Private banking is growing as a distinct discipline within Islamic finance. Both within the Islamic world, and among international banks, the need to provide Shariah-compliant offerings to high net worth individuals is going to become steadily more important.

Partly, this is a function of demographics: the rising wealth of the Muslim world. It is hard to put precise figures for the world’s 1.6 billion Muslim population, but Cap Gemini and Bank of America Merrill Lynch reported in their most recent World Wealth Report in June that the number of high net worth individuals in the Middle East stood at 400,000, representing a 10.4% increase during 2010. Between them they had combined wealth of US$1.7 trillion at the time of the survey, up 12.5% year on year.

“The Islamic world has experienced superior growth rates in terms of wealth generation, especially during the last two years,” says Stefan Leins, thematic research analyst at Credit Suisse. He notes that the largest part of the global Muslim community is in Asia, where wealth grew at an average of 5% a year from 2000 to 2009 before leaping 15% from 2010 to 2011. “Much of the Islamic world’s new wealth has been created by the emergence of a growing middle class in large parts of Asia and the Middle East. This leads us to the assumption that wealth generation in the Islamic world is not only superior but also sustainable.”

On top of that, Islamic banks themselves are becoming more sophisticated, and clearly see high net worth advice as a vital source of revenue, particularly as more and more mass market Muslims achieve greater wealth. In Malaysia, Islamic private banking has been a discrete field of finance for years, and it continues to grow. “Moving forward you will see a lot more momentum in Islamic private banking,” says Badlisyah Abdul Ghani, CEO of CIMB Islamic in Kuala Lumpur. And it’s not just because of demographics, but because of the sense that Islamic finance – tied as it is to real, tangible assets – is increasingly seen as resilient in an economic downturn. “Arising from the recent crisis, much of the wealth that used to be managed by conventional private bankers is now coming into the hands of Islamic private banks,” he says. “Islamic banks are now forced to come up with a framework that would be able to facilitate the needs of these high net worth individuals.” Because it is perceived as being more safe? “One of the reasons is that perception,” he says. “The other is centred on pure diversification of exposures, and who manages their funds. They want to be able to spread out a bit in terms of who is managing their wealth.”

CIMB has had a distinct Islamic private banking business for several years; at Maybank, executive vice president Choong Wai Hong says that “establishing an Islamic private bank brand is something we’re exploring right now.” For him, part of the prompt is the fact that Middle Eastern money is becoming increasingly prominent in Malaysia. “Some of these customers are more discerning in what they expect,” he says.

International banks, too, see private banking as an increasingly vital part of an Islamic offering. “It is an area which is getting to be very important,” says Wasim Saifi, global head of Islamic and consumer banking at Standard Chartered. “You’ve got customers who are quite sophisticated. Shariah compliance is an important need, but on top of that they need to balance it with the commercial aspects of that proposition. Unless and until you have a Shariah compliant range of products available, your appeal is not to the entire market.” He says it has become an especially important focus for Standard Chartered in the Middle East, particularly in Saudi Arabia, Qatar, Kuwait and parts of the UAE. “These are places where having a Shariah range of products is becoming a very important plus for a private bank.”

Leins at Credit Suisse says Islamic private banking has “absolutely” emerged as a new discipline. “Many global banks that are active in private banking, such as Credit Suisse, have started to structure a whole range of private banking services in a Shariah compliant way in order to meet Islamic clients’ demands.”

At Citibank, Ahmad Shahriman Mohd Shariff, Islamic banking head in Malaysia, adds: “A separate discipline is required if one considers all the additional obligations and considerations an Islamic investor would have with regards to his wealth.” These aren’t as straightforward as one would think: for example, Shariff points to zakat, a pillar of Islam you can roughly translate as philanthropy, which has quite specific rules for calculation that must be adhered to (see box). “While in the past, these needs were met by Islamic investors privately, there is an opportunity for Islamic financial institutions to offer commercial solutions that will help Islamic investors to meet these needs.”

Clearly, the available product suite to sell to Islamic HNW investors has improved considerably over the years, and continues to do so with every new sukuk. “The most popular instruments in Islamic investing would be the sukuks, especially in the MENA region and Malaysia,” says David Pinkerton, chief investment office of Falcon Private Bank, which is owned from the Middle East. “They have become fairly liquid, and provide investors with fixed income, which is very popular among Islamic HNWIs.” It is common for bankers to insist that Shariah compliance is not a constraint but an opportunity. “Restrictions imposed by the Shariah on investments that are available for Islamic investors should not be seen as a disadvantage,” says Shariff. “The financial crisis in 2008 has shown that there is wisdom in the restrictions imposed, and that Islamic investors who followed the restrictions saw their wealth protected during the crisis.” Shariff would like to see more product development in Shariah-compliant risk management tools, and broader wealth management solutions, but in terms of investment products, that is rarely raised as a problem these days.

But not everyone agrees with that assessment. John Sandwick, a Californian who spent much of his youth living in the Gulf before becoming a Swiss private banker tasked to bring in Arabian private clients, started his own advisory business, called Islamic Wealth & Asset Management, seven years ago in Geneva. He did so partly because his clients were asking for investments that were halal, yet in fact within the private bank many of the assets in their private banking accounts were actually haram, illegal under Shariah, because they were interest-bearing, which is prohibited.

To his mind, most of the process of asset management under Islam ought to be the same as conventional: you start with a client profile, evaluating risk appetite and investment objectives; then you create an investment strategy to fit, typically in an income, balanced or growth strategy; and then you go and buy the appropriate securities. Since it’s only the last of those processes that is any different in Islam, he set about building his approach to asset management the same way, and to do that, he decided he needed a comprehensive database of Shariah-compliant securities, or at least funds. “An asset manager has to examine all the possible securities in the investable universe,” he says. “If he doesn’t, then he is driving blind, and he is not doing his job.”

The first surprise he got was to learn that no such database existed, so with the help of some graduate students in the UK, he set about building one. The next surprise was that the resulting universe was small: 850 Islamic products. And when he filtered out funds that were too small, new, opaque, illiquid, or didn’t have a suitably robust fatwa to assert their Islamic compliance, that number shrank to 150. “It’s pathetic,” he says. “There are 66,000 suitable funds in the conventional universe.” Be that as it may, 150 has proven sufficient to build the sorts of growth, balanced and income portfolios he believes should be widely available for Islamic investors, and he says they have performed exceptionally well, not just in terms of returns but the various measures of the risk involved to get them. “While there are only really 10 fixed income funds to examine, and I would much prefer there to be 2,000, it so happens that 10 does the job. It’s an awful situation to have so few Islamic funds but we have reached the point where there are enough to achieve investment goals in a professional manner.”

Sandwick’s broader objection, though, is that if nobody else really has the database that he has, then how are they conducting asset management? “If you do not have full information on your investable universe, you cannot do asset management,” he says. “People tell me they do Islamic asset management. I say: no you don’t, you do random product sales. If you don’t have the entire universe to select from, I don’t know what you’re doing but it’s not asset management.”

Sandwick’s assertion rests on the assumption that other banks have not done the same level of research that he has, but nevertheless he has a point. There is a dearth of the sort of fund-of-fund or multimanager diversified investment products that are commonplace in the conventional mainstream. What one has instead, particularly from the international banks, is a slew of structured products underpinned, at some level, by derivatives. “Derivatives are the garbage of the professional asset management universe,” he says. “The Bill and Melinda Gates Foundation manages $36 billion. Go find me a single derivative position in there. Go to Calpers; there’s a modest amount, but only when it meets specific investment objectives. Professionals don’t buy this crap. Muslims are told it’s all they’ve got. It’s shameful.” Where, he asks, are the straightforward balanced portfolios? “If I go to [an international banker in the Middle East] and say: show me your conventional US dollar balanced portfolio, he’ll reach on his shelf and get something right away,” says Sandwick. “If I say: give me the same thing – back-tested, optimized, with all your global sorting and filtering – but with fatwa, he can’t do it.”

This touches on another point: private banking is often seen as a source of innovation in Islamic finance, in order to create equivalents to conventional world securities. It is impossible to spend more than an hour at an Islamic finance conference without hearing someone call for more and faster innovation, but a counter-argument runs that the real priority should be doing the simple things right.

On top of that, the differences in Shariah interpretation, particularly between Malaysia and the Gulf, make it difficult to think of a single investment universe that applies to the whole Islamic faith. “It’s a challenge everyone faces,” says Choong at Maybank. “When customers come from the Middle East, we have to be very sensitive about how the same principles of fatwa are interpreted there and here. It’s quite tricky.”

Beyond investment, Islamic private banking is undergoing the same transition as its conventional equivalent in Asia: a shift from pure investment advice to true wealth management. “The special needs of Islamic HNW investors have progressed from finding good Shariah compliant investment opportunities, to having a comprehensive Shariah-compliant wealth management solution,” says Shariff. That includes Shariah-compliant estate planning, takaful (insurance) and zakat (see box).

Pinkerton says that beyond selection of compliance securities, this largely mirrors the conventional world. “Shariah-compliant high net worth individuals have the same basic needs as the conventional investors in terms of capital preservation and income generation.”

But here, too, there are distinct differences. Choong at Maybank points to the concept of faraid, or wealth distribution; this governs the treatment of inheritance under Muslim law. “It is quite specifically governed by Islamic laws,” he says. “How you distribute, to whom – there is no conventional option that a customer can opt for. It is very clearly defined.” Maybank has built the capability within its trustee business to deal with this Islamically, and Choong thinks this will be “one of the anchors” of an Islamic private banking offering.

Whatever form it takes, private banking is going to continue to grow within Islamic finance, simply because every relevant factor is growing: Muslim world wealth; investor sophistication; acceptance of Islamic finance; and availability of investments. There is, quite simply, no reason for it to do anything but grow.

BOX: Islamic philanthropy

The Muslim principle of zakat requires believers to give a fixed proportion of their wealth to charity, although the proportion given – and what constitutes wealth – is widely debated. Additionally, Muslims are encouraged to make voluntary contributions, or sadaqat. Consequently philanthropy is an enormously important part of Islamic wealth management.

“The pattern of giving is not much different from the conventional world, but I think there is more giving among the Islamic high net worth than the conventional, because they see other benefits over and above what they get in this world,” says Badlisyah Abdul Ghani at CIMB Islamic. “Not necessarily the volume but the number of times that they do such giving is more, and they don’t announce it.”

Shariff at Citibank Malaysia agrees. “In general, from an Islamic perspective, philanthropy should be done discreetly with no publicity.” He says Islamic investors approach philanthropy first by calculating their zakat obligations, then adding voluntary donations. “In certain countries, Islamic investors have the option of fulfilling zakat obligations either privately or through a state appointed organization,” he says. “Regardless of the option chosen, an Islamic investor would require good advice on how to calculate the amount of zakat payable, and where possible to tie payment of zakat to tax planning as well.” This, he says, is an area where Islamic financial institutions need to do more to work out how they can provide appropriate solutions to investors.

The requirement for philanthropy has also found application in the fund management world. Last year Maybank’s Islamic banking arm created a fund through which parts of the returns go to a particular Shariah-approved charity; it represented an easy and compliant way to fulfill philanthropic duties.

On first glance, the dynamics supporting the Islamic fund management industry look very strong. In the GCC markets of the Middle East in particular, the region is galvanized by high oil prices so that at both an institutional and an individual level, wealth is growing. As that wealth requires a greater range of products to be invested in, and since these are all Muslim countries, shouldn’t that be the spur to a dramatic increase in Islamic asset management?

Well, yes and no. It’s true that retail investors in the Middle East and in Malaysia have firmly embraced Islamic funds. This is nowhere more true than in Saudi Arabia, where the mutual fund industry is overwhelmingly Islamic: about 80% of funds sold in the country are Shariah-compliant. The degree of penetration varies elsewhere from market to market – entrenched in Kuwait, popular but not dominant in Malaysia (where Islamic unit trusts are 10.6% of the market in volume terms) and Bahrain, limited in the United Arab Emirates – but it is certainly true to say that many individual investors have welcomed the opportunity to invest in a way consistent with their faith.

For institutions, though, it’s a different story. The Middle East is best known, in institutional terms, for its vast sovereign wealth funds: the Abu Dhabi Investment Authority, believed to be easily the biggest of them all; the Kuwait Investment Authority; the Qatar Investment Authority; the parts of the Saudi Arabian Monetary Agency that fulfill sovereign wealth duties; and several other smaller funds. But none of these invests in a Shariah-compliant way. They might well consider Shariah-compliant mandates if there was a demonstrable advantage in doing so in terms of returns or risk diversification. But just for the sake of religion? Not at all.

Even in the strictest Islamic country of them all, Saudi Arabia, one could not say that SAMA is Shariah compliant. It’s true that it tends to invest with elements of Islamic principles in its mandates, such as avoiding investments in alcohol and gaming. But one of the central tenets of Islamic finance – the biggest, really – is that the idea of interest is prohibited. Money cannot turn into more money without performing some purpose along the way, such as trade. Now, for a central bank, that’s clearly implausible: the vast majority of many central banks’ holdings, including Saudi’s, are US Treasuries or similar securities – which, very obviously, pay interest.

