ISLAMIC BANKING AND FINANCE

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ISLAMIC BANKING AND FINANCE

• WHATS IN IT FOR CANADIAN COMPANIES?
• Mohammad Fadel
• Canada Research Chair in the Law and Economics of
  Islamic Law
• University of Toronto Faculty of Law
• October 16, 2006

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OVERVIEW OF ISLAMIC BANKING SECTOR

• Centers of Islamic Finance
• Malaysia
• Persian Gulf
• United Arab Emirates (Dubai)
• Bahrain
• England ????

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History of Islamic Banking

• Local Islamic banks formed in the 1970s in Muslim
  countries such as Malaysia, Pakistan and Dubai
• Originally emphasized joint-venture structures
  akin to private equity
• Quickly evolved to provide short-term credit
  facilities by using the murâbaha structure

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History of Islamic Banking (II)

• With increase in scale, Islamic banks began to
  branch out to more complex financing schemes,
  including
• Retail banking, including, deposit taking and
  consumer lending
• Bonds (sukûk)
• Medium- and Long-term leases (ijâra)

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History of Islamic Banking (III)

• Impact of 9/11 Reverse Capital Flight
• Perception of hostile climate in many Western
  jurisdictions, in particular, the United States,
  led to repatriation of dollars by Arab investors
  to Middle Eastern banks
• Islamic banks, along with conventional banks in
  the region, benefited from this reverse flight of
  capital
• Increase in Oil Prices Led to Dramatic Increase
  in Liquidity in the Gulf

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History of Islamic Banking (IV)

• Conventional Banks Open Islamic Windows
• Conventional banks began to respond to requests
  from Muslim clients to offer products that
  complied with Islamic law
• As the size of the potential market became clear,
  conventional banks responded with the creation of
  divisions dedicated to Islamic banking

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History of Islamic Banking (V)

• Conventional International Banks with Islamic
  Windows
• Citigroup
• HSBC
• Deutsche Bank
• UBS
• ABN AMRO
• Standard Chartered Bank

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History of Islamic Banking (VI)

• Almost all regional banks have followed the
  international banks in creating Islamic windows
  and some have converted, or are in the process of
  converting, to the Islamic banking model

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Size of Islamic Banking Sector

• No precise measure of size of deposits held in
  Islamic banks or Islamic divisions of
  conventional banks
• Ranges from a low of 250 billion to a high of
  750 billion
• As much as 300 billion held in Islamic
  investment funds awaiting investment
  opportunities
• Arab investors hold approximately 800 billion of
  assets in European banks, with a growing trend to
  invest that money in Islamic products

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Role of Islamic Finance in World Credit Markets

• Demand Side
• Sovereign Debt
• International Agencies
• Corporate Debt
• Project Finance
• Consumer Debt

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Sovereign Islamic Debt

• In recent years, several Islamic Countries and
  their instrumentalities, as well as non-Islamic
  countries, have issued sovereign debt in the form
  of sukûk
• Department of Civil Aviation, Dubai 1 billion
• Qatar 700 million
• Pakistan 600 million
• Malaysia 600 million
• German State of Saxony-Anhalt 100 million
• Bahrain 79.5 million

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International Agencies

• International Agencies Have Issued Sukûk in
  recent years
• Islamic Development Bank 400 million
• World Bank 200 million

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Islamic Corporate Debt

• Private Issuances of Sukûk
• DP World 3.5 billion 7.5 sukûk, convertible
  into equity at the time of a qualifying initial
  public offering
• National Central Cooling Company 200 million,
  rated BBB- by SP
• Listed on London Stock Exchange
• Previous issuance by same issuer listed on
  Luxembourg Stock Exchange

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Islamic Corporate Debt (II)

• Global issuance of sukûk has exceeded 20 billion
• Dow Jones Citigroup Sukûk Index
• Comprised of seven sukûk
• 2.8 billion aggregate principal amount
• Each issue rated at least A by SP
• Average tenor 3 years

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Islamic Corporate Debt (III)

• Biggest challenge thus far is limited secondary
  trading market for sukûk
• Demand for sukûk has far exceeded supply
  offerings typically oversubscribed, even after
  substantial upsizing of the offering at times
• DP World offering originally contemplated for
  2.8 billion but was upsized to 3.5 billion to
  meet excess demand no road show needed to market
  the offering

