Chapter 23

Human Resource Management of Islamic Banks: Responses to Conceptual and Technical Challenges

Volker Nienhaus

1. INTRODUCTION

The Islamic finance sector continues to grow rapidly. Initially, the growth was driven by increasing transaction volumes of a rather small number of Islamic banks. Since the early 1990s, the number of Islamic financial institutions and the total customer base increased considerably, and the last decade saw the establishment and expansion of Islamic windows, Islamic subsidiaries of conventional banks, and the conversion of conventional into Islamic banks. In addition, global conventional players designed Islamic products for high-net-worth individuals and for institutional clients. The competition among Islamic banks and between Islamic banks on the one side and Islamic windows and products of conventional banks on the other side has been intensified substantially, with quantitative and qualitative human resource implications for Islamic banks: they need more and better-qualified personnel, which still is in short supply.

Given the competitive situation, the high growth rates of past years, the experiences of the recent financial crisis (which did not leave Islamic financial institutions untouched, albeit to a lesser degree than their conventional counterparts), and the specifics of Islamic finance, the human capital requirements are particularly high—in product development and product placement (in retail as well as investment banking), but also in risk management, dispute resolution, and restructuring. Islamic banks’ personnel must be familiar with conventional banking products and their status in relation to Islamic requirements, as well as with existing Islamic alternatives and their commercial advantages and disadvantages compared to the conventional products. Executives and staff members must be able to explain the value proposition of Islamic products to individual and institutional Muslim and non-Muslim customers. Furthermore, the management of Islamic financial institutions must be able to design Shari’ah-compliant financial innovations in order to meet the diversified needs of the customers and to keep up the ever-increasing scope of conventional techniques, procedures, and products. Finally, it is often claimed that Islamic banking ties finance to the real economy. Therefore, the personnel of Islamic financial institutions might need more knowledge about the nonfinancial sector than conventional bankers if they take on and hold entrepreneurial risks on their balance sheets, instead of securitising loans and selling them off as it has become the general trend in conventional banking over the last decade.

2. RECRUITMENT, RETENTION, AND QUALIFICATION OF PERSONNEL

The human resource literature usually deals with the recruitment, retention, and retirement of “human capital.” Since retirement issues are not yet of major concern for Islamic banks, this topic will be ignored in the following. With respect to recruitment and retention, the following takes up topics of the conventional literature and relates them to the specifics of Islamic banking.

2.1 Broadening the Recruitment Base

Islamic banks in total can recruit personnel basically from two different groups of potential employees: first, from people seeking first-time employment; and second, from people already employed in the conventional banking sector. None of these people can generally be expected to have in-depth knowledge of Islamic finance. However, the Islamic financial sector has attracted the attention of students and practitioners who are willing to learn about its specifics—on a basic or more advanced level, and with a theoretical or practical orientation. This is substantiated by the growing number of higher education and training institutions offering an increasingly broader spectrum of study programmes and training courses:

• Several universities in Western and in Muslim countries allow for a specialisation in Islamic finance within their postgraduate programs in accounting, banking, and finance. Others have integrated the Islamic perspective into general business administration and finance courses. Specialised MA and MS programmes in Islamic finance are offered by universities in Muslim countries as well as by Western universities (in particular in the United Kingdom).
• A wide array of programmes and training courses for professionals in banking, finance, insurance, and accounting are offered by many institutions in Europe, the Middle East, and Asia. New forms of distant learning and web-based content delivery are spreading all over the world. Main target groups are part-time students and employees of the Islamic finance industry who are looking for additional professional qualifications to promote their professional career. The number of course providers and diplomas and certificates has mushroomed so that quality assurance has become a major issue.
• The number of commercial one- or two-day seminars, conferences, and workshops on specific subjects such as sukuk, home purchase financing, risk management, or takaful has exploded.

Given the recent response of the education and training industry to the growing manpower needs of Islamic financial service providers, it seems that the number of recruitment candidates with a basic and even more specific understanding of Islamic finance is increasing and will continue to do so in the foreseeable future.

While all these initiatives have broadened the pool of talents with knowledge in Islamic finance considerably since the mid-2000s, an increasing number of graduates with academic Islamic finance degrees complain that it is difficult for them to find employment in the Islamic finance industry. This may be due to the fact that the business of many Islamic financial institutions (in particular of Islamic windows and subsidiaries of conventional banks) is largely a Shari’ah-compliant replication of conventional finance. If, for example, 80 percent of the transactions are commercially very similar to conventional transactions, then it can be more cost effective to hire staff with experience in conventional banking and familiarise the new employees with Islamic specifics in in-house training programmes than hiring university graduates with academic expertise in Islamic finance but limited knowledge of conventional finance and no practical experience. Providers of academic degree programmes in Islamic finance should take this into account and design their curricula accordingly. In particular, they should equip graduates to work in conventional financial institutions where they can gain the experience that will make them more attractive as recruits to Islamic financial institutions.

