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Risk profile of Islamic banksClaudio 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 contractsLiability 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 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 Funding

Liquidity management Investment

Demand deposits

Islamic funds

(mudaraba)

Securitisation

Investment accounts

Sukuk

Outside the conventional bank’s

boundary

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A taxonomy of Islamic contractsAsset side

P&LS contracts

Financial needs Insurance

Musharaka

Mudaraba

Takaful

Asset management

Islamic fund

Partnership finance

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A taxonomy of Islamic contractsAsset side

No P&LS contracts

Short-term financing Long-term financing

Murabaha

Salam

Ijara

Istisna

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 bank’s 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 / bank’s 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

-

P S Investment accounts

(restricted)

Demand deposits

(non interest bearing)

- +

Stability

Having both debt and equity features, are PSIAs to be

accounted for as off-balance-sheet ?

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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?

Shareholders’ claims

Dividend (after PER’s depreciation and IRR’s depreciation)

Control rights

Shareholders’ claims

Dividend (after PER’s depreciation and IRR’s depreciation)

Control rights

PSIAs holders’ cash flow rights

Return in line with market interest rates (after PER’s depreciation against the displaced commercial risk)

No control rights

PSIAs holders’ cash flow rights

Return in line with market interest rates (after PER’s depreciation against the displaced commercial risk)

No control rights

Islamic bank contracts - Liabilities

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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?

unrunrr PERIRRPSIARWA - PSIARWA )-(1 - PSIARWA -OR RWA total

capital eligible ratio capital

Capital ratio in case of profit smoothingCapital ratio in case of profit smoothing

where:RWA = Risk Weighted Assets OR = Operational RiskRWA PSIAr = RWA funded by Restricted PSIAs RWA PSIAunr = RiWA funded by Unrestricted PSIAsRWA PERIRRPSIAunr = Risk Weighted Assets funded by Profit Equalisation Reserve and Investment Risk Reserve of Unrestricted Profit Sharing Investment Accountsα = 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 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 customer’s promise to pay; with or without customer’s appointment ;the enforcement of customer’s promise;The mitigation techniques (collateral or deposit).

Short-term financingShort-term financing

Compare with the IFSB’s requirement

Islamic bank contracts - Murabaha

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Islamic bank contracts - Murabaha

Counterparty monitoring

+ with customer’s appointment and instalment payment (“revolving” murabaha)

without customer’s promise

-

with customer’s appointment

with customer’s promise

- +Knowledge of the underlying market

Credit risk

Market riskrisk due to the

existing implicit option to buy

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Islamic bank contracts - Salam

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:bank’s role;the presence of parallel contract (parallel salam);the standardization of the underlying asset.

Short-term financingShort-term financing

coun

terp

art

perf

orm

ance

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 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 customer’s appointment,the sale of underlying asset at the end of the contract (the customer’s promise to buy the underlying asset);the mitigation instruments (collateral or takaful contract).

Long-term financingLong-term financing

Compare with the IFSB’s requirement

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Islamic bank contracts - Jiara

Counterparty monitoring

+ with customer’s appointment and promise to buy the underlying asset

without customer’s promise to buy the underlying asset

-

with customer’s appointment

without customer’s appointment

- +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

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: customer’s (full version)/underlying asset’s cash flows (limited version);the presence of parallel contract (parallel istisna):the underlying business risk.

Long-term financingLong-term financing

coun

terp

art

perf

orm

ance

risk

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Islamic bank contracts - Mudaraba

Mudaraba (PL&LS 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

Partnership financingPartnership financing

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Islamic bank contracts - Mudaraba

Firm’s cash flow

Bank’s pay-off

In the example, if the firm’s cash flow is positive the bank’s participation is 50%

Bank pay off in tipycal mudaraba

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Islamic bank contracts - Mudaraba

Firm’s cash flowStrike

Prefixed level

Bank’s pay-off

According to several Islamic schools it is possible to determine a prefixed level of bank’s partecipation on firm’s cash flow against the moral hazard of the counterpart.

It’s similar to pay-off’s put option (short position) on firm’s cash flow

Bank pay off in mudaraba with maximum profit

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Islamic bank contracts - Musharaka

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

It is the purest Islamic contract

thanks to the sharing of risk

Partnership financingPartnership financing

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Islamic bank contracts – Risk unbundlingContract / Risk Credit Market Liquidity Operational

Salam

Murabaha

Ijara Istisna

MusharakaMudaraba

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 - Asset and liability

No P&LS contracts with high operational risk

P&LS contracts inside the commercial bank’s boundary

MurabahaSalam Ijara

IstisnaMudarabaMusharaka

Demand deposits(qardh hasan)

Investment accounts(mudaraba)

Islamic funds(mudaraba)

Losses’ absorption of investment deposits

Mudaraba on both asset and liability sides

Typical Islamic bank’s 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 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 bank’s 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 Shari’ah board are required. This board provides guidance and supervision in the development of Shari’ah-compliant products to ensure that they meet the requirements of Islamic law. A Shari’ah 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 riskReturns 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 bank’s 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

Conclusions - The concerns for supervisors

Market risk: the specific dynamics of underlying market of asset-based contracts (no P&LS contracts) can create several concerns to the banks in case of unexpected price shocks or liquidity crisis

Market risk: the specific dynamics of underlying market of asset-based contracts (no P&LS contracts) can create several concerns to the banks in case of unexpected price shocks or liquidity crisis

Credit risk: the moral value of borrower’s promise and the enforcement’s mechanisms of this promise imply different standards of credit screening and monitoring

Credit risk: the moral value of borrower’s promise and the enforcement’s 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”

Operational risk: the endogenous factors of operative risk are under control thanks to the Sharia “deterrent”

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 don’t use the P&LS contracts while on the liability side the degree of freedom in managing PSIAs is limited.

Islamic banks operating in Europe (Islamic Bank of Britain, for example) have a simple business, mainly retail. In particular, on

the asset side they don’t use the P&LS contracts while on the liability side the degree of freedom in managing PSIAs is limited.

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, bank’s 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).

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