Islamic Finance

A technology
perspective
Marco Lichtfous Patrick Laurent Patrick Nieles Charif El Baba
Partner Partner Senior Manager Senior Manager
Governance Risk Technology & Enterprise Operations Excellence Operations Excellence
& Compliance Applications & Human Capital & Human Capital
Deloitte Deloitte Deloitte Deloitte

Modern Islamic finance effectively began in the 1960s

but it only came of age in the last 20 years when banks
started to offer sophisticated Islamic products and
finance arrangements.

Today Islamic finance technology solutions have The basic rules to be followed are:
matured and there is a concerted effort across the
• The prohibition of riba, commonly translated as
industry to standardise Sharia-compliant products.
interest. Interest in any form is forbidden as it is
We will look into the various challenges a financial
considered unearned income and therefore unjustly
institution might face when considering opening a fully-
gained. Any risk-free investment or guaranteed
fledged Islamic bank or just a window operation, i.e. a
income is considered usury
conventional bank offering Islamic products.
• Money is not a commodity and cannot be traded as
But let’s first start with some background information such because it has no intrinsic value if not used to
on Islamic finance for the readers who might not yet be buy tangible assets
familiar with the concept. • The prevalence of justice at all costs; financiers are
not allowed to exploit entrepreneurs in any way
Understanding Islamic finance
• Uncertainty or gharar of any form is prohibited.
Islamic banking is governed by the Islamic law known Therefore any contract which involves an element of
as Sharia that was formed some 1,400 years ago. It speculation or gambling is forbidden. For example
aims to provide banking services while staying within futures and options or derivatives are not permissible
the Sharia boundaries. The law has been specifically as the returns from such investments rely on events
formulated to eliminate malpractice and exploitation in the future which may or may not take place. Both
while encouraging healthy trade and commerce. While parties have to agree on the terms of a particular
Sharia is a complete set of laws that are to be followed contract and Sharia law forbids transactions where
by every Muslim, only a restricted portion pertaining to the subject or price cannot be fixed and agreed upon
banking transactions applies to Islamic finance. in advance
1
Islamic banking is governed by the Islamic law known
as Sharia that was formed some 1400 years ago
• A percentage of the bank’s net revenue will be paid Naturally, several methods and forms of Islamic
as a charitable tax called zakat to the community, banking have evolved as institutions constantly reform
usually used to finance community projects rules to cope with economic changes and customer
• Investments are based on a risk-sharing principle expectations.
where profits and losses will be shared based on
a previously agreed ratio. Although an IFI cannot Overview of today’s Islamic finance market
charge or pay interest, its main purpose is profit. • Islamic financial assets are estimated at US$ 1.6
An Islamic bank invests in businesses, industries and trillion. Considering that there are over two billion
real estate and shares the profit as well as any losses Muslims in the world and an increasing interest from
with the owners and investors. As the bank’s profit
160
non-Muslim investors, the Islamic banking potential
is linked to the success of the business, the risk of is massive
140
exploitation is greatly reduced
• Sukuk issuance, a product equivalent to bonds
• 120
There are certain businesses and contracts that are in conventional banking, has been increasingly
prohibited by Sharia as they go against the teachings
100 successful since 2005
of Islam. For example, it is prohibited (‘haram’) to
80 • Islamic finance is growing at a rate of 15% to 20%
gamble or to trade harmful substances like alcohol
every year, spanning mostly Asia and the Middle East
and
40 drugs, contracts based on interest rates,
but starting to make inroads into the West. For the
contracts based on high volatility, debt contracts at a
20 most part, and mainly due to the underlying guiding
discount and forward foreign exchange transactions
0
principles, the industry has remained unaffected by
2005 2006 2007 2008 2009 2010 2011 2012the 2013
global financial meltdown
Although Islamic countries have followed Sharia law for Source: Reuters, Bloomberg
financial transactions for a long time, applying them • More than 700 Islamic financial institutions operate
to form a feasible banking system is a trend that has worldwide in some 75 countries, of which 75% are
picked up momentum only in the past two decades. full-fledged Islamic finance institutions and 25% are
window operations as part of conventional banks

Global Islamic assets (US$b) Issued Sukuk volume (US$b)