Although a general qualification of employees in Islamic finance is useful, it is not sufficient for Islamic banks in a competitive environment. Their success will not depend mainly on standardised products available from many competitors, but on their own specific products. Familiarising employees with the distinct features of such products remains a prominent task of in-house training departments of each Islamic bank. The growth of external training facilities enables Islamic banks to concentrate their limited training capacities on their specifics. In-house training programmes also offer good opportunities to familiarise employees with the mission, vision, and values of the institution in order to strengthen their motivation and engagement. Unfortunately, empirical studies on the internal human resource development strategies of Islamic banks are still lacking.

2.2 Payment and Benefits

A competitive base salary has to be offered for the attraction of new employees (especially if they are to be hired away from conventional banks). Competition may force Islamic banks—at least in the medium to long term—to offer higher salaries for many positions than conventional banks, because Islamic banks require a “double” qualification of their employees in techniques of conventional banking and Islamic finance.

A competitive base pay is not only important for the first-time recruitment of employees but also for retention efforts, since it is costly to replace qualified personnel. Cost factors are not only expenses for new recruitment and training, but in particular the opportunity costs associated with the loss of the specific expertise of a leaving person. Especially in the case of middle and top managers, these opportunity costs can be considerable. The problem is aggravated further if the leaving person is a bearer of “trade secrets.” Thus, in general, it makes sense to make efforts to keep qualified personnel, and retention is one of the major dimensions of human capital management.

However, Islamic banks will hardly be able to recruit and retain highly qualified employees and executives if they cannot offer, in addition to the fixed salaries, attractive performance-related rewards. A vast number of different premium and incentive schemes has been designed for the conventional finance sector. However, not all schemes are readily applicable in Islamic institutions because of Shari’ah or market limitations. For example, schemes of performance-related rewards for top managers and chief executives are often based on stock options. But where stocks of Islamic banks are mainly held privately, and active secondary markets are virtually nonexistent, the otherwise effective instrument of stock options cannot be applied in the Islamic financial services industry.

Without empirical research it is impossible to say how serious the problems of staff fluctuation in the Islamic financial sector are and what kind of performance-related rewards are granted. It would be illuminating to know how many people have left Islamic financial institutions to take up new jobs either in other Islamic, or in conventional financial institutions, or in institutions of the nonfinancial sector (with or without a relation to Islam). Such figures could give an indication, for example, of the strength of the “Islamic commitment” of personnel and could shed some light on the importance of ideological factors for the human capital management of Islamic financial institutions.

The base salary is usually supplemented by other benefits for employees, including, for example, healthcare contributions, housing support, and retirement schemes. Islamic banks can also offer such benefits in principle, but the specifics of a Shari’ah-compliant health insurance or pension plan (as provided by takaful undertakings) may be more complex and difficult to explain to and be appreciated by the beneficiaries than conventional packages.

2.3 Work Environment and Motivation

Job satisfaction is a precondition for continuous and long-term employment in a company. It is the result of a complex bundle of conditions, actions, and circumstances. Islamic financial services are “ideological” products. Those involved in the production and marketing of these products should have a common and consistent understanding of the Islamic content and of its relevance. An explicit mission statement will help to clarify the main issues, to homogenise attitudes, and to motivate the personnel.

For many people, “Islamic” finance implies more than just legally interest-free contracts, and therefore an Islamic financial institution should support some “Islamic” activities outside its core business (for example, charitable events, scholarship programs, healthcare programs for the poor, Islamic art exhibitions, and so on).

A strong commitment of employees to their company will reduce fluctuations of staff, enhance the productivity of the human capital, and improve the economic performance.

