Islamic Banks - Their strategies and ratings
This special comment is based on a speech delivered by Christine Kuo , a Moody's VP/Senior Analyst, at the 6th IFSB Summit on 7 May 2009 in Singapore.

Professionals in the Islamic banking sector are often asked whether the current strategies adopted by Islamic financial institutions will prove effective at competing at the global level in the long run. Since a strategy is a plan of action designed to achieve certain goals, its effectiveness can be assessed only in relation to these well-defined goals.

From the rating perspective, an effective strategy is one that allows a particular Islamic bank to grow its business while delivering a stable and good financial performance, thereby making it stand out against credit ratings of other global banks.

While Islamic banks in different countries operate under different environments and are at different stages of development (and therefore require different strategies), we can still find a set of common characteristics among their various strategies that benefit their long-term ratings.

To address this topic and related issues, this report is organised into the following five sections:

(1) summary of those characteristics in strategies that benefit ratings;

(2) specific strategies adopted by various Islamic banks;

(3) rating implications of these strategies;

(4) selective rating issues concerning Islamic banks; and

(5) how relevant stakeholders could affect strategies and ratings of Islamic banks.

Characteristics in strategies that benefit ratings

Moody's assigns ratings to banks globally, irrespective of their form or nature, and that includes Islamic banks. In assigning ratings to banks, Moody's first evaluates a bank's intrinsic safety and soundness thereby arriving at a Bank Financial Strength Rating (BFSR), and then factors in potential support from the relevant providers to derive the bank's ratings for deposits and debt. This analytical framework is common to all types of banks, so the ratings of Islamic banks are comparable to those of conventional banks globally.

It is worth noting that an Islamic Financial Institution (IFI) is an institution that limits the scope of its business to comply with a set of ethical and moral guidelines derived from the teachings of Islam. It should be noted that there is nothing that stops a 'conventional' bank from operating the same ethically-driven model. It would still be Shari'ah compliant despite not being 'branded' as such. IFIs focus on a subset of global finance consistent with Shari'ah, thus the skills and experience applied to rating broader and more universal institutions is equally applicable and valuable in the Islamic context.

In accessing a bank's financial strength, Moody's considers factors such as franchise value, risk positioning, regulatory environment, operating environment and financial fundamentals. Of these factors, regulatory and operating environments are outside of a bank's control, but bank strategies can definitely affect the other factors in the long term.

Strategies that improve franchise value

Franchise value is about the solidity of a bank's market standing in a given geographical market or business niche. A solid and defensible franchise is a key element underpinning a bank's ability to generate and sustain recurring earnings, to create economic value and, thus, to preserve or improve risk protection in its chosen markets.

The Islamic brand is economically valuable; in many instances Muslim depositors will happily pay a small premium for conducting their finances in what they perceive to be an ethical way. With a large addressable population and relative immaturity there is still scope for solid long-term growth.

Moody's believes strategies leading to sustainable entrenched market position, improved geographical and earnings diversification, and increased earnings stability can enhance a bank's long-term franchise value.

Size is important because diversification is harder to achieve when an institution is small. It should be noted, however, that a bank dominant in smaller but more favourable markets may have a higher franchise value (which could translate into greater earnings stability) than a bigger bank with a highly price-sensitive customer base in a competitive market.

It follows that it is better for Islamic banks to have a strategy that helps achieve a stronger position in a few selective markets than one which results in marginal positions in many competitive markets.

Strategies that improve risk positioning

A bank's risk positioning is a fundamental qualitative factor in Moody's credit analysis; the current credit woes apparent in the global market once again highlight its importance. In this regard, we view positively strategies that improve corporate governance, controls and risk management, financial reporting transparency, credit risk concentration and liquidity management. Strategies that set a conservative market risk appetite are also considered favourably.

Improving risk positioning is particularly relevant. Although Islamic banks are able to pass through a negative shock on the assets side to the investment depositors, displaced commercial risk is at stake.

Islamic banks have a number of buffers to manage displaced commercial risks. These are profit equalisation reserves which contribute to smooth earnings across the cycle; investment risk reserves which absorb negative shocks on asset values; Mudarib fees which can always be decreased in a discretionary manner to avoid penalising the depositing Rab al Maal; and shareholders who can always provide Qardh Hasan to profit-sharing depositors. In a stress situation, those IFIs sufficiently equipped with such mitigating instruments would be considered more resilient to downturns.

