Under IFSA 2013, it is no longer about Product Innovation. It is about Product Compliance.
2 weeks ago I had a session with some bright individuals discussing the Islamic contracts commonly used in Corporate Banking financing structures. We went through almost all the available Islamic financing contracts such as Murabaha, Ijara, Musyaraka and Mudharaba, where I highlighted that all these contracts now have their own Policy Document issued by Bank Negara Malaysia (BNM). The Policy Documents, in my opinion, are a concise version of a lot of Sharia regulations and great reading source. It becomes a reference point where management roles and responsibilities are outlined, operational behaviour laid down, and theoretical basis is justified and explained.
It is a matter of time, I told the participants, that these Policy Documents are taken in their full context and finally developed into a comprehensive structure with clear compliance to Sharia requirements. We, as Islamic Bankers, are in for an exciting period of development where we will have a chance to develop “real” Islamic banking contracts.
The moment I said that, I realised it is NOT TRUE!!!
THE IMPACT OF IFSA 2013
The popular belief is that IFSA 2013 is meant to realign all the Islamic Banking regulations in the Islamic Banking Act, Takaful Act and various major guidelines into a single overarching Act. IFSA 2013 consolidates the various practices into more clarity and re-classification of concepts. However, the perception that Islamic Banking in Malaysia as an innovative development hub would no longer hold true. “Innovation” was the key thinking and pride-point prior to IFSA 2013; now I believe the right word is “Compliance”.
When we first started the Islamic Banking journey in late 1990’s and early 2000s, BNM encouraged a lot of product innovation from Banks as there were no existing guidelines. We looked at the various structures that provides the desired outcomes and discussed with Shariah Committee on the design and component of products without breaching Sharia rules. BNM was supportive on us developing these “innovative” products. Some may have been controversial (such as Bai Inah, Bay Ad Dayn, Wadiah and Bai Bithaman Ajil) but it encourages discussions alongside the mantra that “whatever is not explicitly prohibited, is permissible“. Sometimes we were forced to think outside of the box, especially for sophisticated products mirroring conventional. We also received support from Sharia Committees whom temporarily approved “innovative” products with the understanding that over time, a better solution were developed as replacements.
Now with the issuance of the Policy Documents, such innovation becomes limited. Innovation is now ring-fenced around compliance to Shariah rules (either from regulators or internal Shariah Committee), and the Banks are expected to follow these rules to the letter. Breaches to these rules becomes the responsibility of the Bank’s Shariah Committee and detailed deliberation is greatly expected to provide the solution. Compliance first; if it is not covered in the documents, it probably cannot be done without a lot of effort.
CHOOSING THE SIMPLEST ALTERNATIVE
With compliance now being the vogue vocabulary with BNM, Banks had to look hard to the Policy Documents to ensure the requirements are identified and gaps filled for fear of breaches or fines. The gap analysis falls into the line whether “are we complying to the requirements?” and not “how do we do this without it becoming a gap or compliance issue?”. Both Shariah and Bank’s Product teams would now look on how to comply with Policy Documents instead of using the Policy Documents as a reference to develop a product.
What I noticed since 2014 is the obsession to comply with Islamic contract requirements, and if the team feels it is difficult to comply, the next logical step is to avoid such contract altogether and seek an alternative contract which is easier to comply with. For example, the Murabaha Policy Document issued in 2014. I have to say it is a beautiful document, and outlines the requirements for Murabaha Purchase Orderer (MPO) that reflects the full Sharia requirements of ownership transfers, risk taking, profit and management of actual assets.
These requirements, which in the eyes of many Banks, may be difficult to fully comply with due to many reasons: shortage of expertise, systems infrastructures limitation, people understanding, complicated processes, operational risks, credit issues and fund management requirements. Instead of the risk of breaching the Policy Documents, Banks opt for something less “complicated” which offers “similar” structure. The default solution is Tawarruq Arrangement i.e. Commodity Murabaha.
Or, the teams looks at Ijara Policy Document. It outlines further the roles and responsibilities of lessor and lessee, while the asset remained in the Bank’s ownership throughout the lease tenure. Again, if a roadblock occurs where a Bank cannot fully comply… Tawarruq Arrangement provides a quick solution. With very defined rules outlined in Tawarruq Policy Documents, the Banks are confident that offering Tawarruq will not breach any guidelines.
Tawarruq, therefore becomes the default Islamic contract in the market. When I asked the participants during case-studies to the question “What contracts should be used for this structure?”, the answers are unanimous “Tawarruq”. And they are not wrong.
DISRUPTION IN ISLAMIC CONTRACTS
Making Tawarruq as the “all-problems-solved” structure is having an unfortunate result to the industry. While the issuance of the Policy Documents as a reference was to galvanise the development of various Islamic contracts, the Banks have an easy way out in Tawarruq. Now, the rest of the contracts are in danger of being sidelined in favour of continuous development in Tawarruq.
For example, the Home Financing product which had evolved from BBA in the 1980s to Diminishing Musharaka in the 2000s. When BBA was introduced, practitioners and Sharia teams identified several practical issues that over a period of time needed to be resolved such as ownership transfer, rights to sell, and sale of properties under construction. These issues led to the development of Diminishing Musharaka as an alternative solution.