There are modest signs of growing institutional interest in Islamic asset management. Several Saudi fund managers say they do have some Shariah-compliant mandates from institutions in the country, although all say that at this stage Islamic finance is to a very large extent just a retail story. And in Malaysia, there have been steps towards greater Islamic investment among institutions, notably Khazanah, the state investment arm which holds stakes in many of Malaysia’s largest corporate enterprises; it conducts all of its fundraising in a Shariah-compliant way through the sukuk markets.

In between retail and institutional, the ground is muddier. High net worth individuals and family offices are a very important part of Gulf wealth, and it is very difficult to generalize about their own investment preferences since they are so individual. But this is perhaps an area within which Islamic asset managers can start to bridge the divide between the low average investment volumes of retail and the high volume but disinterested masses of institutions.

Global fund managers have, by and large, been happy to watch and wait before launching Islamic funds. In the Gulf, for example, a rule of thumb is that many managers will want to be pretty sure of getting $50 million of assets in the door – in some cases $100 million – before it seems a good idea to launch a new fund. Going Islamic requires an infrastructure: most obviously, you need Shariah advisors, who are far from cheap, to endorse your products as Shariah compliant.

And while it might seem straightforward to simply launch an Islamically compliant version of an existing fund, it’s not actually that simple. Let’s say you have a US equities fund, and you want to put a Shariah screen over it. That’s easily done. But given that you’ve now removed all the financial institutions, don’t you want to have a rethink about the rest of the portfolio too? Everything about it has changed – its overall risk profile, the weighting of various sectors – and a diligent portfolio manager is likely to want to start from scratch rather than just accept what the overlay has come up with. It’s clearly easier for passive funds, but as a general comment launching an Islamic range is not as straightforward as it might at first appear.

Also, the available assets to underpin Islamic funds could be more widespread. Equities are easy enough: a simple screening service can help to find which stocks are compliant and which not, and in Malaysia, some 88% of total listed securities are Shariah-compliant (63.83% by market cap). In sukuk, though, the supply is more limited: Malaysia, where there were 181 outstanding sukuk in December 2010 worth RM319 billion and representing 57% of the total bond market, is really the only place with any secondary market liquidity in sukuk, and even there it’s modest. Beyond that, real estate is inherently suited to Islamic finance, but only if the tenants and the property’s financing are compliant.

Probably more international managers would have launched Islamic ranges had the financial crisis not, belatedly, hit the Gulf so hard. Gulf states were about a year behind the rest of the world in entering the financial crisis, and are correspondingly slow to emerge from it again, a process complicated by social unrest in the region. Many stock markets, notably Saudis, remain considerably below their pre-crisis highs, which in turn has meant that the willingness of individual capital to seek new investments has diminished too. If international fund managers didn’t think it made sense to launch Shariah ranges of funds in 2007, it certainly doesn’t make any greater sense now.

That said, there is a counterpoint to that argument. Islamic finance itself escaped the financial crisis very well, even if the economies in which it is prevalent did not. Islamic finance insists on tangible assets performing a real function; that counted out many of the derivative products that brought western institutions unstuck. There is, perhaps, a greater appreciation among mainstream investors, for whom religion is not a consideration, that an Islamic fund constitutes a useful diversifier in risk terms.

One exception to the reticence of foreign houses to go Islamic is Saudi Arabia, where the picture looks slightly different. Many of the biggest houses in Saudi have long-standing foreign involvement – HSBC in Saudi British Bank (now SABB), for example, or more recently Goldman Sachs in NCB Capital, which is the biggest issuer of Islamic mutual funds in the world. All of these institutions have widespread Islamic fund ranges, but they are basically domestic.

And another exception may prove the way forward. When Malaysia launched the Malaysia International Islamic Financial Centre (MIFC), it sought to attract foreign fund managers to set up Islamic ventures in Malaysia, aiming to make them a hub for global Islamic capital. Several, among them Nomura, Aberdeen, BNP Paribas, Principal (through a joint venture with Malaysia’s CIMB), Franklin Templeton, Prudential and India’s Reliance have gone ahead and launched such ventures, attracted in part by seed capital from Malaysia’s key institutional investor, the Employee Provident Fund. It’s not yet clear whether any of these are actually sourcing new money into Malaysia, which was MIFC’s intended goal; but it does demonstrate that in order to get internationals to take the Islamic route, they first need to see some money committed.

One of the many initiatives that would follow the establishment of the CMA was a requirement that all Saudi financial institutions hive off their asset management, brokerage and investment banking units into separate entities, and in the wake of that it set about issuing new licences both for established players and new ones who wanted to set up these investment units. It swiftly became clear that it was going to issue plenty of them. From eight authorised persons – the formal title for licensed bodies – at the end of 2005, there were 45 by the end of 2006, 80 by 2007 and 110 by the end of 2008. A peak was hit that year – 12 more were issued in 2009, but 12 more revoked, leaving the final number the same – and while the CMA does continue to issue new licences, such as to Lazard Saudi Arabia last June and QInvest in January, today the AP list runs to a more modest 92 and is expected to come down from there.

So far this year, far more CMA announcements have been about cancellation of licences than issuing of new ones. Financial Transaction House, which grew out of the corporate finance arm of Anderson Worldwide and was one of the very first to be licensed in June 2005, had its authorization as an arranger and advisor on securities cancelled in April; Assets Financial House Company, another early licensee back in 2006, went the same way in March; and Arab Experts Capital and Kuwait’s The National Investor had their licences cancelled in February. In each case, the CMA said this was at the company’s own request. Elsewhere there is consolidation, such as the merger of CAAM Saudi Fransi and Calyon Saudi Fransi into Fransi Tadawul, which was then re-named Saudi Fransi Capital. The whole thing is affiliated with Banque Saudi Fransi, which in turn is 31.1% owned by Credit Agricole. Others are amending their licences, such as GIB Capital, which in April had its Dealing as an Agent licence replaced with a Dealing as a Principal and Underwriter licence.

Further consolidation is seen as inevitable. “There are way too many players at this point,” says Jawdat Al-Halabi, CEO of NCB Capital. “The market is big enough to manage a good number of players, but the issue is that from my perspective everybody wants to do everything. That is not sustainable and I believe we will see consolidation and a rationalization of services.”

“When the split between the commercial banks and investment banks took place, it was followed immediately by the crash,” he adds. “So most companies, still in start-up mode, faced an extremely difficult time.” If, as some expect, the minimum capital levels are increased for the investment banking industry – they’re already high by international standards on the commercial banking side – then that is likely to thin the field further. “It will remain to be seen if every player is willing to commit additional capital, because that’s going to require a return,” says David Dew, CEO of SABB.

Five years on from the beginning of the new licensing process, Euromoney asked three CEOs of investment banking businesses spun off from established heavyweights how the market had changed for them, and where the opportunities lie today. In some sense these are the groups that had it easiest: they had established businesses to start with, and they could continue to use the branch networks of their affiliated commercial banks as a way to source customers.

NCB Capital, for example, came out of National Commercial Bank, and was the first investment banking arm of a local institution to be approved by the CMA in 2007. Among other things, this group was behind the Al Ahli mutual fund range, which remains the biggest in asset terms in Saudi Arabia and the region as a whole; all told NCB Capital now has over a million clients and US$15 billion under management. Al-Halabi likes to believe that “we do not rely on what we had from our parent,” and points to new funds and a discretionary portfolio management business that have been built since separation, but acknowledges “NCB were the pioneers of this business.”

Correspondingly, wealth management is the biggest growth area for NCB Capital, including asset management and wealth advisory. “We are the Kingdom’s largest manager of wealth and this is where our greatest opportunity is today,” Al-Halabi says. He also sees potential for growth in brokerage, and in underwriting sukuk issues. “It’s still a nascent market but the need to issue sukuk to finance projects and companies is growing, and there aren’t that many players focusing on that.”

Al Rajhi Capital came out of Al Rajhi, the largest Islamic bank in the world by assets. Its CEO, Gaurav Shah, tries to develop his asset management, brokerage and investment banking businesses in tandem. “The challenge for me as CEO is to ensure that we have the right business mix: enough stable annuity income from asset management and brokerage, with a healthy business pipeline within investment banking side, which is more deal-focused,” he says.

Another house with a long-established asset management business – he puts the group’s market share in Saudi Arabian mutual funds at 9.2%, with a near doubling of assets in the last two years – Shah also sees this as one of the key areas for growth. “Diversifying the client base is very important, and there are emerging new clients,” says Gaurav Shah, CEO of Al Rajhi Capital. “If you look at the west, insurance is the backbone of the asset management industry; it’s still an emerging sector in Saudi Arabia. I’m very positive about the contribution of this sector to the growth of the local asset management industry.” Al Rajhi has made a point of trying to bring international appetite into Saudi Arabia too, and launched a Saudi equities fund in Luxembourg recently on the Credit Suisse platform.

Another theme is diversification by asset class and product. “To achieve greater diversification and predictability of returns, you need a developed fixed income or sukuk marketplace combined with a multi-asset class approach to investors. It is essential for product providers such as us to offer investors this choice and a more diversified offering,” Shah says. He sees the biggest challenge in asset management not so much as other competitors, but the nature of investors themselves. “When 10 to 12 companies account for 60 to 65% of market cap, a lot of investors feel they can invest on their own. Building a managed investment culture, which asset management provides, takes time.”

To Shah, investment banking has some distance to go, though he feels advisory is a growing trend. And he believes opportunities are growing in institutional brokerage rather than just the retail area that has been the focus to date.

And what of Islamic? Al Rajhi is one of several purely Islamic banks in Saudi Arabia, and is often considered to be among the most strict Islamic institutions in the world in terms of compliance. It’s clearly a point of difference but Shah is keen to avoid that being the only selling point. “We compete with conventional and Islamic banks based on our products, people, processes and the risk-adjusted returns we aim to generate on a long-term basis,” he says. “Competition is always fierce and the product selection is always based after benchmarking with the entire industry – Islamic and conventional.”

Nevertheless, the momentum of Islamic finance in Saudi Arabia is overwhelming, particularly on the retail side (HSBC estimates 80 to 90% of retail banking product is now Islamic); with every passing year it becomes a more dominant force in the mutual fund industry. And providers say it is becoming an institutional story too.

HSBC Saudi Arabia was in the first round of newly licensed entities under the CMA, spun out of SABB, which was formerly known as Saudi British Bank. HSBC owns 40% of SABB; SABB in turn earns 40% of HSBC Saudi Arabia, and HSBC the other 60%. Walid Khoury, the chief executive of that business and formerly SABB’s treasurer, is building the business on the foundation that HSBC is both a global institution and one with a long-standing historical attachment to Saudi. “The mission as we view it is to bring international expertise to Saudi Arabia, and bring international connectivity to Saudi customers through our network.”

Khoury believes that “the deal flow does not justify that very large number” of APs in Saudi Arabia, and expects M&A among them. He notes that “the premise from which a lot of APs started – being everything to everybody – is not tenable in the long term.”

For institutions like these, it will be interesting to see how the internationalisation of the Saudi capital markets continues in years to come. It has already opened some distance: until recently foreigners could only get access to the Saudi stock market through mutual funds, and even then were restricted. Now a swap arrangement allows for synthetic exposure to Saudi securities. “In coming years there probably will be an opening,” says Khoury. “Right now foreigners can have access to the Saudi stock market through swap products, but a lot of fund managers cannot use these instruments because they are deemed as derivatives. They have to have direct access, and we believe over the next few years that will happen – with some rules, of course, like in some other markets around the world.” When it happens, Khoury says, “it will bring new institutional money, and more stability, as this money will be sticky if it is coming from long-only managers.” From that would follow entry into world stock market indices, a corresponding weight of capital, and a great deal more business for the brokerage operations of all these competing operations in Saudi.

Al-Halabi says “the opening of the market is a great thing and will expand the opportunity here,” but adds: “doing it gradually is in my view very prudent. You don’t want to create chaos in the market. We know the CMA is heading towards more openness, but you will not see it all in one go.”

At the same time, domestic institutions are becoming increasingly savvy. The Saudi Arabian Monetary Agency, the country’s central bank, fulfils some of the roles of a sovereign wealth fund but is generally conservative and fixed income-dominated in its allocations. But newer state investment entities, such as the endowment fund of the King Abdullah University of Science and Technology, are already becoming known for a sophisticated approach to questions of asset allocation and investment technique. Much of this capital will flow overseas – indeed, the whole business model of many of the foreign businesses licensed by the CMA is to assist it in doing so – but the increasing savvy of local capital ought also to support the sustainability of the industry.

