SPECIAL COMMENT GCC Islamic Investment Banks : Mid-Crisis ...ddata.over-blog.com/4/08/16/46/GCC.pdf · GCC Islamic Investment Banks : Mid-Crisis Collapse to Force Improved Risk Management

SPECIAL COMMENT

GLOBAL BANKING SEPTEMBER 22, 2010

Table of Contents:

EXECUTIVE SUMMARY 1 OVERVIEW: THE FALL – AND RISE? – OF THE SCIB MODEL 2 RECENT DEVELOPMENTS 2 OUTLOOK FOR SCIBS REMAINS UNCERTAIN – BUT NOT BLEAK GIVEN ROBUST DEMAND 3 1997-2007: THE BENIGN DECADE 4 BUSINESS MODEL COLLAPSE AS SUB-PRIME CRISIS EVOLVED INTO MASSIVE LIQUIDITY SHOCK 7 SCIBS’ STRUCTURAL WEAKNESSES REVEALED 11 SCIB BUSINESS MODEL FAR FROM MORIBUND – BUT RATHER AN EVOLVING INVESTMENT PLATFORM 14 MOODY’S RELATED RESEARCH 17

Analyst Contacts:

PARIS 33.1.53.30.10.20

Anouar Hassoune 33.1.53.30.33.40 Vice President - Senior Credit Officer [email protected]

LIMASSOL 357.2558.6586

Mardig Haladjian 357.2569.3011 General Manager [email protected]

GCC Islamic Investment Banks: Mid-Crisis Collapse to Force Improved Risk Management

Executive Summary

The pre-crisis moves towards developing the concept of Shari’ah-compliant investment banking (SCIB) were brought to a halt by the onset of the global financial crisis and severely undermined by the spectacular defaults of a few SCIBs mid-crisis. Any recovery of the tarnished SCIB concept would require that lessons from the crisis – such as the need to improve risk management – be applied. A potential rebirth of this subsector is likely to take a different form from the pre-crisis model. Specifically, Moody’s expects SCIBs to evolve away from being the preserve of boutique investment houses created by individual investment bankers. Instead, Moody’s believes that the SCIB concept could re-emerge in the form of specialised business lines of larger Islamic banking groups seeking to diversify.

Islamic finance may be a relatively recent phenomenon, but the concept of Shari’ah-compliant investment banking (SCIB) is an even newer innovation. Just a decade ago, very few investors would have expected Gulf Finance House, Arcapita Bank, Unicorn Investment Bank or the Investment Dar to become major players in the Arabian Gulf’s financial landscape. Some time before the crisis, these institutions were among the most profitable, innovative, dynamic and attractive wholesale institutions within the booming Islamic finance industry. They diversified the sector by moving away from pure banking intermediation and into more sophisticated investment/merchant banking lines of business, like private equity, asset management, brokerage, infrastructure and structured real-estate finance, as well as advisory, corporate and project finance – thereby laying the groundwork for an SCIB sector.

These developments and innovations meant that – just before the crisis – Islamic finance was poised to enter a new era that would bring Islamic finance closer to the profit-and-loss sharing, asset-backed and real-economy financing ideals, which traditional Islamic universal banks had not previously been able to handle fully. Specifically, Islamic finance was on the cusp of moving beyond its sole focus on raising cheap murabaha or wakala deposits (so as to recycle them into safe, stable and expensive retail and corporate loans) – and to adopt a greater emphasis on risk-taking instead. However, the onset of the financial liquidity crisis prevented the dawning of this new era, and almost led to the collapse of the SCIB model.

This report reviews developments from 1997-2007, identifies the three groups that were central to the inception of the SCIB model and assesses the impact of the crisis. It also analyses the prospects for this sub-sector and the possible rating ranges that the (as yet unrated) SCIBs might attain under Moody’s rating methodology.

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2 SEPTEMBER 22, 2010

SPECIAL COMMENT: GCC ISLAMIC INVESTMENT BANKS: MID-CRISIS COLLAPSE TO FORCE IMPROVED RISK MANAGEMENT

Overview: The Fall – and Rise? – of the SCIB Model

» As a whole, Islamic banking has been one of the most resilient niches of the global financial industry, and yet its investment banks have been suffering more so than any other sector in the GCC region.

» The speed at which the SCIB model failed was alarming: the most innovative and in-demand concept since the birth of modern Islamic finance around 40 years ago was wiped out in just a few months.

» Despite being a very profitable and robust concept, the SCIB model did not survive its first wave of negative economic cyclicality

» The SCIBs’ large capital base proved insufficient protection against liquidity droughts

» At a time when SCIBs were at their weakest, the rest of the Islamic finance industry provided very little (if any) external support.

» The SCIBs backed by more resilient retail-oriented universal parents – although less prominent during times of economic growth – were better able to survive the crisis than the standalone and/or more high-profile institutions.

