credit risk management in islamicbanks - bank · pdf filebail-in akin to islamicbanking model?...

CREDIT RISK MANAGEMENT IN ISLAMIC BANKS

IFSB-INCEIF EXECUTIVE PROGRAM

29 April 2013

Strictly Private & Confidential

AGENDA

1. ISLAMIC BANKS AND THE FINANCIAL CRISIS

2. RISKS IN ISLAMIC BANKS

3. CREDIT RISK GOVERNANCE & CULTURE

4. CREDIT RISKS BY SHARIAH CONTRACT4. CREDIT RISKS BY SHARIAH CONTRACT

5. CREDIT RISK MITIGATION

6. CREDIT RISK MONITORING AND MEASUREMENT

7. COLLECTIONS & RECOVERY

8. INTERNAL CAPITAL ADEQUACY ASSESSMENT PROCESS

9. Q&A

Risk management division 2

ISLAMIC BANKS AND THE FINANCIAL CRISIS

Risk Management Division 3

15 TRILLION US DOLLARS LOST

More than cumulative profits of global banks in history of banking


1 5,0 0 0,0 0 0,0 0 0,0 0 0

ISLAMIC BANKS WERE MOSTLY SPARED

Three main reasons

-No exposure to derivatives, CDO’s, MBO’s. Financing rooted in real economy

-No international exposures; mostly locally focused bank’s with high proportion of financing activity focused on retail banking

-High capital ratio’s, mostly comprising common equity


BUT EUROZONE CRISIS CAN CONTINUE TO AFFECT

Islamic Banks could face second round effects

-Real Estate crash (Islamic banks with exposure in Europe?)

-High exposure to assets of which credit quality and liquidity are uncertain (equities, corporate finance)

-Difficult to find high yielding alternative asset classes to invest in without having to compromise on risk profile.

-High exposure to government sponsored infrastructure projects which could be affected if local economies start to feel impact of continued global risks


EUROZONE CRISIS

From bail-out to bail-in


BAIL-IN AKIN TO ISLAMIC BANKING MODEL?

Investment Account Holders can lose (part of) notional

-IAH’s share in profit with bank, but are liable to credit and market risk losses

- Strong relationship between IAH and underlying investment (asset). Partnership model

-Will this bail-in help or hurt Islamic Banking model?


Loss in confidence in Bank’s have resulted in

significant inflows in physical gold and even virtual

currencies such as bitcoin

RISKS IN ISLAMIC BANKS


RISK PROFILE OF ISLAMIC BANK

Financial Risk Business Risk Treasury Risk Governance Risk

Credit Risk Operational RiskALM RiskRoR Risk

Risk Management Division1

0

Market Risk

Equity Risk

Solvency Risk Hedging Risk Reputation Risk

Transprncy Risk

Shariah Risk

Fiduciary Risk

Iqbal, Mirakhor: Introduction to Islamic Finance, theory and practice

Focus of Presentation


IFSB Guidelines based on international best practices

• Guiding Principles of Risk Management for IFS

IFSB-1


1

• Capital Adequacy Standard for IFS

IFSB-2

• Guiding Principles on Governance for IFS

IFSB-6

• Guiding Principles on Conduct of Business for IFS

IFSB-9

IFSB-1 PUBLISHED STANDARD

On Credit Risk

•IIFS shall have in place a strategy for financing, using various instruments, in compliance with Shariah, whereby it recognizes the potential credit exposures that may arise at different stages of the various financing agreements

Principle 2.1

Principle 2.2


2

•IIFS shall carry out a due diligence review in respect of counterparties prior to deciding on the choice of an appropriate Islamic financing instrumentPrinciple 2.2

•IIFS shall have in place appropriate methodologies for measuring and reporting the credit risk exposures arising under each Islamic financing instrumentPrinciple 2.3

•IIFS shall have in place Shariah compliant credit risk mitigating techniques appropriate for each Islamic financing instrumentPrinciple 2.4


Based on best practices

• Risk Acceptance Risk Control

• Preventive


3

• Risk Acceptance Criteria

• Risk Policies

• Application Scorecards

Underwriting Standards

• (Limit) Monitoring

• Watchlists

• Vintage/Month on Book analyses

• Segmentation

Risk Control• Preventive

management (x-days)

• Rescheduling

• Special debt collection campaigns

Credit Recovery

Feedback Loop

CREDIT RISK GOVERNANCE AND CULTURE


4

CREDIT GOVERNANCE STRUCTURE AT BANK ISLAM

Board Financing

Risk Committee BoardBoard Risk

Committee


5

Business Credit Risk Analysis

Financing

Committee A

Financing

Committee B

Underwriting and

Committee

Underwriting and

Investment

Committee Management

CRO

CULTURE

Most important element in a bank!