For the long-standing commercial banks, less has changed. “The pace of change in commercial banking is slower than in the investment banking arena,” says Dew. There are some relatively new players – Bank Al Bilad and Alinma Bank being the main ones – while some subsidiaries of foreign banks are attempting to enter wholesale banking and develop corporate and treasury businesses, catering for the biggest companies in the country. “So there’s some level of increased competition for sure, but not as extensive as on the investment banking side.”

Here, too, the sense of growing openness is a prompt for growth. Dew is on a second stint in Saudi having been chief operating officer from 2001 to 2004. “There is no question from an economic perspective Saudi is now more open,” he says. “Trade and investment flows in both directions are significantly stronger and the core economic strategy of the country does make a huge amount of sense.” That is, at its core, an oil and gas story, with an increasing downstream element in petrochemicals, but increasingly mining and minerals are being developed along with financial, shipping and other supportive sectors. “The economy is playing to its strengths and engaging with the rest of the world on its own terms,” he says.

Across the board, there is pressure on headcount. One person who used to work at an executive level in Saudi Arabian banking considers this the biggest problem the industry faces. “The banking system remains shambolic,” he says. “There are poor levels of human capital, very high staff turnover, and high levels of absenteeism and lack of engagement, driven by Saudization [a national policy to increase local Saudi employment in the private sector], generous pensions and CMA requirements for qualified staff.” This last, he says, “should be good, but it has ignited a bidding war for the very small pool of talent. And the Arab Spring is likely to further deter new talent arriving without further pay rises.”

While bankers on the ground today agree that competition for talent is still intense, many feel that it was at its worst when the new licences were being awarded en masse between 2006 and 2008, not now. There is also widespread agreement that the talent pool is better than people think. “In Saudi there is a huge focus on education,” says Shah, “with very, very bright local Saudi talent. You have to compete to retain people, but that’s not special to Saudi: you have to create the right work culture, training opportunities and sophistication of product so you are where everybody wants to work.” Khoury at HSBC says “there is very strong competition and a strong bid for Saudi talent”, but says firms like his have developed programs to grow the available pool, hiring graduates fresh from universities and training people “to make the leaders of tomorrow. Salaries and packages have evolved normally; they’re not that different from what we might see elsewhere.” David Dew on the commercial banking side at SABB says “we continue to get a reasonably good supply of Saudi graduates: the quality is good and probably getting better every year. We do see that as talent emerges it has more and more opportunity; people can move up fairly quickly and can begin to command pretty attractive packages. The starting point hasn’t changed a great deal, but competition for talent and the leaders of tomorrow is quite intense.”

Al-Halabi agrees. “The key issue is to have the right environment for our people, their development and training, and the right compensation for the team,” he says. “New entrants with deep pockets can buy anybody. But if we, as an industry, want the financial sector to grow and be successful, everyone should be willing to invest in developing local talent.”

BOX: Saudi and regional unrest

As soon as it became clear that the protests in Tunisia and Egypt were spreading around the Middle East, investors started casting a nervous glance towards Saudi Arabia.

“The biggest risk to the market is the possibility of political unrest reaching Saudi Arabia,” says Joe Kawkabani, chief investment officer for MENA equity at Franklin Templeton Investments in Dubai. But his fears – from the perspective of investor stability – haven’t been realised. Pro-democracy campaigners announced intentions to protest on Facebook, attracting thousands of followers, but fewer turned up for protests on the ground. Subsequent attempts have attracted fewer and fewer people. The government tightened security, and – crucially – religious scholars issued statements outlawing protests in the country as unIslamic. “It’s important to note the big role the army and clergy play in the country,” Kawkabani says. “When the government, army and clergy are aligned, it’s very hard to implement change.” Behind the scenes, King Abdullah also held meetings with tribal chiefs, many of whom subsequently pledged allegiance.

To cement all this, on March 18 the King announced a series of measures designed to head off any dissatisfaction before it got going. He set a new minimum wage of R3,000 (US$800) for all Saudis – a 38% increase; announced a bonus of two months wages to all government employees and students; new unemployment benefits; 60,000 new jobs in the military; and funds to construct 500,000 new social housing units. In total, it has been reported that these measures involved some $93 billion of spending. And this all followed $37 billion of handouts the previous month. “The reaction on the streets was overwhelmingly positive,” says Kawkabani. “The next day was a public holiday and people were driving around waving pictures of the king.”

None of this is the democratic reform that has been called for in other Middle Eastern states, but it appears to have been enough to keep the population content for the moment, and does have broader economic knock-on effects. “It’s beneficial to the economy and will promote consumption and bank lending,” says Kawkabani. “The only downside we can see is wage inflation across the country.”

With a soaring oil price and foreign exchange reserves of over $400 billion, it’s not hard for Saudi to spend its way out of trouble. And few on the ground feel any sense of political change. “What’s happened in the region in the last three months does impact investor sentiment, but we strongly believe the fundamental outlook and trend over the next four to five years in Saudi Arabia remains solid and has not changed,” says Shah.

Al-Halabi agrees. “With all these things that have been happening around us, I was worried we would see flight of capital,” he says. “On the contrary, we have seen little of that.” And Dew at SABB speaks of “a mood of cautious optimism and stability. There are headwinds but there are more reasons for a positive than a negative outlook, and the sense is that is mirrored by our customers.”

Qatar is just weeks away from finding out if it will be included in the MSCI Emerging Markets index – a potentially pivotal event not just for the country’s stock market, but the whole GCC region. The Gulf has long been an oddity in index terms: prosperous, developed and resource-rich nations that don’t feature in major world benchmarks. Finally, the anomaly may be about to be corrected.

Gulf markets have been missing for a variety of reasons. Saudi Arabia, much the biggest and most liquid, can only be accessed by foreigners through a swap structure, which counts it out of major indices. Kuwait has accessibility issues too; and most of the rest have been deemed too small, too young, and often restricted as well.

But last year MSCI served notice that things could be about to change. The index provider reconsiders where countries fit in its indices once a year in its annual market classification review, completed at the end of May each year and announced in June; any changes then take effect a year later, giving markets and fund managers time to adjust. Last year, MSCI declined to move Qatar and the UAE from its frontier markets index, where they reside today, to the closely-followed emerging markets index. But it declined in such a specific way that the signal was very clear: deal with the issues we’ve identified, and you’ll be in next year.

In Qatar’s case, MSCI highlighted two things: strict foreign ownership limits (there is a 25% ceiling), and the frequent use of dual account structures, with segregated custody and trading accounts. The use of these structures, MSCI said, “because of unlimited access by local brokers to trading accounts remains an issue that needs to be addressed for the market to meet emerging marker standards.”

There’s a lot to be gained from market inclusion. Ryan Salam at Franklin Templeton Investments estimates that Qatar would take up 62 to 100 basis points of the MSCI Emerging Market Index if included, and since about $400 billion of institutional capital tracks the fund, that would translate to $2.5 billion to $4 billion of capital coming into Qatar (the UAE, by contrast, would get about $1 to 1.5 billion). “If you look at the last six months trading, that translates to a 70 to 100% increase in traded value in Qatar,” he says. “And if you assume all emerging funds are to track the index you can more than double those numbers.”

Qatar Exchange could clearly see the opportunity, and set about a review of its market infrastructure, upgrading its trading technology in September and then announcing a key new reform on March 17. This is the adoption of the Delivery Versus Payment (DVP) rules. These rules allow custodians to participate in the cash settlement cycle, and to confirm or reject trades for settlement, with rejected trades remaining with the broker for settlement. This means that custodians have full control of their securities – and so the dual account structure that MSCI objected to becomes optional (though it is not being removed outright). This was clearly done to comply with MSCI concerns – indeed, the potential upgrade was explicitly mentioned in the exchange’s March statement – and will be followed by other reforms: the exchange mentions a central counterparty, direct market access through sponsored access, securities lending and borrowing, margin trading and covered short selling as possible further innovations. “I strongly believe that Qatar will be included to the classification this year,” says Abdul Hakeem Mostafawi, country head for HSBC in Qatar – which, as the only custodian bank in the market, has been instrumental in the reform process and has been working with Qataris public institutions on the MSCI issue since 2007. “Every passing year the market has improved its systems and possesses growing investor confidence. The Qatar market has been able to live up to its promises and has been able to deliver on time.”

There hasn’t, though, been any mention of a change in foreign ownership rules, which is partly because it’s not the exchange’s place to change them. Instead, some close to Qatar believe that the foreign ownership limit could be lifted – perhaps to 49% – by an Emiri decree before the end-May deadline, that being the quickest way to get such a change through. Others are less sure. “There is still sufficient headway for foreign investments,” says Mostafawi. “I am confident during the coming months listed companies will work on improving their foreign ownership levels. Increasing the foreign ownership levels freely could have an adverse impact on the entire market. Therefore it has to be done systematically.” But others feel that, particularly if foreign ownership is perceived to be a deal-breaker, Qatar’s rulers are likely to think raising the limit a sacrifice worth making.

Salam says it’s not the end of the world if Qatar is not included. “There hasn’t been much chatter about it until last week, and it hasn’t been priced in,” he says. But it has become another reason for more and more investors to start to look more closely at the island state. Until now, global fund managers with any interest in Qatar – or any Gulf market – have had to express it through an off-index bet, which is a risk and an effort. Inclusion would not only alleviate that effort but also make it essential for global emerging market managers to consider the market. Under that arrangement, omitting Qatar would become the off-index bet instead.

Qatar has found itself in something of a sweet spot, and sometimes for unexpected reasons. The headlines are well known: one of the world’s largest bounties of natural gas, 16% GDP growth in 2010 which the IMF expects to grow to 20% in 2011, compound annual growth rates of 40% and 53% respectively in imports and exports between 2006 and 2009, and a diversification strategy anchored by $145 billion of projects over the next seven years. That’s before one considers the trophies: the successful World Cup bid for 2022, and the somewhat brazen asset-gathering approach of its sovereign wealth fund, the Qatar Investment Authority.

But on top of that, unrest elsewhere in the Middle East has, if anything, served to help Qatar so far, particularly in comparison to neighbouring Bahrain, which until this year had built much of its prosperity on being a peaceful entrepot through which to serve the far bigger economies of Saudi Arabia and Kuwait. When the region’s landmark asset management conference, Fund Forum, announced that this year for the first time it will be held not in Bahrain but in Doha, it underlined the sense that Qatar (like the UAE) has been able to gain some of that stable and steady reputation. Qataris are, to be blunt, absolutely loaded: the country had the world’s highest per capita GDP in 2010, according to the IMF, and the wealth is distributed more widely than is sometimes the case elsewhere, with housing grants upon graduation, free land and amenities and almost 100% employment rates. There is little reason to revolt in such an environment, but the Prime Minister has nevertheless announced some changes in the elected parliament system to head off challenges; unlike Bahrain, it doesn’t face the issue of a minority group ruling over a majority (in Bahrain’s case, Sunnis ruling a majority Shia population).

“In my view, political stability in Qatar is very positive and will continue for the foreseeable future,” Mostafawi says. Indeed, following on from Qatar’s role hosting peace talks about Libya, he believes the country may be gaining a role as a moderator and mediator. While not all are quite so optimistic, there’s no question Qatar has escaped much of the unrest elsewhere in the region. Youssef Nizam, head of equity research at Audi Capital Saudi Arabia, sees the country’s size and GDP as clear assets. “They have deep pockets to tap, and with a small population it might be easy to minimize – not avoid, but minimize – political risk coming from unrest,” he says.

Nizam has made Qatar his key overweight. “The major reason is the GDP growth,” he says. “Qatar has made huge investments into the natural gas business and many investments are starting to materialise now and will be reflected in the economy. It is a country rich with resources but small enough to be able to deploy those resources within the country: a small prototype that is easily manageable compared to other countries in the region.” With MSCI inclusion, Nizam says, “definitely the multiples will tend to expand. It will be more covered by foreigners and Qatar will have its share of the huge inflow of funds that tracks the index. It will definitely be a positive catalyst.”

This coverage point is one of the many slow-burning benefits inclusion would bring, and in some senses the main one. “A lot of people are already cognizant of how attractive Qatar is economically,” says Emad Mansour, CEO of Qatar First Investment Bank, “so I’m not sure it’s going to lead to a major movement of assets into Qatar in the short term. But in the medium to long term I think it means the market becomes more in focus, with more companies covered by the big brokerage houses.”

MSCI inclusion would also be a major shot in the arm for the Qatar Financial Centre, which has so far not attracted the same volume of foreign institutions as has the Dubai International Financial Centre (though whether the DIFC has succeeded in bringing in much foreign capital, as opposed to helping foreigners to take capital out in the other direction, is a different question). The QFC shifted its focus some years ago to a focus on insurance, reinsurance and asset management, and on the last of these MSCI inclusion would clearly help. “Developing Qatar as the pre-eminent hub for asset management in the region is one of the Qatar Financial Centre Authority’s key strategic objectives,” says Yousuf Al-Jaida, director of strategic development for asset management and banking at the QFCA. “Qatar’s accession from frontier to emerging market status would therefore be hugely beneficial in delivering that aim as well as a big endorsement of what has already been achieved in Qatar developing world-class regulatory and financial market infrastructure.”

