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Kulsanofer Syed Thajudeen 1200071

A Critical Assessment on Product Development & Innovation within the Islamic Financial Services Industry

By Kulsanofer Syed Thajudeen 1200071 International Centre for Education in Islamic Finance (INCEIF) Malaysia

Date of Submission 18 November 2012

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A C rit ic al As s e ss me n t o n Pro d u ct Dev elop me nt & In n o v atio n wi th i n th e Isl a mi c F i nanc ia l S er v ic es In d u stry


The Issues in Product Innovation
Kulsanofer Syed Thajudeen September 2012 1.0 Introduction

In order for Islamic finance to be a viable alternative to conventional banking, it is necessary for Islamic Financial Institution (IFI) to offer innovative products addressing consumer demands. It is not sufficient to take conventional products and just change a few terms and conditions. The ultimate aim should be to come up with truly Shariah based products. In addition, the different demands of the various customer segments have to be considered. Product innovation is a buzzword now in the industry as IFIs clamour to introduce new products that can entice people to participate in it. This paper will mainly be on the issues and challenges of developing and innovation new Shariah-compliant financial products.

Literature Review There are many papers on the topic of product innovation in Islamic Finance because innovation is crucial to maintain competitiveness in todays business environment. The business world now points to the fact that development of successful new products is probably the single most important issue facing managers today Poolton, J. and Ismail, H.(2000). Innovation allows the IFIs product differentiation to ensure comparative advantage among IFIs.

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For example, Devlin (1995) refers to the term innovation in the delivery system of financial services as an opportunity to gain competitive advantage which would give, say, a retail banking service provider the basis for differentiation. Similarly, Prajogo and Sohal (2001) find that innovation has a crucial role in securing sustainable competitive advantage in todays competition

There is a huge collection of literature on conventional financial products with regards to innovation. In an extensive study of the available literature on New Service Development (NSD), John and Storey (1998) have included a wide range of research articles and books on this subject. In addition to that, most conventional banks and other financial institutions are having their own innovation and service development departments. Bowers (1985) finds in a survey that practitioners across the financial industry believe that service development is vital for future competitive strength.

In comparison to the conventional finance, there is a dearth of information on innovation in Islamic finance literature. There is a need for a consolidated body of relevant literature documenting various aspects of Shariah-compliant financial innovation.

History of Islamic Bank The first Islamic bank was established in Egypt in 1963 by Ahmad El Najjar. The key principle used was profit sharing (non-interest based philosophy of Shariah). By the end of 1976 there were 9 such banks in the country. These banks neither charged nor paid interest but their activities were mostly limited to trade and industries where these banks invested directly or as partners of depositors. They were more like financial institutions rather
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commercial banks. The first bank to be explicitly based on Shariah principles was established by the Organization of Islamic countries (OIC) in 1974, called Islamic Development Bank (IDB). This bank primarily provided funds for development projects between member governments. The bank charges fees for financial services and provides profit sharing financial assistance for projects.

The vast development in Islamic finance occurred in 1980s. Although, non payment of interest in the main principle applied but Islamic Financial Institutions have evolved to include other Islamic principles such as property rights, sanctity of contracts and the rules of sharing risk. 1 Basic Principles in Products Classical writings on Shariah, some of which date back to twelve centuries ago mentioned three essential sharing-based financing contracts,namely, equity sharing (Musharakah), equity sharing with a sleeping partner (Mudarabah) and crop-sharing (Muzaraah). They also mentioned three salebased financing contracts: deferred payment sale (al bay al ajil), forward sale with cash advance (Salam) and manufacturing financing sale (Istisna). Lastly classical writings also mentioned leasing (Ijarah) as a form of financial contracting. (Kahf, 2006)

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Current Product Innovation Several nancial instruments have been developed and are considered innovations in Islamic nance.

1) Profit-Rate Swap Commerce International Merchant Bankers Berhad Islamics Islamic prot rate swap, a Sharia-compliant version of an interest rate swap, is considered an innovation in Islamic nance. It is not derived from the trading of exchange of interest rates but rather, from the trading of real assets (Euromoney, 2006).