Moody’s believes that the SCIB model still has the potential to re-emerge as a credible banking sub-sector, even though it has been tarnished by a succession of spectacular defaults. The SCIB concept looks set to evolve away from independent investment bankers setting up boutique investment houses toward the largest Islamic banking groups seeking business and geographic diversification. Indeed, the SCIB model is a useful vehicle to build up and boost business volumes at a time when basic banking intermediation is yielding incrementally lower margins and dominant Islamic banks are experiencing pressures in their home markets.

Moody’s does not currently rate any SCIBs. However, any potential assignment of credit ratings to SCIBs would follow the analytical rating approach to wholesale investment banking activities that was detailed in Moody’s Special Comment, entitled “An Update - Challenges and Key Ratios for Wholesale Investment Bank Ratings”, published in December 2009, as well as the approach laid out in Global Securities Industry Methodology , published in December 2006.

Recent Developments

Since mid-2009, Gulf Finance House (GFH), a leading Bahrain-based SCIB has been under negative market scrutiny. In 2009, it announced net loss of US$728 million, against a US$262 million profit in 2008. However, by early 2010, it was on the verge of defaulting on a tranche of its US$300 million murabaha facility granted by West LB. It narrowly avoided default after arduous negotiations with the debt-holders. In February 2010, the maturity of the tranche was extended until August 2010. This was eventually viewed as a selective default. GFH was then faced with the challenge of having to rapidly identify asset classes that could be sold within a six-month period in order to mitigate its liquidity issues.

GFH is not the only SCIB to have undergone difficulties: The Investment Dar (TID), a Kuwaiti investment house, defaulted in May 2009, followed by Kuwait’s International Investment Group (IIG)

http://v3.moodys.com/viewresearchdoc.aspx?docid=PBC_121653�



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which defaulted in both April and July 2010. Arcapita Bank and Unicorn Investment Bank (UIB), both based in Bahrain, have managed to avoid default, but their liquidity, financial performance and capital base were put under tremendous pressure.

While the Islamic financial industry seems to have been resilient to the current crisis relative to their conventional counterparts, it is far from being a risk-free segment. The most affected line of business within the industry was undoubtedly that of investment banking. And yet, until 2007, SCIBs were portrayed by market participants as having significant potential, benefiting from cheap funding, high liquidity, exceptional profits and robust capitalisation. At the time, the combination of these four factors led them to pursue investments in riskier markets and asset classes – such as private equity, infrastructure or real estate, mostly in emerging markets ranging from the Maghreb to Southeast Asia. Some business was also booked in the private equity markets in Europe and the US. While GFH focused more on infrastructure, Arcapita invested heavily in private equity, and both were eager to improve their asset-management capabilities. Moreover, some other SCIBs were beginning to discover the merits of unfunded business lines. For instance, UIB, Liquidity Management House (LMH, the investment banking subsidiary of leading Kuwait Finance House) and Al Rajhi Capital (ARC, that of Al Rajhi Bank) further enhanced their advisory and structuring services, until they eventually became significant players in the GCC’s debt and capital markets.

However, when the region’s economy started to fracture under the stresses of the global liquidity drought, the pro-cyclical nature of SCIBs became more pronounced. The illiquid nature of their investments contributed to rapid asset-value declines at a time when their wholesale and short-term funding features were rapidly damaging their liquidity profile. This structural feature of SCIBs’ asset-liability management – which was once a benefit when ample liquidity was chasing too few assets – started to turn negative when too many impaired assets were available to serve massive liquidity withdrawals. After all, it is the business of an investment bank to invest long-term and take risks; but when funding is short-term and stresses are mounting sharply and rapidly, simple, traditional contingency plans become largely ineffective, except when an SCIB is backed by a parent with a large and sticky retail-deposit base. In addition, the crisis revealed that SCIBs also had heavy concentrations across the board, by name, sector, geography and business lines.

Outlook for SCIBs Remains Uncertain – But Not Bleak Given Robust Demand

The outlook for Islamic investment banking is not necessarily bleak. Firstly, demand for investment banking services in the GCC remains robust, especially for those that are Shari’ah-compliant. The GCC economies still have an appetite for ambitious investments in infrastructure, and especially in the energy, logistics, communication and transport sectors. Within the power industry for instance, the inception in 2008 of First Energy Bank in Bahrain, which complies with the rules of Islam and focuses on renewable energy, signalled appetite for further specialisation in the SCIB universe.

Secondly, the future of SCIBs is deeply correlated to that of the whole Islamic financial industry, which continues its unabated growth despite global and regional turmoil. Although the whole sector has been affected by the liquidity issue, investors in the Muslim world continue to value Shari’ah-compliant services, as shown by the ever-growing market share of Islamic finance in Muslim countries. As a proficient vector of innovation and sophistication, SCIBs remain vital components for the modernisation of Islamic finance as a credible alternative to conventional solutions.