Al-Jaida says allocations to MENA-wide assets are going up already, and that MSCI inclusion “will clearly add a lot of momentum to Qatar’s financial services industry. We expect the long term upside for volume growth in assets management out of Qatar to be significant, beyond the direct benefits to the Qatar Exchange itself in terms of liquidity and capital inflows.”

BOX: Knock-on effects

If Qatar does get MSCI approval this year, it may well be joined by the UAE. Last year MSCI said it “continues to be encouraged by the planned future enhancements by the Emirati regulator,” which included increased foreign ownership limit levels, equal foreign access to the local equity market, and a DVP settlement system like Qatar. MSCI noted, though, that “these future enhancements were announced some time ago”, and that “international institutional investors are hopeful that [financial turmoil] will not bring any further delay in the implementation of the proposed enhancements. Investors would also welcome a public roadmap from the regulator and the exchanges providing visibility on the timetable of implementation of these changes.”

At the time of writing, the UAE was continuing to make the right noises but appeared to be behind Qatar in implementing changes. It is now running short of time, but fund managers in the region think the benefits of inclusion are such that the necessary changes will be made. The fact that the UAE has historically had three separate exchanges adds some complexity but is not considered likely to be too problematic as the MSCI has never raised it as an issue before.

An interesting question is whether the demonstration effect of new inflows coming into Qatar or the UAE, if included, could prompt others to act. Kuwait used to be considered a likely candidate for index inclusion, but the MSCI last mentioned it as a candidate in 2009, and then said access restrictions were too difficult. Might Kuwait change those restrictions in order to join GCC peers in the market?

But the bigger question is about Saudi Arabia – by far the largest economy and stock market in the Gulf. There has been a gradual opening up of the Saudi market to foreigners: where once they could only get access by buying mutual funds (and even then under some restriction), they can now get exposure to Saudi stocks through swap arrangements. This is some way short of the direct access that index providers would require, but clearly a step in that direction.

If Saudi did further liberalize, there would still be one headache to resolve: the fact that MSCI and Saudi Arabia are scarcely on speaking terms following a dispute about commission, royalties and licence approvals. That, though, is probably an argument for another day.

Best bank in the Asia region: CIMB Islamic

With activity in the Gulf having been so subdued since the Dubai near-default in 2009 – and, more recently, upheaval in the Middle East – the bank that leads the way in Asia has its strongest ever claim to be leading the way worldwide too. Step forward CIMB Islamic, whose market share as an underwriter of global Islamic sukuk, based on Dealogic’s numbers, hit a remarkable 24.2% in the 2010 calendar year.

Sukuk are clearly not the only way one should judge an Islamic bank, but they provide the most international comparable criterion for influence in the global Islamic markets. And apart from being pm the most deals, and dominating global volume, it was on the deals that mattered. It was, for example, the only regional lead manager (the others were Barclays Capital and HSBC Amanah) on the pivotal US$1.25 billion five-year sovereign sukuk from Malaysia in May, which was the largest ever dollar sovereign to issue Islamically, and came in the middle of the sovereign debt crisis in Europe, hitting a $6 billion order book with more than a quarter of demand coming from the Middle East.

CIMB Islamic is full service, from investment banking to consumer banking and asset management, discussed in more detail in the Malaysia award. But the asset management arm in particular cements the sense of an institution that is regional more than local. CIMB’s Islamic asset management offering runs alongside the CIMB-Principal Asset Management business, jointly owned by CIMB and the vast 130-year-old US house. And almost everything it announces these days has a regional bent: the absorption of Thailand’s BT Asset Management into the CIMB-Principal business in August, allowing CIMB to sell a full range of mutual funds into Thailand, including Islamic; the launch of the CIMB Islamic Global Commodities Equity Fund last year, which gave exposure to Shariah-compliant global equities benefiting from commodity demand. It is one of the world’s leading Islamic asset managers.

While many of its most notable efforts have been domestic, some of them have a global impact. CIMB Islamic CEO Badlisyah Abdul Ghani was instrumental in the development of the Bursa Suq Al-Sila’, the world’s first Shariah-compliant commodity trading platform, which is attempting to streamline commodity trading – and, through it, bank liquidity – across the Islamic world. As a lender, some of its most significant deals have been for multinationals, notably a 12-year $100 million loan, structured around the bai’ al-inah form, for Hewlett Packard in October. And then there are the bricks-and-mortar investments CIMB has built in the Islamic world, from its Bank Niaga stake in Indonesia to its ventures in Bahrain and Brunei. Malaysia wants to be a global hub for Islamic capital, and CIMB more than any other Malaysian bank is its flag-bearer.

Best bank in Malaysia: CIMB Islamic

CIMB Islamic continues to impress in domestic Islamic banking in Malaysia. There are banks that can compete on branches, or assets, or number of mutual funds, or research, or advisory, but it would rarely be the same bank twice. What stands apart with CIMB Islamic is that it is either the leader or a close second in every area from investment banking to consumer and asset management.

We don’t yet have the 2010 full-year numbers, but as of September 30 CIMB Islamic had RM34.8 billion in total assets, a 27.4% increase in just nine months, and entirely in keeping with the stellar growth of a business that had just RM0.5 billion as recently in 2005. Deposits (R0.4 billion in 2005, RM21.25 billion in September) tell a similar story, but actually one can look at any metric in the business – total gross financing, home financing, hire purchase – and see the same picture. And that’s just the consumer side.

In investment banking, CIMB clearly stands supreme in sukuk – with its role on the US$1.25 billion sukuk for the Malaysian sovereign, discussed above, the clear standout – but is also powerful on the equity side, with Shariah-compliant deals including Petronas Chemical Group and JCY International during 2010. It continues to win the important domestic sukuk deals too: a bookrunner role on a RM1.1 billion sukuk for Pembinaan BLT, a state-backed issuer, in January is illustrative.

Whether in esoteric capital markets or mum-and-dad personal finance, CIMB continues to innovative. The ijarah concept is gaining in popularity in Malaysia – previously it was mainly a Gulf staple – and in 2010 CIMB applied it to home financing for the first time in Malaysia, through its Ijarah Property Financing-I product. Its RC-I CM product is a Shariah-compliant revolving credit facility based on commodity murabaha. And then there’s the excellence in Islamic asset management, discussed in more detail in the regional award, as is the bank’s support for the Bursa Suq Al-Sila’ commodity trading platform. In credit cards, financing, wealth management, transaction banking and treasury there is a full-service range of products available and most of them have included some market firsts.

For all that, investment banking is still seen as CIMB Islamic’s strongest suit, and in that respect its immediate prospects are somewhat dependent on both the debt and equity markets, and their appetite for new issuance. But Badlisyah Abdul Ghani runs a business that has consistently stayed ahead through innovation and steady growth, and has seen off tougher markets than this one.

Best bank in the Middle East; Best bank in Saudi Arabia: Al Rajhi Bank

The world’s biggest Islamic bank, Al Rajhi continues to be considered the leader not only in Saudi Arabia but the Middle East region. It is, by Islamic banking standards, vast: at the end of 2010 it had total assets of SR184 billion, upon which it generated profits of SR5.1 billion for the first three quarters of its 2010-11 financial year. Its three million customers give it half of the national consumer finance market in Saudi Arabia.

Al Rajhi was, until very recently, just a Saudi Arabian story, but that changed in 2006 when it moved into Malaysia. It did so in a big way, and has 20 branches already, with plans to open many more. Unlike Kuwait Finance House – its obvious rival for the title of best bank in the Middle East – Al Rajhi opted to go into Malaysia with a full service offering, with all of its core banking products including retail. It is a grand ambition that can only be attempted with deep pockets.

With critical mass attained in Malaysia, Al Rajhi has now turned its attention to its own region, with approval gained in 2009 to open branches in Kuwait and Jordan. Kuwait has been the first to get underway, and again Al Rajhi says it has gone in to “serve all the needs of its retail and corporate clientele,” suggesting a full service offering in due course. In 2010 Al Rajhi announced plans to open five branches in Jordan within a year.

Still, there’s no question Al Rajhi is chiefly a Saudi story; the reason it qualifies for a regional award is in large part because Saudi matters more than almost all other Middle Eastern markets put together. Within that market, Al Rajhi excels on every metric: assets, profitability, headcount, customer base, branches, points of sale and lending.

More than sheer scale, it continues to launch new products and be innovative. Cash management and trade finance services, both undergoing electronic revamps, had excellent years in 2010. And the bank led a new Shariah-compliant bond, sukuk al-amanah Li al-Istithmar, in Malaysia. This is worth looking at in some detail: Al Rajhi was a lead manager on this RM5 billion debt programme by Cagamas, the Malaysian national mortgage company, starting with a RM1 billion print. It was structured in such a way as to be tradable in the Middle East, which generally takes a more conservative stance towards sukuk than do the Malaysian markets. Correspondingly, 33% of the deal went to the Middle East, much higher than usual. This raises big possibilities for further cross-border, cross-tradable deals.

Al Rajhi is, too, one of the strongest players in asset management in Saudi Arabia, although the stand-out in that area is NCB Capital and its Al-Ahli range.

Best bank in Qatar: Qatar Islamic Bank

QIB is the clear leader in Islamic banking in Qatar: impeccably connected to the state and top institutions, and with a critical mass that is going to be tough for anyone to compete with domestically.

Islamic banking is relatively powerful in Qatar: 31% of the total market, accounting for QR149 billion in total assets as of December 2010. Within that, QIB accounts for 35% of the Islamic pool, and 11% of the total banking assets of Qatar overall (and 30% of financing).

The bank has built its name on project and real estate financing, both in the public and private sector. It has funded many of the significant infrastructure and real estate projects in Qatar in recent years, including a record QR4 billion syndicated Islamic facility for the Qatari Diar development group; financing for Qatar Airways; a 25-year US$250 million facility to build a power and desalination plant, and US$150 million on a similar financing for the construction of the RAF A1 desalination project; financing for Qanat Quartier, within the landmark Pearl development; and The Gate construction project, a mixed use real estate project in Doha’s West Bay.

But in recent years it has grown considerably in consumer business too, having moved from one branch in 1983 and eight in 2005 to 28 today and 35 by 2012.  A recent example of innovation in this area was its Hemaya investment product, a Shariah compliant investment vehicle that has proven enormously successful in Qatar.

Like several other of the bigger Gulf institutions, QIB has sought to expand beyond its home boundaries in recent years. It is the key shareholder in Asian Finance Bank, one of the three Gulf institutions that went into Malaysia with full-service licences in the middle of the last decade (the others are KFH and Al Rajhi); it is also a key shareholder in Arab Finance House, in Lebanon; and has interests in Indonesia, Yemen, Syria and the UK, as well as plans in France, Turkey and Kazakhstan. It has also signed a memorandum of understanding with Woori in Korea and BPCE in France.

QIB has the best possible local backers, since the QIA – the country’s sovereign wealth fund – is now the bank’s largest shareholder. This will help strategically and in expansion. It also has muscle: authorized capital of QR2.1 billion at the end of 2010; QR51.8 billion of assets (32% year on year growth); customer deposits and absolute investment deposits of QR30.3 billion (up 49%); and a financing portfolio of QR29.3 billion, up 30%. Return on average equity was 17.9% in 2010, and capital adequacy stands at 17.4%.

This strength helped QIB launch its debut international sukuk in 2010, a US$750 million deal that attracted some US$6 billion of demand.

Best bank in United Arab Emirates: Dubai Islamic Bank

You wouldn’t call Dubai Islamic Bank a business that is shooting the lights out, but it’s still the obvious leader in UAE Islamic banking. Where other Islamic banks around the world boast double digit growth rates, often more than 20%, DIB’s deposits are steady and assets (at just under AED90 billion) growing around the 7% mark annually. But then again, this is the first true fully-fledged Islamic bank, formed back in 1975, so perhaps it’s unreasonable to expect lung-busting growth every year.

It tells you something that, after the AED806 million profit number, the first figure DIB highlights in its 2010 results announcement is provisions, bulked up by AED864 million over the year. That’s a reflection of a crushingly difficult business environment in Dubai, though most in business there feel is a feeling the worst is over. Still, in that environment DIB logged a net operating income (before those provisions) of just under AED 1.9 billion, showing that the well-established core businesses continue to do what they’re meant to.

The simple things worked for DIB in 2010: a focus on balance sheet strength and growth in the retail franchise. DIB upped its presence to 68 branches nationwide in 2010, with six new ones during the year, serving 1.2 million customers in a country whose rather fluid population is usually around the four million mark. Retail accounted for 49% of group revenues in 2010. Perhaps the most salient figure on the whole DIB balance sheet at the moment is the capital adequacy ratio of 17.8% under Basel II, a key differentiator in these uncertain times. Both Moody’s and Fitch upgraded their outlooks on the bank in 2010 (it publicly parted ways with S&P) and at the time of writing it was believed to be the only major bank in Dubai with a stable outlook from both.

