of liquid instruments and lack of an Islamic interbank market. The ratings agency expects the growth in Islamic banking assets to slow sharply in 2009, to around 10-15% from 20-30% last year. Islamic banks share the same pain with their non-Islamic counterparts, facing a fall in equity valuations and a slump in Gulf real estate, to which they are heavily exposed. Although 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 do conventional banks. At the end of 2007, only 10% of Gulf Arab Islamic banks’ liabilities were bonds and other long-term liabilities, compared with 23% at conventional banks, according to McKinsey & Company. Islamic banks need to diversify funding sources, that are still highly dependent on retail deposits. As liquidity has dried up marred by low oil revenues, Islamic banks need to diversify their products and better manage their cash. Islamic hedging products, derivatives, liquidity and risk-management tools are all in their early stages of development. Derivatives are viewed positively given their application to risk mitigation. Moreover, practitioners and scholars are becoming increasingly open to more aggressive hedging structures. These would be of particular importance for project finance, a key banking business in the Gulf Arab region that still has a large number of infrastructure projects in the pipeline. But developing new products is an arduous process, as Islamic scholars need to establish their compliance with Shariah law, which is open for interpretation. The current financial crisis has hit banks worldwide, and is driving the industry to diversify their strategies to include key segments such as Islamic bonds, or Sukuk. Sukuk issuance in 2008 dropped 60% from 2007, due to debates over the Shariah-compliance of some types of Sukuk. Although the industry has remained relatively crisis-proof due to the asset-backed nature of its transactions, the theory is increasingly being tested by economic and legal realities. Recently, the United Arab Emirates bailed out Islamic mortgage lenders Amlak and Tamweel. Furthermore, Emirates Industrial Bank (EIB) and Real Estate Bank (REB) will be merged to form Emirates Development Bank, which would consolidate and absorb struggling finance firms, acting as more of a rescue vehicle.

Sri Lanka: In January 2005, the Banking Act was amended to allow Islamic banking products, following which two existing conventional commercial banks — namely Union Bank of Pakistan (now acquired by Standard Chartered Bank, Pakistan) and MCB of Pakistan — opened Islamic windows

Others US: IFIs must comply with State and Federal regulations, no separate approvals are required UK: Financial Services Authority (FSA) provides a regulatory framework. The government has undertaken various initiatives such as modifying tax legislation to promote Islamic finance. France: Has applied for Islamic banking license and decided to implement a set of regulations aimed specifically at Islamic banking Germany: Listed as a potential base for Islamic banking

1.2 Islamic Banking during the Economic Crisis

Source: Oman Economic Review, KFH – Asian Economic Outlook & Prospects in IF, Islamic Finance News, Bank Negara Malaysia, QFCR & Blominvest

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February 2009

1.3 Growth Drivers for Islamic Banking

1.3.1 Large and Young Muslim population globally The growing Muslim population across the world has been the primary factor for the success of Islamic finance. It is only natural for Islamic countries to establish an economic system in line with Shariah principles that also define the general lifestyle. Muslims account for nearly 24% (≈ 1.6 bn) of the world population. Apart from the primarily Islamic nations, Indonesia and Pakistan have the world’s fourth- and sixth-largest Muslim populations, respectively, accounting both for 30% of the total. Therefore, it is in the interest of Islamic financial institutions to gain a foothold in these countries in the long-term. In addition, many of these Muslim dominated countries are characterized by young populations with more than 50% of its citizens are yet to reach adulthood. During 2002-2006, the Muslim population grew at an average of 1.9%, higher than the world’s population growth rate of 1.2%. Furthermore, it is expected that the Muslim population will account for nearly 30% of the world’s total by 2025.

1.3.2 Low penetration in Muslim‐majority nations – for both conventional and Islamic products

Loans-to-GDP and deposits-to-GDP ratios are key metrics indicating the penetration level of the banking sector. With the exception of Jordan, Malaysia, Lebanon and the UAE, penetration of conventional banking products is low in countries with large Muslim populations. In Kuwait, Qatar and Oman, the cumulative value of loans and deposits is very low relative to the per capita GDP level. However, the proportion of Islamic assets to the total assets of the sector is highest in Saudi Arabia and Kuwait. The low penetration, despite high per capita, GDP can be explained on account of surplus oil money (implying little or no need for credit), uneven wealth distribution, and assets held in overseas investments and accounts (i.e., domestic deposits not correctly indicating actual wealth levels). Meanwhile, religious and cultural aspects have played a significant role in this as well.

Muslim Populations (Millions)

202

160

72

71

26

15

6

4

2

2

0.703

0.575

0.002

0 50 100 150 200

IndonesiaPakistan

EgyptTurkey

Saudi ArabiaMalaysiaJordan

UAEKuwait

LebanonQatar

BahrainOman

Source: CIA World fact book & Blominvest

World Muslim Population growth trend (1980 ‐ 2025E)

0

5

10

15

20

25

30

35

1980 1990 2007 2025E

% of world pop

ulation

Source: Country wise Central Banks, , IFIS, KFH, Blominvest

Source: IMF, Country wise Central Banks, BlominvestBHN: Bahrain, KWT: Kuwait, QTR: Qatar, OMN: Oman, SAR: Saudi Arabia,

PKT: Pakistan, UAE: United Arab Emirates, EGT: Egypt, JRD: Jordan, LBN: Lebanon, MYA: Malaysia, INA: Indonesia, TKY: Turkey

Loa n/GDP Ve rs us GDP Pe r Ca p i ta (USD)

BHNKWT

QTRSAROMN

UAE

EGT

JRD

LBN

MYA

TKYINA

0%

20%

40%

60%

80%

100%

120%

140%

0 12,000 24,000 36,000 48,000 60,000 72,000 84,000

GDP Per Capita (USD)

Loan/GDP

PKT


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A significant number of Muslims have avoided the conventional banking system for religious reasons. If the penetration of conventional banking products is low, the penetration of Islamic banking products is even lower. As a percentage of the total banking sector’s assets, Islamic banking is above 20% only in Saudi Arabia, and Kuwait. Paradoxically, the two countries with the largest Islamic populations (absolute and percentage-wise) – Indonesia and Pakistan – are in low single-digits. In terms of Islamic financing, Malaysia was the most developed at the end of 2007, driven by a diversion of conventional loans into Islamic substitutes to support the authorities’ push in this area.

1.3.3 Increasing wealth of Muslim nations, due to higher oil prices

One of the key factors in the resurgence of Islamic fortunes in the 20th century was the discovery of vast oil deposits in the Gulf region. The increasing global dependence on oil, and higher oil prices have led to a per-capita GDP increase of 85-130% in Pakistan, Jordan, Malaysia, Bahrain, and Saudi Arabia between 2000 and 2008. While it has more than doubled in the UAE, Kuwait, Indonesia and Oman, GDP per capita surged a staggering 263% in Qatar during this period. Egypt has been left behind due to multiple factors such as the decline in tourism post 9/11, flotation of the Egyptian pound that depreciated 40% resulting in import inflation, and stern fiscal policies.

Excess liquidity has created enormous development opportunities in oil-rich countries like Saudi Arabia, Kuwait, Bahrain, the UAE, Qatar, Iraq, Iran and Algeria. According to the latest MEED estimates (November 24, 2008), more than USD 2.91 trillion worth of development projects are either under way or in the pipeline, making GCC countries the world’s largest project finance market. The investments span across leisure, residential, infrastructure and industrial developments as the governments seek to forge a stronger and more diversified economic future. However, the petrodollars are also expected to result in significant foreign investments. According to McKinsey, the GCC states currently have approximately USD 2 trillion in foreign assets. It estimates that export of crude oil will earn these states between USD 5 trillion and USD 9 trillion from 2007 to 2020 (depending on oil prices) and they will invest 30% to 60% of the gains abroad. The re-deployment of these surpluses accumulated during the recent up-cycle in oil prices till mid 2008 will have a profound impact on Islamic banking and finance, among other things.

GDP Per Capita (USD) 2000 2008(E) YoY Change

Pakistan 539 1,000 85.53%

Egypt 1,550 2,109 36.06%

Indonesia 807 2,181 170.26%

Turkey 4,225 11,463 171.31%

Malaysia 3,992 7,866 97.04%

Saudi Arabia 9,216 21,221 130.26%

UAE 23,446 56,667 141.69%

Kuwait 17,013 46,397 172.71%

Qatar 29,290 106,460 263.47%

Jordan 1,742 3,267 87.54%

Lebanon 4,909 7,376 50.25%

Oman 8,271 21,704 162.41%

Bahrain 11,890 25,245 112.32%

Source: IMF, Country wise Central Banks, BlominvestBHN: Bahrain, KWT: Kuwait, QTR: Qatar, OMN: Oman, SAR: Saudi Arabia, UAE: United Arab Emirates, EGT: Egypt, JRD: Jordan, LBN: Lebanon, MYA: Malaysia, INA: Indonesia, PKT: Pakistan and TKY: Turkey

Depos i ts /GDP Versus GDP Per Capi ta (USD)

BHN

KWT QTROMN

UAEEGTJRD

LBN

MYA

INA

0%20%40%60%80%100%120%140%160%180%200%220%240%260%280%300%

0 10,000 20,000 30,000 40,000 50,000 60,000 70,000 80,000 90,000

GDP Per Capita (USD)

Loan/GDP

PKT SAR

TKY

Source: IMF, Blominvest

Contribution of Islamic assets to total banking assets

45

30

14 13 137 6

3 3 4 2

05

101520253035404550

Saudi Arabia

Kuwait

Qatar UA

E

Malaysia

Bahrain

Jordan

Egypt

Turkey

Pakistan

Indonesia

Source: Country wise Central Banks,, M.S &Blominvest (Saudi Arabia’s core Islamic banks accounts for 15% of total Banking assets)

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February 2009

Cumulative Oil revenue in the GCC s tates

1.5 1.9 2.4 2.8 3.22.1 2.8 3.5 4.1 4.72.63.6

4.55.4

6.23.8

5.16.4

7.68.8

0

5

10

15

20

25

2012 2014 2016 2018 2020

Oil re

venue USD b

n

US D 100/bbl US D 70/bbl US D 50/bbl US D 30/bbl

Oil prices are the key determinant of the quantum of wealth available to the GCC states for re-investing. McKinsey estimates that, even at USD 50 a barrel, the GCC countries will earn a cumulative USD 4.7 trillion by 2020, representing 2.5 times their earnings over the past 14 years. At USD 100 a barrel, the region would earn USD 8.8 trillion by 2020. The long term view remains despite being tempered by prevailing oil prices below USD 50. Even Muslim states without significant oil resources have benefied by remittances from non-residents. The money these workers remit home has contributed significantly to the economies of the West Bank, Gaza, Pakistan, Egypt, Lebanon and Jordan. In addition, the GCC states and their corporates have been investing directly in other Muslim-majority countries like Pakistan and even those farther away such as Malaysia and Indonesia. As wealth increases (boosted by increased oil and commodity prices) and Islamic financial alternatives become more readily available, the demand for Shariah-compliant products can only increase. Such products will range from basic deposits and credit products to wealth management and insurance products. At the wholesale end, corporates are expected to explore Shariah-compliant financing (loans, debt and equity) and cash management, as well as investment opportunities.

1.3.4 Spiritual attraction: a greater focus on Islamic identity

The principles underlying Islamic banking were outlined in the Quran and the Sunnah by Prophet Muhammad more than 1,400 years ago. Besides economic factors, the emergence of Islamic finance is related to the revival of Islam and the desire of Muslims to live in accordance with the Islamic law or Shariah. In addition, the emergence of Islamic finance and wealth has coincided with the independence of many Muslim-majority nations from the 1940s through the 1970s – giving the Islamic people a stronger sense of identity. With Shariah-compliant financial products, Muslims can choose a wide array of banking products that do not compromise their principles. With gradually better understanding of Islamic financial products and improving accessibility, there is every reason to expect increasing demand for Shariah products.

1.3.5 Government and regulatory support for the development and promotion of Islamic banking

Governments of Bahrain, Pakistan, and Malaysia have been supportive of the development of a strong Islamic banking system alongside the conventional banking system. Malaysia is the standout example. To achieve the status of a leading global Islamic finance hub, the central bank of Malaysia, Bank Negara Malaysia (BNM), put together a 10-year financial sector master plan. In 1983, BNM spearheaded the establishment of the first Islamic bank in Malaysia – Bank Islam, followed by Bank Muamalat.

Country Year of Independence

Iran 1979 UAE 1971 Qatar 1971 Bahrain 1971 Kuwait 1961 Malaysia 1957 Sudan 1956 Pakistan 1947 Indonesia 1945 Saudi Arabia 1932 Turkey 1923 Egypt 1922 Jordan 1946

Lebanon 1943

Source: CIA World fact book

Source: McKinsey Quarterly( may 2008), BlominvestSource: McKinsey Quarterly( may 2008), Blominvest

GCC S tates ' S hare of Cumulative Oil Res erves (2007‐2020)

62%14%

13%

9% 2%

S audi A rabia UAE Kuw ait Qatar Oman


14

To achieve critical mass and increase competitiveness within the Islamic banking industry, BNM allowed commercial banks to offer Islamic banking services under a separate Islamic Banking Scheme (IBS) in 1993. Subsequently, BNM liberalized the industry further by allowing foreign banks to offer Islamic banking services under the same scheme. This was followed by the development of Islamic money and capital markets in Malaysia, with inter-bank activity and clearances progressively automated. In 2007, BNM implemented tax and finance incentives to further promote Malaysia as the centre of Islamic finance. Some of the key tax incentives include:

• 10-year tax exemption for Islamic banks and Takaful (insurance) companies on income derived from Islamic banking business conducted in international currencies (including transactions with Malaysian residents). • Tax exemption for profits received by non-residents from financial institutions established under the Islamic Banking Act 1983, and other financial institutions approved by the Minister of Finance. • 10-year tax exemption for local and foreign companies managing funds of foreign investors established under Shariah principles and approved by the Securities Commission (SC). • Tax deduction for issuance costs incurred for Islamic securities. • Stamp duty exemption of 20% on instruments used in Islamic financing products approved by the National Shariah Advisory Council (NSAC) or the SC for a period of 3 years. • Special-purpose vehicles established solely for issuing Islamic bonds need not be subject to tax or tax administrative procedures;

1.3.6 Demand from non‐Muslims, wider acceptance of Islamic banking products

Islamic Banking has overcome the barriers of religion and faith and is now finding increasing support among non-Muslim customers and countries. Islamic banking products are attractive to non-Muslims due to the following reasons that differs them from conventional products

• Certainty of repayments, making Islamic financings akin to long-term fixed-rate loans. • Appeal of profit-loss sharing. • Underlying set of values (prohibiting deception, embracing accountability and transparency). Malaysia is a good example of Islamic banking products being widely accepted by non-Muslims, at both the retail and corporate ends. Interestingly, the nation’s second-largest Islamic operation (by financing) is owned by a bank of Chinese origin and a largely Chinese customer base – Public Islamic Bank. Products include mortgages, car loans, and Islamic bonds (Sukuks). The Sukuk market has grown exponentially, from below USD 0.3 bn to USD 85 bn over the past 7 years. There remains substantial growth potential, as Sukuk issuance currently accounts for less than 0.5% of the global bond market.

1.3.7 Participation of conventional banks in Islamic banking With growing demand for Islamic financial products and services, conventional banks in many Muslim-majority countries have also begun to offer Islamic banking. Through Islamic banking offerings, conventional banks are not only able to cross-sell a new range of products to existing customers, but also stand to reach out to new clientele. For conventional banks, the expected benefits from the increased volume and scope of the business are likely to outweigh higher operating costs. In Malaysia, conventional banks bring scale to the new business, and quickly overtake their pure Islamic banking competitors (which have previously enjoyed a monopolistic environment). In most cases, conventional banks can leverage their existing customer base and infrastructure to cross-sell the new products.

15

February 2009

2. Regional Islamic Banking Overview

2.1 Economic Overview Based on the importance of oil sector in their economies, countries within the MENA region can be broadly categorized into two groups - resource-rich (oil exporting) and resource-poor (oil importing) countries. Out of the countries included in the research, all GCC states belong to the former group, while Egypt, Jordan and Lebanon are in the latter. Amongst the GCC states, Saudi Arabia has the highest proven oil reserves and is thus the most oil-dependant economy (which contributes 54.4% of the country’s GDP). Bahrain, on the other hand, has minimum reserves with oil contributing only 26% to its GDP. Resource-rich countries can be further categorized on their per capita hydrocarbon resources. Here, Saudi Arabia with its relatively large population stands out, having much lower per capita endowment.

With shrinking oil resources as well as the realization that oil-based economy cannot be sustained over the long-term, the six GCC countries have followed the strategy of economic diversification. Bahrain is leading the way, basing its economy on finance (financial services accounted for a 22% share in the country’s GDP during 2007). Other countries, particularly UAE, are competing with Bahrain as a regional financial hub, Qatar with its developing gas industry and Oman with strong services sector, are following. Oil-importing countries, lacking the natural resources which the economy could be based on, naturally have more diversified economies. In countries like Egypt, Jordan and Lebanon, services sector is the major contributor to the GDP.

GDP growth for the Middle East region was 6% in 2007, which was more than the global average of 5%. In the face of recent developments, the IMF reduced its growth estimates to 6.1% and 5.3% (from 6.4% and 5.9%) for 2008 and 2009, respectively; the World Bank puts these figures at an even lower level 5.9% for 2008 and 4.1% for 2009, but forecasts GDP growth of 5.5% in 2010. With an average growth estimate of 6% for 2008 and 4.7% for 2009, the regional growth outlook is better than the global estimates. This healthy growth is on account of huge foreign reserves and the continued demand for energy.

Oil prices, domestic demand and credibility of policy frameworks, affected by the impact of the global financial crisis, will continue to drive growth within the region. According to forecasts, oil prices will fall as the recession continues in 2009, resulting in lower exports and fiscal revenues in the GCC countries. By that, government spending, which forms a considerable part of domestic demand will be reduced. At the same time, tighter credit conditions will further limit new investment projects, and reduce private consumer demand. Further challenges faced, especially by the Gulf countries, include equity crash which is unlikely to pass soon given the current conditions; and real estate market slump, which recently forced the UAE to unveil plans of taking over its two largest mortgage institutions. The latter can be a cause of concern for the banking system since it is exposed to Gulf property.

Resource‐rich (oil exporting) countries* Resource‐poor (oil importing) countries* Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, UAE

Egypt, Jordan, Lebanon

Real GDP growth in the Middle East

5.7%

6.0%6.1%

5.3%

5.9%

4.8%

5.2%

5.6%

6.0%

6.4%

2006 2007 2008E 2009E 2010E

Source: IMF, Blominvest

Current account balance in the Middle East

438.6

253.9 257.0365.0 376.9

0100200300400500

2006 2007 2008E 2008E 2010E

USD bn

0%

10%

20%

30%

Current account balance, USD bn

Current account balance, % of GDP

Sources: IMF, Blominvest

Hydrocarbon sector in GCC countries

39.0%

54.4%

26.0%

45.3%52.1% 56.6%

‐10%

10%

30%

50%

70%

UAE SaudiArabia

Bahrain Oman Kuwait Qatar

(Growth %)

0

10000

20000

30000

40000

(Barrels)

Share of the sector in GDP (in %) Oil endowment per capita (Bbl)

Sources: Country wise Central Banks, CIA, Blominvest


16

This contraction in exports will likely affect all the countries in the region, especially those that are resource-poor. These countries face the danger of further deterioration of their current accounts as FDI, of which a large part flows from the Gulf states, will drop.

In October, IMF projections for 2008 and 2009, assumed a growth in the current account balance for the Middle Eastern region, from 18.4% of GDP in 2007 to 22.9% in 2008 and a decline to 17.1% in 2009. However, in the face of the recent changes in oil price, a correction in the above forecasts is not unlikely to occur. Despite lower oil import bills, the global slowdown and lower FDI will also adversely affect the current account balances of these countries. In spite of the positive effect of the fuel price drop on current accounts of oil importers, high share of hydrocarbon in total exports of resource-rich countries (from 47% in UAE to 95% in Kuwait) coupled with their higher external balances in absolute value than those of the resource-poor group, will most likely lead to a downward revision of the current account forecast for the region. Additionally, non-oil exports and regional FDI inflows will be adversely affected by the global slowdown.

Fiscal surplus of the region as a whole is expected to remain positive; however, due to the fall in oil revenues, previous estimates of rising fiscal savings are likely to be revised. The average price of oil which would balance GCC states’ budgets is USD 47, is well below the forecasts for 2008. Egypt, Jordan and Lebanon, whose budgets did not balance in 2007, are expected to maintain their deficits in 2008. However, decline in commodity prices will reduce pressure on public spending as fuel and food subsidies decline. In the year ending June 2008, the region (especially oil-exporting countries) experienced a liquidity surge, resulting from high oil revenues. Managing this liquidity became a challenge, especially with rising inflationary pressures and limited monetary policy choices due to the dollar peg. Important to note that all GCC countries have dollar pegged currencies except Kuwait. Interest rates declined as liquidity increased. This, coupled with high price levels, caused dynamic credit growth and further increase in inflationary pressures. However, in mid-2008, the situation started to change due to a list of important factors such as: outflow of speculative funds betting on the countries’ decision to appreciate their currencies against dollar; measures to curb credit growth (like raising reserve requirements) taking effect; credit demand outpacing deposit growth; and international funding drying up with the beginning of global crisis.

