Institutional Infrastructure for Islamic Bank Mergers and Acquisitions in the GCC countries - Research Proposal Example

Dissertation Proposal for the Topic al Infrastructure for Islamic Bank Mergers and Acquisitions in the GCC countries INTRODUCTION Background of the Study The relatively new field of Islamic banking is quickly gaining ground as a vital element in global financial services. In February of 2007, the Kuwait Finance House embarked on a RM 2.16 billion (US$626 million) bid to acquire a controlling stake in Rashid Hussain, a global Malaysian finance group. The bid accounts for 32% stake in the target, and plans are mentioned to infuse a further RM 12 billion in the group to create a world-leading Islamic banking group. This signals a developing trend in Islamic finance – namely, consolidation. Until the present, there has been little incentive to merge with or acquire other banks, because most Islamic banks are currently building scale by growing organically. It is estimated that assets of this category of banks are increasing by anywhere from 15% to 20% a year. It is only when this organic growth has slowed down, and industry has matured, that banks would seek attainment of economies of scale through acquisition and merger (Asiamoney, 2007). Khalid Yousaf, managing director of Islamic finance at Dubai’s International Holdings Group, sees Islamic finance as going through an adolescence phase, characterized by the opening of new branches and expansion overseas without feeling the pressure to control or minimize costs and to improve on profitability, since higher margins are currently prevailing industry-wide. However, this stage will not last long. The next stage will be the maturing process, when competition intensifies, profit margins grow thin, and “the urge to merge will take over the organic process.” Razi Fakih, CEO of HSBC Amanah, agrees, stating that at present the Islamic finance sector remains a highly fragmented industry. The figures bear him out: the top five conventional banks in the Gulf states (excluding Oman) account for a combined market share of 22%, while the top five Islamic banks account for only 9% (Asiamoney, 2007). With the exclusion of international banks with Islamic operations such as HSBC and Deutsche, domestic Islamic banks tend to operate entirely within their country of origin with little plans of branching out to other countries. Of the more than 300 Islamic banks worldwide, majority are capitalised at less then US$25 million. There are rare exceptions, though. Some domestic Islamic banks that have announced acquisitions or expansions are the following: 1. Dubai Islamic Bank (DIB) recently announced a plan to expand significantly in Pakistan to as many as 70 branches in two years. 2. Kuwait Finance House bid for acquisition of a Malaysian bank 3. Dubai Investment Group has already acquired 49% of the Bank Islam of Malaysia 4. Al Rajhi Bank of Saudi Arabia, allegedly the world’s largest Islamic bank, had begun operations in Kuala Lumpur with much high-profile publicity. 5. The proposed merger of National Bank of Dubai and Emirates Bank is under government auspices, although neither are exclusively Islamic institutions. 6. Badr al-Islami, Mashreqbank’s sharia-compliant finance subsidiary, expressed interest in acquiring a conventional bank in the UAE, and thereafter simultaneously open an Islamic window (MEED, 2006). Despite these early attempts at consolidation, there is little resemblance between these mergers and the huge conglomerates in conventional banking such as Chemical-Chase-Jardine Fleming-Bank One-JPMorgan.. though such will eventually be inevitable. Still, there are marked differences between Islamic banking and conventional banking. Islamic banking adheres to the Koranic prohibition against charging interest. It creates it revenues in other ways. For instance, on corporate loans, and Islamic bank may draw income from equipment leased to the borrower. In the case of credit cards, the bank buys the goods and sells them to the cardholder at a markup on a deferred payment basis (Lachner, 2008) There are some visionaries, however, who believe that Islamic banking could cater to non-Muslims as well. Hussain Al Qemzi, CEO of Noor Islamic Bank, directs his vision towards expanding to other continents and becoming the largest global Islamic retail bank in five years. He expects to do this by acquiring banks in Asia, Africa and Europe. He expects that his bank will be able not only to expand the use of Islamic banking not only among Muslims, but also to penetrate the non-Muslim market as well. He bases his assessment on the simplicity of their banking model, and the philosophy that everyone in the world has the same financing needs, which his bank can meet whatever the customer’s faith will be (Lachner, 2008). Aim and Objective The aim of this dissertation is to study of the status of mergers and acquisitions among Islamic banks, or between Islamic and conventional banks, within the Gulf Cooperation Council region. Its ultimate objective is to draw up a set of recommendations to enhance institutional development and consolidation in the Islamic banking and finance industry. Main Research Question How may the Islamic banking industry attain progress and development through consolidation in the form of mergers and acquisitions? Related Sub-questions 1. How could Islamic banking be essentially described, and in what ways does it differ from conventional banking, that impact upon its growth and development? 2. What stage of development is the regional Islamic banking sector situated in, and what direction should it take in order to achieve optimal growth and development? 3. What strategies and innovations are necessary in the sector for it to pursue the desirable course of action? 