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Issue 2

Islamic Banking & Technology Challenges How ETHIX financial solutions ensures “Sharia Compliance”

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Contemporary Islamic banking has gained significant traction in recent years with an estimated annual growth rate in excess of 15%. Islamic banking continues to make its mark far beyond its traditional majority Muslim nation base, making considerable strides into the well-rooted conventional financing sectors.

Having weathered the challenges of the recent financial turmoil due to their prudent investment strategies and driven by strong investor demand on both the individual and corporate sides, the total Islamic industry continues to be the beacon for socially responsible banking.

With this increased interest in Islamic finance comes an increased demand for Islamic banks. Due to the huge logistical, regulatory and economic challenges of establishing a new bank, many well-established players across the Middle East and North Africa have opted to convert undercapitalized, non-performing banks in a bid to tap the rising demand for Shariah compliant products and, most importantly, avoid the heavy investment and logistical requirements to launch a completely new bank. As in the case of the National Bank for Development in Egypt (acquired by Abu Dhabi Islamic Bank).

• Meanwhile,otherbankssuchastheKuwaitInternationalBank(for-merlyKuwaitRealEstateBank)andAhliUnitedBank(formerlyTheBankofKuwaitandtheMiddleEast)havesoughttogainacompeti-tive advantage by relaunching themselves as fully fledged Islamic banks.

Overcoming hurdlesOne of the greatest challenges in launching an Islamic bank is having access to a well-established independent and active Shariah board. While this process can be rapidly increased by utilizing already existing Shariah boards, it is the implementation of the Shariah board’s rulings into the day-to-day running of banking operations, product development and product rollout that serves as the greatest hurdle to Shariah compliant operations and transformation.

Islamic Banking & Technology Challenges

2Islamic Banking & Technology Challenges

4Gartner Research: Islamic Banking: Opportunity or Money Pit for Conventional Banks?

7About Us

IslamicBanking&TechnologyChallengesispublishedbyITS.EditorialsuppliedbyITSisindependentofGartneranalysis.AllGartnerresearchis©2011byGartner,Inc.Allrightsreserved.AllGartnermaterialsareusedwithGartner’spermission.TheuseorpublicationofGartnerresearchdoesnotindicateGartner’sendorsementofITS’productsand/orstrategies.Reproductionordistributionofthispublicationinanyformwithoutpriorwrittenpermissionisforbidden.Theinformationcontainedhereinhasbeenobtainedfromsourcesbelievedtobereliable.Gartnerdisclaimsallwarrantiesastotheaccuracy,completenessoradequacyofsuchinformation.Gartnershallhavenoliabilityforerrors,omissionsorinadequaciesintheinformationcontainedhereinorforinterpretationsthereof.Theopinionsexpressedhereinaresubjecttochangewithoutnotice.AlthoughGartnerresearchmayincludeadiscussionofrelatedlegalissues,Gartnerdoesnotprovidelegaladviceorservicesanditsresearchshouldnotbeconstruedorusedassuch.Gartnerisapubliccompany,anditsshareholdersmayincludefirmsandfundsthathavefinancialinterestsinentitiescoveredinGartnerresearch.Gartner’sBoardofDirectorsmayincludeseniormanagersofthesefirmsorfunds.Gartnerresearchisproducedindependentlybyitsresearchorganizationwithoutinputorinfluencefromthesefirms,fundsortheirmanagers.ForfurtherinformationontheindependenceandintegrityofGartnerresearch,see“GuidingPrinciplesonIndependenceandObjectivity”onitswebsite,http://www.gartner.com/technology/about/ombudsman/omb_guide2.jsp.

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Islamic banking may have its idiosyncrasies but its technological requirementsarenodifferent.Therefore,anITsolutionthatcanenablebusiness conversion from conventional to Islamic, at the same time allowing the existing business model to continue without hindrance, is a serious proposition.

Asaresult,technologyand,morespecifically,IslamicITsolutionsaremajorfactorsinleadingthetransformationprocess.ThisiswheretechnologyexpertslikeInternationalTurnkeySystems(ITS)takefrontstage in easing the transformation. As a complete broad-spectrum Islamic information technology and banking solutions provider, their mandate is to provide banks with technological solutions and technical services required for the conversion of conventional banks, allowing banks to increase product development and rollout across the entire enterprise while offering reduced cost of total ownership and implementation.

When a chief technology officer speaks to a service provider, one of the main issues tackled first is the core banking system. More often than not, a bank would prefer to choose a service provider that offers a one-stopsolutionlikeITS’sETHIX.

Tailor-made solutionsETHIXisanIslamicbankingsolutionthatenablestherestructureandlaunching of new Islamic products in a timely and efficient manner. ETHIXsolutionisawebservicesbasedsolutionthatoffersservicesandfunctions for Islamic finance, Islamic investment, core banking, delivery channels, trade finance and other banking services, which in turn enhances the bank’s competitive edge.

