market driven or shariaa driven
DESCRIPTION
published by Data investment consult lebanon CEO - Mr Maan Barazy thjis paper looks at ilamic finance adaptability to Basel 3 0 - In the aftermath of the global financial crisis and the financial stability forum of the IMF and the Basel III regime, effective liquidity risk management is denoted in this paper as a multiple equilibria between the challenge for compliance and the quest for Sharia’ah debt driven instruments is seen crucial for the sustainability of risk islamic banking. This paper looks towards the profitability of Islamic instruments and where their core risks. It also argues that the issue of sukuks and the compliance effort towards Basel laws are not helping islamic financeTRANSCRIPT
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D ATA& I N V E S T M E NT C O N S U LT M I D D L E E A S T A N A LY T I C S
R I S K R E S E A R C H
D A T A I N V E S T C O N S U L T . C O M
Sharia’ah Driven or Market Driven?
Effective Liquidity Risk management as a Multiple
Equilibria between The Challenge for Compliance and
the Quest for Islamic Debt Driven Instruments
By Ma’an Barazy Certified Islamic Sharia Advisor and Auditor – AAOIFI – President/CEO Data and
Investment Consult Lebanon – The Center for Islamic Finance
Last Update: February2012
ABSTRACT : In the aftermath of the global financial crisis and the financial stability forum of
the IMF and the Basel III regime, effective liquidity risk management is denoted in this paper
as a multiple equilibria between the challenge for compliance and the quest for Sharia’ah debt
driven instruments is seen crucial for the sustainability of risk islamic banking. This paper looks
towards the profitability of Islamic instruments and where their core risks. It also argues that
the issue of sukuks and the compliance effort towards Basel laws are not helping islamic finance
M A R K E T A L E R T R E A S O N F O R R E P O R T :
B A S L E I I I H E A T S U P
Inside Whereas the conventional financial system focuses primarily on the economic and financial aspects of transactions, the Islamic system places equal emphasis on the ethical, moral, social, and religious dimensions, to enhance equality and fairness for the good of society as a whole. The system can be fully appreciated only in the context of Islam's teachings on the work ethic, wealth distribution, social and economic justice, and the role of the state.
Analyst : Maan Barazy BS- MA – CISAA- AAOIFI –
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to provide practical solutions and directional credibility in promoting the role and scope of
Maqasid al Shari’ah (Objectives of Shari’ah) and maslaha (Public Interest); governance and
measured reinterpretation of principles of fiqh-ul muamlaat (jurisprudence of transactions) by
dynamic ijtehad (the making of a Shari’ah decision by personal effort, independent of any
school of thought) leading to the standardisation of cross border regulatory and tax regimes and
a legal architecture that is secure and capable of being enforced.
KEYWORDS: Liquidity Risk; Islamic Compliance; Sukuks; Debt; Basel Laws; Maqasid Al
Shari’ah
The paper will be divided into three parts. First part will explain the current situation of IFIs,
explaining the factors behind their growth in local and international markets and discusses the
advantages of IFIs’ system that makes them unique and attractive to all customers. Secondly, it
will present a model discussing the two types of challenges before IFIs internationalization:
challenges as recognition of their activities versus the maqasid al Shari’ah. The paper also looks
at the other set of challenges existing in liquidity management of IFIs and the challenge of
compliance within the internationalization of basle laws. Thirdly, the paper will provide some
solutions that can be implemented to facilitate the process of internationalization and provide
practical solutions and directional credibility in promoting the role and scope of Maqasid al
Shari’ah (Objectives of Shari’ah) and maslaha (Public Interest); governance and measured
reinterpretation of principles of fiqh-ul muamlaat (jurisprudence of transactions)in IFIs.
The global financial crisis has brought to the forefront wide issues, including re-evaluation and
internationalization of standards and the need for vital reforms however there is a need for
international bodies to look at the Islamic finance system with its link to the real economy, and
emphasis on transparency and disclosure.