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Islamic Finance and Project Finance

• Infrastructure projects in the Gulf region
  largely financed on a corporate basis until the
  mid-1990s
• Sadaf, a joint venture between Shell Oil and
  Saudi Arabian Basic Industries Corporation
  (SABIC), first important project finance
  transaction in Gulf region, closed in 1995
• Project Finance now preferred structure for
  infrastructure investment

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Islamic Finance and Project Finance (II)

• Islamic sources of capital traditionally played
  minor role in project finance in Gulf
• In recent years, however, no deal gets done
  without a substantial Islamic tranche
• Financing needs exceed capacity of commercial
  banks and export credit agencies
• Desire of project hosts to diversify sources of
  capital and take advantage of local capital to
  the extent feasible

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Islamic Finance and Project Finance (III)

• Rabigh Refinery and Petrochemicals Project,
  Kingdom of Saudi Arabia
• 9.9 billion total cost, of which 5.8 billion
  was debt
• 4.1 billion equity split 50-50 between Saudi
  Aramco and Sumitomo Chemical
• 2.5 billion loan provided by Japan Bank for
  International Cooperation
• 1 billion loan from Saudi Public Investment Fund
• 1.7 billion commercial loan
• 600 million Islamic tranche

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Islamic Finance and Project Finance (IV)

• YANSAB Project
• 5 billion greenfield petrochemical project
• 3.5 billion debt
• 1.067 billion, 13-year tranche from Saudi Public
  Investment Fund
• 850 million, 12-year Islamic tranche
• 700 million export credit agencies tranche
• 533 million 12-year commercial bank tranche
• 350 million working capital facility
• ABN AMRO was sole arranger, underwriter and
  bookrunner on deal

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Islamic Finance and Project Finance (V)

• Future Demand for Project Finance
• Last two years saw 40 billion of project finance
  in gulf region
• Saudi Arabia estimates it will invest 90 billion
  in domestic power generation over the next
  fifteen years
• Other states in the gulf also investing heavily
  in infrastructure projects, particular
  petrochemical
• There will be a continuing demand in the region
  for capital to invest further expansion of the
  regions infrastructure

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Opportunities for Canadian Banks

• Deal flow shows no sign of abating
• International banks have shown an ability to
  compete successfully
• Because of the size of new deals, Islamic banks
  need to partner with international banks to take
  advantage of their larger distribution networks
• Success of sukûk issues means that conventional
  market investors have grown comfortable with
  their structure and will invest in them so long
  as credit profile meets investors needs

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Opportunities for Canadian Banks (II)

• Success in penetrating markets for arranging
  credit could lead to mandates in upcoming equity
  offerings
• Future opportunities to advise in connection with
  an inevitable consolidation of banks in the Gulf
  region
• Opportunities for wealth management of wealthy
  Islamic investors
• Merrill Lynch identified 300,000 U.S. dollar
  millionaires in the Middle East

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Opportunities for Canadian Issuers

• Canadian Issuers, public and private, may
  consider tapping the Islamic capital markets
• Because of Islamic finance is asset-based,
  Canadas mining industry is a natural fit with
  the structures so far developed in Islamic
  finance
• Because of high-liquidity of Islamic banks and
  Islamic investment funds, issuers who tap this
  market may be able to obtain relatively favorable
  pricing relative to the conventional market

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Opportunities for Canadian Infrastructure Firms

• Because of infrastructure boom in Gulf region,
  large premiums have been paid on Engineering,
  Procurement and Construction contracts
• Successful competition for infrastructure
  projects inevitably requires support of export
  credit agency
• Export Development Canada would have an important
  role to play in promoting Canadian firms
  expertise in the region

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Conclusion

• Islamic finance and conventional finance are
  quickly converging in the Gulf region
• As conventional investors gain more comfort with
  Islamic structures, cost differential between
  Islamic products and conventional products have
  almost disappeared
• As a result, Islamic products may be more
  practical because they appeal to both Islamic and
  conventional investors

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Conclusion (II)

• It is not too late for Canadian banks to compete
  for business in the Islamic finance arena
• To do so successfully, they will need to
  establish a presence in the region, as have their
  competitors