4. What impediments and problems tend to hinder the progress of Islamic banks? 5. What recommendations could be made to enhance growth and consolidation in the Islamic banking industry? Methodology The method to be used will be qualitative, because the purpose of the research is to identify and substantiate the important aspects that influence the merger and acquisition process among Islamic banks in the GCC region. As this is going to be in the nature of an industry study, this paper proposes to use the framework suggested by Porter’s Five Forces Model, and the Resource-Based-View (RBV) method of analysis. Porter’s model will create a picture of the external competitive environment of the Islamic banking industry, while the RBV method will assess the internal resources and working environment of the industry among and within Islamic banks. Porter’s Five Forces Model is depicted as follows: Diagram of Porter’s Five Forces Model of Industry Competition Source: MBA Quiz, 05/02/2007, http://www.mbaquiz.com/porter-five-forces As is evident from the model, five forces create an impact upon the players within an industry and among themselves. These five forces are: 1. Barriers to entry – These are the forces that would influence the ease or difficult of a new industry participant in establishing his business in the industry. Generally, high entry barriers would mean that not many new firms will be able to successfully penetrate the industry. The fewer the firms are, the greater the market share each industry participant can expect to have. The kind of competition will depend upon the product. If the industry produces a highly specialized product, then even the existence of just a few firms in the industry could heighten the competition, as in an oligopoly. 2. Bargaining power of suppliers – This force describes the degree to which providers of raw materials and resources necessary for the industry to produce, are able to command the price of the materials they supply. For instance, if the supplier is a monopoly producer, then the price such supplier demands will have to be met by the firms within the industry. Such supplier thus has a high bargaining power over the industry. 3. Bargaining power of buyers – This describes the degree to which buyers may command the price at which the firms within the industry should sell their products. When there are many producers, or when the general buying public is supported by legislation that dampens prices, then bargaining power of buyers is high, and the firms will have to sell at their prices. 4. Threat of substitutes – This force represents the competitive threat posed by the ability of substitute products to draw market share from the industry. In the case of products that are not highly differentiated, for instance, and cheaper substitutes or reasonably similar quality are present, then it is possible for some of the demand to be satisfied by the substitute, to possible detriment of the firms within the industry. 5. Competitive rivalry – Within the industry itself, firms compete against each other for market share. This analysis will compare firms against one another and how differentiated their products may be in order to attract market share. For the internal analysis of the industry, the Resource Based View will provide the framework for assessment. The RBV approach, first developed by Wernerfelt (1984), determines the strategic resources that a firm may draw upon in order to attain its objectives. The framework identifies the superior resources existing within the firm that determine its competitive advantage, and to protect those resources through some form of isolating mechanism in order that it does not get diffused throughout the industry (Barney, 1991). Data The data to be used shall come from studies and reports made available in the public domain, and industry analyses created by financial information services and investment advisories. LITERATURE REVIEW This research takes the form of an industry study that is undergoing a major strategic shift. The Islamic banking system is graduating from a lower level of operations – that of individual organic growth – to one that is sophisticated, consolidated, and with the potential scope and power of a major multinational institution. As such, literature dealing with the various aspects of Islamic banking as an aggregate (as suggested by the following study by Al-Muharrami et al., 2006) shall be reviewed in this chapter. Market structure in the Arab GCC banking system Al-Muharrami, Matthews, and Khabari (2006) arrived at a view of the market structure of the Arab GCC banking system, that focused on bank concentration ratios and an evaluation of the monopoly power of banks for the ten years leading to the study. According to their findings, Kuwait, Saudi Arabia, and the UAE have moderately concentrated markets and are proceeding towards positions that are less concentrated. On the other hand, Qatar, Bahrain and Oman are highly concentrated markets, with Bahrain and Qatar operating under conditions of monopolistic competition, while Kuwait, Saudi Arabia and the UAE operate under perfect competition. Results for Oman were inconclusive, as the study failed to reject monopolistic competition for that market. The study suggests that there is merit to examining the banks of the GCC countries as an aggregate. Overall, the GCC banking system may be characterized as operating under conditions of monopolistic competition, although there are sufficient variations that exist within each country. Implications of globalization: Convergence in global financial standards As the Islamic banks of the GCC prepare to expand globally through the merger and