• Identification with the institution’s larger goals: It is a plausible assumption that identification with the institution’s larger goals is more the case in Islamic financial institutions than in conventional ones. The reverse side of this coin is a larger potential for disappointment and frustration of personnel. The idealised view of Islamic finance, based on the theories of Islamic economics, claims that Islamic banking is superior to conventional finance with respect to efficiency (allocation), justice (distribution), and stability—provided that Islamic banking is based mainly on the sharing of entrepreneurial profits and losses of productive activities in the real economy. This, unfortunately, is not an accurate description of the financing business of most Islamic banks. Much of Islamic banking is based on Shari’ah-compliant contracts for such transactions as sales on credit and leasing which allow the financier a fixed rate of return. In economic terms, such returns are somewhat similar to a form of simple interest. It took quite a while for chief executives and Muslim scholars to acknowledge the discrepancy between the idealised view and the actual practice of Islamic banking. Arguments can be found why in a transition period or in a mixed system Islamic banks cannot have recourse to the more distinctive profit- and loss-sharing instruments of Islamic finance. However, such arguments ignore the problems of asymmetric information and adverse selection, which imply that such instruments are appropriate only in particular circumstances even in widely “Islamised” systems. Nevertheless, employees and managers of Islamic banks may have a hard time explaining to sceptical clients and outside observers what the substantial difference between their modes of finance and those of conventional banks is. It needs to be more widely understood that the distinctive character of Islamic finance cannot be reduced to a mere avoidance of fixed rates of return. Arguably, more attention is required to the substance of compliance with the principles of Islamic finance and less attention to matters of mere form.
• Be that as it may, the identification of staff with the larger (systemic) goals of Islamic finance becomes more difficult when it is discovered that some Islamic financial institutions earned (or lost) much money in international commodity and currency transactions and real estate bubbles. The potential for disappointment and frustration could be reduced by more realistic and phased mission statements of the Islamic finance institutions, but also by sufficient realism in external academic and training courses and in the supportive literature.
• Accountability versus paternalism: In many enterprises, job satisfaction and motivation were boosted by giving more operational autonomy and responsibility to staff and lower-level managers (“decentralisation”). However, the literature on business cultures usually attests to the existence in more traditional societies of a centralised paternalistic management style. This is supplemented by the observation that in such cultures professional careers often depend less on individual performance but more on the membership of networks (defined by family relations, geographic origin, and so on), a phenomenon to which the term “nepotism” is sometimes applied. While nepotism may be seen as a means of coping with information asymmetry in labour markets (“better a mediocrity kept honest by loyalty within network relations than a more able person with no such restraints”), it has a cost in terms of performance. More generally, the related phenomena of paternalism and “top-down” management styles have a negative effect on motivation and innovative thinking. Insofar as the more traditional societies include Arab and most other Muslim countries, the above constitutes a potential drag on the competitiveness of firms headquartered in such countries, including Islamic financial institutions.
• More insidiously, a network factor may also play a role with respect to customer-related decisions: members of some networks may get preferential treatment when it comes to the financing of projects. Paternalistic and network interventions are of particular relevance for those Islamic financing techniques based on risk and return sharing and require the assessment of business plans and project proposals. If a preferential treatment of some clients is due to an intervention from higher management levels, then equal cases are not treated equally, and the accountability for decisions becomes blurred. Such practices impede effective teamwork, undermine the idea of participation, and obstruct performance-based human capital strategies.
• Should conclusions of general studies be correct—that there is a general tendency toward paternalism and related phenomena such as rent seeking in the business culture of countries with more traditional societies—then it is of great importance that the Islamic financial institutions headquartered in such countries explicitly decide to break with such traditions and to implement safeguarding organisational structures. Further empirical studies on this topic are highly desirable but still lacking.
• Learning traditions and use of knowledge: Another element in some Middle Eastern and Asian societies could be an obstacle to rapid human capital development in certain countries where Islamic finance is present—namely, the general learning and education culture. The second Arab Human Development Report, published by the United Nations Development Programme (UNDP) in 2003, deals with many shortcomings of education systems based on traditional authority (accepted without reflection), learning by heart, and uncritical reproduction. If this characterises learning habits of people and if these habits did not change over the last decade, then firms within an industry operating in a dynamic environment with innovative, knowledge-based products might run into trouble if their employees have such a mindset. While such considerations are potentially applicable to all firms in such an environment, the contribution of an institution’s own personnel to the evaluation and improvement of products, procedures, and strategies is much more important for Islamic banks striving for innovative Shari’ah-compliant products than for conventional banks. But an effective contribution of the institution’s own employees requires not only the readiness of hierarchically lower staff members to articulate critique but also the related willingness of hierarchically superior managers listen to critique from below and to attach a positive value to it. It seems that neither the learning culture nor the paternalistic, top-down management style typical of some societies encourages such constructive critique. Thus, in such societies there is a danger that valuable potentials of the human capital of Islamic finance institutions will not be utilised. This may be even worse in relation to Shari’ah boards: for regular bank personnel, well-established Shari’ah scholars are factually unassailable exogenous authorities.

