There are many arguments for and against the Islamic window model, and countries have lined up on either side of the issue – with some jurisdictions such as Qatar banning them altogether. MOINUDDIN MALAM explores the issue.
Islamic banking and finance assets have crossed US$1.3 trillion and are growing at an average annual rate of 19%. This was one of the key messages in Ernst & Young study entitled ‘Growing Beyond: DNA of Successful Transformation’, a World Islamic Banking Competitiveness Report 2012-13 presented during the annual World Islamic Banking Conference held in Bahrain in December 2013. The report expected the Islamic banking growth story to remain positive, growing 50% faster than the overall banking sector. The competitive pressures have forced the existing conventional banks in such territories to address the issue by initiating the ‘Islamic window’ models within their existing infrastructure. Markets with higher demand for Islamic banking present a better opportunity set; however, each market player intending to start up an Islamic window will need to carve out its own unique market penetration strategy based on the breathing space allowed by their regulators in this segment.
The evolution of Islamic windows
An Islamic window by definition can be a department or a division or even a separate finance company set up by a conventional financial institution which offers Islamic products and services to customers who prefer Islamic finance over conventional finance. The reason for a conventional entity to set up an Islamic window can be twofold: (1) to keep the existing customers who are now opting to switch to Islamic finance and (2) to attack new customers from existing banks, including Islamic, based on superior products and services extended by the conventional financial institution.
The best and the most rational reasoning for any regulator to allow an Islamic window model is the cost efficiency ratios and the underlying profitability of fully-fledged Islamic banks: where conventional banks are still enjoying better industry average return on equity (ROE) at 15% compared to 12% of Islamic banks. This is where the Islamic windows can step up and deliver.
While every Muslim-dominated jurisdiction has seen the advent of Islamic banking and Islamic windows, there is no uniformity on their operational model. This has even led one jurisdiction (Qatar) to disallow conventional banks to offer Islamic products and services through Islamic window operations. The purpose of this paper is to put forward what could be possibly a ‘perfect model’ of an Islamic window with pros and cons for the conventional banks to consider.
Today there are over 200 Islamic financial institutions (IFIs) operating from Indonesia to Canada with quite a number of jurisdictions having fully-fledged Islamic banks as well as Islamic finance companies and Islamic windows; however, most of them do not have a perfect Islamic window model. The concept of an Islamic window within a conventional bank goes back some 20 years hence it is not new; however, there is relatively little written on this concept and the basics which should be considered carefully by conventional institution or even the guidelines issued by their regulator on this subject matter. Perhaps the most advance and evolved model of Islamic windows is found in Malaysia where both law-makers and regulators have proactively supported the Islamic banking and finance industry. However, their Islamic window model has also evolved and has gone through changes over a period of time. While there are a few variations of models for Islamic windows operating in conventional financial institutions of all sizes – and with a focus sometimes as narrow as a handful of resources and a small segmental approach or as wide as a larger set-up with full coverage – there is no one model which can be branded as the most efficient and correct one. If one examines these Islamic windows, one would realize that each has evolved based on the internal buy-in and even political maneuvering within the conventional bank which does not necessarily mean that they have opted for the perfect model. If one evaluates the Islamic window operations which started far earlier for international banks than domestic, one would see how these models have fared. While there are few examples of success here these too are not perfect whereas there are more examples of unsuccessful attempts. While one can always learn from why Islamic windows in these international banks folded or were minimized, it is interesting to note that in most cases, the financial institution simply wanted the Islamic window to capture what was perceived to be large pool of deposits especially in the Middle East based on the inherent expertise of the institution. In other words, they only encouraged the formation of an Islamic window to create products wrapped around in a Shariah compliant structure for onward sale to Shariah compliant customer. One can also say that they were not really looking to advance Islamic finance but were merely trying to take advantage of the situation and when the situation was not in their favor they simply walked away from the model and sadly from the Islamic industry.
What is the Shariah acceptability of Islamic windows?
Shariah scholars have approved any conventional bank to establish an Islamic window subject to the bank complying with the guidelines set up by the Shariah Scholars. They have also accepted the conventional bank can sell and market Islamic products and services. Some Shariah scholars have expressed their concerns with conventional banks operating Islamic windows due to the fact that the conventional banks do not comply within their terms of incorporation and statutes the support and advancement of Islamic Shariah-based banking. Additionally, an objection is also raised at times on the source of funding of the conventional banks coming from prohibited activities such as interest-based dealings or a common funding pool of non-Halah sources. Shariah scholars have permitted conventional banks to operate Islamic windows subject to the underlying contract as well as the modus operandi being Islamically acceptable. Furthermore, most Shariah scholars agree that any income source can be purified and cleansed and then subsequently directed to Shariah permissible channels through the Islamic window.
So what are the generally accepted guidelines under which an Islamic window can function? The following are some basic guidelines:
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Establish a working Shariah Supervisory Board (SSB) and strictly comply with its guidance.
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Shareholders, board of directors and the management of the bank to accept the concept.
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Shariah coordination, research and training across the bank.
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Develop Shariah-focused policies and support infrastructure.
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Islamic banking code of ethics to be abided across the bank.
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Establish Shariah compliance and governance including review, audit and remedial policies.
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Develop products and services which fully follow the Shariah guidelines.