We therefore believe that the SCIB model will incrementally mutate into specialised business lines of larger groups rather than stagnate as a collection of more or less successful independent boutique

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investment houses. To overcome extreme market volatility, SCIBs will require stable funding, which can only be provided by an existing base of sticky (retail) deposits. As governments and regulators are unlikely to provide support to institutions without a retail franchise and with high risk appetite, the solution is twofold: SCIBs will either resort to long-term funding – which we do not envisage in the short term given recent events – or obtain backing from larger, more resilient and benevolent parents.

This is also likely to inform the strategies of the large Islamic commercial banks that are seeking to diversify their business lines away from pure traditional banking intermediation. KFH, the second-largest Islamic bank globally, created its own investment-banking arm LMH in 2007. Other banks have adopted similar strategies: Al Rajhi Bank with ARC, and Dubai Islamic Bank (DIB) with Millennium Capital (now renamed DIB Capital). Thanks to the liquidity made available alongside the parent’s safer funding mix, these investment banking subsidiaries/business lines can more easily weather unexpected ruptures in the economic cycle. This highlights that the Islamic financial industry is not yet mature enough to host standalone investment banks, regardless of the powerful shield of their commercial parents. By going universal, Islamic banks can begin to think of themselves as diversified financial groups that are better equipped to explore new horizons beyond the natural borders of their home markets.

Note on statistics The financial statistics used in the sections below are extracted from a portfolio of nine Shari’ah-compliant investment banks : The Investment Dar (TID), Arcapita Bank (Arcapita), Gulf Finance House (GFH), Unicorn Investment Bank (UIB), Khaleeji Commercial Bank (KHCB), Liquidity Management House (LMH), DIB Capital (DIBC), Al Rajhi Capital (ARC) and First Energy Bank (FEB). Our study mainly focuses on the last three years: 2007, 2008 and 2009. We used only public information, as Moody’s does not rate these institutions. In some instances, public information was not available for one or more of entities in the portfolio, and therefore an aggregated statistic (e.g. capital adequacy) for the portfolio could not be computed. In this case, the entities selected to capture that statistic are explicitly listed. Otherwise, Moody’s uses its own estimates based on public information.

1997-2007: The Benign Decade

The first investment banks claiming to operate according to Shari’ah requirements appeared in the late 1990s in the GCC region. They aimed to provide innovative and complex Islamic investment and financing products bringing high yields to a limited number of professional investors, mainly high net-worth individuals or institutional clients. These first investment banks broadened the horizons of Islamic finance, as Islamic finance had up to that point been limited to commercial banking, serving retail and corporate customers with basic services.

The inception of SCIBs was possible due to a confluence of several factors. First of all, in the late 1990s, the development of the Islamic finance industry was beginning to gain significant momentum. An innovation phase produced more sophisticated instruments providing clients with Shari’ah-compliant securitisation, sukuk, syndication and more innovative hedging and fund structures enhancing the disintermediation process of the sector. The industry was becoming so appealing through the significant margins it registered on the retail side that it attracted new players: conventional banks operating Islamic finance business lines, global brands diversifying into Shari’ah-compliant solutions, and new market entrants that specialised in one or more business lines (mortgage

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finance and investment banking being the most attractive). GFH and Arcapita (previously First Islamic Investment Bank) were among the most aggressive pioneers of this momentum in the late 1990s.

Moreover, the industry was becoming more institutionalised, as evidenced by the emergence of the Islamic Financial Services Board (IFSB) in 2002, the International Islamic Financial Market (IIFM) in 2001, and the Liquidity Management Center (LMC) in 2002. Whiles this vigorous development of Islamic finance was taking place, all the GCC region’s economies were expanding and diversifying, recycling the profits of the oil sector’s strong growth, boosted by high hydrocarbon prices in Shari’ah-compliant asset classes. From 1997 to 2007, the region benefited from growing oil revenues that were partly allocated by the region’s governments to developing their non-oil sectors and strengthening their respective budgets. In particular, real estate and infrastructure – two asset classes that were particularly attractive to Islamic investors – had the lion’s share of private-sector investments. The financing needs created by this boom resulted in abundant liquidity. In this context, Islamic finance had become strong enough and sufficiently equipped to directly compete with the more established financial markets, economically, technically and culturally.

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Structural demand for financing meets abundance of investable funds The GCC saved much of the 2003-08 oil windfall

Source: IIF, Samba

GCC: $2.8 trillion project pipeline

Source: MeedProjects

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In response to this trend, many experienced investment bankers – mostly from the GCC region –realised the great economic potential of Islamic finance and launched investment boutiques. We have identified three groups involved in the inception of SCIBs over recent years.