Some of the arguments indicating potential obstacles to the unfolding of the human resource potentials of Islamic banks are a bit “soft” in terms of solid empirical support; nevertheless, fractional evidence and “industry talk” indicate that they are by no means irrelevant. The softness of the arguments is due to a huge backlog in empirical research at the firm level.

3. SUPPORT INFRASTRUCTURE FOR ISLAMIC FINANCIAL INSTITUTIONS

Many Islamic banks have the character of universal banks—that is, they provide services in a wide range of markets, from retail to investment banking. Given the scarcity of qualified personnel, it is a serious challenge to be competitive. The gathering of information and the timely dissemination of market-related and company-specific knowledge can become decisive competitive factors in a knowledge-driven industry. In recent years a number of institutions and companies emerged which provide specialised information and consultancy services for the Islamic finance industry, ranging from market data to legal advice and ratings of companies and instruments (e.g., sukuk). This allows especially smaller Islamic banks to replace expensive in-house activities by the purchase of external services at lower cost and/or higher quality.

3.1 Knowledge Management in the Islamic Sector

Industry-wide institutions (such as associations or federations) can improve the knowledge base and knowledge management of Islamic financial institutions—for example, by maintaining databases, disseminating best practice examples, formulating guidelines and minimum standards, negotiating with national and supranational regulators, lobbying for Islamic finance, or conducting market research. Recourse to a high-quality support infrastructure can boost the effectiveness of the scarce and expensive human capital in individual firms of the Islamic financial services industry. The production of financial services is primarily based on financial resources and on knowledge—in particular, on the knowledge of how to mobilise and employ funds in a profitable and Shari’ah-compliant way, how to meet the demands of depositors and entrepreneurs, how to reconcile conflicting interests of clients, and how to adapt to legal and regulatory requirements. Not the least is knowledge of financial needs and capabilities of customers.

For its continued existence and growth, the Islamic financial sector has to manage different types of knowledge:

• Firm-specific tacit knowledge is company- or business-related knowledge (intellectual capital) embedded in people who work for an employer, such as an Islamic financial institution. Relevant parts of firm-specific knowledge are tacit and nontransferable: if an individual leaves the company, his or her tacit knowledge will be lost and the human capital of the company (not necessarily of the industry) will be reduced. Therefore, retention of qualified staff and executives is a prime concern if replacement costs are high (e.g., due to a general shortage of qualified people or to their particular tacit knowledge). This is particularly relevant to Islamic financial institutions whose techniques are less well documented in the academic and professional literature than those of conventional institutions.
• Firm-specific organisational knowledge originates from and relates to the operations of an Islamic financial services firm. It is a largely explicit and codified knowledge (for example, written down in procedural manuals, explicated in standard contracts, and so on), and it is transferable. This type of knowledge rests within the company and can be transmitted to new personnel. The organisational knowledge includes the corporate culture or the business style of a company, which may not be written down (that is, it may not be fully explicit or codified) but which nevertheless can be transmitted to new members of the organisation. The organisational knowledge manifests itself as an intangible asset that contributes to the market value of a firm.
• Industry-specific knowledge is shared by all Islamic financial service companies and covers those features that distinguish Islamic from conventional finance. Very often, sectoral knowledge is gathered and disseminated by industry-specific associations with a broad membership or support base from Islamic financial institutions. The dissemination of sectoral knowledge may be directed toward internal and external addressees. Internal addressees are the members of the association who receive, for example, industry data for benchmarking purposes, best practice examples, recommendations for accounting procedures, general legal advice, or industry forecasts. External addressees receive, for example, basic facts and figures about the industry, information on job requirements and employment opportunities, or shared views and opinions on envisaged regulations. In the early years of Islamic finance (the late 1970s to the 1980s) the International Association of Islamic Banks (IAIB) played—to some degree—such a role, but with the growth and diversification of Islamic finance, it could no longer represent the majority of Islamic banks. In 2001, the General Council for Islamic Banks and Financial Institutions (CIBAFI) was set up in Bahrain with a global mission similar to IAIB. It became internationally more visible in the last years. With a national mission, the Malaysia International Islamic Financial Centre (MIFC) was launched in 2006 to promote Malaysia as a major hub for international Islamic finance. More targeted industry-specific services are provided by expert bodies for legal and accounting issues such as the Islamic Fiqh Academy of the Organization of the Islamic Conference, or the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the Islamic Financial Services Board (IFSB) (discussed later in this chapter).
• Customer-specific knowledge is a firm-specific asset embedded in the human resources of an Islamic bank and relevant both for consumer banking and business finance. Some Islamic banks make efforts to become comprehensive financial service providers for retail customers. They supplement their “classic” banking services by the offer of more advanced investment and takaful products. In particular, the sale of complex family takaful products raises the human resource requirements—both with respect to product development (or product selection and purchase, e.g., in the case of bancatakaful) and product sales (regarding the identification of customers’ needs and the explanation of complex products). In business finance Islamic banks often claim to support productive ventures of entrepreneurs in the real economy. If Islamic banks would boost their financial engagement in entrepreneurial ventures (especially on the basis of profit-sharing and risk-bearing contracts), they would need personnel with expertise and understanding of nonfinancial markets, with the ability to evaluate business plans and to assess business risks, and with a sound apprehension of the business environment of corporate customers. These are qualifications that are not taught in Islamic finance programmes, and people with such knowledge and expertise are very rare. The shortage of this kind of human resources may to some degree explain the relatively limited engagement of Islamic banks in real economy ventures apart from real estate and trade finance.