Nonetheless, to date few, if any, Islamic banks have passed on losses to their depositors. If the buffers mentioned above are inadequate, the IFIs could experience funding pressure as deposits are moved to other financial institutions.

Additionally, Islamic banks tend to have greater concentration in assets and liabilities compared with conventional banks. They also face challenges in managing liquidity and risk due to the limited range of instruments available.

Moreover, Islamic products are less commoditised and require more tailoring and oversight, and this leads to substantial overheads and operation risk.

Strategies that improve financial fundamentals

We break down our analysis of a bank's financial fundamentals into five sub-factors, namely profitability, liquidity, capital adequacy, efficiency and asset quality. Some financial metrics necessarily reflect a bank's franchise value and risk positioning, but a prudent financial policy also plays an important role in shaping these numbers.

For instance, a bank with a strategy to maintain a conservative financial policy is likely to keep its capital and liquidity ratios higher then most of its peers. The result is a stronger balance sheet and which can better withstand adverse economic cycles. For Islamic banks with significant exposures to equities and properties, conservative financial leverage is particularly important in view of the volatility in the values of these investments.

Most of the strategies of Islamic banks try to achieve profitable asset growth. The differences in their strategies mainly reflect the state of development of Islamic banking and their positions in their respective home markets, their aspirations for the medium and long term, and the resources they have.

Organic growth in home market

This is the main strategy adopted by almost all Islamic banks across different countries since decent growth potential still exists at home. While organic growth does not allow for quantum leaps in assets and earnings, this strategy is of lower risk.

Market with low penetration: strategic focus is on increasing awareness

For markets where Islamic banking has low penetration, such as Indonesia, North Africa, Turkey, Jordan and (probably) the Sultanate of Oman (where Shari'ah-compliant finance is expected to pick up), there is plenty of room for growth and the level of competition is relatively low. Moreover, Islamic banks in these markets are mostly still small in size. Therefore, they are not keen on acquisitions or venturing overseas. Instead, they focus on growing customers and businesses at home. Their major competitors are conventional banks in the same markets and their strategies involve conversion of conventional banking assets into Shari'ah-compliant assets. Increasing awareness of Islamic banking services is essential at this stage.

More mature market: strategic focus is on providing competitive products and services

In the more mature markets, such as Malaysia, Sudan and most countries within the Gulf Cooperation Council (GCC), low-hanging fruit have already been picked. Therefore, Islamic banks need to set their strategies to compete not only with the conventional banks but also with their Islamic banking peers. The target is to increase the wallet share of existing customers, to attract Muslim customers who still bank with conventional banks, and to attract non-Muslim customers if the markets have significant non-Muslim populations. Being able to offer competitive products and services is the critical factor to success.

A few larger Islamic banks have been expanding outside of their home markets to tap other Muslim populations as there is a natural brand affinity. Kuwait Finance House (KFH) is one such example. It has established subsidiaries and associate companies in the Gulf and wider Middle East and North Africa region (MENA), as well as in Asia. Its subsidiaries in Bahrain, Malaysia and Turkey are key to the group's regional expansion strategy.

Its foreign expansion is expected to continue, especially in North Africa (including Morocco), the Gulf region (including Saudi Arabia) and Muslim Asia.Other examples are Al Rajhi Bank and Dubai Islamic Bank. The former ventured into Malaysia in 2006, while the latter launched its operation in Pakistan in the same year. Finally, most Islamic banks established in the UK have majority or strategic bank shareholders headquartered in the Gulf region.

Mergers and acquisitions

This option is adopted by only a very small number of Islamic banks as the potential for organic growth is still great. However, as business and the number of Islamic banks grow, the markets will become more mature and competitive. At that time, Islamic banks operating in fragmented markets would likely pursue M&A strategies for asset and earnings growth.

For example, there are 17 Islamic banks in Malaysia, a mid-size economy with GDP of approximately $200 billion. Islamic banking assets account for less than 20 per cent of total banking system assets. Since the largest Islamic bank (Maybank Islamic Berhad) accounted for only about 2.2 per cent of these assets, this implies that all Islamic banks are small and the market is fragmented. The market is currently growing and profitable, but competition is rising which will drive down margins gradually. This development could lead to market consolidation over the medium term.

