Principles and Practices of Islamic Banking

Khalifa M Ali Hassanain

Principles and Practices of Islamic Banking

Hassanain, Khalifa M

ISBN 9960-32-304-8 Islamic development Bank, 2016 King Fahd National library cataloging –Publication Data

Copy Rights Notice © Islamic research and Training Institute 2016 All rights reserved. All parts of this work are subject to sole ownership of Islamic research and Training Institute (hereinafter referred to as ‘Copyright Holder’) and remains exclusive property of the Copyright Holder. No part of this work may be copied, reproduced, adapted, distributed, modified or used in any other manner or media without prior written authorization of the Copyright Holder. Any unauthorized use of this work shall amount to copyright infringement and may give rise to civil and criminal liability. Enquiries and communications concerning authorization of usage may be made to the following: Islamic Research and Training Institute Member of the Islamic Development Bank Group P.O.Box 9201 - 21413 Jeddah Kingdom of Saudi Arabia E-Mail:[email protected] Disclaimer The content of these course have been developed solely for educational and training purposes. They are meant to reflect the state of knowledge in the area they cover. The content does reflect the opinion of the Islamic Development Bank Group (IDBG) nor the Islamic Research and Training Institute (IRTI). Acknowledgement This textbook was developed as part of the IRTI e-Learning Program (2010), which was established and managed by Dr. Ahmed Iskanderani and Dr. Khalifa M. Ali.

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Table of Contents Chapter 1 – Fundamentals of Islamic Financial Intermediation ...... 8 Chapter Introduction ...... 8 Islamic Intermediation Contracts ...... 9 Basic Nature of Islamic Financial Intermediation ...... 9 Understanding the Balance Sheet of an Islamic Bank ...... 9 Financing Instruments in Islamic Finance...... 11 Investing Instruments in Islamic Finance ...... 12 Types of Islamic Financial Institutions ...... 13 Chapter Summary ...... 16 Chapter 2 – Framework for Risk Analysis of Islamic Banks...... 17 Chapter Introduction ...... 17 Types of Risks for a Bank ...... 18 Basics of Risk Management ...... 19 Components of the Risk Management Process ...... 19 Motivation for a Better Risk Management Process ...... 21 Modes of Evaluation of a Bank ...... 21 Framework of Appraisal ...... 22 Analysis of the Overall Banking Sector ...... 23 Financial Analysis of Banks ...... 24 Framework for Risk Analysis of Banks ...... 25 Principles of an Effective Risk Analysis ...... 25 More Principles of an Effective Risk Analysis ...... 26 Analytical Tools ...... 27 Chapter Summary ...... 29 Chapter 3: Credit Risks with Assets and Their Management ...... 31 Chapter Introduction ...... 31 Standards and Types of Policies ...... 32 Policies to Reduce Credit Risk ...... 33 Credit Risks Specific to Islamic Banks...... 35 More Credit Risk Specific to Islamic Banks ...... 35 Analysis of Credit Risk in Asset Portfolio ...... 36 Credit Review of Individual Customers ...... 36 Interbank Deposits ...... 37 Review of Off- Balance Sheet Items ...... 38 Chapter Summary ...... 38 Chapter 4: Managing Nonperforming Assets ...... 38 Chapter Introduction ...... 38

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Review of Nonperforming Assets ...... 39 Reasons for an Increase in Nonperforming Assets ...... 39 What is Asset Classification? ...... 41 Rules of Asset Classification ...... 42 Loss Provisioning ...... 43 Standards for Level of Provisioning ...... 43 Approaches for Managing Asset Losses ...... 44 Workout Procedures ...... 44 Chapter Summary ...... 45 Chapter 5 – Operational and Specific Risks for Islamic Banks ...... 45 Chapter Introduction ...... 45 Operational Risks for Islamic Banks ...... 46 Adapting Basel III Measures for Islamic Banks ...... 47 Risks Arising from Islamic Banking Principles ...... 47 Practices to Manage Displaced Commercial Risk ...... 49 The Use of PER & IRR ...... 50 Managing Risk for Mudarabah Accounts ...... 50 Governance Issues in PER & IRR ...... 50 Fiduciary Risk...... 51 Consequences of Fiduciary Risk ...... 51 Reputational Risk...... 52 Chapter Summary ...... 53 Chapter 6 – Asset Liability Management and Liquidity Risk ...... 53 Chapter Introduction ...... 53 The Main Risks for Islamic Banks ...... 53 ALM and Islamic Banks ...... 54 The Risk of ALM for Islamic Banks ...... 55 Deviations That Increase the ALM Risk ...... 55 Liquidity Risk ...... 56 Approach to Liquidity Management ...... 57 Determining and Fulfilling Liquidity Needs ...... 57 Liquidity Risk for Islamic Banks ...... 58 Liquidity Risk Mitigation by IFIs ...... 58 Chapter Summary ...... 59 Chapter 7: Market Risk ...... 59 Chapter Introduction ...... 59 Market Risk ...... 60 Price Volatility ...... 61 Types of Market Risks for IFIs ...... 61