Haitham Abdou, group director of marketing & Banking Business SolutionsatITS,statesthattheETHIXsolutionwasdevelopedfromscratch, specifically for the Islamic banking industry rather than a conventional solution that has been fine-tuned to meet specific Shariah requirements.HegoesontostatethattheprincipalbehindtheETHIXsolution is that it is a fully customizable, tailor-made product allowing for complete flexibility.

Existing solutions have parameters that allow each individual Shariah board to specify differing products in accordance with their Shariah interpretation; these rigid predefined parameters can, however, have a tremendous impact on dictating bank workflow and operating procedures, limiting productivity and hindering scalability.

ETHIXFinancialsolutionswasDesignedtoensurethebasicprinciplesofShariaCompliance,However,theproductdoesnot“Dictate”shariacompliance. Due to the diversity of compliance between sharia boards, ETHIXwasdesignedtoallowthedefinitionofShariaacompliancefromthegroundup,thusensuring100%shariacomplianceasper

the decisions of each bank’s Shariaa board. Such a concept has allowed for the quick deployment of the product for banks converting to Islamic, startup Islamic banks, or Islamic windows coexisting with a conventional environment while maintaining all the rules and guidelines of a sharia compliant process.

Shariah complianceHaithamfurtherelaborated:“ITSrealizedthatitwouldbeimpossibleto ensure that our product could accommodate every single Shariah board; for vendors like ourselves, a rigid platform would require considerablecustomizationonbehalfofthecustomer.”Thus,ETHIXwas created from the ground up to offer complete flexibility in defining Shariah compliance, so that the product would not be limited by rigid constraints.

TheETHIXsolutionsmainadvantagelieswithitscertificationbytheAccounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).ThiswasachievedbycreatinganIslamicpieceofclayonwhich the main principals cannot be broken, allowing the customer to start building Shariah compliance from the ground up. It is this “novel approachthathasallowedITStohavethesamesystemrunninginover30financialinstitutionsindifferentcountriesandregions,alladhering to different Shariah rulings, while running on one line of code”,Haithamelucidates.

As a completely customized product created with the considerations required for Shariah compliance, the customer is therefore not required to wait for product updates and development from the solutions provider. By dispensing with box-ticking measures, the customer is able to update and create products on the fly, allowing the customer to launch products and services very quickly and bringing them to market without hindrance.

ETHIXisaculminationofITS’sbusinessknowledgeandknow-how,synthesizing their technological expertise and product flexibility. Ease of integration with conventional systems has also been a central feature.TakingconventionalproductstructuresandmappingthemintotheirIslamiccounterpartshasallowedITStoimplementthefirstIslamic window for a conventional bank in the Middle East, such as theCommercialBankofDubai.ITSlookssettocontinuethistrendbysigninguptoassistLibya’slargestbank,GumhouriaBank,increatingits first Islamic window.

Source:ITS

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Islamic Banking: Opportunity or Money Pit for Conventional Banks?

As many conventional banks search for ways to boost revenue, some may turn to Islamic product offerings that have the potential to contribute significantly to their business growth strategy. CIOs need to be ready to deliver an informed technology assessment of this new market opportunity.

Key Findings

• IslamicbankingisexperiencinghighermarketgrowthratesinAfrican and Western countries than in other regions of the world.

• StandardizationofIslamicbankingprocessesisatanearlystageofmaturation; this will increase the risk associated with the selection of core banking systems.

• FormostWesterncountries,therealpotentialofIslamicfinancialservices is located in the securities and wealth management space.

Recommendations

• Includedistinctbranding–similartodirectbanksspawnedfromconventionalbanks–andstand-alonecorebankingtechnologysupport within the business case for Islamic banking.

• Createavendorshortlistwithaheavycriteriaweightingonlocalbank references; current Islamic banking market requirements can differ significantly by region.

STRATEGIC PLANNING ASSUMPTION

Through2014,corebankingsystemswillbeunabletosimultaneouslysupport conventional retail and Islamic banking businesses without significant customization.

ANALYSIS

IntroductionGartnerdefinesIslamicbankingasasystemofbankingorbankingactivity that is consistent with the principles of Islamic law (Sharia) and its practical application through the development of Islamic economics. Sharia prohibits the payment or acceptance of interest fees for the lending and accepting of money.

Also, recognizing that the prevailing model for banking worldwide is non-Islamic,thisresearchwillusetheterm“conventional”todescribethis predominant banking approach.