One positive aspect of the global slowdown for the whole region is the decrease in price pressures. Inflation, which reached double digits in the third quarter of 2008 for many MENA countries, is expected to ease, allowing monetary policies to focus on supporting growth. Additionally, in the GCC, it is believed that the investment projects revision, forced by the credit squeeze, will lead to the cancellation of the less realistic and inefficient initiatives that previously resulted from excess liquidity. Investments that will take place are likely to be extended in time, supporting the region’s mid-term economic outlook. Furthermore, timely measures taken by central banks in the countries aiming at ensuring liquidity in the region should insulate them from the full negative impact of the credit crunch. On the whole, the global crisis is expected to lead to slower sustainable economic growth in the region.

Inflation in the Middle East

7.0%

10.6%

14.4%

11.3%

15.8%

0%

5%

10%

15%

20%

2006 2007 2008E 2009E 2010E

Sources: IMF, Blominvest

17

February 2009

2.1.1 Comparative Economic Indicators and Ranking

All figures for 2007 * Assuming 100 for the year 2000, except Egypt where 2001/2002=100 ** For Egypt, data given is for fiscal year 2007‐2008 *** Oil and gas sector combined Sources: IMF World Economic Outlook Report 10/2008, CIA World Factbook, The Economist Intelligence Unit, Bank Audi, The Gulf Times, Central Bank of the United Arab Emirates, United Arab Emirates Ministry of Economy, Saudi Arabian Monetary Agency, Central Bank of Bahrain, Bahrain Ministry of Finance, Central Bank of Oman, Central Bank of Kuwait, Qatar Central Bank, Central Bank of Jordan, Jordan Department of Statistics, Banque du Liban, Central Bank of Egypt Rank GDP growth Investments/GDP Current account/GDP Money supply/GDP Fiscal balance/GDP Employment

1 Qatar Qatar Kuwait Egypt Kuwait Qatar

2 UAE Jordan Saudi Arabia UAE UAE Kuwait

3 Egypt Lebanon UAE Bahrain Qatar UAE

4 Bahrain Saudi Arabia Bahrain Lebanon Saudi Arabia Saudi Arabia

5 Jordan Egypt Qatar Kuwait Bahrain Egypt

6 Oman UAE Oman Saudi Arabia Oman Jordan

7 Kuwait Oman Egypt Qatar Jordan Oman

8 Saudi Arabia Kuwait Lebanon Oman Egypt Bahrain / Lebanon

9 Lebanon Bahrain Jordan Jordan Lebanon ‐‐‐

UAE KSA Bahrain Oman Kuwait Qatar Jordan Lebanon Egypt**

GDP (USD bn)* 117.99 247.86 13.37 28.32 67.57 31.20 13.27 24.64 96.13

GDP per capita (current prices, USD ‘000)

42.501 15.724 22.771 15.714 33.687 78.754 2.766 6.569 1.739

Inflation (%) 11.1 4.11 3.4 5.50 4.98 13.76 5.4 9.3 8.81

Investment (USD bn) 40.44 83.28 3.48 8.13 22.05 29.34 4.47 5.42 33.12

Current a/c balance (USD bn) 37.01 95.12 2.90 4.0 47.47 10.45 ‐2.98 ‐2.63 0.9

Money supply (USD bn)

154.04 177.97 14.92 15.88 66.80 32.32 2.11 16.44 141.60

Interest rate (%) 4.25 5.5 5.3 6.02 6.25 5.55 7 12 10

Velocity of money circulation 1.02 2.11 1.32 2.52 1.65 2.10 7.58 1.50 1.12

Fiscal balance (USD bn)

30.21 47.15 0.11 104.45 32.81 10.46 ‐0.87 ‐2.56 ‐12.04

Fiscal balance to GDP ratio (%) 15.69 12.3 0.6 0.14 29.83 14.7 ‐5.25 ‐10.39 ‐7.5

Population (mn) 4.49 24.24 0.76 2.7 3.40 1.2 5.72 3.75 75.05

Unemployment rate (%) 2.4 5.63 20 15 1.5 0.5 13.5 20 9.1

Contribution of oil to economy (%) 38.6 54.4 26.0 45.3 52.1*** 56.6*** n/a n/a n/a


18

2.2 Regional Industry Overview – MENA Snapshot of Islamic Banking in the Region as of December 31, 2007. Countries

Market Capital

Local Branches (actual)

Total Assets

Total Financing & Investment activities

Total Deposits

Bahrain 3,387 62 4,856 1,434 2,825 Kuwait 16,613 62 38,291 21,775 20,688 Qatar 8,162 67 11,395 7,032 6,693 Saudi Arabia 25,873 525 43,501 75,073 51,635 Egypt 156 33 5,617 3,804 5,137 Jordan 464 56 2,252 1,103 1,954 UAE 3,613 138 42,368 28,592 31,454

Total 58,268 943 148,281 138,813 120,387

The Islamic banks in the MENA region have achieved strong growth during the years 2003 to 2007 with a CAGR of over 31% in assets. They outperformed the banking system as a whole that registered an average CAGR of about 23.9%. At the end of 2007, there were 20 publicly listed pure Islamic banks in the region with a combined asset base of USD 148.3 bn. The graph indicates that between 2003 and 2007, the CAGR of Islamic Banking Assets within the region, was more than that of conventional banking.

With strong Islamic traditions and a large Muslim population, backed by higher liquidity, Saudi Arabia leads in terms of Islamic Banking assets. The numbers indicated in the above table (for the kingdom) are lower than actual, as dual banking services are permitted, and such information is not publicly traded. The Saudi Arabia based Al Rajhi bank is the world’s largest Islamic bank. Bank Al Bilad, Al Rajhi Bank and Bank Al-Jazira accounted for 15.17% of total banking assets in Saudi Arabia and 30% of total Islamic banking assets in the MENA region. However, during 2006, Islamic banking assets in Saudi Arabia accounted for 45% of the total banking assets. Therefore the actual growth and penetration of Islamic Banking in the kingdom, and in countries where conventional banks are permitted to provide Islamic products, are difficult to ascertain.

CAGR ‐ Islamic Banks Assets Vs. Total Banking Assets (2003 to 2007)

0%10%20%30%40%50%

Bahrain

Kuwait

Qatar

Saudi Arabia

Egypt

Jordan UA

E

Total Banking Assets Growth Islamic Banks Assets Growth

Source: Country wise Central Banks, Company wise annual reports, Blominvest

Note: Market Capital, Local Branches and Total Assets of Saudi Arabia include only Bank Al Bilad, Al Rajhi Bank and Bank Al‐Jazira, which are the only three Islamic banks. Other Saudi banks provide both Conventional and Islamic banking.

(in USD mn except Local Branches)

Source: Company wise annual reports, Bloomberg, Blominvest

Islamic Banks Assets as % Total Banking Assets (2007)

30%

15% 14% 13%

6%3% 2%

0.0%5.0%

10.0%15.0%20.0%25.0%30.0%35.0%

Kuwait

Saudi Arabia

Qatar

UAE

Joran

Egypt

Bahrain

Note: Saudi Arabia includes assets of only core Islamic banks (Bank Al Bilad, Al Rajhi Bank and Bank Al‐Jazira)

Source: Country wise Central Banks, Company wise annual reports, Blominvest

19

February 2009

During 2007, Kuwait’s full-fledged Islamic banking assets accounted for 30% of the total banking assets, the second-highest in the region. The large Muslim population, their corresponding low banking penetration and the increasing awareness and acceptance for Shariah-based products, will ensure continued growth of Islamic banking relative to conventional banking. During the last couple of years, the large regional liquidity has contributed to above normal growth rates in the overall economic activity in the region and in the Islamic banking industry in particular. Given the global economic environment, growth is expected to be lower than the earlier CAGR of 31%. Some countries have also restricted the number of new entrants to the Islamic banking sector and thereby monitoring growth. However, such regulations are being gradually revised and may lead to higher growth in Kuwait and Jordan. In order to promote Islamic banks, clear regulatory guidelines are being set. With this objective, Dubai, Bahrain and Qatar have established Islamic Banking Centers and Institutions. The Islamic banking industry in GCC, which had so far been largely insulated from the global financial crisis, bagan to feel the pinch as the ongoing turbulence hits the industry’s main source of funding and property values in the Gulf Arab region. According to Moody’s, aggregate growth in Islamic banking assets is expected to slow down to 10-15% during 2009. Slowing economic growth in other parts of the world and oil prices touching historical lows are the main concerns for the sector. However, Islamic banking in GCC, that is supported by ample liquidity in the system, strong retail environment and the government’s willingness to promote the industry, will continue to grow at a moderate rate in the near future before resuming more rapid growth.

Shariah compliant assets in the MENA region The GCC states, with Shariah-Compliant assets worth USD 262.7 bn, hold the largest share of the pie worldwide. Saudi Arabian institutions provide the largest share of the GCC total, accounting for 35% of the aggregate, followed by Kuwait (24%), the United Arab Emirates (18.7%), Bahrain (14.2%) and Qatar (8%). Elsewhere in the MENA region, Iranian institutions remain dominant, accounting for 94.8% of the non-GCC MENA total of USD 248 bn.

Islamic Banks Assets Growth Vs. Total Banking Assets Growth (2007)

0%10%

20%30%40%

50%60%

Bahrain Kuwait Qatar SaudiArabia

Egypt Joran UAE

Total Banking Assets Growth Islamic Banking Assets Growth

Source: Country wise Central Banks, Company wise annual reports Blominvest

Geographic al dis tribution of reported s haria as s ets , GCC , 2008

35%

24%

19%

14%8%

S audi A rabia Kuw ait UAE Bahrain Qatar

Note: Others include Tunisia, Algeria, Lebanon and Palestine

Source: The Banker, Blominvest Source: The Banker, Blominvest

Geographic al dis tribution of reported s haria as s ets , non‐GCC MENA, 2008

95%

2% 1% 2%

Iran Egypt J ordan Others


20

2.3 Competitive Landscape

2.3.1 Metrics for listed banks in the region (As on 31st December, 2007, except Market Cap. which is as on 10th December, 2008)

Bahrain Banks M Cap (USD mn) P/E P/B P/R EPS(USD) DPR ROA ROE NM C/I

Bahrain Islamic Bank 540 8.09 1.08 3.85 0.11 31.28 4.57 19.1 47.55 0.23

Al Salam Bank ‐ Bahrain 366 5.96 0.87 3.49 0.05 N.A. 6.22 18.69 54.77 0.45

Shamil Bank of Bahrain 2,481 7.99 1.53 5.18 0.09 N.A. 4.31 20.84 64.84 0.31

3,387 7.3 1.2 4.2 0.1 31.3 5.0 19.5 55.7 0.3

Qatar Banks M Cap (USD mn) P/E P/B P/R EPS(USD) DPR ROA ROE NM C/I

Qatar International Islamic Bank 1,894 13.56 2.76 8.35 1.88 N.A. 5.23 25.37 61.6 0.13

Qatar Islamic Bank 4,044 11.54 3.13 8.55 2.89 19.01 6.93 28.26 74.09 0.19

Masraf Al Rayan 2,224 14.09 1.63 10.87 0.79 N.A. 8.21 12.91 77.13 0.12

8,162 13.1 2.5 9.3 1.9 19.0 6.8 22.2 70.9 0.1

Kuwait Banks M Cap (USD mn) P/E P/B P/R EPS(USD) DPR ROA ROE NM C/I

Boubyan Bank 1,949 28.88 3.91 10.92 0.06 N.A. 2.97 14.54 37.82 0.3

Kuwait Finance House 13,618 13.61 2.88 4.51 0.59 40.51 3.64 26.51 33.12 0.26

Kuwait International Bank 1,046 16 1.82 4.39 0.09 42.91 2.05 11.97 1.26 0.67

16,613 19.5 2.9 6.6 0.2 41.7 2.9 17.7 24.1 0.4

Saudi Arabia Banks M Cap (USD mn) P/E P/B P/R EPS(USD) DPR ROA ROE NM C/I

Al Rajhi Bank 22,791 13.26 3.62 8.4 1.27 41.86 5.61 29.46 63.34 0.24

Bank Al Bilad 1,963 101.64 2.37 7.68 0.06 N/A 0.52 2.36 7.56 0.67

Al Jazira 1,119 5.22 0.89 2.39 0.95 13.97 4.32 18.11 4.29 0.46

25,873 40.0 2.3 6.2 0.8 27.9 3.5 16.6 25.1 0.5

UAE Banks M Cap (USD mn) P/E P/B P/R EPS(USD) DPR ROA ROE NM C/I

Abu Dhabi Islamic Bank 1,797 8.59 1.22 2.29 1.39 51.29 1.91 18.77 26.61 0.19

Dubai Islamic Bank 2,401 3.53 0.85 1.47 0.23 47.93 3.38 26.39 31.35 0.24

Sharjah Islamic Bank 958 11.66 1.58 4.73 0.07 N/A 3.26 13.92 40.6 0.34

Emirate Islamic Bank 254 N/A N/A N/A 0.32 N/A 1.74 20.75 24.81 0.28

5,410 7.9 1.2 2.8 0.5 49.6 2.6 20.0 30.8 0.3

Egypt Banks M Cap (USD mn) P/E P/B P/R EPS(USD) DPR ROA ROE NM C/I

Egyptian Saudi Finance Bank 65 N.A. 0.69 0.55 N.A. N.A. N.A. N.A. N.A. 0.83

Faisal Islamic Bank of Egypt 91 N.A. 0.21 0.09 N.A. N.A. N.A. N.A. N.A. 0.67

156 N.A. 0.5 0.3 N.A. N.A. N.A. N.A. N.A. 0.8

Jordan Banks M Cap (USD mn) P/E P/B P/R EPS(USD) DPR ROA ROE NM C/I

Jordan Islamic Bank for Finance and Investment 464 14.31 2.47 3.81 0.5 N.A. 1.5 18.48 26.6 0.3

Source: Bloomberg, BlomInvest

21

February 2009

2.3.2 Multiples Comparison

From a valuation perspective, Bahrain’s Islamic Banks present the maximum opportunities. The sector is trading at 7.3x earnings and 1.2x book value and net margin of 55.7% is well above the MENA average multiples. Compared to other MENA countries, Islamic banking penetration is very low in Bahrain. However, backed by well-established regulatory system, Bahrain has a huge growth potential.

Islamic Banks in the UAE are trading with 7.9x earnings and 1.2x book value multiples. The sector is supported by a well-diversified economy together with relatively lower cost to income ratio of 26%, as compared to the MENA average of 37%. Qatar Islamic Banks are currently trading at 13.1x earnings and 2.5x book value multiples. Moreover, the EPS of USD 1.9, the net margin of 70.9% and the return on assets (ROA) of 6.8% all represent the highest figure in the region. Other than that, return on equity (ROE) of 22.2% is the second best in the region, while the cost to income ratio of 15% is the lowest. The premium commanded by Qatar Islamic banks is on account of higher value derived from a mature banking industry and overall attractiveness of the sector. With massive projects underway, Islamic banks are likely to report impressive results directly translating into good stock performance. Saudi Arabian banks are currently trading at 40.0x earnings and 2.3x book value multiples, which are much higher than the MENA average. Apart from this, cost to income ratio of 46% is also significantly high, while return on investment ratios (both ROE and ROA) are below the MENA average of 19.1% and 3.7%, respectively. Cost to income ratio of 41% and net margin of 24.1% (lowest in the region) makes Kuwait Islamic Banks less attractive. The banks are currently trading at 19.5x earnings and 2.9x book value multiples. Low penetration of banking sector may act as a support to the industry in the near-term. However, banks will have to improve their margins to create value. Among the non-GCC countries, Islamic banks in Egypt appear least attractive as the cost to income ratio is 75% (highest in the region). The Jordan Islamic bank is currently trading at 14.3x and 2.47x book value multiples. This definitely seems like a good value proposition with the recent changes in Jordan.


22

2.4 Market Dynamics The development of Islamic banking is closely tied to the development of the Islamic Banking Law. This interrelation has impacted the growth of Islamic Banking in the Western world such as UK, the Netherlands and recently Germany, where suitable laws have been enacted. Contrary to the above, the development of Islamic banking in the Middle East is driven by customer demand and not by regulations. In fact, not every country has a proper Shariah-compliant banking law, and regulatory systems across the world are not uniform and coordinated.

2.4.1 Country‐wise regulatory frameworks for Islamic banking

2.4.2 Banking Laws and the growth of Islamic banking

Entry barriers for Islamic banks in the region are relatively more intense than those for conventional banks. These barriers are linked with (a) requirement of Shariah-compliance; (b) prohibiting/discouraging conventional banks to operate Islamic windows to ensure a clear division between Shariah-compliant and conventional banking; and (c) provision of limited licenses for Islamic banks. However, these restrictions are not always explicit in the legislation and can only be interpreted from steps taken by the various Central Banks.

Oman is at one end of the spectrum and does not allow Islamic banking at all, while Bahrain, Qatar and the UAE have relatively low entry barriers with the latter two promoting the growth of Islamic Banking via their financial centers, where conditions for setting up banks are more liberal.

Country Regulatory Authority Islamic Banking Law

Shariah committee Shariah Standards

Accounting Standards

At Central Bank At Bank Level

Bahrain Central Bank of

Bahrain

No law but Prudential Information and Regulatory

Framework exists

Shariah Supervisory Committee

Shariah Supervisory Board

AAOIFI AAOIFI

Egypt Central Bank of

Egypt N/A N/A N/A N/A IAS

Jordan Central Bank of

Jordan Banking Law of 2000 N/A Shariah Board AAOIFI IAS

Kuwait Central Bank of

Kuwait Banking Law N/A Shariah Board N/A IAS

Lebanon Banque du Liban Law No. 575 of 2004 N/A Shariah Auditing Unit AAOIFI IAS

Qatar Qatar Central

Bank Banking Law of 2005 N/A

Shariah Control Board

AAOIFI AAOIFI

Saudi Arabia SAMA No law N/A N/A AAOIFI AAOIFI

UAE Central Bank of

UAE Islamic banking law exists N/A Shariah Board AAOIFI IAS

Country Barriers to

entry Product innovation

Bahrain Low High

UAE Low High

Jordan Moderate Moderate

Lebanon Moderate Low

Qatar Moderate Low

Egypt High Low

Kuwait High Moderate

Saudi Arabia High Moderate

23

February 2009

Islamic Banking in Arab Countries Bahrain, now established as a major regional hub, has eased entry barriers for new Islamic banks. Currently, there are 6 Islamic retail banks and 20 Islamic wholesale banks in the country, resulting in the highest concentration of Islamic financial institutions in the Middle East. The regulatory framework is well-developed and reasonably transparent. The Prudential Information and Regulatory Framework is the first framework especially designed for Islamic finance and provides a good platform for overall governance

In Egypt, out of 7 banks with Islamic operations, only one has been established since 2000, reflecting the reluctance of institutions to enter this market. While Islamic windows are operational in 5 banks, a lack of adequate regulation impedes the overall growth of Shariah-compliant finance.

In Jordan, demand for Islamic banking is estimated to be high; However, no new Islamic banks have been established in recent years. One of the reasons behind this, is the lack of government support for Islamic financial institutions. Contrary to countries like Kuwait, where Shariah-compliant banks are surely supported by the authorities, there are no strong connections between Islamic organizations and the Jordanian government. Therefore, the status quo in the banking industry between conventional and Islamic banking is maintained. The situation is similar to the one in Egypt.

In Kuwait, the number of Islamic banks that can operate in the country is limited. Currently, there are three licensed institutions, all of which used to be public. Islamic windows run by conventional banks are not allowed. Thus, new entries into the market seem unlikely unless there is a change in regulations. In addition to that, Kuwait is not granting any new licenses; Therefore, the conversion of the Commercial Bank of Kuwait into a fully Islamic bank, announced in early 2008, is still not completed.

In Lebanon, the minimum paid-up capital required from Lebanese conventional banks to establish an Islamic institution is USD 20 mn, whereas the minimum capital required from a foreign bank is USD 100 mn. Of the four full-fledged Islamic banks in the country, two are foreign-owned. Islamic windows are not allowed.

Oman does not have an Islamic banking sector as it does not allow Shariah-compliant financial institutions, and the situation doesn’t appear to be changing in the near future. The governor of the Central Bank of Oman believes that all banks should be international, and do not deal with specific operations and regulations.

Qatar opted for an initial period of license restriction to test the Islamic banking concept with only two banks allowed until 2006. Since then however, as restrictions have been eased, the market has developed manifold and today almost 10 banks offer Shariah-compliant products. In 2005, the government established the Qatar Financial Center (QFC) to attract financial institutions and capital into the country. QFC regulations are liberal and allow a relatively quick and easy establishment of Islamic wholesale financial institutions.