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Market Risk from Mudarabah and Musharakah ...... 64 Issues due to Mudarabah and Musharakah ...... 65 More Market Risks for IFIs ...... 66 Measuring Market Risk ...... 67 Value at Risk (VAR) Model ...... 67 Value at Risk (VAR) Model – Calculation ...... 68 The Table-based Measurement Model ...... 68 Other Measurement Tools ...... 69 Measuring Market Risk for IFIs ...... 69 Liquidity and Duration Gap Measures ...... 70 Rate-of-Return Risk for IFIs ...... 70 Managing Market Risk for IFIs ...... 71 Mark-to-Market ...... 71 Position Limits ...... 72 Stop-Loss Requirements ...... 72 Limits to New Market Presence ...... 73 Marking to Market for IFIs ...... 73 Effective Market Risk Measurement and Management...... 74 Chapter Summary ...... 76 Chapter 8: Governance in Islamic Banks ...... 77 Chapter Introduction ...... 77 Basis for the Governance Model in Islamic Finance...... 78 Basel III Core Principles Regarding Bank Supervision ...... 78 Basel III Core Principles and IFIs ...... 79 The Role of the Sharī‘ah Board ...... 80 Issues for Sharī‘ah Boards ...... 81 Other Agencies Monitoring Sharī‘ah Compliance ...... 82 Chapter Summary ...... 84 Chapter 9 – Improving Sharī‘ah-based Governance for Bank Accounts ...... 84 Chapter Introduction ...... 84 Improving Sharī‘ah Governance ...... 85 Concerns of Account Holders in Islamic Banks ...... 86 Protection for Unrestricted Investment Accounts ...... 88 Issues Relating To Treatment of Fund Reserves ...... 88 Challenges in Islamic Corporate Governance ...... 89 IFSB Principles for Corporate Governance ...... 90 Challenges for Regulatory and Legal Infrastructures...... 91 Chapter Summary ...... 92 Chapter 10: Transparency in Islamic Banks and Other FIs ...... 93

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Chapter Introduction ...... 93 Benefits of Transparency ...... 94 Reinforcing Transparency and Accountability ...... 94 Importance of Disclosure ...... 95 Key Aspects of Disclosure ...... 95 Importance of Quality of Disclosure ...... 96 Limitations of Transparency ...... 97 Transparency in Financial Statements ...... 97 Transparency and Disclosure Issues ...... 98 Challenges With Respect to Disclosure Issues ...... 99 Scenarios to Address Transparency Issues ...... 101 Chapter Summary ...... 102 Chapter 11 – International Financial Reporting and IFIs ...... 103 Chapter Introduction ...... 103 Need for International Financial Disclosure Standards ...... 104 Qualitative Characteristics of Financial Information ...... 104 Process of Reporting Financial Information ...... 105 Type of Information Required ...... 106 The Main International Standards on Reporting ...... 106 Deficiencies in Accounting Practice ...... 107 International Standards and IFIs ...... 108 The Efforts Towards Transparency in IFIs ...... 109 Key Issues Regarding Transparency in IFIs ...... 109 Chapter Summary ...... 110 Chapter 12: Capital Adequacy Norms and Islamic Banking ...... 111 Chapter Introduction ...... 111 Key Characteristics of Capital ...... 112 Two Perspectives on Capital ...... 112 Importance of Capital Structure and Adequacy ...... 112 Basel I and Basel II Norms ...... 113 Pillar 1 of Basel II for Islamic Banks ...... 114 PLS in Islamic Banking and capital Adequacy ...... 115 IFSB Standards and Risk Management in Islamic Banks ...... 115 Determining Risk Weights for Islamic Banks ...... 116 The IFSB’s Recommended Methodology for Risk Weights ...... 116 Risk Weights and CAR for Types of Risk ...... 117 Pillar 2 of Basel II for Islamic Banks ...... 118 Pillar 3 of Basel II for Islamic Banks ...... 119 Chapter Summary ...... 119

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Bibliography ...... 120

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Chapter 1 – Fundamentals of Islamic Financial Intermediation

Chapter Introduction

Fundamentals of Islamic Financial Intermediation. Financial intermediation is critical for the efficient functioning of the financial systems in an economy. The nature of intermediation between those who provide funds and those who use them depends upon how it is done and who does it.

Financial intermediation is different from other economic activities because it involves obtaining and processing information on financial entities, claims and contracting.

Primarily, any financial intermediary transforms assets, facilitates orderly payments, offers broking services and transforms risk for its clients. .

Asset transformation happens when intermediaries try to match demand for financial products with their supply. The process alters the maturity, scale and location of the assets and liabilities of the suppliers and users of funds.

The financial intermediaries also provide payment services through electronic fund transfers, settlements and clearing.

Another function of financial intermediaries is the provision of brokerage, bringing together lenders and borrowers and offering collateral, financial advice, guarantees and custodial services.

