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How to Manage Risk andImprove Profitability
AMR MOHAMED EL TIBY
John Wiley & Sons, Inc.
Copyright C 2011 by Amr Mohamed El Tiby. All rights reserved.
Published by John Wiley & Sons, Inc., Hoboken, New Jersey.Published simultaneously in Canada.
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Library of Congress Cataloging-in-Publication Data:
El Tiby, Amr Mohamed, 1956Islamic finance : how to manage risk and improve profitability / Amr Mohamed El Tiby.
p. cm. (Wiley finance ; 640)Includes bibliographical references and index.ISBN 978-0-470-88023-4 (hardback); ISBN 978-0-470-93010-6 (ebk);ISBN 978-0-470-93008-3 (ebk); ISBN 978-0-470-93011-3 (ebk)
1. Banks and bankingIslamic countries. 2. RiskIslamic countries. I. Title.HG3368.A6E47 2011332.1dc22
Printed in the United States of America
10 9 8 7 6 5 4 3 2 1
To my mother,To the soul of my father,To my wife and children
Mohamed, Nada, and Khaled
List of Tables xi
PART ONEUnderstanding the Origins 1
CHAPTER 1Introduction to Islamic Banking 3
CHAPTER 2History and Development of Islamic Banking 7
The Early Days of Islam 7The Modern Islamic Banking System 9Regulatory Agencies for Islamic Financial Services 14The Spread of Islamic Banking 17Summary 23
PART TWORisk in Islamic Banking 25
CHAPTER 3The Nature of Risk in Islamic Banking 27
Banking Risk and the Inherent Risk Associated with IIFS 29Summary 43
CHAPTER 4The Inherent Risk in Islamic Banking Instruments 47
Murabahah 47Salam and Parallel Salam 49Istisna and Parallel Istisna 50Ijarah and Ijarah Muntahia Bittamleek 52Mudarabah 54Musharakah and Diminishing Musharakah 56Summary 57
CHAPTER 5Operational Risk in Islamic Banking 59
Noncompliance with Shariah Rules and Principles 60Fiduciary Risk 61Legal Risk 63Major Concerns with Legal Risk 68Summary 69
CHAPTER 6The Islamic Capital Market 71
Definition, Role, and Importance 71The Islamic Bond Market (Sukuk) 72Sukuk Structure and Types 73Challenges Facing the Development of the Market 76Summary 78
PART THREECapital Adequacy 81
CHAPTER 7The Importance and Role of Capital-Literature Review 83
Definition, Functions, and Importance of Capital 84History of Capital Adequacy Regulations 88The Need for Banking Regulations and Supervision 89Summary 93
CHAPTER 8The Regulatory Framework of the Conventional BankingSystem: Basel I and II 97
The Regulatory Bodies 97Basel Capital Accord I: 1988 101Basel Capital Accord II: 2004 105
The Revised Framework 107Three Methods for Calculating Operational Risk 113Summary 117
CHAPTER 9The Regulatory Framework of Islamic Banks 119
Background 119The Capital Adequacy Standard (CAS) 120The Definition and Role of Capital 123Determination of Risk Weights 124Credit Risk 126Minimum Capital Requirements for Islamic Financing Assets 130Recommendations 138
PART FOURCorporate Governance 141
CHAPTER 10The Supervisory Review Process and Issues 143
The Supervisory Review Process 143Supervisory Issues of Islamic Banking 146Issues Specific to Islamic Windows 147The Relationship between Banking Supervision and
Bank Risk Management 148Summary 149
CHAPTER 11Corporate Governance in Islamic Banking 151
Definition of Corporate Governance 153Corporate Governance Models 155The OECD Principles 156The Corporate Governance Framework 157Mobilization and Use of Funds 161Issues in Islamic Windows 164Shariah Governance System 165Summary 169
CHAPTER 12Market Discipline and Transparency in Islamic Banking 171
The Disclosure Framework for IIFS 172Market Discipline Issues 176Summary 179
CHAPTER 13Challenges Facing Islamic Banking and Recommendations 183
Conclusions 184Recommendations 185
About the Author 199
List of Tables
Table 2.1 The Development of Islamic Banking from 1965to Present 10
Table 3.1 IFSB Principle for General Requirement 28Table 3.2 Islamic Banking Risk 29Table 3.3 IFSB Principles for Credit Risk 32Table 3.4 IFSB Principles for Equity Investment Risk 34Table 3.5 IFSB Principles for Market Risk 36Table 3.6 IFSB Principles for Liquidity Risk 38Table 3.7 IFSB Principles for Rate of Return Risk 40Table 3.8 IFSB Principles for Operational Risk 42Table 7.1 Bank Capital Definition Matrix: Conventional
and Islamic 94Table 8.1 Business Line and Beta Factor 115Table 9.1 Classification of Capital in Islamic Banking for
Capital Adequacy Calculation 124Table 11.1 General Governance Approach of IIFS 159Table 11.2 Rights of Investment Account Holders (IAH) 160Table 11.3 Compliance with Shariah Rules and Principles 160Table 11.4 Transparency of Financial Reporting in Respect of
Investment Accounts 161Table 11.5 General Approach to the Shariah Governance System 167Table 11.6 Competence in the Shariah Governance System 167Table 11.7 Independence in the Shariah Governance System 168Table 11.8 Confidentiality in the Shariah Governance System 168Table 11.9 Consistency in the Shariah Governance System 169
A s many would say that the worst of the financial crisis is now behindus, it is indeed an opportune time for the expert materials (such as thisbook) on the issues of risk and profitability, particularly with reference tothe Islamic financial services industry.
As is well known in the Islamic banking and finance industry, Islamicbanking refers to a system of banking or banking activity that is consistentwith the principles of Islamic law (shariah) and its practical applicationthrough the development of Islamic economics.
Islamic banking arguably emerged (and many view it) as a viable alterna-tive model to conventional banking. The Islamic financial services industry,while still at a growing stage compared with its conventional counterpart,is progressing with a consistent pace.
Banks, conventional as well as Islamic, are subject to a wide rangeof risks in the course of their operations. Islamic banks, however, face anadditional set of unique risks that arise from the shariah-compliant financingstructures that they employ. I hope readers will have a better understandingof the risks associated with Islamic banking after reading this book.
There has been a growing amount of capital availability with the Is-lamic banks and they have been aggressively looking for new investmentopportunities.
The supply of funds coincided quite naturally with the demand forinfrastructure projects in the Middle Eastern Muslim countries. As a result,not only were Islamic banks able to participate in large-scale projects, butalso innovation and financial engineering in refining the Islamic financingtechniques experienced expon