Sharia’ah standards could take a lead in developing international standards for the new
financial regulatory architecture. The state of the Islamic banking system and its financial
arm is widening according to global consultancy Ernst and Young, the global Islamic
Finance will hit the mark of 1.1 trillion U.S. dollars in 2012, up from 826 billion dollars in
20111. However, a closer look at recent developments reveals a mixed picture. Profits of
Islamic institutions are not as stable2 as the trend suggests and Islamic banking systems are
caught in more than a challenge the most pressing of all is compliance and standardization
1 During the pioneer days in Islamic Finance from 2000 to 2005, profit growth rates of over 300 percent per year were quite common. In October last year, another Islamic lender Dubai Bank was taken over by the United Arab Emirates (UAE)'s largest
bank Emirates NBD at the order of the Dubai government. Dubai Bank posted a net loss of 290.6 million Dirham (79 million dollars) in 2009 and had since then not reported figures anymore. 2 While for example the Middle East's oldest Shari'ah-institution Dubai Islamic Bank (DIB) achieved a 2011-net profit of 1 billion Dirham (272.7 million dollars), an increase of 27.8 percent compared to 2010, DIB's rival Emirates Islamic Bank (EIB), on the other hand, lost 448 million Dirham (122 million dollars) last year, down from a profit of 59.43 million Dirham (16.18 million dollars) the previous year, as the EIB suffered losses with securities investments.
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of procedures as islamic finance is threaten with the quest for a multiple equilibria between
the challenge for compliance and the quest for Sharia’ah debt driven instruments
Basel III was born, focusing on regulating solvency and liquidity to ensure banks have sufficient
capital to return deposits in the event of a crisis and are able to survive a protracted liquidity
freeze, whilst being less dependent on the vagaries of short term credit markets. With the BIS
(Bank for International Settlements) releasing new regulations for capital framework and
liquidity management, banks can start assessing and adapting their systems to ensure they are
compliant, however, does Basel II or III rationale really apply to the Islamic banks?
The Islamic banks are not allowed predetermined fixed return from debt or loan according to
Shariah principals. They mobilize funds on the basis of profit and risk sharing. The relationship
between Islamic banks and its customers is not of debtor and debtee rather it is of investor and
investee based on partnership. The distinct nature of relationship with customers and different
kinds of financing and investing activities entail unique risks besides general risks faced by the
Islamic banks. Furthermore, the scope and intensity of different risks are not similar to both type
of banking. For instance, Islamic banks face market risk both on their banking book and trading
book transactions whereas conventional bank face market risk only on their trading book
transactions.
Such differences in liability side and asset side items of Islamic banks from conventional banks
and unique nature of risks face by the Islamic banks involve various challenges for compliance
of Basel II capital adequacy requirements for Islamic banks. Basel II guidelines disregard the
sources of funds for conventional banks and assess risks arising from uses of funds to safeguard
the interest of depositors for full repayment of their money. However, in Islamic banks the
investment accounts are profit and risk sharing contracts. The Islamic banks neither guarantee
payment of any return nor liable to repay principal in full. In case of losses, both the shareholders
equity and investment accounts absorb losses. According to AAOIFI standards, the restricted
investment accounts are classified as off balance sheet items and unrestricted investment
accounts are lie between deposits and equity. This unique nature of investment accounts as
sources of funds create challenges to comply with the guidelines of Basel II capital adequacy
requirements. The AAOIFI proposed to include 50% of the risk weighted assets financed by the
investment accounts in calculation of capital adequacy ratio.
However, this proposal overlooked the asset side of the Islamic bank. The assets of Islamic
banks are generally backed by real estate or commodities which entail more risks than
conventional banks. Thus risk weighted assets of Islamic banks are likely to be more than
conventional banks. The IFSB, however, in its standard for capital adequacy proposed to cover
the different risks faced by the Islamic banks in line with the Basel II guidelines such as credit,
market and operational risks and assign risk weights to different Islamic financial activities.
While considering profit and risk sharing sources of funds, it excludes the risk weighted assets
that are financed by the investment accounts.
Both AAIFI and IFSB agreed to maintain 8% CAR proposed by the Basel II for Islamic banks.
However, some of the research studies proposed higher level of capital adequacy for Islamic
banks than the conventional banks. The Islamic banks are also facing some other challenges
which include non availability of alternatives to derivatives and exposed to more liquidity risk
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compared to conventional banks. Basel II capital adequacy requirements emphasize using
derivatives for hedging but Islamic banks are not allowed to use such instruments due to non
Shariah compliant nature. The alternatives to these hedging instruments are still limited to
Islamic banks. Furthermore, the Islamic banks are exposed more liquidity risk due to
undeveloped short term money market for Islamic financial instruments.
