Growth Model for Islamic Finance: the Collaborative Model

Compliance with religious beliefs and methods is at the heart of the origin, law and practice of Islamic finance. This compliance translates itself in various aspects of operations, products and service delivery of financial services. In day-to-day handling, compliance manifests across three broad dimensions: structure, process and documentation.

• Structure: This refers to the chosen underlying compliant financing structure, such as murabaha and ijarah etc.
• One product – many structures: Typically most products can be offered under more than one compliant structure. For example – letter of credit (LC) based import financing can be offered under musharaka or murabaha (see table below) structures. Credit card offerings have been structured under al tawarruq or ujr (fees).
• One offering – composite structures: Certain product offerings have more than one underlying compliant structure. For example bai inah and wadiah are combined to handle credit card offerings in certain Asian markets. Another structure, al tawarruq, has an in-built murabaha structure.
• Process: Process refers to linear flow of activities that are not to be omitted or are to be performed only in the prescribed order.
• Documentation: Refers to evidencing of requirements originating from the underlying structure, roles along the transaction (e.g. master/agent, agency and buyer/seller), flow of asset and services, removal of dependency and uncertainty (gharar) – in a recorded form.

Islamic Finance Compared to Conventional Banking

At a high level, the common ground between Islamic and conventional banking appears to be transaction services such as account services, remittances, clearing, standing instruction administrations etc (see figure below). From a conventional bank perspective these are fee-based services. From an Islamic financial institution these are ujr based services.

Significant differences emerge about the structure, process and documentation dimensions when financing activities are considered. This is primarily due to difference in approach to financing: fund-based (conventional) compared with asset-based (Islamic). When financing assets in a Shari’a compliant manner, products that are considered ‘general lending’ (off the shelf) in conventional banking assume ‘aspects of complexity’ that are usually observed in structured finance products offered by conventional banks. This could be the underlying cause of a notion that Islamic finance transactions are time consuming. Differences also spring from institution specific Shari’a governing board and accepted practices at a country and regional level. Also, there are other notions that direct appeal of Islamic compliant financial services is only to a limited customer base and at times operations and processes are less customer centric.

Are Differences Posing Challenges?

When compared to conventional banking where the underlying practices and approach are largely similar (with additional regional/country specific differences) and have rapidly evolved over the last century, the ‘commonality’ in operations and structures across Islamic financial institutions (IFIs) is often limited. While this fosters innovation, at a high level it poses the following growth challenges:

• Tight coupling of practices, people and systems to institutions and operating country.
• Lack of large banks operating in all existing Islamic finance markets.
• Restriction of movement of talent (due to tight coupling and hence scarcity) across IFI markets.
• Lower volumes and limited scale benefits.

As a step towards commonality, organisations such as the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) have been successful in creating recommended standards. Adoption of standards is improving. However the above challenges largely remain. When viewed critically, one can understand that the customers’ of IFIs increasingly expect a balance and not a trade-off. There is a need to address these issues while managing the projected growth expectations in parallel.

Is There a Need for a Different Operating Model?

The next level in IF can be achieved by taking ‘balance’ to the next level. Currently, the first dimension of balance, i.e. between the core principles of faith and application to finance/banking, has been achieved. The next level of balance will be between individual bank space and collaborative space. IFIs need to explore collaborative models, though the drivers may be different. At a high level four such drivers are:

• Broad-basing: Limited commonality as detailed above has lead to challenges. In a bid to overcome them, broad-basing will be a target for all parties involved in both development as well as running of IFIs.

• Real alternative: Islamic finance needs to grow beyond the niche, if it is to emerge as a viable parallel model to conventional banking.

• Growth: Most IFIs are reporting or are targeting strong growth rates in the short to medium term. In certain markets the growth is expected to come from customer uptake from the conventional banking side. Conventional banking customers will need to be won over.

• Competition: With conventional banks opening Islamic finance windows/subsidiaries they will be looking to explore synergies¹ in operating models within institutions. When viewed as competition, IFIs will have to contend with pure conventional banks and windows of conventional banks (backed by synergistic models). Historically, conventional banks have taken the circuitous route of going it alone and are now (in the last five years) keen to take on collaborative operating models. As a legacy, most of them have been saddled with point solutions and armies of application(s) and aligned teams that are refreshed at every imperative (market side changes, regulatory or otherwise). Some of the drivers for looking at collaborative models are cost take-out, growing volumes, high investments, regulatory requirements etc. Conventional banks (with Islamic windows) seem to be poised to get into a position of next level of balance. IFIs will have to get their act right to handle such competition. Also, IFIs should evaluate collaborative models now to avoid taking the same circuitous routes as their conventional counterparts.

The Collaborative Model

To summarise: compliance ‘assurance’ delivered as a managed service through an aligned collaborative operating model will be a compelling proposition that will catapult IFIs to the next level of balance. Two key aspects of the proposition are detailed as follows:

• Managed service/utility:The utility(s) will be institution(s) that can deliver compliant Islamic financial services (operations and IT) back to back to subscribing/partner IFIs. From an Islamic finance perspective, a utility can be viewed as a partnership (musharaka). The utility will need to constitute a Shari’a board that will act like the central Shari’a board for all subscribing/partner institutions. The board can be constituted from subscribing institutions/supporting development organisations (see ownership below). Subscribing institutions can have increasingly lighter Shari’a boards as more processes and structures are governed by the Shari’a board of the utility. Similar models are commonplace from the conventional banking side e.g. in some European markets, the operating model is structured in a manner where product management, IT and operations are common or shared (collaborative space), whereas distribution and customer handling are left to individual banks (competitive space). While this may be an end-state, subscribing institutions will need to retain lighter delivery platforms at their end during the evolution. Utility structures could provide a basis to address all of the challenges described in section above.