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Transparency, discloser, reporting and adapting standards
Experimentation by various regulators has led to two distinct formulas for setting up Islamic windows. The most evolved Islamic banking model is that of Malaysian which requires fully independent Islamic branches to be separated from conventional whereas the wholesale banking products could be a combination of business originators or product specialists or both. This model is gaining popularity in other jurisdictions. The second model is where a centralized Shariah or Islamic business division is set-up by the bank where it uses combination of delivery channels mixed with conventional distribution channels to sell Islamic products and services. At one extreme, under this model, banks are not even forced to a separate auditable balance sheet or even segregating the funding center and booking the deals in conventional books directly. There can be any minor changes in the above two models to differentiate between what the regulator will allow in any jurisdiction or what the customers will accept eventually obviously everything must be ultimately approved the SSB. The key point of consideration and most critical success factor to be seriously considered is that whatever model is being adapted by the stakeholder or pushed by the regulators, the model must not compete internally with the existing conventional franchise. Islamic windows must be seen as supplementing the existing business of the conventional bank by servicing existing customers who may elect to choose Islamic banking and targeting new customers, without cannibalization.
Why should conventional banks be allowed to operate Islamic windows?
Should the regulator in any jurisdiction disallow conventional banks to compete with 100% Islamic banks? Perhaps the shareholders of 100% Islamic banks will agree and claim that since they do not offer conventional products & services; similarly, conventional banks should not be allowed to offer Islamic products and services through their Islamic window. This is a very narrow, naïve and negative approach. Competition is healthy and in long run it always weans out the weaker institutions from most suitable, efficient and the fittest. Additionally, competition is always good for the end users as it provides them a choice between different product providers. The pressures exerted due to positive competition that international, regional and local conventional banks’ Islamic windows should prompt Islamic financial institutions to exercise more diligence and care to introduce better quality products that have at par service standards, if not better. It is only through competition by Islamic windows that pure Islamic financial institutions have been forced to take a hard look at the inefficiencies in their operating structure and risk assessment models. Prior to full advent of Islamic windows in any jurisdiction, the customers were at the mercy of pure Islamic financial institutions as there were no service standards, quality check, price efficiency, transparency, etc.
If one looks at recent studies by leading consultancy firms inclusive of McKenzie, Ernst & Young, AT Kearney, etc., they all highlight the inherent weakness of the pure Islamic banks being weaker systems, operational inefficiencies, lack of product & services diversification, quality and services issues, higher cost to income ratios, weaker risk assessment systems, concentration on few sectors, etc. In the wake of the subprime crises with led to financial meltdown of the global markets, while Islamic banks were shielded due to their inability (for Shariah compliance reasons) to take part in the highly speculative products such as derivatives and multiple securitization, their limitation in lack of diversity in asset classes (with major concentration on real estate industry) have also arguably put a temporary breaks to the exponential growth Islamic banks were used to. Again, it must be emphasized that the main reason for Islamic banks being sheltered from global financial downturn could also may be mainly due to nascence stage of Islamic finance rather than any construed effort by the industry experts to stay away from it. However, a better and a positive argument would be that unless conventional banks participated in Islamic financing, Islamic banking would not have grown to the proportion it has reached today and the fame it has acclaimed as well. A very simple example of this is the Sukuk industry in which if once looks are international Sukuks one would note that at times majority (up to 70% or even higher) allocation has been taken by conventional banks which goes to show that to support the argument that Islamic finance is not simply for only 100% Islamic banks. The challenge to becoming a more efficient operator in a challenging circumstance could not have been taken that seriously by 100% Islamic banks if there were no competition from the Islamic windows of conventional banks – with customers being the ultimate winner.
Framework for a ‘real’ Islamic window
A fully functional and cost effective Islamic window requires following:
1. Strategy, key initiative and objectives: Being an integral part of the conventional bank, the Islamic window initiative should have a very clear strategy. There are only two possible strategies which the Islamic window should adapt as all else are bound to create confusion, confrontation and ultimate failure. The stakeholders of the conventional bank should have the complete clarity on the strategy they are adapting when they set up the Islamic window as well. Rather than toying with one model versus another year-on-year, the focus should be based on the ultimate target. Is the purpose of starting the Islamic window to simply stop the existing customers shifting to a 100% Islamic bank or to build up a model which can be converted into a standalone Islamic bank as and when the opportunity presents itself through regulatory changes or acquisition targets? Islamic windows should not be set up simply because of market trends or due to pressures of stakeholders as this initiative requires a concerted effort by everyone in the conventional bank not just the Islamic banking personnel to set up the operations. Hence, once the stakeholders of the bank have decided to establish Islamic windows, the senior management across the bank need to take the ownership to deliver the model successfully. This means that the approved strategy for the Islamic window must be layered with key initiatives that should have well-defined objectives which should be ultimately modeled to target certain market share in the segments it would like to penetrate against measurable revenues / expenses expectations. The success of an Islamic window is in buying in of the initiative by the management of the conventional bank and each one of them taking ownership for its successful launch and continuing support. The objectives must be converted into measurable targets both qualitative and quantitative. Each target need to have a well-defined process duly supported by all the functionalities under a service level agreement and turnaround time.