2) Sukuk Sukuk is an Islamic investment certicate, where each holder owns an undivided benecial ownership interest in the underlying assets. Consequently, Sukuk holders are entitled to share in the revenues generated by these assets, as well as being entitled to share in the proceeds of their realization. (Box, 2005;). The sukuk was styled based on the bond. There is a lot of room to diversify the types of sukuk available in the market. The market is increasingly moving from the lease and lease back Sukuk structures of first generation towards Sukuk based on co-ownership contracts (Musharaka Sukuk) or management agreement (Wakala Sukuk or Investment Agency Sukuk). There is a need for a global Sukuk market where securities are listed on international exchanges such as London, Dubai, Singapore, Hong Kong, New York or Paris. Structuring of Sukuk in the future is expected to incrementally move towards more complex Sharia compliant securitizations. A more liquid market, enabling transparent and efficient secondary pricing of Islamic Sukuks, will encourage greater disintermediation.
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3) Islamic Funds/ Islamic Unit Trusts An Islamic mutual fund or unit trust is simply an investment scheme that pools funds from numerous individual or institutional investors and invests in Shariah-compliant stocks, sukuk money market instruments. An investor wishing to participate with a mutual fund would do so by purchasing units offered by the mutual fund. The price or value of these units varies daily according to the value of the assets held by the fund. This is styled based on the conventional Unit Trusts

4) Islamic Private Equity Funds It is similar to the Islamic mutual fund, except in this case the investments are made in companies that are not listed on the public stock exchange. Venture Capital and Private Equity are ideal Islamic compliant investment structures as is applies the concept of profit and loss sharing. It is based on the conventional Private Equity Fund.

5) Takaful The recent boom in real estate and infrastructure projects in the GCC has created substantial demand for mortgage protection products and home owners Takaful plans. The rising awareness among Muslims for halal financial products has increased the demand for Takaful. Global Takaful contributions grew by 19% in 2010, to US$8.3b. Global Takaful contributions are expected to reach US$12b by 2012. Saudi Arabia remained the largest market in GCC. It is based on the conventional insurance.2

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6) Infrastructure and Project Finance Islamic finance is expected to play a significant role in the project finance market in the GCC region. With the growth of the Islamic finance market in recent years, experience has shown that major projects can be commercially financed either fully from Islamic finance or by means of both conventional and Islamic finance arrangements. The key reason for the growth is due to the Shariah-compliant structures that are now being more widely recognised and secondly, Islamic banking across the region can now operate at highly competitive rates for these key infrastructure projects. This growth in demand for Islamic finance has led to further development of Shariah-compliant structures for infrastructure or project financing. It is based on conventional banking.

7) Islamic REITS According to the Malaysian Securities Commissions Guidelines, Islamic Real Estate Investment Trust (REITS) is a trust investment vehicle that invests or proposes to invest at least 50% of its total assets in real estate. An investment in real estate may be by way of direct ownership or a shareholding in a single-purpose company whose principle assets comprise real estate. The objective of the Islamic REITS is to provide unit holders with a stable distribution per unit with the potential for sustainable long-term growth of such distributions. It is based on conventional REITS.

9) Hedging Some of the Shariah compliant hedging tools currently being introduced include, Profit Rate Hedging and Foreign Exchange Hedging. For example, Bank Islam Malaysia offers the Wiqa Profit Rate Swap, which is an agreement to exchange profit rates between two
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counterparties, normally fixed rate party and a floating rate party. The Wiqa Cross Currency Swap, is an arrangement between two parties to exchange a series of profit and principal payments denominated in one currency, for another series of profit or principal payments denominated in another currency, based on a notional principal amount over agreed period.(Bank Islam,2012). It is based on conventional hedging.

Islamic Pension Fund Another nancial service innovation was introduced by HSBC, which became the rst UK bank to offer a pension fund that is in compliance with the requirements of Shariah. The HSBC Life Amanah Pension Fund is the latest addition to a portfolio of products offered by HSBC Amanah Finance, the Groups global Islamic nancial services division, which was established in 1998 to provide Islamic alternatives to conventional banking (HSBC, 2012). It is based on conventional pension fund.

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Issues in Product Innovation 1) Islamic Financial Products are similar to conventional products The main issue in product innovation in Islamic Finance is the fact that all the products are based on the conventional financial products available in the market. Although Shariah compliant contracts are used, the outcome of the products are the same. There is a need for product differentiation. Islamic Finance Institutions need not follow the trend of the conventional banks. 2) Standardization in Shariah Rulings for Product Innovation Another important issue is Islamic Finance requires its financial products to be Shariah compliant. The financial products need to be approved by Shariah scholars before it can be marketed. Unanimity among the Shariah scholars on the Shariah compliance of the products is a valid problem. The absence of universal standards to govern the Islamic products compounds the problem. Due to these problems the product development process becomes protracted. There is a need for standardization of Shariah rulings and hence Islamic financial products across the globe. The lack of uniformity among Islamic institutions as to the interpretation of Sharia on certain issues can hamper the structure of a project finance transaction (De Belder and Ruder, 1999; Martin, 1997; Yasseen, 2005). 3) Mature Management Wise governance of the Islamic financial institution is of utmost importance. Without it the performance of the industry will be affected in a negative manner. Good governance occupies the most important place in the Islamic finance industry (Rifaat, 2006).

