Strategic investment in information systems and technology is key to the continued growth and expansion of the Islamic banking sector.
While analysts predict growth in demand for Islamic banking services from existing and developing markets1, they also note challenges are involved in meeting that demand. In particular, Islamic banks need to implement the capability to:
- bring Shariah-compliant financial products to market in an efficient and responsive manner; and
- establish internal systems to manage risk, complexity, processes and Shariah compliance.
Vendors of both conventional banking systems and stand-alone Islamic banking systems have and continue to develop solutions to assist banks in improving their product capability, speed to market, internal efficiency, risk management and compliance.
Acquiring and implementing Islamic banking systems (whether as a standalone system or as an overlay or module to a conventional system) presents a number of challenges to legal and procurement teams. While certain operational challenges will be common to both conventional and Islamic banking systems, Islamic banking systems present unique compliance challenges which must be managed and resolved so as to avoid both risking the relevant bank’s reputation and losing business in the Islamic banking sector.2
This article reviews the evolution of banking technology, describes a number of challenges and risks in procuring and implementing Islamic banking systems and outlines ways in which legal and procurement teams may address these challenges and risks.
- Evolution of Information Systems and Technology in the Banking Sector
Technology innovation has significantly impacted the conventional banking sector3. Identifiable trends in technology adoption and innovation within the sector include:
- Moving customer focus from individual branches to retail networks to multiple distribution channels (e.g., branch, ATM, phone and Internet);
- Moving from bespoke or internally-developed systems to shared systems built on common standards (e.g., BACS/Swift payment processing, ATM networks);
- Moving from manual to automated processes (e.g., cheque processing); and
- Diffusing from core products of savings and loans to multiple financial service products (e.g., insurance, pensions and funds).
These trends have, in turn, stimulated the growth of standardised products, systems and interfaces within conventional banking as well as the growth of the outsourced service provider market (providing conventional banks with access to improved services and business processes).
The Islamic banking sector’s technology needs mirror those of the conventional backing sector. However, until recently, there was a perception within Islamic banks that there was a paucity of systems catering to Islamic principles.4
This perception is changing. A recent purchasing guide to Islamic banking systems5 identifies 30 specialist Islamic banking technology vendors and over 40 Islamic banking systems. This guide includes providers that focus on the Islamic banking market, such as Path Solutions and ITS, and providers who will be familiar to users of conventional banking systems, such as Misys, Oracle, Sungard and Temenos.
This proliferation of vendors and systems represents a positive step for Islamic banks; creating choice, generating competition and driving innovation in the Islamic banking technology sector. However, the proliferation of vendors does not reduce the risks associated with acquiring and implementing an Islamic banking system nor reduce the need to properly identify and manage such risks as part of the procurement and contracting process.
- Conventional Risks Across All Banking Sectors
In some respects, the risks associated with acquiring and implementing an Islamic banking system are no different from the risks associated with acquiring and implementing a conventional banking system.
By way of example, as per a conventional banking system, the contract for the implementation of an Islamic banking system needs to address the following risks:
- Operational and delivery risks, such as:
- The implementation running over budget or over time;
- The implementation not completing;
- The delivered system not meeting the bank’s requirements, being over-engineered, of poor quality, inefficient or difficult to maintain; and
- The bank’s requirements changing over time;
Intellectual property risks, such as ensuring that the bank:
- Has sufficient rights to use the system;
- Owns any bespoke developments or innovations which give it an advantage over its competitors; and
- Is not “locked in” to a relationship with a vendor by restricting use of the system should the bank terminate its relationship with the vendor; and
Liability risks, such as:
- Protecting the bank from third-party claims related to its use of the system;
- Ensuring the bank may bring a claim to recover its actual losses in the event of a breach by the vendor; and
- Ensuring the bank’s exposure to liability from the vendor is commensurate with the bank’s fees paid to the vendor.
Each of these risks are significant; IT journals regularly feature stories of failed systems implementation projects and the material losses caused by such failures (figures above US $100 million are not uncommon)6. Banks must address these risks as essential elements in agreements with vendors. Buyers should take great care in determining the manner in which an Islamic banking system implementation is priced, vendor performance is incentivised, and implementation is governed and managed.
- Unique Challenges in the Islamic Banking Sector
Beyond the conventional risks, acquiring and implementing an Islamic banking system presents a number of unique challenges that banks need to address as part of the procurement and contracting process. A number of these challenges, and suggestions as to how they can be met, are outlined below.
4.1 Absence Of Standardisation
One of the major recognised challenges in procuring Islamic banking systems is the absence of a single interpretation of Shariah law7; a bank’s Shariah supervisory board ultimately determines Shariah compliance. This leads to the absence of common standards across banking systems, which makes it difficult for a bank to procure an Islamic banking system with reasonable certainty that the system will comply, “out-of-the-box”, with Shariah law. Organisations such as the Accounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB) have attempted to improve standardisation, but such standards are neither mandatory nor universally accepted.
This uncertainty over standards also leads to scenarios where vendors claim to offer systems that are “Shariah-compliant”, in the sense that they comply with an AAOIFI or IFSB standard, but the use of such a system may not actually comply with the requirements of a bank’s Shariah supervisory board.