In some cases, depending on conditions and regulations, Islamic banks with entrenched positions in their home markets may also consider using M&As to establish their presence overseas. For example, Dubai Islamic Bank has acquired a majority stake in the Bank of Khartoum, the largest bank in Sudan, whereas Abu Dhabi Islamic Bank has acquired Egypt's National Bank for Development with a view to converting it into a fully fledged Shari'ah-compliant bank within two years.

Under current market conditions, M&A activity may be driven by necessity rather than by choice. In the UAE for instance, there are two troubled Islamic mortgage lenders or "home finance companies" facing difficulties due to liquidity issues, and are effectively in the process of being nationalised (although their status is still unclear as the Federal government has yet to announce its final decision on the matter). The two companies together -- Tamweel PJSC (Tamweel) and Amlak Finance PJSC (Amlak) -- have about 60 per cent of the market, but have shown themselves to be just as vulnerable as any other wholesale-funded conventional counterparts.

Per se, a merger would not solve the issue; however, it would give birth to one large systemically important institution that would be easier to regulate, control, fund and strengthen from the perspective of its public-sector shareholder.

Strategic partnerships and joint-ventures

This strategy is popular among Islamic banks which want to build presences overseas. It is also used by banks seeking technical expertise in markets and/or products from other institutions. To facilitate the formation of partnerships and joint ventures, the Islamic banking businesses of conventional banks often need to be incorporated.

For example, Abu Dhabi Commercial Bank of the UAE and RHB Bank of Malaysia have entered into a strategic alliance. While both also operate conventional banking businesses, two reasons given for the partnership involve the ability to leverage each other's strengths in Islamic banking, while they also share the goal of developing a global Islamic banking platform.

Reacting to a crisis scenario

As is often the case in the field of Islamic banking, larger banks and smaller contenders tend to react differently in a situation of stress, which the overall market has been experiencing for several months. While larger Islamic financial institutions, like Saudi Arabia's Al Rajhi Bank or Kuwait's KFH, prefer to protect asset liquidity, capitalisation and their reputation at the expense of growth and profitability, smaller banks –- when they can afford to adopt such an opportunistic view -- are keen to quickly gain market share.

Such a strategy is apparent in the competitive UAE market. At a time when market liquidity has been scarce, most banking players tend to refrain from lending, leaving room for those competitors with ample asset liquidity to use their own balance sheets to capture extra shares of the lending market. For instance, Dubai Bank, one of the UAE's smaller Islamic banks, pursued such tactics: prior to the crisis, the bank managed to accumulate sizeable asset liquidity on its balance sheet, which it extensively used across 2008, resulting in a doubling of its size despite the worsening global credit woes.

Funding was less of a constraint for IFIs, because of market perception that these players will be more resilient than conventional peers amid global credit turmoil. The market acknowledged that Islamic banks could not carry on their balance sheets any toxic assets (in the form of highly-leveraged structured instruments or global investment banks' shares) simply because these are considered "haram" and therefore not eligible for investment as per Shari'ah Boards' fatwas.

In practice, a phenomenon of customers switching savings from conventional banks (perceived as riskier), to Islamic banks (perceived as less directly and indirectly exposed to 'subprime') has been recorded across a number of countries, especially in the UAE, Kuwait and Bahrain.

Rating implications of these strategies

The rating implications of different business strategies need to be considered in relation to individual institutions and the likely impact on their business and financial profiles.

Organic growth in home market

􀂄 Good for long-term ratings, as long as not too aggressive

This strategy is usually good for long-term ratings since the expansion of market positions could improve franchise value. To the extent that growth is a result of tapping new customers, the strategy would also serve to reduce concentration risk and increase earnings diversification. Moreover, organic growth in home markets involves tapping business in a familiar operating environment. And since strategy is implemented by the existing management team, it has lower execution risk.

But overly aggressive growth could still harm bank credit profiles. An institution's risk management system and infrastructure often cannot keep pace with strong business growth. This may be indicated by the experiences of Tamweel and Amlak which became exposed to construction risk by funding under-construction properties. As a result, asset quality problems could surface later. Worse still, if growth is supported by debt-like hybrid capital instruments, any capital buffer utilised to support potential loss from the risk assets will thin

􀂄 Example: Al Rajhi Bank

In September 2006, Moody's upgraded Al Rajhi Bank's financial strength rating to C- from D+. The rating action was to recognise the bank's strengthened franchise, improved financial fundamentals and strong capital base. Organic growth outside of home market

􀂄 Potential higher diversification benefits, but with higher short-term risk

The small size and/or a maturing nature of home markets often drive financial institutions to seek long-term and sustainable growth abroad. Such an expansion strategy is inevitable and, in the long term, beneficial. However, growing the business in less familiar markets, and sometimes in more volatile and often constrained environments, brings near-term challenges.

