Risk Profiles of Islamic Bank

8/8/2019 Risk Profiles of Islamic Bank

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Risk profile of IslamicbanksClaudio Porzio & M. Grazia Starita

University of Naples Parthenope
http://www.bancaditalia.it/


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Agenda

A taxonomy of Islamic contracts Islamic bank contracts: their typical risk

profile Liabilities Assets

Murabaha Salam Ijara Istisna Mudaraba

Musharaka Risk profile of Islamic banks Conclusions


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A taxonomy of IslamiccontractsLiability side: short-term (liquidity management) and long-term(investment) funding; banking book mobilisation (ijara, especially).Asset side: contracts with or without Profit and Loss Sharing (P&LS)

P&LS contracts can be subdivided according to the different needs(financial, insurance and asset management) satisfied.

No P&LS contracts allow short and long term financing.

Asset finance requires the lender to purchase the asset and to sell it onto the borrower at a higher price with instalment payments.

Partnership finance requires the lender to participate in the equity ofthe transaction.

Lease finance involves the lender acquiring the asset, leasing it to theborrower in exchange for rental payments.


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A taxonomy of IslamiccontractsLiability side

Funding

Liquiditymanagement

Investment

Demand

deposits

Islamicfunds

(mudaraba)

Securitisation

Investmentaccounts

Sukuk

Outside theconventional

banks boundary


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A taxonomy of Islamiccontracts

Asset side

P&LS contracts

Financialneeds Insurance

Musharaka

Mudaraba

Takaful

Assetmanagement

Islamicfund

Partnershipfinance


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A taxonomy of Islamiccontracts

Asset side

No P&LS contracts

Short-term financing Long-term financing

Murabaha

Salam

Ijara

Istisna

Lease

financeAsset finance

Assetfinance


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A taxonomy of IslamiccontractsThe parallel with conventionalfinance

Salam Householders lending

Murabaha Mortgage with banks ownership(in the first step of contract)

Ijara Renting / Leasing

Istisna Sale of real estate under contructionMusharakaJoint venture / investment deposits

Mudaraba Limited partnership / Investment accounts

Mudaraba Mutual funds / banks performance bonds

Qardhhasan

Demand deposits 11(current accounts)

Takaful Insurance contractAsset Backed Securities

Asset side

Liability side

Other


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Islamic bank contracts -Liabilities

Lossesabsorption

+ P SInvestmentaccounts

(unrestricted)

Equity

- P SInvestmentaccounts

(restricted)

Demanddeposits

(non interestbearing)

- +

Having both debt andequity features, are

PSIAs to be accountedfor as off-balance-

sheet ?


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There is a commercial pressures on Islamic banks to offer market-based returns andrepay in full on due date to ensure PSIAs continue to be funded (displacedcommercial risk).

What is the boundary between shareholders claims and investment accountholders claims? What happens in a liquidation scenario?

What relationship between control rights and cash flow rights?

Shareholders claims

Dividend (after PERsdepreciation andIRRs depreciation)

Control rights

PSIAs holders cashflow rights

Return in line withmarket interest rates(after PERsdepreciation against the

displaced commercialrisk)



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Profit smoothing Profit Equalization Reserve(PER)

Unexpected loss against displaced commercialrisk Investment Risk Reserve (IRR)

Capital adequacy? Is a different approach to itscalculation and accounting standards necessary?

unrunrrPERIRRPSIARWA-PSIARWA)-(1-PSIARWA-ORRWAtotal

capitaleligibleratiocapital

+

=

Capital ratio in case of profitsmoothing

where:RWA = Risk Weighted Assets OR = Operational RiskRWA PSIAr = RWA funded by Restricted PSIAs RWA PSIAunr = RiWA funded byUnrestricted PSIAsRWA PERIRRPSIAunr = Risk Weighted Assets funded by Profit EqualisationReserve and Investment Risk Reserve of Unrestricted Profit Sharing InvestmentAccounts

= percentage of assets financed with PSIAunr


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Murabaha (purchase and resale) involves three parties:the purchaser/importer, the seller/exporter, the bank. The lastprovides finance by purchasing the desired commodity andreselling it to the purchaser at a prefixed higher price (mark-

up) payable in installments.The key risk is that the bank must have title to the goods atsome point in the transaction. The main risk drivers are linkedto:

the contract structure: with or without customers promise to pay;

with or without customers appointment ;the enforcement of customers promise;

The mitigation techniques (collateral or deposit).