Development of Islamic banking in Saudi Arabia is hampered by the lack of clear laws, and technically Shariah-compliant finance is against the constitution. In practice however, Islamic finance institutions are present in the market, but they operate in a challenging environment with many licensing conditions being discretionary and subject to strong government influence. This directly reflects on the fact that only 4 out of 14 banks have been opened since 2000.

The UAE market is relatively competitive, with a large number of banks serving a limited population. Additionally, in 2004 the Dubai International Financial Center was established with the objective of making UAE one of the major global onshore financial hubs. To this end, a lot of incentives were introduced, most importantly a much more liberal business environment than in the rest of the country, especially in terms of foreign ownership. In spite of retail banking being excluded from DIFC regulations, a number of international institutions (such as HSBC Amanah or Citibank) have established operations there.

2.4.3 Availability of financial products Compared to conventional banking, the launch of new and innovative Islamic products is rare. The primary reasons are the unavailability of common regulations across banks and the required adherence to Shariah principles that make new product development a challenge. In the MENA region, Bahrain and the UAE emerge as relative leaders, reflecting their role as regional financial centers. The lowest rate of product innovation/introduction was recorded in Egypt, Lebanon and Qatar. This is not in line with Qatar’s ambitions to challenge Bahrain and the UAE as a financial hub and will need to be addressed over a period of time to boost further progress.

2.4.4 Availability of support services As the absence of interest makes structuring of Islamic financial product particularly difficult, the industry has to rely on efficient and Shariah-compliant IT systems. Like the overall sector, these systems have to be built on Shariah principles (resulting in their specific features, like facilitation of profit sharing). Moreover, a system devised for Shariah-compliant finance has to deal with different regulatory requirements (like accounting or reporting rules) across different regions, such as VAT in Western countries and Zakat (giving


24

a percentage of income to charity) in the Middle East. Similarly, it has to cater for different interpretations of Shariah laws across countries. Another challenge for IT providers lies in the early stage of development of the sector, implying that processes as well as products are still evolving. The newest developments include Basel II accord, which is becoming obligatory for an increasing number of Islamic banks although firm regulations on its provisions with regard to Islamic banking are still in development stage. Looking ahead, multiple banking channels are certain to be introduced, like internet or mobile banking (these are less popular within Islamic banking); thus furthering the need of IT innovation in the sector. Development of Shariah-compliant flexible and innovative IT solutions will strongly influence the growth of Shariah-compliant financial services. As for the moment, most Islamic banks in the Middle East are still forced to use systems customized to suit conventional banking operations better.

2.4.5 Trends in Islamic banking Consolidation is expected as a result of Basel II implementation (many small family-owned banks are unlikely to afford the large capital requirements) and market conditions due to the credit crunch. Although the regional market is considerably fragmented, efforts aimed at creating a regional leader, which could compete with global players offering Islamic services are evident. The most prominent example is Bahrain’s Unicorn Investment Bank, which has set up a special fund to buy out and convert banks around the world. In terms of consolidation approaches, Islamic banks typically buy another Islamic bank or acquire a conventional bank and convert it into a Shariah-compliant unit before merging with the main entity.

The retail segment of Islamic finance in the region has the biggest share in the overall market, and is expected to remain dominant. The penetration of corporate Islamic banking is lower than that of the retail segment; two relatively best performing activities are asset management and corporate activities. The area offers high growth potential, and increasingly sophisticated customer needs are expected to drive growth of investment as well as specialized banking.

2.5 Recent Developments UAE 22‐Nov‐08 16‐Nov‐08 16‐Nov‐08 11‐Nov‐08

• Amlak Finance, a pioneer of home finance in UAE, and Tamweel, UAE's largest real estate financier, has begun

formal merger procedure and the new entity will be functioning in line with Islamic Shariah. The merger will create the UAE's largest real estate financier under the umbrella of the federal government in Abu Dhabi. This merger is a key development for the UAE's financial sector because the new company will be a pillar for further growth of the real estate financing field in the country

• Emirates Islamic Bank entered into a strategic agreement with the Real Estate Regulatory Authority to promote

the region through various initiatives. According to the agreement, Emirates Islamic Bank will utilize RERA's expansive network of marketing channels, online and otherwise, to make their unique and wide product portfolio available to RERA's customers

• SALAMA Islamic Arab Insurance Company, said to be the world's largest Takaful and Re‐Takaful group,

announced its strategic alliance with NCB Capital, described as the region's largest bank, in a bid to further promote the spread of Shariah‐compliant insurance solutions. As a result of the alliance, SALAMA will offer its customers a host of Shariah‐compliant, open‐ended, unit‐linked funds through regular savings and protection plans, with a minimum contribution of AED 200 per month.

• Dubai's Al Salam Investment links with top German bank to create regional Islamic finance powerhouse. QNB

Al Islami and QIIBQIIB will contribute QAR 700 mn and QAR 300 mn, respectively to the Shariah‐compliant funding facility

Saudi Arabia 29‐Nov‐2008 6‐Nov‐2008

• The Islamic Development Bank (IDB) will issue new Sukuk (Islamic bonds) in order to collect funds from the

international market place so as to support member countries affected by the global financial crisis. IDB has increased its capital to USD 25 bn to meet development requirements of member countries

• The Capital Market Authority in Saudi Arabia has announced its approval for Kuwait Finance House (KFH) to

establish Saudi Kuwait Finance House (SKFH). The wholly‐owned subsidiary of KFH has a capital of SAR 500 mn, and will commence its investment business in Saudi Arabia

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February 2009

Qatar 8‐Dec‐2008 2‐Dec‐2008 11‐Nov‐2008

• QNB Al Islami, the Islamic branch of Qatar National Bank, and Qatar International Islamic Bank extended a QAR

1 bn (USD 275 mn) Ijara finance facility to Qatar Real Estate Investment Co., or Alaqaria, for future projects. The QIAQIA decided, during last October, to buy between 10% and 20% of locally listed banks' capital to boost confidence amid concerns over the escalating global economic crisis.

• Al Rayan BankAl, Qatar's second‐largest Islamic lender, said it will sell between 10% and 20% of its capital to

Qatar Investment Authority, the country's sovereign wealth fund • QNB Al Islami, a fully owned affiliate of Qatar National Bank, will launch operations of its first branch outside

Qatar in Sudan's capital Khartoum. The bank's Sudan branch holds a wholesale banking license and will provide a full range of banking services and products including investment savings, unrestricted deposit account, corporate finance, project finance and trade finance, according to the statement

Kuwait 4‐Dec‐2008 30‐Nov‐2008

• Kuwait Finance House rated first in profits and second in assets in The Banker's List for the Top 500 Islamic

Institutions in the World. • Kuwait's Rasameel Structured Finance had been granted a license by the Dubai Financial Services Authority to

operate as an Islamic investment bank in the Dubai International Financial Center. Rasameel Investment Bank Ltd. will provide a range of specialized financial services including capital markets, financial advisory, investment and asset management, and Shariah finance guidance

Jordan 16‐Sep‐2008

• Industrial Development Bank to become Jordan Dubai Islamic Bank. The Jordanian‐UAE consortium will invest

in IDB via its subscription into the bank's capital increase of 26 mn shares, giving the consortium a 52% stake in the bank's new capital

Egypt 29‐May‐2008

• Abu Dhabi Islamic Bank acquired National Development Bank of Development in Egypt. The new strategy of the

company includes the expansion of ADIB’s customer offerings and strengthening of its local and international market presence

Bahrain 2‐Dec‐2008

• Al Salam Bank‐Bahrain announced the launch of a strategic partnership with Tadamon International Islamic

Bank in the Islamic hospitality sector in a step affirming the solidarity of the Islamic banking industry and its ability to provide unique investment solutions. The USD 158.7 mn (SAR 600 mn) deal is considered to be the second for Al Salam Bank‐Bahrain as it has recently announced a similar investment in the same field

2.5.1 Impact of the Economic crisis in the MENA region

Islamic finance is still relatively insulated from the global credit crisis that has impacted conventional banks, primarily because of its profit-sharing requirements and insistence that assets underpin transactions. Furthermore, the current financial crisis has turned the focus towards Middle Eastern sovereign funds which have the financial strength to bail out some of the big names in the west. These funds in particular, and the region in general, have seen rapid growth with new financial institutions being set up and existing players opening Shariah-compliant banking windows. However, while Islamic banking has been less impacted by the global financial crisis from a systemic point of view, it has been affected in other ways - especially in terms of market confidence, pricing of products and valuation of assets. This is not because the product is at fault but because investors are cautious and the pricing is under pressure. Valuations of assets of Sukuk already issued, especially real estate assets, have been affected. In other words, investors in Sukuk, which are about to mature could lose out on returns as the value of assets involved declined due to the credit crunch.

Source: Various news agencies


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3 Critical Success Factors

In the MENA region, Egypt has a very low Islamic banking penetration rate of Islamic Banking compared to other countries. With high inflation, low per capita income and lack of adequate Islamic banking regulations and governance, this clearly indicates an opportunity for future growth. Saudi Arabia remains the most attractive in the region, due to the low penetration of both Islamic and conventional banking. With the strong emergence of the private sector, and the aggressive government spending plans, the Saudi Arabian banking sector has entered a phase of strong lending growth likely to be boosted by the inclination of corporate towards expanding operations in the country. Jordan is another under-penetrated market for Islamic banking and recent developments show significant potential for growth. Being a regional hub for project and wholesale financing, Bahrain has the highest banking penetration in the region. However, it registered the second highest rate for Islamic banking with full-fledged Islamic commercial banks accounting for 42% of the GDP at the end of 2007. Kuwait recorded the highest Islamic banking penetration rate as demand for these institutions are constantly increasing.

Banking and Islamic Banking Penetration (in terms of Assets to GDP)

2003 2004 2005 2006 2007

Bahrain Total Banking Assets As Times of GDP 11.3 12.5 13.7 17.2 21.2 Islamic Banking Assets As % of GDP (Note 1) 46.4% 57.4% 78.4% 112.1% 142.0% Egypt Total Banking Assets As Times of GDP 1.6 1.7 1.8 2.1 2.2 Islamic Banking Assets As % of GDP 4.4% 4.9% 5.2% 5.8% 6.4% Jordan Total Banking Assets As Times of GDP 2.5 2.6 2.9 3.1 3.3 Islamic Banking Assets As % of GDP 15.5% 16.4% 18.1% 18.8% 19.4% Kuwait Total Banking Assets As Times of GDP 1.2 1.2 1.3 1.5 1.9 Islamic Banking Assets As % of GDP 21.7% 22.3% 29.0% 37.1% 54.6% Qatar Total Banking Assets As Times of GDP 1.1 1.1 1.4 1.8 2.4 Islamic Banking Assets As % of GDP 13.6% 15.3% 17.6% 26.6% 34.5% Saudi Arabia Total Banking Assets As Times of GDP 0.8 0.9 1.0 1.1 1.3 Islamic Banking Assets As % of GDP 10.7% 10.2% 9.7% 9.4% 9.1% United Arab Emirates Total Banking Assets As Times of GDP 1.2 1.4 1.8 2.2 2.9

Islamic Banking Assets As % of GDP 12.2% 14.9% 21.0% 30.4% 37.0%

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February 2009

Except in Egypt, the average Islamic bank operating cost to income ratio is below 50%, signifying high efficiency. More interestingly, the majority of countries recorded an operating cost to income ratio for Islamic bank, better than that of the total banking sector. The ratio indicates that Islamic banks have been able to identify better opportunities and utilize resources more efficiently. However, the total banking system has higher average return on equity of 21.5% compared to 19.1% for Islamic banks in the region. In Bahrain and Jordan alone, Islamic Banks average ROE is higher than that of total banking system.

From the capital adequacy ratio standpoint, Islamic banks are not lagging behind. Banks like Kuwait Finance House (KFH) and Al Rajhi bank (the largest Islamic bank in the world) registered CAR of 23% and 24% in 2007, exceeding the 12% requirement imposed by the Central Bank of Kuwait.. This shows that banks have sufficient liquidity to face critical situations. Nonetheless, this does not hold true for the entire region. In countries like Egypt and Jordan, proper regulations and governance still have to be established to save the sector from the current global crisis. Net margin for 2007, was high in the system. Islamic Banks in Qatar reported a net margin of 70.9%, the major contributor being Qatar Islamic Bank with a net margin of 74.0%. This trend was backed by robust economic growth and a pipeline of new projects in the country. Bahrain Islamic banks also reported strong net margins with the support of well-structured regulations and governance. Many factors including growing awareness and acceptance of Shariah-based products, economic growth in the region and increasing liquidity contributed to this surge in margins and assets of Islamic Banks. Though Islamic banks in the region did not witness any major fallouts pertaining to the global economic crisis, they are not entirely immune to it. With oil prices touching historical lows and the continuing global economic slowdown, asset growth is expected to remain slow in the near future, which will in turn affect net margins. However, the impact on Islamic banks remain lower than that on the conventional banking system.

Operating Cost to Income (2007)

0%

20%

40%

60%

80%

Bahrain Qatar Kuwait SaudiArabia

UAE Egypt Jordan

Islamic Banks Total Banking

Source: Company wise annual reports, Bloomberg, BlomInvest Source: Company wise annual reports, Bloomberg, Blominvest

Return on Equity (2007)

0%5%

10%15%20%25%30%35%

Bahrain Qatar Kuwait SaudiArabia

UAE Jordan

Islamic Banks Total Banking

Note: Egypt has not been included because of its very low ROE

Net Margin (2007)

0%

10%

20%

30%

40%

50%

60%

70%

Bahrain Qatar Kuwait Saudi Arabia UAE Jordan

Source: Company wise annual reports, Bloomberg, Blominvest

Note: Egypt has not been included because of its very low Net Margin


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4. Opportunities and Challenges

4.1 Opportunities

4.1.1 Islamic Microfinance and Socially Responsible Investments The underlying principle of Shariah law states that a business should not be aimed at wealth accumulation, but rather it should focus on the sustainable development of the society, and thereby fostering social equality. The economic goals of Islam and microfinance are largely consistent. Thus, it is natural that the subject of microfinance, as a poverty alleviation tool, has come to prominence in the context of Islamic finance. The average GDP per capita for the MENA region is less than USD 25,000, which reflects that the region in general is still developing. An estimated 72% of people living in Muslim-majority countries do not use formal financial services. Although some conventional microfinance institutions exist, there is still a sizeable population that rejects non-Shariah-compliant services. At present, supply is concentrated in countries like Indonesia, Bangladesh and Afghanistan, but demand for Islamic microfinance is strong. Jordan was among a group of surveyed countries where 20% to 40% of the people cited religious reasons for not using conventional microloans.

Despite considerable demand, the Islamic microfinance market is still in nascent stages. There is a dearth of institutions providing such services; However, one such institution is the Islamic Development Bank based in Saudi Arabia. Its Islamic Solidarity Fund for Development recently committed USD 500 mn to the development of microfinance through its Microfinance Support Program. In January 2008, Noor Islamic Bank and Emirates Post Holding Group announced the start up of a company offering Islamic banking services to the low income groups in the UAE. Still, the market is extremely under exploited, with mainly NGOs reaching the mass population.

An average Islamic micro-loan does not differ significantly in size from a conventional micro-loan. The most common Shariah-compliant microfinance product is Murabaha (used in over 70% of the cases). Other popular choices are Ijara, Musharaka, Mudaraba, and Takaful. The primary challenge is the absence of a benchmark business model that lays adequate emphasis on operational efficiency and risk management. There is also a question about the Shariah compliance of the services given the specific customer segments these target. Finally, the range of products offered is still narrow, and does not cater all low-income groups’ needs. The Islamic rule of Zakat (donations to the poor), which is still perceived as a form of charity, is however supported by Islamic microfinance,. In order to ensure sustainability and growth in the long run, the sector will need to move towards commercial funds.

4.1.2 Infrastructure and Project Financing State-sponsored development projects, that focus on areas like infrastructure and industry, have witnessed a surge. This is on account of excess liquidity and government initiatives to diversify from reliance on oil and gas. Since in those countries (with the exception of Oman) Islamic banking most often has a political support, an increasing number of Shariah-compliant financial institutions have benefited from contracts involving financing of such projects, mainly through Sukuk issues.

According to MEED Insight, there could be up to USD 25 bn worth of Shariah-compliant project finance deals in the GCC by 2012, accounting for up to 25% of the total project finance market. According to the Kuwait Finance House, over the next 10 years the GCC countries need to finance projects worth USD 800 bn, thus presenting a massive growth opportunity.

At the moment, most of the corporate Islamic banking is concentrated outside the Arab region. On the contrary, Islamic banks in the Arab region offer mainly retail products, while a lot of investment deals are concluded with the involvement of banks from the non-Muslim countries. A classic example is Japan’s Sumitomo Mitsui Banking Corporation, that specializes in project financing in the Middle East – including Shariah-compliant deals, such as Petro Rabigh project in Saudi Arabia and debt financing project for Nakilat, a subsidiary of the Qatar Gas Transport Company. The challenge for banks of the region is to compete with foreign institutions for a larger market share. The progress has been gradual. To date, the largest project funded by Islamic banks was for Saudi Basic Industries Corporation and Saudi Arabian Mining Company, where 3 out of 7 underwriting banks were from the MENA region.

As the market for projects funded by Islamic banks comes of age, its participants are faced with some key challenges. It is yet to be seen to what extent they are able to design innovative products necessary for increasingly sophisticated transactions. Furthermore, they are facing regulatory hurdles common to the whole Shariah-compliant industry, the biggest being the enforcement of creditors’ rights.

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4.1.3 The role of Islamic investment funds in promoting cross‐border Islamic investments

Islamic investment funds are a dynamically developing segment within Islamic finance. According to a recent Ernst & Young report, Islamic investment funds in Saudi Arabia are preferred over conventional ones; In Malaysia as well, they are preferred by both Muslim and non-Muslim investors. In the GCC, investors are willing to choose Islamic investment funds over conventional ones when comparable terms are offered. Owing to their Shariah-compliant nature, Islamic funds yield higher returns. Even so, the acceptance of such funds depends greatly on the country and its culture where the project is taking place.

Developing Muslim countries like Iraq and Malaysia, are major markets for Islamic funds. Such countries tend to embrace Islamic investments more readily, partly due to religious beliefs. Other than that, the specific nature of Islamic finance, which focuses on social development rather than wealth accumulation, also supports its growing acceptance. Thus, returns or incentives offered on such investments are likely to be more beneficial.

Currently, an increasing number of countries, including non-Muslims, are embracing the concept of Islamic funds, allowing them to further diversify their portfolios and manage assets more efficiently. Japan and the UK are now issuing sovereign Sukuk, while corporate Sukuks are being issued worldwide in countries such as Brazil.

4.1.4 Tapping the non‐Muslim market in times of a worldwide meltdown

Though Islamic finance has predominantly started to provide access to financial services to Muslims who reject conventional products, it has gained popularity among non-Muslims as well. While some find the ideology of sharing profits and losses and contributing to the well-being of the society appealing, others find the asset-backed operations more secure. Despite the latter, Islamic finance is gaining popularity amongst non-Muslim countries and customers.

Shariah-compliant banking continues to expand outside the MENA region on account of Muslim minorities in different countries and on the willingness of governments and banks to tap Middle East liquidity. Increasingly, Islamic banks are setting up in non-Muslim countries. In the UK, it is estimated that 20% of Shariah-compliant deposit accounts are opened by non-Muslim customers. In the United States, the chairman of both Lariba American Finance House and the Bank of Whittier estimates that almost 95% of the customers are non-Muslims and include Jews and Christians. Sukuk is emerging to be especially popular across the world. At the moment, entities in more than 15 non-Muslim countries have expressed interest or announced their plan to issue Sukuk.

At the same time, Islamic banking is seeking to position itself as a secure alternative to conventional banking, claiming it “funds the real economy” and would not be susceptible to the financial crisis, which has affected conventional finance. Two main factors make Shariah-compliant banking immune to the crisis. On one hand, Islamic banking lack investment activities in highly leverage companies and derivatives that were the main causes of the crisis. On the other hand, Islamic finance institutions, being in their early development stages, are mildly exposed to the global system. At the same time, such institutions are looking to diversify their investment instruments, which will further strengthen the sector against high risks.

However, the degree to which Islamic finance is immune to the global crisis, is currently being challenged. The industry’s lack of toxic assets helped it escape the first stage of the turmoil. However, generic reasons like the shortage of liquid instruments and the lack of an Islamic interbank market make the industry particularly vulnerable to such liquidity crises. The signs are already there. Sukuk issuance in 2008 dropped by 60% compared to 2007 (although part of this decrease should be attributed to the debate over Sukuks’ compliance with Shariah), and the United Arab Emirates was forced to bail out two of its Islamic mortgage lenders in November 2008.

Still, the financial crisis has certainly helped Islamic finance spur interest among non-Muslim countries, which are looking at features that might contribute to the system’s stability. This was made clear when US officials announced that experts in the Treasury Department are studying the efficiency of Islamic banking and its utility in fighting the crisis. This presents an exceptional opportunity for Islamic financial institutions as they can tap new markets by stressing on the difference between Shariah-compliant and conventional services, and the efficiency of the former in difficult times.