Until Islamic banks have seasoned their overseas operations and demonstrated that they are able to deliver stable earnings, increased risk profiles may outweigh any benefits. However, once seasoned, the income and risk diversifications benefits would be more evident since assets in overseas markets generally have a lower risk and earnings correlation than have risk assets in the same market. The less correlated and better diversified the new markets, the higher the diversification benefits.

􀂄 Example: KFH

KFH's international operations are growing in importance, and have started to confer visible diversification benefits to the group as well as brand credibility overseas. The performance of foreign subsidiaries has improved over the past few years. This development has somewhat altered its culture in a positive way, forcing it to more efficiently allocate resources across the organisation and experience more intense competition.

Mergers and acquisitions

􀂄 High execution and integration risk, and financial leverage often rise

M&As of material sizes always trigger rating reviews. While the reviews do not always lead to rating actions, when the latter do take place they are often negative for acquirers. The possible results include changing an institution's rating outlook to negative, placing ratings under review for possible downgrade, or simply rating downgrades.

Negative rating actions are more common, and mainly reflect the many risks involved in such a strategy, including execution risk, integration risk, regulation risk and financing risk. With M&As involving targets outside of home markets, the risk is still higher.

Until now, Moody's has not taken any negative rating actions on any Islamic banks as a result of their M&A initiatives, mainly because the acquirers have been able to absorb the added risks without creating too much pressure on their own balance sheets. This has in turn been due to the relatively small sizes of the transactions.

Strategic partnerships and joint ventures

􀂄 Rating neutral in most cases

Moody's recognises that strategic partnerships and joint ventures could be a lower risk strategy for tapping into less familiar business lines or markets. And this strategy sometimes results in an increase in capital, which is good from a rating perspective.

Nonetheless, it is not uncommon to hear of disagreements among partners in terms of the formulation and execution of business strategies. And since each partner emphasises its own primary businesses, and it takes time to form a consensus and resolve any potential conflicts of interest, slow action or inaction could prevent the realisation of full possible benefits.

Moreover, not many strategic partnerships or JVs have brought big enough benefits to transform the business and financial profiles of its investors.

Selective rating issues concerning Islamic banks

While the underlying operations and economics of Islamic banks are substantially similar to those of conventional banks, we see some risk issues that could affect the ratings of Islamic banks.

The limited scope of eligible asset creates asset concentration risk. Non-deposit liabilities could have concentration risk as well due to the relatively small number of Islamic financial institutions available to participate in the inter-bank market. There is also only a small range of Shari'ah-compliant instruments available for managing or transferring risks.

For example, Al Rajhi Bank is highly exposed to the sovereign, primarily through murabaha placements with the government and balances with the Saudi Arabian Monetary Agency. This is in line with other Saudi Arabian banks. If we were to add to this situation the bank's top 19 group exposures and come up with an estimate of its top 20 exposures relative to Tier 1, then the amount could be quite sizeable. This is a common feature for rated Saudi banks and which significantly constrains their BFSRs.

In the case of KFH, the institution has some industry concentration in the property sector, with direct and indirect real estate exposures in Kuwait and internationally (exposure to the US real estate market appears negligible). In its loan portfolio alone, real estate and construction represented 12 per cent of exposures, whereas direct investments in properties accounted for 2.8 per cent of total assets at end-2007. At the same time, like most other GCC banks, single-borrower concentration is rather high.

KFH is also more exposed to market risk since direct investments are a key component of its business model and it has a marked preference for equities (in addition to Sukuk and property).

Focus on tangibles had led to increased property-related financings at IFIs, affected by relatively undiversified nature of the economies. As the real estate markets are highly volatile in the GCC, the concentration risk is magnified.

Challenges in liquidity management

Liquidity management is structurally more challenging at Islamic banks because there is still a significant shortage of liquid instruments, despite the efforts of the various central banks to provide a variety in which Islamic banks can place their surplus cash. In fact, Tamweel and Amlak would have gone insolvent if not for the government with liquidity being the issue.

