​

THE EFFECTIVENESS OF DESIGNING NEW ISLAMIC FINANCIAL INSTRUMENTS AND PRODUCTS IN LINE WITH PRODUCTION LEAP

​

ALIJA (ALI) AVDUKIC

UNIVERSITY OF DUNDEE SCHOOL OF BUSINESS

​

�

Presented at the

Webinar of Iranian Association of Islamic Finance

18^th August 2024

FACTOR 1: NEW INSTITUTIONAL ECONOMICS

• New Institutional Economics (NIE)--takes a broad/comprehensive view of economies
• Studies the structure and evolution of economies
• Uses four levels of analysis
• Culture
• Institutions
• Organizations
• Markets/transactions

​

CULTURE (I)

• Culture entails
• Ideology, beliefs, values and norms
• ‘Patterns of thinking, feeling and acting—software of the mind’ (Hofstede and Hofstede)
• ‘…the means by which people communicate, perpetuate, and develop knowledge about attitude towards life’ (Geertz)
• ‘All human contributions to ideas, perceptions, customs, socio-political systems, and economic constructs’ (Arab HDR 2003)

​

INSTITUTIONS (II)

• The nature of polity, state, constitution, laws, justice system, etc.
• Would include public institutions like the executive, judiciary, legislation, courts, and bureaucracy
• Defines the property, human, and political rights

​

​

​

ORGANIZATIONS (III)

• Groups of individuals with common purpose of achieving certain goals (firms, nonprofits, unions, schools, etc.)
• Structure and governance issues
• Efficiency and incentive structures
• Minimization of transactions costs

​

• Allocation and exchange of resources, goods and services takes place
• ‘Nexus of contracts’
• Technology, costs and risks determine the type of markets and products/contracts used

​

Markets/Transaction (iv)

NIE - Dynamics of Economic Structures

• Intrinsic Evolution
• Starts at culture (A1, A2, A3)
• Stock and production of knowledge determines institutions/organizations
• Speed and direction of change depends on rate and kind of learning, respectively

Culture

Institutions

Organizations

Transactions

A1

A2

A3

NIE - Dynamics of Economic Structures

• Marginal Adaptation
• Starts at the transactions level (B1, B2, B3)
• Change in preferences/ technology—niche market
• Organizations/institutions change to meet demand

​

Culture

Institutions

Organizations

Transactions

B3

B2

B1

NEW INSTITUTIONAL ECONOMICS AND ISLAMIC BANKING AND INSURANCE

• Organizations
• Islamic banks
• Non-bank financial Institutions (Takaful, microfinance institutions, etc.)
• Markets and transactions
• Islamic contracts
• Islamic financial products
• Financial markets and instruments (sukuk, derivative instruments, mutual funds, etc.)

​

​

• Culture
• Ideology, beliefs, values and norms
• Origins of worldview, thought, concepts
• Islamic economic/financial principles
• Institutions
• Laws
• Regulation

​

FACTOR 2: HALAL & HARAM

Substance

Process

Context

Source

THE IMPORTANCE OF PRODUCT DEVELOPMENT

​

• We live in an ever-changing world where new products are introduced to us almost on a daily basis.
• How creative, innovative and useful the product is can play a vital rule in how well it is received and sold.
• The growth of any industry depends largely on its ability to successfully create and launch new products and services.
• As such, successful institutions are the ones that are able continually to develop new superior products and services that can deliver unique benefits with real added value to their customers.

WHAT IS PRODUCT DEVELOPMENT

• Product development can be defined as “the activities required to transfer an idea into commercial product to be introduced into a new or existing market”.

​

• Product development aims at:
• Development of an entirely new product that satisfies a newly defined customer needs or niche markets; or
• Renewing the product’s life cycle through modifying the existing product’s features, benefits or presentation.

​

​

• Each institution needs to define its own product development process by capitalising on its own strengths and overcoming its weaknesses to achieve the optimal process.

​

PRODUCT DEVELOPMENT CRITICAL SUCCESS FACTORS

PRODUCT DEVELOPMENT STRATEGY

• Successful development of new products requires the institution to establish its product strategy. To do this, the institution should:
• understand its market conditions, including its customers, competitors…etc
• identify its own capabilities and competence to be able to make successful decisions.

​

​

​

​

The new product strategy needs to be comprehensive, reflect consensus and should be communicated clearly in order to address all issues related to new product development

PRODUCT DEVELOPMENT STRATEGY APPROACHES

• The choice of the strategy depends on whether the institution is looking to tackle a new opportunity or face a possible threat.

​

• As the internal circumstances of the institution and the market conditions will be constantly changing, the use of one strategy might not be viable in the long run. Therefore, most institutions use a mix of strategies to ensure readiness to all possibilities.

