Of apples and oranges

A relative lack of product diversity is frequently cited as a weakness of Islamic finance as it stands today.
The lack of product diversity is obvious to anyone observing the market.
Fairly basic bank deposits still dominate, although equity and money market funds have grown in number.
Although GCC sukuk issuance is growing, the market remains small and illiquid. Individual funds tapping other asset classes tend to relatively few and far apart.
This state of affairs is a direct consequence of Shariah-compliant finance being a young industry.
In the absence of genuine need and demand, markets cannot be merely innovated or regulated into being.
How then do you compete against other fruit stands when you only have access to apples and oranges? In essence, I would suggest, there are three options.
First, you can try to source other kinds of fruit in the hope that your product offering will over time come to match that of others. But this is dependent on ensuring secure supply lines and consistent quality.
Secondly, you can have a fruit stand that looks more pleasant than other fruit stands, is reliable, and offers, dedicated friendly service. Human capital development and proper processes are in principle equally available to all organizations.
But thirdly, and perhaps most importantly, apples and oranges need not mean just apples and oranges.
They can be combined in different proportions to produce a fruit salad.
They can be processed, separately or in various combinations, into juice or jam. They can be candied or dried… The list goes on but the point is that a limited range of inputs need not mean an equally limited array of outputs.
The first one of these three options is the preferred alternative of those who maintain that Islamic finance, in order to be truly competitive, needs to match conventional finance on all key indicators.
Problematically, attempts to rush this convergence — and effectively accelerate an evolutionary process that even for conventional finance took centuries to unfold — can create problems in terms of yield, risk, or even Shariah-compliance.
Under the circumstances, there may be a case for reinventing creativity, at least in the near term. Improving the service level and trying to develop an advice-based relationship with customers is likely to boost loyalty by ensuring that customer needs are better understood and met.
But the third option may offer even more potential for differentiation.
The basic idea would be to use basic Shariah-compliant inputs to create products with different risk-return profiles so as to cater to the needs of different client segments.
This can be done even with a relatively limited number of assets classes.
For instance, the GCC equity markets alone are diverse and established enough to provide the building blocks for a number of different themes. Compare a basic tracker fund to an actively managed fund.
A product focusing on the largest blue-chip names is a world apart from one based on smaller growth companies.
Sectoral funds are possible as are funds involving different markets.
Additional flexibility is available through combinations of different asset classes.
Such innovation would doubtless create potential new challenges in terms of administration, risk management, regulatory approvals, etc.
But it would change the game in one fundamental way: It would focus on making the most of the established, available building blocks that known to be Shariah-compliant as opposed to trying to find new ones.
One potential challenge with this type of innovation is the fact that hybrid products may be perceived to be complex at a time when more and more investors have come to abhor complexity due to its potential lack of transparency and perceived riskiness.
But the key here is to use inputs that are simple and recognizable and potentially augment this through advisory relationship that offer customer greater, more cost-effective flexibility by enabling them to move money between products.
— Jarmo T. Kotilaine is chief economist at The National Commercial Bank