Short-term financing

Compare with the IFSBs requirement

Islamic bank contracts -Murabaha


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Islamic bank contracts -Murabaha

Counterpartymonitoring + with customersappointmentand instalmentpayment(revolving

murabaha)

withoutcustomerspromise

- with customersappointment

withcustomers

promise- +

Knowledge of the underlying market

Creditrisk

Marketrisk

riskdue tothe

existingimplicit

option to

buy


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Islamic bank contracts -Salam

Salam (purchase and resale) involves two parties: thebank as purchaser and his borrower as seller. It is anagreement to purchase, at a prefixed price, a specific

kind of commodity not available with the seller. Thecommodity will be delivered on a specified future date.

The risk profile of Salam depends on:

banks role;

the presence of parallel contract (parallel salam);the standardization of the underlying asset.

Short-term financing

count e

rpart

perform

anc

e

risk


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Islamic bank contracts -Jiara

Ijara (leasing): due to the asset-backed nature of the operation,the bank retains ownership of the asset until maturity, helping toreduce the credit risk of the counterparty. The bank shares in the riskthrough its responsibility for maintenance and insurance.

The main risk drivers are:the customers appointment,the sale of underlying asset at the end of the contract (thecustomers promise to buy the underlying asset);the mitigation instruments (collateral or takaful contract).

Long-term financing

Compare with the IFSBs requirement


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Islamic bank contracts -Jiara

Counterpartymonitoring

+ withcustomersappointmentand promise

to buy theunderlying asset

withoutcustomerspromise to buythe underlying

asset

- with

customersappointment

without

customersappointment

- +

Knowledge of the underlying asset

Creditrisk

The fullcollateral can

mislead increditworthin

essassessment

Marketrisk


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Islamic bank contracts -Istisna

Istisna: the bank finances work in progress orconstruction of a building or an installation and thensells it to the customer; it is payable in instalments.

The main risk drivers are linked to:

the type of contract: customers (fullversion)/underlying assets cash flows (limitedversion);

the presence of parallel contract (parallel istisna):

the underlying business risk.

Long-term financing

count e

rpart

perform

anc

e

risk


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Islamic bank contracts -Mudaraba

Mudaraba (PL&LS agreement): a contractbetween a bank (acting as a silent partner) and oneor more entrepreneurs (the bank and the depositor

in case of PSAs): The bank provides theentrepreneur with the funding for a specificcommercial activity. The entrepreneur does notcontribute any funding himself, but contributes

management expertise. The entrepreneur earns anagreed portion of the profits (management fee).

The profit balance is payable to the bank.The default event is indefinite and collaterals (orguarantees) are not allowed

Partnership financing


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Firms cash flow

Banks pay-off

In the example, if the firms cash flow is positive the banksparticipation is 50%

Bank pay off in tipycal mudaraba


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Firms cashflow

Strike

Prefixedlevel

Banks pay-off

According to several Islamic schools it is possible todetermine a prefixed level of banks partecipation onfirms cash flow against the moral hazard of thecounterpart.

Its similar to pay-offs put option (short position)

Bank pay off in mudaraba with

maximum profit


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Islamic bank contracts -Musharaka

Musharaka: partnership between a bank and anentrepreneur: both contributing capital to a project andsharing in its risks and its rewards. A formal contract isnormally in place, outlining the obligations and rights ofboth parties: profits can be allocated in any pre-agreedratio, and losses are borne in proportion to the capital ofeach partner.

The risk profile of musharaka depends on:

the underlying asset;the goal of contract such as the link withother contracts (diminishing musharakafor householders, for example).

It is the

purestIslamic

contractthanks to the

sharing of

Partnership financing


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Islamic bank contracts Riskunbundling

Contract / Risk Credit Market Liquidity Operational

Salam

Murabaha

IjaraIstisna

Musharaka

Mudaraba

Market and credit risks are more ntensely

interdependent and connected

Relevant market risks are strictly

connected to liquidity risks

hign

medium

low


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Islamic bank contracts -Assetand liability

No P&LS contracts with highoperational risk

P&LS contracts inside thecommercial banks boundary

Murabaha

Salam

Ijara

Istisna

MudarabaMusharaka

Demand deposits

(qardh hasan)

Investment accounts

(mudaraba)

Islamic funds(mudaraba)

Losses absorptionof investmentdeposits

Mudaraba on both asset and liability sides

Typical Islamic banks balance-sheet


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Risk profile of Islamic banks

Even though Islamic scholars consider mudaraba and musharaka as

preferable Sharia-compliant financing vehicles, Islamic banksconcentrate on selling the lucrative murabaha markup financing.

The most common activities (trade and commodity finance, leasing,fund/asset management, etc) of dedicated Islamic banks are essentiallyno different to similar activities practised by many conventional banks.

HoweverCertain risks are of greater significance compared toconventional banks.

Creditworthiness, solvency and profitability are influenced bytheir unique characteristics.