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4.1.5 Islamic insurance In the insurance sector, a niche market exists, consisting of those who do not wish to use conventional insurance services as their elements go against the Shariah law. This is why Islamic insurance, or Takaful, has been created. Based on a conservative growth rate of around 15% annually, Takaful premiums are worth an estimated USD 16 bn across the MENA region. It is the fastest growing segment of Islamic finance according to many analysts, as the market is still hugely underserved. Middle East insurance market – comparison with industrialized markets

Source: Swiss Re Sigma, Blominvest Bancatakaful, or selling Islamic insurance through banks, is gaining ground. However it is not the most popular distribution channel in the Middle East. It is more efficient than the still dominating direct sales, and can achieve economies of scale. There are three forms of bancatakaful model. First, Islamic banks may establish their own Takaful subsidiaries to channel their products. This model has been followed by HSBC Amanah. Qatar Islamic Bank recently announced the set up of similar operations. Sometimes, a new insurance brand will be created to differentiate between the two lines of businesses (like in the case of Malaysian Maybank Fortis and its subsidiary, Etiqa Takaful Bhd). Second, some banks establish joint ventures with insurance companies, to distribute co-designed products via banks’ branches. Such a joint venture deal was announced in April 2008, by Ahli United Bank and the UK’S Legal and General Group. Third, the bank solely provides the distribution facilities, while it is up to the insurer to wholly design products. Products are then distributed under either the bank’s or the insurer’s brand, depending on the agreement.

Setting up bancatakaful in every case requires significant investments in human resources as well as in promoting Takaful beyond its religious advantage. However, both parties can benefit: insurance operators gain access to a bank’s distribution network and a bigger pool of potential customers, while banks get the opportunity to better promote investment products (such as Shariah-compliant mutual funds or principal-protected investments) along with Takaful. According to a recent survey in Malaysia, 68% respondents said they would be interested in products that combine principal protection, investment diversification and insurance cover.

Insurance market regulations play a part in the bancatakaful development, particularly in the Middle East. In Saudi Arabia, banks offering insurance services have an advantage as banks are the only channel allowed for investment-linked insurance products.. Egypt is on the other side of the spectrum as it prohibits banks from selling life insurance or receiving commission from sales.

4.2 Challenges

4.2.1 Risk management Due to the specific rules governing Islamic banks, the risks they are subject to differ significantly from those faced by conventional banks. A specific feature of Islamic banks is the profit and loss sharing agreement (PLS), and the requirement that all (or almost all) operations should be asset-backed, thus impacting both sides of the balance sheet. Thus, a bank is free to manage its depositors’ funds, and returns are determined by the profits or losses incurred (this is true for most investment and savings accounts, while demand deposits in general have to be repaid at par value). This shifts part of the credit risk from the bank to the depositors, while putting the latter in a position of a private equity investor with limited rights, rather than depositors, as they do not have the legal means to influence the bank’s activities. Owing to this feature, Islamic banks’ liabilities are considered more immune to external factors. Thus , their equity base is actually larger than recorded.

On the other hand, however, Islamic banks bear larger risks on the assets side than do their conventional counterparts. When they provide loans through a PLS agreement, they become susceptible to market risk, along with credit risk, as they will only reclaim their loan if the borrower makes a profit. Apart from proved negligence or mismanagement, there is no recognizable default on the part of the customer. Furthermore, due to Shariah rules, the use of cash collaterals is mostly restricted. As such, this creates a much riskier environment than fixed-interest loans within conventional banking. In addition to that, while non-PLS agreements are considered less risky as the underlying asset can serve as a sort of collateral, they still carry the market risk connected with the value of the asset The latter can either be low in the deferred-sale contracts, or can fall over time in the case of Ijara.

Insurance indicators Middle East Industrialized markets Life Non‐life Life Non‐life

Insurance penetration (share of insurance premiums in the GDP) 0.1% 1% 5.6% 3.6% Insurance density (premium per capita in USD) 19.4 57.5 2,218 1,434.1

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February 2009

Because of the afore mentioned features of Islamic banks, their resemblance to private equities exceeds that to conventional banks. They require more complex administration that involves the determination of profit and loss sharing on different investments in different industries. Other than that, due to the number of projects and activities banks may be de facto involved in, standardization of operations is a challenge. Additionally, most existing risk management instruments are not considered Shariah-compliant and thus cannot be used.

Another risk specific to Islamic banks is the asset-liability mismatch. Due to the nature of Shariah-compliant contracts, assets tend to have much longer maturity period than liabilities. This is coupled with relatively undeveloped interbank money markets and secondary Sukuk markets. As a result, Islamic finance seems to be particularly vulnerable to liquidity crunches.

With such a specific nature of risk, Islamic banks need a specific risk management approach. Reserve requirements in this case should be relatively higher to cater to huge default risk as well as to prevent depositors’ losses in case of poor performance and rapid capital outflow. In addition to that, engaging some of bank’s capital into its investment operations and not only depositors’ funds, would limit the risk of moral hazard. In fact, Islamic banks tend to be more conservative than their conventional counterparts, possibly leading to lower profits. Also, because of the PLS principle and the implied lack of protection for depositors, information disclosure requirements should be particularly strict in Islamic finance. Islamic products According to their Exposure to the different kinds of risk (according to industry experts) Rank Credit risk Market risk Liquidity risk Operational risk1 Musharaka Istisna Salam Istisna 2 Mudaraba Salam Ijara Salam 3 Salam Musharaka Istisna Musharakah 4 Istisna Mudaraba Musharaka Mudaraba 5 Ijara Ijara Murabaha Murabaha 6 Murabaha Murabaha Mudaraba ijara

Source: Khan and Habib Ahmed (2001), Risk Management: An Analysis of Issues in Islamic Financial Industry, Jeddah: IRTI

4.2.2 Shariah interpretation ‐ differences among countries and regions The absence of a single deciding authority concerning the Sharia is a major challenge. Decisions are left to various authorities in the region leading to differences in acceptable practices among countries, and particularly between the different areas such as the Middle East and t South-Eastern Asia. As a result, a product or service may be considered Shariah-compliant in one country, but not in another. These differences may result from protectionist or nationalist factors, but are often theological. For example, Malaysia follows the more liberal Shafi school of Sunni Islaml, whereas in Saudi Arabia, the strictest jurisdiction, that is the Wahhabi form of the Hanbali school, is dominant.

Moreover, because of the development of Shariah interpretation, a banking practice that is now accepted, may be prohibited in future, or vice-versa. A new product may be embraced in one country but considered non-compliant in another, which may or may not change with time. Recently, a panel of scholars at the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) said that many of the Sukuks issued to date are not Shariah-compliant, despite the fact that they have already been approved by a Shariah board.

These differences form a major obstacle for banks that wish to expand internationally. Product that are acceptable in the domestic market may turn out to be a failure in another market. Product innovation is also discouraged, as it should be approved by two Shariah boards, at a bank and at a state level. This will take more time to accept a new product, and the outcome is never certain. Furthermore, this acceptance process is mandatory in all countries where the new product is to be introduced.

There is an ongoing debate between market players and innovators on one hand, and religious scholars on the other. The formers are lobbying for Shariah harmonization, while the latter fear this might harm the very nature of Shariah flexibility. Despite that, the establishment of independent international organizations such as the AAOIFI or the IFSB (Islamic Financial Services Board) is a step towards Shariah uniformity across the globe.


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4.2.3 Product innovation Due to the absence of one central Shariah board, to make decisions on the Shariah-compliance of banking products, multiple boards are active on different levels: starting with international institutions, to country and bank levels. Therefore, demand for scholars to work on these boards is large, compared to a low supply as it is still a growing market. This job is highly demanding as the candidate should have a large and profound knowledge of both the Sharia and the financial field

According to Gulf media, Shariah scholars can earn up to USD 100,000 a year, given them strong incentives to be trained. However, due to the amount of time needed to master the two fields, universities are unable to train people fast enough to satisfy the demand. At the same time, the availability of only few experienced scholars forces them to work in as many shariah boards as possible in order to meet the demand, increasing by that the risks of conflicts of interest..

This shortage of specialists has a major impact on product innovation, as every new product has to be accepted by a Shariah board before it can be introduced to the market. Furthermore, due to Shariah requirements, Islamic products tend to be more complicated than their conventional counterparts, since they usually involve more than one concept, and non-standard transaction structures. Thus, more human resources are needed for the development of these products. This is another obstacle for the industry’s growth and innovation, that can be eliminated as soon as new Shariah scholars with sufficient financial skills enter the market and reduce the current gap between supply and demand.

4.2.4 Regulatory issues Islamic banking in its modern form is believed to have started in the 1960s. Since then, it has developed dynamically, however its growth was not matched by the development of an adequate and uniform regulatory framework. The environment is highly fragmented, with no universally accepted standard. This is particularly difficult for Islamic banks, as they need to comply with both accounting standards, and Sharia regulations, unlike other conventional banks. Regulatory levels vary among different countries. In addition to that, two main challenges are still facing the Islamic banking sector in different countries. On one hand, it is still not decided whether Islamic banks should be viewed as a stand-alone entity, separate from conventional banks, or whether they should be both combined under a common general banking system. On the other hand, the accounting standards to be followed are still unclear. No standard framework specifies which one of the International Financial Reporting Standards, International Accounting Standards, AAOIFI standards or Malaysian Accounting Standards should be used to control the Islamic banking sector. Local accounting standards that contains a mixture of all the above mentioned, may also be used in their relative countries.

To overcome such challenges, international initiatives have been taken to create general industry standards. Today, the main organizations dealing with international standards are the AAOIFI and IFSB. They have no legal power over Islamic financial institutions in some countries; however their standards can be incorporated by country authorities into the legal framework.

A recent and significant regulatory change has come with the introduction of Basel II. It is likely to bring some uniformity into Islamic banking and it is gradually being adapted across countries, yet is still a major challenge (although adoption of the accord in MENA is relatively slow). The major challenge of the Basel II implementation lies in the difference in the risk profile between Shariah-compliant banking and conventional banking for which the accord was designed for. Thus, before the accord can be adapted by Islamic institutions, sizeable adjustments must be made in terms of capital adequacy guidelines. The Application of Capital Adequacy Standards is published by the IFSB as a standard for capital adequacy,; however, it is not as broad as the main Basel II directive, and so far is not legally binding in all countries. Another major problem is the lack of sufficient historical data within Islamic finance, necessary for proper risk measurement; information disclosure is much worse than in conventional banking, and the industry is still in its nascent stages.

33

February 2009

5. Country‐wise Islamic banking overview

5.1 Bahrain

Bahrain competes with Dubai for becoming the regional financial hub, focusing on Islamic banking. Currently, Bahrain leads with its in place regulations and innovative Shariah-based products. It is home to internationally renowned institutions such as AAOIFI (Accounting and Auditiong Organization for Islamic Financial Institutions), LMC (Liquidity Management Center), IIFM (International Islamic Financial Market) or IIRA (Islamic International Rating Agengy), and its Central Bank encourages development of the sector through a comprehensive regulatory framework for Islamic banks as well as support of innovation (the National Shariah Board is in charge of Sukuk issues but does not control new products accepted by individual banks’ Shariah Boards, which has resulted in increasing popularity of products like Islamic credit cards or Tawaruq). As of November 2008, there are 417 financial institutions in Bahrain, including 59 IFIs. The banking industry in Bahrain is the combination of both wholesale (investment and offshore banks) and retail (commercial banks) banking. The sector consists of 88 conventional banks (24 retail and 64 wholesale) and 26 Islamic banks. The financial sector has a 22% share in GDP, making it the second most important industry in the country. In 2007, total banking assets increased 31.2% YoY, reaching BHD 92.4 bn ($245 bn). During the first half of 2008, it increased 26.6% to BHD 101.5 bn. However, the latest Central Bank data suggests that total banking assets declined 2.2% in Q308, due to reduction in wholesale banks’ assets and also due to changes in licensing framework. During the period 2003-2008, retail banking assets grew at a CAGR of 41.8%, and wholesale banking assets at 21.9%. Total domestic credit at the end of 2007 constituted 60.3% of GDP, similar to the MENA average; the penetration rose dynamically reaching 79.5% in Q3 FY08. In terms of growth rate, Islamic banking has outperformed total banking, growing at a CAGR of 40.9% between 2003 and 2007, against 24.9%. During 2007, Shariah-compliant assets grew 34.6%, close to the total banking industry growth rate. However, in the first half of 2008 it grew 45.8% to reach USD 21.1 bn. Bahrain is originally an offshore banking center and a regional hub for project and wholesale financing. This holds true for the Islamic sector as well: among the banks operating in accordance with Shariah rules, 20 are under wholesale license while only 6 are commercial banks. There are three listed Islamic retail banks in Bahrain: Al-Salam Bank –Bahrain, Bahrain Islamic Bank and Khaleeji Commercial Bank. The other three Islamic retail banks (Al Baraka Islamic Bank, Shamil Bank of Bahrain and Kuwait Finance House Bahrain) are private. At the end of 2007, the share of the biggest Islamic Banks (Al-Salam Bank –Bahrain, Bahrain Islamic Bank and Shamil Bank of Bahrain) in the total retail banking reached 9.8%. The Islamic wholesale banking industry includes 20 banks, and accounted for 5.9% of the total in 2007. Islamic wholesale and retail banks assets have grown with a CAGR of 48.8% and 28% respectively during the period between 2003 and 2007. The year 2007 saw a moderation in industry growth, partially due to changes in the prudential regulations related to the retail sector and some licensing changes.

Characterized by the largest IFIs concentration in the Middle East, Bahrain leads the way in Islamic banking innovation, with the Central Bank of Bahrain providing support to the industry. In these conditions, Islamic banks in the country have flourished: in the period 2003‐2007, their assets grew with a CAGR of 40.9%, and at the end of 2007 they accounted for 6.7% of the total banking assets, with this ratio increasing to 9.3% in the third quarter of 2008. This dynamic performance can be contrasted with the growth rate of the whole banking system, which increased by 18.5% between the third quarter of 07 and 08 (end of period).

Total Vs Islamic Banks Assets

0

20

40

60

80

100

2003 2004 2005 2006 2007

(in BD billion)

0%10%20%30%40%50%60%

Total Banking Assets (BD billion)Total Islamic Banking Assets (BD billion)Total Banking Assets Growth (in %)Total Islamic Banking Assets Growth (in %)

Source: Bahrain Central Bank, Blominvest


34

During 2007, the consolidated balance sheet of the banking system stood at 21.2 times the GDP (constant price) as compared to 142% of consolidated balance sheet of Islamic banks to GDP. Islamic Banking accounts for a small share of the total banking sector. However, it is bound to grow and gain a bigger market share as the popularity of Shariah-based products increases and regulatory frameworks improve.

The range of products offered by Islamic banks includes deposits and financing arrangements as well as Shariah-compatible investment funds. Primary products of the retail Islamic banking industry are, Ijara, Mudaraba, and Musharaka.

Bahrain’s well structured Islamic banking system has caught the attention of many foreign companies. Recently, the Central Bank of Bahrain granted a Category 1 Investment Business License (Islamic Principles) to Al-Khabeer International BSC with an initial paid-up capital of over USD 100 mn. The government is also seeking opportunities from other countries as well. To be part of the booming real estate sector in Saudi Arabia, Bahrain's International Investment Bank has set up an Islamic mortgage finance company there, with an initial capital of SAR 375 mn.

5.2 Egypt

Even though Egypt was the first country to start Islamic banking in 1963, Islamic Bank Assets in Egypt account for a mere 3% of the total banking system. The system is lagging behind mainly because of the lack of regulations and government support. Muslims comprise around 90% of the total Egyptian population of around 80 mn. In fact, Egypt is attracting players from across the border like UAE based Tamweel, which is partly owned by Dubai Islamic Bank and Noor Islamic Bank.

Going forward, the Islamic banking industry in Bahrain is expected to register moderate growth, on account of increased competition. The industry is well-supported by the regulator, which encourages innovation while providing sound regulatory framework. However, increasing exposure to the real estate sector and decreasing oil prices are the growth impediments in the near term, and Islamic banks have turned out to be vulnerable (albeit less than their conventional counterparts) to liquidity constraints.

The Islamic Banking sector in Egypt has not followed the regional growth trend due to the lack of support from the central bank and also because of low per capita income. Combined assets of Islamic banks in Egypt have grown with a CAGR of 15.7% for the period from 2003 to 2007 and accounted for 3% of total banking assets. During the first half of 2008, Islamic banks in the country registered a consistent growth of 14.6% to reach EGP 33.8 bn from EGP 28.6 bn during the same period last year.

Total Vs Is lamic Retail As s ets

0.0

5.0

10.0

15.0

20.0

2003 2004 2005 2006 2007

( in BD billion

0%

50%

100%

150%

Total Retail Bank A s s etsTotal Is lamic Retail Bank A s s etsTotal Retail Bank A s s ets Grow thTotal Is lamic Retail Bank A s s ets Grow th

Source: Bahrain Central Bank, Company wise Annual Reports, Blominvest

Total Vs Is lamic Wholes ale Bank As s ets

0.00

20.0040.00

60.00

80.00

2003 2004 2005 2006 2007

( in BD billion

00.20.40.60.81

Total Wholes ale Bank A s s ets

Total Is lamic Wholes ale Bank A s s ets

Source: Bahrain Central Bank, Company wise Annual Reports, Blominvest

35

February 2009

The Islamic Banking industry in Egypt has two fully fledged Islamic banks and five banks with both conventional and Islamic banking components. During 2007, there were 41 banks with 3,056 branches across Egypt. This number dropped from 62 banks in 2003 due to the government’s increased reform measures and consolidation activity in the banking sector. Islamic Banks consisting of Egyptian Saudi Finance Bank and Faisal Islamic Bank have a network of 33 branches. Main products include Murabaha and Mudaraba.

Penetration of the Islamic baking industry in Egypt is very low. Fully fledged Islamic Bank Assets as % GDP has increased from 4.4% in 2003 to 6.4% in 2007. Total bank assets as times stood at 220% of GDP for the year 2007. The low penetration of Islamic Banking will be a growth opportunity once the central bank supports Islamic banking by creating proper regulation and governance.

5.3 Kuwait

The banking sector in Kuwait presently comprises 17 banks, which include six local conventional banks, one specialized bank (namely Industrial Bank of Kuwait (IBK), three Islamic Shariah-compliant banks, and seven branches of conventional foreign banks.

During 2007, the Kuwaiti Islamic banks surged at current rates of about 50%, supported by the demand for Shariah-compliant products. This rate of growth might moderate to about 20% by the end of 2009, partially due to an increasing base of Islamic banks and in part due to the current economic crisis. In line with the trend, Islamic banking in Kuwait is becoming increasingly popular and now claims 30% of the country’s total banking assets. During the period 2003 to 2007, combined assets of Kuwait Islamic banks registered a strong 5-year CAGR of 36.6%. During the first nine months of 2008, combined assets of Kuwait’s Islamic Banks increased 27% to KWD 9.5 bn ($33.1 bn) as compared to KWD 6.8 bn ($23.7 bn) for the same period last year.

Total Bank As s ets (end of J une)

0

500

1000

1500

2004 2005 2006 2007 2008

( in LE billion

0%5%10%15%20%25%

Total bank A s s ets Grow th

Source: Egypt Central Bank, Blominvest

Fully‐fledged Is lamic Bank As s ets

0

10

20

30

40

2003 2004 2005 2006 2007

( in LE billion

0%5%10%15%20%25%

Is lamic Bank A s s ets Is lamic Bank A s s ets Grow th

Source: Company Wise annual reports, Blominvest


36

The operating environment for Kuwaiti banks remains strong due to high oil prices in the booming local and regional economies, and unabated government spending across key economic sectors. This, together with healthy net margins and excellent cost efficiency, results in superior profitability. Nonetheless, Kuwait’s economy is relatively undiversified, with half of the country’s GDP being generated from oil-related activities. Modest non-oil and private sectors result in scarce attractive lending opportunities, leading to large exposures and industry concentrations in banks, particularly to the commercial real estate and construction sectors. Meanwhile, Islamic banking witnessed higher growth than the conventional banking sector due to increased availability and acceptance of Islamic banking and Islamic banking products. Presently, Kuwait has three Islamic banks: the industry leader Kuwait Finance House (KFH)-; Boubyan Bank, and Kuwait International Bank. Furthermore, in June 2008, the central bank of Kuwait licensed the Bank of Kuwait and Middle East to become an Islamic Bank, thus taking the number of Islamic banks in the country to four.

In recognition of the growth prospects in the domestic market, Kuwaiti banks have begun expanding their operations in the region, either through organic growth or through acquisitions. Although their foreign operations are currently limited, further regional expansion will make a sustainable contribution to their respective profitability and impact their financial strength depending on the risk profile of these operations. Meanwhile, in pursuit of becoming a leading global Islamic bank, KFH is increasing its presence in Turkey, Malaysia and Bahrain, and also seeking new overseas opportunities. Recently, the Capital Market Authority (CMA) in Saudi Arabia approved the Saudi Kuwait

Finance House (SKFH), which is fully owned by KFH with a capital of SAR 500 mn, to start its investment business in Saudi Arabia. KFH is also studying investment opportunities with International Enterprise Singapore; the lead agency under the Ministry of Trade and Industry.

