Governance Risk Management and Financial Product Development in Islamic Financial Institutions

Table of Content

1 Introduction
1.1 General Introduction to the Topic
1.2 Specific Introduction to the Central Topic
1.3 Problem Definition
1.3.1 Problem Statement
1.3.2 Research Questions
1.4 Outline of the Paper

2 About Islamic Finance
2.1 Characteristics of Islamic Finance
2.2 Structural Distinctions Between Both Types of Institutions

3 New Product Development
3.1 Introduction
3.2 NPD in Conventional and Islamic Financial Institutions
3.3 Approaches Toward New Product Development

4 Risk Management
4.1 General Remarks
4.2 Risk Management in Islamic Financial Institutions

5 Risk Factors
5.1 Operational Risk
5.1.1 Definitions
5.1.2 Operational Risk in Conventional and Islamic Financial Institutions
5.1.3 Countermeasures
5.1.4 Best Practice Guidelines
5.2 Reputation Risk
5.2.1 Definitions
5.2.2 Reputation Risk in Conventional and Islamic Financial Institutions
5.2.3 Countermeasures
5.2.4 Best Practice Guidelines
5.3 Transparency Risk
5.3.1 Definitions
5.3.2 Transparency Risk in Both Financial Institutions
5.3.3 Countermeasures
5.3.4 Best Practice Guidelines
5.4 Shari’ah Risk
5.4.1 Definitions
5.4.2 Shari’ah Risk in Islamic Financial Institutions
5.4.3 Countermeasures
5.4.4 Best Practice Guidelines
5.5 Fiduciary Risk
5.5.1 Definitions
5.5.2 Fiduciary Risk in Conventional and Islamic Financial Institutions
5.5.3 Countermeasures
5.5.4 Best Practice Guidelines
5.6 Marketing Risk
5.6.1 Definitions
5.6.2 Marketing Risk in Conventional and Islamic Financial Institutions
5.6.3 Countermeasures
5.6.4 Best Practice Guidelines

6 Success Factors of New Financial Products
6.1 General Remarks
6.1.1 Contributing Factors to Conventional Financial Product Success
6.1.2 Contributing Factors otof Islamic Financial Product Success
6.1.3 Characteristics of Successful Conventional Financial Products
6.1.4 Characteristics of Successful Islamic Financial Products

7 Research Framework
7.1 Summary of the Hypotheses
7.1.1 Section 1: New Product Development
7.1.2 Governance Risk Management
7.1.3 Success Factors
7.2 Research Methodology - Qualitative Research
7.2.1 Research Planning
7.2.2 Research Execution
7.3 Sample Determination

8 Research Results
8.1 Research Phase
8.2 Analytical Issues
8.2.1 Section 1: NPD Process Details
8.2.2 Section 1: Control Measures - Utilization
8.2.3 Section 1: Control Measures - Frequency
8.2.4 Section 1: Department(s) with Biggest Influence
8.2.5 Section 1: Major Problems in NPD Process
8.2.6 Section 1: Departments With More Influence
8.2.7 Section 2: Treatment of Governance Risk
8.2.8 Section 2: School of Thought Followed
8.2.9 Section 2: Most Important Governance Risk Factors
8.2.10 Section 3: Biggest Success Factors
8.2.11 Section 3: Governance Risk Management and Product Success
8.2.12 Section 3: Governance Risk Management Adequate
8.2.13 Section 3: Improve Governance Risk
8.3 Summary

9 Conclusion, Contributions and Limitations
9.1. Conclusion
9.2 Contributions
9.2.1 Academic Contributions
9.2.2 Managerial Contributions
9.3 Limitations
9.4 Future Research

Bibliography

Appendices

Appendices, Figures and Tables

Appendices

Appendix A: Overview of the Risk Profile of an Islamic Financial Institution

Appendix B: Hypotheses and Respective Interview Questions

Appendix C: Interview Schedule

Appendix D: Clarifying Questions

Appendix E: Interview Transcripts

Appendix F: Transcripts of Clarifying Questions

Appendix G: Results of Hypotheses and Unrelated Questions

Figures

Figure 1: Governance Risk Aspects

Figure 2: Typical Decision-Stage Model in the Form of a Stage-Gate Process

Figure 3: Ansoff Matrix

Figure 4: The Average New Product Portfolio

Figure 5: Frequency of New Product Activities Typically Conducted

Figure 6: Sequential and Overlapping Phases of Development

Figure 7: Governance Structure of Conventional and Islamic Financial Institutions

Figure 8: Overview of the Preparation Procedure for Qualitative Interviews

Tables

Table 1: Thematic Sections and Their Respective Hypotheses

Table 2: Results of Hypothesis 1

Table 3: Results of Hypothesis 2a

Table 4: Results of Hypothesis 2b

Table 5: Results of Hypothesis 3

Table 6: Results of Unrelated Question 1

Table 7: Results of Unrelated Question 2

Table 8: Results of Hypothesis 4

Table 9: Results of Hypothesis 5

Table 10: Results of Hypothesis 6

Table 11: Results of Hypothesis 7

Table 12: Results of Hypothesis 8

Table 13: Results of Unrelated Question 3 Table 14: Results of Unrelated Question

Abstract

Product development is crucial in every industry that is still growing as the rules of the game are not yet set and there is an opportunity for shaping the industry. This counts particularly for the Islamic financial industry, where competition for market shares is tough and where financial institutions have to be creative in order to come up with new ways of meeting and exceeding the demands of the market. In Islamic financial institutions, financial product development is of particular importance, as Islamic finance is a niche market that showed tremendous growth since it was established. Yet a new financial product has no worth if its risk aspects are not accounted for and properly addressed. If this is not the case, the product will fail and, in the worst case, will become a liability in the institution’s product portfolio and will harm the reputation of the institution. Various aspects were examined in this paper. One part related to how the various governance risk factors, meaning the risk aspects that are under direct control financial institution, are addressed in the new product development process within Islamic financial institutions. Product development was another aspect, as little is known about what new product development model is used in Islamic financial institutions. Finally, it was considered to be of interest whether governance risk management made a contribution toward the probability of the new product becoming successful in the market and what the new Islamic financial product success factors were in general. In order to study these aspects, eight participants from four Islamic financial institutions located in the United Arab Emirates were interviewed.

The results showed that the product development process within Islamic financial institutions resembled a decision-stage model and is very interactive, with simultaneous processes being quite important in order to keep time-to-market to a minimum. Simultaneously, several problems that occurred in the NPD process were uncovered. It was also shown that adequate governance risk management of an Islamic financial product starts in the new product development process already. It can hence make a valuable contribution toward making the new product a success. Particularly the Shari’ah department, which assured that the product was compliant with Islamic law, is worth mentioning as an important business function here. Nonetheless, there were various problems in addressing every governance risk management aspect in practice, although certain aspects were directly linked to product success factors. Hence there is some room for improvement within Islamic financial institutions, as this is the only way of assuring that new products will become assets in an institution’s product range.