Market InformationIslamic financial services are nearing $1 trillion in reported managed assets,withabout700Islamicfinancialinstitutions(IFIs)spreadthroughouteveryregionoftheworld.TheIslamicbankingsystem(IBS)market–thatis,themarketofthetechnologiesthatenablethesefinancialproductstobebought,soldanddistributed–ispredictedtobea$1.2billionmarketin2011andtogrowata10.9%compoundannualgrowthrate(CAGR)between2009and2014,whiletheexternalITspendingcomponentwillhaveahigherCAGR,at18.1%.TheIBSmarketisexpectedtoreach$1.6billionin2014.Asconsumertrustin

conventional banking waned during the recent economic downturn, Islamic banking enjoyed marked market expansion. Islamic banking is perceived by its customers as a mutually beneficial partnership, and is regarded by some banks as an opportunity to re-establish a connection with consumers. Whwth?

GrowingdemandisevidentforIslamicproductsfromnewmarketssuch as African and Western countries. An increasing number of conventional banks will open Islamic banking windows (see Note 1) in a conventional branch environment, mixing both conventional and Islamic banking capabilities.

TheIslamicbankingmarketwillcontinuetogrowatadouble-digitpace.Thisisbasedon(1)theincreasingMuslimpopulationinparticularregions,(2)newlyavailableassetsfromunbankedpopulations, and (3) the relatively low effect of the financial downturn in the high economic growth regions such as the Middle East and Asia/Pacific.

Moreover,Westerncountries–asaconsequenceofnewlegislationalreadyintroducedorabouttobe–willencouragehigheradoptionlevels of Islamic financial services although these changes will primarily impact the Islamic bond (Sukuk) market. For example, in France, fiscal instructions for Sukuks, Murabaha, Ijara and Istisna were publishedinAugust2010(seeNote2).

What’s the Technology Impact?Similar to retail banking technology trends, the replacement process of in-house Islamic banking software with commercial off-the-shelf (COTS)systemsisaccelerating,especiallyinmatureIslamicbankingmarkets such as the Middle East. Drivers for Islamic banking core replacement align closely to those of conventional banks. However, the Islamic banking market lacks consensus industry product definitions, such that the core banking offerings of this market differ considerably. For example, if a vendor develops product support for a Middle Eastern bank, an Indonesian bank may find these product supportsinadequatefortheirlocalmarket.Thissituationincreasesthe risk associated with the selection of core banking systems, as banks may purchase systems that have to be highly modified to gain approval (a fatwa) from certified Islamic scholars.

However, there are signs that the Islamic banking market is on a path of progressive maturation, with an undercurrent of activity to establish standard policies and corresponding products beyond the proprietary and localized approach currently in practice. For example, an emphasis on standardization of processes that comply with Islamic law(Sharia)isgatheringmomentumamongmorethan150Islamicfinancial institutions that are members of the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI; www.aaoifi.com/aaoifi/).Thisgroupoffinancialinstitutionsandothermemberstakeholders, such as vendors and consulting firms, are expected to consolidate business requirements for Sharia compliance, but this is not expected to become effective for the next few years, and regional differences may persist beyond this time frame.

Gartner Research:

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In addition to the lack of a single set of Islamic banking standards and correspondingly low adoption rates, banks that enter this market are faced with the choice of distributors offering Sharia-compliant products ortwovendortechnologymodelchoices(seeFigure1):

• ConventionalcorebankingsystemswithanIslamicbankingmodule

• Pure-play,Islamiccorebankingsystems

Gartnerbelievesthatleveragingasinglecoresystemforsimultaneousconventional and Islamic banking support for multiple regions is not feasible at this time without increasing operational risk and raisinghigherlevelsofdeploymentandoperationalcomplexity.Theunderlying architecture of these core systems is not yet sufficiently advanced to accommodate the component granularity required to easily leverage multiple go-to-market models.

ThefullandtrueintegrationbetweentheIslamicandconventionalcore banking systems within banks supporting an Islamic window is a major pain point. Achieving such full integration between products from the same provider is the minimum expected requirement; however, many banks are requesting full integration of coexisting products from different providers.

FIGURE 3Representative Vendors for Islamic Module and Pure-Play Core Systems

Source:Gartner(June2011)TCS=TataConsultancyServices

Gartnerpredictstheevolutionarytrackforcoresystemdesign,especially those supporting retail banks, won’t be available to support this“dualdeployment”modelthrough2014.Intheinterim,increasedlevels of customization will be required to bridge the integration gaps.

Bottom LineTheIslamicfinancialservicesmarketissteadilymaturingandisexperiencingincreasedgrowth.BasedonGartner’s2010IslamicBanking Survey (see Evidence), Islamic banking windows seem to be enjoyinglesssuccessthanthepure-playbusinessmodel.Giventhatconsumer trust remains low, it shouldn’t be surprising that prospective Islamic banking consumers have a perception that an intermingling ofconventionalandIslamicbankingmayoccur–thismodelwillstuntmarket penetration. Not unlike the opportunity for direct banks that spawnedfromconventionalbankswithseparatebranding,Gartnerpredicts that the need to maintain a separate identity and brand for Islamicbankingcenters–andITsystems,too–willbemosteffective.