Over the period 2003–2007, the consolidated Islamic deposits witnessed a strong CAGR of 25.3%. In 2004, the CBK introduced the 80:20 rule, to curb lending and encourage retail deposit collection (in October 2008, this rule was relaxed to 85:15 to ease credit restrictions).


0

10

20

30

40

2003 2004 2005 2006 2007

(In KD

billions)

0%10%20%30%40%50%60%

Tota l banking AssetsIs lamic Banking AssetsTota l Banking Assets GrowthIs lamic Banking Assets Growth

Source: Kuwait Central Bank, Company wise annual reports, BlomInvest

Banking Indicators (Total Banking)

0%

20%

40%

60%

80%

2003 2004 2005 2006 2007

(in %

)

Total Bank Loans as % GDP Total Bank Deposits as % GDP

Source: Kuwait Central Bank, BlomInvest

Total Bank Deposits Vs. Islamic Bank Deposits

0

5

10

15

20

2003 2004 2005 2006 2007

(in KD billions)

0%

10%

20%

30%

40%

50%

Total Bank Deposits Islamic Bank Deposits

Total Bank Deposits Growth Islamic Bank Deposits Growth

Source: Kuwait Central Bank, Company wise annual reports, Blominvest

Total, Is lamic and Conventional Banks

02468

1012141618

2003 2004 2005 2006 2007

( numbe

rs in actual

Conventional Banks Is lamic Banks Total Banks

Source: Kuwait Central Bank, Blominvest

37

February 2009

The Fully fledged Islamic assets to GDP ratio stood at 54.6% as compared to total banking assets to GDP ratio of 185.1% for the year 2007. The Islamic banking penetration in Kuwait is low compared to other countries in the MENA region. Nonetheless, there is big room for growth for both the conventional and Islamic banking sectors. Islamic Banking is well positioned to capture this opportunity because of increased awareness and acceptance, new line of products and innovative software solutions. In Kuwait, Retail lending is predominantly driven by the spending power of the Kuwaiti population (Kuwaiti nationals account for only around one third of the country’s population of 3.5 mn). Banks primarily target public sector employees – a steady and well-rewarded target market that accounts for around 90% of Kuwaiti nationals – although there is budding interest in lending to expatriate private sector workers.

All banks compete aggressively to differentiate themselves through their service and product offerings. The largest players – Kuwait Finance House (KFH) and National Bank of Kuwait (NBK) – dominate the retail banking sector. Salary accounts designed to lock in customers and cross-sell them credit cards and personal loans of up to several monthly salaries are the most prominent in the product offerings.

KFH has the maximum exposure to mortgage lending – an area that could experience challenges due to a sharp correction in residential real estate prices in 2008. This is partly because a legislative amendment bans legal entities from owning residential real estate or collateral – and Islamic financial institutions such as KFH are exempt from this ban due to the asset-backed nature of their business. By contrast, a large portion of the conventional banks’ retail credit portfolios comprises lending to finance share purchases, thus raising their exposure to market-induced credit risk (despite hefty collateral).

5.4 Jordan

Islamic banking in Jordan has been operational for around 2 decades now, but the industry’s assets still account for a small share of the total banking sector. However, there has been a growing demand for Shariah-compliant banking institutions, as Islamic banking tools became more efficient and flexible to cater to a varied clientele. The trend seems to be changing with large banks like Dubai Islamic Bank, Jordan Dubai Capital and Dubai International Capital planning to acquire controlling stake in Industrial Development Bank of Jordan to form Jordan Dubai Islamic Bank. This move is likely to boost the overall growth and penetration of Islamic banking in the country.

Jordan's Islamic banking industry consists of only two Islamic banks, Jordan Islamic Bank for Finance and Investment (publicly listed) and Islamic International Arab Bank (private). The two Islamic banks, accounted for 8.17% of the total banking assets in 2007. Jordan Islamic Bank for Finance and Investment was established in 1978, as a public shareholding limited company to carry out Shariah-compliant banking, financing and investment operations and also in accordance with the provisions of the Jordan Islamic Bank's Special Law. The bank has been rated by Fitch Rating as BB- for long-term, B for short-term, 3 for support and C/D for individuals. It operates with 56 local branches and 69 ATMs.

The Islamic International Arab Bank is a private company, services of which include deposits, loans and credit cards and asset management including fund management, all in accordance to Islamic principles. In 2007, total assets of the bank reached JOD 594 mn ($840.8 mn) recording a YoY increase of 3.35%. The bank operates with 19 branches and 10 ATMs.

Recently, Moody’s said that the outlook for the banking sector in Kuwait is shifting to negative for the first time in over a decade. Even though Kuwaiti and regional banks are well-capitalized and better positioned than those in other emerging economies, large scale exposure to the real estate is worrisome. The Kuwaiti government has urged banks to consolidate to prevent losing major parts of their assets. S&P maintains that Islamic bank are not immune to the global slowdown, citing the fact that they have been unaffected during H108, but have been hit since then due to their exposure to the materials and energy sectors. Islamic banks as well have been affected due to falling commodity and property prices, though not as heavily as conventional banks. However, many in the industry view the current financial turmoil as an opportunity for Islamic banking to flourish as a safer alternative.

The Jordan Islamic Banking industry is supported by the country’s economic stability and growing demand for Shariah-based products. Jordan Islamic Bank for Finance and Investment, the only listed Islamic bank in Jordan, registered a CAGR in assets of 13.1% for the period 2003 to 2007. Total assets of the bank accounted for 6% of total banking assets during 2007, and increased in H108 by 16.6% to JOD1,825mn compared to 1,565.3 mn recorded in the same period of 2007.


38

Jordan Islamic Bank for Finance and Investment recorded an asset to GDP ratio of 19.4% during 2007, while the consolidated balance sheet of the banking system stood at 3.3 times the GDP. The low penetration rate of Islamic Banking provides opportunity for growth subject to government policies . However, high banking penetration indicates that Islamic banking will face stiff competition.

5.5 Qatar

The Banking industry in Qatar consists of 11 local banks registered with the central bank and 7 foreign banks with branches in Qatar. Under the list of local banks, there are 3 Islamic banks fully operating under Shariah principles, 3 conventional banks with Islamic windows and 5 conventional banks with no Islamic banking operations..

Despite the fact that the Qatari banking sector is one of the smallest in the GCC in terms of total assets, loans and deposits, it achieved significant growth over the past 5 years.

On the whole, Qatari banks are enjoying stellar financial performance, adequate capitalization, as well as good asset quality. Besides that, banks enjoy government support, which is continuously working on regulating and improving the efficiency of the financial services sector. Over the past 12 months, financial performance has been supported by fast increasing volumes, despite pressure on net margins due to mounting price competition. Some leading players have started to diversify geographically to gain scale.

At the end of 2007, only three Qatari banks operated in full compliance with Shariah principles, namely Qatar Islamic Bank, Qatar International Islamic Bank and Masraf Al Rayan. However, since the change in QCB regulation on Islamic windows in 2005, some conventional Qatari banks created Islamic subsidiaries or branches. This is notably the case for the three leading banks: Qatar National

The banking sector in Qatar benefited from rapid economic growth. As a result, Islamic banks posted strong results over the past few years. During the period expanding from 2003 till 2007, combined assets of Qatar Islamic Banks, including Qatar International Islamic Bank, Qatar Islamic Bank and Masraf Al Rayan, generated a impressive CAGR of 44.5% and accounted for 14.1% of total banking assets for the year ended 2007. In the third quarter of 2008, total assets of Islamic banks increased by 31.4% to reach QAR 56 bn ($ 15.4bn) from QAR 38.5 bn ($10.6 bn) recorded in the same period a year earlier.

Islamic Banking Assets (Jordan Islamic Bank for Finance and Investment)

0500

1,0001,5002,000

2003 2004 2005 2006 2007

(in JD m

illion)

0%5%10%15%20%

Islamic Banking Assets Growth %

Source: Company wise Annual Report, BlomInvest

Total Banking Assets

0

10,000

20,000

30,000

2003 2004 2005 2006 2007

(in JD m

illion)

0%

5%

10%

15%

20%

Total Banking Assets Growth %

Source: Jordan Central Bank, BlomInvest

Jordan should collaborate with other countries such as Dubai, Bahrain and Malaysia, in order to exchange ideas, knowledge and work on developing an Islamic financial market. The conversion of Industrial Development Bank into Jordan Dubai Islamic Bank is critical to the industry. A considerable Muslim population of 6 mn provides potential growth opportunities supported by policy reforms and robust economic growth.


0

100

200

300

400

2003 2004 2005 2006 2007

(in QR billion

)

0%

20%

40%

60%

80%

Total Bank Assets Total Islamic Assets

Total Bank Assets Growth Total Islamic Assets Growth

Source: Qatar Central Bank, Company wise annual reports, Blominvest

39

February 2009

Bank (QNB), Commercial Bank of Qatar (CBQ), and Doha Bank (DB). Shariah-compliant assets, offered by both fully Islamic banks and Shariah-compliant windows (or branches) of conventional banks, experienced strong growth of more than 95% in 2006. This trend is likely to continue as banks see Islamic banking as an opportunity to attract new clientele.

Islamic banking assets in Qatar witnessed a strong growth over the last couple of years, mainly driven by robust economic growth, increased demand for Shariah-based products and government willingness to promote the Islamic Banking industry. Many underway projects, including petrochemical, housing and construction projects are demanding Shariah-based products and this is likely to act as a future driver for Islamic banking.

Qatar Islamic Bank (QIB) is the largest Islamic Bank in the country, accounting for 8.5% of the total lending market share. The bank has international presence in collaboration with the Arab Finance House in Lebanon, the Asian Finance Bank in Malaysia and Durat Al Doha in the Cayman Islands. The bank is seeking opportunities in Egypt, Turkey and Kazakhstan for potential expansion of its Shariah-compliant banking operations. The product portfolio in the industry includes Murabaha, Ijara, Istisna, and Mudaraba.

During 2007, Islamic Banks registered a deposit to GDP ratio of 9.42%, whereas the loans to GDP ratio stood at 61.9% for the same period. Compared to the MENA average of 74%, Qatar’s Islamic banking penetration remain low. In addition, total banking assets represented 240% of GDP as compared to 34.5% of GDP for Islamic banking assets. The latter shows that Islamic banks in Qatar have the opportunity to participate in the total banking growth, in addition to gaining additional market share from conventional banks.

5.6 Saudi Arabia

Saudi Arabia strictly adheres to Islamic laws, therefore Islamic banking is not only exceptionally popular within the society but has also benefited from the authorities’ support since its inception. As a result, all Saudi banks have Shariah-compliant operations, either in the form of Islamic windows or as fully fledged Islamic banks.

The Saudi Arabian banking sector, that combines fully-fledged Islamic banks and institution running both Shariah-compliant and conventional operations, recorded an asset growth of 27.3% during the first nine months of 2008 to reach SAR 1,269.9 bn ($338.6 bn) over the same period a year earlier. Combined bank deposits and total credit also grew at a healthy pace, growing by 19.1% to SAR 804.12 bn ($214.4 bn) and 36.1% to SAR 962.39 bn ($256.6 bn) respectively. Combined assets of fully-fledged Islamic Banks (Al-Rajhi, Al-Jazira, Al-Bilad and Al Inma Bank ) registered a CAGR of 22% during the period from 2003 till 2007, and accounted for 15.2% of total bank assets during 2007.

The region as well as the country has huge investment potential. Multi-billion-dollar projects are in the pipeline at various stages from various sectors. Qatar has launched an impressive domestic investment program aimed at diversifying its economic base from the hydrocarbon sector. It is likely to spend around USD 221 bn on different projects over the next 5 to 6 years continue diversification. The banking sector would be one of the major beneficiaries of this scale of projects and regional diversification program. Islamic Banks have to compete with conventional banks with Islamic window. They do not have monopoly in the system, and conventional banks are launching innovative Shariah-based products to capture the industry. In particular QNB Al Islami now has substantial market share in Islamic banking, while Doha Bank (Doha Islamic), CBQ (Al Safa Islamic) and other originally conventional banks, are aiming to increase the competitiveness of their Islamic offerings.

Going forward, the Islamic Banking industry in Qatar has a great potential for growth backed by a booming economy, new line of projects and people’s increasing acceptance of Shariah-based products. Compared to Saudi Arabia and Kuwait, Islamic banking in Qatar still claims a small share in the total banking assets. With the increased awareness, the Islamic banking industry in Qatar is expected to grow well in the near future.

Source: The Central Bank, BlomInvest

Banking Indicators

0%

20%

40%

60%

80%

2003 2004 2005 2006 2007

(in %)

Total Bank Deposits as % of GDP

Total Bank Loans as % of GDP


40

Source: The Central Bank, Company annual Reports, Blominvest

Banking Indicators

0%

50%

100%

150%

2003 2004 2005 2006 2007

Total Bank Assets as % of GDP

Fully‐fledged Islamic Bank Assets as % of GDP

The Saudi Arabian banking sector comprises 22 commercial banks, including 12 local banks and 10 branches of Gulf and foreign banks. Out of the 12 local banks, four (Al-Rajhi, Al-Jazira, Al-Bilad and Al Inma Bank) are standalone Islamic banks. The abovementioned are all listed banks; however, Alinma Bank does not report its results. Al Rajhi is the third-largest Saudi bank, and the world's largest Islamic financial institution with total assets of SAR 124.9 bn ($33.3 bn) recorded at the end of 2007. The Remaining Saudi banks run both conventional and Shariah-compliant operations.

Between 2003 and 2007, the three reporting fully fledged Islamic banks’ assets grew by 22%, faster than 18.5% recorded by total banking assets. Thus, the analyzed period turned out to be more beneficial for institutions focusing solely on Shariah-compliant operations than for those who tried to capture both Muslim and non-Muslim markets. In 2006, the banking industry experienced a slowdown as a result of the stock market crash in the country.

The Islamic banking industry’s size can be conveniently quantified as most Saudi banks separate their Shariah-compliant credit facilities and deposits from the conventional credit facilities. The only bank that does apply such differentiation is the Arab National Bank. Financial information for Al Inma Bank is not available.

On the loans and deposits front, Islamic banking is growing faster than the total banking industry, reflecting the regional trend and its early stage of development. During 2007, Islamic banks financing and investment activities increased by 24.1%; while deposits rose by 30.5%. On the other hand, the total banking industry’s loans and deposits grew by 19.7% and 21.4%, respectively. Despite the healthy growth in total assets, loans and deposits, commercial banks registered a 12.7% drop in profits during 2007, on account of a plunge in brokerage and asset management fees.

Total bank assets stood at 132.3% of GDP as compared to fully-fledged Islamic bank assets penetration of 20.1% for 2007. Combined with the low penetration of the banking sector and expansion in overseas markets, Islamic Banks in Saudi Arabia have a lot of growth potential. The Islamic banking sector can benefit from the expansion into the market without having to compete for the customers with the conventional service providers.

Total Banking Assets

0

200

400

600

800

1000

1200

2003 2004 2005 2006 2007(in SAR billion)

0

5

10

15

20

25

30

Total Banking Assets Total Banking Assets Growth

Source: Jordan Central Bank, Blominvest Source: Company wise annual reports, Blominvest

Fully‐fledged Islamic Bank Assets (excluding Al Inma Bank)

0

50

100

150

200

2003 2004 2005 2006 2007

(in SAR

billion)

0%

10%

20%

30%

40%

Fully‐fledged Islamic Bank Assets Growth %

Going forward, the second biggest population among the group of analyzed countries combined with low banking penetration and strong preference for Shariah-compliant services clearly presents attractive growth opportunity for Islamic banks in Saudi Arabia. The industry is further helped by huge investment projects, initiated mainly by the state but with spillover effects for the private sector, of which a large part is still underway despite the financial crisis. Key players in the industry are expanding their presence in Kuwait, Malaysia and Asia. However, falling oil prices are a key risk as Saudi economy is highly dependent on the petroleum sector.

41

February 2009

5.7 UAE

During 2007, the number of national banks operating in the UAE increased to 22 from 21 at the end of 2006. Presently, there are 23 national banks and 22 foreign banks. Out of the 23 national banks, 8 are fully operating under Shariah principles (4 of which are public companies) and the remaining banks have both conventional and Islamic banking operations.

The UAE banking sector, the largest in the GCC by total assets, continued its positive trend in 2007. Benefiting from a benign operating environment and a strong demand for credit, operating profits for most banks grew in double digits. The economy continues to gain from oil prices.

Profitability for most banks remains high; while banks are expected to remain profitable they will require some governmental assistance. Rapid growth in lending in recent years did not affect asset quality.

Islamic banking is continuously gaining popularity in the UAE. Two new Islamic banks (Dubai�based Noor Islamic Bank and Abu Dhabi�based Al Hilal Islamic Bank) were established in the UAE in 2007 and 2008. The two largest UAE Islamic banks are Dubai Islamic Bank (DIB) and Abu Dhabi Islamic Bank (ADIB). Conventional banks also have Shariah�compliant subsidiaries and Islamic windows to facilitate Islamic transactions. However, the sector has entered into a moderate growth phase, due to increased competition from conventional banks with Islamic windows.

Incorporated in 1975 in Dubai, the Dubai Islamic Bank was the first bank in the world, specialized exclusively in Islamic financing instruments. The bank provides all types of financial and banking services in accordance with the Shariah that prohibits usury. In 2007, the company’s total assets accounted for 53.8% of the total Islamic bank assets.

Banking penetration in the country continued to grow in 2007. The ratio of credit deployment to GDP stood at 95.4% in 2007 up from 80.5% in 2006, while deposits to GDP ratio was 98.1% in 2007 as compared to 83.1% in 2006. During 2007, total banking assets represented 2.9 times the GDP as compared to Islamic banking assets that recorded a value of 37% of GDP. Given the high penetration in the banking sector, Islamic banks have to compete with the conventional banks for market share.

The UAE banking system is less exposed to the financial turmoil than the Bahraini banking sector. Due to the lack of detailed disclosure, exact losses of the GCC banks are difficult to quantify (although this has improved in 2007 due to the implementation of IFRS 7). Additionally, some UAE and GCC banks have exposures to (mainly international) hedge funds, mutual funds and other managed funds, which might have incurred losses. These exposures are not material. However, the international credit market turmoil has affected UAE banks through spread widening.

Banking Indicators

0%

50%

100%

150%

2003 2004 2005 2006 2007

Total Bank Deposits as % of GDP

Total Bank Loans as % of GDP

Source: The Central Bank, Company wise annual Report, Blominvest

The UAE Islamic banking sector’s performance continues to benefit from the buoyant economic environment. Overall banks’ performances in 2007 were very encouraging, with all banks (except Abu Dhabi Commercial Bank) registering double�digit annual growth in operating income during the year. It should be noted that compared with the results of 2005, profitability in some banks showed either shy or negative growth.. Combined assets of Islamic banks in UAE have grown with a CAGR of 43.4% for the period 2003 to 2007. Islamic Bank assets’ share in total bank assets increased to 12.7% during 2007 from 10% in 2003. Whereas for H108, total assets of Islamic Banks in the UAE increased by 30.5% to AED 181.1 bn ($49.3 bn), from AED 138.8 bn ($37.8 bn) during 2006.

Total Vs Is lamic Bank As s ets

0

500

1000

1500

2003 2004 2005 2006 2007

( in AED billion

0%

20%

40%

60%

80%

Total Bank A s s ets

Total Is lamic Bank A s s ets

Total Bank A s s ets Grow th

Source: The Central Bank, Company wise annual Report, Blominvest


42

5.8 Oman and Lebanon Oman does not allow Islamic banking operations as a separate entity. The country promotes a single banking system and thus is now encouraging Islamic banking within this context. Islamic banking is a relatively newer concept in Lebanon. The Parliament passed the laws and regulations to govern it in February 2004. According to these regulations, the Central Bank of Lebanon (BdL) is the supervisory authority. Thereafter, the BdL circulated the first executive circular which paved the way for the country’s first Islamic bank. Currently, there are four fully-fledged Islamic banks.

• Arab Finance House, part of Qatar Islamic Bank Network, established at the end of 2004, is now the largest comprehensive Islamic bank in Lebanon

• Al Baraka Bank Lebanon, part of the Dallah Baraka Network established in 1993 as a merchant bank and operates

under fiduciary laws and in compliance with Shariah directives. It became a fully-fledged Islamic bank in 2007 • Lebanese Islamic Bank, part of Credit Libanais Bank, one of the largest conventional banks; and

• Blom Development Bank, part of the BLOM Group.

Islamic Banking in Lebanon is still in nascent stages. But with the central bank’s vision to promote the industry, Islamic banking is expected to flourish in the years to come.