Group 1: “Pure-play” boutiques

The first generation of SCIBs comprised three investment boutiques created in the second half of the 1990s: one Kuwaiti company, TID (1994) and two Bahraini companies, Arcapita (1996) and GFH (1999). All three directly invest 60% to 90% of their assets in the following areas: real estate (especially TID and GFH), private equity (especially for Arcapita) and infrastructure (an area in which GFH was perceived by the market as an expert investment boutique). Aside from these direct investment activities, those companies provide small asset-management services through restricted and unrestricted profit-sharing investment accounts. However, more than half of their revenues are derived from the investment banking services they provide, which mostly includes acquisition and placement fees related to their core business activity. This troika of SCIBs represents the most profitable group, which registered steady growth until 2007. Indeed, from 2002 to 2007, their combined total assets almost doubled every two years, reaching US$10.4 billion in 2007, while net income doubled each year. In 2007, these specialised investment banks were outperforming the market average, with an average return on equity (ROE) of 33% and an average return on assets (ROA) of 10%.

Group 2: Specialists

The second wave of SCIBs consists of two Bahraini boutiques, UIB and KHCB, which were both created in 2004, and FEB, which was launched in 2008. UIB’s innovative Shari’ah-compliant investment banking services mainly consist of: financial advisory, fund structuring, facility structuring, sukuk arranging, M&A and, more broadly speaking, corporate finance. Consequently, it allocated only a little more than a third of its assets to direct investments in 2007. It also provides growing off-balance-sheet asset-management solutions through restricted investment accounts. KHCB presents a different profile, as it transitioned from an investment banking background and began developing its commercial banking capabilities. Although most of its profits came from investment banking in 2007 and 2008, it is continuing to provide more retail and corporate banking services after having formerly been strictly a wholesale bank. Just before the crisis enveloped the GCC region, this second generation of SCIBs suffered relatively less than the first group of pioneers, as the business diversification of the second-generation SCIBs was higher and their investment leverage was lower. After a very prolific 2006 in terms of returns, these banks presented more realistic results in 2007 with an average ROE of 15%, less than half the results achieved by the pioneers, and an average ROA of 9%, derived from a much smaller total asset base of US$1.2 billion at year-end 2007. FEB, a late entrant, pursues a business model close to that of UIB, but in addition to that it focuses on the broader energy sector, which includes hydrocarbons and alternative power.

Group 3: Subsidiaries

Following the success of the established SCIBs in these early years, the three leading GCC-based Islamic commercial banks decided to penetrate the market by creating investment banking subsidiaries, thus emulating the business models of the universal banks. Therefore, the third phase of the Shari’ah-compliant investment banking model comprised KFH’s LMH, DIB’s Millennium (now DIBC) and Al Rajhi’s ARC (formerly known as Al Rajhi Financial Services). The most important feature of this category of SCIBs is that they are backed by large commercial banks, not only in terms of liquidity provisions in case of need, but also in terms of operations from shared services, business referrals and capital flexibility. However, public information regarding their financial performance is scarce.

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FIGURE 2

Pre-crisis profitability of SCIBs (2007)

Even if all these SCIB groups shared similar steady growth in assets and financial performance, they started to show, as early as 2007, different paths in their respective risk-return profiles. This had important consequences in the way they managed (or failed to manage) subsequent economic shocks. The success of SCIBs, which began in a benign decade from 1997 to 2007, entrenched their structural weaknesses as well as the nascent differences between the different SCIBs – all of which were then exposed by the crisis.

Business Model Collapse as Sub-Prime Crisis Evolved into Massive Liquidity Shock

When the financial crisis erupted in mid-2007, the Islamic finance industry remained relatively healthy and insulated, and recorded robust performance. Some commentators wrongly labelled Islamic finance as a “risk-free” sector. However, the significant defaults of TID and GFH since early 2009 and the growing difficulties of the rest of the Islamic investment banking community makes this assessment dubious, as the structural weaknesses of the Islamic financial industry started to become more obvious. The crisis was a unique opportunity for the industry to prove that it had the capacity and ability to react and absorb shocks, but not for all its sub-segments. While the commercial banking sector seems to have emerged from the crisis relatively unscathed, the investment banking sector could not have been more different, as it suffered a very sudden and sharp dip in performance as losses mounted.

Financial performance: From spectacular peaks to deep losses in a few years

Previously, some SCIB shareholders had earned a 40% ROE (as in the case of TID and GFH in 2005), although market turbulence suggests that this is highly unlikely to be repeated. Excluding FEB, LMH, DIBC and ARC, the five other SCIBs of our sample group distributed just under US$600 million of dividends in 2007, and declared none in 2009. More significantly, the SCIBs in our portfolio recorded an aggregate net income of US$1.2 billion in 2007, with the pioneer SCIBs capturing more than 80% of that total. For the same year, their combined average ROE and ROA was 30% and 10%, respectively. In 2009, the profits earned in 2007 contracted by two thirds, with an aggregate loss of US$768 million.1

1 This excludes TID, which did not make public its 2009 income statement.

GFH alone, the best-performing SCIB pre-crisis, accumulated a US$728 million loss. The portfolio’s aggregate ROE and ROA for 2009 was deeply negative, at -18% and -8% respectively, and would probably be worse still if TID’s numbers are included.