Like many of the highlighted Middle East banks in this report, DIB has impeccable connections: its chairman is Mohammed Ibrahim Al Shaibani, whose day job is director-general of His Highness The Ruler’s Court of Dubai. And it’s also in a position to take advantage of lower asset valuations and grow where prudent, which it did in 2010 by increasing its stake in Tamweel, the Islamic home finance provider, to 58%, becoming the majority shareholder. And even in a conservative year, there was still scope for innovation: DIB was behind Emirates REIT, Dubai’s first real estate investment trust, and launched a new personal financing product, Al Islami Salam Finance, and a host of takaful products. Finally, its Dar Al Sharia consultancy and advisory subsidiary has gone from strength to strength, under the guidance of UAE uber-scholar Hussain Hamed Hassan.

Best bank in Kuwait: Kuwait Finance House

By far the biggest Islamic institution in Kuwait, KFH is also one of the Middle East’s few true international players. The regional award is always a choice between KFH and Al Rajhi.

KFH has grown steadily over the last decade, outpacing its native Kuwait. Its asset base, which stood at KD2.4 billion in 2001, was KD12.5 billion by the end of 2010, making for an annual average growth rate of 18.1%. Deposits are up fourfold, to KD7.6 billion, over the same period, and shareholders’ equity six times over to KD1.29 billion, an 18.3% annual growth rate. Net profits have been less dramatic in their growth rate, but have nevertheless doubled over the last decade and stood at KD106 million in 2010.

Bader Abdul Muhsen Al-Mukhaizeem, the chairman and MD, described 2010 as a year of “consolidation and cohesion” for KFH, as it was for many in the Gulf. It shifted investment – both in terms of its own portfolio and its offerings to customers – towards fixed income, low risk, high-liquidity opportunities; it continues to build its consumer business, launching a new family card, the Al-Ousra, in 2010; and it is a long-standing leader in real estate and aviation finance. It is considered to have one of the best electronic systems in the region, manifesting itself both at the treasury level and the individual, with various new smart mobile offerings launched during the year; it’s also evident in revamped credit procedures, anchored around a new documentary credit system called Trade Wind.

Just as Al Rajhi has opened in Kuwait in 2010, so its regional rival is doing the same in reverse. Saudi Kuwait Finance House is up and running and has received a licence to provide a SR500 million real estate investment fund. KFH has long-standing strength in Turkey, which it continues to build upon, launching a new gold investment fund through the Istanbul stock exchange during 2010. It also has branches in Germany and Dubai, as well as its KFH Malaysia and Bahrain businesses, which have eight branches apiece.

KFH is the second-largest Islamic bank worldwide by assets, and continues to impress in the region for its financial strength. Fitch gives it an A+ long-term rating, S&P A-, and Moody’s Aa3. Capital adequacy ratios (14.22% total, and 14.15% tier one, as of December 2010) are down slightly from 2009 but still well above the regulatory minimum of 12%.

BRUNEI: Bank Islam Brunei Darussalam

Competition is not especially fierce in Brunei, the less so since two of the main Islamic banks in the country, Islamic Bank of Brunei and Islamic Development Bank of Brunei, merged to form Bank Islam Brunei Darussalam. BIBD wins the title: in a small country, 14 branches and 600 staff is plenty enough to be dominant. Add its two subsidiaries – Takaful BIBD, which offers Islamic insurance, and BIBD Al-Tamwil, which offers hire purchase financing for vehicles and consumer products – and the group has more or less cornered the market.

For a modest domestic customer base, BIBD is pretty much full service. Its BIBD Securities arm handles brokerage to help its nationals invest in Shariah-compliant equities in Kuala Lumpur and Singapore; its investment banking division has been building an asset and fund management team steadily since the merger; and it offers corporate advisory, wealth management, investment and retail services.

There are more dynamic institutions in the Islamic world than BIBD: the most recent financial statements on its web site date from 2008 and its news section is a host of releases on blood donation campaigns and Toy Story 3 promotions. But still, BIBD is in an interesting place. Brunei has long since wished to diversify away from oil, and set up its Brunei International Financial Centre in 2000, where growth has been modest but the penetration of Islamic banking has been around 40% of total assets – much higher than most other nations. Since the announcement of a banking and insurance order in 2006, and a takaful order in 2008, the legislative environment is now in place, and there is a Shariah financial supervisory board now established at a state level. If Brunei does succeed in making itself a hub for Islamic capital, then nobody is better placed for the opportunities than BIBD.

The bank is also growing steadily. In January it reported a 14.8% rise in profits for the previous financial year to B$101.99 million (though it tells you something that the figures from that January AGM were from 2009). It has B$4.42 billion in total assets, and it has been appointed as a joint lead on some significant sukuk issues by issuers including Islamic Development Bank and General Electric Capital Corporation.

Pakistan: Meezan Bank

Meezan Bank, the first and largest Islamic bank in Pakistan, consolidated its hold on this award over the last 12 months. Firstly, it makes a compelling case based on scale: in January it announced its 222^nd branch across 63 cities in Pakistan. Irfan Siddiqui, president and CEO, has always talked of providing quality Shariah-compliant banking “to every citizen of Pakistan at their doorstep”, and that vision moves closer by the day; some achievement, since when he started saying it eight years ago, it was the smallest bank in the country. It also has the best (local) rating among Islamic banks in the country, at AA.

Secondly, its results are consistently strong. In February it announced its full-year results for 2010, with 61% growth in net profit for the year to Rs1.65 billion. Earnings per share were comfortably up, deposits grew 31% to Rs131 billion, and investments increased 139% to Rs 55 billion. Shareholders received 15% bonus shares in an effort to boost paid-up capital to Rs8 billion (the State Bank of Pakistan had earlier declared a Rs7 billion minimum, a requirement Meezan has now met a full year earlier than scheduled).

Other developments during the year included setting up a new car financing partnership with Indus Motor Company, and the launch of a new Mudarabah-based business account called Meezan Business Plus. It is also an increasingly successful asset manager.

There is huge opportunity in being the biggest Islamic bank in Pakistan. The country has one of the biggest domestic Muslim populations in the world, interest in Islam is clearly increasing – with more and more people wanting to invest their money in keeping with their faith – and individual wealth is climbing too. As more and more people shift from conventional to Islamic banking products, Meezan is ideally placed to benefit.

Indonesia: Bank Syariah Mandiri

The market for Islamic finance in Indonesia, while little developed, is becoming extremely competitive, with five new commercial Islamic banks licensed over the last 18 months in addition to the entrenched players. Of those who have been here longer, two compete in terms of assets, brand and overall standing: the Shariah versions of Bank Mandiri and Bank Muamalat.

A case can be made for both, but we have opted for Mandiri, which is starting to bring the strength of the conventional parent into its Islamic operations too. It is the national leader in assets – in the third quarter of 2010, it had Rp28.05 trillion in assets, up from Rp22.04 trillion at the end of 2009. Profits are still modest, at Rp291 billion in 2009 (the most recent full-year figure yet disclosed), but that’s still a fourfold increase since 2006 and the trajectory is encouraging. It had already beaten that figure in the first nine months of 2010, earning Rp320 billion.

Mandiri has had time on its side: it has had a designated Shariah team ever since the merger that created the overall Bank Mandiri back in 1999, and Bank Syariah Mandiri was formed the same year. It claims some 513 offices operating in 33 Indonesian provinces – one would imagine this involves some overlap with the broader network, but it’s not simply a statement of the overall Mandiri branch count, which is over 900. As a free-standing Islamic entity it has, for example, 220 ATMs in its own right, and claims a staff headcount of some 7,000 in September 2010, although again it seems likely there must be some overlap with the parent in that number.

BSM was upgraded by Fitch in early January to AA(idn); Fitch also upgraded its subordinated Islamic bond from 2007. These upgrades were chiefly predicated on the support from Bank Madiri itself, which put in Rp200 billion over 2008 and 2009 and is believed to be adding an additional Rp400 billion this year in order to bolster the Shariah bank’s capital adequacy ratio to 12%.

Like Islamic finance more broadly in Indonesia, BSM hasn’t done a whole lot so far but shows potential. Fitch, in its upgrade, noted robust financing growth, higher financing yields, a satisfactory deposit mix, and a falling (but still high) non-performing financing ratio (4.2%). It also has a healthy 117.5% provision cover. In the year ahead the bank is expected to expand its micro and SME portfolio in order to lower the concentration risk it faces through corporate financing.

Bahrain: Al Baraka Banking Group

At a time when one of Bahrain’s biggest and oldest Islamic banks, Bahrain Islamic, was announcing a BD39.7 million (US$105 million) loss for 2010, its rival Al Baraka was announcing a $193 million net profit, up 15% year on year. While other banks in the increasingly troubled kingdom have shrunk, Al Baraka’s total assets went up 21% to $16 billion. While others have stopped lending and investment, finance and investments at Al Baraka rose 21% to $11.4 billion.

Customers are getting the message too. Deposits and investment accounts were up 23% to $13.6 billion at the end of 2010, a clear sign of confidence.

Al Baraka chairman Shaikh Saleh Abdullah Kamel attributes the relative strength of Al Baraka to “a model that reflects the true values of Islamic banking and far-sighted business strategies,” which may or may not be a suggestion that not everyone has stuck to those true values and is now suffering accordingly. But it certainly hasn’t come at the cost of expansion: Al Baraka is arguably Bahrain’s most outwardly ambitious Islamic group, and now has 370 branches across 13 countries. In 2010 it opened a new commercial bank in Syria, and launched a new head office for its Turkish business. In October, it completed a merger with Emirates Global Islamic Bank Pakistan and so was able to turn its existing Pakistan branches into a local commercial bank, creating an entity with US$710 million of assets and 89 branches across the country. Next up: Libya – although it’s possible that might now be on hold for a while. Nevertheless, it expects the total number of branches worldwide to hit 500 within the next three years.

Back home, it remains a powerful and comprehensive bank with a full range of operations on the retail and commercial side. It has revamped HR, technical and operational infrastructure, and is working on joint financing of new projects with the Islamic Development Bank.

At the time of writing, with the Saudi army crossing the causeway to Manama, it was not clear just how events were going to pan out in Bahrain. “Not now,” said one person in Bahrain when asked for their opinion on the best Islamic bank. “There are gunshots in the back garden.” Bahrain has built itself on being a hub of stability and reason, and a loss of that status would have an immense impact on businesses there. But, set up in Bahrain in 1984, Al Baraka continues to look one of the strongest names in the country and the region.

Revolutions give power to ordinary people. They make for great TV: what is more enthralling than a country finding its popular voice?

But markets hate them.

The scenes playing out in the Middle East right now are truly momentous and will change the shape of the countries affected forever. At the time of writing, Tunisians and Egyptians had brought down their governments, and Libyans were attempting to bring down theirs in a situation so violent it borders on civil war. In Bahrain, Yemen, Iran and Jordan, protests of varying magnitude (met with state responses of equally varying magnitude) have taken place. And even in places where major protests have not been launched, many governments have set about modest reform in the hope of stopping the same thing happening there, notably with an uncharacteristic redistribution of state wealth in Saudi Arabia.

A remarkable time. But from the point of view of the emerging markets investor, it’s not all good news, for several reasons.

Firstly, a shift to democracy is almost universally seen as a good thing for a country’s population, and ultimately (though countries like China would of course disagree with this) for the country’s overall prosperity.  But it doesn’t happen straight away. Look at Indonesia: it was, under Suharto, quite the emerging market darling, a magnet for foreign investments into power and infrastructure despite being far from democratic. The people got their way, and Indonesia is hailed today as a model for how democracy can work; the economy is buoyant and the market soaring. But it took a decade of pain and underperformance for that to happen. It’s reasonable to assume that, while what’s happened in Egypt is good news for Egyptians, it could take just as long for that to manifest itself in robust economic performance.

The truth is, there are countries in the world that the west likes trading with and investing in precisely because there’s no spectre of a change of government. Singapore is the classic example: since the government isn’t going to change in this generation, people know there’s no threat to its free-market environment, no danger of an unexpected change in the rules of engagement. To varying degrees, the autocracy of China, the United Arab Emirates (which is home to Dubai and Abu Dhabi) and Vietnam have suited foreign investors just fine. Look what happened when Malaysia, after 40 years of unquestioned one-party rule, finally developed a credible opposition party which won one third of the seats in a general election two years ago: foreign capital fled the country and the markets sank. Markets hate change.

One might argue that developments in the Middle East affect nobody’s portfolio here in Australia. Superficially, that’s probably true. A handful of emerging market funds might hold a big Egyptian stock like Orascom Telecom, but generally the Middle East occupies a tiny part of emerging markets portfolios, which are overwhelmingly tilted towards Asia, then Latin America, then Eastern Europe, then South Africa, with the Middle East and the rest of Africa last. In particular, Gulf markets such as Saudi Arabia, Kuwait and the UAE don’t feature in the MSCI Emerging Markets index, and as a consequence most international fund managers don’t feel any need to monitor those markets or invest in them.

