TO BE IN A

COMPETITIVE EDGE:
PERILS OF INNOVATION

Rosita Chong

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1.0 INTRODUCTION
 Rapid process of globalisation  rapid pace
of innovation  devastating disruption in the
financial system Current financial
turmoil.
 However, in a highly globalise financial
market, innovation the main
differentiating factor in order to be
COMPETITIVE and to ensure SURVIVAL-
ABILITY.
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What Does Competitiveness Mean?

 According to the definition by Porter,

competitiveness focussed on the prosperity
derived from economic activity that create
values by providing products and services at
prices above their cost of production.

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What does innovation mean?

 The act of introducing new or relatively new

product or process.
 Important in the study of economics,
business, technology, sociology and
engineering.
 It is considered it as the engine of growth by
many economists.

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Innovation in the Financial Industry
 Like in any other industries, innovation is part
of the dynamic process of what Schumpeter
called ‘creative destruction’.
 It has driven forward and raised the living
standard of people in the market economies.
 However, if innovative activities are stretched
too far out brings more harm than
benefits

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2.0 FINANCIAL INNOVATION

 Innovation is considered as a common tool

with which a financial organisation could
ensure comparative advantage in its
business activities over others.
 One form of innovation related to business
is financial innovation.

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2.0 FINANCIAL INNOVATION
 What is financial innovation?
 Jacque (1999) refers financial innovation to any
new development in a national financial system or
the international financial system that
(i) enhances the allocation efficiency of the
financial intermediation process, and
(ii) improves the operational efficiency of
the financial system by
reducing the costs and/or risk of
transactions in the primary and secondary
markets in which financial instruments are
traded.
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2.0 FINANCIAL INNOVATION
 It refers to the various activities related to
financial products, which banks created in order
to mitigate or manage risks.
 It has allowed firms of all industries to raise
capital in large amounts and at a lower cost than
they would otherwise.
 an ongoing process whereby private parties
experiment to try to differentiate their products
and services, responding to both sudden and
gradual changes in the economy

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2.0 FINANCIAL INNOVATION
 Tufano (2002) classified financial innovation as
(i) new financial intermediaries such as venture
capital funds,
(ii) new financial instruments such as collateralised
mortgage obligation or credit derivatives,
(iii) new financial markets such as
insurance
derivatives,
(iv) new financial services such as e-trading or e-
banking and
(v) new financial techniques such as Leverage Buy
Outs.

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2.1 Drivers of
Financial Innovation
 According to Poole (2008), financial markets are always
innovative and there are various drivers of innovation, namely;
(i) Technological advances : In the 1950s  credit
card was introduced because of advancement of
computer and communication technology has enable a
high- speed processing of credit card transactions
feasible, (ii) Profit motive,
(iii) Response to
regulation and government policy.
(iv) Opportunity to earn a market rate of interest on
transaction balances when interest rate on bank and thrift
deposits were capped by law.
(v) Lower cost of producing the existing financial services,
(vi) Response to risks due to globalisation such as
exchange rate, interest and political risk ,
(vii) Lower mortgage rate charged to borrowers.
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2.2 Perils of Innovation
 History is full of examples of innovation that led to
instability (Poole, 2008).
 Example of such is the innovation in the mortgage
industry
 It has enabled loans to be made available to many
people including those who have poor credit rating
 the recent sub-prime lending crisis
 The crisis has proven that it may be good to provide
loans to as many poor as possible in order to enable
them to buy houses, however, if such innovative
activities are undertaken excessively, there will be
perilous consequences to the economy.

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What is Sub-prime Crisis?
 Sub-prime crisis is a phenomena whereby
mortgages are offered to low-income high-
risk borrowers,
 Sub-prime lending is new innovation
 It enables lenders with high risk profile to take
up loan, and banks and other lenders transfer
the risk off their balance-sheets by shifting
and dicing the principal and income streams
into securiticised tranches to suit investors
seeking yields (Wignall (2007).
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What is Sub-prime Crisis?
 What happened that led to the crisis?
 It was that financial innovative activities have
further developed through the process of
securitizations.
 According to Check (2008), financial
innovation through securitisation has allowed
banks to sell the mortgages to investment
firms on Wall Street.

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What is Sub-prime Crisis?
 The investment firms then bundled the top-grade
mortgages with the low quality mortgages.
 This was later sold as mortgage-backed securities
to investors providing relatively high returns, but at
the same time they appeared safe because they
were backed semi government entity such as by
Fannie Mae and Freddie Mac.
 The innovative breakthrough has made it possible to
convert the bad mortgages into triple-A, investment
grade, mortgage-backed securities.
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Illustration on Securitisation of MBS

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3.0 INNOVATION:
THE MALAYSIAN
EXPERIENCE
 Most of the innovation in the financial markets in
Malaysia has been derived from the innovation on
Islamic financial product.
 The word financial innovation in Malaysia takes its
meaning particularly with reference to innovation in
the Islamic banking industry.
 It relates to the effort of Islamic banking to create
Shariah-compliant new ideas and possibilities in
order to meet their increasing concerns about
product development as well as liquidity and risk
management.
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3.0 INNOVATION:
THE MALAYSIAN
EXPERIENCE
 There has been an increasing interest in the
demand for alternative financial instruments
in the country and around the world.
 The interest in particularly the Islamic
financial instruments has been evident
especially after the Asian financial crisis of
the late 1990s and the recent Global financial
crisis.

