ISLAMIC BANKING AND FINANCE:ISLAMIC BANKING AND FINANCE:

WHAT’S IN IT FOR CANADIAN WHAT’S IN IT FOR CANADIAN COMPANIES?COMPANIES?

Mohammad FadelMohammad FadelCanada Research Chair in the Law and Economics of Islamic LawCanada Research Chair in the Law and Economics of Islamic Law

University of Toronto Faculty of LawUniversity of Toronto Faculty of LawOctober 16, 2006October 16, 2006

OVERVIEW OF ISLAMIC BANKING OVERVIEW OF ISLAMIC BANKING SECTORSECTOR

Centers of Islamic FinanceCenters of Islamic Finance

MalaysiaMalaysia

Persian GulfPersian Gulf

United Arab Emirates (Dubai)United Arab Emirates (Dubai)

BahrainBahrain

England ????England ????

History of Islamic BankingHistory of Islamic Banking

Local Islamic banks formed in the 1970s in Local Islamic banks formed in the 1970s in Muslim countries such as Malaysia, Pakistan Muslim countries such as Malaysia, Pakistan and Dubaiand Dubai

Originally emphasized joint-venture structures Originally emphasized joint-venture structures akin to private equityakin to private equity

Quickly evolved to provide short-term credit Quickly evolved to provide short-term credit facilities by using the facilities by using the murâbahamurâbaha structure structure

History of Islamic Banking (II)History of Islamic Banking (II)

With increase in scale, Islamic banks With increase in scale, Islamic banks began to branch out to more complex began to branch out to more complex financing schemes, including:financing schemes, including:

Retail banking, including, deposit taking and Retail banking, including, deposit taking and consumer lendingconsumer lending

Bonds (Bonds (sukûksukûk))

Medium- and Long-term leases Medium- and Long-term leases (ijâra)(ijâra)

History of Islamic Banking (III)History of Islamic Banking (III)

Impact of 9/11 – Reverse Capital FlightImpact of 9/11 – Reverse Capital Flight

Perception of hostile climate in many Western Perception of hostile climate in many Western jurisdictions, in particular, the United States, led to jurisdictions, in particular, the United States, led to repatriation of dollars by Arab investors to Middle repatriation of dollars by Arab investors to Middle Eastern banksEastern banks

Islamic banks, along with conventional banks in the Islamic banks, along with conventional banks in the region, benefited from this reverse flight of capitalregion, benefited from this reverse flight of capital

Increase in Oil Prices Led to Dramatic Increase in Increase in Oil Prices Led to Dramatic Increase in Liquidity in the GulfLiquidity in the Gulf

History of Islamic Banking (IV)History of Islamic Banking (IV)

Conventional Banks Open “Islamic Windows”Conventional Banks Open “Islamic Windows”

Conventional banks began to respond to requests Conventional banks began to respond to requests from Muslim clients to offer products that complied from Muslim clients to offer products that complied with Islamic lawwith Islamic law

As the size of the potential market became clear, As the size of the potential market became clear, conventional banks responded with the creation of conventional banks responded with the creation of divisions dedicated to Islamic bankingdivisions dedicated to Islamic banking

History of Islamic Banking (V)History of Islamic Banking (V)

Conventional International Banks with Conventional International Banks with Islamic Windows:Islamic Windows:

CitigroupCitigroup HSBCHSBC Deutsche BankDeutsche Bank UBSUBS ABN AMROABN AMRO Standard Chartered BankStandard Chartered Bank

History of Islamic Banking (VI)History of Islamic Banking (VI)

Almost all regional banks have followed Almost all regional banks have followed the international banks in creating the international banks in creating “Islamic” windows and some have “Islamic” windows and some have converted, or are in the process of converted, or are in the process of converting, to the Islamic banking modelconverting, to the Islamic banking model

Size of Islamic Banking SectorSize of Islamic Banking Sector

No precise measure of size of deposits held in No precise measure of size of deposits held in Islamic banks or Islamic divisions of Islamic banks or Islamic divisions of conventional banksconventional banks

Ranges from a low of $250 billion to a high of $750 Ranges from a low of $250 billion to a high of $750 billionbillion

As much as $300 billion held in Islamic investment As much as $300 billion held in Islamic investment funds awaiting investment opportunitiesfunds awaiting investment opportunities

Arab investors hold approximately $800 billion of Arab investors hold approximately $800 billion of assets in European banks, with a growing trend to assets in European banks, with a growing trend to invest that money in Islamic productsinvest that money in Islamic products

Role of Islamic Finance in World Role of Islamic Finance in World Credit MarketsCredit Markets

Demand SideDemand Side

Sovereign DebtSovereign Debt

International AgenciesInternational Agencies

Corporate DebtCorporate Debt

Project FinanceProject Finance

Consumer DebtConsumer Debt

Sovereign Islamic DebtSovereign Islamic Debt

In recent years, several Islamic Countries and In recent years, several Islamic Countries and their instrumentalities, as well as non-Islamic their instrumentalities, as well as non-Islamic countries, have issued sovereign debt in the countries, have issued sovereign debt in the form of form of sukûksukûk::