The Islamic banks while facing unique and somewhat extra risks, compared to conventional
banks, can implement Basel II capital adequacy requirements with certain modifications
according to the distinct nature of Islamic financial activities, with accommodating differences in
liability side and devising different risk weights on asset side of their balance sheets. Nonetheless
they have to focus on developing short term money market for liquidity management, to develop
alternative to Shariah compliant derivatives, and last but not least to develop standardized
Islamic products to avoid Shariah non-compliance risk.
Further, exposure to other investment risks stemming from equity markets, sukuk, real-estate and
ownership stakes in other businesses remain a source of concern when overdone or undertaken
purely for speculative gains. Such investments at global level also bring in currency risk into the
market risk. However, this is of lesser concern to banks in the GCC where the currency is pegged
to US dollar than to Islamic banks in other MENA countries and other parts of the world. Islamic
banks, are some of the best capitalized in the world and show capital levels that far exceed the
regulatory requirement. However, the Islamic finance industry is still faced with several
weaknesses and challenges that may undermine its progress. These include the lack of
customized prudential standards for Islamic financial institutions (IFIs) in many jurisdictions
where Islamic finance is practiced; accounting and auditing standards for IFIs similarly are not
fully developed; the legal underpinning of Islamic transactions are not yet robust especially in
the case of dispute there remains uncertainty whether the court ruling is based on Sharia’ah or
civil law; there is also uncertainty of how insolvency and default should be handled; the different
interpretations of Sharia’ah rulings across the jurisdictions; the lack of standard documentation
which in turn contributes to the high cost of transactions and financing and the pressing issue of
liquidity management in Islamic finance.
The rapid growth of the Islamic finance industry has also exposed the global shortage of skilled
and experienced professionals in the sector. There is also a scarcity of Sharia’ah scholars with
adequate knowledge of banking and finance. In addition, there has been relatively little research
on the functioning of Islamic financial systems around the world. Sukuk and infrastructure
should be a natural fit. While the sukuk market has flourished over the last four years, these have
concentrated more on raising finance for balance sheet purposes; refinancing existing more
expensive debt including very often conventional finance debt; overcoming the mismatch
between short-term deposits and longer term liabilities by raising longer term financing; and
providing working capital and funds for expansion.
Given that Islamic banks are liquid and inherently risk averse, the sector avoided many of the
speculative products that contributed to the recent economic turmoil. Nevertheless, Islamic banks
were not totally immune to the situation: many were left exposed due to over-expansion and
excessive risk concentrations, notably in the real estate sector.
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Financial institutions must have more and higher quality tier 1 capital (which includes common
equity and certain minority interests, as well as deferred tax assets). Tier 1 capital must be fully
effective at absorbing losses and tier 2 capital (which includes undisclosed reserves, revaluation
reserves, general provisions, hybrid instruments and subordinated term debt) must absorb more
losses in order to protect capital. Capital, which is additional to minimum capital requirements, is
needed to address systemic and procyclicality risks.
The first point to note is that the capital structures of the significant majority of Sharia’a-
compliant banks are dominated by tier 1 capital in common equity form, often in excess of 80
per cent of capital resources. In addition, most have capital adequacy ratios noticeably higher
than those seen in the conventional banking sector. The reasons for this can be explained by a
combination of complexities and Sharia’a prohibitions in raising alternative and lower quality
forms of capital, which result in: • The lack of Islamic subordinated debt.
• The lack of hybrid and callable capital structures due to the prohibition of Gharar
(conditionality and uncertainty). As a consequence of these factors, the capital structures and
above average capital ratios of Sharia’a financial institutions put them in a favourable
position relative to many of their conventional counterparts. The capital adequacy positions
of Sharia’a-compliant banks will also benefit from:-
• The modest role of Trading Book businesses as Sharia’a principles prohibit short selling and
impose strict limitations on the use of derivatives. Sharia’a financial institutions will be
negligibly impacted by the higher capital charges for such operations.
• The modest and very limited use of derivatives and securitised structures by Sharia’a-
compliant banks will result in not being adversely impacted by the additional capital charges
that are being applied to address the inherent risks in such products (e.g. wrong way risk).