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4) Lack of expertise to develop new products Developing products according to the Shariah is not an easy feat. The need for highly skilled and experienced shariah committee members therefore increases with the development of innovative Islamic financial products and services. To meet this human capital requirement, large financial institutions can act as knowledge centres to attract foreign talent from the existing international financial hubs, as well as retain local talent.( Grewal, 2011) 3) Lack of Financial products to manage liquidity Another often-mentioned challenge in the Islamic finance industry is the issue of liquidity. It is no secret that Islamic financial markets currently lack the liquidity, breadth and depth of conventional financial markets. Islamic financial institutions (IFI) product range has developed rapidly over the last ten years to meet the demand from both retail and corporate entities. However, IFIs still face the challenge of a lack of instruments to manage liquidity. For one thing, Islamic banks cannot manage liquidity at hand in ways similar to traditional banks investing in notes or government treasury securities. Also, it has no Sharia alternative in the market and at the right size. The above factors deprive Islamic banks of the nancial instruments which the banks can use to manage the maturity gap at the lowest risk possible. Also, Islamic nancial services are of a different nature and differ from those provided by conventional banks, either in transactions or activities that require approval of the Shariah committee. This is the main difference between the operations of conventional bank and Islamic institutions (Rifaat,2006).As a result, products are short-ended given the current constraints. Therefore, it is critical for Islamic financial institutions to innovate and revolutionise Shar`ah-compliant products to enhance and manage liquidity.
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4) Risk of rate of return The risk of rate of return is a prevalent problem facing Islamic nancial institutions. In order to counter the problem, there is a need to find Islamic solution suitable for these instruments. The refusal to sell debt and investment guarantees is one of the major principles of Islamic banking activities. However, selling debt can be considered acceptable on condition that the sale does not result in dealing in interest. The risk of the rate of return can be managed by a variety of instruments in conformance with Shariah, despite the fact that some of these instruments are under study to raise them up to a standard acceptable internationally in the management of the risk of return (Arbuna, 2006).

5) International banks The growing demands for halal financial products has forced International banks to offer Islamic finance but they treat Islamic nancial products from entirely a marketing perspective. They are able to compete with the IFIs because of their sheer size. The

differentiating point for Islamic banks, if they comply fully with Sharia, is in combining both the religious intentions and compliance with Shariah, a condition which cannot be met by conventional banks (Al Yasseen, 2007). The entry of the international effect has a two pronged effect. One, the entry of international banks in the Islamic nance industry will lead to upgrading the service level and quality of local banks. The entry of foreign banks in the Islamic nance industry has two contrasting aspects. The positive aspect is the diffusion of knowledge on Islamic nancing. However, the negative aspect is that these banks, because of their educational background, might not
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improve the functioning of Islamic nance in an appreciable manner. This will have a negative impact on the development of Islamic products in terms of compliance with Sharia (Hafeth, 2006).

6) Bank interest The issue of accepting dealing in bank interest (riba) is a controversial one. The Sheikh Al Azhar in Egypt made a ruling (fatwa) that charging bank interest is not a violation of Sharia. However, such an issue must be decided by a consensus of Islamic scholars, and the consensus is that bank interest is a violation of Sharia. Some scholars at Al Azhar oppose the Fatwa from Iran that say that charging bank interest is not a violation of Sharia (Al Alaywi, 2006). The differences between the Islamic scholars on that issue have not been resolved.