INNOVATION PROCESS

• Innovation is a process that leads to a significant improvement on an existing product or service, or to the conception of a new creative product.
• The success of new products depends largely on their creativity and the added value they bring to the customer through innovation.
• Based on this, it is critical for the institution to create the right environment for the product development team in order for them to be creative and add value through innovation. This is specifically critical if the institution has adopted a proactive strategy where innovation is the backbone of success.
• Innovation can be driven by different factors such as:

​

TYPES OF INNOVATION ACTIVITIES

A set of activities leading to minor modifications or adaptations to existing products

Creating a completely new service or product from scratch, which is a riskier approach

Usually used with a reactive product development strategy

Usually used with proactive product development strategy

INNOVATION PROCESS FOR SERVICES

• The requirements for innovation in service are similar to those for the product innovation. However, services are easily replicated by competitors with less capital and shorter time. Therefore, financial institutions have to continuously innovate to protect their competitive advantage.
• Service differentiation is a key requirement to successful service development which can be achieved by focusing on one or more of the following ways of innovation

INNOVATION IN ISLAMIC FINANCIAL INSTITUTIONS (IFIs)

• Islamic financial products and services are different by nature as they are required to adhere to Shariah requirements in addition to the legal and regulatory framework. Therefore, innovation in Islamic finance becomes more challenging.

​

• The product structure has to strike a balance between:
• Shariah compliance
• Regulatory requirements; and
• Commercial viability

​

But, are Islamic products any different?

• Financial products are designed to fulfil a need
• Retail products are more likely to be genuinely needed
• The end result of the product may be identical or very similar in conventional and Islamic
• It is the structure and the process that determine whether the product is Shariah compliant or not (but this needs to be explained properly to the customers)

​

Hence, so far the differentiation factor is still missing from Islamic retail products

​

​

INNOVATION & PRODUCT ENGINEERING IN IFIs

• Innovation in Islamic financial institutions can be achieved through any of the following approaches

​

​

TYPES OF PRODUCTS IN IFIs

• Based on the type of innovative approach applied, Islamic financial products can be classified into the following types:

PRODUCT DEVELOPMENT PROCESS

​

• Product development process may include various steps, however, no set formula can be used by all institutions to achieve successful new products.

​

• While there is no unique process that fits all, most of the models portray a sequence of various stages with several steps within each stage.

​

• It is not about what are the right steps in the process, but rather the need for having a formalized, step-by-step process that is then customized according to the needs of the institution and the product at aim.

​

​

​

PHASE 1

PHASE 2

PHASE 3

PHASE 4

PHASE 5

Concept Development

Product Definition & Analysis

Post Launch Monitoring & Review

Product Launch

Product Implementation

Product Development Process in IFIs

Idea Generation

Idea Screening

Concept Paper

Initial Shariah Approval

Initial Management Approval

The Product Definition Paper

ALCO Approval

Regulatory Approval (when necessary)

Creating the Implementation Plan

Developing Legal Agreements

IT System Development & Testing

Sales & Marketing Plan

Product Procedure Manual

Product Final Approval (Shariah & Management)

Staff Training

Final Customer Testing

Product Launch

Ongoing Monitoring

Shariah Audit

Regular Reviews

PHASE 1

PHASE 2

PHASE 3

PHASE 4

PHASE 5

Concept Development

Product Definition & Analysis

Post Launch Monitoring & Review

Product Launch

Product Implementation

Product Development Process in IFIs

ROLE OF THE SSB IN PRODUCT DEVELOPMENT

Product Launch

Product Concept prepared defining the underlying Islamic principles and product features

Initial review of the SSB on the principle and the product’s main conditions

Scholars review the final documentation and issue their approval

Regular & periodic Shariah audit for ongoing assurance throughout the product life cycle

Product documentation reviewed by legal and compliance

Building the product’s documentation according to the directives received from the Scholars

EXAMPLE OF SUCCESSFUL PRODUCT INNOVATION ��“IFAAS MUDARABA SOLUTION”

THE CHALLENGE

• Significant growth of Islamic Finance in the last 2 decades;
• Islamic banks relying heavily on Murabaha/Tawarruq based solutions to avoid risks associated with Mudaraba, Musharaka and Wakala;
• Controversy over Tawarruq solution Shariah compliance and its true spirit;
• Limited and uncompetitive offering means inability to fulfil client needs;
• Industry struggling to satisfy clients, Shariah scholars, regulators and the shareholders;
• Products need to be Shariah compliant by spirit, fulfilling client needs, being market competitive and profitable;

Therefore, offering finance products based on Mudaraba, Musharaka and Wakala is the right solution to bring the industry back to its right path and achieve Maqasid Al-Shariah.

IFAAS award-winning solution uses a set of control functions that reduces the risks associated with the preferred modes of Islamic finance while keeping the structure compliant with Shariah requirements.

ISSUES WITH TRADITIONAL MUDARABA

• Mudaraba is a partnership agreement whereby one party provides capital (Rab al Mal) and the other party provides labour (Mudarib);
• Although Mudaraba is preferred from a Shariah point of view, it has major issues that make banks reluctant to use it:

​

​

​

​

​

​

​

​

• IFAAS solution has been designed specifically to solve these issues whilst adhering to AAOIFI Shariah Standards.