1 Introduction

1.1 General Introduction to the Topic

Islamic finance is on the march. The underlying logic is simple: All investments and services are consistent with the principles of Islamic law, called Shari’ah, which literally means ‘a clear path to be followed and observed’ (Hourani, 2004a). This clear path is followed only if profit does not stem from interest (riba), speculation (gharrar) or sectors that are considered sinful according to the Qur’an (haraam), namely everything that involves alcohol, tobacco, entertainment, gambling or pork, just to name a few. Instead, charity should be promoted (zakat) and mutual benefit must be at the heart of every transaction with the notion of sharing profits and losses (Hourani, 2004b). Due to the fact that transactions are asset-backed by the financial institution that provides them, there is less risk involved (Euromoney, 2008).

The high potential of Islamic finance is clear for three reasons. The first reason relates to the emergence of a new consumer type, as there is increased demand for a Shari’ah-compliant way of investing that stems from increased globalization. The middle class from emerging markets rose from one third to 56 percent between the 1990s and 2006 (The Economist, 2009). Many Muslim countries can be found in the list of emerging markets, such as Egypt, Pakistan and Indonesia. With the Muslim population’s level of wealth increasing, demand for a way to invest in accordance with Islamic law is increasing rapidly (Reuters, 2009a). With the Muslim population of the world exceeding 1.5 billion people (about 21 percent of the world population) and due to the fact that it is the fastest growing religion, it becomes clear why the general conditions for Islamic finance are so favourable (Central Intelligence Agency, 2009). The second reason relates to the global trend for sustainable investment; the fact that Islamic finance is an ethical way of investing which does not invest in harmful businesses and instead donates purified gains to charity is becoming more and more attractive among non-Muslim investors as well (Global Finance, 2007). The Shari’ah aspect makes Islamic financial products an alternative to socially responsible investments (Khan, 2009).

The last reason is a matter of trust; in the face of the financial crisis that began shattering the world in 2007, many investors lost confidence in the traditional banks and their practices (Reuters, 2008; CNN, 2009). Due to no speculation being involved in its investments, Islamic financial institutions (called IFIs from now on) suffered less from most of the recent financial turmoil (Sydney Morning Herald, 2008). Today even the Holy See states that ‘the ethic principles on which Islamic finance is based may bring banks closer to their clients and to the spirit which should mark every financial service’ (Bloomberg, 2009). According to recent estimates, IFIs could increase their assets under management from roundabout $700 billion to over $1.6 trillion in 2012 (Reuters, 2009). Moody’s, the credit analyst, goes further and estimates the Islamic financial sector’s potential to be worth up to $4 trillion (CNN, 2009). But how to get to this number?

1.2 Specific Introduction to the Central Topic

Before answering that question, it pays to take a closer look at the industry’s roots. The necessity of an Islamic way of financing first appeared in the late 19th century when Barclays Bank in Cairo raised capital for the construction of the Suez Canal. This resulted in opposition from pious Muslims due to the fact the interest was raised. In 1953, Dr. Ahmad El Najjar laid the foundations for Islamic finance with the inception of Mit Ghamr Local Savings Bank, the first Islamic bank (Iqbal & Mirakhor, 2007a). Since then, Islamic finance has seen two-digit growth numbers on a yearly basis. Nonetheless, Islamic financial assets account for only 1 percent of global banking assets to date (Sydney Morning Herald, 2008). Islamic finance can hence be considered a nascent industry in the development stage even today due to the fact that there is little standardization of Islamic financial practices (Reuters, 2009). Browsing through journals and books about the industry shows that although very successful products have been launched so far (e.g. sukuks), the development of new products and services is considered vital in order to succeed in this highly competitive market^[1] (Iqbal & Mirakhor, 1999; Elfakhani et al., 2007a). Cooper et al. (1994a) pointed out that successful product innovation is fundamental for achieving business success in a highly competitive field. According to Ayub (2007a), the need for innovative Islamic financial products cannot be overemphasized. So far, IFIs focused more on growth and financial innovations in the past, with risk management being the second string all along (PricewaterhouseCoopers, 2008). Since no financial institution in the world can afford it to neglect risk management, new product development (NPD) paired with reasonable risk management seems essential for IFIs to prevail. However, this is not easily accomplished: Literature reveals that among the challenges Islamic banks have to face before issuing new financial products, two risk aspects seem to be major hurdles and deserve special attention in the NPD process, namely governance risk (consisting of several risk factors) and marketing risk.

Governance risk is the risk arising from failure in governing the institution, negligence in conducting business and meeting contractual obligations and attracted the attention of policy­makers recently (Iqbal & Mirakhor, 2007b). It plays a crucial role in the overall risk profile of IFIs and is vital to address as early as possible. As it can be seen, governance risk can be split up into five sub-risks (see Figure 1 below).

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Figure 1: Governance Risk Aspects

(Source: Iqbal & Mirakhor, 2007c)

Operational risk entails the risk of running inefficient processes within the IFI. Fiduciary risk, which evolves from not performing in accordance with standards applicable to fiduciary responsibilities, is a further aspect of governance risk that needs to be taken seriously. Not acting in the interests of shareholders and depositors can do great harm to an IFI (Iqbal & Mirakhor, 2007d). Transparency risk represents the potential of not disclosing information on which to base assessments on performance and the overall risk profile. This is a result of a lack of standardized accounting practices at IFIs (Iqbal & Mirakhor, 2007e). Shari’ah risk is basically the most unique risk, since it addresses the most distinguishing feature of IFIs, namely being in accordance with Islamic law. It is therefore astonishing that the Shari’ah supervisory board seems to be not always fully integrated in the product development process (DeLorenzo, 2006a). Related to Shari’ah risk is reputation risk, which occurs in cases of mismanagement or negative publicity (Iqbal & Mirakhor, 2007f). Another risk factor worth considering that is not part of the framework is marketing risk, which is examined for two reasons. First, marketing is considered to be involved when it comes to reducing reputation risk. Second, marketing is confronted with unique challenges that can be addressed by a marketing department within an IFI. In order to be of interest for the market, the optimal new financial product should be transparent, socially responsible, appealing in financial terms and must yet comply with Shari’ah law. Integrating all these requirements into the NPD process assures that the market reacts favourably to a new product and eventually determines whether the new product will be successful. Risk management in total is considered to be ‘grossly under-developed in IFIs’, with the necessity for ‘implementing proper risk measurements, controls and management’ (Iqbal & Mirakhor, 2007g). Hence extending the governance risk framework as proposed would capture the most important risks that an IFI can manage. Governance risk management is particularly interesting in combination with NPD. Yet the academic literature on Islamic financial product development is not ample in its scale. Two studies on new service development in the financial services industry by Alam & Perry (2002a) and Edgett (1996a) serve as a good starting point however. Especially the former (Alam & Perry, 2002b) is of interest in the case at hand, since it explicitly asks for replicating the study in another setting. Hence using the underlying framework in an Islamic financial product development setting would fill a gap in the academic literature. It might come as a surprise that nothing is known about how NPD is handled within IFIs, not to mention what NPD model is applied. Despite the variety in approaches that exist, two types of models are addressed mostly in academic literature due to its high prevalence: The activity-stage model and the decision-stage model.

