Size will matter in Islamic banking

But the fact is it could have been even more of a trailblazer if it had got its way last year, when it bid to buy a 33% stake in Rashid Hussain, the Malaysian financial services group. It got as far as striking a preliminary agreement with the seller, Utama Banking Group, and outlined plans to invest a total of RM12 billion in the group and turn it into an Islamic banking powerhouse.

It didn’t happen: Utama opted instead for Malaysia’s key pension fund, the Employees Provident Fund. And so this is still the transaction Islamic banking is waiting for – a truly transformative, intercontinental acquisition to make a global Islamic banking leader. But it’s still possible, and when it comes it’s very likely to be KFH who achieves it. The Malaysia managing director Dato’ K Salman Younis told the author last year that, in Indonesia, “we have identified some target banks where we know the owner’s desire to divest. There are four or five of them. Once we get the green signal from the parent company, we will be able to move.”

KFH apart, though, most other Islamic banks are more sluggish. Al Rajhi’s expansion into Malaysia was all the more notable because it marked the first time it had ever ventured outside Saudi Arabia. Its behaviour in Malaysia suggests a more ambitious view of the world – it opened with 12 branches, quickly announced plans to get to 50 by 2010, and launched a blanket marketing campaign from Kuala Lumpur city centre lampposts to the airport trains – but the bank looks less likely to expand by acquisition. Dubai Islamic Bank is growing with gusto – last year it said it aimed to open 70 branches in Pakistan – but again, it’s organic.

So why don’t mergers happen? There are several answers.

One: Islamic banks are just too busy. Most estimates (McKinsey is a frequently cited source) say that Islamic banking is growing by 15 to 20% a year. If you’re doing that, the challenge is finding enough people to run your own business. Why bother acquiring a whole other shop that would need integrating? With growth rates and margins like this, anyone new can set up a new franchise from scratch without having to pay a premium for an acquisition.

This is an argument that relates to the maturity of the sector. For the moment, Islamic banks are opening branches, and in some cases expanding overseas; the imperative isn’t, yet, to cut costs and improve profitability, because margins have been so good. (There’s also been no need to look overseas when pickings have been so rich in home markets.) But in time, that focus will undoubtedly shift, as the increasing competition from all these players starts to push margins down. That’s when mergers are likely to get more attention as an idea.

The second argument is regulatory, and this applies in particular to anything cross-border. Many Islamic countries have restrictions on foreign ownership, or limit the number of licences that can be awarded to foreign entities.

A third concerns Shariah interpretation. If KFH had succeeded in buying Rashid Hussain, there was much conjecture about how it would have integrated its assets. KFH is considered one of the most conservative institutions in the world in Shariah terms, and there are marked differences in interpretation between Malaysia and the Gulf, which makes cross-border acquisitions trickier than they already are.

For a long time, there was a fourth argument: high equity valuations, particularly in the Gulf, made takeovers prohibitive. Still, that argument has gone firmly out the window following the recent plunges in Gulf stock markets along with everywhere else in the world.

Which brings us to an important point: could the much tougher global environment be the catalyst for consolidation? Islamic banks by and large have come through the credit crunch in better shape than their conventional peers, since many of the securities that triggered sub-prime in the first place are off limits to Shariah banks. But there’s no escaping it completely, and the rates of growth will surely slow. A 20% growth rate can’t last forever anyway: it’s a function of starting from a low base, and maintaining that pace becomes more difficult with every passing year. Also, we have been in the midst of a period of asset transfer, as more and more funds have moved across from conventional to Islamic structures as awareness and regulation have permitted. That free kick to Islamic asset growth will be gone sooner or later, and asset gathering will have to come from other sources, perhaps acquisition.