2. Head of Islamic window: Success of any initiative is based on the front-end leadership. Islamic Widow should have a leader who should be responsible for overall Islamic window initiative and who should be the focal point to drive the Islamic window strategy and objective across the bank. Ideally, the person should have a number of years of Islamic banking experience and above all should have the passion to do the right thing without sacrificing Shariah governance and compliance. The head of Islamic window should be the key spokesperson for the bank and should lead all Islamic initiatives within the bank directly reporting to the chief executive of the bank. In an ideal situation, the bank should embed Islamic business enablers and managers in areas such as retail, corporate, treasury, trade finance, investments, operations, audit, etc. who should have dual reporting lines – one to the head of the Islamic banking window and the other to the business enabler/administrator group head. The role of Islamic business manager is to assure that annual targets are assigned to the team, to manage reporting and monitoring of performance and essentially liaise between the centralized Shariah governance unit and the product managers. The head of Islamic banking should have joint Islamic targets with the other business heads where the business heads should cascade clear and measurable targets to their teams. Lastly, it is critical that the head of Islamic banking should directly report to the CEO of the bank and should be part of the executive committee; in which the Islamic window needs to get the same respect as other businesses within the bank. The critical success factors are the empowerment of the head of the Islamic window to have a strong voice in the executive committee, the acceptance of the business model by the other business heads and the dual matrix reporting structure for Islamic managers who are embedded in various areas of banking.
3. Shariah Supervisory Board: A fully functional Shariah Supervisory Board (SSB) consisting of reputable and experience Islamic Shariah scholars is an integral part of any Islamic financial intermediary including an Islamic window. A minimum of three Shariah scholars should be implemented, with one being the chairman along with two members. The Shariah board is independent and is the consultative advisory body which will approve all products and services, issue Fatwas, approve the financial statements of the Islamic window, etc. It is preferred that at least one if not all of the Shariah scholars are locally based and should have executive authority to approve anything on behalf of the SSB to be ratified by the SSB in its next meeting. The SSB function is to support the Islamic window as well as guide it in terms of Shariah discipline, governance and compliance. Generally, Shariah scholars are very supportive of Islamic banking growth and at times even approve the Islamic window to go ahead with the Shariah approval of other Islamic banks and Islamic windows so long as one or two of the Shariah scholars in those institutions are common with the SSB of the bank. This flexibility is critical especially when and if the Islamic window participates in a club or syndication transaction where time is short and a full bench SSB is not possible for any reason. The role of the SSB so far has been kept very limited where it has been seen that IFIs including Islamic windows outsource this activities to few selected companies that have now mushroomed over last five-plus years. While the value these entities add is definitely positive, the whole concept is highly debatable as they operate on a purely profitable basis as they usually charge on a transaction-by-transaction basis. Whereas the concept of an SSB as being more advisory/consultative needs be on a pure non-executive and non-commercial advisory whereby the Shariah scholars are engaged and generally receive a token amount for their contribution. An independent SSB will bring more respect to IFIs where one should consider using them beyond simply as a conduit for products and documents approval or for the issuance of Shariah Fatwas. The SSB could be potentially and practically engaged in town hall meetings with bank’s personnel, direct customer interaction, visiting bank’s various premises to engage and review the Islamic banking activities, training and certification, etc.
4. Secretary to SSB: The role and responsibility under this critical functionality requires a qualified person who will act as a liaison between the Islamic window and the SSB. The basic role of the secretary to the SSB is to organize the SSB meetings, prepare the agenda, hold the meeting, take minutes, prepare Fatwas, advise the SSB guidelines to the bank etc. The secretary should be preferably a relatively young Shariah scholar with some banking experience who can also perform other roles for the Islamic window which include training and basic Islamic banking certification for the sales/relationship teams, visiting the various units/branches of the bank to guide them, reviewing Islamic structures and documentation, act as custodian for all Shariah-related and all other standardized Islamic banking documentation, manage the Shariah compliance role across the bank, assist the various units on any Shariah-related issues of transactions, etc. This is a pivotal role and needs an individual who can quickly pick up banking knowledge and acumen in addition to having the required Shariah knowledge base and qualification. From experience it has been seen that most innovation in products and services in Islamic banking has failed mainly when there has been a lack of understanding on this front that creates a bigger gap between conventional and Islamic products and services which does not bode well for Islamic windows. The SSB usually interacts with the Islamic window’s management through a secretary to the SSB who needs to have direct access to the board of directors (BoD) of the bank so as to liaise, if required, between the SSB and the BoD.
5. Shariah governance, compliance and audit: The basic Islamic window model hinges strongly upon the level of Shariah governance, Shariah compliance and Shariah audit. Once the Islamic window establishes the SSB with a clear charter, contractual arrangement and ultimate authority, then Shariah governance, compliance and audit functions need to be established. As most of the time, the SSB may not be easily accessible or even not based on the same physical location/jurisdiction; the secretary to the SSB should also double up and head the Shariah governance & compliance unit. The approvals on products and services by way of minutes of the meetings or issuance of Fatwas must be carefully implemented by the product or task manager within the Islamic window regardless of wherever they are embedded or not. To overlook and assure proper implementation of the Shariah approvals and the Fatwa, Shariah compliance and Shariah audit play a critical role. Non-compliance on any approval or Fatwa may make the underlying transaction non-compliant and in the worst case scenario, the resultant profitability will have to be given away to charity. Shariah compliance and Shariah audit are two independent functions and these should also be independent of business, enabler and administrator groups. Shariah compliance relates to independent spot checking of business, operations, staff’s familiarity of Shariah requirements on different products and services processes, etc. Shariah compliance is the control structure necessary to assure that nothing slips between audits, which may be more time-related and cyclical. The role of Shariah compliance is to ensure that while the products and services are approved by the SSB and so are the underlying documents, it handles the situation should there be any Shariah repugnant activities and businesses that may be included in the Islamic banking fabric by sheer ignorance, the chance of which is greater in a Islamic window operating within a conventional bank than a standalone Islamic bank. Shariah audit needs to reflect the standards issued by AAOIFI and IFBS. Ideally, the Islamic window should establish an independent Shariah Audit Red Flags manual and train the existing internal audit department of the bank to also pick up a sample of Islamic deals and accounts during their normal audit of the bank. Any Shariah-related matters and red flags should be raised to the Shariah auditor who should be able to seek a solution or action planning as deemed fit and can further escalate the matter to the Shariah governance unit.