• The lack of leverage and contingent risks, auger well for Islamic banks in so far as the new
leverage ratio is unlikely to have anything more than a very modest impact.
• Liquidity is, however, one area where both conventional and Sharia’a-compliant banks are
likely to be impacted in different ways. Firstly, there remains a dearth of liquid Islamic
instruments. Despite progress in the deepening of Islamic liquidity markets, notably the
increased Sukuk issuance by the AAA rated Islamic Development Bank, there is a lack of
eligible liquidity instruments and central bank facilities. However, these limitations are offset
by the relative lack of contingent and leveraged liquidity risk; a generally low reliance on
interbank funding; and for many banks strong depositor loyalty.
• The lack of meaningful levels of preference shares, even in Sharia’a jurisdictions that permit
this form of capital.
Unavailability of hedging instruments for Islamic financial institutions was used to be cited as a
hurdle in the growth of these institutions, but during the crisis this perceived weakness became a
strengthening factor for them Islamic banks have a large amount of liquidity and thus have kept a
larger proportion of their assets in liquid form than their conventional counterparts. Islamic
commercial banks in the GCC region enjoy a large liquidity buffer in the form of high reliance
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on retail depositor base, a large part of these deposits consisting of non remunerated current
accounts. At the same time, Islamic investment banks are exposed to whole sale funding and
private funds.
Interpreting the system as “interest free” tends to create confusion. The philosophical foundation
of an Islamic financial system goes beyond the interaction of factors of production and economic
behavior.
Whereas the conventional financial system focuses primarily on the economic and financial
aspects of transactions, the Islamic system places equal emphasis on the ethical, moral, social,
and religious dimensions, to enhance equality and fairness for the good of society as a whole.
The system can be fully appreciated only in the context of Islam's teachings on the work ethic,
wealth distribution, social and economic justice, and the role of the state.
The Islamic financial system is founded on the absolute prohibition of the payment or receipt of
any predetermined, guaranteed rate of return. This closes the door to the concept of interest and
precludes the use of debt-based instruments. The system encourages risk-sharing, promotes
entrepreneurship, discourages speculative behavior, and emphasizes the sanctity of contracts.
This is a view that I feel confident to share as close to the Maqasid of al Sharia’ah and a view
close to the development of man and its spiritual goals in life. Having said that one can sense that
the recent explosion of debt driven instruments and their allocation efficiency occurs in the IFIs
because investment alternatives are strictly selected based on their productivity and the expected
rate of return.
Islamic banking and the global crisis
As the global financial crisis became a global economic crisis, it has started to affect Islamic
banks and financial institutions in an indirect manner. The business model of many Islamic
banks that relied on murabaha financing and predominantly invested only in the real estate sector
and in the previously growing equity markets is now facing higher risks.
The Basel II regime for capital adequacy failed to prevent the financial crisis. Hopefully the
proposed Basel III provisions are aimed to strengthen the risk management and micro-prudential
regulation of the financial system and to boost its resilience and soundness. In the Islamic
finance space, it is important to ensure that the regulatory and supervisory framework is
consistent with global financial reforms, especially in the context of Islamic finance increasingly
becoming mainstream and integrated into the global financial system. In this connection, the
IFSB itself has announced that it was preparing exposure drafts of two new standards on
liquidity risk management. These standards will complement Basel III liquidity standards by
providing guidance on Basel III's application to Islamic financial institutions.
The Islamic banking sector has demonstrated more resilience against the financial crisis mainly
due to avoidance of interest. The requirement to abstain from interest made their financing
activities more tied to real economy and also required them to avoid exposure to toxic financial
derivatives. The commercial risk associated with Islamic banking activities and the non-
availability of lender of last resort facility to these banks also forced them to hold liquid assets in
greater proportion than their conventional counterparts. All these factors helped them during the
crisis. The impact of the crisis came to these banks late and indirectly through a slowdown in the
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real economy. Some banks were affected due to their asset concentration in the real estate sector.