Property prices in the UAE have fallen for the first time since 2002 with reduced consumer spending. At the same time, the credit crunch is compelling banks to tighten lending and forcing developers to cancel projects and slash jobs. In this adverse scenario, the UAE, which was hailed as remaining isolated from the global meltdown, had to make AED 120 bn ($32.7 bn) available for banks to prevent a credit crunch and is merging its two largest Islamic mortgage providers, Amlak Finance and Tamweel, with the state-owned Real Estate Bank (REB). DIB holds a 19.98% stake in Tamweel and is thus exposed to this crisis. .However, Islamic banking is estimated to maintain its growth trajectory with volumes being the fore-drivers. Financing and Investment activities demand is anticipated to emanate from corporate and consumer/personal loan seekers. Changing demographics and an increase in expatriate population would drive personal loan demand while infrastructure development, growing interest in the manufacturing sector, need for accommodation and further development of tourism-linked industries is seen as the demand-pushers for corporate loans. At the same time, with growing awareness of Islamic banking products and aggressive steps for marketing and relationship building carried out by the Islamic banks, it would offer stiff competition to their conventional counterparts in the race for market share.

43

February 2009

6. Future Outlook During 2009, the Middle East economy is expected to grow at around 4.7% (IMF). The governments’ initiatives to diversify from an oil-based economy towards non-oil sectors like construction, retail, transportation, and financial services were funded by record oil revenues in 2008 due to the soaring of oil prices that reached an all time high of $147 a barrel in July. However, this outlook may slow down as oil prices are witnessing a sharp decline. Average real GDP growth in the GCC is expected to slow to 3.6% in 2009 from 5.7% in 2008 due to reduced oil production and substantially lower oil prices, in addition to tighter credit conditions. Countries that lack oil resources, may witness a falling real GDP growth to around 6.6% in 2009 from 7.1% in 2008, according to IMF figures. Countries like Egypt, Jordan and Lebanon are likely to be more insulated from the global crisis due to domestic reforms, relatively shielded financial sectors, heavy public expenditures and moderately low dependence on commodities and external sector. However, such countries may be indirectly affected as FDI and remittances from the GCC will fall.

While big financial institutions collapsed in the face of the ongoing economic crisis, Islamic Financing gained prominence. Currently, Islamic banking assets and assets under management are estimated at over USD 800 bn. Islamic banking has largely escaped the fallout from the global financial crisis as the lack of structured products prevented Islamic banks from investing in assets that turned toxic for conventional banks. Nonetheless, if the crisis escalates further, experts believe that the Islamic banking industry will be impacted due to its heavy reliance on property investments. According to Moody’s, Islamic financial institutions in the Gulf have so far shown strong resilience in turmoil, but they are not risk-immune. The latter is caused by the shortage of liquid instruments and the lack of an Islamic interbank market. The ratings agency expects a slowing growth in Islamic banking assets in 2009 to around 10-15% from a 20-30% this year. In addition, the sukuk issuance in 2008 has declined 60% from 2007, due to the ongoing credit crunch and the uncertainty surrounding the new AAOIFI standards on Islamic bonds.

However, the long-term outlook for Islamic banking is optimistic and will likely take lead in funding major projects as the conventional banking system is struggling to cope up with the liquidity crunch. Proponents of Shariah practices, which bans interest and trading in debt, have been promoting Islamic banks as being immune to the global financial meltdown. In October 2008, Kuwait's commerce minister, Ahmad Baqer, was quoted as saying that the global crisis will prompt more countries to increasingly adopt Islamic principles in their economies. U.S. Deputy Treasury Secretary, Robert Kimmet, announced that experts at the treasury are now studying features of Islamic banking as a less risky banking option in the face of current turmoil (Source: Washington Post). Islamic banking has remained positive so far, despite the current challenging global financial environment,' said Mr. Zeti Akhtar Aziz, the central bank governor of Malaysia, the Southeast Asian leader in Islamic banking. The number of Islamic banking institutions and banking assets has witnessed a dynamic growth, over the last decade. According to the World Islamic Banking Competitiveness Report (WIBC) the majority of Islamic banks are growing faster than their conventional banking peers.

With a few exceptions, most GCC based Islamic banks will continue to focus on their domestic markets, where Shariah compliant lending opportunities are widening, both in the retail (with a nascent mortgage market emerging) and the corporate side (where Islamic tranches have become increasingly common). Currently, Islamic banking assets in the GCC account for around 56% of the total Islamic banking assets. The contribution is continuously increasing, reflecting their entrenchment in servicing households. During 2008 and beyond, Islamic banks are expected to focus on the diversification of their products and services.

First, larger players seek larger market shares through geographical diversification - a couple of leading GCC-based Islamic banks have started exploring newer markets going beyond the natural borders of Islamic universe. Second, operating diversification will also intensify -. Shariah-compliant commercial banking will dominate; however, alternative business lines such as Shariah-compliant securitization; Islamic investment banking, including private equity; and asset and fund management are attracting a wider clientele. Primarily, these services are targeted towards high net worth individuals (HNWI) (300,000) with an estimated worth of USD 1 trillion, (Source: Merrill Lynch Capgemini World Wealth Report) catering to their sophisticated and savvy requirements. Third, diversification of funding continuums is expected to address the natural constraints faced by Islamic financiers in terms of balance-sheet management. Provided that the market conditions become more attractive, Islamic banks are likely to be heavy buyers and active issuers of Sukuk, especially to cope with widening maturity mismatches between Shariah-compliant assets with longer tenors and funding sources still heavily reliant on short-term customer deposits. Fourth, diversification of asset allocation and further portfolio granularity are critical, especially in view of Islamic banks’ natural appetite for property-related exposures considering the decline of the real estate markets. In this context, Moody’s expects to assign ratings to a few more Shariah-compliant banks, in addition to the eight fully fledged Islamic financial institutions that have already been rated so far.

Asset quality in the recent past has been a cause of concern for some of the Islamic banks in the region. Non performing loans levels are expected to drop in the future as Islamic banks concentrate on retail banking, especially consumer loans and credit cards which have relatively lower level of delinquencies. However, banks have been maintaining adequate provisions to counter high NPLs. In order to benefit from increasing demand for consumer finance, the banks will increase their lending, that will lead to higher provisioning. The corporate sector is expanding its capacity to take advantage of the tremendous opportunities available in the region. This calls for increased safety cushion by the Islamic banks.


44

According to a recent study by McKinsey entitled ‘The World Islamic Banking Competitiveness Report 2007/08: Capturing the Trillion Dollar Opportunity’, the value of Islamic banking assets and assets under management is expected to reach USD 1 trillion by 2010. Growing capital under Islamic management will lead to the development of Islamic banking and infrastructure in the Muslim world, and will provide ever-increasing opportunities for the Islamic financial products. With an appreciation of the relevant principals of the Shariah and the ability to address concerns of conventional lenders, borrowers and project sponsors have successfully demonstrated that conventional and Islamic banking can run in parallel. Consequently, the market for Islamic banking is expected to exhibit robust growth in the foreseeable future. In many markets, Islamic banking has evolved from being a niche offering to be a mainstream financial service.

45

February 2009

7. Appendix

7.1 Appendix 1 ‐ Major Islamic Banking players in the region

7.1.1 Abu Dhabi Islamic Bank

• Established in 1997, ADIB commenced its operations with a paid-

up capital of AED 1 billion. • It has a subsidiary in Egypt and a representative office in the U.S. • ADIB provides commercial banking services including deposits,

loans and credit cards; investment banking activities including advisory services; asset management; private equity investments.

• The founders of ADIB hold 39% of its equity while the remaining 61% is held by approximately 100,000 shareholders. The bank’s shares are traded on the Abu Dhabi Stock Exchange.

Key Ratios FY05 FY06 FY07

Revenues Growth (%) 195.71 62.86 22.25

Earnings Growth (%) 180.14 65.84 34.58

Total Assets Growth (%) 74.90 63.55 21.36

Total Deposits Growth (%) 88.43 32.12 24.38

Net Margin (%) 23.74 24.17 26.61

Return on Assets (%) 1.97 1.95 1.91

Return on Equity (%) 19.52 23.84 18.77

Financing and Investment Activities to Deposits

84.21 60.60 25.38

Cost to Income 0.16 0.16 0.19

Peer Group Analysis ADIB DIB Sharjah

Price/Earning 6.73 3.83 9.20

Price/Book 1.18 0.90 0.81

Price/ Revenues 2.17 1.58 3.59

Asset Turnover Ratio 0.07 0.07 0.06

Market Cap. (AED in mn) 9,450 32,972 4,466

Source: Bloomberg

Abu Dhabi Islamic Bank at a Glance

No of Employees 1654

Corporate Headquarters Abu Dhabi, UAE

Revenue ('000) AED 2.887.997

Network 45 branches and 124 ATM

Ownership Public

Date founded 1997

Bloomberg Code ADIB DH

Reuters Code ADIB.AD

Zawya Code ADIB.ADSM

Senior Management

Chairman Juuan Owaida Al Khaili

Vice Chairman Khaled Abdullah Khoury

CEO Tirad Mahmoud

Major Shareholders Holding (%)

Emirates International Investment Co. 44.02%

Abu Dhabi Investment Council 7.61%

Public 48.37%

Total Income Distribution

87%

12% 1%

Total Income from Islamic Banking Activities

Investment Income

Other Income

Key Financials AED '000

FY05 FY06 FY07

Total Revenue 1,451 2,362 2,888

Operating Profit 1,065 1,923 2,208

Net Profit 344.5 571.01 768.47

Earnings/ Share 3.45 3.98 5.12

Total Assets 22,189 36,290 44,042

Total Liabilities 20,167 33,521 38,621

Shareholders' Equity

2,021 2,768 5,417

Source: Bloomberg

Company Overview


46

7.1.2 Al Rajhi Bank

Wed Sep 20 2006 Daily GCC* Market Review

• Established in 1978, with the merger of a group of companies into Al Rajhi Trading and Exchange Corporation.

• Operates through a network of 500 branches in Saudi Arabia and 15 in Malaysia, and 2400 ATMs, and over 8,000 POS machines across Saudi Arabia.

• Al Rajhi provides commercial banking and investment banking services including deposits, loans and credit cards, asset management, corporate advisory and brokerage.

• Al Rajhi has won EuroMoney's 2005 best bank in the Kingdom award. In 2006, Al Rajhi Bank was named the best bank in Saudi Arabia for year 2006 by The Banker Magazine and Financial Times Business, UK.

• The bank’s shares are traded on the Saudi Stock Exchange.


Revenues Growth (%) 53.76 29.56 ‐1.54

Earnings Growth (%) 91.88 29.62 ‐11.67


Total Deposits Growth (%) 15.91 ‐0.79 22.74

Net Margin (%) 70.57 70.60 63.34


Return on Equity (%) 51.20 43.40 29.46


27.97 11.39 16.62


Peer Group Analysis Al Rajhi Bank Bank Al Bilad Bank Al Jazira

Price/Earning 13.26 101.64 5.22

Price/Book 3.62 2.37 0.89



Market Cap. (SAR in mn) 175,837 12,075 14,737

Source: Bloomberg

Al Rajhi Bank at a Glance


Corporate Headquarters Ryiadh, Saudi Arabia

Revenue ('000) 10,182

Network Over 500 branches and 2400 ATM

Ownership Public

Date founded 1978

Bloomberg Code RJHI AB

Reuters Code 1120.SE

Zawya Code 1120.SSE

Senior Management

Chairman and CEO Suleiman Bin Al Rajhi

CFO Mohammed Chamseddine

COO Willian Van Buren


Suleiman Bin Abdulaziz Al Rajhi 24.60%

Saleh Bin Abdulaziz Al Rajhi 13.60%

Government Organization 9.90%

Abdullah Bin Abdulaziz Al Rajhi 5.90%

Public 49.00%


99%

1%


Other Income

Key Financials SAR'mn

FY05 FY06 FY07

Total Revenue 7,982 10,342 10,182


Net Profit 5,633 7,301 6,449

Earnings/ Share (SAR)

62.59 10.82 4.78

Total Assets 95,037 105,208 124,886



13,469 20,179 23,606

l b

Company Overview

47

February 2009

7.1.3 Bank Al Bilad

Bank Al Bilad at a Glance


Corporate Headquarters Ryiadh, Saudi Arabia

Revenue ('000) 958,873


Ownership Public

Date founded 2004

Bloomberg Code ALBI AB


Zawya Code 1140.SSE

Senior Management

Chairman Musaed Al Sinani

CEO Razi Chafiq Faqih

CFO Kaher Ikbal Shaikh

Major Shareholders Holding (%) Mohammed Ibrahim Mohammed Al Subeaei

11.90%

Abdullah Ibrahim Mohammed Al Subeaei 11.10%

Abdulrahman Saleh Abdulaziz Al Rajhi 6.90%

Abdulrahman Abdulaziz Saleh Al Rajhi 6.50%

First Investment Company 6.40%

Public 57.20%


100%


Key Financials SAR 'mn

FY05 FY06 FY07

Total Revenue 170.52 669.58 958.88

Operating Profit ‐18.22 192.80 252.76

Net Profit ‐98.09 178.12 72.46

Earnings/ Share ‐1.64 0.59 0.24

Total Assets 7,005 11,281 16,635



2,899 3,024 3,104

Source: Bloomberg

• Established in 2004, with the merger of eight money exchange houses, with a corporate capital of SAR 3 billion.

• Operates through a network of 60 branches, and 240 ATMs in Saudi Arabia. Represents Saudi Arabia's first-ever public flotation of bank shares via the Internet.

• Islamic bank that provides Islamic business finance, retail banking and investment products including deposits, loans, and credit cards.

• Al Bilad's wholly owned subsidiaries are AlBilad Brokerage & Securities Management Co. and AlBilad Real Estate Co.



Revenues Growth (%) n/a 292.67 43.21

Earnings Growth (%) n/a 281.58 ‐59.32

Total Assets Growth (%) n/a 61.04 47.46

Total Deposits Growth (%) n/a 100.69 61.48

Net Margin (%) ‐57.53 26.60 7.56

Return on Assets (%) ‐2.80 1.95 0.52

Return on Equity (%) ‐6.77 6.01 2.36


n/a 88.92 35.29


Peer Group Analysis Bank Al Bilad Al Rajhi Bank Bank Al Jazira

Price/Earning 101.64 13.26 5.22

Price/Book 2.37 3.62 0.89




Source: Bloomberg

Company Overview


48

7.1.4 Bank Al Jazira

Bank Al Jazira at a Glance


Corporate Headquarters Jeddah, Saudi Arabia

Revenue ('000) 1,447


Ownership Public

Date founded 1975

Bloomberg Code BJAZ AB


Zawya Code 1020.SSE

Senior Management

Chairman Taha Abdullah Al Kuwaiz

CEO Khaled Oudghiri

VCEO Ziad Tarek Abal Al Khail


Rashed Abdul Rahman Al Rashed and Sons Company

22.20%

Union Brothers for Development Company 6.50%

National Bank of Pakistan 5.80%

Saleh Abdullah Mohammed Kamel 5.00%

Public 60.50%


96%

4%

Investment Income Other Income

Key Financials

SAR 'mn FY05 FY06 FY07

Total Revenue 1,590 2,615 1,446

Operating Profit 877.50 2,089 804.86

Net Profit 874.39 1,973 805.20


Total Assets 14,168 15,712 21,564



2,977 4,250 4,789

Source: Bloomberg

• Established in 1975, Al Jazira the first of the foreign banking operations converted into a local joint stock entity.

• Bank Al Jazira is an Islamic bank that has commercial and Islamic banking services locally and internationally, such as investment advisory, asset management, international and local brokerage services. In addition to providing corporate finance through a wide range of Islamic financial instruments.

• Bank Al Jazira has become a premier bank in the Kingdom providing high net-worth individuals and corporations with innovative Islamic financial solutions.



Revenues Growth (%) 115.60 83.61 ‐39.05

Earnings Growth (%) 365.73 125.75 ‐59.21



Net Margin (%) 2.61 3.77 4.29

Return on Assets (%) 7.03 13.21 4.32

Return on Equity (%) 41.55 57.52 18.11


n/a n/a n/a


Peer Group Analysis Bank Al Jazira Al Rajhi Bank Bank Al Bilad

Price/Earning 5.22 13.26 101.64

Price/Book 0.89 3.62 2.37




Source: Bloomberg

Company Overview

49

February 2009

7.1.5 Boubyan Bank

Boubyan Bank at a Glance

No of Employees 450

Corporate Headquarters Qiblah, Kuwait

Revenue ('000) 49.08

Network 9 Branches

Ownership Public

Date founded 2004

Bloomberg Code BOUBYAN KK

Reuters Code BOUK.KW

Zawya Code BOUBYAN.KSE

Senior Management

Director Bader Khaled Al Baher

Managing Director Yaqoub Youssef Al Muzaini

CEO Ahmad Fayed Al Gebali


Kuwait Investment Authority 20.00%

The Investment Dar Company 20.00%

Public 60.00%


74%

26%


Investment Income

Key Financials KWD 'mn

FY05 FY06 FY07

Total Revenue n/a 29.80 49.08

Operating Profit 6.98 18.61 33.16

Net Profit 6.85 10.26 18.56

Earnings/ Share 0.007 0.010 0.018

Total Assets 328.47 504.34 745.99

Total Liabilities 221.55 383.93 606.44


106.92 120.41 139.49

Source: Bloomberg

• Established in 2004, with a paid-up capital of KWD 100 million for the purpose of exercising all activities of the banking business in accordance with the rules and regulations of the Central Bank of Kuwait.

• Boubyan Bank provides commercial banking and asset management services according to Islamic law.

• Kuwaiti citizens are the major stakeholders owning 76% of its shares. This bestows on the bank the privileged status of being a national project with established trust.

• The remaining shares are owned by Kuwait Investment Authority and the Public Institution for Social Security. The bank’s shares are traded on the Kuwait Stock Exchange.


Revenues Growth (%) n/a 189 64.68

Earnings Growth (%) n/a 53.54 47.90

Total Assets Growth (%) n/a 87.10 80.93

Total Deposits Growth (%) n/a 84.79 82.37

Net Margin (%) 53.17 34.42 37.82


Return on Equity (%) 10.26 9.12 14.54


n/a 56.65 27.59


Peer Group Analysis Boubyan KFH KIB


Price/Book 3.91 5.56 1.60



Market Cap. (KWD mn) 763 4,940 591

Source: Bloomberg

Company Overview


50

7.1.6 Dubai Islamic Bank

Dubai Islamic Bank at a Glance


Corporate Headquarters Dubai, UAE

Revenue ('000) 6,007


Ownership Public

Date founded 1975

Bloomberg Code DIB UH

Reuters Code DISB.DU

Zawya Code DIB.DFM

Senior Management

Chairman Mohammed Al Shaibani

Vice Chairman Sheikh Khaled Bin Al Nehyan

CEO Abdullah Ali Al Hamli


Investment Corporation of Dubai 29.80%

Saeed Ahmad Lootah 7.20%

Government Organization 4.29%

Public 58.71%


2%

24%

74%


Investment Income

Other Income

Key Financials

AED 'mn FY05 FY06 FY07

Total Revenue 2,696 4,576 6,008


Net Profit 1,061 1,560 2,500


Total Assets 42,998 64,434 83,739



3,839 8,824 10,665

Source: Bloomberg

• Established in 1975, one of the first Islamic banks in the UAE, DIB ranked as the sixth largest commercial bank and the largest Islamic bank in the UAE in terms of total assets, which amounted to AED 83.7 billion by the end of 2007.

• Operates through a network of 50 branches in Dubai and 7 in Pakistan, and 275 ATMs in Dubai. It has representative offices in Iran, Turkey and Sudan.

• DIB provides Islamic commercial banking activities including deposits and loans; investment banking activities including advisory services; asset management including fund and portfolio management.

• The bank’s shares are traded on the Dubai Financial Market.


Revenues Growth (%) 83.40 69.75 31.28

Earnings Growth (%) 130.15 47.03 60.27



Net Margin (%) 39.36 34.09 31.35


Return on Equity (%) 31.65 25.46 26.39


56.40 26.61 38.06


Peer Group Analysis DIB ADIB Sharjah


Price/Book 0.90 1.18 0.81



Market Cap. (AED in mn) 32,972 9,450 4,466

Source: Bloomberg

Company Overview

51

February 2009

7.1.7 Kuwait Finance House

KFH at a Glance


Corporate Headquarters Murqab Area, Kuwait

Revenue ('000) 831.15


Ownership Public

Date founded 1977

Bloomberg Code KFIN KK

Reuters Code KFIN.KW

Zawya Code KFIN.KSE

Senior Management

Chairman Bader Abdulmohsen Al Mukhaizim

Vice Chairman Samir Yaacoub Al Nafisi

CEO Mohammed Al Omar


Kuwait Investment Authority 24.08%

Public Authority for Minors Affairs 10.48%

Kuwait Awqaf Public Foundation 8.23%

Public 57.21%


61%

35%

4%


Investment Income

Other Income

Key Financials KWD 'mn

FY05 FY06 FY07

Total Revenue 375.75 578.99 831.15

Operating Profit 255.65 374.73 577.20

Net Profit 118.69 162.00 275.27

Earnings/ Share 0.122 0.132 0.166

Total Assets 4,681 6,314 8,797



989.36 915.27 1,495

Source: Bloomberg

• Established in 1977 as Kuwait's first Islamic Bank with an aim to develop and promote Islamic Banking worldwide.

• KFH provides commercial banking services including deposits, loans and credit cards; invests in real estate, aviation, financial services and other sectors; asset management services.