A firm’s position in intra-industry competition (that is, competition among Islamic financial institutions) depends mainly on the firm- and customer-specific knowledge. Human capital management is in large part about the generation, utilisation, and retention of tacit individual knowledge. Organisational knowledge in general is a major topic of research work and consulting activities under the headlines of knowledge management and learning organisations. On the one hand, knowledge is a major input for the production of Islamic financial services. On the other hand, the generation and application of new knowledge in Islamic finance (for example, in the form of interest-free financial engineering or new laws and regulations) take place at a fast pace. Thus, Islamic financial institutions must pay attention to the knowledge dynamics in their markets and surroundings and to information and communication technologies.

3.2 External Expertise Supplementing Internal Competencies

For the growth of the whole Islamic finance industry, industry-specific knowledge becomes crucial. Activities of financial services firms in the conventional sector have contributed to and are backed by a huge knowledge base. For example, conventional banks and other financial institutions have been operating all over the world for decades (or even centuries); business practices are well documented, profit and loss accounts and balance sheets of many banks are published as time series data and subject to intense analysis and media coverage; depositors and lenders are well informed about the industry; finance and banking has grown into an advanced and diversified subject of academic teaching and research; accounting, legal, and regulatory standards have evolved gradually; banks and other financial institutions as well as money and capital markets have overcome national or regional fragmentations and form a global finance network.

Compared to this level of development, the Islamic financial services industry is still in its infancy. The number of actors as well as their sizes are relatively small; the range of products is still rather limited on the one hand but confusingly differentiated in details between banks on the other hand; comprehensive financial disclosure is more the exception than the rule; benchmarks are rare and media reports are more directed toward insiders than toward the general public; many, if not most, clients of Islamic banks have only a very limited knowledge about the specifics of Islamic finance; the academic community (inside and outside the Muslim world) is only gradually recognising Islamic finance as a subject for serious study and research; accounting practices, legal requirements, and regulatory procedures still differ considerably between countries; Islamic financial markets are geographically still fragmented and lack the depth and sophistication of conventional financial markets, and a global Islamic finance network is a desire but not yet the reality.

Especially in such a fragmented market, independent service providers who work for several Islamic finance institutions can realise economies of scale and scope and can reduce costs and human resource requirements of smaller individual Islamic banks. Specialised companies can, for example:

• Reduce the cost of data and information collection and processing.
• Collect case studies and identify best (or worst) practice examples of techniques, operations, structures, and so on.
• Organise data and design methodologies for benchmarking and performance assessments.
• Provide expertise to Islamic banks for organisational, legal, and marketing issues.

Recourse to external service providers can enhance the efficiency of a bank’s personnel in its daily operations. Gradually a support infrastructure comparable to that of the conventional finance sector is emerging. Examples of institutions and companies are as follows:

• Each financial institution has to observe its specific market segment, but for benchmarking and planning purposes it also needs more general market data. Companies with a strong reputation for data collection and processing for conventional financial markets have entered the Islamic industry. Dow Jones & Company and FTSE (a company owned by The Financial Times and the London Stock Exchange) publish whole families of Islamic stock market indexes. The REDmoney Group is provider of a global Shari’ah index series and publisher of a news journal (Islamic Finance News) out of a Muslim country (Malaysia). The comprehensive online Islamic Finance Information Service (IFIS) portal was set up by the Euromoney Group, and it gives subscribers access to, inter alia, databases on global sukuk issuers, takaful, Islamic funds, Islamic project finance, Islamic syndications, Shari’ah scholars, and global law firms with Islamic finance expertise. Recently Thomson Reuters started to publish the “Islamic Interbank Benchmark Rate” (IIBR), which provides an indicator of the average expected cost of short term Shari’ah-compliant interbank market funding.
• Accounting, auditing, and governance issues are addressed by AAOIFI from the business perspective and by IFSB from the regulators’ perspective. Both AAOIFI and IFSB develop guidelines and standards for operational and structural issues. The adoption of these accounting, auditing, and governance standards reduces the need for the development of individual solutions—that is, less manpower is needed in these fields. AAOIFI and IFSB standards are included in many academic programmes and training courses of the specialised educational and training institutions for Islamic bank personnel, and both institutions also offer training and awareness programmes of their own.
• The development of the Islamic finance industry and Islamic financial markets is the subject of teaching and research by institutions such as the Islamic Research and Training Institute (IRTI) of the Islamic Development Bank (IDB) in Jeddah or the International Islamic Universities in Islamabad and Kuala Lumpur. Industry-related programmes of higher education (leading to certified professional qualifications or academic degrees) and applied research are the mission of the International Centre for Education in Islamic Finance (INCEIF) with the International Shari’ah Research Academy for Islamic Finance (ISRA), established by the central bank of Malaysia. In the Gulf region, the Bahrain Institute of Banking and Finance (BIBF) established a Centre for Islamic Finance in 1997, and the Qatar Foundation has set up the Qatar Faculty of Islamic Studies (QFIS) in 2007 with an emerging research centre for Islamic economics and finance.
• More complex financial deals require special legal expertise, especially if contracts have to be in conformity both with Shari’ah law and the secular national or international commercial law. Specialised law firms (again mainly located in the United Kingdom and the United States, with a presence in the Middle East and Asia) provide such services. Representatives of law firms and other consultants such as accounting firms are often listed as speakers at the numerous Islamic finance seminars and conferences. The services of specialised consultants (who can exploit economies of scale and scope) allow smaller Islamic banks to participate in or even launch complex financial transactions. The cost of the employment of highly specialised experts is too high for the relatively low frequency of complex transactions in smaller banks. Similarly, the availability of external legal advice can reduce costs of the design of innovative Islamic products.

Human resource problems of Islamic banks can be mitigated by an increasing standardisation of products and techniques. When formerly firm-specific knowledge converts into industry-specific knowledge, it can be integrated into academic curricula and industry-focused training programmes of external service providers, and will gradually become common knowledge no longer requiring firm-specific investments. Besides AAOIFI and IFSB, other institutions are working on templates and framework agreements that could reduce transaction and learning costs. For example, Hawkamah, the Institute for Corporate Governance, works on corporate governance issues in general and governance recommendations for Islamic financial institutions in particular. Of more operational relevance are the efforts of the International Islamic Financial Market (IIFM) to develop a generally applicable “Tahawwut (Hedging) Master Agreement” (in cooperation with the International Swaps and Derivatives Association) and to come up with a template for Shari’ah-compliant repo transactions. Such initiatives replace efforts of individual banks so that scarce human resources in the structuring and legal departments would be set free for more firm-specific tasks.

4. SHARI’AH-COMPLIANCE ISSUES

The top management of Islamic financial institutions has to identify the present and anticipate future financial needs of retail customers, entrepreneurial clients and institutional investors. This requires farsightedness with respect to trends in the national and international economy and in the Islamic and conventional financial markets. It is a major challenge for the leadership and top management of Islamic financial institutions to anticipate future needs and demands, to develop innovative products in due time, and to prepare the institution for the provision of new services. This is not different from what is expected from chief executives of conventional banks, but the scope for action of the top management of Islamic banks is more restricted than that of conventional firms: in addition to general legal requirements and state regulations, Islamic financial institutions are subject to the requirement of Shari’ah compliance of all products and procedures.

4.1 Shari’ah Scholars and Shari’ah-Compliance Officers

Very specific human resources, which cannot be found in conventional finance, are required to secure the Shari’ah compliance of all products and procedures of an Islamic financial institution. Two different types of positions have to be filled:

When the first Islamic banks were established in the 1970s, the shareholders installed Shari’ah boards and gave them the authority to decide on the permissibility of products and techniques (although Shari’ah-board rulings and recommendations are legally not binding because the corporate laws of most countries allocate the ultimate decision power to the board of directors). The board positions were filled with recognised Shari’ah authorities with expertise in Islamic contract law and contemporary finance. But the number of scholars with such a multidisciplinary qualification was rather limited, and the rapid growth of the industry led to the accumulation of large numbers of Shari’ah board positions by the most prominent scholars.