The activity-stage model has clear-cut roles for every department. The major flaw of this approach is the insular view each function along the NPD process has. Lots of consultation and reworking is needed with this model, which doesn’t make it very practical (Trott, 2005a). Islamic financial product development requires the interaction of many functions, which would make this model not very attractive from a practical point of view (Ayub, 2007b). A more interactive model seems to be more promising in this context, such as a decision-stage model. Here, various decisions are taken among the stages with regular feedback loops that address progress of each individual stage (Trott, 2005b). Due to the different aspects that have to be considered in the NPD process and the high amount of interdisciplinary amount of communication between the departments, it is assumed that the model in use is close to the stage-gate model by Cooper (2009) (see Figure 2 below).

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Figure 2: Typical Decision-Stage Model in the Form of a Stage-Gate Process

(Source: Cooper, 2009)

In this model, so-called ‘gate-keepers’ decide whether the product is worth moving on to the next stage or whether it should be scrapped (Cooper, 2008a). Interviews are expected to clarify this and other issues in more detail. Once this is clear, the addressing of governance risk within the NPD process will be examined. Afterwards it should be evaluated what the exact product success factors of Islamic financial products are. Factors that characterize ‘winners’ among new financial products have been characterized already (Cooper & de Brentani, 1991; Easingwood & Storey, 1991), just as what makes overly successful new financial products so successful (Cooper et al., 1994b). It will be interesting to see what makes Islamic financial products successful and whether the existing range of success factors can be amended by unique aspects of Islamic finance.

1.3 Problem Definition

1.3.1 Problem Statement

This paper will evaluate on the NPD process in detail, how governance risk is addressed in the process and how handling it appropriately can contribute to new product success. It shall strive to find an answer to the following problem statement:

‘How can a new product development model be applied to Islamic financial product development and how to address governance risk management in order to contribute towards new product success?’

1.3.2 Research Questions

By splitting up the problem statement into research questions, it will be assured that the following aspects are dealt with thoroughly:

1) What NPD model serves as a basis in the product development process of Islamic financial institutions?

This is the starting point of the paper. Preferences of IFIs regarding which NPD model they use should be made clear by this question.

2) How is governance risk management addressed in the NPD process?

This question should evaluate on how the sub-categories of governance risk are managed in detail, meaning what risk management measures are implemented by IFIs.

3) What factors determine success of new Islamic financial products?

This question aims at finding out what characteristics successful Islamic financial products share. By combining the outcomes of this question with the exact responsibilities of the involved departments in the NPD process determined before, the final research question is:

4) How can governance risk management make a contribution towards new product success and how should governance risk management be used most efficiently?

1.4 Outline of the Paper

The first chapters of the study will give the paper a theoretical foundation in the form of a literature review. Chapter 2 will serve as an introduction into Islamic financial services and is meant to give the reader some background knowledge about Islamic finance. Chapter 3 will present all aspects of the NPD process. Chapter 4 gives an overview of risk management practices in both Islamic and conventional financial institutions and demonstrates where the differences lie. A detailed presentation of the governance risk factors an IFI is exposed to will be presented in chapter 5 together with a brief outline of the remaining risk factors. A thorough evaluation of new financial product success factors will be given in chapter 6. Chapter 7 will be about the research methodology. The research results together with discussions of the results are presented in chapter 8. A final conclusion together with research limitations and areas for future research are provided in chapter 9.

2 About Islamic Finance

2.1 Characteristics of Islamic Finance

Islamic finance is the practice of finance consistent with the ethos and values of Islam as specified by the Shari’ah (Ayub, 2007c). The Shari’ah serves as a guide for Muslims to live. It is mainly based on four sources: (1) the tenets from the Qur’an, the basic source of Islamic law, (2) the Sunnah, which consists of the sayings and deeds approved by the prophet, (3) Ijmas, which are edicts that Islamic scholars agreed upon and (4) Qiyas, comparisons of similar circumstances using common sense (Abdul-Rahman, 2010e). Furthermore, Islamic financial activities have to adhere to Shari’ah principles that have to be considered in order to contribute toward a better society. Five principles serve as a foundation for IFI operations (Lewis & Algaoud, 2001). First, transactions must be free of interest (riba), as interest generates inequality in the economy. The Prophet was supposed to have said that dealing in interest is like committing a murder (Abdul-Rahman, 2010a). Therefore, IFIs are not allowed to charge costs on any kind of loan (Ayub, 2007d). Second, IFIs are supposed to donate to charity (zakat) in order to bring justice to society. Third, business has to be conducted on the basis of lawful (halal) activities, i.e. activities that are not forbidden (haraam) in Islam. Fourth, gambling (maysir) is prohibited and there should be no speculation (gharrar) in transactions. Prohibiting gambling should prevent people from accumulating wealth without any effort, and the ban on speculation aims at protecting individuals from undertaking ventures without sufficient knowledge. Finally, a religious supervisory board, called Shari’ah board, ensures that these principles are adhered to in order to achieve what Abdul-Rahman (2010b) said: Comply with the laws of the land without violating the laws of God.

2.2 Structural Distinctions Between Both Types of Institutions

IFIs differentiate themselves not only through a more advanced philosophy and motivation behind its operations, but also through different structures and business practices. Structural differences between IFIs and conventional financial institutions can be grouped into two themes: (1) structure and (2) interactions with other market players (Abdul-Rahman, 2010c). Concerning the structure, it can be said that IFIs are generally smaller compared to conventional financial institutions, which can be global players such as Citigroup or BBVA. This is a result of the limited investment horizon mentioned in the prior section, as conventional financial institutions have no borders in their investments. Furthermore, IFIs have a different approach towards ownership of the institution. IFIs put more emphasis on the shareholders’ ownership role by empowering them to assist in shaping an IFI’s directions and procedures. A further distinction can be made regarding coordination - Conventional financial institutions have a pyramid-shaped structure due to their big scale. In contrast, IFIs focus on self-organizing markets and on creating networks of communities, which is more decentralized and allows for taking regional aspects into account (Abdul-Rahman, 2010b). The way an IFI interacts with other market players differs from the approach taken by conventional financial institutions as well. The main reason behind this might be the IFIs’ strong orientation towards contributing to a better society. In conventional financial institutions, cooperation with other players in the industry usually takes place with the hidden agenda of avoiding competition in a dog eat dog environment. On the other hand, IFIs consider opponents as participants stimulating innovation and efficiency.

3 New Product Development

3.1 Introduction

If a company decides its growth strategy, it is about to engage in a risky activity. When chosen carefully and conducted properly, it enables the company to increase its market share tremendously. A growth strategy that does not suit the market can turn out to be a disaster for a company on the other hand. The best way to get an overview of a company’s options is to look at the Ansoff Matrix (1968a), which categorizes growth into four categories.

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Figure 3: Ansoff Matrix

(Source: Ansoff, 1968a)

Market penetration and market development involve the use of current products and are considered to be comparatively less risky for a company than product development and diversification (Ansoff, 1968b). Whereas diversification is basically about acquiring other companies, product development is a unique opportunity for a firm: It is a chance to shape the marketplace through offering new or improved products to existing markets (Trott, 2005c). This particularly applies to industries that are still in the growth stage, i.e. the Islamic financial industry. The academic world agrees in the importance of developing new products: Edgett (1996b) sees NPD as an ‘essential weapon in both offensive and defensive initiatives’, Calantone & di Benedetto (1988) consider NPD as a ‘better way to keep a strong competitive position in today’s market’ and Trott (2005d) urges companies to ‘develop new products that will enable them to compete over the coming decades’.