• In 1993, KFH established Al-Emna Real Estate Company (AERE) to manage its real estate portfolio while in 2002 it established Kuwait Finance House (Bahrain) as a 100% owned subsidiary to manage its Bahraini operations. In addition, KFH owns 20% in Sharjah Islamic Bank.

• The bank’s shares are traded on the Kuwait Stock Exchange.


Revenues Growth (%) 88.27 51.04 43.55

Earnings Growth (%) 59.50 36.50 69.91



Net Margin (%) 30.96 27.98 33.12


Return on Equity (%) 23.02 22.32 26.51


14.19 22.83 42.81


Peer Group Analysis KFH KIB Boubyan


Price/Book 5.56 1.60 3.91



Market Cap. (KWD mn) 4,940 591 763

Source: Bloomberg

Company Overview


52

7.1.8 Masraf Al Rayan

Masraf Al Rayan at a Glance

No of Employees 200

Corporate Headquarters Doha, Qatar

Revenue ('000) 1,546


Ownership Public

Date founded 2006

Bloomberg Code MARK QD

Reuters Code MARK.QA

Zawya Code MARK.DSM

Senior Management

Chairman Dr Hussein Ali Al Abdullah

Vice Chairman Dr Issam Youssef Jinahi

CEO Adel Mustafawi


Kuwait Finance and Investment Company 7.23%

Issam Youssef Jinahi 2.50%

Other Corporate Corporations 7.66%

Government Organizations 7.28%

Abdulrahman Mohammed Al Jismi 1.11%

Saleh Ali Abdulrahman Al Rashed 1.00%

Public 73.22%


18%

82%


Investment Income

Key Financials QAR 'mn

FY06 FY07

Total Revenue 1,780 1,546

Operating Profit 112.82 1,361

Net Profit 112.82 1,192

Earnings/ Share 0.15 1.60

Total Assets 4,324 10,191

Total Liabilities 245.75 5,033

Shareholders' Equity 4,078 5,159

Source: Bloomberg

• Established in 2006, Masraf Al Rayan has a broad range of services and products which are in accordance with Shariah principles.

• Masraf Al Rayan provides commercial and investment banking services; consumer financing and project financing facilities for personal and corporate; investment advisory services; funds management.

• Received the “Best New Bank Award” at Bankers Middle East Award Ceremony in 2008, the “Best New Islamic Bank” from Islamic Business & Finance Awards 2007, and “Best Corporate Account” at The Bankers Middle East Product Awards 2008 ceremony.

• The bank’s shares are traded on the Doha Stock Market.

Key Ratios FY06 FY07

Revenues Growth (%) n/a 334.27

Earnings Growth (%) n/a 428.48

Total Assets Growth (%) n/a 135.68

Total Deposits Growth (%) n/a 2,115

Net Margin (%) 63.38 77.13

Return on Assets (%) 5.22 8.21

Return on Equity (%) 5.53 12.91


n/a 3,594

Cost to Income 0.37 0.12

Peer Group Analysis Rayan QIIB QIB

Price/Earning 13.46 13.56 11.54

Price/Book 1.56 2.76 3.13



Market Cap. (QAR in mn) 17,175 7,750 18,724

Source: Bloomberg

Company Overview

53

February 2009

7.1.9 Qatar International Islamic Bank

Wed Sep 20 2006 Daily GCC* Market Review

Company Overview QIIB at a Glance

No of Employees 327


Revenue ('000) QAR 779,220


Ownership Public

Date founded 1990

Bloomberg Code QIIK QD

Reuters Code QIIB.KA

Zawya Code QIIK.DSM

Senior Management

Chairman Sheikh Khaled Bin Thani Bin Abdullah Al Thani

Vice Chairman Sheikh Abdullah Bin Thani Bin Abdullah Al Thani

CEO Abdulbasit Al Shaeebi


Islamic Development Bank 16.66%

Public 83.34%


56%

44%

Total Income from Islamic Banking Activitie

Investment Income

Key Financials QAR '000

FY05 FY06 FY07

Total Revenue 762,503 668,926 779,220


Net Profit 465,624 401,474 479,995

Earnings/ Share(QAR)

22.92 9.88 6.87

Total Assets 6,335,647 8,397,934 9,951,209

Total Liabilities 5,453,358 6,970,291 7,594,825


882,289 1,427,643 2,356,384

Source: Bloomberg

• Established in 1990, QIIB was established by a group of Qatari shareholders and operates in accordance with Sharia principles

• Operates through a network of 12 branches, and 40 ATMs in Qatar.

• QIIB provides commercial banking services including loans and deposits, personal and consumer banking, credit cards and money transfers; retail financing and housing mortgages; investment advisory services.



Revenues Growth (%) 203.42 ‐11.01 16.49

Earnings Growth (%) 455.12 ‐13.78 19.56


Total Deposits Growth (%)

17.10 30.49 8.96

Net Margin (%) 61.94 60.02 61.60


Return on Equity (%) 70.55 34.76 25.37


31.52 7.07 18.55


Peer Group Analysis QIIB Rayan QIB

Price/Earning 13.56 13.46 11.54

Price/Book 2.76 1.56 3.13



Market Cap. (QAR in million)

7,750 17,175 18,724

Source: Bloomberg


54

7.1.10 Qatar Islamic Bank

Qatar Islamic Bank at a Glance

No of Employees 622


Revenue (QAR in million) 1,694


Ownership Public

Date founded 1982

Bloomberg Code QIBK QD

Reuters Code QISB.QA

Zawya Code QIBK.DSM

Senior Management

Chairman Sheikh Jassim Bin Hamad Bin Jassim Bin Jabr Al Thani

Vice Chairman Mohammed Bin Abdullatif Al Manaa

CEO Salah Jaidah


Public 100.00%


57%

42%

1%


Investment Income

Other Income

Key Financials QAR in million

FY05 FY06 FY07

Total Revenue 871.76 1,573 1,694

Operating Profit 687.14 1,295 1,359

Net Profit 511.25 1,012 1,255

Earnings/ Share (QAR)

7.71 9.04 10.52

Total Assets 9,551 14,888 21,336



2,153 4,334 4,747

Source: Bloomberg

• Established in 1982, QIB developed into one of the top-ten listed companies in the country with QAR 18.72 bn in market capitalization by the end of 2007.

• QIB provides commercial banking services including deposits, loans and credit cards, letter of credit and bank guarantees; asset management services including fund and portfolio management; brokerage services; real estate financing and development.

• QIB's subsidiaries include Al Jazeera Islamic Company and Al Aqar Real Estate Development and Investment. Its investments include the Arab Finance House established in Lebanon in 2003. QIB and the Gulf Finance House incorporated QINVEST in the Qatar Financial Centre in 2006. QIB entered the Far East in 2007, with the establishment of the Asian Finance Bank. QIB established the European Finance House in London to become operational in 2007.



Revenues Growth (%) 56.99 82.18 7.73

Earnings Growth (%) 77.26 97.95 24.05


Total Deposits Growth (%) ‐61.83 294.72 39.71

Net Margin (%) 59.21 64.34 74.09


Return on Equity (%) 28.74 31.87 28.26


40.42 29.73 52.06


Peer Group Analysis QIB Rayan QIIB

Price/Earning 11.54 13.46 13.56

Price/Book 3.13 1.56 2.76



Market Cap.(QAR in million) 18,724 17,175 7,750

Source: Bloomberg

Company Overview

55

February 2009

7.2 Appendix 2 – Evolution of Islamic Banking

7.2.1 Overview Islamic Banking is governed by the Shariah (Islamic Law), sourced from the Quran and the Sunnah. The Islamic law (Shariah) prohibits taking or giving interest (Riba) which is the most essential feature of Islamic banking. The basic sources of Shariah principles are the ‘Quran’ and the ‘Sunnah’, which are followed by the consensus of the jurists and interpreters of Islamic law.

Profit sharing and fee�based financing approaches are developed in compliance with Shariah laws. These special modes of financing have emerged in retail, private and commercial banking for debt and capital markets, insurance, asset management, structured and project financing, derivates, etc.

7.2.2 Principles of Islamic banking The Prohibition of Interest (Riba)

The prohibition of usury or interest (Riba) is clearly the most significant principle of Islamic Finance. Riba translates literally from Arabic as “an increase, growth or accretion”. According to Islam, money lending should not generate unjustified income. As a Shariah term, it refers to the premium that must be paid by the borrower to the lender along with the principal amount, as a condition for the loan or for an extension in its maturity, which today is commonly referred to as interest. Riba represents, in the Islamic economic system, a prominent source of unjustified advantage. All Muslim scholars are adamant that this prohibition extends to any and all forms of interest and that there is no difference between interest‐bearing funds for the purposes of consumption or investment, since Shariah does not consider money as a commodity for exchange. Instead, money is a medium of exchange and a store of value.

Profit and Loss Sharing (PLS)

PLS financing is a form of partnership, where partners share profits and losses on the basis of their capital share and effort. Unlike interest‐based financing, there is no guaranteed rate of return. Islam supports the view that Muslims do not act as nominal creditors in any investment, but are actual partners in the business. The justification for the PLS‐financier’s share in profit is his effort and the risk he carries. Similarly, if the investment makes losses, his money would be lost.

Gharrar

Any transaction that involves Gharrar (i.e. uncertainty and speculation) is prohibited. Parties to a contract must have actual knowledge of the “subject matter” of the contract and its implications.

Maisir Prohibition of Maisir (gains made from speculative activity, or ‘unfairly earned income’).

7.2.3 Classical Islamic banking During the 8th-12th centuries, early forms of proto-capitalism and free markets were present in the Caliphate, where an early market economy and early form of merchant capitalism was developed which some refer to as "Islamic capitalism". A vigorous monetary economy was created on the basis of the expanding levels of circulation of a stable high-value currency (the dinar) and the integration of monetary areas that were previously independent. A number of innovative concepts and techniques were introduced in early Islamic banking, including contracts, bills of exchange, long-distance international trade, the first forms of partnership (Mufawada) such as limited partnerships (Mudaraba), and the earliest forms of credit, debt, profit, loss, capital (Al-mal), capital accumulation (Nama al-mal), circulating capital, capital expenditure, revenue, cheques, promissory notes, trusts ( Waqf), startup companies, savings accounts, transactional accounts, pawning, loaning, exchange rates, bankers, money changers, ledgers, deposits, assignments, and lawsuits. Organizational enterprises similar to corporations independent from the state also existed in the medieval Islamic world, while the agency institution was also introduced. Many of these early capitalist concepts were adopted and further advanced in medieval Europe from the 13th century onwards.


56

A variety of approaches have been adopted in different jurisdictions to authorize Islamic financial services. Among these are two somewhat distinct approaches: • A policy framework approach that requires legal reforms and distinct licensing initiatives; and • A market-driven financial engineering approach that encourages the development of Shariah-compliant products and services

within the existing legal and licensing regimes

7.2.4 Industry structure – Islamic Financial Services Industry

7.2.5 Evolution of Institutional framework

7.2.6 Modern Islamic Banking Initiation of modern Islamic banking dates back to 1963 with the establishment of Mit ghamr saving association in Egypt followed by Tabung Haji in Malaysia in the early sixties. However, present‐day Islamic banking debuted in 1975, when the Islamic Development Bank (a multilateral development financing institution) and the Dubai Islamic Bank (the first commercial bank) were established and mandated to operate in adherence to Shariah rules and principles. Since then, Islamic banking has made significant progress worldwide, particularly in South‐East and South Asia, the GCC region and the Middle East.

7.2.7 Industry structure – Islamic banking

Source: AAOIFI, IFSB, IDB, Islamic Finance News, News Run & Blominvest

Islamic financial architecture

Islamic non‐bank financial institutions

Takaful and re‐takaful operators

Islamic banks Islamic capital markets and their players

Islamic financial services industry

Leasing and factoring companies, housing cooperatives, microfinance institutions, private equity/venture capital, etc.

Islamic insurance and re‐insurance

Payment‐settlement systems, trading and clearance systems, e‐banking, support facility providers, legal framework, rating institutions,

Brokerage houses, investment banks, fund management institutions, etc.

Source: Blominvest

57

February 2009

7.2.6 Modern Islamic Banking Initiation of modern Islamic banking dates back to 1963 with the establishment of Mit ghamr saving association in Egypt followed by Tabung Haji in Malaysia in the early sixties. However, present-day Islamic banking debuted in 1975, when the Islamic Development Bank (a multilateral development financing institution) and the Dubai Islamic Bank (the first commercial bank) were established and mandated to operate in adherence to Shariah rules and principles. Since then, Islamic banking has made significant progress worldwide, particularly in South-East and South Asia, the GCC region and the Middle East.

7.2.7 Industry structure – Islamic banking

In the GCC and South Asia, which are home to more than 50% of the total Islamic banking industry, as well as in other countries, based on a policy framework approach, the most dominant and dynamic strategy has been to allow a dual banking system, whereby Islamic banking co-exists alongside conventional banking. In this framework, Islamic banking services are offered through three types of governance structures: • Full-fledged Islamic banks, either newly licensed or converted from conventional banks: Major progress is being made in a

number of jurisdictions in transforming conventional institutions into Shariah-compliant institutions; • Islamic banking windows of conventional banks; • Islamic banking subsidiaries of conventional banks, either newly established or converted from existing Islamic windows. For

Islamic banking windows and subsidiaries, the overriding regulatory concern has been the prevention of any mixing of Shariah-compliant and non-compliant income that could create confidence issues, leading to fund withdrawals. Hence, such windows and subsidiaries have to comply with firewall requirements, including separate capital for the two types of banking services in some countries.

Based on the industry organization, Islamic banking differs from country to country. This depends on the regulatory environment in a country: countries either encourage development of Islamic products and services within existing legal regime, taking a free-market approach, or regulate the whole Islamic financial services market. These approaches lead to the establishment of one of three banking models: conventional economy where Islamic financial institutions exist as private institutions, officially proclaimed dual banking model, or a national Islamic banking system. Pakistan was initially in this group but later adoptedOn the other hand, Iran and Sudan, where the public sector has a large share in the banking system, have adopted the strategy of complete conversion of their banking systems into totally Shariah-compliant ones, leaving no place for conventional banking. the dual banking strategy. However, in the near future, conventional banking will also be permitted in the semi-autonomous Southern Sudan.

Full‐fledged Islamic bank Islamic banking window

Examples: Standard Chartered Bank, Mashreq Bank, First Gulf Bank

Islamic subsidiary of a conventional bank

Examples: Kuwait Finance House, Dubai Islamic Bank, Bank AlJazira

Examples: Citi Islamic Investment Bank, HSBC Amanah, ABC Investment Bank

Types of governance structures

Source: Blominvest


58

Banking model Country Private institutions in a conventional economy Kuwait, Saudi Arabia, UAE, Egypt, Jordan, Lebanon, the WestDual banking model Malaysia, Indonesia, Bahrain, Sudan, Pakistan

National Islamic banking system Iran

The general trend has been to convert Islamic windows into separate entities – subsidiaries, and conventional banks into full-fledged Islamic banks (a spectacular example of a conventional bank turning fully Islamic was the Saudi Arabian National Commercial Bank). An important issue for banks offering Islamic services along with conventional ones is the clear division between the two types of incomes and assets; their mixing would lead to the loss of customer confidence.

Within the MENA region, Bahrain is considered to be the hub for Islamic finance, which has been mainly due to its better regulatory framework and financial architecture. The UAE is trying to contest Bahrain’s position especially through the Dubai International Financial Center. Saudi Arabia is the third country where Islamic banking is particularly popular, however in terms of infrastructure it still lags behind.

In Kuwait, Qatar, Saudi Arabia, UAE, Egypt, Jordan and Lebanon, Islamic financial services are offered within the existing regulatory regime, with the authorities giving more or less encouragement, but nevertheless they are driven by market demand. Bahrain, having established a dual banking model, has also adopted specific banking law governing Islamic finance and thus its regulatory framework is considered the most developed in the region. In all these countries Islamic banking industry is supervised by the central monetary authority –the Central Bank (with the exception of Saudi Arabia, where this role is played by the Saudi Arabian Monetary Agency). Oman does not allow Islamic services; it maintains that there should be no special kind of banking, and one system should serve all.

Within different banking models, banks also operate within different governance structures. Islamic financial services can be offered by full-fledged Islamic banks, Islamic subsidiaries of conventional banks, or Islamic banking windows of conventional banks. While the former ones are popular in different regions, Islamic subsidiaries are particularly common in Saudi Arabia, and Islamic windows - in Malaysia.

With respect to the financial engineering approach, an increasing number of conventional financial institutions worldwide are positive that in the medium term, if allowed by regulators, most banks will be able to offer Shariah-compliant services alongside their conventional banking activities. The regulatory response has been positive. In an increasing number of jurisdictions, the regulatory authorities have approved contracts such as Murabaha and Ijara, which banks in their jurisdictions may use to offer financing to their clients. However, such an offering of asset-side products falls short of the definition for a “full Islamic window” operation, which also mobilizes funds in a Shariah-compliant manner.

There are two different forms of the financial engineering approach. One form of the approach does not allow full Islamic window operations as described above. Instead, it encourages Shariah-compliant investment opportunities to be offered in the form of mutual funds. The other form of this approach permits full Islamic window operations as well as full-fledged IIFS, provided they are able to comply with existing banking regulations, although tax rules may be amended to avoid the double taxation of Shariah-compliant financing transactions based on Murabaha or Ijara contracts. However, in either case, Shariah compliance is considered to be a matter of market discipline rather than a regulatory issue. At most, supervisory authorities are concerned with the Shariah-compliance of the institution or Islamic window. In contrast, in the policy approach, Shariah compliance is usually considered to be a regulatory issue.

Source: Blominvest

59

February 2009

7.2.8 Product development over the years

7.2.9 Product Trends For product development different countries follow different approaches. In the Middle East (UAE and Bahrain), product development is left entirely to the service providers. This includes the Shariah compliance as well. Sudan is an exception, whose central bank has notified modes of Islamic finance. However, these are not detailed agreements rather abridged versions for providing general direction. In the Far East (Malaysia, Indonesia) the approach is different. Generally, there are varying levels of involvement of the central banks in product development. In Malaysia, Bank Negara Malaysia has not issued any guidelines and approves all the products. Indonesia has incorporated the modes within the regulations rather than as separate guidelines.

Formerly Islamic bank focused remained on offering plain vanilla products following standard concepts like Murabaha and Ijara finance covering mostly the asset financing options, newer structures will slowly emerge with multiple concepts merged together at various lifecycle stages. Common concepts that are fee (Ujr) based transactions will also be used frequently.

The next phase of product offerings will focus on these new structures covering multiple concepts, where apart from the religious aspects of banking requirements, the process and reward requirements will also be significant. Process adherence for all these products, strengthened by documentation support, will be identified as a major compliance requirement while selecting technology solutions.

Accordingly, standard financing concepts may emerge as frontrunners with more investments coming in from both banks and customers.

• Musharakah or participatory finance will be recognized as a safe means of finance, with the bank getting into ownership mode. Islamic financing concepts like Ijara, Tawarruq and Murabaha will grow with inbuilt features like known future cash flow, to provide customers comfort for financial planning. At the same time, to take advantage of floating financing options, customers will opt for floating rate based Ijara and other finance products.

• The secondary market for fixed return investments like that of Sukuks will grow – they have already experienced huge momentum in recent years. Today the outstanding market for Sukuks stands at around USD 70 bn, with large corporate houses presenting their own Sukuk issuance plans. The Sukuk market is experiencing an inclusive growth originating from traditional Islamic finance markets like Malaysia and the UAE. Sukuk being almost a fixed income instrument similar to ‘bonds’, can be treated as ‘asset backed security’. The growth of the Sukuk market is somewhat assured with huge economic activities running in parallel in most countries where Islamic finance is popular.

1970s

• Commercial bank

1980s

• Commercial

bank • Project

finance and

1990s

• Commercial

bank • Project

finance and syndication

• Equity ( )

• Commercial bank

• Project finance and syndication

• Equity • Ijara(leasing) • Sukuk(Bonds) • Structured

alternative assets

2000 • Commercial

bank • Project

finance and syndication

• Equity • Ijara(leasing) • Sukuk(Bonds) • Structured

alternative assets

• Liquidity management

2007

Source: Kuala Lumpur Islamic Finance forum & Blominvest


60

• Central banks will present ‘Non Interest Bearing Papers (NIBP)’ as sovereign debt for resource mobilization. With more Islamic banks investing in these kinds of products, the inclination will be to create a secondary market for these instruments.