6. Human resource planning and training: The most critical resource in Islamic finance today is the human capital. While it is difficult to find experienced Islamic bankers for various functionalities, there are basic Islamic banking courses available which provide certifications and have been approved by the various Shariah scholars around the world. It is, however, critical that key Islamic window resources must have relevant Islamic banking experience. As conventional banking has taken its time to establish best practices in all fields including human resources planning and training, for Islamic window, there should be no difference on the yardstick. Based on the strategy adapted by the stakeholders of the bank, regardless of howsoever the Islamic window model is set-up; the bank needs to impart basic Islamic banking training to its existing enabler groups as well as business groups and administrator groups who will be the touch points for Islamic products and services. The Islamic window is not a fully-fledged stand-alone operation and therefore will depend for the most part on the conventional banking personnel to assist in successfully delivery of the Islamic products and services with similar service quality and turnaround time. Therefore, when setting up an Islamic window training plays a key role. Developing in-house training modules which consist of basic training on Islamic banking-related Shariah topics and specific product training will be necessary. The basic training on Islamic principles and contracts should be ideally set-up on an e-learning platform and must be mandatory for everyone in the bank including all personnel whether business, enabler or administrator group across the bank without limitation. The specialized and focused product and services training courses should be targeted to the sales, operational, accounting, risk, technology teams who are responsible for selling, assessing, processing, managing and monitoring the respective product and/or service. Additionally, each area of specialization needs to make sure that their staff are specifically trained for competently delivering the outcome required from them, for example, product manager for liabilities in retail should know how Murabahah, Mudarabah and Wakalah structures works and how profit management systems, profit equalization reserves, etc need to function with or without automated systems.
7. Products and services: An ideal Islamic window should have the capability to replicate all existing conventional products and services (subject to SSB approval) into the Islamic framework from retail to wholesale banking. In the event the existing bank has product managers at all segments then they should work hand-in-hand with the Islamic structuring team to create the Islamic products and services. Else, the Islamic window should hire a core product development team to make all Islamic products and services available to the bank. The key here is to make sure that while Islamic structures typically make Islamic documentation slightly lengthier and cumbersome, the process, the delivery channel and serviceability should match the conventional products and services. It should be also possible to buy product off the shelf and adapt them to existing standards of the bank in those markets where Islamic banking is more developed than others. Needless to add that while adapting to offer Islamic product and services whether through a pure Islamic bank or through an Islamic window, the concept of risk remains the same. Additionally, the way practice is prevailing globally, risk does not change between the conventional funding and Islamic window-based funding excepting structural difference and some product variation. The point being, Islamic windows also operate under the same risk policy of the conventional bank with very few adjustments. While putting together Islamic products and services for customers, banks should remember that their best customers are their own employees and all Islamic products and services should also be made available to them at the same preferential rates and basis as it does on the conventional front.
8. Product development: Islamic product development requires a team effort between the product development unit, Shariah, legal, compliance, marketing, branding, accounting, auditing, risk management, processing, operations, technology and the business. The combination of the task force or team is determined by the product manager who may also include third party vendor. In an organized institution, product development itself is a disciplined approach which is systematic and the methodology is captured in a product development manual. It also varies from retail products which may be governed under a product program that is parameterized product to wholesale banking product which is generally governed under the wholesale risk policy and structuring guidelines. The principle that Islamic window needs to follow is that all Islamic products and services which are essentially the alternative solution to a conventional product or service is governed under the same risk guidelines, follows same if not similar processing channels, has same level of quality, presale and post sales servicing in addition to price/cost to be the same if not better. In other words, Islamic products and services, despite being document-heavy, should be fully aligned to its conventional counterpart. Each Islamic product should follow the same flow as that of conventional product and if such conventional product is parameterized under a product program then Islamic product should be identical with relevant Shariah compliant factors build-in. It is preferable to have a common product program which clearly segregates the process or methodology for both while maintaining the common factors at the same. Whatever the product and services offering may be, it is should be technology enabled for both retail and wholesale banking customers with viewing, transferring, investing, etc. Today, product and services should be technology enabled and everything should move to online, mobile, smart phone, etc., basically IT enabled with ease of transacting everything with double back-up security firewalls.
9. Enabler/back office support: The key strength of being part of a conventional bank is that all back office functions are standardized and manualized, and a similar set-up needs to be put together for the Islamic window. If not correctly mapped, aligned, managed, transitioned and implemented with right maker – checker system, this may cause issues with product performance and tarnish the window’s reputation with frequent customer complaints. While the product manager creates Islamic concept papers, structuring guidelines, gets product approval, provides legal documentation, working process mapping and charting and training; it is the bank’s operations which will write the SOPs for the Islamic window and credit admin who will issue the correct set of Islamic documentation. The financial affairs or accounting units of the bank who will codify the entries, create general and product specific ledgers as advised by the product managers including dos and don’ts consideration under different Islamic structures used to put together the product or service. Ultimately, everything boils down to the IT system which needs to be flexible to absorb the changes required to run Islamic products and services. There are independent standalone Islamic banking software systems available in the market but the question remains: “Does the existing system interact with any new systems or modules?” This requires a carefully thought out framework and will at times need new procedures or work around in place to assure that Islamic transactions are properly processed. Additionally, new Islamic systems may not be the most economical way for the Islamic window model. Hence, back office activities includes very complex, interlinked and interdependent set of activities from one unit to another and Islamic products and services need to follow the suit of the conventional alternative in terms of perfect alignment so as to have same turnaround time, delivery mechanism, service quality both pre- and post sales. Every aspect of the enabler roles and function will need to be checked for acceptability under a Shariah compliance mechanism. As highlighted above, basic Islamic banking training across the board will assist the bank in rolling out a balanced Islamic products and services.