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FIGURE 3

The end of a business model ? Net Income (million USD)

Dividends (million USD)

Returns on assets (x) and equity (y)

Dividends excluding LMH and DIBC. All data exclude ARC. 2009 numbers without TID; and 2007 numbers without FEB.

A significant increase in leverage over a short period

Although they benefited from a conservative gross leverage (Total Assets/Total Equity) not exceeding 3.3x (due to Shari’ah rules, debt covenants and business requirements), the SCIBs’ total assets were rising rapidly every year, with a 38% growth from 2007 to 2008, while their total equity increased only 23%. However, this conservative approach only partially reflects the banks’ asset liquidity, which started to deteriorate in early 2008. SCIBs’ illiquid risk assets rose 26% between year-end 2007 and year-end 2008, after significant and necessary deleveraging in 2008 to deal with maturing short-term debt. This liquidity issue became all the more visible in 2008, as the sample banks’ illiquid assets for the first time reached twice the size their total common equity, meaning that a 50% impairment on this portfolio could eradicate the capital they had accumulated during the previous decade.

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FIGURE 4

A sensible increase in leverage in a short period of time

Illiquid Assets = 70% of investment portfolio + net loans + other assets TCE = Total Common Equity IRA = Illiquid Risk Assets = 70% of investment portfolio + net loans

Deteriorating capital adequacy, despite shareholder support

In 2007, the combined TCE of the sub-portfolio consisting of GFH, Arcapita, UIB, FEB and KHCB was approximately 35% of risk-weighted assets. This apparent overcapitalisation (which does not properly capture concentration risks as per Basel II’s Pillar 2) began to decline in 2008, despite capital injections by shareholders, reflected in a TCE increase of 70% in 2008. This was quickly absorbed by an equivalent rise in their RWAs, itself a consequence of deteriorating asset quality. The net result was a 7 percentage point decline in the sample banks’ TCE-to-RWA ratio, to 28% at year-end 2009.

FIGURE 5

Deteriorating capital adequacy

Figures excluding TID, LMH, ARC and DIBC; FEB figures starting from 2008.

Concentrated wholesale funding brings high sensitivity to market confidence

SCIBs did not take the opportunity to improve their asset liquidity on the back of their 38% asset growth in 2008. On the contrary, their illiquid assets still contributed more than 60% of their balance sheets during 2007-2009. Such asset illiquidity was completely inconsistent from an ALM perspective, with the wholesale, concentrated and short-term nature of their funding mix. Unsurprisingly, their

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core funding base (equity + borrowings + customer deposits) as a proportion of assets declined steadily across 2008, before recovering in 2009. This was not due to renewed funding sources, but rather because of massive asset disposals, usually with deep discounts weighing on their P&L.

To be able to handle emergency balance-sheet management, the GCC SCIBs had to stagnate their investments and accelerate asset sales in a very adverse environment. The predicament of the banks became clear in 2009: the earlier years’ increase in short-term debt made them even more vulnerable to further liquidity shocks. In 2008, term borrowings represented only 17% of long-term funding sources, the rest representing shareholders equity. In this context, GCC SCIBs had to resort to very expensive short-term deposits to stay in business, but this did not allow them to quickly build the adequate and diversified funding that was necessary to manage the looming liquidity crunch. In 2007, borrowings from financial institutions with less than a year’s maturity amounted to 31% of their total liabilities. This figure rose sharply to 38% in 2008. It was only in 2009, after the asset disposals that most GCC SCIBs conducted, that reliance on short-dated funding began dropping again, at the expense of financial performance and capital ratios. In addition, not all SCIBs survived this downturn: TID, GFH, IIG are cases illustrating the structural imbalances embedded in SCIBs’ ALM architecture.

FIGURE 6

SCIB’s funding mix is extremely sensitive to confidence

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SCIBs’ Structural Weaknesses Revealed2

Until 2007, SCIBs benefited from a very favourable economic and liquidity environment, especially due to the boom in the real-estate and infrastructure sectors, and supported by massive government spending within these sectors. Meanwhile, an increasing number of regional investors were attracted by the high yields that SCIBs were offering through their recycling of a growing amount of oil wealth into investments that fell outside the remit of their plain-vanilla banking activities. With a 34% equity-to-asset ratio, shareholders felt shielded against possible downturns, despite the high-risk, volatile and imbalanced nature of the business they were helping to build. The perception of sound capitalisation was largely artificial in the sense that it underestimated the profound impact of sector-wide concentration risks and inadequate liquidity management. On the revenue side, the bulk of operating revenues used to derive from the investment book, with very high placement, management and performance fees. Above all, SCIBs registered stellar performance for one main reason: available and cheap liquidity. This element was at the heart of their business model, consisting of borrowing short to invest long on behalf of their investment constituencies, while keeping on-balance sheet a portion of their illiquid investment portfolio that was incommensurate with their liquidity and capital profile. As long-term funding was inferior to illiquid assets, a cash capital deficit gradually emerged – which is the fundamental flaw of SCIBs. In numerous instances, we have commented on the importance of cash capital surpluses to survive liquidity crunches, and how their absence would preclude standalone investment-grade ratings for SCIBs under our methodology,