Top scholars hold 50 and (much) more board positions; this may be taken as an indication of a particular shortage of human resources in this area. But it could also be the result of strategic decisions of shareholders and CEOs to take (or keep) the same scholars on board as other Islamic banks with which they maintain intensive commercial relations. This may coincide with the interest of the Shari’ah scholars for whom board positions are not only attractive because of reputation but also financially. If the membership in a Shari’ah board promotes the achievement of individual goals of scholars, it is plausible to assume that Shari’ah board members are interested in their reappointment. This may create a de facto lack of independence from the board of directors who suggests candidates and determines the remuneration, and from the shareholders who appoint the Shari’ah board members. In addition, Shari’ah board members have to be aware that the interests of the management may be well represented in the board of directors. This all leads to the hypothesis that Shari’ah board members will not ignore the interests of the management when they formulate a legal opinion (fatwa) regarding products, contracts, techniques, or procedures of their Islamic bank. This does not mean that they accept whatever new financial product or transaction is submitted by the management: it must be a prime concern of the Shari’ah board that the Islamic character of the institution is not questioned by the general public. But the Shari’ah boards must also bear in mind the commercial success of their institutions, and so they make efforts to develop Shari’ah-compliant functional equivalents of what the management initially had proposed.

The accumulation of 50 and more board memberships violates not only Western standards of good corporate governance (issued, for example, by the OECD or the EU), but also recommendations of AAOIFI and IFSB on the composition and procedures of Shari’ah boards. Only very few countries—Malaysia is the most important example—have taken measures to limit the number of board memberships and to increase substantially the number of qualified persons who could fill the board positions in a growing number of Islamic financial institutions. In general, it is a challenge and opportunity for universities with strong departments both of Islamic law and of economics and finance to launch interdisciplinary programmes for the next generation of Shari’ah scholars.

4.2 Changing Attitudes of Shari’ah Boards: From Restrictive to Permissive

In the early years, Shari’ah boards rejected quite a number of products and business techniques submitted by the management. But over the last decade it seems that the basic attitude of Shari’ah boards has changed. Their verdicts have become far less restrictive and much more permissive. Thus the spectrum of Shari’ah-compliant techniques and products was widened considerably.

The authority of Shari’ah boards of individual Islamic banks is somewhat restricted in those countries that have declared AAOIFI standards binding for their Islamic financial institutions, and in those countries that have installed national bodies as the highest authorities for Shari’ah-compliance assessments: for example, the Higher Sharia Supervisory Board of the Bank of Sudan (established in 1993) and the Shariah Advisory Council of Bank Negara Malaysia (established in 1997). National boards shall ensure consistency and credibility of Islamic finance in general, which could reduce the human resource requirements of the industry. The discretionary power of individual Shari’ah boards of Islamic banks could be constrained if the national boards adhere to a restrictive interpretation of Shari’ah principles. However, if the national boards are more permissible and allow in principle a wide range of products and techniques, they de facto reduce their role to that of the final instance for the clarification of doubtful cases and in dispute settlement.

In a highly competitive environment, the perspectives of a bank will depend crucially on its innovative potentials. In order to keep a competitive edge and to protect against rapid imitation, neither the management nor the Shari’ah board of an innovative Islamic bank have an interest in too much public disclosure of the commercial and Islamic qualities of financial innovations. Islamic banking is by its character more complicated (because it has to meet the requirements of secular law and the Islamic legal system) and less transparent than conventional banking: the need to keep “Islamic business secrets” (to prevent rapid imitation by competitors) makes it more opaque than riba-based banking. Credibility for the Islamic qualities of the products and transactions is thus not achieved by disclosure but by the reputation and public recognition of the members of the Shari’ah board.

In contrast to the early years, when Shari’ah opinions restricted the scope of instruments and products of Islamic banks, today’s Shari’ah boards seem to be much more permissive. A microlegalistic view has become dominant which decomposes complex financial techniques, products, and contracts into a number of basic components that resemble (or are identical with) legal figures of the traditional Islamic commercial law. The Shari’ah quality of these components is then assessed for each component separately. If no objections are raised against any component, the total product gets sanctioned (unless it is an obvious circumvention of the prohibition of riba). This method seemingly supports financial engineering and product innovation in the Islamic segment of the financial market, but it has one very serious weakness: Elements which are perfectly legitimate separately may interact in such a way that—from a macro-systemic perspective—the result may come into conflict with fundamental principles underlying Islamic law and Islamic economics. The dispute over the legitimacy of “Islamised” banking practices in Pakistan from the mid-1980s to early 1990s is a well-documented historical case, while the critique of tawarruq or of repurchase guarantees for sukuk at the issuing price are more recent examples.

