March 5 (Bloomberg) -- Islamic banks say their small scale and a lack of risk-management products makes it harder for them to compete, after Ernst & Young LLP warned lower profitability threatens to slow expansion of the $1.8 trillion industry.
The average return on equity at Shariah-compliant lenders was 11.6 percent in 2011, compared with 15.3 percent at their non-Islamic counterparts, according to a December report by Ernst & Young that covered 12 countries. The use of hedging and treasury solutions is lagging behind, Haszeri Hussin, head of Islamic global markets at Hong Leong Islamic Bank Bhd., a unit of Malaysia’s fourth-biggest lender, said in a March 1 interview.
Financial holdings that comply with the religion’s ban on interest will grow at least 11 percent in 2013 to more than $2 trillion, compared with average annual expansion of 19 percent over the past four years, Ernst & Young forecast. Shariah banks had an average $17 billion of assets in 2011, less than the $65 billion for non-Islamic lenders, resulting in operating costs as a proportion of holdings that were 50 percent higher, said Ashar Nazim, the company’s global head of Islamic banking.
“Most Islamic banks have very basic risk infrastructure and most of these institutions operate in domestic markets which are highly competitive,” Nazim said in a Feb. 28 interview from Bahrain. “Growth is becoming more challenging to achieve.”
The International Islamic Financial Market, a Bahrain-based standards-setting body, only endorsed the Shariah-complaint equivalent of interest-rate swaps in Malaysia in November 2011 and then announced a globally accepted format last March.
Banks including CIMB Group Holdings Ltd. and HSBC Holdings Plc asked Indonesian authorities to allow Islamic products to be used to hedge against exchange-rate swings, Adiwarman Azwar Karim, a member of Indonesia’s National Shariah Board, said in August. Shariah-compliant currency hedging products, available in Malaysia and some Gulf Cooperation Council countries, are not widely used. The GCC comprises Saudi Arabia, United Arab Emirates, Qatar, Bahrain, Kuwait and Oman.
Islamic “banks are forced to be more conservative in their investments as the risk-management tools aren’t there,” Raj Mohamad, managing director at Singapore-based consulting company Five Pillars Pte., said in a Feb. 25 interview. “Overheads are much higher as a proportion because of their small size.”
Slower growth may damp demand for Shariah-compliant bonds, sales of which have dropped 12 percent this year to $7 billion, data compiled by Bloomberg show. Issuance reached a record $46.4 billion in 2012.
AlHuda Center of Islamic Banking and Economics in Lahore, Pakistan, estimated last month that there is a global shortage of about 50,000 professionals in the industry. That has led to costs rising for Shariah-compliant lenders as they are forced to pay higher wages to attract and retain staff, Ernst & Young’s Nazim said.
The average yield on global Shariah-compliant notes was steady at 2.85 percent yesterday, the HSBC/Nasdaq Dubai US Dollar Sukuk Index shows. The premium investors demand to hold the securities over the London interbank offered rate, or Libor, widened one basis point, or 0.01 percentage point, to 176 basis points.
Islamic debt sold internationally has returned 0.5 percent this year, according to the HSBC/Nasdaq index, compared with a 1.4 percent decline in emerging-market notes, JPMorgan Chase & Co.’s EMBI Global Index shows.
Shariah banking may still grow about 50 percent faster in coming years than the overall financial sector in several major markets, according to the Ernst & Young report. Indonesia’s industry may expand fivefold to $83 billion by 2015, while Turkey’s may triple in size in the next decade to more than $100 billion, it said.
“All in all Islamic banking growth will still outpace the conventional, because of the smaller base and increasing awareness,” said Five Pillar’s Mohamad. “More and more people see Islamic finance as a value proposition instead of just a religious choice.”
The lag in profitability was more pronounced in Southeast Asia, where the ratio between profit and equity was 14 percent for Shariah lenders and 19 percent for the non-Islamic banks, according to the Ernst & Young report. The study compared non-Islamic and Shariah lenders in Malaysia, Indonesia, Saudi Arabia, Bahrain, Kuwait, Qatar, UAE, Jordan, Egypt, Turkey, Pakistan and Bangladesh. The total assets figure was based on data from 22 Islamic banking markets.
Shariah-compliant financial holdings make up 19 percent of Malaysia’s banking system and 4.2 percent of Indonesia’s, central bank data show. That compares with 49 percent in Saudi Arabia and 33 percent in Kuwait.
“Only once the market share is equal can Islamic banks truly compete in terms of profitability,” Hendiarto Yogiono, finance director at PT Bank Muamalat Indonesia, the nation’s second-largest Islamic lender, said in a March 1 interview in Jakarta. “We are now focused simply on expanding our loans business until profitability eventually improves as a function of larger scale and a more mature industry.”
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