7.2.10 Comparative analysis of Islamic financing

FEATURES MURABAHA MUDARABA MUSHARAKA SALAM/ISTISNA IJARA Nature of Financing Trade financing Equity financing Equity financing Contract pre‐financing Lease financingType of Financing Deferred sale Deferred sale Joint venture profit

sharing Deferred contract sale Leasing

Period (Not Determined by Shariah)

Short‐term: 1 month to 2 years

Medium‐term: 1 to 5 years

Long‐term: 3 to 25 years

Short‐term: 6 month to 3 years

Medium‐term: 2 to 5 years

Role of Bank in Management

None No management but periodic follow up and condition imposed

Full management and control which can be delegated

Full control and follow up as contracting party

Full management and control on the use of finance

Source of Repayment • Client cash flow

• Repossession/Resale of goods sold

• Security held

• Mudaraba cash flow

• Asset value of Mudaraba

• In case of breach of contract or negligence, recourse to security

• Musharaka cash flow

• New asset value of Mudaraba

• Client cash flow

• Repossession of contracted assets

• Security

• Client cash flow

• Repossession of leased assets

• Security

Collateral Yes, to guarantee debtor’s payment obligations; Guarantee of supplier’s good standing

Yes, but only to guarantee payment of capital and profit which is due and payable

Yes, but only to guarantee payment of capital and profit which is due and payable

Yes, to guarantee performance under the contract

Yes, to guarantee payment or rent and return of leased assets

Legal Recourse Yes, in the event of non payment and breach of sale contract

Yes, in the event of breach of Mudaraba contract, management and negligence

Yes, in the event of breach of Musharaka contract, management and negligence

Yes, in the event of breach of the Istisna contract and poor quality

Yes, in the event of breach of contract and considerable damage of leased assets

Financing Criteria As for usual loan business, but additional risk over delayed payment and limited operational exposure

Profit and viability of business dictate the return of income and capital. Structure is more suited to fund raising (mutual funds)

Profit and viability of business dictate the return of income and capital. Thus strong customer, good management and sound transaction required. The bank is able to take an active part in the management of the business (Portfolio management).

The bank has a financial exposure to the customer and a performance exposure the manufacture contractor, which could extend to contractor liability. Presently not acceptable to SAMA for contractor finance

Same risk as operating lease‐ i.e. exposed to the underlying value of the asset at the end of the period, but cannot vary the rental rate or hedge the funding rate exposure

Insurance Needs Certain commercial and operational risks need to be fully insured in all modes of financing to protect the bank’s interest

Certain commercial and operational risks need to be fully insured in all modes of financing to protect the bank’s interest




61

February 2009

Asset Ownership Bank is seller of goods with deferred payment

Bank has mutual ownership of the Mudaraba fund

Bank share on an equity basis in the Musharaka

Bank is owner of the contracted assets

Bank is owned of the leased assets

Rate of Return • Agreed mark up per Murabaha contract

• Once set it cannot be varied throughout the life.(Funding rate risk)

• No limit on the level of mark

• Mark up can be LIBOR related

• Penalties for late payment should go to charity

• Sharing of profit with full bearing of financial losses, as per Mudaraba contract

• Management

(Mudarib) can share up in the profit, in addition to fees

• Management

will not share loss

• Profit/Loss sharing as per Musharaka contract

• Management may gain additional profit share, but;

• Management will only share in any loss up to their capital share

• Agreed mark up or rental income, as per the Istisna contract

• Funding rate risk

• Late payment

risk

• Rental income and residual value of the leased assets, as per the Ijara contract

• Funding rate

risk • Late payment

risk • Residual

value exposure

Overall Risk Low High Medium Low Low

7.2.11 Islamic concepts applied to conventional banking products

Saving Accounts Under the Mudaraba (profit sharing) concept, the Islamic bank will utilize a depositor’s funds to make Shariah‐compliant investments and share the profits (at pre‐determined profit sharing ratios) with the depositor. Strictly abiding by Mudaraba would mean uncertain returns (even losses) for depositors; in practice, banks give a projected return (similar to what a conventional savings deposit would pay) and guarantee the principal. The return to the depositor is classified as profit, not interest.

Financings (Assets / Mortgages / Vehicles) Applying the Murabaha (cost plus) concept, the Islamic bank purchases the goods for the customer, and re‐sell them to the customer, adding a mutually agreed profit margin. The customer then pays the sale price for the goods in installments, effectively obtaining ‘interest‐free’ financing. The mark‐up (or profit margin) replaces interest. Depending on the agreement between bank and customer, ownership of the asset may be transferred to the customer from the onset. Because of its simplicity, this is the most commonly used concept for asset financing. This structure also involves another concept, Bai Bithaman Ajil – because the customer repays the bank in installments, i.e., on a deferred basis. Financing is also commonly arranged under the Ijara (leasing) concept. The Islamic bank purchases the asset and rents it to the customer. Typically, the bank sells the asset to the customer on expiry of the lease term. However, in some cases, the customer may not be obliged to purchase the asset at the end of the lease term. The key, under Ijara, is that the bank retains title to the asset until maturity and assumes all risks (damage, maintenance, and insurance) to the asset until maturity. The bank will therefore charge the customer the costs associated with these considerations in addition to rental. Ownership of the asset and the cost‐driven charges distinguish an Ijara transaction from one structured under Murabaha.

Source: Blominvest


62

Project Finance The Islamic bank provides finance to a customer for a specific commercial activity. The customer does not contribute any funding and provides management expertise for which they earn a pre‐determined portion of the profits as management fees. The balance of the profits is payable to the bank. The bank and customer are partners in this transaction. Under the Mudaraba concept, the bank (capital provider) will share in the gains, but will bear 100% of any loss.

Islamic Credit Cards Islamic credit cards are an innovative product applying the Tawarruq concept. Under this concept, one bank buys a commodity asset and immediately sells it to the customer on a deferred payment basis. (i.e. commodity asset is not the good or service that the customer ultimately wants to purchase. The asset is used for facilitating this transaction, and is typically a tradable commodity such as platinum or copper.) The customer then monetizes the asset with a third party, thus receiving a cash amount (with which to pay for his ultimate purchase), with a deferred obligation and mark‐up paid to the financial institution, usually on an installment basis. Through this convoluted transaction, interest is replaced by the mark‐up. The purchasing and instantaneous selling of the commodity help fulfill the condition of having an asset‐backed transaction – with the bank and customer conceptualized as participants in a trade, rather than engaged in a creditor‐debtor relationship. For conventional credit cards, late payment charges are the norm. In Islamic banking transactions, such fees are prohibited. In fact, this would constitute Riba al‐jahiliyyah, the worst form of Riba (usury, or gain in excess of loan principal) condemned in the Quran. In practice, the creditor charges a late payment fee but channels it to charity.

Islamic Bonds (Sukuk) Sukuk involves the creation of a special purpose vehicle (SPV) that will receive funds from investors. These proceeds are then used to purchase the targeted asset. A third step is for the SPV is to lease the asset to the Sukuk issuer, for an agreed rent. Investors collect a periodic rent, as opposed to coupons or interest in a conventional bond. Depending on how the deal is structured, the issuer will typically make a contractual promise to acquire the asset at maturity, at par value – this would be equivalent to redemption of a conventional bond at maturity.

7.2.12 How does Islamic banking differ from conventional banking? Islamic banking differs from conventional banking because the banking activities carried out must be consistent with Islamic law (Shariah). Generalizing, Islamic banking relationships typically take the form of partnerships, while conventional banking relations are often of the creditor‐debtor type.

Characteristics Islamic Banking System Conventional Banking System

Business Framework Based on Shariah laws ‐ Shariah scholars ensure adherence to Islamic laws and provide guidance.

Not based on religious laws or guidelines ‐ only secular banking laws.

Balance between Moral and Material Requirement

The requirement to finance physical assets which banks usually take ownership of before resale reduces over extension of credit.

Excessive use of credit and debt financing can lead to financial problems.

Equity Financing with Risk to Capital

Available. Enables several parties, including the Islamic Bank to provide equity capital to a project or venture. Losses are shared on the basis of equity participation while profits are shared on a pre‐agreed ratio. Management of the enterprise can be in one of several forms depending on whether the financing is through Mudaraba, Musharaka, etc.

Not generally available through commercial banks, but through venture capital companies and investment banks which typically take equity stakes and management control of an enterprise for providing start‐up finance.

Penalty/Late payment

Penalties on late payments are prohibited. If penalties are levied, they must be re‐channeled to charities.

Fees are typically charged for late payments.

Ethical Transaction Transactions and activities that involve engagement with unlawful business sectors such as gambling and brewery are not allowed

Besides money laundering and the financing of criminal activities, how customers utilized borrowed funds is typically unrestricted.

Source: Blominvest

Source: Blominvest

63

February 2009

7.2.13 Development of different asset classes in the Islamic fund Equities • Remain the dominant asset classes for Islamic funds with allocation higher than in conventional mutual

fund • Cognizant with Islamic funds through the use of screening mechanisms

Fixed Income • Underdeveloped as an asset class with allocations reflecting the lack of depth in Sukuk and other fixed income product offerings

• Increasing issuance will alleviate supply shortages, while increasing sophistication may potentially lead to

further diversification into fixed income Balanced • Underdeveloped, particularly in markets where fixed income asset s are limited

• Funds providing exposure to equities and money markets would appear to be potential growth area as both

asset classes are popular Money market • Popular in comparison to conventional mutual funds

• Largely a reflection of increased demand in the Middle East for less risky investments following stock market

corrections Other • Allocation to real estate and private equity are significantly above that found in conventional mutual funds

• Both asset classes fit well with Shariah compliant investments

S hariah c ompliant funds by geographic al mandate

67% 63%49% 51%

5% 13%7% 8%

15%14%

10%27% 29% 25%11%

7%

0% 0%

0%10%20%30%40%50%60%70%80%90%

100%

Europe North America Middle Eas t A s ia Pac ific

Equity Fixed Income Balanced Money Market Other

Source: Eurekahedge Islamic Fund Database, Investment Company Institute, E&Y $ Blominvest

Comparis on of S hariah c ompliant fund with c onventional mutual fund

52% 42%

7% 22%10%

20%13%6%18% 10%

0%

20%

40%

60%

80%

100%

S hariah Compliant Fund Univers e Conventional Mutual Fund Univers e

Equity Fixed Income Balanced Money Market Other

Source: Eurekahedge Islamic Fund Database, Investment Company Institute, E&Y $ Blominvest


64

Global Islamic Sukuk Issuance (USD mn)

0

20,000

40,000

60,000

80,000

100,000

2003 2004 2005 2006 2007

0.00

0.10

0.20

0.30

0.40

0.50

%

Total Islamic Issues

Islamic Issues as a % of Global bonds Issues

Source: IFIS data, Bank for International Settlements, Blominvest

7.2.14 Key Sukuks Announced in 2008 Issuer Amt (USD mn) Sector Country Abu Dhabi National Energy Co 1,500 Power UAE DOHA Bank 1,000 Financial services Qatar Khabary Fahaleel Future City 1,842* Real Estate Kuwait Islamic bank of Thailand 175 Financial services Thailand National Central Cooling Co 570 Industrial product UAE Govt of Kazakhstan 2,000 Sovereign Kazakhstan Govt of Thailand 500 Sovereign Thailand

Till-date, 2008 announced Sukuk pipeline estimated at USD 34.5 bn

Real estate, financial services and infrastructure (power/ oil & gas/ roads) sectors are expected to dominate the primary Sukuk market in 2008

The UAE is anticipated to lead at 35.1%, followed by the Malaysia at 21.3% and Kuwait at 12.2%

2008 will see Sukuk debuts in new markets such as Thailand, Indonesia, Hong Kong and Kazakhstan

Source: Bloomberg, Blominvest * Kuwaiti Dinar denominated Sukuk

Total value of announc ed S ukuk pipeline by s ec tor 2008 (US D 34.5 bn)

Real es tate26.4%

Pow er19.5%

Auto 0.2%

Cement2.2%

Financ ial s erv ices35.6%

S hipping0.2%

S overeign11.9%

Conglomerate3.7%

Oil & Gas0.1%

Cons truc tion0.1%

Source: Bloomberg, IFIS, Country wise Central Banks, Blominvest

Total value of announced Sukuk by country 2008 (USD 34.5 bn )

Switz0% Malaysia

22%

HK1%

Thai2%

Qatar6%

Kazakhtan6%

Kuwait10%

UAE36%

Indonesia4%

IDB1%

France1%

Pakistan2%Bahrain

3%

Saudi6%

65

February 2009

Number of Global Islamic Equity Funds

0

20

40

60

80

100

120

140

2002 2003 2004 2005 2006 2007

Source: Failaka International, IOSCO Report, Blominvest

7.3 Appendix 3 ‐ Mandatory Standards in Islamic Finance Recognizing the need for uniform standards in Islamic banking, the industry has made efforts to develop an international regulatory framework and a broader Islamic financial architecture. This initiative is still in its nascent stages: most of the institutions have been established after 2000, and the full uniformity among them is yet not achieved. The scope of activity of these bodies varies from publishing standards (Accounting and Auditing Organization for Islamic Financial Institutions, Islamic Financial Services Board), to promoting Islamic finance (General Council for Islamic Banks and Financial Institutions, International Islamic Financial Market), to provide other supporting services (Arbitration and Reconciliation Center for Islamic Financial Institutions, International Islamic Rating Agency, Liquidity Management Center, Islamic Research and Training Institute).

From banking operations standpoint, the most important institutions are AAOIFI and IFSB, whose standards are increasingly adopted by countries as legal obligations. These standards will help the financial institutions in gaining better corporate governance, accountability, transparency and international creditability.

AAOIFI (Accounting and Auditing Organization for Islamic Financial Institutions)

Started in 1991 in Bahrain, the organization sets internationally recognized Shariah standards on accounting, auditing and governance; its standards are legally binding in most MENA countries

Number of standards

• 68 standards on accounting, auditing, governance, ethical, and Shariah Standards,

including a statement on capital adequacy

Total value of Global Islamic Fund (USD mn)

0

5,000

10,000

15,000

20,000

25,000

30,000

2002 2003 2004 2005 2006 2007 2008 E

Source: Source: Failaka International, IOSCO Report, Blominvest

Islamic equity funds market is one of the fastest growing sectors within the Islamic financial industry

Prior to 1995, there were approximately 10 equity funds on the market. Since 1996, the number of equity funds has doubled every year to over 120 funds as of today, estimated at USD 14.5 bn and is growing by 12%-15% per annum

Much of the money flowing into equity funds has come from founding institutions or high profile investors

Total value of Islamic equity funds estimated at USD 20 bn in 2007, projected to reach USD 26 bn in 2008


66

• 25 financial accounting standards • 5 auditing standards • 6 corporate governance • Code of ethics • 30 Shari ah standards • Uses International Accounting Standards as basis

IFSB (International Financial Services Board)

Started in 2003 in Malaysia, the board sets standards for the effective supervision and regulation of Islamic financial institutions; less popular in MENA than AAOIFI

Present Standards

• The Guiding Principles of Risk Management – 15 Guiding Principles divided into 7 parts

• Capital Adequacy Standard – this standard is divided into 7 sections, C1 to C7

• The Guiding Principles of corporate governance – 7 guiding principles, which are divided into 4 parts

Source: Blominvest

7.4 Appendix 4 ‐ Regulatory Environment and Key Developments In the early 1980s, conventional banking risk management techniques were applied to Islamic banking as there were no specific standards for risk management in Islamic banking. The original Basel 8% norm of capital adequacy was applicable to Islamic banks also. When Basel II was introduced, Islamic banks attempted to find ways of managing the risks specific to them. It was realized that the provisions in Basel I, and later on, Basel II, were insufficient for handling risks in Islamic banking. Pillar I of Basel II did not cater to the complexities of the Islamic contracts. However, Pillar I and Pillar II are fundamentally applicable to Islamic banking also.

Due to the gaps in existing risk management standards, the Islamic Financial Services Board (IFSB) attempted to systematize the risk management framework for Islamic banking. It released the risk framework for IFIs in 2005. The role of IFSB is commendable as it brings the risk management discussion to the core of risk recognition. IFSB stresses the need to recognize the risks at the point of origin. It also recognizes that the risks are dynamic and change during the lifetime of the contracts. IFSB has come also out with a set of standards for Pillar 1, Basel II norms dealing with capital adequacy.

The mitigation techniques are sometimes unique in Islamic banking due to the absence of standard insurance and other mitigation methods. Shariah-compliant risk mitigation techniques can solve the problem to a certain extent. The most critical issue in Islamic banking is liquidity risk management. Due to the challenges related to intra-bank money market and other money market instruments, coupled with heightened risks of defaults, liquidity management is one of the most important factors in Islamic banking. Shariah and Accounting standards The Shariah board is integral to all Islamic banks. The board monitors the working of the bank and every new

transaction that is doubtful from a Shariah standpoint has to be cleared by the board AAOIFI and IFSB are the two main international standard‐setting organizations that promote and enhance the soundness and stability of the Islamic financial services industry The standards are used as guidelines by the regulators in different countries In the absence of a single authority every bank appoints a Shariah committee to oversee new products or services Various Islamic countries have their own regulatory framework pertaining to Islamic Banking

Basel II IFSB has come out with a set of standards for Pillar 1, Basel II norms dealing with capital adequacy These standards are proposed for ‘non insurance’ institutions offering only Islamic products Like Basel, the application of these standards is entirely on the discretions of country’s regulatory authority The regulatory authority while implementing these standards, may apply them with or without modifications to institutions with ‘Islamic windows’

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The standards have been made mandatory in Qatar, and the regulators in Bahrain and Saudi Arabia have asked the institutions to implement them by 2008

7.5 Appendix 5 ‐ Key Global Issues Taxation & Legal Issues Various products under Shariah ‐ Murabaha, Ijara, Tawarruq etc. attract government

taxes at multiple levels. This is because, in a single transaction the property/commodity is bought and sold more than once. The issue has been addressed in many countries like UK and Bahrain but still poses problems in most Western countries

Risk Management Since IFIs are prohibited from investing in debt markets, ‘impure’ sectors and hedging instruments like derivatives, the risk is higher as compared to other conventional banks. Also, inability to charge default interests for late payments and imposition of preconditions to levy penalties result in higher business risk for IFIs

Regulatory & Disclosure The disclosure norms are less stringent and the absence of a single global regulatory regime creates issues in cross‐border transactions

Excess Liquidity Due to prohibitions on investing in debt markets, ‘impure’ sectors and hedging instruments, the secondary and inter‐bank market is underdeveloped. This causes a major threat to the excess funds with banks which remain unutilized and fail to earn adequate returns.

Fragmentation The industry is fragmented with small players that are unable to compete with international players for large‐scale project finance deals

Source: S&P – IF Outlook 2006, McKinsey & Co. – 2006 Islamic Banking Competitiveness Report & Blominvest

Source: IFSB, AAOIFI, News Run, Blominvest


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7.6 Appendix 6 ‐ Acronyms

6m08 First 6 months of 2008 8m08 First 8 months of 2008 9m08 First 9 months of 2008 AAOIFI Accounting and Auditing Organization for Islamic Financial Institutions ADIB Abu Dhabi Islamic Bank AED UAE Dirham AERE Al‐Emna Real Estate Company AFM Authority for the Financial Markets ATM Automated teller machine bbl Barrels BD Bahraini Dinar bn Billion BNM Bank Negara Malaysia C/I Operating cost to operating income CAGR Compound annual growth rate CAR Capital adequacy ratio CBE Central Bank of Egypt CBK Central Bank of Kuwait CBL Central Bank of Lebanon CBQ Commercial Bank of Qatar CBS Central Bank of Syria CEO Chief Executive Officer CFO Chief Financial Officer CMA Capital Market Authority COO Chief Operating Officer DIB Dubai Islamic Bank DIFC Dubai International Financial Center DPR Dividend payout ratio EFH European Finance House EIU Economist Intelligence UnitEPS Earnings per share FDI Foreign direct investment FSA Financial Services Authority FY Financial Year GCC Gulf Cooperation Council GDP Gross domestic product IAS International Accounting Standards IBS Islamic Banking Scheme IDB Industrial Development Bank IDB International Development Bank IDB Islamic Development Bank IF Islamic finance IFI Islamic financial institution IFIS Islamic Financial Information Service IFSB Islamic Financial Services Board IIRA Islamic International Rating Agency IMF International Monetary Fund IOSCO International Organization of Security Commissions IT Information technology JD Jordanian Dinar JDIB Jordan Dubai Islamic Bank JIB Jordan Islamic Bank for Finance and Investment KD Kuwaiti Dinar KFH Kuwait Finance House

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KIA Kuwait Investment Authority LE Egyptian Pound LIBOR London interbank offered rate LNG Liquefied natural gas M Cap Market capitalization MENA Middle East and North Africa mn Million NIBP Non Interest Bearing Papers NM Net margin NSAC National Shariah Advisory Council OIC Organization of the Islamic Conference P/B Price to book value P/E Price per earnings P/R Price to revenue PLS Profit and loss sharing QFC Qatar Financial Center QFCRA Qatar Financial Center Regulatory Authority QIB Qatar Islamic Bank QIIB Qatar International Islamic Bank QNB Qatar National Bank QR Qatari Riyal RERA Real Estate Regulatory Authority ROA Return on assets ROE Return on equity S&P Standard & Poor's SAC Shariah Advisory Council SAMA Saudi Arabian Monetary Agency SAR Saudi Arabian Riyal SC Securities Commission SKFH Saudi Kuwait Finance House SPV Special purpose vehicle SR Saudi Riyal UAE United Arab Emirates UK United Kingdom USD US Dollar VAT Value added tax VCEO Vice Chief Executive Officer WTO World Trade Organization YoY Year on year

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