But what exactly is a new product? Griffin sorted new products into six categories, which are presented in Figure 4 below. ‘New to the world’ products refer to the first of their kind and are the ‘true’ new products, whereas ‘new product lines’ are concepts that are now new to the market, but new to the company developing them. ‘Repositionings’ encompass new applications for current products. ‘Additions to existing lines’ are basically complementary to

product lines the company has so far. Although different from the present product offering, an ‘addition to existing lines’ is not different enough to be a new line by itself. ‘Cost reductions’ may seem to be out of place here due to no real new characteristics. ‘Product improvements’ are simply enhancements of a current product line (Griffin, 1997).

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Figure 4: The Average New Product Portfolio

(Source: Griffin, 1997)

More surprising is the fact ‘new to the world’ products make up only a small proportion of the new product share with 10 percent, presumably due to the high risk they represent to the company developing them. However, developing new product lines is associated with more risk for a company (Trott, 2005e). As this new product type occurs more often with a total share of 20 percent, it is chosen to be examined further. Therefore, when mentioning new products and NPD, it is meant in the sense of ‘new product line’ products.

3.2 NPD in Conventional and Islamic Financial Institutions

Academic literature focuses mainly on the development of tangible products (Alam & Perry, 2002c). However, the development of financial products is different since the majority of the products within the financial sector is intangible. As Islamic financial product development is tilted toward services, unique characteristics of services have to be considered in the NPD process within IFIs. Wolak et al. (1998) mention four unique characteristics of services: (1) Intangibility, (2) inseparability, (3) heterogeneity and (4) perishability. Intangibility refers to the lack of physical elements involved in a service. This presents a certain risk for the customer, as he cannot fully assess the service prior to purchase. Inseparability relates to simultaneous delivery and consumption of a service. With heterogeneity, the authors refer to the potential for high variability in service delivery. This partially applies to financial products as well, for example in investment advisory. Due to the fact that IFIs have to act according to practices specified by the Shari’ah department, IFIs have more potential to vary in service quality. Perishability relates to the inability of storing a service. Both IFIs and conventional financial institutions have to deal with perishability due to the inseparable nature of financial services. Another feature of services that has to be taken into account is the heightened comprehension of customer requirements (Vermillion, 1999).

It is a good starting point to examine the new product development model for conventional banks developed by Alam & Perry (2002e). Their model consists of ten stages: (1) Strategic planning, (2) idea generation, (3) idea screening, (4) business analysis, (5) formation of a cross-functional team, (6) service design and process system design, (7) personnel training, (8) service testing and pilot run, (9) test marketing and, finally, (10) commercialization. Depending on time-to-market pressure, these activities can be carried out in both linear and parallel fashion. From the ten activities mentioned, three are considered as crucial, namely idea generation, idea screening and the formation of cross-functional teams (Alam & Perry, 2002d). However, things look different when managers have to assess the frequency of certain activities carried out. Edgett (1996c) asked managers to evaluate the frequency of 13 activities being applied in a typical NPD process. The results can be seen in Figure 5 below. Although idea screening was considered to be very important by Alam & Perry (2002d), it is only applied in 57.5 percent of the cases. Activities applied most regularly are preliminary market assessment, actual product development and the establishment of process procedures. Contrary to what we might have assumed, training of personnel is done in every second process, a post-launch review of new product performance is conducted in 32.5 percent of the cases and detailed market research is carried out in only a fifth of the NPD processes.

Idea screening Preliminary market assessment Preliminary technical assessment Detailed market study/market research Business/financial analysis Product Development Process procedures System design & testing Personnel training Test marketing/trial sell Pre-commercialization business analysis Full-scalelaunch Post-launch review & analysis

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Figure 5: Frequency of New Product Activities Typically Conducted

(Source: Edgett, 1996c)

These results are striking when we consider how every bank stresses its high standards in its products, services, staff and customer orientation. At least with regard to NPD, this is apparently not the case, which is reflected in the new product success rate of 62.5 percent (Edgett, 1996d). When asked about the quality of execution of the single stages, the stages considered to be carried out best were product development, preliminary market assessment and full-scale launch, respectively. Interestingly, stages with the worst scores on quality of execution were pre-commercialization business analysis, detailed market research and test marketing, respectively (Edgett, 1996e). Unfortunately, there are no studies available that give insights about activities carried out in IFIs. It may be assumed that the only key difference of the NPD process relates to the most unique component of an IFI: The Shari’ah department. It makes sure that all of the bank’s activities are compliant to Islamic law (Ayub, 2007e). There is no information available regarding the integration of the Shari’ah department in the NPD process, which is why one can only assume what role the Shari’ah department has in the process. The same counts for the integration of the marketing function.

3.3 Approaches Toward New Product Development

The interesting part starts when thinking about the details of the NPD process, i.e. cooperation between the departments involved and the arrangement of processes involved. Although there might be industry-wide standards that need to be adhered to or agreement on what activities have to be carried out, it is the knowledge of when and how these activities are conducted that ultimately separates a high-performer from the rest of the industry.

So what are the options a company can apply concerning NPD? It was already pointed out in the introductory chapter that two product development models got the most attention so far: Activity-stage models and decision-stage models (Trott, 2005a).

The activity-stage model is an established product development model. Invented by Booz, Allen and Hamilton in 1968, it presented the NPD process as a chain of stages (Saren, 1994). Regardless of the enhancements of the activity-stage model and the fact, that the model is still widely used in practice, it is not a good choice for developing new financial products in IFIs for various reasons. First, time-saving simultaneous activities are not considered in this model. This, however, is considered as vital for developing new financial products, as speed- to-market is key here (Drew, 1995a). Second, the model does not account for differences in tangible and intangible products. Third, industry specific conditions are not taken into account. Fourth, there is not much interaction between the departments involved in the process, which stresses the need for cross-functional interaction at all stages (Crawford, 1994). This shortcoming is assumed to be grave in the case of IFIs, as compliance and operational standards have to be adhered to at all time. A more recent development is the stage-gate model invented by Cooper in 2004. A decision-stage model gives guidance on the steps that need to be undertaken and which control measures should be put in place (Cooper, 2008b). As it can be seen in Figure 2, a decision-stage model consists of various stages in which certain tasks are performed, either by a single department or by multiple departments working together. Between the stages are ‘gates’, which consist of a so-called ‘gate-keeper’ (such as a department head) that either gives the project green light or scraps it.

Compared to the activity-stage model, many shortcomings of the older model have been resolved with this model. First, work at each stage is carried out in a cross-functional manner, meaning that ‘no department owns a stage’. As Alam & Perry point out in their study, the formation of cross-functional team is considered very important in the NPD process in the financial sector (Alam & Perry, 2002d). Second, the stages can be carried out simultaneously or overlap, which gives the company the possibility to increase speed-to-market (Drew, 1995b). Third, the costs of each stage are increasing with ongoing advancement in the process, which reduces the risk of developing products that turn out to be not feasible at later stages. Fourth, it allows for flexibility in the NPD process - No single NPD process looks the same. Fifth, the integration of ‘gate-keepers’ in the process helps to increase productivity (Verona, 1999). Finally, a decision-stage model can be thought of as an ‘open source’ model and allows for continuous improvement (Cooper, 2008a). Figure 6 shows how an NPD process can look like, with Type A representing an activity-stage model and Types B and C representing a decision-stage model.