10. Co-mingling of funds: What differentiates between a true Shariah compliant Islamic window and a ‘dressed-up’ Islamic window is the co-mingling of funds. Due to lack of expertise, most conventional banks start their Islamic windows by offering Shariah compliant products and services which are not truly segregated within the balance sheet and income statement of the conventional bank. As the concept of Islamic window is catching on and more conventional banks are opting to take this route, SSBs as well as regulators are making some mandatory provisions which include segregation of customer accounts between Islamic and conventional. Moreover, SSBs require that Islamic window to be treated as a virtual bank within a bank which should have a separate, audited balance sheet and income statement where each and every asset, income, revenue, expense as well as provisions need to be captured. In other words, for an effective Islamic window, there should be no co-mingling of Islamic funds with conventional funds. This requires much work including setting up different general ledgers where Islamic transactions are booked end-to-end, careful assessment of existing core banking capabilities and developing an IT infrastructure which captures and keeps the segregation between the conventional and Islamic accounts, printing of different or common stationery, etc. The prohibition of co-mingling of funds also means establishing an Islamic funding center within the main funding center of the bank which looks at interbank liquidity management and deposit mobilization tools for effective asset and liability management.
11. Cost allocation mechanism
The bank needs to know the profitability of every product so as to decide what type marketing strategy – whether “push” or “pull” – will need to be deployed. All financial institutions have a well-defined costing methodology to basically split the cost associated with running any product or services. The ability to break-up the cost of delivering and servicing a product or service plays a more so critical role in Islamic window scenario depending upon the various functionalities within its conventional arm for effective delivery on their part with the same or even better turnaround times. The idea is that there should not be any difference between how a conventional institution allocates costs of its conventional product or service to its various functionalities as compared to Islamic. Additionally, in case the Islamic window it is using the same channels for distributing its Islamic products and services as that of conventional, hence one should be able to assess the incremental revenues generated by Islamic window without matching incremental expenses. The idea is to scale-up productivity without scaling up same level of direct costs associated with selling. A robust cost allocation methodology tied with specific service level agreement with turnaround time will only have better operational efficiencies and enhance customer service. Islamic banks are known to have a higher operational cost which emanates from having no or lose control on cost allocation model which is one major benefit Islamic windows can have over 100% Islamic banks.
12. Cost of funds and transfer pricing
Cost allocation is one factor and the other factor which affects the product is the cost of funds. Islamic window needs to develop various types of fund raising instruments from retail to corporate and bank-to-bank deposits schemes from overnight to longer maturities at market driven rates. While current accounts and saving accounts (CASA) are least costly, these are also least predictable. Historical analysis shows that there is a systematic risk of reduction in CASA levels when other investment opportunities are made available to depositors. Additionally, Islamic banks have always competed with conventional banks operating in the same economy for deposits hence rate sensitivity is always present. Cost of funding needs to be kept well checked if the Islamic window has created a mismatch between the duration of assets with liabilities. Usually, assets are not easily re-priced and this could affect the bottom line drastically in case the liability re-price more frequently due to market pressures. There should be a disciplined way to transfer funding cost to asset acquisition through transfer pricing mechanism that takes into account liquidity premium and risk premium. Having an efficient transfer pricing mechanism means that the Funding Center which handles conventional funding should also be responsible for Islamic fund and should keep checks and control on overall cost of funding of the Islamic window.
13. Deposit mobilization
Islamic windows usually don’t have any capital whereas most of the Shariah Supervisory Boards across the Islamic world prefer the any Islamic lending to be funded by Islamic liabilities/capital. In the case of Islamic windows, segregation of Islamic books with the conventional books all the way across for everything including assets, liabilities, revenues, expenses, etc., means that Islamic window should also have its own distinct deposit mobilization strategy. For the retail segment, Islamic windows have a variety of instruments from current account, savings account, fixed deposits, etc based on Qard Hasan, Mudarabah, non-discretionary Wakalah, etc. where it can attract liquidity from the market. With corporate segment it can raise time deposits through commodity Murabahah or non-discretionary Wakalah. To plug the liquidity gaps, Islamic windows need to have their service level agreement with the conventional bank’s treasury and funding center so that they can line-up from overnight to near term liquidity on Islamic contracts from other funding sources. If there was one most critical success factor for an Islamic window then it is the ability to mobilize deposits to funds the Islamic assets. The emphasis being to maintain a health asset to deposit ratio of less than 100% at all times. There is no correct mix of what level of retail, corporate and near term liability should be maintained or what should be the mix of current account and non-current account deposit ratios, these things vary from one jurisdiction to another and on saving habits of the consumers. This also directly links with asset liability management and duration mismatch which should be also considered by the asset liability committee of the conventional bank.