4.2 Complexity of Products and Processes
Islamic financial products can be more complex than conventional financial products as a result of the use of sale contracts, leasing arrangements, agency and profit-sharing arrangements, and other structures in place of straightforward interest-bearing loans, bank accounts and other conventional banking products (such as credit cards and insurance). This presents banks with two challenges: banks must ensure that Islamic banking systems vendors fully understand the complexity of the bank’s products that the Islamic banking system needs to support; and the bank needs to clarify in the system contract whether or not the vendor needs to support the relevant bank’s product in order to avoid contract disputes.
4.3 Need to Segregate Conventional Banking Funds and Islamic Banking Funds
Conventional banks operating an Islamic banking window may overlook the need to segregate conventional banking funds and Islamic banking funds. Shariah compliance and local financial regulations may require the bank to keep conventional banking funds completely separate from Islamic banking funds8. This separation extends to physical as well as logical separation; a bank may need to operate parallel banking system infrastructures and processes, which will increase costs. Banks providing both conventional and Islamic banking services should note this risk when dealing with vendors who claim to provide a single system that can service both conventional and Islamic banking clients.
4.4 Use of Commercial Levers to Drive Correct Behaviour
Contracts for conventional banking systems typically include commercial levers that drive the correct behaviour from the vendor (e.g., liquidated damages for delayed implementation) and the customer (e.g., interest payable on late payment of undisputed invoices). While the use of such levers in contracts for Islamic banking systems may be prohibited (in the case of interest) or limited (to the extent that liquidated damages may result in unjust enrichment), such levers are important to give the vendor comfort that the bank will pay on time and while providing the bank comfort that the vendor will deliver a working system on time. Although
mechanics have been developed (discussed in more detail below) to deal with these issues in Shariah-compliant documentation, the fact that such mechanics cannot completely reflect the risk-allocation in conventional contracts may impact the relationship between the parties.
- Dealing With These Challenges
Ensuring that an Islamic bank (or conventional bank providing an Islamic banking window) properly addresses these challenges requires the involvement of the bank’s procurement and legal teams.
5.1 Define Requirements
The bank’s request for proposal to be sent to vendors of Islamic banking systems must clearly set out the bank’s current and future functional and technical requirements for a banking system, together with statements as to whether the bank requires compliance with any of the known AAOIFI or IFSB Islamic banking standards and/or with internal bank standards. If local law requires a bank to purchase the system or third party software from a local entity or reseller, then these requirements should also be identified and included in the request for proposal, the final contract between the bank and the vendor, and should form the basis of the acceptance criteria used to determine whether the vendor has met its contractual obligations.
5.2 Fix the Implementation Price
The provision of clear requirements also enables a vendor to price for the implementation of a system with greater certainty, and accordingly assists the bank in locking the vendor into providing a system on a fixed-price basis. In the alternative commercial model, implementation on a time-and-materials basis is not in the bank’s interest, as that model requires the bank to bear the risk of cost-overruns and will erode the bank’s business case for the system if the implementation is delayed.
5.3 Carry Out, and Permit, Due Diligence
The bank also needs to carry out due diligence on potential vendors and their relevant products to determine whether they can provide a system that meets the bank’s compliance requirements and, following down-selection to a limited number of vendors, permit such vendors to carry out due diligence on the bank’s existing systems and processes. Affording vendors such an opportunity reduces the potential for arguments over the scope of requirements during implementation. The opportunity for due diligence can also be linked to the provision of a contractual remedy for damages in the event the vendor fails to deliver a system that meets the bank’s requirements.
5.4 Manage and Control Change
Given the complexity of Islamic financial products and the fact that a determination of Shariah compliance may not be provided until after a contract with a vendor is signed, the relevant contract must be able to accommodate and deal with change. To the extent that such change is predictable (e.g., an increase in the number of system users) such change should be accommodated through the contractual pricing mechanisms, giving the bank the certainty of predictable pricing. Where a change is unpredictable (e.g., the introduction of a number of additional requirements to ensure Shariah compliance) the vendor should be obliged to demonstrate (with supporting evidence) that its costs have been materially increased by the new requirement, and produce evidence of having reviewed alternative solutions to accommodate the change without an increase in the price (e.g., by diverting resources from other tasks). The bank should always retain the choice to accept the lower service/cost option.
5.5 Use of Liquidated Damages
While interest is prohibited under Shariah law, the payment of liquidated damages is not, provided that such amounts do not exceed the actual damage suffered by the recipient of the
damages. Accordingly the parties may agree for such a sum to be payable by the customer for late payment of undisputed invoices and by the vendor for implementation delays. As an alternative, the contract may, and arguably should, specify an amount to be payable to charity by either party instead of liquidated damages for late payment and/or implementation delays.
Further growth in the development and proliferation of Islamic banking systems is likely in the next few years. Banks providing Islamic financial products will enjoy exciting opportunities, but such banks should be mindful to address the risks associated with Islamic banking systems and the way in which they are procured and implemented.
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