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Figure 6: Sequential (Type A) and Overlapping (Types B and C) Phases of Development

(Source: Takeuchi & Nonaka, 1986)

4 Risk Management

4.1 General Remarks

IFIs have the objective to serve their customers and maximize shareholder value through the provision of financial services mostly through managing risks (Ahmed & Khan, 2001b). Before going into details, it makes sense to define risk management first. The definition by Jorion & Khoury (1996) as well as the one by Ahmed & Khan (2001c) were reviewed for this purpose. The former definition of risk management was deemed most suitable as this is the definition used by the Islamic Development Bank as well. According to Ahmed & Khan (2001c), risk management is the ‘overall process that a financial institution follows to define a business strategy, to identify the risks to which it is exposed, to quantify those risks and to understand and control the nature of risks it faces’.

4.2 Risk Management in Islamic Financial Institutions

Comparing the risks of conventional financial institutions to those IFIs reveals that there is some overlap in the risks both institutions are facing - Examples include market risk, liquidity risk, operational risk and credit risk (Ahmed & Khan, 2001d). However, applying standards and procedures applied in conventional financial institutions in an Islamic setting is not to be recommended, as IFIs have different risk attributes that require a more prudent regulatory approach (Sarker, 1999). Certain risks which an IFI has to deal cannot be found at a conventional financial institution and vice versa. Shaikh & Jalbani (2009) mention five major aspects that make risk management in IFIs so unique. First, due to IFIs’ prohibition to engage in unnecessary risk and uncertainty, all financial transactions have to be backed by tangible assets such as real estate or entities like airplanes. Another aspect relates to the mutual benefit element and the sharing of profits and losses. This split-up of risk and return has to be properly defined in the transaction contract in order to avoid any disputes. As there are no Islamic courts or official litigation systems in place, the settlement of disputes that might emerge from inadequate composition of contracts is a serious risk in Islamic banking (Hassan & Lewis, 2007a). Third, IFIs are confronted with the challenge of complying with two regulations: the conventional regulatory standards used in the host country and the Shari’ah regulations, which are issued by the Shari’ah department that can be found in each IFI. A good example of how litigation charges based on non-compliance with state legislation can lead to unfavourable public relations is the case of Shamil Bank of Bahrain EC vs1.

Beximco Pharmaceuticals Ltd (Junius, 2007). Fourth, as IFIs restrict themselves to asset- backed financing, there is no short-term financing in the form of simple borrowing like it is the case with conventional financial institutions. This makes matching assets and liabilities particularly challenging, resulting in higher assets and liabilities management (ALM) risk. Finally, Shari’ah compliance does not allow for the use of derivatives such as options and futures. The leeway for transferring risks is therefore very limited. Ahmed & Khan (2001e) recommended three risk management components that should be in place for an adequate risk management system within an IFI. The first component consists of establishing an appropriate risk management environment paired with policies and procedures in place. The second component is all about maintaining processes related to measuring, mitigating and monitoring risks. The last component addresses the implementation of internal controls.

The good news is that an IFI overstrained with the task of enhancing its risk management system is not entirely on its own. It can consult two institutions for advice: The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB). The AAOIFI tells the IFI what the underlying regulations for compliance are and the IFSB gives guidance in order to comply with the regulatory framework most efficiently. The AAOIFI is a non-profit organization founded with the purpose of issuing standards regarding operational issues of an IFI (AAOIFI, 2010a). Key standards have been published for (1) Accounting, Auditing & Governance and (2) Shari’ah issues (AAOIFI, 2010b). The IFSB is younger than the AAOIFI and was founded with the aim of promoting a more transparent and prudent Islamic financial services industry (IFSB, 2010). The IFSB has published a variety of guiding principles for IFIs to follow.

Yet risk management remains to be a delicate issue; A survey carried out among 17 IFIs by Ahmed & Khan (2001f) reveals that IFIs are successful in creating a decent risk management environment (the first component mentioned before), but that the other two components (risk measurement and internal controls) show room for improvement.

5 Risk Factors

5.1 Operational Risk

Managing operational risk and holding adequate capital reserves as protection against losses is important for every financial institution, both conventional and Islamic - The Barings Bank bankruptcy in 1995 made this clear to the financial industry. Operational risk is considered to be the second most critical risk in IFIs (Ahmed & Khan, 2001a). Other Islamic scholars agree on the heightened exposure to operational risk aspects due to the unique challenges that come with Islamic finance (Iqbal & Mirakhor, 2007c).

5.1.1 Definitions

Having reviewed the definitions coined by the Basel Committee on Banking Supervision (BCBS) (Bank for International Settlements, 2003), the State Bank of Pakistan (SBP) (SBP, n.d. a) and Jobst (2007), the latter definition was deemed most appropriate and will be used over the course of this paper. Jobst (2007) describes operational risk as the risk resulting from inadequate execution of business activities, inappropriate internal processes and IT infrastructure, misbehaviour by employees or from external events such as non-compliance with the legal framework or ethical standards. This may occur both inside (internal risk) and outside (external risk) of a bank. Internal operational risk aspects are those arising from deficits within the bank and can stem from three sources, namely processes (process risk), human failures (people risk) and failure in technological operations (system risk). Process risk is the risk arising out of insufficient processes within the bank, failure to execute processes or inadequate process mapping in general. People risk is the risk of human failures, be it management or regular employees. System risk refers to either problems or outright failure in system operations within the bank’s IT landscape. Whereas internal operational risk aspects focus on potential disruptions in operations within the bank, external operational risk aspects encompass those that are arising from the bank’s environment.

5.1.2 Operational Risk in Conventional and Islamic Financial Institutions

A survey conducted by the Basel Committee on Banking found that out of the eight event types where operational risks may occur, most losses occurred in two categories, namely (1) execution/delivery/process management and (2) clients/products/business practices (Grody et al., 2006a). On closer examination, errors were mostly attributable to systems failure, transaction processing failures and financial reporting (Grody et al., 2006b). Following Jobst’s (2007) definition, these risks are mainly internal as they can be classified to be process risk and system risk. IFIs, on the other hand, show problems that go deeper, such as in the case of administrative matters. Contracts serve as a good example here: unlike conventional contracts, Islamic contracts need to comply with both Islamic and conventional law, which are sometimes hard to align. An unfavourable result of this fact is a court decision to the disadvantage of the IFI (Junius, 2007; Reuters, 2009b). As there is no standardization comparable to conventional banking, legislation is assumed to continue being a problem for IFIs. Besides the legal challenge, other operational issues remain problematic within IFIs. Iqbal & Mirakhor (2007c) mention various internal operational risk aspects that troubled IFIs in the past, such as employee incompetence. This is quite an issue when considering the circumstance that supply of trained personnel is rather scarce (Ayub, 2007f). Further problems that were observed in IFIs were fraud, technical risks and malfunctioning internal control systems, which cover all internal operational aspects as defined by Jobst (2007).