Ensuring that proper assumptions are established and expectations set for technology, deployment into the Islamic banking market is crucial.Gettingthisrightwilldeterminewhetherthismarketprovestobe a genuine revenue opportunity or an investment money pit.

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Evidence

Theinformationinthisresearchwassupplementedbyseveralsources,suchaspreviousGartnerresearchstudies,anecdotalevidencefrom client inquiries with vendors and end users, the results of two dedicatedsurveys,andtheanalysisofmorethan300Islamicbankingdealssignedinthepastfiveyears.ItwasalsotestedthroughGartner’susual rigorous peer review process.

Inparticular,resultsfromtwosurveyshavebeenusedinthisresearch:

• The2010IslamicBankingSurveywasaglobalstudyof13leadingIBSprovidersthataccountedfor82%ofthemarketshareinIBSspending.Thissurveywasconductedinearly2010.

• The2010IslamicBankingUpdateSurveywastheannualupdateof the previous global study to reinforce the view of the market and the positioning of the IBS providers. Fourteen leading IBS providers thataccountedfor85%ofthetotalmarketshareinIBSspendingwereincludedinthisupdate.ThissurveyupdatewasconductedinJanuary2011.

• Morethan300IslamicbankingdealshavebeenmonitoredandtrackedbyGartnerduringthepastfiveyears.Keycontractmetricshave been analyzed for more than one-third of these deals and haveenabledGartnertobetterdefinethemarketanditsbehaviors.

Source:GartnerIndustryResearch,G00213298,DonFree,VittorioD’Orazio,20June2011

Note 2Islamic Product DefinitionsMurabaha is the sale of goods with an agreed-to profit markup on the cost. Murabaha sale is of two types. In the first type, the Islamic bank purchases the goods and makes it available for sale without any prior promise from a customer to purchase it. In the second type, the Islamic bank purchases the goods ordered by a customer from a third party and then sells these goods to the same customer. In the latter case, the Islamic bank purchases the goods only after a customer hasmadeapromisetopurchasethemfromthebank(source:AccountingandAuditingOrganisationforIslamicFinancialInstitutions; AAOIFI).

Ijara means letting on a lease. It refers to the sale of a definite usufruct of any asset in exchange for a definite reward. It refers to a contract of land leased at a fixed rent payable in cash and also to a mode of financing adopted by Islamic banks. It is an arrangement under which the Islamic banks lease equipment, buildings or other facilities to a client, against an agreedrental.(source:AssociationofIslamicBankingInstitutionsMalaysia)

Istisna is a contract whereby the purchaser asks the seller to manufacture a specifically defined product using the seller’s rawmaterialsatagivenprice.ThecontractualagreementofIstisnahascharacteristicssimilartothatofSalaminthatitprovides for the sale of a product not available at the time of sale. It also has a characteristic similar to the ordinary sale in that the price may be paid on credit; however, unlike Salam, the price in the Istisna contract is not paid when the deal is concluded. A third characteristic of the contractual agreement of Istisna is similar to Ijarah (employment) in that labor is requiredinboth(source:AAOIFI).

Note 1 Islamic WindowTheIslamicwindowisthepracticesetupbyaconventionalfinancial institution that provides Islamic financial services in compliance with the Sharia law.

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About ITS

Market leaderITSisafullservicecompany,with25officesworldwide,coveringall geographical locations including a centralized state-of-the-art managed datacentre.Thisnetworkofon-the-groundresourcesallowsITStooffer24/7localsupport.Haithamcontinuesbysaying:“ITSisnotjustanIslamicbankingsolutionsprovider,wearetheITpartnerofanorganization.Throughtheirsupplierstheyareabletoprovideeverythingfromhardwareand security through to storage and document management solutions. Thisgivesusanextrauniquevaluepropositionoveranyotherprovider,”Haitham summarizes.

ITShasreceivednumerousawardsoverthelastyearorsoforitsIslamicsolutions from its instrument definition engine, Islamic product definition engine,anditsworkflowandaccountingsolutions.ThesolutionscompanylookssettocontinuethistrendwithETHIX,whichhasbeenwidelytestedthroughoutitsexistingpartnerships.ITS’sgloballaunchshouldseeexpansionacrossthefareastintoAsiaPacific,aswellasmovingintonewareasinEuropeandtheUnitedStates.

ITS’sobjectiveistobecomethegloballeaderinIslamicbankingsolutions.Ifinitialsuccessisanythingtogoby,theprovenstatusofITS’sIslamicsolutions will guarantee that the future is indeed technologically driven.