But the problem is, global capital behaves in odd ways, and has a frustrating habit of treating all emerging markets as a single bloc – when something unpredictable happens in one, it tends to impact sentiment to all of these far-flung countries. That’s patently absurd, but it is exactly what happens, and it’s happening again now, with money leaving Asia – which certainly is a significant part of Australian investments – rather than just the Middle East. A Bank of America Merrill Lynch survey in March found that allocations to emerging market equities faced their sharpest ever one-month fall in February of this year, with only 5% of global fund managers now overweight emerging market equities compared to 43% in January. And according to the fund flow tracking group EPFR Global, in the year to February 28, US$6 billion of institutional money left the Asia ex-Japan equity markets, and US$1.5 billion left China country funds alone. Melbourne-based IG Markets analyst Ben Potter notes “a resumption of the ‘risk-off’ trade, with money flowing from riskier assets and currencies into perceived safe havens.”

This isn’t all about Middle East tension: other problems have been a perceived overvaluing in emerging market equity at the start of the year, concerns about inflation in Asia and the measures central banks might use to deal with it, and in particular rising food prices. Also relevant is the fact that many managers think developed markets, particularly the US, are finally ready to grow again and present a better risk-return trade-off than emerging markets. “Asia’s markets have had a dismal start to 2011, with equity, bond and even currency markets barely holding their heads above water,” says John Woods, chief Asia strategist at Citi Private Bank. “A widely held view that higher food prices – and now higher oil prices, caused by unrest in the Middle East and North Africa region – will elicit a tighter fiscal and monetary response from policymakers has provoked a sharp movement of institutional investment money out of the region.”

“The severity of the recent correction suggests investors are concerned – even convinced – that higher food and energy prices could upset Asia’s growth and further stoke inflation,” Woods says. “This is in sharp contrast to last year, when they were more positive about growth than they were concerned about price pressures or value.”

Another problem is that events in the Middle East clearly have an impact on the oil price, which has knock-on effects of its own. “We think what is happening in the MENA [Middle East and North Africa] region matters and that markets are increasingly vulnerable,” says Wood’s colleague Richard Cookson, global chief investment officer. “Not because higher oil prices are an inflation threat in the longer term, but because they threaten growth.” Correspondingly Citi Private Bank is reducing risk in its portfolios, and was already underweight Asian equities even before the unrest in the Middle East.

Similarly, Nomura analyst Rob Subbaraman argues that fuel prices could push food prices higher, which is also bad for Asia. “If the flare-up in MENA intensifies, the likely further run-up in commodity prices could impart a sinister supply-side shock to much of Asia, hurting growth and exposing vulnerabilities,” he says, highlighting India, the Philippines and Vietnam. Asia doesn’t export all that much to the MENA region: India has the highest exposure, with 21.2% of merchandise exports in 2009 going there, according to Nomura, but most are at around 5%. “The far more important channel through which Asia’s economies would be affected is a continued surge in oil prices and, quite plausibly, food prices too,” says Subbaraman. “Given that spreading social unrest in MENA was triggered partly by high food prices, governments around the world have more incentive to shield the poor by controlling food prices, providing food subsidies, restricting trade and stockpiling.” This tends to exacerbate supply-demand imbalances; within Asia, he suggests Hong Kong, Korea, the Philippines, Taiwan, Singapore, India, Japan and China are all exposed to worsening trade positions from further rises in food and energy prices.

So what does all this mean for investors? Mainly, that just because you don’t hold any Middle Eastern stocks through your managed funds or your super, it doesn’t automatically mean that you’re not exposed. Emerging markets can have the best story in the world – and, over the long run, they probably do – but if global capital decides to be fickle and flee to more predictable developed markets, then those emerging market investments are going to suffer accordingly no matter what their merits.

Box: Emerging markets funds in Australia

Fund researcher Morningstar tracks 49 emerging market funds sold in Australia, although many of them are structural variations of the same product, such as a retail and a wholesale version of a fund.

Some of them have attracted considerable assets in Australia: Morningstar logs the biggest, the Lazard Emerging Markets Fund, as having A$1.241 billion under management. Other large funds include Colonial First State’s emerging markets fund, an index fund from Vanguard, and emerging funds from Arrowstreet, Aberdeen, GMO and Dimensional. Several other of the most famous names in emerging market investment, most notably Templeton and Schroders, have their products available here without yet having attracted as many assets.

In fact, many Australians have emerging market exposure through a different model: Asia-only funds. Morningstar tracks a further 40 such investment options in Australia, including by far the biggest of all: the Platinum Asia fund, from home-grown Platinum Asset Management, which has A$3.63 billion under management. Funds from Aberdeen and BT have also attracted considerable inflows. This category includes a handful of country-specific funds, focusing on China and India.

Middle East exposure in these funds is typically minimal. When most fund managers talk about Asia, they tend to mean an area going as far west as India and sometimes Pakistan, but not the Middle Eastern markets – so they don’t appear at all in the Asia funds. In the broader emerging market funds, Egypt – which has the oldest and deepest stock market in the region – is the most common name to appear: in the Lazard fund, for example, it accounted for 2.4% of the portfolio in January, although that represented quite an overweight from its 0.4% weighting in the MSCI Emerging Markets index. Turkey typically accounts for a bigger chunk (6.1% in the Lazard fund) but it tends not to be considered a Middle Eastern market, and instead something of a middle ground between that region and Europe.

It’s no surprise that sovereign wealth funds capture the attention of the world’s asset managers. Estimates of the total wealth these enterprises manage typically range from $3-4 billion, and in most cases they outsource generous amounts of that wealth to external managers.

Attention typically focuses on a handful of the biggest names such as the Abu Dhabi Investment Authority, Kuwait Investment Authority, Government of Singapore Investment Corporation, Norway’s Government Pension Fund Global, or newer arrival the China Investment Corporation. But one of the most interesting trends in this area is the emergence of a newer wave of secondary sovereign entities: far smaller than the more famous behemoth famous, but representing either the emergence of a new bloc of capital, a newfound sophistication in investment technique, or both.

In this article we take a look at three institutions that illustrate the trend: the Petroleum Fund of Timor-Leste in East Timor; the Abu Dhabi Investment Council; and the endowment fund of KAUST, a new science and technology university in Saudi Arabia.

PETROLEUM FUND OF TIMOR-LESTE

To find the next generation of sovereign funds one most go to some obscure parts of the world. A prime example is East Timor, whose sovereign fund is a fascinating story reflecting the emergence of the country itself.

East Timor is one of, if not the, newest countries in the world (depending on how one views the status of Kosovo, and whether you’re reading this after South Sudan becomes a sovereign state). But when it came into being in 2002, it did so as a miserable new entrant into the world economy. Neglected by Indonesia when it was part of that country, and cruelly damaged on the road to independence, Timor had (and largely still has) an infant mortality rate of almost one in 10, a male life expectancy of 47, and 40% of the national population in poverty.

But it had a bounty: plentiful oil and natural gas reserves in the Timor Sea. Hammering out sharing agreements with Australia took several acrimonious years, but today East Timor gets 90% of the Bayu-Undan oil and gas field (being exploited by a ConocoPhillips-led conglomerate which expects the field to be good until 2023 and to provide 4 trillion cubic feet of natural gas and 500 million barrels of condensate); 50% from the Greater Sunrise field, with almost twice as much gas and 300 million barrels of condensate; and 90% from any further finds within the Joint Petroleum Development Area. One way or another East Timor is likely to get at least $20 billion from these fields, and possibly much more.

Many new countries have found themselves with the gift of hydrocarbon reserves and have then destroyed themselves as a consequence. But from the outset, Timor has stood out for the prudence of its approach to its assets. The Petroleum Fund was set up in 2005 in order to build up its assets for the future. It has certainly not been without controversy: in a country where there is not enough money to educate or heal people, it is highly contentious to put all the money from commodities away for the future, and today there is something of a compromise with some funds withdrawn for expenditure and the majority saved for the future. And since oil and gas account for 170 times more than the second-biggest national revenue provider (coffee), based on official 2008 numbers, it’s very clear that these commodities are the country’s only shot.

But, in this poor and unlikely location, the fund is among the world leaders for transparency, accountability and governance: when the Peterson Institute for International Economics tried to put together a scorecard for sovereign wealth funds based on those criteria, East Timor’s fund ranked 3^rd behind New Zealand and Norway, ahead of democratic and transparent beacons like Canada, Alaska and Australia, and an absolute mile ahead of anything in Asia or the Middle East (ADIA ranked 32^nd).

So, today, a visit to the fund’s website, hosted within the central bank, reveals precise assets under management, holdings, allocation and performance, all of it revealed on a quarterly basis. Absolutely everything is spelled out: what can be withdrawn and in what circumstances; what external mandates might be announced; how the benchmark is composed. It’s perhaps not surprising to hear that one of the Norway sovereign fund’s senior management serves on the Timor fund’s investment advisory board.

At this stage, the fund is deeply conservative: it got up and running just ahead of the financial crisis and was in no rush to diversify out of treasuries – a decision that may have made it the best performing sovereign fund in the world during the worst months of the crisis. Whether because of nervousness, lack of expertise or conscious decision, it still hasn’t. Its global benchmark today is 90.4% US government treasuries in a 0-5 year duration; a further 2% in 5-10 year treasuries; 2.6% AAA government or supranational dollar debt; 1.4% AA; and then a sprinkling of Australian, euro, UK and Japanese government bonds. Until recently BPA, the central bank, ran 80% of that portfolio (most of the short-dated Treasuries), while the Bank for International Settlements ran 20%, including the non-US holdings.

While that’s hardly the most exciting allocation, returning just 1.6% in the quarter to September 30 2010, it has served the fund well: given that modest performance but mostly because of new revenues from the oil fields, it has grown from US$3 billion in 2007 to $6.6 billion in September 2010, even after a quarterly withdrawal of $175 million for the quarter to the state budget (which doesn’t sound much but is substantial in a poverty-line country with a population of just a million).

That conservatism might suggest little reason for foreign asset managers to get excited, but there are gradual signs of that wealth being ready to be trusted to external managers. Back in 2009, the Ministry of Finance asked the BPA to consult a manager for an equity portfolio – and on September 7 2010, that finally happened, with Schroders getting a contract to put 4% of the fund into global equities. That chunk, about $260 million, was apparently deployed in October.

And this is exactly the reason international managers ought to look off the beaten track. Timor’s fund will never be ADIA, but it’s very likely to hit $20 billion within the next decade or so; that’s not so far short of, for example, the Korea Investment Corporation. And, over time, as confidence and sophistication grow, it is likely to put more and more of its capital to work in a structure in line with other sovereign wealth funds around the world. Plus, it’s highly unlikely to feel it has that expertise available in the national capital, Dili, which suggests that most of the non-Treasury allocations will be outsourced.

ABU DHABI INVESTMENT COUNCIL

ADIA obviously gets the headlines, but there are a host of other sovereign wealth entities in the United Arab Emirates. In Abu Dhabi alone, for example, there is Invest AD (formerly the Abu Dhabi Investment Company), Mubadala Development Company and the Abu Dhabi Investment Council (known as The Council, or sometimes ADIC 2).

A look at the last of these illustrates the possibilities for international managers in sovereign vehicles beyond what you might call the mother ship. The Council is one of the newer ones, and was set up only in April 2007. Like ADIA, it is an investment arm of the government of Abu Dhabi, and again like ADIA it is responsible for investing government surpluses for the future good of the people, by achieving strong returns and diversifying the economy away from oil. It also has a direct investment mandate to broaden Abu Dhabi’s economic base and help local companies to develop internationally.

In some respects The Council looks a bit like a holding company or a Temasek, in that it holds major stakes in several of Abu Dhabi’s leading businesses: National Bank of Abu Dhabi, Abu Dhabi Commercial Bank, Union National Bank, Al Hilal Bank, Abu Dhabi National Insurance Company, Abu Dhabi Aviation Company, and Invest AD (which is itself a sovereign investment vehicle).

In other ways, however, it looks like a more nimble version of ADIA. It has a dedicated special situations division, for example, which ADIA does not. And this gets to the heart of the big question about The Council: why is it there? Who needs another sovereign wealth fund in Abu Dhabi?

Many feel that ADIA simply became too big to be able to move quickly. It has never revealed its precise assets under management and estimates vary dramatically, but Cerulli believes the total to be between $400 and $500 billion. With such a large amount, one has to deploy a lot of capital into a position for there to be any point in doing so – and that can be difficult in, for example, small caps or special situations. There are political and personal reasons mooted too, but the idea of a quick-acting sovereign fund as an adjunct to ADIA has a lot to recommend it. Some even say that ADIA is beta and The Council is alpha, but in fact a large part of ADIA’s assets are actively managed.

