KUALA LUMPUR/SYDNEY, July 18 (Reuters) - A proposed three-way merger in Malaysia will create the world's first Islamic bank that will have enough clout to challenge the dominance of conventional, often Western, banks in the industry and influence the way Islamic finance deals are made.
The Islamic units of market leaders such as HSBC Holdings PLC and Standard Chartered PLC have long used their parents' vast networks to win leading roles in global deals. Most of such deals involve designing and distributing Islamic bonds, or sukuk, a fast-growing segment in the sector.
By contrast, local banks in the Islamic world lack the scale and reach to entice corporate and sovereign issuers from Europe and Asia. Many of them are owned by wealthy families or the state, and fear of losing control has limited mergers and consolidation in a still highly fragmented industry.
In comes Malaysia, whose government is keen to make leaders out of the country's banks in global Islamic finance. Last week, CIMB Group Holdings Bhd, RHB Capital Bhd and Malaysia Building Society Bhd secured regulatory approval to begin their merger talks.
Their amalgamation would yield a stand-alone Islamic bank that is separate from the conventional banking operation of the enlarged bank. This Islamic bank will have a cross-border presence sizable enough to win big mandates, as well as a Malaysian model of Islamic finance that is regarded by many investors to be simpler and less confusing, analysts say.
"The next meaningful stage for Islamic banking is a bank with connectivity across key markets and separate markets," said Abdul Rauf Rashid, country managing partner for EY Malaysia. "Putting together and creating this large entity is a start, but the next step is integrating them into one powerful unit that can go out and build the market."
The merger would include the creation of a so-called mega Islamic bank. Malaysia's central bank defines such an entity as having a minimum $1 billion in paid-up capital.
A successful merger may pave the way for other Malaysian banks to follow suit as they expand globally. That would help internationalise the Malaysian model of Islamic finance, analysts say.
Malaysia also has the capacity to standardise industry practices, which vary due to different interpretations of Islamic law, they say.
Malaysia has a centralised, top-down approach to creating sharia-compliant products. Other countries have allowed sharia boards of individual Islamic banks to decide whether their products and activities obey religious principles. The latter approach sometimes leads to disagreement over the design of a product and even confusion among investors, analysts say.
Some investors have decided to stick with the big conventional banks such as Standard Chartered. The banks have their own Islamic scholars and the financial clout to lead in the structuring of Islamic finance deals.
"When we have mega banks, and trim down to fewer players, it will be easier to harmonise things. Bearing in mind that it will go global, we are positioning Malaysia as the leader for Islamic banking," said Johan Lee, partner at Kuala Lumpur-based law firm J.Lee & Associates.
The mega Islamic bank concept has been discussed in the industry for years. Previous efforts have failed to take off partly because of scant interest from the private sector.
Most banks in the Middle East are retail-oriented or lack the financial expertise to compete with large multinationals. Al Rajhi Bank - Saudi Arabia's largest listed lender and the world's biggest Islamic bank - has never issued a sukuk and is only now developing its investment banking business.
Smaller Islamic banks in the region such as Qatar Islamic Bank and Al Baraka Banking Group are hardly in the league of Western banks when it comes to Islamic finance.
But change is in the air, with Islamic finance now holding a greater share of the banking sector in Asia and the Middle East - a third in the case of Qatar. Growing economic links among these regions are also renewing a push to standardise the rules of Islamic finance and banking.
The Bahrain-based International Islamic Financial Market - an industry body that creates specifications for Islamic finance contracts - is now developing its first-ever contract template for sukuk.
The sukuk market is forecast to grow 14 percent to $130 billion in issuance in 2014 compared with last year, a Thomson Reuters study shows.
Efforts by Malaysia to sell its version of sukuk financing will face a number of obstacles, particularly in dollar-denominated issuances.
Most dollar-denominated sukuk are issued across a myriad of markets, must be approved by scholars in each institution wishing to buy them, and are thinly traded.
This segment is also dominated by Western banks and is attracting a growing number of Gulf-based lenders, all eager to capitalise on the expected rush of global issuance. Hong Kong and Luxembourg are among the governments aiming to issue sukuk later this year.
Size could help the proposed Malaysian mega Islamic bank win a larger share of such business, and more crucially, lead in the design of those deals.
"They will still have to adapt to each country's culture of doing things...we just need to focus on the products that work for multiple markets," said Mohamed Ridza, partner at Kuala Lumpur-based law firm Mohamed Ridza & Co.
The question is whether a full-fledged Islamic bank of that size can survive without support from a conventional bank as its parent.
"Being larger does not necessarily lead to greater efficiency, better profitability or improved bank credit fundamentals," said Simon Chen, Singapore-based banking and Islamic finance analyst at Moody's. (Additional reporting by Denny Thomas in HONG KONG; Editing by Ryan Woo)