By Narendra Mistry, Chief Product Officer (CPO), Universal Banking, Finastra
Islamic finance first emerged in the 1970s in the Middle East and North Africa (MENA), and although a relatively young industry, it has registered accelerated growth throughout the years. It is already present in more than 80 countries, and according to the Islamic Financial Services Board’s (IFSB’s) “The Islamic Financial Services Industry (IFSI) Stability Report 2023”, the industry was worth an estimated US$3.25 trillion in 2022. It recorded a 6.2-percent year-on-year growth rate and is projected to reach US$4.94 trillion in value by 2025.
There are three main ways in which the industry can grow further: by gaining market share in existing markets, by expanding into other Islamic markets and by using the esteemed reputation and ethical principles that underpin Islamic banking to support growth in markets that are not traditionally associated with it.
Technology is a crucial prerequisite in achieving this growth, and only the right technology combined with a deep understanding of Islamic finance can enable agility and lead to steady growth, equipping Islamic financial institutions (IFIs) to offer market-leading products and seamless customer experiences while leveraging the enhanced distribution capabilities of truly digital banking.
Key differences between Islamic and conventional banking
Simply put, Islamic finance underpins banking services that follow Sharia principles. The financing process is addressed in a fundamentally different way in Islamic banking than in conventional banking. Interest is strictly forbidden, including for loans and customer deposits. Instead, IFIs use equity participation—the IFI shares the profits and losses associated with the account. They also invest in ethical trading activities and are required to ensure that profit payouts are conducted in line with Sharia principles.
Islamic finance is all about banking that aligns with specific customer values, such as the belief that money does not inherently have value but is a means to exchange products and services. This is prevalent in the MENA region and around the world. For example, there are several Islamic finance services in the United Kingdom. Although predetermined principles underpin Sharia, the concept also corresponds with the rising worldwide demands for banks to reflect the ethos of their customers, such as ethical, sustainable and responsible banking.
Compared to conventional banking, the Islamic-banking operating model adds a new layer of complexity. The procedures and controls involved are rigorously focused on upholding Sharia compliance and ensuring that the right financing products are offered. Violations during this process can generate risk and impact customer loyalty.
Running two core banking systems
The standard approach for banks running both conventional and Islamic banking is to deploy two different core banking systems. This approach can lead to increased complexities, risks, degraded customer experiences, data-exploitation difficulties and enterprise-agility limitations. Deploying two different systems usually means that the systems are not based on the same technology stack, so even if deployed in the Cloud, two IT (information technology) teams are needed. These added complexities often translate into tremendous costs.
Using two core banking systems also means that compliance measures with national and international regulations must be implemented twice. This is an ongoing exercise as rules and regulations continually evolve and new products are introduced. Managing credit risks promptly is another challenge, as having to view and extract data from two different systems is more time-consuming and resource-intensive.
With a few exceptions, technology vendors have poorly served IFIs, offering mostly slightly modified versions of conventional-banking or Islamic-banking systems built on outdated technologies that can’t keep up with the unique needs of IFIs. Notably, most IFIs (74 percent) have expressed concerns about the limitations imposed by legacy infrastructures and outdated technologies. These constraints make it difficult for them to adapt to evolving market dynamics and stay competitive in the face of technological advancements. Outdated applications and legacy infrastructures also hinder their ability to use data effectively and increase cybersecurity risk. A CIBAFI (General Council for Islamic Banks and Financial Institutions) study highlighted that technology and cybersecurity are among the most cited risks mentioned by Islamic banks.
The right technologies equal new opportunities.
IFIs tend to pick systems designed to be pre-play Islamic core-banking systems with the assumption that they will reduce risks, but these systems are often developed with limited functionalities and can hold back growth and even increase risks.
The great news is that choosing a system that can support both conventional and Islamic banking doesn’t have to cause a Big Bang effect. This journey doesn’t need to include a wholesale architecture transformation right away. Instead, Islamic banks can improve their performance, security and scalability by gradually adopting the best solutions. Microservices-based architecture and composable banking support this approach, enabling banks to quickly integrate new functionalities and solutions from third-party fintechs (financial-technology firms) to promote agility and innovation.
IFIs need to adopt a modern, proven and resilient platform that meets the sector’s requirements, is capable of supporting Islamic-banking operations and facilitates the adoption of innovative technologies to improve customers’ experiences, streamline processes and enable innovation in their products and services, hence empowering them to pursue growth.
The Cloud, for instance, enables banks to become more agile, collaborative and customer-focused. Adopting cloud-based technologies is an efficient way for Islamic banks to scale their operations, reduce costs, quickly adapt to new regulations and improve data management and security. By tapping into the growing ecosystem-driven nature of financial services, banks can also implement innovative applications that deliver additional value while reaching prospective customers through new routes to market (RTMs).
Open banking, artificial intelligence (AI) and machine learning (ML) are also becoming more prevalent. Open banking enables the secure and free movement of customer data through APIs (application programming interfaces), with customers’ permission, making financial services more personalised and accessible than ever before. At the same time, AI and ML facilitate analyses of rich customer data to identify preferences and trends. IFIs must understand what their customers want from their banks and offer services that truly meet their demands. In fact, according to a study conducted by Boston Consulting Group (BCG), 79 percent of Saudi customers would share their data to improve banking services.
Islamic banks, and all banks generally, must have the flexibility to deliver differentiated value for their customers while continuing to grow their businesses. Partnerships are crucial for banks to remain agile and implement these offerings at a quick time to value (TTV). By partnering with software companies and fintechs that have the right skills, experiences and robust technologies, IFIs can continue to innovate and quickly deploy new solutions that truly accommodate customer needs. Collaboration is key for banks to stay ahead of the game and embrace the future while delivering success today.