5.1.3 Countermeasures

When an IFI wants to handle operational risks within the organization, it has to decide on an operational risk model first. Operational risk models can either have a bottom-up view (based on analyzing potential loss events on the individual process level) or a top-down view (based on starting at the firm level and then moving down to business line activities). Haubenstock & Hardin (2003) argue to use a bottom-up approach, as the events leading to operational losses can be determined more easily. Other scholars note that bottom-up models hinder an organization in getting a big picture of the problem due to overdisaggregation of processes (Gelderman et al., 2006a). Hence it is recommended to use both types of models in order to offset the disadvantages of each model (Currie, 2004). There are three approaches towards operational risk models: (1) The process approach (bottom-up), (2) the factor approach (bottom-up) and (3) the actuarial approach (top-down) (Moosa, 2007b).

Under the process approach, individual processes are under scrutiny. For measurement, a range of analyses may be used, such as statistical quality control, reliability analysis, fuzzy logic and Bayesian belief networks.

The factor approach aims to detect the exact determinants of operational risk, both at the firm level as well as on the process level. Examples of the used analytical tools are CAPM-like models and risk indicators. Especially the latter can be observed frequently in the financial sector, called risk mapping. Risk mapping is a process that (1) assesses (2) foresees and (3) controls operational risks in addition to giving answers on (4) how (5) where and (6) to what extent things can go wrong (Scandizzo, 2005a). The purpose of risk mapping is mainly the identification of key risk indicators (KRIs), which are proxies for the drivers of operational risk. KRIs should be relevant (related to the frequency of operational failure), measurable, easy to monitor, auditable (well-documented) and non-redundant (Scandizzo, 2005b). Once

the relevant KRIs are pointed out, they have to be presented cohesively in one document. This is called an Operational Scorecard and enables management to get an overview of key phases and their risk potential (Scandizzo, 2005c). Nowadays determining and monitoring KRIs is considered to be a sophisticated way of tracking operational risk and estimating losses. This does not have to be necessarily quantitative - Although this is to be preferred due to reduced subjectivity, quantitative operational risk management tools have been reported to be problematic in the past due to a lack of internal and external data (Moosa, 2007a). As the American Risk Management Association published an extensive list of 1809 KRIs for both banking and non-banking organizations in 2003, it made tracking operational risks much easier (Grody et al., 2006c). A list of IFI-specific KRIs is yet to be developed.

Finally, the actuarial approach focuses on the distribution of losses resulting from operational risk incidents. Here, the possibility for risk incidents is estimated statistically through empirical loss distribution techniques and the extreme value theory. In practice, both the factor approach and the actuarial approach can be observed, as they complement each other well.

5.1.4 Best Practice Guidelines

IFIs can get some advice on how to proceed regarding operational risk from notable institutions on the national level (i.e. the SBP) and on the international level (i.e. the IFSB). The most important advice from the IFSB comes in the form of a recommendation regarding the calculation of the capital reserve to be held for emergencies resulting from operational activities. The SBP gives more practical advice through hints regarding what to address in operational risk management (SBP, n.d. a). According to the guideline, IFIs should account for the entire range of material operational risks that might have an effect on its operations, particularly losses stemming from failed internal processes, people, systems and external events. Furthermore, the IFI is advised to have implemented a reliable IT infrastructure in the form of management information systems. Besides having a proper IT system in place, the IFI should identify KRIs and establish a code of conduct with instructions to act on and, finally, delegate responsibilities in order to tackle operational risk incidents adequately.

5.2 Reputation Risk

Reputation risk is getting more and more an issue for today’s organizations. A survey carried out in the name of the Economist Intelligence Unit revealed that CEOs consider reputation risk to be the biggest risk to their companies’ global business operations, with 59 percent of them agreeing on reputation becoming a key source of a competitive advantage (Economist Intelligence Unit, 2005 a). Simultaneously, reputation is difficult to grasp and hard to measure. Nonetheless, a loss in reputation can have serious consequences on an organization’s market share and profitability. Considering that the ways of managing reputation risk are poorly developed compared to other risks makes reputation risk management a tricky task (Economist Intelligence Unit, 2005b).

5.2.1 Definitions

As several definitions have been reviewed (Davies, 2002; Iqbal & Mirakhor, 2007f; Economist Intelligence Unit, 2005b) and were deemed to be not appropriate in the context, the definition of Stansfield (2006a) will be used from now on. Stansfield (2006a) defines reputation in the context of financial institutions. According to him, reputation is shaped through public perception in several ways, i.e. through financial performance and strength, corporate social responsibility, client trust and client service, corporate ethics, corporate disclosure practices and relations with regulatory authorities and compliance.

5.2.2 Reputation Risk in Conventional and Islamic Financial Institutions

For financial institutions, trust is everything. As Stansfield (2006a) pointed out, the factors that eventually determine trust in a conventional financial institution come out of the areas of operations and management, corporate social responsibility, customer relationship management, shareholder management and compliance with regulations. For the financial institution to protect its brand, earnings and capital, these factors have to be handled properly, i.e. not in isolation from each other (Godwin & Freese, 2005). Research revealed that the CEO bears the primary responsibility for reputation risk, with the board of directors being mentioned second and the head of risk management being on third place (Economist Intelligence Unit, 2005 c). It is good that reputation has such a high priority in the board room, and top executives should bear ultimate responsibility if anything goes wrong.

5.2.3 Countermeasures

Reputation risk has to be addressed both actively and passively (Economist Intelligence Unit, 2005d). Concerning crisis prevention, an IFI can maintain its reputation through improving both ‘hard’ and ‘soft’ elements (Stansfield, 2006b). ‘Hard’ elements are those that are easy to quantify and hence more tangible, such as financial strength, technical expertise or client service. ‘Soft’ elements are harder to quantify and less tangible, but nevertheless of equal importance. Examples include corporate ethics and compliance. Especially the compliance aspect cannot be stressed enough in this context.

In order to advance reputation, an IFI has several means to choose from, such as (1) the use of promotional activities in the form of advertising campaigns or social responsibility initiatives, (2) core business improvements like product development initiatives or the development of a unique product/value/service proposition or (3) corporate level initiatives (i.e. optimal corporate governance and disclosure practices or best ethical practices).

5.2.4 Best Practice Guidelines

At the time this paper is written, no best practice guidelines from regulatory bodies such as the IFSB or the AAOIFI exist. Nonetheless, common sense stipulates that good management and a solid financial performance in combination with a good containment strategy are the foundation for optimal reputation risk management (Stansfield, 2006c).

5.3 Transparency Risk

The current financial crisis not only shows that financial institutions need to have sound business practices and processes in place, but that they also have an obligation to disclose relevant information and to make their operations as transparent as possible. This is vital in order to have market discipline, as it is assumed that the market wants to do business with an IFI if it meets the disclosure requirements (Islamic Economics Research Centre, n.d. a).

5.3.1 Definitions

Several definitions were reviewed (Bank for International Settlements, 1998; Linsley & Shrives, 2005a; Iqbal & Mirakhor, 2007e), but only the first one was considered most appropriate. The BCBS defines transparency as ‘public disclosure of reliable and timely information that enables users of that information to make an accurate assessment of a bank’s financial condition and performance, business activities, risk profile and risk management practices’. Hence transparency risk can be defined as the risk of not disclosing reliable and timely information to market participants.