Moreover, displaced commercial risk is always possible should an Islamic financial institution's assets yield returns for profit-sharing investment account (PSIA) holders that are lower than expected, or worse still, show negative rates of profits. While PSIAs are supposed to absorb losses -- other than those triggered by misconduct or negligence -- it remains to be seen how such account holders would react to losses on their accounts.

Historically, Islamic banks in the GCC have kept very large proportions of core liquidity on their balance sheets in the form of short-term international Murabaha and central bank deposits, at the expense of extra revenue. This approach has proved to be a wise choice in a region prone to numerous cycles and recurring shocks, and given that their investment portfolios tend to be more illiquid as stress situations worsen.

How the relevant stakeholders could affect the strategies and ratings of Islamic banks

Of the various stakeholders in Islamic banks, it is the regulators, shareholders, company management and employees, and customers which have key roles in shaping an Islamic bank's business strategy and performance and so affect its intrinsic financial strength. Additionally, regulators could influence an Islamic bank's deposit and debt ratings according to their capacity and willingness to provide systemic support in time of stress.

Regulators can affect a bank's strategy and ratings through their influence on the regulatory environment and systemic support. A more favourable regulatory environment could contribute to better BFSRs, while systemic support could further lift deposit and issue ratings as the joint-default probability is lower.

A bank regulator's principal objectives are usually focused on protecting depositors and promoting a healthy banking system. As such, the interests of a bank regulator are often aligned with the interests of depositors, bond holders and other creditors.

Through a combination of effective regulations, active supervision, and aggressive and prompt enforcement, a strong regulatory environment can promote sound banking practices and limit excessive risk taking. As a result, a bank's financial strength is often improved.

The level of systemic support is a result of the capacity and willingness of the national government to support troubled banks. Moody's firstly determines whether the countries in which the Islamic banks are domiciled are high, medium or low support countries. We then apply the appropriate level of support based on the importance of the respective bank to the system.

Tamweel and Amlak are examples of systemic support prevalent in jurisdictions where IFIs have been growing (i.e., the GCC).

Shareholders

Balance of growth and returns

The presence of active shareholders often pressures financial institutions to report higher returns on equity (RoE). To the extent that this is achieved by improving franchise and other business fundamentals, which lead to better financial metrics, the bank's long-term ratings will benefit.

However, if a higher RoE is achieved mainly by a more aggressive use of financial leverage, e.g., to make sizeable acquisitions financed by debt and other lower-quality capital instruments, or to conduct a large number of share buybacks, the bank's ratings would be pressured.

Many equity investors have under-estimated the risk of financial leverage in the past. However, we are now seeing that change in light of the prevailing global crisis.

Management and employees

Financial institutions, including Islamic banks, need to solve the most fundamental incentive problems so that strategies that involve excessive risk taking or a focus on short-term gains are discouraged. Staff tend to act based on how they are evaluated and compensated. Ill-devised performance metrics and compensation systems inevitably lead to a weak corporate culture and problems that undermine an institution's long-term prospects.

Client characteristics matters

Client characteristics could affect bank business profiles and financial results. For example, some Islamic mortgage originators in the UK note that the prepayment rate is higher, and the delinquency rate lower, than for conventional customers of similar income. Another example is that the customers in the GCC countries are willing to accept low or no returns on their deposits.

We note that the difference between Muslim and non-Muslim customers, in terms of credit quality and cost of deposits, is not significant across all markets. The point is that customer behaviour does have implications onbank performance; therefore, a selection of target clienteles could affect bank financial strength when distinctions do exist among different classes of customers.

To sum up, it is impossible to lay out one best strategy for all institutions, but Moody's believes those strategies that improve franchise value, risk positioning and financial fundamentals will benefit an Islamic bank's financial strength rating, which is comparable on a global basis.

Various strategies can be adopted by Islamic banks to achieve profitable growth and enhance their competitiveness, but the resulting immediate and long-term risks and benefits differ. It is worthwhile to point out that while asset growth is important, appropriate systems and infrastructure to address risk issues need to be in place to support sustainable growth. Therefore, strategic focus needs to be timed, with risk management being implemented first followed by growth.

Finally, regulators, shareholders, management and employees, and customers all have roles in shaping an organisation's strategy and could influence ratings. When it comes to global comparisons, Moody's believes it is more important for Islamic banks to build strong franchises in selective markets and businesses, and to maintain sound financial profiles as opposed to big balance sheets