Financial intermediaries facilitate the spread of risks between households and businesses by offering products that can take care of the needs of both.

Ancient Islamic society was familiar with intermediation and intermediaries. Financiers, called Sarrafs, mediated between buyers and sellers, facilitated safety and surety of cross-border payments and issued letters of credit and promissory notes.

It is also believed that the Sarrafs helped each other out in times of a liquidity crisis. On completing this chapter, you will be able to:

 Identify the three types of Islamic financial intermediation contracts.  Describe the basic nature of financial intermediation in Islamic finance.

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 Explain the typical components of the balance sheet of an Islamic bank.  Describe the types of financing instruments used in Islamic finance.  Describe the types of investing instruments used in Islamic finance.  Describe the types of Islamic Financial Institutions (IFIs).

Islamic Intermediation Contracts

The Sharī‘ah recommends a variety of financial intermediation. It covers areas such as transforming assets, facilitating payments, managing risk and acting as a custodian.

There are three classes of intermediation: The first class of services is through a combination of finance and entrepreneurial skills. The second class of intermediation is based on trust. It involves the parking of assets with a third party for security reasons. The third type of intermediation is the provision of implicit and explicit guarantees between economic agents. This acts as a risk cover in financial transactions.

Basic Nature of Islamic Financial Intermediation

Islamic financial institutions differ in their risk profiles from conventional financial institutions because the type of financial intermediation defines the risk for Islamic financial institutions.

In Islamic financing, the Mudarabah is the most important and basic type of intermediation. Mudarabah is the most common type of contract used for bank deposits in Islamic finance. Conversely, to provide credit to customers, banks mostly use the Murabaha contract, which is a cost plus sales contract.

In a Mudarabah contract, the financier or the bank or owner of capital enters into a partnership with an entrepreneur with business skills, on the condition that profits and losses will be shared.

This contract can be used by banks to raise funds for deposits or for acquiring assets. An Islamic bank has to intermediate between the depositors, entrepreneurs and the bank itself by closely monitoring the project performance.

The Mudarabah contract has been covered in detail in Chapter 6 of Course 1.

Understanding the Balance Sheet of an Islamic Bank

The balance sheets of Islamic banks can be presented in two different ways - according to the maturity profiles of assets and liabilities or according to their functionality.

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Although most Islamic banks prefer the functionality-based balance sheet, the maturity-based view is equally important because it gives an idea of institutional-level exposure.

Liabilities On the Liabilities side, Islamic banks follow the two-window approach. This model divides liabilities, apart from the equity capital, into two windows – the demand deposits and special investment accounts.

Depositors can choose the window through which they want to invest their funds. The special investment account is not really a liability in Islamic banks because investors are partners and do not make immediate claims on the funds. In conventional banks, such accounts are pure liability.

Special or restricted investment accounts are frequently represented as off-balance sheet transactions being managed by the bank.

Under Basel III guidelines, Islamic banks, like their conventional counterparts, must maintain adequate reserves (less than 100 %) to cover for only one month’s deposit run-off. This potentially allows Islamic banks to offer accounts free of maintenance fees.

Funds placed as demand deposits or Amanah with banks must be given back on demand at par value. Money in the special accounts is meant for investment and the depositors are aware of the risks of doing so.

The investors are the sources of funds or Rabbul-māl and the bank acts as the agent or Mudarib for the investors.

Profits from special investment will figure under the Assets column and cannot be counted as liabilities. Investors share both profits and losses.

Some Islamic banks offer a limited Mudarabah account with a restricted profit-and-loss sharing arrangement called the Musharakah. Such accounts are targeted specifically towards high-net worth depositors and are highly customised.

Assets Under Assets, the choice of instruments is more. For short-term maturity investments, there are trade financing and financial claims from a sales contract such as Mudarabah and Salam.

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For the medium-term, leasing or Ijarah contracts and manufacturing contracts or Istisna’a are possible. For the long-term, there can be Musharakah partnerships.

An Islamic bank can also provide medium and long term funds by forming a syndicate with other institutions. In this arrangement, the bank appoints an external entrepreneur to be the agent while it acts as the principal.

Like conventional banks, Islamic banks can offer fee-based customised services, guarantees and underwriting services.

Financing Instruments in Islamic Finance

Financial instruments are used to finance trade and the sale of commodities or property. These include rents to be paid against the use of an asset through the Ijarah and Istisna’a contracts. Collateral for such funding is the product being funded and that functions as short-term assets for the bank. These contracts have been covered in detail in Chapter 5 of Course 1.

Murabahah The Murabahah contract is the most popular financial instrument for purchasing commodities or products on credit.

The financier buys the raw material or commodity for an entrepreneur who does not have the capital to do so.

Both of them agree on a profit margin and add that to the product cost. The payment is delayed until the entrepreneur has manufactured the product.

According to the Sharī‘ah, the funds must finance an original sale and not existing inventory. The financier must also take responsibility for the product.

