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Book: Product Development in Islamic Banks

The predicament contemporary Islamic finance practice faces is at two levels: the first is foundational and the second legal. At the foundational level, Islamic finance is considered to be a part of an Islamic economic system which has an inherent social orientation.

Islamic banking began in the 1970s with the aim of providing financial services compatible with Islamic law. Driven by market forces it has grown rapidly in Muslim countries and in international financial sectors. It is projected to grow at an annual rate of 15-20% and a key factor determining this future growth is the availability of new products that will satisfy the needs of various segments of society.

While other texts discuss the basic principles and contracts used in Islamic banking and finance, few discuss how these can be used to develop financial products. This book fills that gap, starting with the basic principles that form the building blocks of contemporary Islamic financial products and then discussing the more intricate issues relating to product development processes.

Habib Ahmed is the ‘Sharjah Chair in Islamic Law and Finance’ at Durham University. Prior to joining Durham University in August 2008, he worked at the National Commercial Bank and Islamic Development Bank (IRTI) in Saudi Arabia and taught at the University of Connecticut, National University of Singapore, and University of Bahrain.

Table of Contents:
1. Introduction

In an interview conducted for this book, a senior official of an Islamic bank in Malaysia disclosed the following: ‘Almost 70 percent of our customers are non-Muslims. In fact, we find it difficult to sell products to Muslims clients as they ask many questions about the authenticity of Islamic products’. This statement reveals the paradox facing Islamic banking practice today. On the one hand non-Muslims, who can use conventional financial services, are choosing Islamic financial products in large numbers. They do so, not due to religious reasons, but because they find the terms and conditions of the financing attractive. For Muslim clients, however, terms and conditions are not the only factors determining their business with Islamic financial institutions. For them, dealing with Islamic banks is a matter of faith. As such, compliance of banking practices with principles and rules of Shari’ah becomes vital for them.

The predicament contemporary Islamic finance practice faces is at two levels: the first is foundational and the second legal. At the foundational level, Islamic finance is considered to be a part of an Islamic economic system which has an inherent social orientation. The overall goal of this system is to realise the objectives of Islamic law (maqasid al-Shari’ah) which should manifest in the economy as enabling growth, justice and equity. This implies that other than fulfilling the legal requirements, an Islamic financial system should also cater to the social needs of a society. Other than Islamic economists and scholars, many other stakeholders of the industry expect the Islamic financial sector to play this social role. This is evident from a survey of 1,500 stakeholders conducted by Dusuki (2008) in Malaysia, who finds that the bulk of the local communities, customers and depositors identify alleviating poverty, contributing to social welfare and promoting sustainable development projects among the key goals of Islamic banking.

From the legal perspective, the contention is that the Shari’ah requirements are being diluted. The crux of the condemnation is focused on the products offered by the Islamic financial sector, which increasingly appear to be mimicking those of conventional finance. In doing so, the legalistic forms of contracts are fulfilled but the substance and spirit are not. For example, in a recent study Dusuki and Mokhtar (2010) find that only 11 out of a total of 560 sukuk (Islamic bond) issues (or around 2 per cent of the total) qualify to be asset-backed as these fulfil the legal Shari’ah requirements of an actual sale of the underlying asset to the investors. The remaining 98 per cent of the sukuk replicates conventional unsecured bonds with the sale of the underlying asset not being actual, from both accounting and legal perspectives.

The failure of Islamic finance to fulfil the legal requirements has generated criticism from both detractors and proponents of the industry. At the extreme end of the spectrum, the Islamic financial industry has been denounced as a ‘deception’ and ‘charade’ (Saleem 2006a,b). Seniawski (2001) and Holden (2007) identify the current practice in the Islamic financial industry as ‘legal hypocrisy’ and Hamoudi (2007) calls it ‘semantic fantasy’ and ‘jurisprudential schizophrenia’. ElGamal (2007a, 2008) claims that Islamic financial institutions are ‘rent-seeking Shari’a arbitrageurs’ using ‘ruses to circumvent prohibitions’ of Islamic law at the product level. More recently, some Shari’ah scholars have joined the Islamic economists in pointing out problems with the legalistic approaches of approving Islamic financial transactions. Usmani (2007) points out the majority of the sukuk issues in the market replicate conventional bonds and are not in line with the spirit of Islamic law. Similarly, DeLorenzo (2007) is critical of total return swap and declares it to be unacceptable even though the form is Shari’ah compatible.