Higher profitability, cheaper and more stable deposits, and highercustomer loyalty than for conventional peers tend to be offset byweaker liquidity; greater concentration; and more heterogeneous andless rigorous regulatory, accounting and disclosure frameworks.


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Credit risk peculiarities Transformation of credit in risk into market risk and viceversa A different bundling of credit and market risks between the bank and

its financed customer. As collateral levels are typically higher than in conventional banks, a

significant part of assets must be converted to real assets over acertain period of time.

The legal environment is crucial for allowing an efficient loan recovery. Many products tend to carry higher asset and operational risk. Musharaka and mudaraba expose to heightened asset risk and

potentially limits the banks ability to foreclose on loans and recoverbad debts. They carry a fair amount of potential risks, as recognitionof impaired transactions can be assessed only at the end of a

contract. Overall, may be difficult to judge an Islamic bank's asset portfolio risk.


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Credit risk managementThe credit risk management functioning of an Islamic bank is

essentially no different from that of a conventional bank evenif some aspects are key: loan sanctioning process, loan bookconcentrations, loan impairment, collateral valuations and riskappetite.

A higher transparency and a clear distinction between the riskmanagement and the Shariah board are required. This boardprovides guidance and supervision in the development ofShariah-compliant products to ensure that they meet therequirements of Islamic law. A Shariah board should notinvolve itself with the actual granting of credit, as it is doubtfulwhether scholars are sufficiently skilled in credit analysis.


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Performance riskReturns achieved in Islamic banking seem to be high and haveattracted the attention of conventional banks. This is due to: the benign operating environment that Islamic banks, mainly those based in

oil-producing countries, have benefited from;

the asset quality remained healthy; the margins on some products tend to be high partly reflecting the lack of

pricing transparency but also limited competition (at least until now);

as much of an Islamic banks funding comes from interest-free customerdeposits, its cost of funding is typically lower than that of a commercial bank.This, in turn, boosts its net profit margin and net profit from financing

activities line although it leaves income vulnerable to falling asset yields.


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Governance and compliance Governance structures are quite peculiar because the

institution must obey a different set of rules - those of theHoly Qur'an - and meet the expectations of Muslimcommunity by providing Islamically-acceptable financing

modes. Many different interpretations of Sharia law can exist at

bank and country level. Although this has hamperedproduct standardisation, the resulting lack of productcomparability and pricing transparency has helped to

benefit margins. smoother throughout the cycle, as IFIsdo not pay fixed interest on debt and because theyengage in profit-and-loss


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Conclusions - The concerns forsupervisors

Market risk: the specific dynamics ofunderlying market of asset-basedcontracts (no P&LS contracts) can createseveral concerns to the banks in case of

unexpected price shocks or liquidity crisisCredit risk: the moral value ofborrowers promise and theenforcements mechanisms of thispromise imply different standards of

credit screening and monitoringOperational risk: the endogenousfactors of operative risk are under controlthanks to the Sharia deterrent


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Conclusions - The concerns forsupervisors The regulation of Islamic banks in Europe

implies several issues (as abovementioned) but what is the degree ofgrowth in Europe?

What is the real concern of Europeansupervisors? Is the framework of theexisting regulation, adequate for Islamic

banks?

Islamic banks operating in Europe (Islamic Bank of

Britain, for example) have a simple business,mainly retail. In particular, on the asset side theydont use the P&LS contracts while on the liabilityside the degree of freedom in managing PSIAs is

limited.


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Conclusions - The concerns forsupervisors

Any regulatory framework has to:

recognise the special features of Islamic finance and, in case, findappropriate responses to them rather than simply applying solutionsalready devised for traditional banks

offer those who use Islamic finance the same degree of protectionoffered to those who use non Islamic finance.

Principles applied (adequate resources, corporate governance, reliablecontrol systems, transparency) are general and cannot be modified.Specific issues relating to Islamic finance (the special position of theSharia Board, banks and customers rights under a contract ofmudaraba), accounting, ) may require specific solutions. In this case, it

is necessary to adjust the domestic fiscal and legal framework to renderit friendlier to the development of Islamic banking (and finance).


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Conclusions - The concerns forItaly

Are there specific problems of compatibility with the existing Italian

regulation?

In addition to products offered, typical risks, investors and depositors protection,

the assessment of corporate governance is crucial.

In fact, in any case:

the authorities cannot give any guarantee as to the Sharia compliance of productsoffered;

the role and responsibilities of the Sharia Board vis a vis top management andshareholders are completely delegated to the bank and its management.

However, some reflections are necessary about the composition of the Boardand its relationships with other stakeholders bank. Although formallyindependent and separate, the effective influence on management depends onthe nature of their relationship with the bank which may take different forms.9

Risk Profiles of Islamic Bank

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