It’s certainly a more opaque institution than ADIA, which itself used to set the benchmark for opacity. These days ADIA produces an annual report with detailed information on asset allocation ranges, governance and even long term performance; at the time of writing, The Council’s web site contained only a picture of some buildings and a brief mission statement: “To assist the Government of Abu Dhabi in achieving continual financial success and wealth protection while sustaining prosperity for the future”, and “to increasingly participate and support sustainable growth in the Abu Dhabi economy.”

We have not yet seen many more satellites come off established sovereign funds, but it’s not impossible that we could do in future. Many of the biggest institutions – Norway’s, Kuwait’s, Singapore’s, China’s – face these scale issues, and a free-reined lower-asset think tank could be a smart way for all of them to deal with it.

KAUST

On a 36 million square metre custom-built site on the Red Sea 80km north of Jeddah, a remarkable new educational institution is taking shape. The King Abdullah University of Science and Technology opened its doors in September 2009 and was by then already an exceptionally well-equipped research university, with specialisms distinct to Saudi Arabia such as water desalination. But that’s just the start, and by 2020 it aims to be among the top 10 universities of its type worldwide.

Ambition like that requires a lot of money to realise, particularly since one of the stated ambitions within the university’s mission and vision statements is to have “a diversified and sustainable revenue base that supports both its operating and capital requirements.”

For this purpose, and with the endowment funds of Yale and Harvard very much in mind, KAUST Investment Management Company was set up. In March 2009, it made a landmark hire as its chief executive and chief investment officer: Gumersindo Oliveros, who was previously the director of the pension plan and endowments at the World Bank.

Although the figure has never been confirmed, it is believed that the new fund was seeded with $10 billion of assets. The board at the time of Oliveros’s appointment makes for interesting reading and shows the scale of the ambition: alongside the Saudi royal family (Prince Khalid bin Adbullah bin Abdulaziz) and government (Ali Ibrahim Al-Naimi, who is the minister of petroleum and natural resources as well as the chairman of KAUST’s board of trustees) are local private sector leaders (Lubna Olayan, the CEO of Olayan financing group, and senior representatives of Saudi Aramco and the Abdullatif Jameel Group) and a couple of striking foreign names: John Brennan, chairman of Vanguard; and Charles Ellis, chairman of the investment committee at Yale University.

Yale is clearly a role model, and those asset managers who have had discussions with the new endowment fund say that it appears to be every bit as sophisticated – at least in what it is talking about doing – as its American cousin. Managers going in for pitch meetings talk about discussions in which typical asset allocation models are discarded in order to talk in detail about thematic investment styles, which might include themes distinct to the Gulf such as water or food scarcity.

The Gulf is not short of well-funded trophy projects, and while we tend to associate these with tall or grand buildings, a commitment to world class education is a logical and laudable way of deploying oil wealth. KAUST could be mirrored by similar institutions in the region.

For the moment, all eyes are on two other Saudi institutions that have been announced but don’t yet appear to be doing a great deal. One is Sanabil al-Saudia, formally launched in 2008 under the supervision of the Public Investment Fund, another state entity. The other is Hassana Investment Co, approved in 2009, to manage the assets of the General Organization for Social Insurance (GOSI), a key Saudi pension fund.

It’s not yet clear whether these new funds will be closer to KAUST’s thinking, or to that of the Saudi Arabian Monetary Agency, the country’s central bank which fulfils some sovereign wealth roles with its considerable assets but is by its nature conservative (and does not at all like being described as a sovereign wealth fund). Either way, these new pools of capital being created around pension funds, academic endowments and other sovereign wealth all suggest opportunity for foreign fund managers.

The first chief executive of the International Islamic Liquidity Management Corporation, the new post-financial crisis body designed to ensure short-term liquidity in Islamic finance, has been appointed. Mahmoud AbuShamma, previously head of HSBC Amanah Coverage in Dubai, will take the top role.

The appointment marks a crucial step in the development of a significant new multilateral. Legally founded on October 10, it has 14 founding shareholders: 12 central banks or monetary authorities, including Indonesia, Malaysia, the UAE, Saudi Arabia, Kuwait, Iran and Turkey; and two multilaterals, the Jeddah-based Islamic Development Bank and the Islamic Corporation for the Development of the Private Sector.

It will issue short-term Shariah-compliant financial instruments in order to help with efficient liquidity management for Islamic banks, particularly around cross-border transactions. It came about as part of a collective effort by the Islamic financial industry globally to take a close look at the financial crisis and work out what had been learned from it. It will issue in a range of major reserve currencies, with the distribution of the Islamic paper through agencies licensed by the shareholders – that is, banks approved by the central banks and monetary authorities.

Mahmoud’s job at HSBC was to take charge of the bank’s key Islamic relationships, which varied from governments to high net worth individuals as well as banks and corporations. Appointing a coverage man to such a position is an interesting move, and perhaps reflects the delicate nature of streamlining the approaches of 12 countries and two powerful multilaterals. He will take a three-year term beginning February 1 2011.

Like so many other pieces of global Islamic infrastructure, IILM will have a head office in Kuala Lumpur, perhaps reflecting the pivotal role that Malaysia’s central bank governor, Dr Zeti Akhtar Aziz, played in setting in up (see profiles in this edition). Indeed, Zeti will be the first chairperson of the governing board, with Yves Mersch, governor of the Central Bank of Luxembourg, as her deputy. Malaysia is trying to push through legislation that will give IILM special status, privileges and immunities.

The board has also announced the scholars who will sit on the IILM’s Shariah committee, all of them on three-year terms. They include some very familiar names who serve widely on international Shariah boards, most notably Malaysia’s Mohd Daud Bakar and Saudi Arabia’s Mohamed Ali Elgari (but not, notably, Bahrain’s Nizam Yaquby), alongside Ahmed Ali Abdalla Hamad, Cecep Maskanul Hakim, Umar Bashir Aliyu and Waleed Bin Hady Al Mullah.

For as long as Islamic finance has been discussed internationally, practitioners have been talking about convergence. No conference is complete without a panel on it; no discussion about global growth in Islamic finance can take place without addressing it. But what does convergence really mean, and how much progress has been made?

The most important distinction to make when talking about convergence is between Shariah opinion, and other standards related to Islamic finance such as regulatory frameworks, tax and accounting treatment. In a nutshell, the first camp will never reach full standardisation, and arguably would be much worse off if it ever did so; the second is where efforts are directed today and where progress is more vital in bringing Islamic finance into the global mainstream.

“We’ve got an opportunity to take Islamic finance to the global stage, and in order to do that we do need to have a great deal more convergence around standards – not just Shariah but tax, legal and accounting,” says Daud Vickery Abdullah, global Islamic finance leader at Deloitte. For Vickery, this means, for example, streamlining Islamic accounting standards in order to dovetail them with International Financial Reporting Standards (IFRS), so that “IFRS understands what Islamic is, and vice versa. There are global standards, everybody understands what they are, and they can accommodate as far as is possible Islamic standards.”

“In order to globalise we need to standardise – but in a rational way,” Vickery says. “Global accounting standards and tax standards: good. More legal definitions and congruence would be good. Greater standardisation on the definition of terminology: what does an ijarah mean, in Malaysia or in Kuwait?”

Several organisations are already involved in trying to make these things happen. Three stand out.

One is the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), a Bahrain-based non-profit body supported by a global institutional membership of 200 members from 45 countries. AAOIFI exists to prepare accounting, auditing, governance, ethics and Shariah standards for the industry, and dates from 1990; its standards have been adopted in Bahrain, the Dubai International Financial Centre, Qatar and several other Middle Eastern and African nations, while some other countries, most notably Malaysia, Indonesia, Pakistan and Saudi Arabia, have issued their own guidelines that closely follow AAOIFI standards. It is a busy organization: its Shari’a Standards 2010 publication contained 41 standards, and its Accounting, Auditing and Governance Standards 2010 report a further 40.

Another is the Islamic Financial Services Board, again a multilateral with widespread participation across the Islamic world, but headquartered in Kuala Lumpur. This is also a standard-setting body, but chiefly concerned with global prudential standards and principles and with a mandate to help promote soundness and stability in the system.

And on the markets side, the key institution for developing standardisation is the Islamic International Financial Market, based in Bahrain and founded collectively by central banks and ministries in Bahrain, Indonesia, Sudan, Labuan (Malaysia), Brunei and the Islamic Development Bank. Its mandate is to standardize Islamic products, documentation and processes.

One could argue IIFM has had the most momentous year of the three. Most practitioners know it for its work around hedging. “What banks need to hedge is currency risk, and fixed to floating [rate risk], because they have mismatches,” says Ijmal Alvi, CEO of IIFM in Bahrain. It achieved a breakthrough in March with the launch of a new master agreement document, called Tahawwut, launched jointly (and crucially so) with the International Swaps and Derivatives Association (ISDA). The document marked the first globally standardized documentation for privately negotiated Islamic hedging products – that is, derivatives such as profit-rate and currency swaps.

There is nothing straightforward about getting something like this to the finish line, and Alvi says it went through 24 drafts as the document passed through industry consultation and Shariah guidance. The endorsement of ISDA, whose conventional master agreement the Tahawwut template closely resembles in structure, was vital in bringing international validation to it. But the work continues, even within this narrow field: IIFM is now working with regulators in jurisdictions around the world to improve the local legal frameworks for hedging products and for close-out netting provisioning, and to develop insolvency laws around the Islamic world accordingly.

Alvi sees that the enabling environment is the key to a market. “With architecture, you create the agreement first, and then you bring the product,” he says. So the next step now is to provide standardising agreements at a product level, around FX forwards and profit-rate swaps, for example, below the overarching Tahawwut framework. As with the master agreement, these documents are going through lengthy consultation both with industry and Shariah advisors; he is reluctant to commit to a timeline beyond “we are trying our best to complete it during 2011, and if we do it earlier it is better for everybody, but we cannot bypass the processes.” When it’s done, he says, “it will provide the whole suite to the industry.” Additionally, banks have to go through their own internal processes with documents, which also takes time.

Alvi and his team continue to work on a host of other standards – in July it launched a paper on I’aadat Al Shira’a, a repo alternative, to help with liquidity management challenges, and it has also been looking at issues around sukuk, although Alvi says they are in too early a stage to be discussed in detail now. But Alvi is also interesting in that he sees that there are limits to beneficial standardisation.

“I often say: we are not supposed to standardise each and every aspect of the industry,” he says. “We are driven by requirements of the industry. It is good to have templates for common kinds of structures, like ijarah. But you cannot put every structure in a standardised form. Each sukuk has certain particular things within it, and within its packaging.”

Another example of, if not convergence, than a common approach to a problem, is the International Islamic Liquidity Management Corporation being built by a collective of Islamic country regulators and central banks, among them Bank Negara Malaysia. “This will issue triple A or double A rated paper, and the shareholders [the countries who back the system] can then nominate any entity within their system to allocate and monetize the assets,” explains Zeti Akhtar Aziz, governor of BNM and one of the drivers behind the new system. “We will have primary dealers identified by shareholders from their financial system, and they will create a market. These instruments will be highly liquid and attractive, and will be issued periodically throughout the year in different reserve currencies.” When interviewed in late October, Zeti said the team had made an offer to a potential CEO and was in the process of “mobilising the team”.

This venture grew out of a financial crisis response in which several groups were tasked to produce a global financial stability report, which generated eight areas within Islamic finance where it was important to put new standards in place. The feeling was that a liquidity framework was so important “we didn’t wait for the report to be finished before we implemented one or two recommendations, and one was the liquidity infrastructure mechanism.” The other was the development of a financial stability board distinct to Islamic finance, “where the regulators discuss possible risks to financial stability in the Islamic financial system.”

Measures like this, by definition, ought to bring a measure of convergence. They demonstrate the industry working together in a way it has never done before; one can argue, in fact, that the financial crisis was the biggest and most important spur towards Islamic financial convergence to date, particularly since Islamic structures fared better than conventional ones in the crisis and now have an opportunity to present more of a case to the financial mainstream.

But that’s all on the prosaic side of regulation, accountancy, tax and law. It’s on the other area, Shariah itself, where things become more complicated.

“Personally, I am not a proponent of Shariah harmonization,” says Raja Teh Maimunah at Bursa Malaysia. “What I would propagate is regulatory harmonization. The world must acknowledge there are two parts to any contract with Islamic banking: one is the legal framework and the other is Shariah compliance. Legal is man’s obligation to another man. Shariah compliance is man’s obligation to God. And a failure to meet your obligations to God does not make your obligation to man invalid.”

It’s a vital distinction, in her view. “In the capital markets, you have a basic framework and then the Shariah compliant elements of it. So with REITs, there can be rules on who the tenants are, how to manage the money – those are things we ought to agree from a regulatory perspective. We can all agree arms and alcohol are not compliant. But in terms of interpretation between contracts, I believe we should allow for differences. It’s OK to have those differences. It provides choice, it gives you options, and it has promoted innovation.”