But with Diminishing Musharaka, there are still operational and legal issues that have yet to be resolved until today. For example, the “right” contract to be used for period of construction, the application of Ijara and the extensive outlining of Wakalah roles and responsibilities. Failure to understand the issues and provide real solutions puts the Bank at risk. There are also legal infrastructures that have yet to be addressed such as land joint-ownership by the Bank (as a partner), and different practices of land offices for the registration of Bank as a partner. These are roadblocks (and credit risks) to the Banks to take the structure further.
THE DOUBLE-EDGE SWORD OF TAWARRUQ
Malaysia is in danger where I foresee that one day the industry itself will became the absolute global expert in Tawarruq and Commodity Murabaha. With Bursa Suq Al Sila as the leading commodity trading platform for the country, backed by the government (as a national bourse), the Tawarruq structure is expected to evolve into an efficient Islamic-structure engine. The processes of Commodity Murabaha will become seamless, and may even integrate into a Bank’s core banking system, the operation for buying and selling commodity will become commonplace and familiar, and this will result in effective processing, awareness of Shariah risks, compliance to trading requirements and well as reduction in overall operational risks.
Banks will one day become so well versed in Tawarruq, they will question the need for other types of Islamic contract, where they may not able to fully comply with.
With such development, more and more:
- capital investments will be made into perfecting the Tawarruq infrastructure, and Banks will also be able to comply with BNM requirements by investing in human capital familiar with Tawarruq.
- product structures will be developed around Tawarruq and once these products are established, it will be difficult to unwind as a prefered product simply due to the ease of the Tawarruq contract requirements.
- variations and hybrid products will be introduced based on Tawarruq, or containing elements of Tawarruq to solve “difficult scenarios” for compliance.
We will one day have an innovative and world class Tawarruq product, but no development in the other major Islamic contracts. Innovation will stall and Banks will choose quick returns and operational ease of Tawarruq. It is a dilemma of the industry where it is heading to “one” major solution for almost all “sale-based products”.
It is unfortunate if Banks chose to abandon the other contract alternatives, where such contracts will never reach its full operational and theoretical potential.
Hoping that a Bank will take the lead to develop products based on all the various Policy Documents instead of relying on only Tawarruq and its variations. The industry needs expansion and enhancement and by focusing on only Tawarruq, the industry will not be able to explore exciting products and expand its horizon. The Policy Documents, as beautifully written as they are, may tragically one day just becomes an academic relic issued by BNM.
Earlier writings on Tawarruq and Commodity Murabahah:
Interesting article in LinkedIn
Interesting and thought provoking read. I just wonder how other regulators function to promote financial innovation in Islamic finance like Singapore. Any thoughts on that?
From what I understand, the Monetary Authority of Singapore (MAS) is very supportive of Islamic Banking financial products. Although there are no specific regulations governing Islamic Banking, but MAS provides a conducive environment for innovation. As long as the products are internally approved by Sharia, and does not breach any existing financial instruments regulations, MAS would not object the instrument.
This is what we in Malaysia saw in the early 1980s where BNM do not have specific guidelines, but rely mostly on the Sharia Committee endorsement of the products proposed by Banks. Innovation were coming fast and furious and BNM allows for that while keeping one eye on the development so that it do not breach any rules.
Middle east also thrived on the infrastructure where there is no governmental guidelines to oversee product development and innovation. Sharia declarations and opinions rule the products that are being developed, and yes this encourages more innovation as Banks are not tied down to specifics in a Policy Document. There are pros and cons to innovation. Providing guidelines may or may not tie your hands towards innovation. It provides clarity, but the more detailed it gets, the less room for manoeuvre for banks.
In short, Malaysia has taken the route where guidelines are issued to be followed. However, other geographies still have ability to become more innovative as it relies on Sharia Committee as the gatekeeper for rolling out new innovative structures and products.
Salam Tuan Amir,
What a beautiful write up. Indeed there is a need and time for islamic banks to shift from tawarruq contract and be innovative. Having said that, there will be challenges on the system whether it may support the product and also are the islamic banks willing to invest for a huge amount?
If I may suggest for central bank to have a list of panel for the it and support application system for islamic banks. Atleast the control of the cost within a range instead the it co might manipulate it and burden the islamic banks.
Nevertheless, the push factor and willingness of islamic banks and solicitors also play the role here. The initiave is there i believe but i guess no one to lead the way. So sit back and relax mode…hee..
My humble views.
Thanks Norhamirullah for your view.
Yes I agree that theres not a lot of push factor now in the market, other than to just comply with the requirements.
One of the things that I was trying to impart a couple of years ago was to encourage IT companies to support the Islamic Banks. Traditionally, what banks do when a new guideline is introduced, they will go to their IT counterparts to have them make the changes in system.
But what I had proposed instead was that the IT companies themselves, proactively look at the Guidelines and change / enhance / build their system and sell it to the Banks with the proposition that the system is already compliant to guidelines.
After many discussions (actually I was being interviewed by the IT company), they unfortunately was not brave enough to take this route. It is reverse engineering. It could have been a good approach that they make their system “compliant” before finding the banks to onboard. Maybe there are some limitations from their end, I don’t know.
All we need is a brave company (that sees the huge opportunity) to take the development of these contracts forward.
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