Islamic finance needs to diversify

July 26, 2009 4:21 pm

Estimates of the size of the industry seem to peak around $1,000bn although more conservative estimates indicate that the overall size of the industry is nearer $750bn.

Equally, the rate of growth of the industry is put at somewhere between 10% and 20% each year thereby making it one of the fastest growing areas of finance.

Even in mid-2009 industry experts are still bandying these same figures around when it is clear that the industry as a whole suffered the same kind of shrinkage as the rest of the financial world.

Sukuk issuance, for example, is down over 50% year on year. The Sukuk industry is facing the same sorts of challenges that the conventional world has faced for many years including defaults and credit downgrades.

Simply put, the Sukuk segment is not growing at between 10% and 20% and some individual Sukuk issues are now trading at 50 cents on the dollar.

Islamic funds, too, are having a rough time. According to analysis by Ernst & Young average
returns for Islamic equity funds for 2008 plunged almost 40%. Private equity as an asset class has barely breathed this year, with the exception of a couple of transactions and there have been no new funds raised. Islamic private equity is not growing at all. And real estate, for long the darling of the Islamic industry, has had the worst ride imaginable.

Narrow focus

The Islamic investment banking world has perhaps been spared the worst excesses of the financial meltdown, in part because of its antipathy to risk but also because the industry itself is less complex. While this lack of complexity may have been a blessing over recent months, it also means that many Islamic investment banks may have been foregoing profits over recent years that they could have been reaping.

But the fact is that Islamic investment banking can be as diverse as its conventional counterpart.

It is true that many Islamic investment banks have been focused too narrowly on real estate of late, but this is not because of any tenets of Shariah but rather that the investment teams at these banks have felt comfortable with real estate and it has offered them spectacular returns.

When asked why they have not diversified into asset classes other than real estate many Islamic investment bank CEOs have, in the past, replied by asking which other asset classes could offer them returns that were better than the typical 250% that they were seeing on their property portfolios.

The practical flaw in this argument has always been a simple one of putting too many eggs in one basket. If any investor, private or corporate, has too great an exposure to any single asset class then it simply is not safe.

A cautious approach to risk should dictate that every investor has exposure to a series of asset classes and that, ideally, at least some of these asset classes should be uncorrelated. In this way, if one asset class takes a metaphorical beating then the other assets in the portfolio should be immune.

Spread of asset classes

The fact is, however, that not enough Islamic investment banks have delved into a diverse range of asset classes and as a result the industry is perhaps not as robust as it could be. While not every bank will want to be involved in every area, a healthier spread of asset classes and diversification away from real estate can only serve to produce an industry that is less prone to market dips and more prone to healthy and sustained profitability.

So what does the successful Islamic investment bank of the future look like? A rapidly maturing beast, is the short answer. Such a bank cannot be locally or even regionally focused but must become an investment bank with a global outlook with a strong base in an established financial centre. This might happen through organic growth but is more likely to be achieved through acquisition.

The question the CEO must ask himself and his team is, ‘How do we become a world-class player with world-class products and services for our clients?’ These products cannot be solely about real estate and must embrace the best of everything. For the bank it also means employing the best people and then keeping them. The talent pool in the Islamic finance industry is notoriously thin and finding enough brilliant people in order to cope with the challenges ahead will be tough, but the rewards for those who succeed will be immense.

The finance industry has taken a battering over the past year and it is not over yet. The same goes for the Islamic finance segment. The winners, of course, will be the banks that diversify and that hire the best and brightest people.

Next article: Islamic private equity