However, there was no case of failure of Islamic bank in the region
The World Bank Group has formally recognized Islamic finance and have designated it a priority
area in its financial sector program. The World Bank's strategy for Islamic finance is based on
four pillars - capacity building and knowledge management; influencing policy and market
development; diagnostic work and analysis in the industry; and providing technical assistance
especially in developing a regulatory framework. The World Bank has always closely cooperated
with the Islamic financial services sector. This demonstrates our commitment to help strengthen
the institutional development of the industry. In Sudan in the Islamic microfinance space, we
have a full program which we hope to see develop to cover other countries and sectors. The
World Bank will play a positive role in industrial development and economic growth, as such.
The World Islamic Banking Competitiveness Report launched at the World Islamic
Banking Conference in Bahrain highlighted that following the 2008-2009 slowdown, 2010
has witnessed clear signs of a global economic revival with the GCC and key markets for
Islamic finance outperforming the rest of the world. In fact the report predicted that the
Islamic finance industry will grow to $1.1 trillion by the end of 2012, a 33% increase on
2010. The report also noted, however, that despite strong growth, profitability has declined
and the road ahead is challenging. In order to meet market expectations, Islamic banks will
have to improve operational performance by learning from conventional banks and
capture new pockets of growth.
According to the report, the small and medium-sized enterprise (SME) and mid-market segments
offer significant opportunity for banks, particularly in emerging markets, given that the SME and
mid-market segments account for approximately 25-35% of loan volumes and are growing faster
than the rest of the market. The report pointed out that in addition to filling selected gaps in
product portfolios through investment in product development, Islamic banks must also
aggressively bolster sales models and design tailored credit strategies for SME and mid-market
segments in order to seize the opportunity they provide.
The report noted that going forward, retail banking will be one of the key drivers of banking
revenue growth in the Middle East and capturing the affluent banking customer segment will be
critical. It also noted that Islamic banks have the opportunity to grow beyond their core
principles but that they are increasingly facing stiff competition from conventional banks who
offer Islamic products. As a result, it is critical for Islamic banks to develop a compelling value
proposition in order to attract affluent customers, which will require defining core elements
including the relationship model, branding, the service model and product offerings.
Exploring the growth opportunities that takaful offers in the GCC market, the report suggested
that, although the GCC insurance market has grown rapidly, it is still under-penetrated. Takaful
insurance represents approximately 36% of the total premiums in key markets and continues to
gain a larger share of the total insurance premium. Despite the faster growth, however, takaful
operators’ Return on Equity (RoE) is lower compared to conventional players. The report said
that strong growth in population in the GCC and a high and fast growing GDP per capita and
private consumption is likely to propel the growth of takaful. With a mix of good demographics
and positive steps in regulation takaful operators are likely to boost their future profits.
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Providing an in-depth analysis on how Islamic banks need to change the way they measure
performance in a liquidity and capital constrained world, the report said that since the crisis in
2008, capital and liquidity pressures have not eased and in order to manage capital and liquidity,
Islamic banks need to ensure that they increase transparency and put in place greater
management discipline and oversight. According to the report, banks need to re-assess their
internal asset and liability pricing for both liquidity and their cost of capital and include it in their
business unit profit calculations
IFIs Risks
In Islamic banks, equity must be interpreted to include the equity of shareholders and the equity
of the owners of unrestricted deposits because the latter carry their share of the risk of losses by
virtue of the Mudarabah contract. Elements of fairness must be taken into consideration in
distributing the losses as well as in distributing equity charges between the share holders and
owners of unrestricted deposits.
The portion of operational-risks minimum capital charges to share holders in Islamic banks is
apparently lower than their counterpart in the conventional banks. Here again the reason is the
Mudarabah contract that does not charge the Mudareb for losses not-resulting from negligence,
fraud or violation of contract including violation of normal and customary professional standard
practices. This means that while the parameters of operational risk weighing and minimum
equity calculation in Islamic banks may be the same as in their conventional counterpart, the
capital burden on shareholders should be lower than that in conventional banks. Trading book
risks, in their literal sense, rarely exist in Islamic banks but quasi-trading book risks are much
higher in I Bs than in the conventional banks. Here again, capital charges should be carried by
both shareholders and owners of unrestricted deposits. Although the supervisory authorities in
countries where there are Islamic banks did not yet fully apply the review procedures suggested
in Pillar 2 of the New Basel Accord, the application of these proposals does not pose any
theoretical or practical impediment to Islamic banking or to Islamic modes of financing.