Shrinking operating revenues

The gross operating income of the GCC SCIBs in our sample sharply declined to US$163 million in 2009 from US$1,061 million in 2008, reflecting their struggle to book new transactions (negative volume effect) and declining asset valuations (negative price effect). At the same time, their fixed charges remained stable, while funding costs escalated. Therefore, as early as 2008, SCIBs’ operating revenues had declined by 25%, whereas their total expenses had grown by almost 15%. This P&L scissors effect worsened in 2009, leaving the banks with very limited room for manoeuvre. This highlights the very weak diversification of their revenue base, their dependence on a very uncertain transaction flow rather than on an existing stock of cash-flow-generating assets, and the cyclical cost of their funding profiles. Indeed, operating income is by far dominated by fees and commissions, themselves a function of volumes of assets under management, the performance of those investments and placement activity. Within this, only 16% comprises relatively less cyclical management fees. Therefore, when the number of new investment transactions declines and investors’ appetite for riskier assets vanishes, SCIBs are left with very little room for manoeuvre in capturing alternative revenue sources. For them, the global financial crisis came too early as their diversification process was underdeveloped. Only banks such as KHCB and UIB managed to mitigate this issue; KHCB accelerated its commercial banking franchise, while UIB reduced its P&L’s dependence on transaction volumes and placed more emphasis on unfunded advisory businesses.

2 Similar conclusions have been derived from the study of global wholesale investment banks in our Special Comment entitled “An Update - Challenges and Key Ratios

for Wholesale Investment Bank Ratings” (Dec. 2009), and from the study of Canadian wholesale banking activities in another Moody’s report entitled “Capital Markets Activities of Canadian Banks: A Growing Risk” (Aug. 2010)





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FIGURE 7

Lack of compensation flexibility removes a natural hedge to revenue cyclicity

Concentration brings pro-cyclicality

A lack of asset diversification and of revenue concentration typically go hand in hand. The details of SCIBs’ asset allocation reveal very high sector and geographical concentrations. Focusing on GFH, TID, UIB and KHCB, 87% of their combined assets were located in the GCC at year-end 2007. In terms of sectors, information gathered from GFH, Arcapita, TID, UIB and KHCB shows that financial institutions rank uppermost and represent 35% of the SCIBs’ total exposures. This figure reflects the active role these SCIBs have taken in investing in new Islamic commercial banks as private equity owners. In this respect, GFH and TID were the most active: GFH took stakes in KHCB among other investee Islamic banks, whereas TID owned shares in Bahrain Islamic Bank and in Boubyan Bank. Real-estate and infrastructure represented 31% of SCIBs’ assets in 2007. These sectors were the most sharply affected by the crisis, both globally and regionally. SCIBs’ asset quality therefore deteriorated because of sector concentrations that were deeply correlated with the sources of the global downturn. In such a context, the lack of expense flexibility is a drawback: one condition for investment banks to reach investment grade is that costs (mainly compensation) falls in lockstep with revenue declines, which is far from obvious for SCIBs with a limited track record in P&L management.

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FIGURE 8

Geographic and sector concentration risks Geographic concentration in 2007

Pool : GFH, TID, UIB, KHCB

Sector concentration in 2007

Pool : GFH, Arcapita, TID, UIB, KHCB

The crisis revealed weak risk-management architectures

The SCIBs’ unsound risk-management architecture is reflected by their concentration risks, poor sector allocation, imprudent liquidity management and imbalanced ALM. In addition, we have found that the public disclosure of these risk factors is usually incomplete and/or non-existent. For instance, TID (which defaulted in May 2009) did not disclose proper risk-management information. Furthermore, in 2007, most SCIBs only applied Basel I, which did not make it mandatory for them to adhere to Basel II’s Pillar 3 disclosure requirements. Only in the 2008 financial reporting data (released during Q1 2009, i.e. quite late in the cycle given extreme circumstances at the time) did we glean a better view of the SCIBs’ approach to risk management, Basel II guidelines and requirements. Even then, not all the information was clearly and consistently released by the SCIBs. However, since 2009, disclosure practices have been improving significantly.