Department of Civil Aviation, Dubai: $1 billionDepartment of Civil Aviation, Dubai: $1 billion Qatar: $700 millionQatar: $700 million Pakistan: $600 millionPakistan: $600 million Malaysia: $600 millionMalaysia: $600 million German State of Saxony-Anhalt: €100 millionGerman State of Saxony-Anhalt: €100 million Bahrain: $79.5 millionBahrain: $79.5 million

International AgenciesInternational Agencies

International Agencies Have Issued International Agencies Have Issued SukûkSukûk in recent years:in recent years:

Islamic Development Bank: $400 millionIslamic Development Bank: $400 million World Bank: $200 millionWorld Bank: $200 million

Islamic Corporate DebtIslamic Corporate Debt

Private Issuances of Private Issuances of SukûkSukûk::

DP World: $3.5 billion 7.5% DP World: $3.5 billion 7.5% sukûksukûk, convertible into , convertible into equity at the time of a qualifying initial public offering equity at the time of a qualifying initial public offering

National Central Cooling Company: $200 million, National Central Cooling Company: $200 million, rated BBB- by S&Prated BBB- by S&P

Listed on London Stock ExchangeListed on London Stock Exchange Previous issuance by same issuer listed on Luxembourg Previous issuance by same issuer listed on Luxembourg

Stock ExchangeStock Exchange

Islamic Corporate Debt (II)Islamic Corporate Debt (II)

Global issuance of Global issuance of sukûksukûk has exceeded has exceeded $20 billion$20 billion

Dow Jones CitigroupDow Jones Citigroup®® Sukûk Index Comprised of seven Comprised of seven sukûksukûk $2.8 billion aggregate principal amount$2.8 billion aggregate principal amount Each issue rated at least A by S&PEach issue rated at least A by S&P Average tenor 3 yearsAverage tenor 3 years

Islamic Corporate Debt (III)Islamic Corporate Debt (III)

Biggest challenge thus far is limited secondary Biggest challenge thus far is limited secondary trading market for trading market for sukûksukûk

Demand for Demand for sukûksukûk has far exceeded supply; has far exceeded supply; offerings typically oversubscribed, even after offerings typically oversubscribed, even after substantial upsizing of the offering at timessubstantial upsizing of the offering at times

DP World offering originally contemplated for $2.8 DP World offering originally contemplated for $2.8 billion but was upsized to $3.5 billion to meet excess billion but was upsized to $3.5 billion to meet excess demand; no road show needed to market the offeringdemand; no road show needed to market the offering

Islamic Finance and Project Islamic Finance and Project FinanceFinance

Infrastructure projects in the Gulf region Infrastructure projects in the Gulf region largely financed on a corporate basis until largely financed on a corporate basis until the mid-1990sthe mid-1990s

Sadaf, a joint venture between Shell Oil and Sadaf, a joint venture between Shell Oil and Saudi Arabian Basic Industries Corporation Saudi Arabian Basic Industries Corporation (SABIC), first important project finance (SABIC), first important project finance transaction in Gulf region, closed in 1995transaction in Gulf region, closed in 1995

Project Finance now preferred structure for Project Finance now preferred structure for infrastructure investmentinfrastructure investment

Islamic Finance and Project Islamic Finance and Project Finance (II)Finance (II)

Islamic sources of capital traditionally Islamic sources of capital traditionally played minor role in project finance in Gulfplayed minor role in project finance in Gulf

In recent years, however, no deal gets done In recent years, however, no deal gets done without a substantial Islamic tranchewithout a substantial Islamic tranche

Financing needs exceed capacity of commercial Financing needs exceed capacity of commercial banks and export credit agenciesbanks and export credit agencies

Desire of project hosts to diversify sources of Desire of project hosts to diversify sources of capital and take advantage of local capital to the capital and take advantage of local capital to the extent feasibleextent feasible

Islamic Finance and Project Islamic Finance and Project Finance (III)Finance (III)

Rabigh Refinery and Petrochemicals Project, Rabigh Refinery and Petrochemicals Project, Kingdom of Saudi ArabiaKingdom of Saudi Arabia $9.9 billion total cost, of which $5.8 billion was debt$9.9 billion total cost, of which $5.8 billion was debt $4.1 billion equity split 50-50 between Saudi Aramco $4.1 billion equity split 50-50 between Saudi Aramco

and Sumitomo Chemicaland Sumitomo Chemical $2.5 billion loan provided by Japan Bank for $2.5 billion loan provided by Japan Bank for

International CooperationInternational Cooperation $1 billion loan from Saudi Public Investment Fund$1 billion loan from Saudi Public Investment Fund $1.7 billion commercial loan$1.7 billion commercial loan $600 million Islamic tranche$600 million Islamic tranche

Islamic Finance and Project Islamic Finance and Project Finance (IV)Finance (IV)