Originally the Murabahah was a contract between the manufacturer of a product and a trader. Today, the banks function as the trader. The Bai‘ Mu’ajjal is a sale with deferred payment where the buyer pays the money in instalments or as a single, full payment.

Both parties agree on a price and the terms of payment at the time of the sale. There can be no charge for deferring the payment.

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The Bai’ al-Salam is a forward sale contract under which the buyer pays for a commodity against deferred delivery.

The buyer and seller agree upon a price that is paid up immediately, but the product is delivered later.

This contract benefits the buyer and seller. The buyer receives money in advance, making it easy for him to invest it in the manufacture, and the seller is free of any price volatility later.

This is similar to a forwards contract. However, in a forwards contract payment is not made in advance.

The Ijarah is a lease contract. Ijarah has two meanings: hire and lease. The contract pertains to hiring of tangible and intangible assets. It involves selling the right to use an asset or usufruct. This contract combines funding and collateral. Its advantage is that it is similar to the conventional lease agreement, the difference being that the leasing agent must own the asset for the period of the lease contract. The other difference is that there is no compound interest on delayed payment.

The Ijarah is particularly useful in financing projects for heavy manufacturing.

The Istisna’a contract is specific to the manufacture of goods. The buyer and seller agree on a price and the specification of the product to be manufactured. The advantage of this contract is that the money need not be paid in advance or even at the time of delivery. The buyer and seller can agree on a mutually beneficial schedule for payment. If at the time of delivery, the product is found to be straying from the original specifications, the buyer has the right to reject it.

The Istisna’a contract is useful in financing projects for heavy manufacturing and the building of infrastructure.

Investing Instruments in Islamic Finance

Investing instruments are used for capital investment. They are of two types – fund management (Mudarabah) and equity partnerships (Musharakah).

The Mudarabah contract is like a partnership where one party provides the funds and the entrepreneur provides the business skills.

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Profits are shared according to a pre-arranged ratio. Losses, however, are borne by the investor. The entrepreneur does not share the losses unless his negligence towards the business is proved. Mudarabah is used on the Asset and Liability sides and can be short, medium or long-term contracts.

The Musharakah is a contract that combines the Shirkah or partnership and the Mudarabah. In this contract two parties come together to share their capital or labour and share profits and losses. They also have similar privileges and liabilities.

The Sharī‘ah specifies various types of partnerships under this type of instrument, with varying degrees of authority and obligation for the investing parties. The Sharī‘ah recommends this type of financing where there is no debt security.

Types of Islamic Financial Institutions

Islamic financing has been evolving over the last few decades, to cater to the growing variety of market needs.

Although the Islamic Republics of Iran, Sudan and Pakistan have all implemented Islamic finance and banking, the growth of Islamic financing has primarily been in the private sector globally.

There are six types of Islamic financing institutions (IFIs).

Islamic financial institutions have been covered in detail in chapters 3 and 7 of Course 1. Islamic Banks

Globally, Islamic banks form the major part of Islamic financial institutions.

They are a hybrid of the conventional commercial bank and an investment bank.

The Republic of the Sudan, The Islamic Republic of Pakistan and the Islamic Republic of Iran have forced all commercial banks to comply with the Sharī‘ah laws.

In other Muslim countries, particularly in the Middle East, most Islamic banks are in the private sector, and are owned by public companies, holding companies or by wealthy individuals.

The two major holding companies – Dar al-Māl Islami group and the Al-Barakah group.

Although Islamic banks have grown worldwide, they fall short of conventional banks in many areas.

There is not a single Islamic bank within the top 100 banks of the world. More than 60 per cent of Islamic banks have assets below $ 500 million, the level that is generally

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considered viable. The largest Islamic bank has assets worth only one per cent of the largest conventional bank.

Islamic Windows

During the 1980s, many Western banks started offering services prescribed by the Sharī‘ah through Islamic Windows.

Western banks started helping Islamic banks invest in trade by appointing a trader to purchase goods for the Islamic banks.

Gradually, Western banks started offering Islamic products without going through Islamic banks.

Some of the Western banks offering an Islamic window include HSBC Global Finance, ABN Amro, American Express Bank, ANZ Grindlays, BNP Paribas, Citicorp Group, Morgan Stanley, Union Bank of Swirtzerland and Standard Chartered Bank (whose brand name for Islamic finance products is Saadiq).

Islamic Investment Banks and Funds

Islamic investment banks are distinct from commercial Islamic banks. Commercial Islamic banks focus on retail and consumer finance, but Islamic investment banks have evolved in response to the market need for large transactions, investment banking and underwriting.

Islamic investment banks have successfully financed large-scale infrastructure projects, such as Hub Power in Pakistan.

Islamic equity funds grew steadily through the 1990s as global equity markets grew at historically high rates.

After a revival in 1990s, there were 150 Islamic funds by the year 2000, of which 85 were equity funds. They were offering commodity, leasing and trade related funds.

Islamic equity financing became popular in the 1990s after global equity markets grew, but is fraught with risks.

