THE LAST WORD
More effort needs to be spent on product innovation to offer clients greater diversity, writes Brian Kettell
The replication and transformation of conventional financial products into their corresponding Islamic analogues have implications for the regulation and supervision of Islamic financial institutions. First, the various lending structures generate different risk and balance sheet exposures for Islamic banks that need to be carefully monitored and managed. While only a few Islamic financial products generate different liquidity profiles from conventional products, the lack of uniformity of standards for Islamic banking practices across Islamic countries makes it difficult to apply the same prudential regulatory standards such as capital adequacy requirements across the board. This calls for more harmonisation of Islamic banking practices, which calls for harmonisation of Shariah standards nationally and internationally. Second, the treatment of profits/losses will have consequences for the balance sheet structure and will require adjustments to meet minimal prudential requirements. For example, in mudaraba transactions, the bank bears full financial responsibility for any losses but shares relative profits with the client. Any losses stemming from uncollateralised equity financing may require higher loan-loss provisioning and additional capital.
Mudaraba transactions are essentially investment partnerships in which all the capital is provided by the financial institution while the business is managed by the entrepreneur/client. Profits are shared in pre-agreed ratios and losses are borne by the bank, which are passed on to depositors.
Third, disclosure requirements may need to be comprehensive and more frequent to inform investors of the investment techniques so they can make decisions based on their risk preference. Maintaining clear transparency and ensuring adequate disclosure of financing mechanisms are important steps towards building the necessary foundations. As part of the international effort to design a regulatory framework for Islamic finance, regulators need to factor in the differences in finance and have at least minimal standards or benchmarks to gauge compliance and assess risks. There needs to be some consistency in regulatory treatment, subject to the particular country’s legal and regulatory regime.
We are seeing plenty of fancy marketing of new Islamic products, but marketing does not qualify as product innovation. What is needed is the creation of products or the development of existing products
Product development is complicated and difficult. It requires a team that embodies creative thinking, extensive knowledge, patience and perseverance nurtured in a business environment that takes risks. Innovators should not be concerned with expenditure or threatened with dismissal if their idea fails. This only cripples creative thinking.
The most important management facet of any financial institution is product development. This is especially true of Islamic financial institutions, because the Islamic finance industry is new and, therefore, behind in product assembly. Customers of Islamic banks are fed up with the market imitating the tools and methods of conventional banking. This was acceptable only when Islamic banking emerged. However, as it consolidated itself and was able to displace its rivals, its customers want new methods derived from the Koran and Sunnah and distinct from fabrication and trickery. Customers no longer want irreligious credit cards or tawarruq. To achieve this, Islamic banks must look towards managing product development, as it is the heart that pumps blood to financial institutions. If this circulation stops, financial institutions die out. This could happen as a result of the inability to develop and create.
Professionals must provide this innovation, so that knowledge can be integrated among bankers, jurists, lawyers, IT engineers, and those who oversee standardisation, policies and procedures. There should be more creative thinking, whether inside or outside the institution. A lack of professionals renders innovation costly to the institution. Professionals are the institution’s real assets.
Inevitably, product development passes through stages, beginning with market research, analysis of the competition and customers’ needs, and considering staff proposals. The next stage concerns developing the idea and must be allocated enough time to analyse the proposal, to amend it as needed to meet the needs of the customer, financial institution and legal environment. The team may begin with one idea that may evolve into a completely different product. This is just one aspect of creativity.
After testing, the next stage consists of finalising policies, procedures and documents, and building computer systems—one of the most important aspects of Shariah-compliant product development. Computer software can replace a great deal of paperwork, considered by many to be one of the shortcomings of Islamic banking. Moreover, it can assist in reducing human error that may cause the product to violate Shariah. Financial centres should work together to address weaknesses in legal and institutional frameworks that are hampering product innovation in Islamic finance.
There are still many countries where the legal and institutional framework is not explicit and transparent about Islamic finance, and the framework developed for conventional finance is being applied to Islamic institutions .It is, however, unclear whether this is sufficiently flexible to address and supervise Islamic finance’s unique mix of risks and special operational features.
There are still many countries where Islamic finance’s legal and institutional framework is not explicit and transparent. Significant weaknesses in the legal, governance and systemic liquidity infrastructure are impeding the spread of product innovations and preventing effective supervision and risk management. There needs to be more done to set supervisory and regulatory standards. This is necessary to support industry development.
Greater standardisation is needed. One way to promote this is through agreement on a set of fatawas issued by Shariah scholars. Some jurisdictions are helping industry practitioners by collating fatawas issued in their markets to serve as a useful aid to those structuring Islamic financial transactions. Some are not.
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