14. Accounting and financial reporting: Shariah requirements vary from one window to another. Most common practice seen with Islamic window viz financial reporting is the management reports which is kept segregated for Shariah purposes yet consolidated from filing and reporting perspective. In case the Shariah Supervisory Board has been able to enforce strict compliance with its Fatwas then Islamic window may be required to prepare a separate audited financial statement which can be consolidated at the conventional bank level for regulatory reporting purposes. This is easier said than done and means that the bank creates separate accounting ledgers at all levels and is able to segregate the customers’ conventional accounts and Islamic accounts while keeping one common customer identification system for those customers who use both type of banking channels. This also means that the all Islamic assets and liabilities are accounted separately including all revenues and expenses. One must remember that each Islamic transaction mode has different requirements in terms of processing and booking. Additionally, the Islamic saving schemes are usually under a Mudarabah structure which essentially requires Profit Management System (PMS) and creation of Profit Equalization Reserves (PER). PMS essentially assists the Islamic window to pool its saving and time deposits mobilized under Mudarabah structure which requires closure of books periodically which is usually done on a quarterly basis where all funds deposited in these types of accounts and the underlying investments made through deployment of these funds with income being produce from them is declared and distributed to the depositors. Islamic banks create PER to create a reserve for equalizing any shortfall in profit in the future periods. Charity process and accounting of charity is also one common aspect in Islamic banking which conventional banks are alien to. This definitely requires complex accounting treatment of keeping the accounting record segregated including customer reporting as the regulator will most definitely require this to be the primary requirement. There is also a need to develop accounting codes and processes based on the various types of Islamic structures bank uses for its products. For example, ready to live-in home financing for end user is different compared to under development home. Similarly, while the home financing under Ijarah can be easily booked as a ‘term loan’; however, delayed payment, payment of insurance, major maintenance, etc. are treated differently under Shariah as compared to say the home mortgage product under conventional banking.
15. Branding and premises: While a lot of stakeholders focus may be diverted into creation a brand image, beautiful marketing collateral and opulent premises even for the Islamic window, it is worthwhile to note here is the taste of the pudding is in what is the actual taste rather than what it looks like on the surface. Islamic windows need to make sure that the level of service quality is either at par or better than its existing conventional bank to really make the difference. While branding, marketing and good looking premises may bring the customers in for the first time, poor level of service quality will not give any repeat business. One needs to develop a two pronged approach to these critical elements while maintaining a good balance between effectiveness and efficiency paradigm. One does not need to go on a spending spree with roadside flags, billboards, banners, newspaper clips, radio and television converge etc. Remember the new brand representing the Islamic window will also carry the legacy of its parent whether good or bad. One needs to use the strength of the parent brand to make its branding and marketing campaign a success. Again, SSBs tend to allow dual branding of a product where in the underlying document whether it is a publicity advertisement or an application form for as simple as current account, so long as the content are Shariah compliant. Depending on the regulatory framework, dual branding can be a huge success and very cost effective. Hence, the recommendation that one should lever the loyalty attached to its parent’s brand and use synergy to enhance the Islamic offering.
16. Marketing an Islamic window: As an Islamic window, the key challenge faced by the bank is how to facilitate the internal acceptance of the initiative while stopping the leakage and capturing the market share. The addition of an Islamic window by a bank in its system definitely does not allow the bank to increase it’s per party exposure allowed by its regulator, it certainly introduces complexities in term of internal processes, risk allocation, product acceptance, etc. Generally, most Islamic windows fail for two reasons (a) they set-up their own dedicated sales and relationship teams to marketing Islamic products & services where they eventually start to compete with the bigger bank hence the conflict and/or (b) where the banks decides to use the existing conventional sales and relationship teams to sell Islamic products & services who do not take this initiative seriously at all. Both strategies are incorrect. The better model is when Islamic window uses a combination of dedicated experts and existing sales and relationship teams to penetrate this segment. As Islamic window will always be treated as younger brother with some favoritism or a step brother in case the buy-in of some business segment is not available, it is critical that at the offset the Islamic window initiative is taken seriously and its acceptability is across the bank from its owners, to its board of directors to its management. Islamic window should be used as a ‘product specialist’ where customers are sophisticated and have existing long term relationship and else they should have ‘originators’ or ‘hunters’ where they target to get new-to-bank customers.
17. Hunters and harvesters: With the dual reporting matrix in place, products and services replicated; targets and budgets jointly made between the head of Islamic banking and different business heads, the real test of the model will be in its execution. At retail level, training needs to be imparted to the retail team through a system where they need to understand the differentiating factors between the conventional products and Islamic which will on work when they are also Shariah certified to sell Islamic products and services through basis Islamic banking/ basic Shariah course and exam. The key to this training is to make sure that the sales team accepts the Islamic product wholeheartedly despite change in the structure principally due to the fact that pricing of both Islamic and conventional is the same, service standard are the same even with slightly lengthy documentation process for Islamic. A preferred retail model should have totally segregated Islamic branches where no conventional products and services are offered. This means dedicated Islamic branches to sell products and services of Islamic window. It may be a costly affair but will create better market perception and customer loyalty. At wholesale banking level, hunter team is more prevalent; however, existing conventional relationship managers and units may show their reservation. The main reason for this is the fact that most conservative Islamic customers would prefer to bank to 100% Islamic bank rather than an Islamic window unless they have become disenchanted from the 100% Islamic bank for some reason and are looking alternatives. It has been seen that at wholesale banking level, customers are neutral and whosoever is able to get to the customer first and convince them to take Islamic products first will win the account. A small hunter team needs to be embedded within units such at SME or commercial banking whose purpose in life is to originate new to bank Islamic customers to be booked by the bank’s existing relationship managers who should have Islamic targets in their KPI and MBO. For large ticket customers including corporate, financial institutions and sovereign entities, a team of specialist Islamic banking professional need to be available as product specialist within the Islamic window or embedded with the business group based on the level of sophistication and segregation by business type within the conventional bank.