Possible Innovations One of the issues of product innovation in Islamic Financial Institutions is the products are based on the conventional banking products. This process can be termed as conversion of conventional products into Islamic products. Professor Volker Neinhaus argued that this can be regarded as conventionalisation of Islamic banking and finance because the process of conversion of products brings the economic profiles of conventional products into Islamic banking. Dr. Humayon Dar, believes that Islamic finance must have distinct social objectives in order to survive in a highly competitive market. Islamic banks must find a niche area and differentiate from the conventional banks. One example is the is Fauji Foundation in Pakistan, which was set up in 1954 as a charitable organisation, and now is one of the largest industrial conglomerates in the country with total assets of over 250 billion Pakistani rupees
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(US$3.5 billion), serving over 7% of the beneficiary population in Pakistan. It has investments in industrial production (e.g., cement, fertilizers, and oil & gas etc.), education, healthcare and financial services. An Islamic foundation is a collective saving and investment programme that allows its members to save together in order to do business for the benefit of all the programme members. This could be a deposit taking institution in itself or may have a deposit taking institution as part of its overall operations. The Islamic Foundation will conduct real businesses where the members will be the direct benefactors of the goods and services provided. The rest are sold in the market and the profits are reinvested within the foundation structure. Members of the Islamic Foundation should be able to enjoy benefits in terms of free or highly subsidised goods and services. For example, if the Islamic Foundation runs a hospital, the members will be treated for free or pay a subsidised rate. Similarly, they must have easy and affordable access to education and other social services. On the other hand, if the Islamic Foundation runs a finance programme, it must give preferential treatment to its members; such as, providing interest-free loans for home purchases and the financing of other durables and household items. The foundation model may based on the waqf (a form of Islamic trust) so that the assets are locked into a structure that creates socially responsible assets. The Islamic foundation is an institution that organises and runs real businesses for the benefits of its members. As examples of such social projects are abound in the West as well as in the Muslim world, there is a need to study these different models in order to develop a new model of Islamic financial intermediation. (Dar, 2012)
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Conclusions The number of Islamic financial products has increased in leaps and bounds to cater to the demands of the growing market. The innovative products have allowed the Muslim investors to partake in previously untapped areas and trends for more sophisticated financial products will be in the rise. The product innovation in the Islamic financial industry thus far has been more towards imitating the conventional financial products. However, there is a need for Islamic Finance to differentiate itself from conventional banking through its products. It is not enough to base it on Shariah compliance alone but it must be to improve society. The financial products must be able to integrate Shariah, Islamic economics and modern day finance to truly represent what an Islamic financial product should be.

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Reference
1) Poolton, J., and Ismail H.2000. New Developments in Innovation. Journal of Managerial Psychology, Vol. 15 No. 8, pp. 795-811. 2) Devlin, J.F. 1995. Technology and Innovation in Retail Banking Distribution. International Journal of Bank Marketing, Vol. 13 No. 4, pp. 19 25 (1995) 3) Prajogo, D.I. and Sohal, A.S. 2001. TQM and Innovation: a Literature Review and Research framework, Technovation 21, pp. 539-558 . 4) Johne, A. and Storey, C. 1998. New service development: A review of literature and annotated bibliography, European Journal of Marketing, Vol. 32 No. 3/4 Pp 184-251 5) Bowers, M.R. 1995. An exploration into new service development: process, structure and organisation, PhD dissertation, Texas A&M University 6) Iqbal, Munawar and Philip Molyneux.2004. Thirty Year of Islamic Banking: History, Performance and Prospects, Palgrave Macmillan, 37 7) Kahf, Monzer. April 2006. Innovation and Risk Management in Islamic Finance : Shariah Considerations. Paper prepared for the Seventh Harvard International Forum on Islamic Finance. 8) Box, T. (2005), Islamic nance turns to securitization, International Financial Law Review,Vol. 24 No. 7, pp. 21-4. 9) Euromoney (2006), Islamic nancial product of the year: CIMB Islamic for Islamic prot rate swap, Euromoney, January 10) Ernst and Young, Industry Growth and Preparing for Regularity Change, The World Takaful Report2012, pg 14 11) Securities Commission Guideline on Islamic Real Estate Investment Trust. 12) Ban k Islam (2012), Bank Islam , available at : www.bankislam.com (accessed on 14 November ) 13) HSBC (2012), HSBCamanah, available at: www.hsbcamanah.com (accessed on 14 November) 14) De Belder, R. and Chris, R. (1999), An overview of project nance and Islamic nance, International Financial Law Review, Banking Yearbook, London, pp. 40-4. 15) Rifaat, A. (2006), Presentation, Al Qabas Newspaper, March 29. 16) Grewal, B.K, Constraints on Growth in Islamic Finance, IFSB 4th Public Lecture on Financial Policy and Stability, 2011 17) Dar, Humayun, Islamic Financial Innovation: Tools and Trends, Islamic FinanceReview, July2012 18) Arbuna, M. (2006), Al Qabas Newspaper, Islamic Services Board Conference, March 29, p. 48. 19) Al Alaywi, R. (2006), Islamic banking products, Al Qabas Newspaper, September 1. 20) Al Yasseen, B. (2007), Interview, Al Qabas Newspaper, March 7. 21) Hafeth, O. (2006), Islamic banking products, Al Qabas Newspaper, September 1.

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