acquisition of conventional banks, there are side effects that must be considered that will impact on the way Islamic finance operates. A study by Irvine (2008) discussed the international convergence of 100 countries on the matter of the International Accounting Standards Board’s international financial reporting standards (IFRS). In its conclusion, the study acknowledged the existence of “powerful pressures for conformity” with the IFRS exerted among the nation states. The emerging and developing countries have worked against the clock to facilitate the adjustment of their financial reporting requirements so that they would be consistent with international accounting standards, in order to gain legitimacy in, and thereby access to, global capital markets. Economic development and increased wealth in the present environment could only be attained through this convergence, and failure to do so would mean exclusion from global opportunities in the marketplace. According to Irvine, in the case of the UAE, the IFRS adoption was undertaken because of “coercive, normative and mimetic pressures” that included the World Bank and multinational corporations, the IASB, the influence of the Big 4 accounting firms (i.e. Pricewaterhouse Coopers, Deloitte Touche Tohmatsu, KPMG and Ernst & Young), and relationships with the UAE’s trading partners. Below is the diagram of the institutional framework pursued in this study (source: Irvine, 2008) Institutional framework adopted by Levine, 2008 concerning the adoption by the UAE of the International Financial Reporting System (Levine, 2008, p.129) Another study probes the implications of globalization on the regulation of corporations by both national and international entities. Arnold and Sikka (2001) approached the issue from two opposing views. The first is that in a globalized world, nation-states cannot take effective actions to regulate multinational businesses, especially those relating to banking and finance. The competing view rejects this, saying that while the nation-state has had to restructure itself in response to the changing global environment, it has always retained the power, functions, and authority to exercise its sovereign will within its jurisdiction, even over multinational businesses. The debate was applied to the forced closure of a Pakistani financial institution, the Bank of Credit and Commerce International (BCCI) which operated in 73 countries. It was found out during the U.S. Senate investigation that the BCCI intentionally adopted an “elaborate corporate spider web” of holding companies, transnational affiliates, banks within banks, and nominee relationships, with the primary purpose of evading government regulation and control. Through this means, the bank provided a mechanism for facilitating illegal activities perpetuated by both bank officials and clientele. In this case, the role of banking regulators played a significant part in, proving that nation-states do have the power over multinationals and “borderless banks” such as the BCCI. Determinants of the efficiency of financial institutions The study determined that in the case of Malaysian banks, the degree of inefficiency remained high particularly one year after start of the Asian financial crisis in 1997. The study focused on three major approaches to analyzing banking operations, that is, the intermediation approach, the value added approach, and the operating approach. Results suggest the decline in technical efficiency is more sudden in the case of the intermediation approach compared to the value added approach and operating approach. Efficiency was found to be negatively related to the expense preference behaviour and economic conditions, while bank efficiency is positively related to loans intensity (Sufian, 2009). In any case, banks’ fiscal health should be assured due to vigilant oversight and compliance monitoring is ensured by the Central Banks of the countries under consideration (Angell, 1986). Measuring efficiency of banking institutions This study sought to achieve a process of benchmarking banks’ operations through the identification of efficiency metrics suitable for identifying best practices, innovative ideas, effective operation procedures, and sound competitive strategies. Global efficiency measures were explored in order to provide a solid foundation to evaluate individual bank performances. Essentially, the study tried to apply quantitative techniques grounded in statistics and econometrics, particularly the data envelopment analysis (DEA) method and neural network approach. While the conclusion appear positive as to the valid use of such methods, there appear to be serious limitations to their use, such as the possibility that targets identified by DEA may be unachievable because the inputs used are not within management control. There is also the limitation that the selected variables are not exhaustive, and the data set is not adequate enough. The author echoed the findings of Avkiran (1999) that the results of both quantitative methods should be supported by traditional financial ratio analysis to yield accurate interpretations of their significance. This, in effect, is an unguarded complement to ratio analysis as superior to the quantitative methods mentioned in determining bank efficiency (Mostafa, 2009). The Infrastructure for Institutional Change Understandably, the economy has been set back by the prevailing financial crisis, and recovery is slow in coming (Emerging Markets Monitor, 2009a & 2009b). The study by Kshetri and Ajami (2008) was prompted by the observation that institutional change occurs at a slow pace in the Gulf Cooperation Council, or GCC, economies. In particular, institutions that promote free enterprise economy