18. Retail offering: An Islamic retail offering can take any shape based on the interpretation of the SSB or what could be their preferred approach of sourcing business from this segment of the economy. While every jurisdiction where Islamic finance is practiced has carefully evaluated the pros and cons of who Islamic windows should or shouldn’t be allowed to market Islamic retail products and services, there are no one perfect way. Learning from the example of few jurisdictions where Islamic banking and finance has taken roots, it is evident that the ultimate choice for retail offering is to have independent Islamic retail branches which have no linkage with conventional branches other than perhaps common reporting lines. The other models experimented by most conventional banks is where existing conventional branches are allowed to also offer Islamic products and services from the same platform with Shariah trained and certified staff. This model presents some mixed hypothesis which may be efficient but in long run dilutes the Islamic offerings. One of which is cost efficiency and the second most common is using the same team to sell common Islamic and conventional products, etc. However, the measurement of what is offered and whom is always very muddy and mystery surveys shows that such approach ultimately reflects poorly on the institution as it is always difficult to bring discipline to a branch which is used to selling conventional only to also offer Islamic. The reason being Islamic documentation being slightly bulkier and more process heavy compared to conventional products and the branch’s sales personnel being more familiar with selling conventional products and services. The view of SSB and the regulator become a key differentiating factor and these two must play a critical role in framing the guidelines of how a conventional bank should offer Islamic products through its branches in an Islamic window model. The orthodox view of few reputable Shariah Scholars has been to avoid mixing the conventional branches with Islamic and maintaining a key demarcation akin to mixing of wine and water under Islamic jurisprudence. Whereas moderate view is that so long as proper training has been imparted to conventional sales team with clear targets and a discipline of offering to “sell Islamic first”, one can use its conventional branches to selling Islamic retail products. In the end, one needs to consider the impression of the customers and how would they look at purity of the offering is what matters the most in either of the two approaches.
19. Wholesale offering: In addition to hunter team for corporate sales, the Islamic window will also need structured finance team depending upon the depth and breadth of the bank. Usually, keeping a team of skilled Islamic banking structuring team which can work with treasury, debt capital market, Syndication, financial institutions, large corporate clients including sovereign and GREs is required especially when any of the existing clients of the banks opt to prefer Islamic solution for whatever reason or fact. In advance Islamic banking jurisdictions over a period of time existing conventional customers both retail and wholesale, have either opted for Islamic or even completely switched their preference for Islamic banking. Unless the existing bank has this expertise and product range, the bank stands to lose its customer to 100% Islamic bank or competing Islamic window of another bank. It has also been seen that bulk of the revenue which the Islamic window will make comes from this ‘natural’ segment and this where the basic conflict starts. Unless the bank, its board and the management have a clear strategy from the very first day Islamic window model does not stand a chance to gain popularity amongst majority of Islamic customers as they will not accept the hodgepodge Islamic window structure and unfortunately the team running the Islamic window will always be blamed for cannibalizing the existing business. Whereas the truth remains, unless the Islamic window exists, the bank would have lost out on the customer as it they start to shift their preference to Islamic. Ideally Islamic window should start with a dedicated team of originators, hunters and harvesters, and with increasing interest in product suits by the wholesale customer, it is ideal to embed Islamic experts in key functionalities such as treasury, financial institution, syndication, debt capital market, etc. However, a core team of Islamic structured finance needs to be within the Islamic window to support everything else that requires core attention i.e., product experts in structured finance.
20. Front end cross-functional support: To keep the strength of the Islamic window personnel to the minimum and have an improved cost to income model, Islamic window will need to cut across all front end business groups and should have experienced people either embedded with dual reporting to the Head of Islamic window; else basic Islamic training needs to be provided to the front end business personnel and relationship managers who can identify any opportunity to bring in the Islamic experts as required. This will only work when Islamic targets are agreed with to all business groups and are cascaded to every relationship and sales team member. The success of the Islamic window will depend purely on the acceptability of the Islamic initiative by the front end function of the conventional bank and how they adapt the Islamic banking themselves. More than often it is seen that the success or failure of Islamic window is based on how the business groups in the conventional bank treat Islamic Initiative itself. If it is perceived to be competing with existing conventional bank then it is bound to fall flat merely because conventional practice has been a established line of business with customer base, performance track record and resources whereas Islamic window will be very new with teething issues. The only way Islamic window is bound to succeed in any environment is when the entire bank wholeheartedly accept this as (1) added value tool (2) an alternate channel to deliver products & services (3) a mechanism to retain existing customer and (4) attract new customers who prefer Islamic finance. It must be emphasized again that while Islamic window resources can and must be embedded into various business, administrator and enabler groups, there should be a central figure head with a core team that has full responsibility to deliver the initiative for the bank else it become a haphazard approach by different business heads and ultimately the bank may not realize its full potential or the desired market share.