• Compliance assurance:The service when provided by an accredited body will provide assurance to customers, partner banks that services provided by the body are fully compliant. This is detailed in terms of common structures, processes and documentation (core operational dimensions of compliance). By far this will also aid in ‘mutual recognition’ of practices and processes. For example, IFIs today have the option of relying on the approval of structure by another IFI (or undertake own assessment). Mutual recognition of structures will improve the speed of execution (to that extent).

A few of the considerations for such a utility along the ‘think, build and operate’ dimensions, in the context of Islamic finance, are as follow:

Think

• Business case:

From an industry and developmental institution perspective the need to drive adoption of standards, increase the commonality and provide a real alternative, among other things, should drive the business case. At an IFI level the same should be considered in terms of efficiencies, savings, time to market, access to best practices, ability to offer wider range of products (through various underlying structures), ability to enter newer markets, etc.

• Structure:
• Ownership: Development organisations such as AAOIFI are rightly placed to influence and possibly own the formation of such utilities. This will also implicitly aid in ‘active standards adoption’. They could establish this utility on their own or along with initial member banks’ (possibly the musharaka structure could be leveraged) and progressively offload stake to newer IFIs or banks that join. Due to the paucity of large IFIs operating in all existing markets and the resultant institutional void, developmental organisations have a larger role to play.
• Geography: The geographic scope of such utility(s) in the initial phase could be looked at on a regional basis. This will help in quick wins at a regional level due to existing regional alignments and differences. As structure and operations mature, scope can be enhanced to provide global coverage.
• Products: As far as product scope is concerned, common aspects that are fee based (ujr based) transactions will be a good starting point. Financing operations in general lending (off the shelf) could form the next (but the major) wave. Care should be taken to improve coverage of all products with various underlying structures. The final wave needs to be fluid to support structured finance transactions. However core aspects of operations, documentation may be pre-defined by the utility to improve speed of execution.
• Governance:

Along with the aspect of central Shari’a board and lighter boards at an IFI level, a governance forum for exceptions and a new structure (and aligned process and documentation) will need to be constituted. Post discussion and approval at the governance forum, acceptable alternatives (for exceptions) along structure, process and documentation need to be configured in the utility’s delivery platform (IT and operations). Member banks could then use all or any of the structures acceptable to them for any given product. The forum could also look at innovation and contribute to fine-tuning of standards.

Build

• IT application(s): The challenges of supporting such a utility in an Islamic finance context will be manifold. Among other things, the greatest emphasis and configurability will be needed along the BPM, BRM and BAM² layers (mid-office). Essentially these will support the three core pillars of operational compliance in Islamic finance – structure, process and documentation. The underlying core engine (back office) would need to be multi-entity enabled, among other things. Some of the best in class components from subscribing institutions may be used in building the delivery platform of the utility. Service orientation will help in future proofing.
• Partners: Realisation of such a utility will need collaboration from experienced organisations to support IT and operations with prior experience in an Islamic finance context. Involvement of partners will foster larger commonality in the sense that it broad-bases generic understanding, improves availability of operational talent to support the utility and eventually the projected growth of Islamic finance as a whole.

Operate

• Operations: A multi-phased approach will be needed to shift processing to the utility in an increasing order of complexity.
• Operational compliance: Mandate for operational compliance (including metrics) needs to be arrived at. Appropriate reports need to be configured to provide an end-to-end view to ensure compliance.
• Service level agreements and pricing will need to be established.
• Structure maturity: Due to availability of structure and aligned operations for any financing structure, institutions will be able to adopt advanced structures beyond common structures such as murabaha.

The utility model could appeal to the multiple types of institutions operating in the Islamic finance market:

• Existing IFIs: It is an opportunity to focus more on growth than just manage the as-is business. IFIs could lead the way by sharing their structures, processes, documentation and teams to build the utility and in that process rationalise their delivery platforms. From a cost perspective it gives them an opportunity to move from fixed costs to variable costs. The utility platform could also provide the support for seamless entry into new markets.
• New IFIs: A utility can alleviate most of the pain points of a new start-up and accelerate maturity. The sheer existence of such a utility will influence the business cases of entities evaluating entry into the IFI sector. New institutions will mean growth.
• New conventional banks: An Islamic finance utility will be a turnkey solution for such banks to enter the Islamic finance market.
• Existing Islamic finance windows of conventional banks: The assurance of compliance coupled with the managed services model could be proposition they cannot ignore.
• Development institutions: Development institutions can shape the growth and value of such utilities and thus improve standardisation and larger commonality.

Conclusion

In the current context there is a need for a growth model to consolidate achievements to-date and catapult Islamic finance to a position of strength. The utility model seems rightly placed to help achieve the next level of balance between individual bank space and collaborative space. Concerted effort from various interested stakeholders will be required to make this happen.