5.3.2 Transparency Risk in Both Financial Institutions

The consistent and timely disclosure of risk-related information is one of the main disclosure principles of both conventional and Islamic financial institutions. This relates particularly to Pillar III of the Basel II Accords, which intends to achieve more market disclosure by conventional and Islamic financial institutions (Bank for International Settlements, 2001a). In order to do so, Basel II gives instructions regarding the (1) characteristics of disclosures and (2) areas where disclosures should occur (Bank for International Settlements, 2001b). Regarding the first requirements, disclosures should comply to certain standards in order to be of value for the market. First of all, one has to distinguish between core and supplementary disclosures. Core disclosures are those that contain vital information and that are important to the basic operation of market discipline. Supplementary disclosures are those with great significance for the operation of market discipline. Another disclosure characteristic that needs to be regarded by financial institutions concerns materiality, i.e. whether an omission or misstatement would have an impact on the decision that is made by the user of the information. A further characteristic is related to proprietary information - Financial institutions do not have to disclose information that might jeopardize their competitive advantage. Disclosure frequency is an aspect that clarifies when information have to be made public. For the most part, the BCBS stipulates information disclosure to occur twice a year, with risk-related information to be disclosed on a quarterly basis. The last characteristic concerns comparability: In order to make a contribution toward market discipline, the BCBS provides information templates in order to enable stakeholders and supervisors to communicate in a common language about risks.

The second aspect is related to the areas where disclosures should be made. The BCBS classifies three thematic fields: (1) capital, (2) risk exposure and (3) capital adequacy. In order to keep this section brief, only the disclosure recommendation regarding risk exposure will be mentioned. Here, the BCBS prescribes to disclose qualitative as well as quantitative information about risk exposure, which also include information about the financial institution’s strategy for managing risk. Although both conventional and Islamic financial institutions adopt the Basel II accords, IFIs have difficulties with the framework. In his research, Ariffin (2008) showed how unsatisfied managers in IFIs are with the Basel II accord, and point to the need of governing bodies (e.g. the IFSB) to adapt the framework to the unique requirements of Islamic finance. This applies particularly to the disclosure of Shari’ah relevant information (Islamic Economics Research Centre, n.d. b). In the same vein, the authors made their point by showing the heightened need of transparency and risk reporting (Islamic Economcs Research Centre, n.d. c). Abdul-Rahman (2010d) confirmed the need for more transparency in Islamic finance.

5.3.3 Countermeasures

Transparency risk management is relatively straightforward compared to managing other risks, e.g. operational risk. The department in charge of transparency and public disclosure (the compliance department) has to make sure that the IFI follows the disclosure obligations imposed by state legislation as well as IFI-specific disclosure requirements.

5.3.4 Best Practice Guidelines

In the section above, Ariffin (2008) called for governing Islamic institutions to shape disclosure principles to the requirements of IFI. This is what happened in December 2007 when the IFSB published guiding principles for IFIs to follow in order to promote transparency and market discipline.

5.4 Shari’ah Risk

Being the raison d’etre of Islamic finance itself, Shari’ah risk is probably the most prominent and most important risk of all risks that an IFI is confronted with (Ayub, 2007g). Failure to comply with Islamic law is a major source of reputation risk that seriously affects an IFI’s attractiveness in the eyes of Muslim customers - 86 percent of depositors of Bahraini Islamic banks stated they would withdraw their deposits if their bank would fail to operate in accordance with Islamic law (Chapra & Ahmed, 2002). As we are about to see, managing Shari’ah risk is hard for an IFI due to its ambiguity.

5.4.1 Definitions

Upon review of the most recent existing definitions of Shari’ah risk (DeLorenzo, 2006b; SBP, n.d. b; Iqbal & Mirakhor, 2007f), it was decided to use the latter definition since it was more extensive compared to the other definitions. Iqbal & Mirakhor (2007f) define Shari’ah risk as the risk which is associated to structure and functioning of the Shari’ah department at the institutional and systemic level. According to them, Shari’ah risk is twofold; it can arise (1) out of the application of different contracts from different jurisdictions and (2) out of non­compliance with Shari’ah rules. One problematic aspect of Islamic law is related to the Islam itself. It is split into two main persuasions: 85 percent of the Muslim world belong to Sunni Islam, with the remaining 15 percent being part of Shia Islam (Oxford Islamic Studies Online, 2009). As the grand majority of Muslims are Sunnites, the Shari’ah will be treated in the sense of Sunni Islam from now on.

The Sunni branch can again be split up into different schools of thought (madh-habs), which are Hanafi, Hanbali, Maliki and Schafi’i, named after their founders (Philips, 2003a). Hanafi is the biggest madh-hab with more than 350 million followers which mainly live in Turkey, Pakistan and other Asian countries as far as Bangladesh. It distinguishes itself from the other madh-habs with its recognition of all four sources of Islamic law alike, also accepting local customs as secondary sources of Islamic law. Hanbali jurisprudence is practiced on the Arabian Peninsula and it is the official madh-hab of the Kingdom of Saudi Arabia. It stresses the Qur’an and the Sunna above other sources of Islamic law and is relatively orthodox compared to the other madh-habs. It considers opinions of companions of the Prophet as well, but relies on the sources closest to the Qur’an and the Sunna in case of disagreement. Maliki recognizes the four sources of Islamic law, although its perception of Ijma differs from the Hanafi interpretation; here, it means the consensus of the community as represented by the people of Medina. Additionally, it considers the edicts of the four rightly guided caliphs that created the Rashidun Caliphate. It is mostly practiced in the North-western African states. Shafi’i uses the Qur’an and the Sunna as main sources of Islamic law, with less importance paid to Ijmas and Quiyas. Passages of the Qur’an must be interpreted according to a consensus of the Muslims or according to the Quiyas if no consensus is reached. Shafi’i jurisprudence is practiced mainly in some Persian Gulf states, Egypt, the Horn of Africa as well as in Malaysia and Indonesia. Keeping in mind that there is no central Islamic authority that might standardize and specify the practices of the different madh-habs, the difficulties that Shari’ah department in IFIs are facing are obvious.

5.4.2 Shari’ah Risk in Islamic Financial Institutions

The responsibility of Shari’ah compliance of an IFI lies with the Shari’ah department. It is looked upon by the IFI’s management and its board of directors and reports its activities to upper management once a year. It is important to know that the IFI is bound to act on Shari’ah department decisions. Among the duties of the Shari’ah department are documenting religious foundations for any decision, helping other employees in the process of innovating new Shari ’ah-based products and services, assisting in establishing operating manuals and transactional procedures, supervising the IFI’s day-to-day operations and, most importantly, certifying contracts and transactions. Product certification serves as a good example here. In order to comply with Shari’ah standards (that are issued by national banks such as the Malaysian National Bank or governing organizations such as the AAOIFI), the product has to get sufficient ratings on various Islamic criteria. Once it has been classified as lawful, it gets a certification through a fatwa by a local scholar (Abdul-Rahman, 2010f).