The dilution of Islamic financial practices both at the foundational and legal levels has disillusioned many proponents of the industry. Disappointment with the current practice of Islamic banking in their failure to fulfil the Shari’ah requirements (social and legal) is summed up by a comment by Dr Muhammed Obaidullah, a well-wisher and founder of the world’s largest internet-based discussion group on Islamic banking and finance. Reacting to a news item about the Indian High Court’s decision to halt Islamic banking plans in the country, he reacted in the following way:

It is indeed a blessing in disguise for India’s 150 million
Muslims, a large majority of whom are poor and whose finan-
cial needs are certainly not going to be taken care of by the
large banks practicing the ‘spurious’ variety of Islamic banking
and investments. The so-called mainstream Islamic banking
and finance is a sham, targeted at high net-worth individu-
als and corporations, against true Islamic ideals and spirits,
a poor attempt to disguise conventional products in Islamic
garb. (Obaidullah 2010)

To understand the context of the criticisms of the practice of Islamic finance, there is a need to reflect on the origins of the industry. Islamic finance was conceptualised under a broader movement of revitalisation of Islamic values, identity and institutions. After a long period of colonial rule, many Muslim countries gained independence in the twentieth century. Muslim scholars and communities in the newly independent nations aspired to revert to institutions and organisations reflecting Islamic values and principles. On the economic front this led to, among others, the study of issues under the banner of Islamic economics. From an urge to seek solutions to economic problems in the light of the injunctions of Islam, economists asserted that the value system of Islam would provide a better concept of economic development and a pragmatic approach to achieve it, not only for Muslims but humanity at large. The scholars envisaged the discipline to realise maqasid al-Shari’ah. In its broadest perspective, the maqasid would include growth and justice (Siddiqi 2004).

One of the first manifestations of Islamic economics was the initiation of Islamic finance. The first experiments of Islamic finance began in the countryside of Mit Ghamar in Lower Egypt in 1963. Under the leadership of Ahmed alNajjar, savings/investment houses operated in small towns in Northern Egypt, providing financing on a profit-loss sharing basis to small entrepreneurs and poor farmers. In the same year, the Pilgrims’ Management and Fund Board (Tabung Haji) was established in Malaysia to help people save money to go for hajj (pilgrimage). The funds were used to invest in industrial and agricultural projects.

After the formation of the Organization of Islamic Conference (OIC) in 1973, the Islamic Development Bank was established in 1975 in Jeddah, Saudi Arabia. The multilateral development bank was formed with an objective of fostering economic development and social progress of member countries in accordance with the principles of Shari’ah. In the same year, the first Islamic commercial bank, Dubai Islamic Bank, was established in the United Arab Emirates (UAE) by a pious businessman named Saeed Ahmed Lootah. Initially, both banks did not have Shari’ah scholars or boards to guide their operations and operated according to their understandings of interest-free banking (Kahf 2004b).

As Islamic banking expanded, professionals from conventional banks and Shari’ah scholars got involved in its operations. While the former group managed the day-today activities of the banks, the latter group provided legitimacy to the operations. The role of Shari’ah scholars was to study individual transactions and approve their compatibility with Shari’ah principles. Initially, Islamic banks attempted to experiment with profit-loss sharing modes of financing. As bankers were not trained to manage the risks of equity-based instruments, they preferred to use debt-like sale-based modes of financing as these matched their background and skills. As Islamic finance grew, however, the main focus of the industry became providing ‘Shzari’ah-compliant structures for conventional products’ (Dar 2007). In doing so, the practice of Islamic banking and finance gradually moved closer to conventional banking products and practices over the years.1 Chapra (1985) and Siddiqi (1983) apprehend that using debt-based instruments not only represents the status quo but also may not conform to the true spirit of Islamic commercial law as they negate the basic principle of risk sharing.

  1. Islamic Law and Finance: Concepts and Principles

The essence of Islam is tawhid which means unity of God (Allah) and creation. Though the word signifies oneness and sovereignty of God, it has implications related to all aspects of life including economics and finance.1 Among others, the concept of tawhid implies that Allah is the owner of resources which are given to mankind in trust. In fulfilling the role of trustee, humans act as vicegerents (khalifah) of God on earth. These notions have implications for property rights and the nature of economic transactions that can be undertaken. All humans are created equal and given freewill by the Creator. An important inference of equality is the concept of justice, which forms one of the hallmarks of Islamic teachings. Tawhid also implies that Allah is the source of knowledge and value. As such, all discussions on law and morality ensue from this concept (Kamali 2008:17). A Muslim is one who accepts the sovereignty of God and freely submits to His will. The will of God is expressed to humans through different Prophets and revelation.

The teachings and commandments of Islam can be broadly categorised into three types: faith and belief (aqidah), ethics and morality (akhlaq), and rules and laws (fiqh) (Laldin 2006: 3). Fiqh consists of laws and principles related to dealings with other humans and the environment…

  1. Islamic Banking: Institutional Environment, Organizational Design and Product Features

A financial system entails markets and intermediaries providing products and services that satisfy various needs of different stakeholders in an economy. The key difference between Islamic finance and its conventional counterpart is that the former abides by the principles of Shari’ah. Grais and Pellegrini (2006a: 13) identify three aspects of Shari’ah requirements for the Islamic financial industry. First, conduct financial transactions in accordance to the laws of Shari’ah primarily by avoiding riba and gharar. Second, promote social benevolence by undertaking activities that foster societal objectives. Finally, develop an integrated Islamic financial system based on the principles and goals of Shari’ah (maqasid al-Shari’ah). While the first requirement relates to the legal requirement of Islamic finance, the latter two deal with the social requirements of Islamic law, discussed in Chapter 1. A key factor that determines the legal and social Shari’ah requirements is the type of products marketed by Islamic banks.