GCC87%

Other MENA3%

Other Asia3%

Europe5%

USA2%

Trading & Manufacturing11%

Banks & Financial Institutions34%

Infrastructure & Real Estate31%

Technology5%

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SCIB Business Model Far From Moribund – but Rather an Evolving Investment Platform

SCIBs’ evolution looks set to be multi-directional

The importance and growth of SCIBs was not directly due to their Islamic nature. Although Shari’ah compliance implies an investment bias towards real estate and infrastructure assets – which are more naturally eligible from an Islamic perspective – it was the seemingly easy and high returns that those sectors registered that first attracted SCIBs. The difficulties SCIBs are currently faced with mostly stem from risk-management failures, characterised by a very low degree of diversification, preference for illiquidity, and an absence of financial flexibility and imbalanced funding strategies. While the Islamic investment boutique model limited the chances of surviving the crisis unscathed, there is still the potential for growth for the Islamic investment banking model. After enduring the recent financial shocks, some SCIBs are now conducting internal reviews and looking more deeply into ways to improve and diversify their business model. For instance, efforts are being made to better organise professional off-balance-sheet asset-management activities targeting high net-worth individuals and institutional investors who require Shari’ah-compliant placements, across a wider range of asset classes. UIB typically focuses on general corporate finance, including advisory, M&A, debt and equity capital markets, structured finance and brokerage. FEB, an energy finance specialist, will likely follow the same path. The business evolution of KHCB is also relevant as it is trying to consolidate its investment banking services with a more robust commercial banking platform. Overall, we believe that the strategic move of SCIBs acquiring larger, more diversified and established commercial Islamic banks offers the most promising potential.

Islamic investment banking remains a very young and under-developed business, and the volatility it can experience (and has experienced) would be better absorbed by strong parents who offer the possibility of building one-stop-shop Islamic financial groups – a must for expanding into new territories outside home markets. KFH, Al Rajhi, DIB have been pioneers in this, but new entrants such as Qatar Islamic Bank (with QInvest), Boubyan Bank (with Boubyan Capital), Bank Al-Jazira (with Al-Jazira Capital) and many others, are gradually building momentum in this area. As such, diversification, liquidity and balance-sheet management, and operating efficiency are not the only challenges to overcome in the medium term. SCIBs also usually suffer from limited balance-sheet capacity. Therefore, if a SCIB was to become part of a larger group, it would give it access to larger balance sheets and economic depth, which we view as key factors of success in investment banking.

Despite a hectic history, SCIBs are useful to the Islamic financial industry

In our view, demand for investment banking services in the GCC region is bound to recover. SCIBs will continue to play a leading role in accompanying the growth, development and sophistication of the Islamic financial industry. They will have a key role in the progress of the sukuk market as arrangers, advisors, placement agents and structuring banks. They will also continue to handle the key task of bringing together investors as shareholders in newly established Islamic banks globally, as private equity investors and proxies. The growth prospects of Islamic asset and fund management is not likely to be as rapid without the impetus of SCIBs, which will likely include new asset classes within fund management that go beyond the preferred habitats of Islamic investors, i.e. real estate and equities.

SCIBs’ 2009 financial perform revealed upheaval in their hierarchy

In terms of financial performance, 2009 is the exact opposite of 2007. The performance of the pioneer SCIBs is very weak. Among them, Arcapita has managed to contain its losses and remain in business,

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escaping default. The future of TID and GFH is, on the contrary, very uncertain. The performance of the second group of SCIBs was almost at break-even, benefiting from its early-stage diversification efforts, and the underleveraged nature of its business model. However, this group is becoming increasingly heterogeneous. We believe that KHCB will continue to evolve into a deposit-taking bank in order to bring more stability to its funding mix, whereas FEB and UIB are likely to focus on corporate finance rather than balance-sheet allocation. Finally, the third group – comprising SCIBs backed by commercial parents – over-performed the market average in 2009, due to the support of their proactive parents. In this category, KFH’s LMH is the regional leader, especially in the sukuk market, followed by Al Raljhi’s ARC, while DIBC’s performance was impaired by the Dubai Inc turmoil.

FIGURE 9

Post-crisis profitability of SCIBs (2009)

Ratings implications

Although we currently do not rate any SCIB, we can formulate general suppositions as to the possible rating implications of the issues we have raised in this report. To achieve investment-grade ratings under Moody’s methodology, firms would probably need to modify their business models, and maintain cash capital surpluses (long-term funding in excess of illiquid assets), improve their expense

UIB

KHCB

Estumated average for LMH, ARC and

DIBC

FEB

0.0%

1.0%

2.0%

3.0%

4.0%

5.0%

6.0%

7.0%

0.0% 1.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0%

TID (estimated)

Arcapita

GFH

-200%

-160%

-120%

-80%

-40%

0%

40%

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

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flexibility, and increase the granularity and liquidity of their assets. Relatively speaking, the pioneer SCIBs would attract lower ratings, and several entities in this group are already in default. The second group, despite its increasing heterogeneity, would attract higher ratings, but would likely not be in the investment-grade range at this stage. This group would probably benefit from some upgrade potential in the medium term once their strategic shift is complete and their business model becomes more seasoned. For the subsidiaries of the third group, parent support would be a key rating driver despite lower standalone/financial strength credit profiles. In any case, no SCIB would receive any systemic support as evidenced, in most cases, by the neutral attitude of regulators towards them throughout the crisis. One exception could possibly be KHCB, now that it has earned a license to collect retail deposits in Bahrain.