YANSAB ProjectYANSAB Project $5 billion greenfield petrochemical project$5 billion greenfield petrochemical project $3.5 billion debt:$3.5 billion debt:

$1.067 billion, 13-year tranche from Saudi Public Investment $1.067 billion, 13-year tranche from Saudi Public Investment FundFund

$850 million, 12-year Islamic tranche$850 million, 12-year Islamic tranche $700 million export credit agencies tranche$700 million export credit agencies tranche $533 million 12-year commercial bank tranche$533 million 12-year commercial bank tranche $350 million working capital facility$350 million working capital facility

ABN AMRO was sole arranger, underwriter and ABN AMRO was sole arranger, underwriter and bookrunner on dealbookrunner on deal

Islamic Finance and Project Islamic Finance and Project Finance (V)Finance (V)

Future Demand for Project FinanceFuture Demand for Project Finance Last two years saw $40 billion of project finance in Last two years saw $40 billion of project finance in

gulf regiongulf region Saudi Arabia estimates it will invest $90 billion in Saudi Arabia estimates it will invest $90 billion in

domestic power generation over the next fifteen yearsdomestic power generation over the next fifteen years Other states in the gulf also investing heavily in Other states in the gulf also investing heavily in

infrastructure projects, particular petrochemicalinfrastructure projects, particular petrochemical There will be a continuing demand in the region for There will be a continuing demand in the region for

capital to invest further expansion of the region’s capital to invest further expansion of the region’s infrastructureinfrastructure

Opportunities for Canadian Opportunities for Canadian BanksBanks

Deal flow shows no sign of abatingDeal flow shows no sign of abating International banks have shown an ability to International banks have shown an ability to

compete successfullycompete successfully Because of the size of new deals, Islamic banks Because of the size of new deals, Islamic banks

need to partner with international banks to take need to partner with international banks to take advantage of their larger distribution networksadvantage of their larger distribution networks

Success of Success of sukûksukûk issues means that issues means that conventional market investors have grown conventional market investors have grown comfortable with their structure and will invest in comfortable with their structure and will invest in them so long as credit profile meets investors’ them so long as credit profile meets investors’ needsneeds

Opportunities for Canadian Opportunities for Canadian Banks (II)Banks (II)

Success in penetrating markets for arranging Success in penetrating markets for arranging credit could lead to mandates in upcoming credit could lead to mandates in upcoming equity offeringsequity offerings

Future opportunities to advise in connection with Future opportunities to advise in connection with an inevitable consolidation of banks in the Gulf an inevitable consolidation of banks in the Gulf regionregion

Opportunities for wealth management of wealthy Opportunities for wealth management of wealthy Islamic investorsIslamic investors Merrill Lynch identified 300,000 U.S. dollar Merrill Lynch identified 300,000 U.S. dollar

millionaires in the Middle Eastmillionaires in the Middle East

Opportunities for Canadian Opportunities for Canadian IssuersIssuers

Canadian Issuers, public and private, may Canadian Issuers, public and private, may consider tapping the Islamic capital marketsconsider tapping the Islamic capital markets

Because of Islamic finance is asset-based, Canada’s Because of Islamic finance is asset-based, Canada’s mining industry is a natural fit with the structures so mining industry is a natural fit with the structures so far developed in Islamic financefar developed in Islamic finance

Because of high-liquidity of Islamic banks and Islamic Because of high-liquidity of Islamic banks and Islamic investment funds, issuers who tap this market may be investment funds, issuers who tap this market may be able to obtain relatively favorable pricing relative to able to obtain relatively favorable pricing relative to the conventional marketthe conventional market

Opportunities for Canadian Opportunities for Canadian Infrastructure FirmsInfrastructure Firms

Because of infrastructure boom in Gulf Because of infrastructure boom in Gulf region, large premiums have been paid region, large premiums have been paid on Engineering, Procurement and on Engineering, Procurement and Construction contractsConstruction contracts

Successful competition for Successful competition for infrastructure projects inevitably infrastructure projects inevitably requires support of export credit agencyrequires support of export credit agency

Export Development Canada would have Export Development Canada would have an important role to play in promoting an important role to play in promoting Canadian firms’ expertise in the regionCanadian firms’ expertise in the region

ConclusionConclusion

Islamic finance and conventional finance are Islamic finance and conventional finance are quickly converging in the Gulf regionquickly converging in the Gulf region

As conventional investors gain more comfort As conventional investors gain more comfort with Islamic structures, cost differential between with Islamic structures, cost differential between Islamic products and conventional products have Islamic products and conventional products have almost disappearedalmost disappeared

As a result, Islamic products may be more As a result, Islamic products may be more practical because they appeal to both Islamic practical because they appeal to both Islamic and conventional investorsand conventional investors

Conclusion (II)Conclusion (II)

It is not too late for Canadian banks to It is not too late for Canadian banks to compete for business in the Islamic compete for business in the Islamic finance arenafinance arena

To do so successfully, they will need to To do so successfully, they will need to establish a presence in the region, as establish a presence in the region, as have their competitorshave their competitors