  1. Innovation and Product Development: Strategy, Structure and Process

Innovation can be viewed as firms’ response and adaptation to the changing conditions of markets and the environment. In a marketplace that is constantly evolving, firms that do not innovate and come up with new products can eventually languish and die’ (Fuller 2005: 1). Two broad categories of factors affecting financial product innovations can be identified. The first is the institutional environment under which financial firms operate. This would include international factors such as increased globalisation, risk and technological shocks, and national factors like the legal and regulatory regimes. Among the important determinants of innovation is the ‘institutional architecture’ that can include supportive public laws, regulations, and institutions that facilitate constructive product development (PD). The second broad category affecting innovation relates to organisational aspects. Some of the organisational factors relevant to innovation in financial institutions are examined next.

  1. Product Development Practices in Islamic Banks

As Chapter 4 demonstrates, product development (PD) is a complex process involving many steps and requiring input from different departments of a bank. While various studies examine PD systems in different industries, empirical works on the financial sector are relatively few. Being a relatively new industry, no detailed study on the PD system in Islamic banking exists. This chapter presents results on the practices of PD in Islamic banks gathered from a survey of Islamic financial institutions. The objective of the empirical work is to examine the status of the PD system and identify the constraints facing Islamic banks in developing new products.

The empirical assessment of PD in Islamic banks is based on two surveys. The first survey examines the status of PD in Islamic banks, based on the answers to questionnaires that were sent to Islamic banks globally. Data on the size of the bank (assets and number of staff), PD unit/department, and policy and procedures related to PD in the organisation were sought. The objective of this survey was to have an overview of the status of the PD systems in Islamic banks globally. Questionnaires were sent to 177 Islamic financial institutions in thirty-six countries of the world. A total of twenty independent Islamic banks from twelve countries responded to the questionnaire.

  1. Islamic Financial Products: Categories and Controversies

This chapter draws on the concepts and results discussed in previous chapters to examine the properties of products provided by Islamic financial institutions. This is done by assessing the Shari’ah requirements. As discussed in Chapters 1 and 3, the Shari’ah requirements have both social and legal dimensions. These requirements are scrutinised in the light of the Shari’ah principles outlined in Chapter 2 and the product development system presented in Chapter 4. To assess products according to their social and legal dimensions, a scheme of classification is suggested. The scheme provides an objective criterion to classify Islamic financial products into three categories: Shari’ah-based, Shari’ah compliant and pseudo-Islamic.

  1. Shari’ah Based Islamic Finance: The Way Forward

This book opened with expressions of concern about the divergence of the practice of Islamic banking from its ideal model. Various chapters in the book attempt to examine the diverse issues related to Islamic financial products and their development processes. Chapter 3 discusses the institutional environment under which Islamic banks operate and Chapters 4 and 5 examine the organisational characteristics affecting product development. Discussions in Chapter 6 identify two scenarios under which Shari’ah principles can be compromised. First, internal and external constraints produce a feasible set that does not have any Shari’ahcompliant alternatives. This will be the case in countries that do not have Islamic banking laws and appropriate supporting regulatory regimes or face technological restrictions to the use of Shari ‘ah-compliant products. In these situations, the options available to Islamic banks may be to use pseudo-Islamic products or have no products at all.

The second situation in which Shari’ah requirements may be diluted is not due to constraints, but because banks choose to do so due to economic reasons. In these cases, the feasible set contains Shari’ah-compliant products. Islamic banks, however, choose to use products that compromise the Shari’ah requirements due to economic factors.


From a bare handful of financial institutions set up in the 1970s to provide services compatible with Shari’ah, the Islamic financial sector has witnessed extraordinary growth and has now become a significant global phenomenon. While the growth of the industry in a short span of time is commendable, concerns about its uniqueness and the direction it has taken are being raised. The inclination of the industry to use Islamic versions of conventional banking products has been accentuated by market-driven and competitive forces whereby economic factors overshadow the Shari’ah principles. The use of pseudo-Islamic products and those replicating conventional products by the Islamic financial industry raises serious questions about the essence and future of Islamic finance.

Siddiqi (2004) asserts that the ingenuity of the Islamic financial sector would be to integrate the vision of a moral society and socially responsible finance into functioning institutions. ElGari (2004) concurs that were the Islamic civilisation thriving, it would be capable of creating a vibrant society with institutions and organisations manifesting the core values of Islam. In this system, organisations including banks would be based on Islamic roots and reflect the features of justice, equity and social welfare.

Bibliographic Information

Title: Product Development in Islamic Banks

Editors: Habib Ahmed

Publisher: Edinburgh University Press

Language: English

Length: 272 pages

ISBN: 9780748639519

Pub. Date: January 2011

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