21. Account planning: With a lean management of the Islamic window, account planning at every level of the conventional bank for Islamic targets and aspiration is mandatory exercise where the conventional team plus Islamic Hunters embedded in various business segments evaluate customer by customer. The basic concept of account planning is to look at possible ways of increasing and/or decreasing the exposure with the customer in all areas with funded, unfunded as well as other ancillary business based on the risk rating, appetite and limit exposures. Islamic window offering is not simply a product offering but is a complete alternative to existing way of banking and account planning should be able to well define the possibility of selling more Islamic products and services to existing customers and identify new segments for further penetration. Preference by customers has always been one argument which prevents Islamic windows to successful penetrate existing clientele of the conventional bank; however, unless the relationship personnel introduces the Islamic capability of the bank by showing them the Islamic products and service, one will not find out the true preference. Additionally, account planning needs to figure out if the existing customers are availing Islamic facilities from other institutions and how the Islamic window should be used to target that business. The entire focus of account planning is to maximize the share of wallet from the customer and to become a primary bank for them. Account planning should ultimately results in measurable Islamic targets being agreed by the conventional relationship personnel as well as for the Hunter teams and the originators.
22. Technology and systems: Having the right IT platform, Shariah-based Islamic banking architecture and experienced Islamic banking IT team is another critical success factor. The challenge being to create a parallel banking platform which seamlessly interfaces with the existing system of the conventional bank while maintaining a fine china wall between the Islamic account management and conventional. This includes creating the Islamic business objectives universe, general ledgers, accounting codes for overall Islamic business segments, products and services accounting codes and booking methodology, product profitability measurements, account maintenance, etc and how all of this is reflected in the system and produced in the management reports and financial statements. The purpose of this is to make sure that Islamic funds, assets, liabilities and expenses are not comingled with the conventional books and could be separately audited by external auditors, to be approved by the SSB and could also be presented to the regulatory examiner. One way of developing a Shariah compliant system is to work with existing legacy system and the core banking platform which the conventional bank has and to modify this which requires more time and resources. The other option is to look at a latch-on Islamic system which can be fully integrated with the existing core banking system. A customer interface is the on-line banking whether at retail or corporate banking level. A user friendly on-line banking system has become an essential tool for any banking institutions and this is also valid for the Islamic window model. On-line banking system should allow customer to enquire, transact, instruct and get reports of their activities at all levels in additional cash management solutions for corporate customers. The better approach is to have the ability to segregate customer-by-customer level into two – conventional and Islamic with both reporting separate statements yet being reflected with the account manager for customer profitability report. The idea being that all hard income from Islamic business should be booked in one consolidated book with shadow reflection to the relationship manager so that their performance can be measured against targets.
23. Credit policies, risk management and legal: Under the present Islamic banking and finance regimes being practiced across any jurisdiction, unfortunately there is no difference in terms of how Islamic banking and finance has evolved. There are exceptions when it comes to Islamic microfinance and that’s about it. Altogether, there is no difference in credit risk between Islamic banks and conventional banks, at least in practice. The key differentiation is in structuring of Islamic transaction which is an added layer of Islamic mode of financing using either the pass through or pay through structure or whether it is assets backed or asset based which at times is also commonly referred as Shariah-backed or Shariah compliant. So long as the current practice continues, the Islamic window also need to adapt a best practice from its parent conventional bank to assure that all its structures fall into the same credit risk policy whether retail or wholesale and are also approved by risk management. With this in mind, standardization need to set-in when it comes to retail, treasury, SME and commercial banking practice where all documentation including but not limited to Common Terms Agreements, Application Forms, Master Agreements for the Islamic modes and the respective operational supplements agreements, Agency Agreements, etc. need to be standardized with. Whereas for structured finance and complex deals including capital market issuances, club deals and syndications will always require third party legal assistance for banks as well as the customer. Another key and critical success factor is risk allocation for Islamic transactions. Unless, Islamic business originators / hunters are not embedded within the business segment there will always be infighting for risk allocation for common customer. Islamic window should not experiment by setting up independent Islamic business originators outside the business segment. As explained above, all conventional relationship managers especially in the wholesale banking should also have Islamic financial targets based on the overall aspiration of the bank and/or Islamic banking growth forecast by industry experts.
24. Regulatory relations: In case where a conventional bank is establishing an Islamic window where there are precedents and the framework is established, this really does not have a big impact; however, in jurisdictions where there are none, it becomes quite critical that the conventional bank establishes a hands-on approach and relationship with its regulator from the Islamic window perspective. Having a Head of the Islamic window who is experienced in setting up such initiatives in the past is the key as there will be too many smaller as well as larger issues which one needs the regulator to comprehend and support positively. As it has been discussed in the ensuing sections that Islamic window can take any shape and for most conventional players it will be better if it is kept as a core product team where business is booked by trained and certified personnel in the conventional side under the Islamic book. As most of the time, in newer jurisdiction both the regulators as well as the financial institutions both have limited experience and learning curve may be limited, hence, the expertise with team in conventional bank setting up Islamic window plays a critical party.
25. Transparency and disclosure: To gain market confidence, the Islamic window must be more transparent and have better disclosure policy as compared to the main stream Islamic banks. In this regards, customer education is one of the key tools and there is nothing better than clearly documented products and services with detail yet simplified features explained in the website of the Islamic window. This also includes opening displaying the Shariah Fatwas in dual language (local language plus English or Arabic) which is duly signed by the SSB. Here a clear follow of what the transaction is; what are the underlying documents; when it was reviewed; discussed and approved should be mandatory disclosures. It is better if the Islamic window adapts a standard format so as to create ease of understanding by the users. In addition to Fatwas, it is always helpful to list glossary of terms the Islamic window uses as well as the FAQs for each and every product no matter how simple they may be.