are lacking in the region. It has already been agreed in principle that the GCC regimes, comprised of the states of the UAE, Kuwait, Bahrain, Saudi Arabia, Oman and Qatar, that future directions should include the strengthening of the rule of law and the adoption of measures towards a free enterprise economy; the realization of these commitments has, however, been unsuccessful. The political and economic liberalization efforts have been described as “reluctant,” “crisis-induced” and “top-down” (Robinson, 1998) as well as superficial (Cook, 2005, 2006). Several implications have been drawn concerning the influence of economy, polity, and society in instituting broader reforms, the most important of which are the following: (a) The principle of minimal dislocation. This principle states that the transition to Western form of capitalism is a major change from the present institutional arrangements of the GCC economies. However, progressive change is sustainable only if there is “minimal dislocation” among the elements involved. In this regard, alignment of GCC businesses to the principles of Islamic economics will likely be more practical than changing to suit the Western form of capitalism. (Kshetri et al., 2008) (b) Complementarity as a strategy to operate in GCC economies. Also called bricolage (Campbell, 2004), this involves combining elements of the existing wider business environment and rearranging them according to a certain strategy. For example, western financial institutions that operate in the GCC area adapt to the principle of Commercial shariah and have greatly contributed to the region’s performance by increasing the number of jobs and introducing foreign direct investments (FDI). (c) Minimizing political and bureaucratic interference in business. The presence of political and bureaucratic interferences have hampered the growth and success of business in the region, similar to how the Chinese government chaotically hindered the progress of Chinese firms at home and abroad (Kshetri et al., 2008) (d) Decline in the production and price of oil as shock to existing institutions. The single most important force that affects the conduct of business in the region is the cost of oil production and the price of oil. Kuwait and Saudi Arabia, in the past decade, had embarked on the early stage of institutionalisation, but because oil prices rose, the motivation to move towards full institutionalization of reforms had weakened. In the future, it is likely that a possible decline in oil prices will shift the power balance in the region in favor of pro-reform elements, such as Western governments and foreign multinationals. (Kshetri et al., 2008) (e) Western educated leaders and technocrats, mobilization of pro-reform actors, and substantiveness of reform measures. These three elements are collectively factors that would enhance initiatives towards institutional reforms. They are catalysts towards the adoption of measures that would hasten long-lasting institutional reform, and the presence of foreign capitalists will continue to provide incentive for reform as in the past (Tignor, 1977). References Angell, N B 1986 Regulation of Business under the Developing Legal System of the United Arab Emirates. Arab Law Quarterly, vol. 1, no. 2, pp. 119-140 Al-Muharrami, S; Matthews, K; & Khabari, Y 2006 Market structure and competitive conditions in the Arab GCC banking system. Journal of Banking & Finance, vol. 30, pp. 3487-3501 Arnold, P J & Sikka, P 2001 Globalization and the state-profession relationship: the case of the Bank of Credit and Commerce International. Accounting, Organizations and Society, vol. 26, pp. 475-499 Asiamoney 2007 Islamic Banking - The urge to merge. April 2007, vol. 18, issue 3. Sourced from Business Source Complete Avkiran, N 1999 An application reference for data envelopment analysis in branch banking: Helping the novice researcher. International Journal of Bank Marketing, vol. 17, pp. 206–220. Barney 1991 Firm Resources and Sustained Competitive Advantage. Journal of Management, vol.17, issue 1, pp. 99–120. Cook, S.A., 2005. The right way to promote Arab reform. Foreign Aff. 84 (2), 91. Cook, S.A., 2006. The promise of pacts. J. Democ. 17 (1), 63–74. Emerging Markets Monitor 2009a GCC: Sukuk Market Recovery? Not Just Yet. 7 September 2009 Emerging Markets Monitor 2009b UAE: Recovery Signs to Watch For. 9 October 2009 Irvine, H 2008 The global institutionalization of financial reporting: The case of the United Arab Emirates. Accounting Forum, vol. 32, pp. 125-142. Kshetri, N & Ajami, R 2008 Institutional reforms in the Gulf Cooperation Council economies: A conceptual framework. Journal of International Management, vol. 14, pp. 300-318 Lachner, D. 2008 Lending on Faith: Noor Islamic Bank Chases Non-Muslim Clientele. Institutional Investor, 00203580, Jun2008, Vol. 42, Issue 6 MBA Quiz 2007 Diagram of Porter’s Five Forces Model of Industry Competition Retrieved 20 February 2010 from http://www.mbaquiz.com/porter-five-forces Middle East Economic Digest. 2006 Badr al-Islami seeks UAE buy. MEED, 9/8/2006, Vol. 50, Issue 36 Mostafa, M M 2009 Modeling the efficiency of top Arab banks: A DEA-neural network approach. Expert Systems with Applications. Vol. 36, pp. 309-320 Robinson, G.E., 1998. Elite cohesion, regime succession and political instability in Syria. Middle East Policy 5 (4), 159–179. Sufian, F. 2009 Determinants of bank efficiency during unstable macroeconomic environment: Empirical evidence from Malaysia. Research in International Business and Finance, vol. 23, pp. 54-77. Tignor, R L 1977 Bank Misr and Foreign Capitalism, vol. 8, pp. 161-181. Wernerfelt, B 1984 A resource-based view of the firm. Strategic Management Journal vol. 5, pp. 171–80. Read More