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Middle EastApril 6 2008

The nature of innovation

As the Islamic finance sector becomes more competitive, innovation will be a key differentiator for attracting customers, writes Joe DiVanna.
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The growth of Islamic finance in the emerging global economy depends on the industry’s ability to innovate new financial instruments. Bank senior executives often equate innovation with technology, yet technology only plays a small part in what is truly innovative.

Banks worldwide – Islamic banks being no exception – frequently assume that implementing a new technology is the sole basis of innovation. Technology belongs in the realm of inventions, not innovation. Innovation is the application of technology to a specific problem, opportunity or circumstance. Numerous failed information technology (IT) projects stand as testament to banks’ failures to understand this fundamental difference.

Innovation is about creating sustainable value with Muslim (and non-Muslim) customers. This value in turn will be the key market differentiator for institutions offering sharia-compliant services. As the composition of the competitive market changes with new banks and non-banks, financial services organisations offering sharia-compliant products will change the focus of existing institutions toward innovation rather than technology. Banking technology is highly commoditised and is readily available to even the smallest of institutions. Because each one can offer almost every product, what will enable a bank to stand out from the pack will be how it applies the technology, packages the offering and demonstrates value to customers.

Islamic finance

The structure of Islamic finance will be shaped by four key factors: customer demand, technological invention, regulatory structures and innovation. Is innovation just the process of creating new products? No, innovation needs to occur at many levels to propel the industry into its next generation of growth.

In Islamic finance there are numerous forms of innovation: market (sukuks), product (sharia-compliant credit cards), service (women entrepreneur banking), quality (high touch banking), infrastructure (for example, payment systems), back office (or processing) and distribution (such as mobile phone banking).

Market innovation

The regulatory structure of a nation combined with the knowledge of sharia scholars determines the level of innovation that any market can absorb. Regulators in Bahrain, Kuwait, Malaysia, Qatar, Saudi Arabia, United Arab Emirates and the UK are eager to set a solid foundation for robust growth in the industry and to date have been increasingly open minded in changing regulations to promote industry growth.

Product innovation

New products are being introduced across the industry as banks and financial services providers that are eager to connect with their customers continue to experiment with packaging sharia-compliant offerings. Concepts such as wakala, which has been seen as a viable form of deposit for retail and wholesale customers, offers an approach whereby the institution agrees to manage funds on an individual basis at an expected rate of return. Banks such as Abu Dhabi Islamic Bank offer a wakala deposit account, managing depositors’ funds individually, not pooled with funds from other investors.

Innovation in service

With the lion’s share of a bank’s attention on product innovation, few banks have been focusing on service. Dubai Islamic Bank has introduced johara banking, which is designed to address the needs of women with specialist banking services. The concept of johara is simple: specialised banking products coupled with a network of predesigned privileges, such as shopping discounts, and health and educational benefits.

Quality innovations

How an institution provides its services, composes its products and designs its offering links it with its customers. Service quality is more relevant to customer retention than any other measure for a bank. Kuwait Finance House is one of the organisations that has implemented service quality improvement programmes that specifically reward excellence in service by employees based on explicit quality of delivery criteria. Customers have a high tolerance for disappointment in rates of returns and unmet profit expectations, but they will change banks quickly if they feel service is below par.

Back-office innovation

One area that will require extensive innovation to be competitive in the long-term is reconfiguring an institution’s back-office operations. Documentation processes for a product such as murabaha (which involves buying and selling permitted commodities, with the return to the depositor taking the form of profit on such trades) increase the cost of administration, reduce profitability and ultimately affect its perceived value to customers.

Disruptive innovation

Innovation in Islamic banking and finance is an intentional adoption of an idea made manifest by its practical application. As Islamic banks begin to focus on innovation, they signal a shift in the industry from institutions buying technology and setting up shop toward knowledge-based competition. What is holding back the industry today is the underlying risk of failure in applying a product in a given market. Therefore, Islamic bankers, like their conventional counterparts, are conservative in their approach and do not introduce innovations until they are comfortable that there is an overwhelming factor of success.

This approach worked well during the first generation of growth in the industry. However, in the unfolding competitive environment, time becomes the negating factor. Innovation in Islamic banking involves understanding how to apply products, technology and services to a specific set of customer needs. What banks must be aware of with regards to innovation is how to fail fast and reward failure as well as success.

Key differentiator

Innovation will be the key differentiator in the market for any organisation offering sharia-based financial services as the second generation of Islamic banking develops. Perhaps more importantly, innovation will be what sets Islamic banking apart from conventional banking as sharia-compliant services become more focused on providing services that directly engage local customers with a specific value proposition.

Joe DiVanna is managing director of Maris Strategies, a Cambridge-based strategy think tank.

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