With their ban on interest, the Gulf Islamic banks that managed to avoid the types of debt which proved toxic for their conventional counterparts are now praying the global crisis will bypass their property holdings. Islamic banks, which manage an estimated $1 trillion world-wide, do not have the same flexibility as conventional banks in managing balance sheet risks, bankers say.
For instance, they cannot reduce exposure to the real estate market by using derivatives. So Islamic bankers watched last week's Cityscape real estate fair in Dubai with intense scrutiny. But even the unveiling of a planned km-high tower failed to allay their fears that a boom in Gulf Arab real estate may be grinding to a halt.
The fate of Islamic banks in the region is closely tied to the property markets as they are required to underpin transactions with physical assets due to the ban on interest, which is viewed as usury under Islamic law.
"Islamic banks may initially have been viewed as less impacted because they are unable to invest in the instruments that caused the current instability some 18 months ago," said Danie Marx, head of treasury and capital markets at European Islamic Investment Bank.
"However, as the instability drags on and the second-phase impact of the crisis spills over into the region, either as restricted liquidity or adverse movement in asset prices, for example in real estate, it could start to hurt them." Confidence in the Gulf property market has been hit by the global financial turmoil, and there are signs that a five-year property boom is set to slow.
Dubai house prices rose 16 percent during the second quarter - but that compared with 42 percent in the first, according to real estate consultancy Colliers International. As the global credit crisis intensifies liquidity has begun to tighten, even in the world's top oil-exporting region, which is flush with cash after six years of rising oil prices.
The chief executive of Malaysia's CIMB Islamic Bank, one of the leading sharia lenders, said on Tuesday some Gulf Arab Islamic banks could fail as frozen credit markets and slumping property prices take a toll, though government aid should save the industry from a prolonged downturn.
But some bankers have raised the question of whether Islamic banks can tap into emergency funds set up by governments the way conventional banks can, due to the ban on interest. The United Arab Emirates government more than doubled its initial rescue package for banks to almost $33 billion on Tuesday, and bankers say its promise to guarantee banking deposits has already restored confidence in capital markets.
However, while the UAE has not released details of how its second cash injection will work, the initial 50 billion dirham facility made additional liquidity available to banks only at rates of interest above the repurchase rate. "The fact that we have not seen instability in the capital adequacy of Islamic banks does not mean that it cannot happen," Marx said.
Figures are hard to come by but Islamic banking operations of international banks have a significant market share compared with regional and solely sharia-compliant players, attracted largely by the region's cash. "The rationale behind the move of Western banks into Islamic banking was to tap the region's deep pockets," said a Dubai-based Islamic banker at an international bank, who declined to be named because of the sensitivity of the topic.
"(Now) the market is shut." Such grim comments by bankers contrast sharply with statements made by Gulf Arab government officials, who have sought to assure investors that Islamic banks are sheltered from the financial storm. Bahraini Finance Minister Sheikh Ahmed al-Khalifa said on Monday most of the country's banks had invested in the booming Gulf Arab region rather than complex foreign assets, and Islamic banks had no exposure at all to the global crisis.
The Islamic bond, or sukuk, market is seen as a measure of both the extent to which Islamic banking has been hurt as well as when it will begin to recover. Mohammed Damak, financial banking analyst at Standard & Poor's, said the liquidity crunch did have an impact on the global sukuk market.
In a report published in September, the agency said global sukuk issuance stood at around $14 billion in the first eight months of the year, down from $23 billion during the same period in 2007.
Despite these short-term concerns, there is an argument that the Gulf Arab region's sound economic fundamentals and strong growth - as well as governments' increased readiness to provide liquidity - could offset the impact of a correction in real estate prices on Islamic banks in the region.
"There is no fundamental shift in the sukuk market. People are just waiting for the right levels to place their deals," said Afaq Khan, chief executive officer of Standard Chartered Saadiq, the Islamic banking business of the Group. "The point is the Islamic liquidity has not gone to another market." Standard & Poor's Damak concurred: "I do expect the Islamic banking industry to grow as rapidly as before, by around 10 to 15 percent per year."