She cites the recent Islamic RM1 billion debt programme set up by Cagamas, the Malaysian national mortgage company, as an example of this. The deal, lead managed by Saudi Arabia’s Al Rajhi bank, uses a structure called sukuk al-amanah li al-isthithmar, or sukuk ALIm, which incorporates principles of structures such as al-iljarah and al-wakalah in order to make it tradable in more conservative Middle East markets, which are normally off limits to more liberally-structured Malaysian securities. Cagamas itself said the issue was a contribution to harmonization, and it also shows how Shariah differences breed innovation. “They came up with it because their Shariah [advisors] weren’t comfortable with the structures we have in the market,” Maimunah says. “We need diversity.”

But for regulation – that’s different. “The world has gone through a terrible crisis,” she says. “Lots of businesses that survived two world wars did not survive, and we as an industry must come up and make sure we have tightened our practices in risk management, providing liquidity, encouraging cross-border trade. And for that to happen, we need convergence on a regulatory framework.”

Many others agree that diversity of Shariah opinion is a good thing. “I’m firmly of the view that the different schools of thought in Shariah are very good, because they drive discussion and product innovation,” says Vickery. “That should be encouraged and should continue.” But that doesn’t mean there’s nothing to be done. “Where we need to standardise is around the process by which a decision is made. Publish the fatwa, have a database: who was involved? What did they look at? How did they reach their conclusion? A lot of the confusion arises from the fact that you’ve got Shariah scholars sitting on multiple boards, and it appears to the man on the street that they have said yes at Bank A and no at Bank B, but the process of making that decision has not been published.” We could, Vickery says, eventually end up with “a sort of book of common law in place, where people say there was a similar situation and this was the conclusion.”

Zeti argues that, in Malaysia at least, this is already happening. “We have a Shariah advisory board in Bank Negara and when they announce their rulings, it is in great detail, providing the rationale for the ruling,” she says. This, too, might lead to some convergence. “There is discussion on parameters and guidelines, so there will be mutual recognition if they comply with these parameters.”

An important spur for convergence has been that scholars, put simply, talk to each other a lot more. “More international scholars of different backgrounds are on the same panels now, exchanging views and ideas and reaching a kind of common congruence on Shariah,” Vickery says. “They may have differences of opinion, but they’re mainly in a minority.”

Zeti agrees. “Scholars in the Middle East and Asia have been discussing the fundamental differences that exist in different jurisdictions,” she says. “Previously there was no such dialogue so there was no convergence.” Bank Negara allocated around RM200 million of funds to facilitating this dialogue and research. “We believe, with dialogue, we will move to greater convergence.”

It is commonplace to say that most Shariah standards are the same anyway, although it’s interesting how widely this number varies: Vickery talks of scholars saying they agree “90 to 95% of the time”, Zeti says there “has been a convergence on 80% of the issues”, and Maimunah says “from where I stand, the differences are only 5%. 95% of the time, we get along.”

But whatever the true number is, that’s not bad. “The 80/20 rule is a good example,” Vickery says. “If you get 80% agreement you’ve got an international standard, as far as I’m concerned. In the conventional world, if you’re trying to agree on how to account for a derivative transaction, we still haven’t decided how to account and accrue income on it, but 80% of the world has agreed. That is critical mass.”

All these issues are becoming increasingly important as Islamic finance becomes more cross-border. Bankers expect further closeness. “From a commercial standpoint, if you are doing a cross-border deal, then the objective must be to be able to reach out to the maximum pool of investors, and the only way to do that is to go for the standard that will clear the majority,” says Tan Jeh Wuan, managing director of the Islamic Bank of Asia in Singapore. “As we see more and more cross-border deals happening, convergence has to take place.” Asked if this is more likely to be towards more rigorous GCC standards or less onerous ones in Malaysia, he says “somewhere in between, but more leaning towards GCC standards.”

For Vickery, a key challenge is improving international perceptions of Islamic finance. “There is still a view out there that this is terrorist financing and they stone women.” But it’s changing. Before speaking to II, Vickery has been working on a proposal on developing interest in Islamic finance in Azerbaijan, Italy, Brazil, South Africa and India. “It’s because these guys are recognising it’s an international phenomenon, a way of tapping liquidity in the GCC, and it’s good for business. And the more international standardisation and transparency there is, the better it is going to be.”

Discovery Channel Magazine, August 2010

Deep in the deserts of Saudi Arabia sits one of the great archaeological marvels of the Middle East: Mada’in Saleh. Like Petra in Jordan – carved by the same ancient tribe, the Nabateans – the site is made up of hundreds of tombs and facades carved deep into the surface of golden sandstone rock, showing incredible precision and artistry for a people who lived 2,000 years ago.

But there’s one major difference between Mada’in Saleh and Petra, or Palmyra, or Persepolis, or any of the region’s great historic treasures: there’s no-one there. No tourists, no touts, no tour buses. Foreigners rarely come because it’s so hard to get visas; Saudis tend to view the tombs with some superstition. In an entire day at the site, I saw perhaps a dozen people. And that is part of the charm.

To see the article as it ran in Discovery, with photography, follow this link: Medain S’aleh (2)

Mada’in Saleh (“cities of Saleh”), also known as Al-Hijr (“rocky place”), was first occupied by humans as long as 5,000 years ago, and at one stage hosted members of the Arab Lihyanite kingdom. But it’s the Nabateans, an empire that rose and fell from 120BC to AD106, who left their mark here.

Their grand and intricate carvings are as remarkable today as they must have been when they were diligently carved into the rock around the time of the birth of Christ. Unlike Petra, whose community included a treasury, theatre and other buildings, Mada’in Saleh’s main sites are mainly tombs: simple chambers cut deep into the sandstone, with ornate facades in front of them, as much as 50 feet high. They are decorated with patterns, vases, eagles, snakes, sphinxes, griffins and suns – but never people. And best of all, more than 30 of them carry inscriptions in Aramaic allowing us to date them (almost all were built between 1BC and 75AD) and in some cases even telling us who carved them: several, for example, were made by a skilled craftsman called Aftah.

Two millenia on, I am being guided around the ruins by Abdul Aziz, who ten years ago retired from a career in the Saudi air force and police department to become a guide to the area. His family, which he reckons has been in the broader area for 1,000 years or more, moved to the nearby town of Al-Ula in his grandfather’s generation; his uncle was effectively the Saudi government’s representative for Al-Ula under King Abdul Aziz, who unified Saudi Arabia into roughly its current form in the 1930s. “At that time they don’t use the word governor,” today’s Abdul Aziz recalls. “They say ‘one of King Abdul Aziz’s people’.” Even then, as de facto head of the town, there was little involvement for his uncle with Mada’in Saleh, barely 20 kilometres to the north; “They don’t know about this place then,” Abdul Aziz says.

Standing in front of one of the tombs in the traditional Saudi dress of white thobe and ghutra, Abdul Aziz explains how the Nabateans would design and carve their tombs. “They started digging from the top down, not the same as if you are building something from the ground up,” he says. In two places in Mada’in Saleh one sees this clearly illustrated where facades have been started but never finished; they remain there, as if suspended, high in the sandstone. The reason for their abandonment continues to puzzle archaeologists today. “Was there a sudden economic or military catastrophe?” asks Professor John F Healy of the University of Manchester in one of his many books on the Nabateans.

The tombs all bear a similar style. “At the top, all of them have five steps coming down towards each other,” says Abdul Aziz. “That is because if anyone attacks or uses the tomb without permission, they feel in their mind it will come five times.” Some scholars suggest the steps represent five gods the Nabateans worshipped.

Most tombs bear clear marks of the chisels used to carve them – either hard stone or iron. The sandstone, so beautiful and ornate yet fragile, is perfect carving material: Abdul Aziz cheerfully takes a hard stone to an outcrop near a tomb to demonstrate how easily it comes away. For bigger blocks, iron chains were inserted into carved grooves in order to remove slabs, and then the facade was smoothed. There doesn’t seem to have been any revolutionary science involved, just talent, patience and hard work, with some tombs taking years to complete.

Different tomb designs reflected status, with the biggest and grandest apparently devoted to the wealthiest and most important families. The biggest are Qasr Al-Bint (castle of the girl), a rock mass containing 31 individual tombs and the largest single facade, 52.5 feet high; and the extraordinary Qasr Al-Farid, hewn out of a single isolated rock. The jagged Jebel Ethlib mountains and spires, reminiscent of the angular formations of Arizona or Utah, provide a stunning backdrop. Every bit the match of Petra’s Treasury, Qasr Al-Farid has the most ornate facade, with four columns where most have two. “Maybe he was rich,” Abdul Aziz concludes.

From an archeologist’s perspective, it’s the inscriptions that really set the place apart. “Right at the top of the door, they write: this is the owner of the tombs,” Abdul Aziz explains. “It says: you are not allowed to use it, or you must pay.” Scholars who have translated the inscriptions from the Aramaic reveal a remarkably specific range of demands: one forbids violating the bones within the tomb, one altering the inscription, one forging documents about the tomb, and one selling it. The recipients of the fines vary from gods to a king or a governor, and some specify a price, often a thousand Haretite sela’s, or “full price” or “double the price” of the tomb. Some get nasty: “May Dushara [the chief Nabatean deity] curse anybody who buries in this tomb anyone except those inscribed above.” Another: “May he who separates night from day curse whoever removes them forever…”

The fact we can even seen these inscriptions after 2,000 years is an accident of circumstances. “Its desert location has protected it both as a result of its very arid climate and its isolation,” noted the International Council on Monuments and Sites in its report to UNESCO supporting the site’s elevation to World Heritage status, which was approved in 2008. “This has led to the good preservation of the decoration of the facades, and has enabled the conservation of many inscriptions in several ancient languages.” If Mada’in Saleh was as humid or windy as Petra, or as popular, there would probably be much less to see today.

Another reason the tombs have been largely undamaged – and are still little visited – is that local people have appeared nervous about coming. Mada’in Saleh appears in the Qur’an, which says that the tribe there – the Thamud – were guilty of idol-worshipping, forbidden in Islam. Told by the prophet Saleh (whose name the site takes today) to repent, the non-believers instead conspired to kill him and were punished by Allah. Even today, some Muslims – and Saudi is among the strictest Islamic state – may consider it against their religion to visit.

Others just don’t know about it. I met a group of young men wandering around the ruins, who were visiting from Buraydah, about 600 kilometres away. “We have been there for the last 20 years and we hadn’t heard about this place until one week ago,” one says.

For whatever reason, the carvings have withstood the test of time much better than most other attempts at civilisation in the area. In the middle of the site is a restored railway station from the old Hejaz railway the Ottomans built between Damascus and Medina in the early years of the 20^th century. But one only has to walk a few yards away from the station to see the tracks disappear, the steel and sleepers long since ripped up and used for other purposes. The railway barely lasted half a century; the Nabatean carvings, unchanged in millennia, look down imperiously upon its wreckage.

Maybe World Heritage status will bring international and local tourism to Mada’in Saleh; Abdul Aziz thinks it’s happening already. “It was crowded last week,” he says. “In total there may have been 100 people.”

But people have been expecting the site to take off for years. Barbara Toy, the intrepid British traveller, passed through here in the 1960s retracing the old incense trade routes. In 1968 she wrote: “One senses that Madain Saleh is preparing to be discovered.” More than 40 years later, it’s still waiting.

BOX: THE NABATEANS

The Nabateans seem to have been an Arab group, originating from southern Jordan (where Petra, the Nabatean capital, is found) and Palestine. Around 120BC they decided to form their own state, sustained by their location on the vital overland caravan routes from southern Arabia to the rest of the world. They did have their own goods to sell, like bitumen, but their prosperity seems to have come from taxing the caravans. Mada’in Saleh appears to be as far south as they got, and was their southern capital.

Apart from their magnificent carving skills, they are important as a link between the Aramaic and Arabic languages; their inscriptions were Arabic-influenced Aramaic and they may have spoken informally in Arabic.

They showed smart engineering for their time, too. Mada’in Saleh is supported by more than 100 wells, while a clever drainage system next to the Diwan place of worship channelled rainfall into a three metre deep storage chamber.

Their kingdom lasted just over 200 years before being incorporated, apparently without a struggle, into the Roman empire on March 22 AD106. While their descendants must exist across Saudi and Jordan, it is no longer possible to talk of distinct Nabatean descent; the culture has long since been absorbed into Arabia.

BOX: CARVING A HOME

The Nabateans were not the only people to carve their dwellings and temples into rock. One of the most remarkable examples is the town of Lalibela in Ethiopia, where 11 churches have been hewn out of the rock, each one from a single block of granite, with the church roof at the level of the surrounding ground. They were built – or excavated – in the 12^th century by King Lalibela, who gives the town its name.

In the Cappadocia region of Turkey, people carved soft volcanic rocks into houses, churches and monasteries. In some towns, they still live in them. And in the Buzau region of Romania, churches and dwellings have been carved into a mountain, inhabited from as early as the 3^rd century AD to as recently as the 19^th.