Islamic equity funds are subject to strict Sharī‘ah laws and go through a strict process of appraisal. Fund managers tend to focus on equities in developed western markets, where it is difficult to find companies that will meet the criterion of the Sharī‘ah. Therefore, it is impossible to maintain a well-diversified portfolio.

The Dow Jones Islamic Market Index (DJIM) keeps track of Sharī‘ah-compliant stocks from a base of 2,700 stocks. The FTSE also tracks stocks that are Sharī‘ah compliant. The S&P 500 Sharī‘ah and BMI Sharī‘ah are other prominent indices tracking Sharī‘ah- compliant stocks.

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The criteria for choosing stocks to be included in Islamic equity funds are covered in detail in Chapter 12 of Course 1.

Islamic Mortgage Companies

Islamic mortgage companies are specifically targeted at Housing communities for Muslims in Western countries.

There are four models of Islamic mortgage in practice.

The first is the Ijarah or lease model.

The second model is based on equity partnership or diminishing Musharakah where the lender and borrower have joint ownership of property. Gradually, the buyer buys out the lender’s share in the property. The lender’s money is returned through a fair rental value of the property. The third model is based on Murabahah. The factor that differentiates this contract from the Ijarah- or Mushrakah-based mortgage is the property transfer tax.

The fourth is a co-operative model, in which members buy equity or Musharakah shares and help each other buy property from a common society fund.

Prominent US agencies in the mortgage industry have recognised the significance of Islamic mortgages and has started underwriting and securitising them. There is a great opportunity for Islamic mortgages in Western societies with a sizeable Muslim population, such as in North America.

Islamic Insurance Companies

The Takaful is the closest Islamic concept to insurance. Takaful means mutual guarantee. It is a solidarity Mudarabah where all members agree to share their losses by contributing periodic premiums as investment. After paying all the premiums, there are entitled to take the residual value of profits. This is the difference between Takaful and other conventional insurance.

The members are also liable for the amounts already distributed, if the amounts paid as premium have been insufficient to meet losses.

Another requirement of the Takaful is that funds collected as premium can only be invested in Sharī‘ah-compliant companies.

Takaful companies can also constitute reserves and for this members have to pay an amount over and above the premium amount.

Takaful companies have been covered in detail in Chapters 9 and 10 of Course 1. Mudarabah Companies

A Mudarabah company is the closest to a professionally managed fund.

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It is incorporated as a separate legal entity with a fund management company being responsible for it.

A Mudarabah company cannot take deposits, and it is funded entirely by equity – by the subscribers’ capital and investment by the public. Mudarabah investment certificates are given to the general investing public.

Profits are distributed among the investors depending on their share. The manager also earns a percentage of the profits.

Mudarabah companies can be multipurpose, with various objectives or with a specific purpose.

Each Mudarabah is a separate entity and one cannot be responsible or liable for the losses of another.

Chapter Summary

You have completed the chapter, `Framework for Risk Analysis in Islamic Banks’. The key points are as follows.

 The Sharī‘ah recommends a variety of financial intermediation for Islamic economies, and they can be categorised as:

o Partnership of finance and entrepreneurial skills.

o Placing funds or assets with a third party as security.

o Provision of implicit and explicit guarantees to reduce risk.

 The Mudarabah is the most important and basic type of intermediation. It involves a partnership between the entrepreneur and the owner of capital.

 The balance sheets of Islamic banks can be presented in two different ways - according to the maturity profiles of assets and liabilities or according to their functionality.

 Financial instruments are used to: o Finance trade

o Sell commodities

o Sell property

o Pay rent through Ijarah and Istisna’a contracts

 The types of financial instruments available include: o Murabahah

o Bai‘ Mu’ajjal

o Bai’ al-Salam

o Ijarah

o Istisna’a

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 Investing instruments are used for capital investment. They are of two types – fund management (Mudarabah) and equity partnerships (Musharakah).

 Islamic financing has been evolving over the last few decades, to cater to the growing variety of market needs. The types of Islamic financial instruments available are: o Islamic banks

o Islamic windows

o Islamic investment banks

o Islamic mortgage companies

o Islamic insurance companies

o Mudarabah companies

Chapter 2 – Framework for Risk Analysis of Islamic Banks

Chapter Introduction

`Framework for Risk Analysis in Islamic Banking’ Risk management has an impact on bank’s profitability and its value and and therefore is important in financial management.

Risk management involves the identification and quantification of the banking and financial risks faced by banks. It also involves:  Strategic planning,  Capital planning and  Asset-Liability Management

On completing this chapter, you will be able to:

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 Identify the types of risks to which any bank is exposed.  Describe the basic aspects of risk management.  Describe the various components of a formal risk management process.  Identify the two key motivations for improving a bank’s risk management process.  Distinguish among four modes of evaluation of a bank’s condition.  Describe the framework of appraisal of a bank, including Islamic banks.  Explain the need for and benefits arising from an analysis of the overall banking sector.  Describe a framework for financial analysis of banks, including Islamic banks.  Describe a framework for risk analysis of banks, including Islamic banks.  Recognise the principles that govern an effective risk analysis.  Identify the kind of questions that comprise a comprehensive risk analysis.  Describe five analytical tools for risk analysis of banks.