1.700 160
16%
1.500 140

120
1.300

100
1.100
80
900
40

700
20

500 0
2008 2009 2010 2011 2012 2005 2006 2007 2008 2009 2010 2011 2012 2013
Source: Central banks Source: Reuters, Bloomberg
• After the latest financial meltdown, an increasing
number of non-Muslim customers and investors
are looking for more socially responsible banking Several methods and forms of Islamic
alternatives, which have proven to be much more
resilient due to the restrictions on risk taking
banking have evolved as institutions
• 56 Islamic countries are members of the Islamic constantly reform rules to cope with
Development Bank (IDB)1 economic changes and customer
• The leading Islamic finance centres are Bahrain,
Dubai/UAE, Kuala Lumpur, Riyadh, Qatar, Singapore,
expectations
London and Luxembourg
• Top management of Islamic banks is not confined
Islamic banks perform the same function as
to Muslim countries but spread across Europe, the
conventional banks: they attract financial resources
United States, the Far East and the Middle East
from individuals and institutions and invest these funds
in businesses that need external finance to support their
Conventional finance vs Islamic finance
activities. However, they share the profit and loss of the
Islamic finance is not so different from conventional business activities and do not rely on interest payments
finance since approximately 80% of competences from the borrowers.
overlap and the same business, regulatory and
technology requirements prevail.

1 Based in Saudi-Arabia, the purpose of IDB is to foster the economic development and social progress of member countries
and Muslim communities individually as well as jointly in accordance with the principles of Sharia
Nevertheless there remain some fundamental differences between the two types of banking:

Conventional banking Islamic banking

Creates value by maturity transformation and pricing Prices goods and services that represent real economic
of money activity

Is based on fixed return on both sides of the balance Is based on sharing profit and risk
sheet (difference being banks ‘spread’ profit)

Does not involve itself in trade and business directly Actively participates in trade and production

Depositors receive a fixed rate regardless of the bank’s Profit is shared with the depositor: the higher the
profitability, thus insulating them from the bank’s true bank’s profit, the higher the depositor’s income
performance

Challenges faced by Islamic finance • Generally speaking the bank acquires the goods on
• Since Islamic products are contract based, these behalf of the customer; if the customer pulls out of
contracts will be enforced under local country laws the contract the goods need to be returned to the
and regulations which might conflict with Sharia law supplier (for example in the case of car loans), which
and may incur additional costs has implications on cost and risks and also calls for a
possible change in business practices and commercial
• Due to the fact that Islamic financing is laws
comprehensively based on Sharia compliance, any
misconduct or wrongly processed transaction could Implications for financial systems
have severe consequences
There is no set of globally applicable Islamic banking
• Late payment fees, penalties, overdrafts, debit standards that allow banks to prove compliance with
interest and overdrawn accounts do not exist in Islamic banking principles in a straightforward way
Islamic banking, which may lead to lower returns or to assess whether a banking application is Sharia-
• If there is any doubt about whether a specific compliant. Instead, an independent Sharia advisory
transaction complies with Sharia, all the profits must board, the members of which are trained and certified
be given to charity, which is an additional risk for the in Islamic and Sharia law and the interpretation thereof,
bank and could impact returns will serve on the IFI's Sharia committee. The advisory
board determines whether the bank’s products and
• Due to a lack of comprehensive interbank Islamic
services respect Sharia.
financing (lending), Islamic financial institutions may
face short and medium-term liquidity issues
Vendors and their systems have to align with the
• There is no or limited standardisation in the products and the guiding principles of Sharia.
vocabulary, financial instruments, documentation
and pricing formulas used in Islamic finance
As stated earlier, Islamic banking and conventional
banking differ in many respects but the same business,
regulatory and technology requirements prevail. Both
use similar customer channels and offer what are,
functionally speaking, the same products.

