Risk profile of Islamic banks

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Risk profile of Islamic banks

• Claudio Porzio M. Grazia Starita
• University of Naples Parthenope

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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 Islamic contracts

• Liability 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 (PLS)
• PLS contracts can be subdivided according to the
  different needs (financial, insurance and asset
  management) satisfied.
• No PLS contracts allow short and long term
  financing.
• Asset finance requires the lender to purchase the
  asset and to sell it on to the borrower at a
  higher price with instalment payments.
• Partnership finance requires the lender to
  participate in the equity of the transaction.
• Lease finance involves the lender acquiring the
  asset, leasing it to the borrower in exchange for
  rental payments.

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A taxonomy of Islamic contractsLiability side
Outside the conventional banks boundary
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A taxonomy of Islamic contractsAsset side
Partnership finance
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A taxonomy of Islamic contractsAsset side
Lease finance
Asset finance
Asset finance
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A taxonomy of Islamic contractsThe parallel with
conventional finance
Salam Householders lending
Murabaha Mortgage with banks ownership (in the first step of contract)
Ijara Renting / Leasing
Istisna Sale of real estate under contruction
Musharaka Joint venture / investment deposits
Mudaraba Limited partnership / Investment accounts
Mudaraba Mutual funds / banks performance bonds
Qardh hasan Demand deposits 11(current accounts)
Takaful Insurance contract
Sukuk Asset Backed Securities
Asset side
Liability side
Other
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Islamic bank contracts - Liabilities
Losses absorption P S Investment accounts (unrestricted) Equity
Losses absorption - P S Investment accounts (restricted) Demand deposits (non interest bearing)
-
Stability Stability Stability Stability
Having both debt and equity features, are PSIAs
to be accounted for as off-balance-sheet ?
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Islamic bank contracts - Liabilities

• There is a commercial pressures on Islamic banks
  to offer market-based returns and repay in full
  on due date to ensure PSIAs continue to be funded
  (displaced commercial risk).
• What is the boundary between shareholders claims
  and investment account holders claims? What
  happens in a liquidation scenario?
• What relationship between control rights and cash
  flow rights?

• PSIAs holders cash flow rights
• Return in line with market interest rates (after
  PERs depreciation against the displaced
  commercial risk)
• No control rights

• Shareholders claims
• Dividend (after PERs depreciation and IRRs
  depreciation)
• Control rights

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Islamic bank contracts - Liabilities

• Profit smoothing Profit Equalization
  Reserve (PER)
• Unexpected loss against displaced commercial risk
  Investment Risk Reserve (IRR)
• Capital adequacy? Is a different approach to its
  calculation and accounting standards necessary?

Capital ratio in case of profit smoothing
where RWA Risk Weighted Assets OR
Operational Risk RWA PSIAr RWA funded by
Restricted PSIAs RWA PSIAunr RiWA funded by
Unrestricted PSIAs RWA PERIRRPSIAunr Risk
Weighted Assets funded by Profit Equalisation
Reserve and Investment Risk Reserve of
Unrestricted Profit Sharing Investment Accounts a
percentage of assets financed with PSIAunr
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Islamic bank contracts - Murabaha
Short-term financing

• Murabaha (purchase and resale) involves three
  parties the purchaser/importer, the
  seller/exporter, the bank. The last provides
  finance by purchasing the desired commodity and
  reselling 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 at some point in the transaction. The
  main risk drivers are linked to
• 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).

