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The global financial crisis has seen both market values and profitability of Islamic banks coming under pressure, narrowing the gap with their conventional counterparts.
Revenues have declined significantly from 2008, particularly driven by a drop in income from investing activity.
From when the financial crisis started, the stock market performance of Islamic banks has generally mirrored the largely downward trend of conventional banks.
In some countries, Islamic banks are losing their advantage compared to conventional banks in terms of market expectations.
A number of Islamic banks have been harder hit by non-performing loans (NPLs) than conventional peers and continue to face the risk from real estate concentrations even as their operational efficiency continues to lag conventional peers.
Declining revenues from investing activities and an increase in provisions are some of the drivers behind this decline in profitability. In analysing the aggregate profitability of the top three Islamic banks in Kuwait, Qatar, UAE and Bahrain, investing activity in 2007 represented 4.9 per cent of total revenues compared with 3.5 per cent in 2008.
Similarly, provisions for the same set of banks in 2007 represented 0.4 per cent of the total costs compared with 1.2 per cent in 2008, says the 2009/2010 WIBC Competitiveness Report launched at the 16th Annual World Islamic Banking Conference (WIBC).
Produced in collaboration with McKinsey & Company, the Competitiveness Report notes that the higher operating costs of Islamic banks compared with conventional banks have also exerted pressure on their profitability.
The operating costs of the largest three Islamic banks in Turkey represent 4.4 per cent of average assets, compared with 3.3 per cent for the whole banking sector. In the Gulf, the operating costs of the largest three Islamic banks in Kuwait represent 2.5 per cent of average assets, compared with 1.6 per cent for the whole banking sector.
Some Islamic banks had a higher NPL ratio in 2008 across key markets. In Kuwait, NPLs accounted for 4.7 per cent of the top three conventional banks by assets, compared with 8.6 per cent for conventional banks. In the UAE, NPLs accounted for 1.6 per cent of the top three conventional banks by assets, compared with 3.0 per cent for conventional banks. NPLs for 2009 may increase further for Islamic banks across these key markets as the full effects of real estate slowdown sink in.
Islamic banks also continue to have a high proportion of real estate assets. According to end of year reports, the top three Islamic banks in the UAE have 26 per cent of their banking assets in the real estate sector, compared to 19 per cent for conventional banks.
In Kuwait, the top three Islamic banks have 24 per cent of their banking assets in the real estate sector, compared to 20 per cent for conventional banks.
Overall, the high concentration of real estate assets in the Islamic banking sector is consistent with previous years. Additionally, returns for top real estate companies have also under-performed the market during the crisis, further undermining Islamic banks' profitability.
On the liquidity front, Islamic banks have a more pronounced maturity mismatch than conventional banks. Based on a sample of the top seven conventional and Islamic banks by assets in the GCC, the net liquidity gap for a contractual maturity period of one to five years was 23 per cent of total assets for Islamic banks in 2008, compared with 16 per cent for conventional banks in the same period.
However, Islamic banks source more funds from deposits than conventional banks. Customer deposits for all Islamic banks in the UAE, Kuwait, Qatar and Saudi Arabia in 2008 represented 69 per cent of liabilities, compared with 54 per cent of all liabilities for conventional banks in the same region and period.
The report says that in the aftermath of the crisis, Islamic banks must now determine their future course of action by exploring four important areas like enhancing and diversifying their business mix, by tapping into new growth business lines, such as personal finance, asset management and various areas of investment banking, where some Islamic banks have been less focussed in the past; improving risk management, in order to mitigate challenges on both credit and liquidity fronts, through upgrading risk management capabilities and skills; lowering cost of operation and improving service quality, to maintain competitiveness for an increasingly demanding market; and exploring international growth opportunities, especially where excess capital is available and can be better deployed in under-penetrated markets.