The same also applies to the disclosure requirements of Pillar 3 since whatever the existing level
of disclosure in Islamic bank may be, the additional information and their standardization do not
pose any theoretical or practical difficulties more than they do for conventional banks.
Liquidity risks ; Market or Sharia’ah driven?
High liquidity in IFIS exists for two reasons:
(1) Given that there is no lender of last resort (LOLR) facility available to Islamic banks, and
given that they do not have access to market liquidity in the form of the interbank market, high
liquidity was maintained purposefully by Islamic banks for risk management purpose.
(2) Excess liquidity prevailed also due to lack of interest-free short-term investment
opportunities as real economic investments require some gestation period. In some parts of the
world such as the GCC region, the liquidity position of Islamic banks had been quite high. For
example, the ratio of liquid assets to total assets was 21.14 percent for Islamic banks in the GCC
during 2007.
Most of the financing activity of Islamic institutions is is being done through murabaha and
ijarah modes followed by that through Istisna financing. For example, of the total financing
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activity of Islamic banks in the GCC region, during 2007 murabaha comprised of 65.4 percent,
ijarah 12.78 percent and istisna 3.83 percent. In a study sample of 30 banks from 9 countries3,
murabaha constituted more than 90 percent of financing activity in Kuwait, UAE and Yemen;
just less than 50 percent in Bahrain; and between 60 to 80 percent in rest of the countries during
the year 2008.
First, Islamic banks’ financing activities are more tied to real economic activities than their
conventional counterparts. Though profit and loss sharing modes of musharakah and mudharbah
provide better risk sharing . On the average, for overall MENA region, the proportion of the real
sector murabaha in total financing was 75 percent during the same year. Murabaha and ijarah
transactions require Islamic banks to know the client‟s purpose and use of finance. These modes
also require ownership of the asset by the bank, albeit for shorter duration in case of murabaha
and longer duration in case of ijarah finance.
This increases the likelihood (or ensures) that the funds are used for their stated purposes.
Thus, it keeps credit tied to real economic activity for each transaction and throughout the tenor
of contract. In conventional bank financing the client is not required to disclose the use of funds
as long as the client is believed creditworthy or can post suitable collateral While ijarah,
murabaha and istisna provide credit, they do so against usufruct, commodity and a future
tangible asset. The credit thus created cannot be easily rolled over. Thus, these modes keep a tab
on the ballooning of debt and credit, again maintaining a tie between the financial and the real
sectors. Recently the increasing practice of tawaruq by some Islamic banks was loosening the tie
of finance with real economic activity and contributing to easy rollover of debt. However, the
very recent fatwa of OIC Fiqh Academy on the prohibition of organized tawaruq is expected to
stop its growth.
Islamic banks avoided direct exposure to exotic and toxic financial derivative products thus
evading them from international pressures. Because of Sharia’ah prohibition against riba and
gharar, the asset portfolio of Islamic banks did not include any CDOs, CMBSs, CDSs and the
like which turned out to be highly toxic for conventional banks and amplifying factor for the
crisis. These derivative products, initially created in the name of hedging needs became device
for highly speculative investments among conventional financial institutions.
The Islamic Financial Services Board (IFSB) has issued Exposure Drafts (EDs) on liquidity risk
management and stress testing for a three-month public consultation period lasting until the end
of 20114. The proposed document on liquidity risk management endeavours to delineate a set of
guiding principles for the robust management of liquidity risk by institutions offering Islamic
financial services (IIFS). In keeping with the objectives of the IFSB, the 22 guiding principles
aim to help develop a prudent, efficient and resilient Islamic financial services industry, thus
enhancing the stability of the overall financial systems in which Islamic financial institutions
operate.
3 Salman syed ali islamic development bank – Islamic Research And Training Institute February 2011 Islamic Banking In The Mena Region; The World Bank Islamic Development Bank- Islamic Research and Training Institute 4 The Islamic Financial Services Board Issue Consultation Documents on Liquidity Risk Management and Stress Testing
http://www.newhorizon-islamicbanking.com/index.cfm?action=view&id=11256§ion=news
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In addition to providing necessary conditions for effective liquidity risk management in the
Islamic financial services industry, these guiding principles outline among others:
1. the salient characteristics of the liquidity risk management process to be undertaken by
IIFS including identification, measurement, monitoring, control, reporting and mitigation;
2. the role of various components in the governance structure as well as that of different
functional and business units in ensuring robust and effective liquidity risk management
by IIFS;
3. the liquidity risk implications of various Islamic financing contracts during different
stages of operations;
4. the important ingredients of supervisory frameworks to monitor the liquidity positions
including initiatives for the development of a robust national liquidity infrastructure,
supervisors' contingency planning for IIFS and supervisors' roles as providers of Shari’ah
-compliant liquidity support to IIFS.