Compare with the IFSBs requirement
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Islamic bank contracts - Murabaha
Counterparty monitoring with customers appointment and instalment payment (revolving murabaha) without customers promise
Counterparty monitoring - with customers appointment with customers promise
-
Knowledge of the underlying market Knowledge of the underlying market Knowledge of the underlying market Knowledge of the underlying market
Credit risk
risk due to the existing implicit option to buy
Market risk
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Islamic bank contracts - Salam
Short-term financing

• Salam (purchase and resale) involves two parties
  the bank as purchaser and his borrower as seller.
  It is an agreement to purchase, at a prefixed
  price, a specific kind of commodity not available
  with the seller. The commodity 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.

counterpart performance risk
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Islamic bank contracts - Jiara
Long-term financing

• Ijara (leasing) due to the asset-backed nature
  of the operation, the bank retains ownership of
  the asset until maturity, helping to reduce the
  credit risk of the counterparty. The bank shares
  in the risk through 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 (the customers promise to
  buy the underlying asset)
• the mitigation instruments (collateral or takaful
  contract).

Compare with the IFSBs requirement
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Islamic bank contracts - Jiara
Counterparty monitoring with customers appointment and promise to buy the underlying asset without customers promise to buy the underlying asset
Counterparty monitoring - with customers appointment without customers appointment
-
Knowledge of the underlying asset Knowledge of the underlying asset Knowledge of the underlying asset Knowledge of the underlying asset
Credit risk
The full collateral can mislead in
creditworthiness assessment
Market risk
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Islamic bank contracts - Istisna
Long-term financing

• Istisna the bank finances work in progress or
  construction of a building or an installation and
  then sells it to the customer it is payable in
  instalments.
• The main risk drivers are linked to
• the type of contract customers (full
  version)/underlying assets cash flows (limited
  version)
• the presence of parallel contract (parallel
  istisna)
• the underlying business risk.

counterpart performance risk
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Islamic bank contracts - Mudaraba
Partnership financing
Mudaraba (PLLS agreement) a contract between a
bank (acting as a silent partner) and one or more
entrepreneurs (the bank and the depositor in case
of PSAs) The bank provides the entrepreneur with
the funding for a specific commercial activity.
The entrepreneur does not contribute any funding
himself, but contributes management expertise.
The entrepreneur earns an agreed portion of the
profits (management fee). The profit balance is
payable to the bank. The default event is
indefinite and collaterals (or guarantees) are
not allowed
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Islamic bank contracts - Mudaraba
Bank pay off in tipycal mudaraba
In the example, if the firms cash flow is
positive the banks participation is 50
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Islamic bank contracts - Mudaraba
Bank pay off in mudaraba with maximum profit
According to several Islamic schools it is
possible to determine a prefixed level of banks
partecipation on firms cash flow against the
moral hazard of the counterpart.
Its similar to pay-offs put option (short
position) on firms cash flow
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Islamic bank contracts - Musharaka
Partnership financing

• Musharaka partnership between a bank and an
  entrepreneur both contributing capital to a
  project and sharing in its risks and its rewards.
  A formal contract is normally in place, outlining
  the obligations and rights of both parties
  profits can be allocated in any pre-agreed ratio,
  and losses are borne in proportion to the capital
  of each partner.
• The risk profile of musharaka depends on
• the underlying asset
• the goal of contract such as the link with
• other contracts (diminishing musharaka
• for householders, for example).

It is the purest Islamic contract thanks to the
sharing of risk
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Islamic bank contracts Risk unbundling
Contract / Risk Credit Market Liquidity Operational
Salam
Murabaha
Ijara
Istisna
Musharaka
Mudaraba
Market and credit risks are more ntensely
interdependent and connected
hign
medium
Relevant market risks are strictly connected to
liquidity risks
low
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Islamic bank contracts - Asset and liability
Typical Islamic banks balance-sheet
Murabaha Salam Ijara Istisna Mudaraba Musharaka Demand deposits (qardh hasan) Investment accounts (mudaraba) Islamic funds (mudaraba)

• No PLS contracts with high operational risk
• PLS contracts inside the commercial banks
  boundary

• Losses absorption of investment deposits

• Mudaraba on both asset and liability sides

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Risk profile of Islamic banks

• Even though Islamic scholars consider mudaraba
  and musharaka as preferable Sharia-compliant
  financing vehicles, Islamic banks concentrate 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 essentially no
  different to similar activities practised by many
  conventional banks.
• However
• Certain risks are of greater significance
  compared to conventional banks.
• Creditworthiness, solvency and profitability are
  influenced by their unique characteristics.
• Higher profitability, cheaper and more stable
  deposits, and higher customer loyalty than for
  conventional peers tend to be offset by weaker
  liquidity greater concentration and more
  heterogeneous and less rigorous regulatory,
  accounting and disclosure frameworks.