In other reports, we have cited the serious weaknesses in the business model of wholesale investment banks, namely risk management failure, confidence sensitivity, imbalanced funding model, opacity and concentrations – and SCIBs are no exception in this respect. Given the difficult times many SCIBs have faced so far, they would be challenged by the same rating weaknesses as most of their global counterparts. In addition, it is a fact of life in emerging markets that SCIBs’ disclosure tends to be relatively opaque by international standards, and this would be a real conundrum for any rating exercise with SCIBs. The extent of disclosure about VaR limits, inventory and assumptions on liquidity positions in particular remains to be seen. Such a risk is critical to bond investors, but at this stage remains untested. It may well be that, without a sufficient amount of transparency, we would simply be unable to compute some of the measures/metrics that are described in earlier reports and are necessary to calibrate ratings on SCIBs.

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Moody’s Related Research

Special Comments:

» Capital Markets Activities of Canadian Banks: A Growing Risk, August 2010 (126542)

» Arab Banks: Shielded Domestic Markets Underpin Resilience To Crisis, June 2010 (125496)

» Global Sukuk Issuance Poised for Boost from New Legislative and Regulatory Initiatives, April 2010 (SF196842)

» Derivatives in Islamic Finance: Examining the Role of Innovation in the Industry, March 2010 (123628)

» An Update - Challenges and Key Ratios for Wholesale Investment Bank Ratings, December 2009 (121653)

» Islamic Banks – Their Strategies and Ratings, May 2009 (115565)

» The Future of Sukuk: Substance over Form?, May 2009 (SF154199isf)

» Frequently Asked Questions: Islamic Finance, Oil Prices and the Global Crisis, February 2009 (114816)

» Gulf Islamic Banks Resilient Amid Global Credit Woes, November 2008 (112431)

» Frequently Asked Questions: Notable Trends in Global Islamic Finance, August 2008 (110404)

» Islamic Finance in France: Strong Potential, But Key Obstacles Persist, July 2008 (109676)

» Islamic Finance: Glossary of Usual Terms and Core Principles, June 2008 (109441)

» Islamic Banking in East Asia – Growing but not without Challenges, April 2008 (108469)

» Islamic Banks and Sukuk: Growing Fast, but Still Fragmented, April 2008 (108331)

» Islamic Finance Explores New Horizons in Africa, March 2008 (108071)

» Islamic Banks in the GCC: a Comparative Analysis, March 2008 (107856)

» The Benefits of Ratings for Islamic Financial Institutions and What They Address, February 2008 (107502)

» Risk Issues at Islamic Financial Institutions, January 2008 (107175)

» Understanding Moody’s Approach to Unsecured Corporate Sukuk, August 2007 (103919)

» Asian Sukuk Poised for Fast Growth: Market Review and Introduction to Moody’s Rating Approach, August 2007 (104446)

» Moody's Approach to Analysing Takaful Companies, May 2007 (102910)

» Takaful: A Market with Great Potential, October 2006 (98913)

» Shari’ah and Sukuk: A Moody’s Primer, May 2006 (103338)

» A Guide to Rating Islamic Financial Institutions, April 2006 (97226)

» Moody's Involvement in Rating Islamic Financial Institutions, April 2006 (97113)



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» Regulation and Supervision: Challenges for Islamic Finance in a Riba-Based Global System, January 2004 (81128)

» Culture or Accounting: What Are The Real Constraints for Islamic Finance in a Riba-Based Global Economy?, January 2001 (63369)

Special Reports:

» Global Sukuk Issuance Surges as Effects of Credit Crisis Recede: Overview and Trend Analysis, November 2009 (SF184627isf)

» Global Sukuk Issuance: 2008 Slowdown Mainly Due to Credit Crisis, But Some Impact from Shari’ah Compliance Issues, January 2009 (SF149211isf)

» Islamic Finance: Sukuk Take Centre Stage, Other Shari’ah-Compliant Products Gain Popularity as Demand Increases, February 2008 (SF124315isf)

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Report Number: 127324

Authors Anouar Hassoune Florence Carasse Peter Nerby

Editors Greg Davies Maya Penrose

Senior Production Associate Wendy Kroeker

© 2010 Moody’s Investors Service, Inc. and/or its licensors and affiliates (collectively, “MOODY’S”). All rights reserved.

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