The Shari’ah department is composed of three to four experts in the field of Islamic law and has the task of ensuring that the IFI’s actions are in strict compliance with Shari’ah principles. For example, in order to comply with Islamic law, an investment must not be haraam, such as investments in companies dealing with alcoholic beverages, tobacco products, entertainment, gambling and recreational activities in general. A suitable investment must also be unrelated to interest, and capital requirements must be fulfilled, such as having an interest income ratio < 5 percent, a debt ratio < 33 percent and total illiquid assets < 33 percent of total assets (Ayub, 2007f). The role of the Shari’ah department differs depending on the IFI’s domicile. One approach can be observed in Malaysia - Here the National Shari’ah department of Islamic Banking passes edicts which are binding to the IFIs that operate in the country. In this case, the Shari’ah department’s role is a mere supervising one. This approach is elegant in the sense that it circumvents the problems of complying with different madh-habs. Another approach can be observed in the Gulf region and other Asian countries, where every IFI implements its own Shari’ah department and sets up its own definition of what is compliant with the Shari’ah. As one can imagine, this creates confusion among scholars about Shari’ah compliance in the light of different madh-habs. In the majority of the cases, proper compliance with Islamic law remains an issue. Standardization through the creation of a central Shari’ah council for IFIs located in Arab states is planned, but is not expected to be realized before 2013 (Arabian Business, 2010).

5.4.3 Countermeasures

For this to happen, the Shari’ah department has to implement (1) an internal control system with strict rules and guidelines the IFI has to follow and (2) a Shari’ah review in order to examine whether the standards have been adhered to. Internal controls should be designed to cover all aspects of the IFI’s operations. These can be related to how product types are to be composed or business activities to be carried out. The guidelines set up by the Shari’ah department ensure that other employees within the IFI know how to act in line with the board’s requirements. These rules give guidance on product and service design, operational issues, structural issues, moral issues, documentation and conformity of Shari’ah-related issues with the legal framework of the state (Ayub, 2007f). The Shari’ah audit serves to check whether the established guidelines have been implemented. These audits should be carried out both by the Shari’ah department and by an independent internal audit department (Ayub, 2007h). The internal Shari’ah audit by the independent internal audit department should help evaluate the extent of compliance regarding Shari’ah guidelines. Hence the Shari’ah department can prevent Shari’ah risk in a prescriptive way through guidelines and in a reactive way through controls.

5.4.4 Best Practice Guidelines

An IFI that wants to meet or even succeed the requirements stated by the AAOIFI has various options regarding best practice advice. The two most prominent options to note are those provided by the IFSB and the SBP. The SBP published a guideline that specifies how to handle Shari’ah-related issues, e.g. what the duties of Shari’ah advisors are, how conflicting Shari’ah edicts are to be addressed and how to integrate Shari’ah compliance in introducing new products and services. Here the Shari’ah department is advised to vet agreements, processes, checklists and manuals about the new product/new service intensively before launch (SBP, 2008). A more extensive advice from the IFSB indicates what to consider when setting up/running a Shari’ah governance system (IFSB, 2009). In either way, an IFI is advised to take Shari’ah-related issues seriously.

5.5 Fiduciary Risk

In today’s business world where banks increase in size while ownership and management is being separated, the issue of financial institutions acting in the interest of the shareholders remains. As we are going to see, fiduciary risk is more troubling for IFIs.

5.5.1 Definitions

Two common definitions exist regarding fiduciary risk (Ahmed & Khan, 2007b; Iqbal & Mirakhor, 2007d). As the latter definition is more specific, it will be used from now on. According to Iqbal & Mirakhor (2007d), fiduciary risk is ‘the risk that arises from an institution’s failure to perform in accordance with explicit and implicit standards applicable to its fiduciary responsibilities (...) toward depositors and shareholders’.

5.5.2 Fiduciary Risk in Conventional and Islamic Financial Institutions

If comparing the governance structures of a conventional financial institution and an IFI, one can see that fiduciary risk is more an issue in IFIs (See Figure 7 below).

Abbildung in dieser Leseprobe nicht enthalten

Figure 7: Governance Structure of Conventional and Islamic Financial Institutions

(Source: Nienhaus, 2007a)

Within conventional financial institutions, fiduciary risk may arise between three parties, namely (1) management, (2) shareholders and (3) depositors. The actions of management and shareholders are affected by general commercial law and banking regulations, as the arrows indicate. Ergo governance problems are best resolved with the provision of strong governance standards.

Governance in IFIs is more complex due to involvement of the Shari’ah department in the governance structure. As mentioned before, IFIs need to ensure that they comply with both state legislation as well as Islamic law. Actions by management and shareholders are determined by the regulatory framework, just like with a conventional financial institution. However, the Shari’ah department and the investment account holders are affected by specific Islamic laws and banking regulations, which increases complexity. There are five potential fiduciary issues that may arise from this governance structure (Nienhaus, 2007b). First, the profit-and-loss sharing characteristic creates a gap in the interests of investment account holders and shareholders; both parties share the profits of the IFI, which are not specified numerically but determined by management. The second problem is linked with the smoothing of returns, i.e. providing stability of returns for Islamic deposits. Management keeps returns relatively stable due to smoothing techniques such as (1) the creation of profit equalization reserves and (2) the commingling of funds. The third issue is a consequence of the second problem; with IFIs smoothing returns and hence reacting on the minimum returns offered by the current interest rate, Islamic finance gives up its distinctiveness and risks becoming more opaque than conventional finance. A fourth problem arises from the independent nature of the Shari’ah department. As it is not subject to instructions from management, the board of directors or the shareholders, the Shari’ah department’s interests can differ from the counterparties’ interests. The final fiduciary problem that may occur relates to the changing attitude of Shari’ah departments over time, which could lead to a breach in Islamic contracts. Over time, traditional contracts had to be adjusted significantly, which sometimes created discrepancies between the ideology underlying Islamic finance and what is practiced in IFIs. This breach relates back to Shari’ah risk, with was said to affect the integrity of the IFI and Islamic finance in general. Fiduciary risk can be a source of other risks, such as Shari’ah risk, transparency risk and reputation risk.

5.5.3 Countermeasures

In order to keep tensions between the involved parties minimal and fiduciary issues manageable, an IFI has several options. The most eminent counteractions are adhering to standards for corporate governance and Shari’ah practices, allocating clear-cut responsibilities and conducting proper audits in order to keep the public updated about these issues. However, things look different in practice, as recent research demonstrates (Safieddine, 2009). The paper shows that participants are aware of the importance of having good governance practices in place, yet only 65 percent of IFIs adopt corporate governance principles as specified by Basel II. Another 60 percent of the participants stated that key employees were not trained in corporate governance issues. The other issue, poor audit quality, stems from the lacking obligation to contain governance-related information - IFIs are only encouraged to do so.

5.5.4 Best Practice Guidelines

The results from the prior section are quite surprising when the sources of best practice advice are considered. One option is a comprisal of the AAOIFI (2010b), which contains six governance standards. Further advice comes in the form of a compendium by the IFSB (2006). Nonetheless, just because regulatory bodies published best practice guidelines does not mean that an IFI cannot set its own corporate governance benchmark.

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^[1] In the course of this paper, for the sake of simplicity ‘new product development’ and ‘product’ are meant to encompass both tangibles and intangibles, i.e. services.