Types of Risks for a Bank

The risk profile of a bank may be influenced by many types of risks:  Financial risk  Operational risk  Business risk  Events Risk Financial risks may arise due to the complexities of the money market and the interdependence of many elements of the money market.\

For example, a bank dealing with foreign currencies will be exposed to currency rate variations daily, but will also face volatility in liquidity or credit positions if it carries open positions in forward trading. Operational risks can arise due to instability in the day-to-day operations and functioning.

Examples of operational risks include, a computer glitch, a problem in following compliance norms or even due to mismanagement of the bank or its funds.

Business risks are those risks that are caused by uncertainties in the business environment. Examples of these can be changes to government and banking related policies, and other related areas such as payment systems and the norms of auditing.

Events risks include natural disasters and other external causes that can undermine the bank’s profitability and capital adequacy.

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Basics of Risk Management

For effective risk management, banks normally have different ways to handle each type of risk and a standard process to deal with the overall risk profile.

This includes setting objective targets for risk management.

Specific risk factors must be identified and the extent of impact of changes in these factors must be calculated. Unexpected changes must be accounted for too.

In addition, these steps must be put in place:  The permissible level of risk exposure must be determined.

 There must be a strategy to hedge over-exposure to risk.

 Responsibility for each type of risk must be defined and assigned and the management process evaluated.

Components of the Risk Management Process

Banks, especially larger banks, must have special strategies to handle risk.

This is particularly so for banks in economies that are developing and still in transition.

Such economies tend to have poorly developed markets and economically unstable environments.

Effective risk management must have certain key components.

Risk Management Authority The first component is a distinct risk management authority at the highest level of the bank to ensure the implementation of the policies of the bank and of the decisions of the asset-liability committee of the bank. This authority should be given a lot of significance and importance in the bank.

Risk Management Strategy

The second component is a well-thought out risk management strategy that is formulated according to the operational requirements and targets. Banks traditionally use a variety of risk management strategies as and when they are faced with a situation, but that may not be enough.

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Formal Decision Making Process

The third component is the formalization of a decision-making process for risk management.

Parameters for risk exposure and relevant decision making should be fixed and incorporated into every business process within the bank.

Parameters for the key financial risks are usually expressed as ratios and can be taken as indicators of what can be acceptable levels of risk exposure. For example, the debt- equity ratio can be used to express the credit risk for debtors of the bank; huge exposure to any one client can indicate a credit risk.

Risk Analysis

The fourth component is a process that bases important business decisions on quantitative and qualitative analyses within defined risk parameters. This process should also include a comprehensive risk analysis to study the minute details of risk factors. This is necessary because the risk factors and their fluctuations are not always obvious.

Data Gathering Process

The fifth component is a well-established process for gathering, and storing data required for risk management strategies.

Data for risk management must be complete, timely, and consistent and cover all possible business processes and functional units in the organization. It should also include information about market trends and other macroeconomic indicators useful for risk management. Development of Quantitative Modelling

The sixth component is the development of quantitative modelling that will enable the simulation and analysis of situations and factors that might impact the risk profile of the bank.

This will help identify the impact of changes on the profitability and net worth of bank.

Banks use a variety of quantitative methods from a simple computer to other more technical modelling. Such techniques are available with other financial institutions or

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software vendors. The type of modelling used decides the intensity of its risk management strategies.

Motivation for a Better Risk Management Process

What can motivate banks to take risks and its management more seriously?

The Basel Capital Accord has agreed that banks must measure their capital adequacy using an Internal ratings-based or IRB approach.

This will increase the bank’s motivation to use quantitative modelling techniques for identifying risk factors and analysis.

The IRB approach will force banks to continuously upgrade and improve their risk management strategies. The general perception is that the market tends to move faster than the ability of banks to perceive associated risks.

When there are changes to the products in the market and changes to the way the market functions, banks find it difficult to simultaneously identify the possible risks.

Traditionally, banks thought it enough to provide for and manage credit risk.

Today, there is a greater awareness that closer detailing and analysis of market and other operational risk factors is essential if the bank must keep pace with market changes.

Modes of Evaluation of a Bank

The changes in the market economy have changed the way banks work with and function in a competitive market economy. Banks have to learn to modify and upgrade their risk management processes and strategies.

It is normal procedure for external agencies to monitor the working of banks and check their viability, safety and compliance to regulation. Such monitoring is conducted annually by four different agencies:  Supervisory bodies  External auditors  Third party evaluators  Central bank evaluators

Supervisory Bodies

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It is standard procedure for supervisory bodies to conduct an evaluation of banks and their operations, their viability and their compliance to the banking system in general.

They also examine whether the bank is fulfilling its obligations to its depositors.

They also ensure that the bank’s activities do not jeopardize the well-being of the entire banking industry.