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3.0 INNOVATION:
THE MALAYSIAN
EXPERIENCE
 A major trend has been the growing integration of
Islamic investments and financing into the global
economy.
 As a consequence of universal changes, a more
diverse innovative vibrant Islamic financial
institution is beginning to take hold.
 A rapid expansion of “Islamic products” that are
being offered by conventional banks whose
clientele are both the Muslim and non-Muslim.
 As Islamic financial institutions now operate in
over 75 countries with assets in excess of USD
230 billion.
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3.0 INNOVATION:
THE MALAYSIAN
EXPERIENCE
 The Malaysian government has rigorously
embarked on development of more Shariah-
compliant to come up with such instruments.
 However, it is important for financial innovation in
Islamic finance to have clear Shariah objectives and
adhere to the requisite principles of Shariah.
 This is to ensure that the Shariah -based innovation
would contribute towards Islamic financial products
that have distinct value propositions with in-built
strategies arising from the essential features of
Shariah.
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 THE MALAYSIAN
EXPERIENCE

INNOVATION is
 pertinent in order to increase the efficiency and
competitiveness of the Islamic financial institutions,
hence, there is a constant need for product
development.
 applies to (i) the creation of new products, and to
(ii) enhancing existing products.
 encompasses developments of Shariah -complaint
products, derivatives and the more complex
structured products that involve financial products
engineering and executive produce.
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3.1 Financial innovation in
Islamic Finance
 The emergence of interest-free Islamic banking
during the last three decades considered as a
financial innovation.
Reason to consider it as an innovation is that it
offers the services of a financial intermediary
without paying and receiving interest, the key
player of the existing financial system.
As a result Islamic banks have been able to
mobilise large amount of deposits that were
otherwise untapped in the Muslim countries
(Noman, 2006).
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3.2 Perils of Innovation
from the Islamic
Perspective
 Itis imperatives that in order to be
competitive, there is a need to innovate.
 However, such efforts should not result in
a diffusion of the Shariah authenticity or
classification of the Islamic financial
products.

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3.2 Perils of Innovation
from the Islamic
Perspective
 Financial innovation often brings with it changes in
the perception of risk.
 Merton (1995) makes the point that “less apparent
understanding of the new environment can create a
sense of greater risk even if the objective level of
risk in the system is unchanged or reduced”.
 Islamic finance is not immune to such perceptions.
 The emergence of Islamic finance on the world
financial landscape presents challenges similar to
that of the conventional finance.
 Hence, Islamic financial engineering has designed
differently from the conventional ones.
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3.2 Perils of Innovation
from the Islamic Perspective
 If financial instruments are mere copy-cats of
the current instruments, then an Islamic sub-
prime crisis might emerge.
 This is because, in line with Merton’s
observation, it is generating concerns on the
inherent risks it presents and their possible
spillover on the rest of the financial system as
it is less well understood than conventional
finance.
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3.2 Perils of Innovation
from the Islamic
Perspective
 With financial innovation, including both through the
Islamic Financial Institutions as well as the
conventional counterpart, various instruments and
structures are emerging to meet the demand for
specific services.
 As a result, the functions of financial institutions are
evolving continuously and becoming more complex.
 Hence there is a need for enhancement in the role
and skills on the part of the regulator to frequently
assess the adequacy and strength of the regulations
that are currently in place.
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3.2 Perils of Innovation
from the Islamic
Perspective

 Too often “innovation” has been achieved by

putting the business and/or misusing fatwa by
taking them out of context.
 There should also be an effort to avoid mere
imitation, for instance, from just mere purification
of current financial transactions from haram (the
prohibited) to designing financial ways and means
that would serve the maqasid al- Shariah
(objectives of Islam).

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4.0 CONCLUSION
 Once Islamic finance is in the correct direction, then it will find
itself in good company.
 There has been a relative decline in bonds and a rise in equity as
means of investment at the international as well as domestic
levels.
 The financial community is now aware of the environmental and
ethical considerations that must attend its choices.
 People want to invest their money in order to have more money in
the future.
 This has provided a window of opportunity for Islamic finance
seeking to serve the Islamic goals of balanced growth, equitable
distribution and mutuality.
 These goals are universally acclaimed by contemporary humanity.

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4.0 CONCLUSION
 With respect to Islamic Finance, the ownership and rights to the
assets in the investment exist at all times as it is a requirement
under Shariah.
 Investors can feel and identify the assets in which they invested,
unlike sub-prime products where investors found themselves no
longer having the ability to sell their invested assets because
they were no longer there.
 Sub-prime type transactions whereby the sub-prime asset are
securitised over and over again cannot occur under Shariah
because it is seen as unproductive and without value to society.
 Irrespective of whether transaction are conducted in local or
global markets, the Islamic financial industry exists in the same
market as the conventional financial industry and look for the
same client base.
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