KUALA LUMPUR - Islamic banks are set to expand, luring mainstream customers compared to conventional lenders, a new report has found.
"Success will be defined in the core markets through the transformation of Islamic banks, Ashar Nazim, Islamic financial services leader at Ernst & Young, told Reuters.
So they are able to compete with the much bigger, conventional boys for mainstream customers.
The report found that Islamic assets of all commercial banks will reach $1.55 trillion this year, $1.8 trillion in 2013 and over $2 trillion mark.
Gulf-based Islamic banks now have $450 billion in assets, about 30 percent of the total, the report said.
Islamic banks will grow as they focus on customers who expect more than just Shari`ah-compliance in terms of products and service and have traditionally relied on conventional banks.
The report predicted that between 100 to 150 new financial institutions could be launched in the next five to seven years to cater to markets that are new to Islamic finance or have low rates of penetration including Egypt, Libya, Indonesia, Pakistan and Bangladesh.
Ten of the 25 fastest growing emerging markets have large Muslim populations.
Islam forbids Muslims from usury, receiving or paying interest on loans.
Islamic banks and finance institutions cannot receive or provide funds for anything involving alcohol, gambling, pornography, tobacco, weapons or pork.
Shari`ah-compliant financing deals resemble lease-to-own arrangements, layaway plans, joint purchase and sale agreements, or partnerships.
Investors have a right to know how their funds are being used, and the sector is overseen by dedicated supervisory boards as well as the usual national regulatory authorities.
The report also showed that the role of pure Islamic banks will also become important by comparison with banks that deliver products just through Islamic windows at their existing branch networks.
"There is no truly fully fledged Islamic bank (that stretches) across international markets or even regional," Nazim said.
He identified a group of 20 Islamic banks as likely candidates to become significant regional institutions.
They now account for 55 percent of total Islamic banking assets after having grown over the past three years at an average rate of 16.2 percent a year, Nazim said.
"It is a lopsided industry at this point ... only 13 Islamic banks have $1 billion or more in equity," Nazim said, adding that the difference between small and large Islamic banks will widen.
The report, however, said that Islamic banks, though they have grown, experienced a decline in profitability and their average return on equity lags behind that of conventional banks by 20 percent.
Return on equity for both Islamic and conventional banks has deteriorated since 2008 in the wake of the financial crisis, dropping to 12 percent in 2011 for Islamic banks, compared with 15 percent for conventional banks, the report showed.
This 3 percent gap is much wider than the 1 percent difference observed in 2008-2010.
The return on assets for Islamic banks dropped to 1.3 percent in 2011 from 1.7 percent in 2008, while rising for conventional banks to 1.7 percent in 2011 from 1.5 percent in 2008.
Operating expenses are 50 percent higher for Islamic banks, while their cost of funds still remain more competitive than for conventional banks, the report said.
Some banks have started to focus on improving efficiency and reducing costs, which could boost their profit margins by about 25 percent within two to three years, Nazim said."The severity of this performance challenge has put many Islamic banks in a difficult place. They have taken the decision to transform the way their businesses work.