“The norms and

� Horizontal information sharing

� Vertical escalation of threats or

fears


6

“The norms and

traditions of behavior of

individuals and of

groups within an

organization that

determine the way in

which they identify,

understand, discuss and

act upon the risks the

organization confronts

and the risk it takes”

� Continuous and constructive

challenging of the organization’s

actions and preconceptions

� Committed leadership

� Incentives that reward thinking

about the whole organization

CREDIT RISKS BY SHARIAH CONTRACT


7


Ijarah

-In case of a non-binding Ijarah, the Bank runs the risk of having to sell the asset at a (much) lower price. Bank also runs the risk of residual vale at end of the lease.

- Normal credit risks with respect to

Asset

- Normal credit risks with respect to periodical payments of installments.


8

Customer

Fund Flow


Commodity Murabahah / Tawarruq

-Exposed when Bank delivers asset to Customer but does not receive payment on time. Higher risk in non-binding MPO.

- The sequence of the ownership transfer of asset and the fact that 2 traders are involved

Customer

1 3 5 6

asset and the fact that 2 traders are involved could expose the Bank to price risk.

-Normal credit risks of non-payment or not according to contract during the life of the transaction


9

Commodity

Trader 1

Commodity

Trader 1

Commodity

Trader 2

Commodity

Trader 2

Asset/Commodity Flow

Fund Flow

2 4


Mudharabah Financing

-Principal – Agent problems; Adverse selection by Customer (info asymmetry)

-Risk especially high when info asymmetry is high and in cases of low transparency (in case Bank does not have appropriate rights

PSRX% case Bank does not have appropriate rights

to monitor participate in management of project)

-In case if misconduct/negligence of customer, Bank’s share of capital is transformed into debt liability (different rules apply to recovering debt)

-Higher capital credit charge


0

Customer

Business

Venture /

Project

Fund Flow

Profit Loss

PSR

X%

1-X%


Salam / Istisna

-Bank is exposed to failure of customer to supply on time or at all, or if specifications of goods/project are not according to agreement. Hence payment could not be secured by selling commodities or project.

-Bank usually enter into parallel Salam/Istisna, but contracts must not be linked. Hence if one leg falls away, the bank is still liable to perform under the other leg.


1

Customer

(Today)

Customer

(delivery)

Asset/Commodity Flow

Fund Flow

CREDIT RISK MITIGATION


2


Techniques

-Know your Client / Enhanced Due Diligence

-Application Scoring Models

-Shariah Compliant Enforceable Collateral and Guarantees-Shariah Compliant Enforceable Collateral and Guarantees

-Clear Documentation

-Operational Considerations

-Proactive Monitoring

-Active Monitoring by Recovery Team


3


Shariah compliant techniques (a few examples)

• Must be Shariah Compliant and of monetary value

• May be underlying or other asset

Pledge of Asset


4

• Without any consideration received from guarantor

• May or may have recourse to debtor

Third Party Guarantee

• May be wadiah or SIA/GIA

Cash

• As collateral in case of default by lessee

Leased assets under Ijarah


Credit Related Operational Risks

-Higher in Islamic Banks than Conventional Banks

-Complex contracts, limited knowledge by staff, systems sometimes not accommodative

-Cancellation risks in non binding murabahah and Istisna contracts-Cancellation risks in non binding murabahah and Istisna contracts

-Difficulty in enforcing Islamic contracts (higher legal risks)

-Shariah non-compliance risks

-Commodity inventory related operational risks (in case inventory is held)


5

CREDIT RISK MONITORING AND MEASUREMENT


6

CREDIT RISK MONITORING

Techniques

-Watchlist

-Credit and Customer Profiling (example next slide)

-Pro active monitoring (early detection system)-Pro active monitoring (early detection system)

-Post mortem reviews

-Sector reviews

-Stress Testing


7

CREDIT RISK MONITORING

Customer Segmentation (Example)