External Auditors The bank’s board usually appoints external auditors and their responsibility is to assess whether the financial statements are true and fair and whether the bank is adhering to the rules laid down by the Board. They also study the policies of the management to ensure that the bank is not exposed to undue risk.

Third Party Evaluations Third part evaluators typically conduct financial assessments, which could be extensive portfolio reviews or limited assurance reviews to study the financial viability of the banks and their institutional weaknesses. These assessments help understand the credit risk of the bank.

This type of analysis becomes necessary when:  The bank is about to participate in the credit line of an international funding agency.  The bank has received or is about to receive a loan from a foreign bank.  The bank is about to establish correspondence banking overseas.  The bank is about to access markets abroad.  The bank is about to get foreign investment or investment from private parties.  The bank is going to be included in a bank rehabilitation programme.

Central Bank Evaluation The central bank of a country is responsible for supervising the banking industry and the performance of individual banks. Although the central bank’s primary responsibility is the planning and implementation of the monetary policy and the macro-level functioning of related industry, it has to be concerned with banks because they are an important part of money supply in the economy.

Framework of Appraisal

While appraising Islamic banks, added attention must be paid to the contractual nature of transactions, which is quite different from conventional banks.

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Appraisal of banks uses certain set parameters to determine performance in many areas.

The parameters are:

 Overall risk profile

 Financial condition

 Viability

 Future prospects

The outcome of this appraisal can be in many forms:

Recommendations for corrective action when institutional weaknesses are found

Recommendations for either reforming the bank or its closure when it seems unviable to run it

Analysis on whether the bank’s situation can be remedied or whether it would threaten the entire banking system

The conclusions of the review are usually sent out as a letter to the shareholders, as a memorandum of understanding or in the form of an institutional programme for development of the bank.

The development programme specifies priorities for improvement. This report carries all the necessary documents to support his claim and the information necessary for the revival. These reports are useful for the bank management, government and lending agencies who might want to participate in the revival.

Analysis of the Overall Banking Sector

A sectoral analysis of banks is significant because it gives an understanding of the sector as a whole.

It provides understanding on the flow of funds into the economy

It allows the authorities to fix norms for the sector as a whole and for groups within the sector.

The norms can then be used to determine deviation by individual banks.

Sectoral analysis also helps in providing an understanding of the changes in the industry as a whole and its impact on other related sectors.

It is also possible to use this analysis to understand the direction in which local and global economies are moving. This kind of analysis may be a better indicator of trends than macroeconomic models that cannot keep pace with the quick changes in the market.

A structured review of banks also provides important inputs to the monetary policy. Details about money supply, credit needs of industry can be collected in a bank

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review. Policy makers can use these details while formulating the monetary policy or the economic policy.

Risk management in banks is complex and difficult to understand.

It needs a holistic perspective to analyse banking and its relationship to the rest of the economy.

A bank must have:

 Good management  Effective strategies  Supervision  Sound macroeconomic policies  Good legal framework  Solid financial infrastructure  Safety nets  Market discipline

To analyse a bank in depth, an analyst must:

 Know the market in which the bank operates.  Understand the regulatory framework.  Be aware of the larger economic context of the bank.

Financial Analysis of Banks

Financial analysis is the study of a bank’s performance over a year and the comparison of the performance against the previous year.

Data collected is converted into financial metrics and used to make decisions for the bank.

The analysis aims to reveal how the bank has performed in absolute terms and with respect to the competition and how it will perform in the future. Additionally, the analysis aims to estimate the value of the bank and its shares based on projected performance. Financial analysis is usually based on financial information provided by the bank itself. This includes financial statements, footnotes, and management discussions.

The statements which contain data about the bank’s performance and its financial condition may not always be up to date.

They may not contain important nonfinancial information or future projections.

The analyst must, therefore, have the ability to use this information and supplement it with information from the industry and the economy.

Projections of future performance are useful in putting a value to the bank’s shares.

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It is also useful in credit analysis, which can yield information on whether the bank is capable of financing projects, paying back debts with interest and whether it will be able to comply with financial regulations.

The sources for such projections are: bank’s projections, bank’s previous financial statements, industry structure and outlook and macroeconomic forecasts. One difficulty in financial analyses is that accounting standards vary widely and analysts have to make adjustments to the financial statements to apply standard global accounting practices.

There are liabilities called off-balance-sheet obligations that are accounted for differently in different places. These differences can affect the ratios based on these entries and the conclusions drawn from those ratios.

For example, in the case of an operating license, the operating lease is treated as a rental contract to show the periodic lease payment. The lessee is actually the owner of the equipment leased out, but the financial statements do not reflect that. International accounting practices, however, do not agree with this.

Framework for Risk Analysis of Banks

Although Islamic banks follow a different type of financial intermediation and accounting policies, risk analysis has to be on par with other banks.

Traditional analyses tend to focus on quantitative measures such as ratios to study liquidity, capital adequacy, extent of lending and so on.

