Islamic investment banks were some of the leading lights in Gulf finance between 2000 and 2007, netting billions of dollars of profits from investments in regional companies and mammoth property projects. But the Islamic investment houses also had some of the most spectacular losses and defaults in the region after the financial crisis set in.
That turmoil forced companies such as Gulf Finance House (GFH) in Bahrain, which lost US$728 million (Dh2.67 billion) last year, and The Investment Dar in Kuwait, which is still in the midst of a stalled debt restructuring, to rethink how they do business, refocusing on stable advisory services and asset management arms that generated steady fees instead of the big, flashy deals that predominated before the crisis.
Now, with debt restructurings and business reorganisations mostly behind them, the Gulf's Islamic investment houses are undergoing an even deeper self-examination, analysts and observers say. The question now is whether investment banking that conforms with Islamic law is a viable business - and if so, how it should be structured. "The kind of model that they were implementing during the boom time is not good for this kind of condition where it's difficult to find funds and liquidity," says an analyst in Bahrain who asked not to be named.
In a report last week, Moody's Investors Service took a fresh look at the problems Islamic investment companies have wrestled with and concluded that they needed to focus on managing risk and ensuring their businesses are not too concentrated, geographically and among economic sectors. They must change the basic structure of their businesses, Moody's said, and consider combinations with better-capitalised corporate parents.
The region's numerous Islamic investment companies were not doomed to failure, the ratings agency pointed out, but still had to make major adjustments and find a new place in the emerging economic reality. "After enduring the recent financial shocks, some [Islamic investment banks] are now conducting internal reviews and looking more deeply into ways to improve and diversify their business model," Moody's said.
"The difficulties [the banks] 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." GFH has been at the leading edge of the effort to find a new way forward for Islamic investment firms. Having suffered losses last year as a result of a concerted effort by its leadership to pare down the balance sheet and revalue assets to reflect current conditions, the company is now searching for a new model.
Ted Pretty, the Australian chief executive brought in last year to engineer a turnaround, told The National earlier this year that taking losses was a necessary first step towards a reimagining of the Islamic investment banking model. "It creates some pain because the rating agencies become a bit nervous, investors become a bit nervous and market sentiment can turn against you. But I think from our point of view, taking that pain was important because you need to really understand what your current position is and you can rebuild from a concrete base," he said.
"You can't rebuild from one that's still built on sand." As they think anew about how to reposition themselves for a return to profit, some independent Islamic investment banks may be forced into the arms of banks with customer deposits and other stable lines of business, to serve as a backstop when markets go awry. One flaw that pushed Islamic investment banks to the brink of default was their over-reliance on short-term financing to invest in long-term projects, a condition that could have been counterbalanced by the presence of a deep-pocketed parent.
They borrowed money mostly for periods of between six months and three years, using the proceeds to invest in financial services businesses and big property projects such as GFH's multibillion-dollar Energy City developments in the Middle East and subcontinent. When the financial crisis made refinancing those short-term loans impossible, the Islamic investment banks were unable to sell their assets quickly enough to repay banks and investors.
GFH narrowly avoided default on a $300m Islamic loan early this year, agreeing on an extension with creditors at the last minute. The Investment Dar defaulted on financial obligations last summer, as did International Investment Group, another Kuwaiti investment house. Lapses such as those could have been avoided, Moody's said last week, if the companies in question had a corporate parent with the financial wherewithal to tide them through hard times.
"Islamic investment banking remains a very young and underdeveloped 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," the ratings agency said. Companies such as Kuwait Finance House, Al Rajhi Bank in Saudi Arabia and Dubai Islamic Bank have already taken this approach, setting up investment banking subsidiaries that operate according to Islamic principles that ban charging or collecting interest, among other strictures.
Others in the region, including Qatar Islamic Bank, Boubyan Bank in Kuwait and Bank AlJazira in Saudi Arabia, have more recently joined the fray, creating subsidiaries to conduct Islamic investment banking activities. But what will come of the existing independent investment houses? Big mergers of Islamic investment banks with established commercial banks have yet to materialise, but there are signs that more such activity may be on the way.
Bahrain's Ithmaar Bank merged operations this year with Shamil Bank, a subsidiary, to form a new bank focused on Islamic consumer banking and moving away from its earlier focus on investments. "We … believe that the [Islamic investment banking] model will incrementally mutate into specialised business lines of larger groups rather than stagnate as a collection of more or less successful independent boutique investment houses," Moody's said.
"To overcome extreme market volatility, [banks] will require stable funding, which can only be provided by an existing base of sticky retail deposits."