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The lowdown

 

Code breakers

Islamic banks face new competition such as the introduction of risky derivatives into their markets. An ‘identity buffer’ makes them more likely to diverge from traditional Islamic codes, says a study by Cambridge Judge academics Maima Aulia Syakhroza, Lionel Paolella and Kamal Munir.

Kuala Lumpur, Malaysia, a key Islamic finance centre
Kuala Lumpur, Malaysia, a key Islamic finance centre

In Islamic finance, there are very strict prohibitions against speculation (maisir) and preventable uncertainty (gharrar), because they are seen in Islamic law as posing potential injustice toward another party.

So how do traditional Islamic banks in countries like Egypt and Pakistan respond to the introduction into their markets of profitable but risky derivatives – a clear “code violation” – by conventional banks from abroad or by homegrown rivals?

Dr Lionel Paolella

This is not a hypothetical question, as big banks such as HSBC and Deutsche Bank have been attracted to the big growth in Islamic finance, whose assets trebled from around $500 billion to more than $1.5 trillion in the past two decades – so “western” banking practices have been introduced to Islamic markets.

A new study by academics at Cambridge Judge Business School, just published in the Academy of Management Journal, looks at how Islamic banks react to adoption of controversial practices like derivatives that challenge traditional Islamic banking codes.

The study concludes that the reaction of traditional Islamic banks depends on whether they possess an “identity buffer” – or relative identity advantage – as being seen as more authentic. This buffer translates into a greater likelihood of violating traditional codes if an “outside” bank introduces the code violation, whereas traditional banks will more likely adhere to the codes if the violator is one of their insider competitors born as an Islamic bank.

Kamal Munir
Dr Kamal Munir

“Insiders… can take on controversial practices necessary to compete with outsiders while keeping their identity as an ‘insider'”, the study says. “An organisation’s decision to adopt or defy a change introduced by others is shaped not merely by its own identity but more importantly by a consideration of the relative difference in identity between itself and the change agent.”

As a result, the paper concludes that it is not identity in itself but the identity buffer that serves as the key factor for a firm, thus influencing its strategy as it faces new competitive threats.

These findings hold implications for many industries in which successful firms are facing identity-based challenges – for example, the issues facing carmakers such as BMW and its slogan – “the ultimate driving machine” – in a world of driverless cars, or how Amazon’s entry into healthcare challenges traditional healthcare providers.

“The identity buffer insiders possess relative to outsiders allows them some leeway to adopt controversial practices while retaining their insider identity,” says the study. “As soon as the identity buffer narrows, the insiders’ propensity to adopt the code violation ushered in by outsiders also weakens.”

To examine Islamic banking codes and their violation, the study focuses in part on the adoption of derivatives by Islamic-born and foreign-born banks, because the risks of derivatives are considered inherently incompatible with Sharia law.

Among other traditional Islamic banking practices, the study also examines zakat, or voluntary annual almsgiving – in which every Muslim earning above a certain threshold will donate about 2.5 per cent of their wealth to charity. The study discusses how some banks shift this responsibility to customers and employees, but banks wishing to enhance their Islamic identity pay this from their own earnings – which amounts to a 2.5 per cent “tax” on profits.

The study is based on data from 108 Islamic banks (full-fledged Islamic banks and conventional-owned) in 12 countries between 2003 and 2014, supplemented by interviews with bankers, lawyers, regulators and others involved in Islamic finance.

The study – entitled “Holier than thou? Identity buffers and adoption of controversial practices in the Islamic banking category” – is co-authored by Cambridge Judge PhD candidate Maima Aulia Syakhroza; Dr Lionel Paolella, University Lecturer in Strategy and Organisation at Cambridge Judge; and Dr Kamal Munir, Reader in Strategy and Policy at Cambridge Judge.