ISLAMIC BANKING

Like their interest-based counterparts, Islamic banks have been badly affected by the global economic crunch which has already caused the property markets in the GCC. It was only in July 2008 that Moody's Investor Service foresaw a golden era for Islamic banking. It then "conservatively" estimated the global potential of the Islamic banking market at US $4,000 billion, compared to US$700 billion at the time - most of it in the GCC region. With such potential, Moody's then said, it had become clearer why governments, eager to please their Muslim populace, were encouraging more Islamic banks to start up and expand outside domestic markets.

Yet the Islamic banking industry brings with it a new set of risks for managers to handle. These institutions are hamstrung by the lack of a viable Islamic inter-bank market. While deposits may be redeemed immediately, Islamic bank assets are usually backed by real estate, and are therefore illiquid. This forces Islamic banks to hold more cash or liquid asset than conventional peers to pare illiquidity risks.

High oil prices were the main factor to the growth of Islamic banking in recent years. It was said in mid-2008 that Islamic banks with hefty balance sheets were not only to gain more retail customers through extensive branch networks, which were often capped in the GCC region for international banks such as Standard Chartered and HSBC, but also were to capture a larger slice of the vast infrastructure finance projects then planned in the region.

Islamic banks are less vulnerable to the effects of the financial crisis because:

* The Islamic banking sector is relatively small and young
* Islamic banks do not make use of the inter-bank money market (frozen because of mistrust between banks)
* Islamic banks have no money invested in uncovered loans and financial derivatives.

Islamic banks enjoy a built-in stabilizer to help them cope with economic downturns, as instead of paying interest to depositors, those with investment mudaraba accounts share in the banks profits. Thus, if profitability declines in an economic downturn, depositors receive lower returns, but if profits rise they enjoy higher returns.

This profit sharing reduces risk for the banks and means they are less likely to become insolvent. However as the banks build up a profit equalization reserve, which can be used to finance pay-outs during difficult years, depositors benefit from some protection of their returns during economic downturns.

The last year has been difficult, if not disastrous, for equity investors, given the fall in stock market prices globally. Investors in equities screened for shariah compliance have also suffered, but less than their conventional counterparts, because they have not invested in the shares of riba-based banks which have fared especially badly during the global financial turmoil. Investors seeking Shariah compliance have portfolios which are more heavily weighted in sectors such as healthcare or utilities where revenue streams are maintained even during cyclical down-turns

Islamic banks, many of which are investment houses, have been heavily exposed to the real estate market, which saw prices start to plummet at the end of last year. They channeled the wealth accumulated during the six year oil boom that ended in mid-2008 into regional real estate through private equity and asset management. The global liquidity constraints will force Islamic banks to look for new customers and sources of funding, including moving into corporate banking, trade finance and retail banking.