​

IFAAS SOLUTION

• Shariah Compliant: based on Mudaraba

​

• Flexible: allows the client to utilise any amount of funds up to the agreed limit (Mudaraba Capital) as and when required to support its working capital;

​

• Reduced risk: uses a set of control functions that reduce the inherent risks of the Mudaraba as a financing solution;

​

• Improved protection: provides greater protection to the bank whilst using the most preferred Islamic financing structure;

​

• Efficient: offers very low transaction cost (compared to other Islamic financial structures) and it can be utilised for multiple purposes including working capital, overdraft and project finance.

?

?

?

?

?

!

?

PRODUCT PROCESS

Bank

Client

STAGE 2. The client can use bank’s funds (Mudaraba capital) as and when required subject to the agreed limit

STAGE 1. The client and the bank agree on the profit sharing ratio and the expected profit rate

STAGE 3. The bank sends a monthly statement showing the amount of Mudaraba capital utilised in the month and the advance profit payment payable by the client for the relevant month

STAGE 4. Client makes the monthly advance profit payments on the relevant payment dates

STAGE 5. The client sends his quarterly management accounts and a confirmation of the achievability of the expected profit rate, based on current business performance

STAGE 6. At maturity, the client sends the final management accounts, the bank calculates the profit for the entire Mudaraba period and makes payment adjustment (if needed)

CONTROLS

• Profit reserve amount that can help in stabilizing the profit payments & offset capital losses

​

​

​

Advance profit payments made on monthly basis

(on account)

​

- Accountancy system

- Past financial performance

- Projected accounts

​

Strict eligibility criteria

On-going Monitoring

​

Stream of monthly income

​

Control to reduce potential losses

​

  Final calculation

Profit calculation

Sale of goods/services only above the cost price

Quarterly Accounts

(completed by the client & reviewed by the bank)

Mudaraba profit is calculated from gross profit, not from the net profit

​

​

RISK MANAGEMENT

The solution can be used in providing different types of financing solutions in accordance with local laws and regulations of each market.

BENEFITS FOR THE CUSTOMER & THE BANK

Customer

Bank

ACHIEVING MAQASID AL-SHARIAH THROUGH PRODUCT DEVELOPMENT - I

• The utilisation of maqasid al-Shariah in the processes of product development can help in filling the gap between the theory behind Islamic finance and the actual practice of the industry.
• This can be achieved by adding additional technical steps to help in controlling the outcome of product development process and drive it towards ensuring that the new Islamic products will in fact fulfil Maqasid al-Shariah as well as the goals of the financial institutions. The following points summarise the new proposed steps:
• Idea generation: When a new product idea is developed, the institution should ensure that the objective(s) of this product is in line with all the essential Maqasid and does not contradict any of the Shariah objectives of creating justice, equality and achieving the well-being of the entire community.
• Idea screening: The selection process for the best concept should include assessment of the benefits that this product will bring first to the customer and then to the society and should not be concerned only with the benefits that this product will be bringing to the institution itself.
• Product Design: The product features can impact the way the product is utilised, whether to achieve the desirable Maqasid only or can be used for helping the customers obtain both the essential and the desirable Maqasid.

​

ACHIEVING MAQASID AL-SHARIAH THROUGH PRODUCT DEVELOPMENT - II

• The legal agreements: The contractual arrangements should be fair and un-bias towards the financial institution and should avoid the usual practice of leaving the clients exposed to all sorts of legal risks. This additional check should be part of the Shariah advisor’s job who should report any potential issues to the SSB. This additional process will ensure that the financial institution will not focus on protecting its interests only as this will negate the objective of the product and disturb the order between essential and complementary Maqasid.
• Shariah audit: The Shariah audit should be used not only to check the correct implementation of the product, but also the way it is used by the customers and whether it is accomplishing the desired results of positive contribution towards achieving the Maqasid. At this stage, the use of principle of harm prevention should be applied using an additional task within the Shariah audit process of the product to filter out any unsuitable or non-compliant usage of the product.

​

This application of Maqasid al-Shariah into the processes of product development should ensure that the new products developed by Islamic financial institutions will fulfil Maqasid al-Shariah and contribute positively to the development and growth of the individuals and the society.

CONCLUDING REFLECTIONS

• Current practice reminds Eliot (1925, The Hallow Men)

“Shape without form, shade without colour,

Paralysed force, gesture without motion...”

​

• But as Rumi would say:

‘How pleasant is to flow without blurring and freezing

…

Now is necessary to say something new’.

​

​

For socially and environmentally responsible value oriented just economic and financing system, which can enable individuals to function and which can aim at well-beings of individuals…

​

Utopias should exist so that realities can be constructed and engineered…

​

Thank you…