56%

44%

60%

40%

20%

30%

40%

50%

60%

70%Gender - Dec 2010

23%

19%

20%

18%15%

6%

25%

19% 19%

16%

12%9%

10%

15%

20%

25%

30%

Age Bracket- Dec 2010TOS%

5%7%

43%

24%

13%

5%3%

25%

35%

18%

11%20%

30%

40%

50%

60%

70%

Financing Size- Dec 2010TOS%


8

1% 0%0%

10%

Male FemaleTOS% NPF Rate %

6%

1% 1% 0% 0% 1%1%

0%

5% 0%2% 5%

7%5%

0% 1%1%

3%11%

3% 2% 1%1% 1% 0% 0%0%

0%

10%

2%

25%

48%

14% 11%

2%

19%

47%

14%19%

3%1% 0% 0% 0%

0%

10%

20%

30%

40%

50%

60%

Income Bracket- Dec 2010TOS%

0% 3% 5%

53%

38%

1%0%5% 6%

55%

33%

0%0%

0% 1% 1% 0% 4%

0%

20%

40%

60%

80%

100%

Tenor Bracket- Dec 2010TOS%

40%

22%

8%7% 5%

4% 3% 3% 2% 1%4%

29%30%

9% 8%

2% 3% 5% 3%1%

5%4%0% 1% 0%1% 1% 1% 0% 0% 2% 0%1%

0%

10%

20%

30%

40%

50%

Top 10 Occupations Dec 2010TOS %

COLLECTIONS & RECOVERY


9

COLLECTIONS & RECOVERY DEFINITIONS

Collection

A procedure aimed at obtaining the repayment of a

debt after the obligation payment due date. Preventing

account from being impaired or loss.

Recovery

P

a

g

e Risk Management Division

Recovery

A process to collect money still owed on accounts after

the financial institution has classified the account as

impaired or has written off the account as a loss.

COLLECTIONS & RECOVERY OBJECTIVES

� Maintaining delinquencies/ losses within acceptable limits

� Generate loss recoveries at desired levels

� Counsel clients who are experiencing difficulty in handling debts

P

a

g


� Ensure consistency with FI’s objectives

� Manage collection and recovery costs efficiently

COLLECTION TOOLS & APPROACH

� Collection system

To assist better management of delinquent accounts

� Reminder letter

Letter to reminder customers on their overdue payment at various delinquent

stage

P

a

g


� Auto Dialer

Automated dialer machine to improve contact rate

� Short Messaging System (SMS)

Short & Precise message to reminder customers on their overdue payment.

� Internet and Email

To locate customer’s contact and email reminder from the Bank to notify

customers on their overdue payment.

COLLECTION TOOLS & APPROACH

� Outsourcing to External Agency

To locate un-contactable and avoiding customers

� Legal Action

Legal proceeding to accelerate recoveries process

P

a

g


� Internal Reschedule & Restructure

Risk mitigation program designed to assist customers in financial distress.

� External Arrangement (AKPK for Consumer/ SDRS for Commercial/ Corporate

Financing)

BNM initiatives to assist customer’s / Company that is in financial distress.

DIFFERENCE BETWEEN ISLAMIC VS. CONVENTIONAL BANK

ISLAMIC BANKS CONVENTIONAL BANKS

The functions and operating modes of

Islamic banks are based on the principles of

Islamic Shariah.

The functions and operating modes of

conventional banks are based on fully

manmade principles (largely capitalism

theory).

Islamic banks have no provision to charge It can charge additional money (penalty

P

a

g


Islamic banks have no provision to charge

any extra money from the defaulters

except for compensation (typically such

proceeds is given to charity). Rebates early

settlement at the Bank's discretion.

It can charge additional money (penalty

and compounded interest) in case of

defaulters. i.e. Later Charges

New AQAD for any change of term and

condition of a facility i.e. restructure

program

Not required

INTERNAL CAPITAL ADEQUACY ASSESSMENT

PROCESS

ICAAP


5

ICAAP

Measurement of risk and required capital under BIS2

Integration of risk and capital in

strategic decisions and planningPillar 1 risks Pillar 2 risks External factors

Risk governance and control

Credit risk

data issues

Credit risk

Country &

transfer risk

Concentratio

n risk Stress tests / scenarios

Risk appetite / capital

management

Coherence of risks

and results (EL vs LLP)

Roles and

responsibilities

• Supervisory Board

• Executive

Committee


6

Market Risk

Market risk

data issues

BIS1 Model risk

Legal risk

Interest rate

risk bank

book

Liquidity risk

Business risk

Strategic risks

Operational

RiskMacro-economic

risksRisk based pricing

Risk adjusted

performance

management

Active credit portfolio

and capital

management

Business planning and

budgeting

management Committee

• Internal audit

• Risk Department

• Finance

Department

• Strategic Planning

• Investor relations

• Branches

Risk governance

• Committees

• Limit system

• Reporting

• Escalations

Minimum Standards for

risk

• Independent

internal control

• Sound risk

assessment

• Risk disclosureRisk Issues Finance IssuesCorporate

Governance

ICA

AP

ICAAP

Specific Credit Risk Issues

-Adequacy of credit risk capital provided under Pillar 1 (compare standardised method with ‘pseudo’ IRB method.

-Credit Migration (PD)

-Credit Mitigation (LGD)

-Single name concentration risk (Herfindahl Hirschmann method)

-Sector concentration risk

-Geographical risk

-Credit Stress Testing (different Shariah contracts might different treatment)


7

THANK YOU

www.bankislam.com.my


THANK YOU

Jeroen P.M.M. Thijs

Chief Risk Officer

[email protected]

credit risk management in islamicbanks - bank · pdf filebail-in akin to islamicbanking model?...

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