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Risk profile of Islamic banks

• 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 a certain
  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 recover bad debts. They
  carry a fair amount of potential risks, as
  recognition of 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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Risk profile of Islamic banks

• Credit risk management
• The credit risk management functioning of an
  Islamic bank is essentially no different from
  that of a conventional bank even if some aspects
  are key loan sanctioning process, loan book
  concentrations, loan impairment, collateral
  valuations and risk appetite.
• A higher transparency and a clear distinction
  between the risk management and the Shariah
  board are required. This board provides guidance
  and supervision in the development of
  Shariah-compliant products to ensure that they
  meet the requirements of Islamic law. A Shariah
  board should not involve itself with the actual
  granting of credit, as it is doubtful whether
  scholars are sufficiently skilled in credit
  analysis.

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Risk profile of Islamic banks

• Performance risk
• Returns achieved in Islamic banking seem to be
  high and have attracted 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 customer deposits, 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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Risk profile of Islamic banks

• Governance and compliance
• Governance structures are quite peculiar because
  the institution must obey a different set of
  rules - those of the Holy Qur'an - and meet the
  expectations of Muslim community by providing
  Islamically-acceptable financing modes.
• Many different interpretations of Sharia law can
  exist at bank and country level. Although this
  has hampered product standardisation, the
  resulting lack of product comparability and
  pricing transparency has helped to benefit
  margins. smoother throughout the cycle, as IFIs
  do not pay fixed interest on debt and because
  they engage in profit-and-loss

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Conclusions - The concerns for supervisors
Market risk the specific dynamics of underlying
market of asset-based contracts (no PLS
contracts) can create several concerns to the
banks in case of unexpected price shocks or
liquidity crisis
Credit risk the moral value of borrowers
promise and the enforcements mechanisms of this
promise imply different standards of credit
screening and monitoring
Operational risk the endogenous factors of
operative risk are under control thanks to the
Sharia deterrent
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Conclusions - The concerns for supervisors

• The regulation of Islamic banks in Europe implies
  several issues (as above mentioned) but what is
  the degree of growth in Europe?
• What is the real concern of European supervisors?
  Is the framework of the existing 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
they dont use the PLS contracts while on the
liability side the degree of freedom in managing
PSIAs is limited.
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Conclusions - The concerns for supervisors

• Any regulatory framework has to
• recognise the special features of Islamic finance
  and, in case, find appropriate responses to them
  rather than simply applying solutions already
  devised for traditional banks
• offer those who use Islamic finance the same
  degree of protection offered to those who use non
  Islamic finance.
• Principles applied (adequate resources, corporate
  governance, reliable control systems,
  transparency) are general and cannot be modified.
  Specific issues relating to Islamic finance (the
  special position of the Sharia Board, banks and
  customers rights under a contract of mudaraba),
  accounting, ) may require specific solutions. In
  this case, it is necessary to adjust the domestic
  fiscal and legal framework to render it
  friendlier to the development of Islamic banking
  (and finance).

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Conclusions - The concerns for Italy

• 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 products offered
• the role and responsibilities of the Sharia Board
  vis a vis top management and shareholders are
  completely delegated to the bank and its
  management.
• However, some reflections are necessary about the
  composition of the Board and its relationships
  with other stakeholders bank. Although formally
  independent and separate, the effective influence
  on management depends on the nature of their
  relationship with the bank which may take
  different forms.9