Banks today deploy core banking systems to support

their business processes, improve operational
efficiencies and abide by regulatory requirements.
Any core system transformation requires enterprise-
wide planning, commitment and resources and it can
possibly be even more complex for Sharia-compliant
systems due to the customisation required to align with
the financial products. The difficulty stems from the
lack of product standardisation throughout the Islamic
finance markets and the interpretation of the Sharia
board. The advisory board determines
This is especially true in the case of Islamic window
whether the bank’s products and
operations where conventional core banking systems services respect Sharia
are tweaked to support Islamic banking activities. In
these cases, the banks are required to maintain separate • Comply with Sharia law as well as with Accounting
entity books for customers and reporting, and ascertain and Auditing Organization for Islamic Financial
a segregation of funds. Institutions (AAOIFI ) and international or local
accounting standards
Islamic banks are always seeking to innovate and
• Support the basic functionalities of Islamic
come up with new products and services in personal
products/contracts such as murabaha, musharaka,
finance, wealth management, bank cards, insurance
mudarabah, istisna, ijarah, etc.
and corporate financing. This requires core banking
solutions that allow banks to build new products rapidly • Involve stringent treasury management to reduce
and ahead of the competition. liquidity risk, since, as previously mentioned, taking
potentially interest-based loans on the market to
An Islamic banking solution must: fulfil short and medium-term liquidity needs is not
permitted
• Cover all lines of business such as investment,
financing, payments, bank cards, treasury • Provide for zakat calculation and holiday treatment
management, trade finance and AML services as per the lunar calendar, both of which are
mandatory under Islamic principles
• Have a profit distribution engine which provides
flexibility in pool definition, profit-sharing schemes, • Provide a strong and flexible workflow to enable
revenue reserves allocation and distribution, the bank to redefine or copy and customise the
alongside the ability to perform ‘what if’ scenarios existing products/processes and aid in new product
prior to the distribution of profits launches
• Provide or customise reports which help the Sharia
board during their routine audits
• Segregate funds: this is especially important in
the case of window operations. It is intended to
maintain the moral purity of all transactions as
funds stemming from Islamic banking cannot be
mixed with funds from conventional banking that
may involve riba, gharar or haram activities. This
sometimes proves difficult, especially if an Islamic
finance layer has been added to the conventional
core banking system; it is therefore common for
banks to choose to use different core systems for
each type of banking
• Screen funds: the concept of screening companies
before investing in them comes from the Sharia
principle that Muslims should not partake in an
activity that does not comply with the teachings of
Islam. There are two types of screening involved:
1. Business activity screening where the company
must show that at least 95% of its gross revenue
is generated by activities which are considered
compliant with the Sharia
2. financial ratio screening to exclude companies that
do not comply with a minimum acceptable level
of leverage, receivables and interest income. It is
now possible to automate the screening processes
through third party applications

The implementation of an Islamic and conventional core

banking system must transform information technology
into an enabler of business by providing an agile
platform to achieve corporate objectives.
From a technology perspective, the market share
will always be inclined towards vendors whose system
will provide flexibility, scalability and is more customer-
centric
It often forms an integral part of a business Given the different requirements and needs, it is
transformation programme addressing key banking important to select the right technology supplier from
issues such as: the start and to provision for sufficient time and effort
• Increasing market share through unique positioning for the vendor’s due diligence and to undertake a
comprehensive RFP process.
• Reducing Total Costs of Ownership (TCO)
• Providing a single customer view and the related A vendor that provides an Islamic banking model, which
activities, portfolios, products, etc. while providing can also be easily modified through configuration, will
customers with a single view of the bank’s products maintain high rankings in vendor evaluations.
and services Furthermore it is crucial that the vendors have local
presences with knowledge of the local regulatory
• Delivering a consistent customer experience across
requirements, local support as well as to maintain
multiple channels and providing full visibility to
skilled Islamic banking experts. It obviously does help
the bank’s sales and servicing agents, enabling
if the vendor and his resources have been involved in
‘anywhere, anytime’ banking
several implementations.
• Providing enterprise-wide information relating
to regulatory reporting and risk management The future of Islamic finance
• Creating less dependency on IT and more flexibility With new markets opening their doors to
for business users Islamic finance, the sector is expected to achieve
unprecedented growth. Tapping into those markets will
Islamic core banking vendors are typically divided into yield great results. Although, it may take some time as
two groups: conventional system vendors that have local regulators and legislation need to adapt the laws
transformed their existing products, and vendors that and regulations to accommodate the specific needs of
offer only Islamic banking systems. Islamic finance, e.g. double stamp duty on mortgage
loans in the UK, etc.
Most of the conventional global core system vendors
(Temenos, Avaloq, SAB, Sopra, Misys, Oracle, TCS, Major Islamic finance organisations are striving to
etc.) have successfully created Islamic banking systems form a set of standardised regulations that can
based on their conventional platforms to fit the Sharia be implemented globally across all Islamic finance
requirements. The other segment is mainly comprised institutions.
of vendors that have only Islamic banking systems and
operate mostly in the GCC region and East Asia (ITS, From a technology perspective, the market share will
BML Istisharat, Path Solutions, etc.). always be inclined towards vendors whose system will
provide flexibility, scalability and is more customer-
There are about 30+ vendors offering Sharia-compliant centric.
systems and with the constant development of financial
products the maturity of those systems will improve.