362 AN INTRODUCTION TO ISLAMIC FINANCE
to their clients. A fi nancial institution which can offer guarantees, enhance
liquidity, underwrite insurance against risks, and develop hedging tools
for a fee, can and should be established. If the basic building blocks of
the Islamic fi nancial system are viewed as a set of “asset - backed” securities,
derivatives can be created synthetically and can be used to share, transfer or
mitigate fi nancial risk. Both on - and off - balance - sheet hedging instruments
should be developed using these building blocks by applying the techniques
of fi nancial engineering.
IFIs need to realize the importance of operational risk that arises from
the failure of controls and processes. Currently, there is a serious lack of a
risk - management culture and of enterprise - level sponsorship of active risk
management. Formulating a strategy for risk management in Islamic fi nan-
cial markets will require a comprehensive and detailed discussion of the
scope and role of derivatives within the Shari’ah framework; an expanded
role for fi nancial intermediaries with special emphasis on facilitating risk
sharing; the application of takaful insurance against fi nancial risk; and the
use of fi nancial engineering to develop synthetic derivatives and off - balance -
sheet instruments.
Standardization
Another operational challenge for Islamic banks is to standardize the proc-
ess for introducing new products into the market. Currently, each Islamic
bank has its own religious board to examine and evaluate each new prod-
uct. Each religious board may have its preferences or adherence to a particu-
lar school of thought. This process needs to be streamlined and standardized
to minimize time, effort and confusion. Some banks have already instituted
a post - product audit process by audit committees to ensure compliance with
the Shari’ah guidelines defi ned by the religious board. However, this needs
to be applied across the industry as a whole.
Consolidation
Given the large number of small institutions, Islamic banks do not enjoy
economies of scale. Indeed, many banks use the facilities of conventional
banks as intermediaries for treasury management, foreign exchange, port-
folio services and investment banking, which reduces their profi t margins.
It is time, perhaps, for Islamic banks to seriously consider merging into
large fi nancial institutions in order to benefi t from economies of scale and
reduced overhead costs through effi ciency gains.
Governance
In principle, the governance model in the Islamic fi nancial system — with
its Shari’ah boards, public - policy institutions, regulatory and supervisory
institutions to monitor the performance of IFIs, and its commitment to