The proposed document on stress testing aims to provide a set of guiding principles intended to
complement the existing international stress testing framework taking into consideration the
specificities of IIFS as well as the lessons learned from the financial crisis so as to contribute to
the soundness and stability of the IIFS particularly as well as the Islamic financial services
industry as a whole.
The 22 guiding principles provide a framework for IIFS with the aim of guiding them in
assessing and capturing vulnerabilities under various stress-testing scenarios including extreme
but plausible shocks. The guiding principles include:
1. identifying how different portfolios respond to changes in key economic variables (for
example benchmark rates, foreign exchange rates and credit quality);
2. assessing the quality of assets to identify existing and potential loss exposures;
3. evaluating potential threats to the IIFS's ability to meet its financial obligations at any
time arising from either funding or market liquidity exposures;
4. estimating the impact of stress events on baseline profit (as profits normally act as the
first line of defence before dipping into capital);
5. analysing the IIFS's ability to meet its capital requirements at all times throughout a
easonably severe economic recession.
There are six guiding principles for supervisory authorities, which can be used as surveillance
tools for periodic assessment of the ‘safety and soundness’ of the financial system, and from a
financial stability perspective, an identification of 'weaknesses' in the financial system and
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structural (systemic) vulnerabilities arising from the specific risk profiles of IIFS individually
and collectively.
This is yet another step by the IFSB to address the liquidity problems faced by Islamic financial
institutions, which have been handicapped in the past by the lack of suitable short term, high
quality liquidity instruments. The first step was the establishment of the Islamic Liquidity
Management Corporation in early 2011, which was confidently expected to have launched its
first short term sukuk by the end of 2011. This latest step should have the effect of beginning to
close the gap with conventional financial institutions and putting Islamic financial institutions on
a more even footing with their conventional counterparts.
CONCLUSION In a nutshell, one can argue that:
1. Islamic bank have qualitatively similar credit risk to conventional banks, therefore the
processes of the calculation of minimum equity requirement for credit risk exposure should not
be different from the methodologies proposed for conventional banks. This means that the IBs
can go along with this part of the Basel II Proposed Accord and the supervisory
authorities would be fair in asking them to abide by these proposals.
2. In Islamic banks, equity must be interpreted to include the equity of shareholders and the
equity of the owners of unrestricted deposits because the latter carry their share of the risk of
losses by virtue of the mudarabah contract. Specifically the case of Bank al Taqwa that was
essentially ruined because of un-prudent placement of funds in these kinds of investment.
3. Elements of fairness must be taken into consideration in distributing the losses as
well as in distributing equity charges between the share holders and owners of unrestricted
deposits.
4. The portion of operational-risks minimum capital charges to share holders in Islamic banks is
apparently lower than their counterpart in the conventional banks. Here again the reason is the
mudarabah contract that does not charge the Mudareb for losses not-resulting from negligence,
fraud or violation of contract including violation of normal and customary professional standard
practises. This means that while the parameters of operational risk weighing and minimum
equity calculation in Islamic banks may be the same as in their conventional counterpart, the
capital burden on shareholders should be lower than that in conventional banks.
5. Trading book risks, in their literal sense, rarely exist in Islamic banks but quasi-trading book
risks are much higher in I Bs than in the conventional banks. Here again, capital charges should
be carried by both shareholders and owners of unrestricted deposits.
6. although the supervisory authorities in countries where there are Islamic banks did not yet
fully apply the review procedures suggested in Pillar 2 of the New Basel Accord, the application
of these proposals does not pose any theoretical or practical impediment to Islamic banking or to
Islamic modes of financing.
7. The same also applies to the disclosure requirements of Pillar 3 since whatever the existing
level of disclosure in Islamic bank may be, the additional information and their standardization
do not pose any theoretical or practical difficulties more than they do for conventional banks.
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