It is not clear to what degree clients of Islamic banks and public opinion leaders require a very strict adherence to the substance of the rules and principles of Islamic commercial law. Rather, evidence suggests that they are more concerned with the observance of formal Islamic legal requirements. The idealised vision of the early years has become a minority position. With conventional banks making inroads into the Islamic finance industry, managers of Islamic banks were eager to introduce Shari’ah-compliant functional equivalents to those structured products that have generated the highest returns (at the price of high risks) in conventional banking. The highest profits (and losses) were made by derivatives, and several Islamic financial institutions have developed (with the approval or even support of their Shari’ah boards) prototypes of Shari’ah-compliant derivatives trading techniques. These prototypes have not yet been rolled out because of some unsettled Shari’ah issues. But it seems that these issues are more of an operational and less of a fundamental nature: It is not the rejection of derivatives and trading in principle but the preference for their own products and techniques that so far hindered the emergence of an active market. There is also more caution in the aftermath of the conventional financial crises, but this means only a postponement and not a cancellation of plans.

Reports on ideas for Shari’ah-compliant trading techniques are taken by critical observers (e.g., many Islamic economists) as an indication that the present Shari’ah scholars are too captive in their micro-legalistic methodology to see the questionable macro-systemic implications of their fatwas. From this perspective it is logical to call for an additional qualification or training of Shari’ah board scholars in Islamic economics (or the inclusion of economists into Shari’ah boards—at least on the national level). This adds another dimension to the human resource requirements of Islamic banks, but it could indeed improve the consistency and credibility of the claims of a superiority of an Islamic finance system in term of allocation, distribution, and stability.

4.3 External Shari’ah Consultancy and Perspectives of Shari’ah Boards

There is a growing awareness that the authenticity and quality of Islamic finance can hardly be ensured by Shari’ah boards whose members are overburdened by too many board memberships, are exposed to many conflicts of interest by memberships in boards of competing companies, are fixated on a questionable micro-legalistic methodology, and are lacking a macro-systemic understanding of their micro decisions.

One way out would be a stronger role played by regulatory authorities. National Shari’ah boards could limit the discretionary power of individual Shari’ah boards—provided that the members of the national board are more restrictive than the members of individual boards. But this cannot be taken for granted, at least not for the time being. However, there is a growing awareness of regulators that a mere microlegalistic Shari’ah compliance does not create a more efficient, just, or stable financial system.

Regulatory authorities should only regulate the basics and leave enough room for financial innovations. But once the basic operational tools are more or less the same for all Islamic banks, innovative products and techniques will become decisive in competition. It is hard to see where Islamic banks could make a breakthrough with financial innovations in retail banking and consumer finance. Most Islamic banks have replicated the full range of conventional services, and a commercial success in this market depends not on product innovation but on pricing and the overall service quality and customer satisfaction. The contribution of Shari’ah boards looks quite marginal.

Much more scope for innovation and unexploited profit potentials can be found in corporate finance, project financing and investment banking. Success in this area depends at least as much (if not much more) on the tax-saving and risk-minimising legal structure of a transaction as on its Shari’ah compliance. Tax issues and secular contract law are beyond the capacity of many Shari’ah scholars. This is where the expertise of law firms and business consultancies comes into play. They bundle top-level financial engineering with first-class Shari’ah expertise and intimate knowledge of relevant markets. They can take recourse to extensive experiences with conventional deals, and they have substantially upgraded their Shari’ah competencies over the last decade. It seems that not only their services (in particular of British law firms and American consultancies) are in increasing demand by Islamic banks in all parts of the world, but also that the most innovative deals have been structured by them. Systematic empirical studies are still lacking, but fractional evidence suggests that the importance of Shari’ah boards for innovations in Islamic finance decreases while law firms and consultancies take the lead. This shifts human resource requirements and worries from the Islamic finance institutions to the external consultants, and it helps to better utilise scarce top-quality human resources.

These trends, taken together, suggest that the importance of Shari’ah boards and individual Shari’ah scholars will decrease in the medium term while state-sanctioned or public authorities and specialised service providers may increasingly influence the development of the Islamic finance system. This, combined with market pressures on Islamic financial institutions to offer products that are close substitutes for conventional products, may mean that the Islamic and the conventional financial sectors are likely to move closer to each other, so that formerly clear demarcation lines become further blurred in the not too distant future. To prevent such a loss of distinctiveness in substance, the top managements of Islamic banks face a formidable challenge. In particular, they need to differentiate their products from conventional ones by innovations that allow them to assert value propositions other than (formal) Shari’ah compliance. To prepare for such a positive development (or to prevent potential negative developments), future studies and scenario exercises may be needed—techniques that are not yet on the agenda of training companies, course providers, and seminar organisers.