However, risk analysis is a constantly evolving field. This upgradation and evolution of practices and procedures is necessary to keep pace with the changes and innovations to the market.

The key element of financial analysis is the balance sheet. Risk-based analysis also includes qualitative aspects such as quality of governance, adequacy of management policies, internal controls and so on. It also views ratios in terms of risk management and in view of the changes in risk profile or the in the nature of risk itself.

The bank must be viewed as a single entity as well as a consolidated enterprise with subsidiaries, each with its own risk profile. This is particularly important when the subsidiaries operate in different locations locally or globally. A peer-based risk analysis should also study whether an individual entity’s accounting policies and practices or business practices are in keeping with the general trends in industry or other peer institutions.

The risk profile of a bank may change due to unique circumstances or could be a harbinger of a new trend.

Principles of an Effective Risk Analysis

Financial analysis involves the comprehensive interpretation of financial data to evaluate performance of the organization and forecast its future performance. Much of the analysis is conducted on the basis of financial statements of the organization.

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Financial statements are prepared using IFRS and Generally Accepted Accounting Practices (GAAP), both global standards. Despite this, financial statements sometimes do not contain important non-financial information that is necessary for analysis.

Financial statements prepared under IFRS do contain information of previous performance and of the asset-liability ratio.

A good analyst should be able to use this information with other industry-level and economy level information to make valid investment conclusions.

Financial analysis may be conducted off-site or on-site.

An off-site review concerns itself with financial conditions and risk exposure and management.

An on-site review is broader and looks at the qualitative aspects such as quality of corporate governance, quality of infrastructure and the management’s ability to use sound management information.

More Principles of an Effective Risk Analysis

If all financial reviews follow a set of practices and established analytical frameworks, what will distinguish a good review from the usual ones?

The analyst must use his knowledge and skill to create a storyline and provide a context to the review in terms of:

 Country

 Sector

 Legal framework

 Accounting and auditing practices

 Corporate governance and

 Financial and operational risk

A good storyline should include data spanning 5-10 years, graphs and industry trends, apart from conclusions and recommendations. Purpose

The analyst must ask himself a few questions before starting the review:

 What is the purpose of the analysis?

 What level of detail will be needed?

 What factors or relationships will influence the analysis?

 What are the analytical limitations and will these limitations impair the analysis?

 What data are available?

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 How will date be processed?

 What methodologies will be used to interpret the data?

 How will conclusions and recommendations be communicated?

Meaning

Most of the times, review ends up as a series of calculations, ratios and charts carrying data and no interpretation.

A good analyst must ask himself the following questions while analysing the numbers and obtain answers through appropriate means.

 What happened? This is established through computation or questionnaire.

 Why did it happen? This is established through analysis.

 What was the impact of the event or trend? This is again established through analysis.

 How did the management respond? This is established through review of the quality of corporate governance.

 What are the recommendations?

 What are the weaknesses and where is the bank vulnerable?

Analytical Tools

There are many models that can be applied to Islamic banks for financial analysis, such as questionnaires and Microsoft Excel. These are typically tools that collect the data in a format that enables the analyst to review data easily.

Questionnaires

Questionnaires should be answered by the bank’s management. The questions should aim to get responses about the bank’s management policies, functioning, control processes and financial and management information.

The questionnaire should address the following:

 The bank’s developmental requirements,

 Overview of the financial services sector and its regulation,

 Overview of the bank’s history and organisational structure,

 Accounting and management information systems and controls,

 The use of information technology

 Corporate governance structure, including key players and accountabilities

 Financial risk management including management of asset-liability mismatches, risks to profitability, credit risk and other major liabilities.

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Data Input Tables

Financial analysis requires the use of input table that will store the data collected in a format that can be used easily by the analyst.

Data tables can be used to create ratios and graphs that can help in risk management and in understanding the financial condition of the bank.

The balance sheet and income statements serve as anchor schedules which can be used together with other schedules.

Output Summary Report

Reports provide a summary of the analyst’s findings about the bank based on material collected through the questionnaire and the financial statements. The reports are informed analyses of the condition of the bank and its risk management strategies. Graphs, charts and ratios are quantitative representations of financial indicators and give the analyst an understanding of how the bank’s future is likely to be. Ratios

Ratios express the relationship between one variable with respect to another.

In finance, different variables are related in many different ways and ratios are used to express all of these.

Ratios are particularly useful indicators in the following areas of risk management:

 Operational efficiency: How efficiently does the bank use its assets? This is expressed by the turnover of current assets and liabilities.

 Liquidity: The bank’s ability to repay debts; measured by the ratio current assets to liabilities.

 Profitability: Relation between the bank’s profit margins and sales, average capital and average common equity.

 Debt and leverage: The risk factor and the returns of the company; measured by volatility of its sales and the amount of borrowed money.

 Solvency: Financial risk measured by the debt ratio and the ratio of cash flow to expense.

 Earnings, share price and growth: Shows the growth of the bank.

 Other ratios required by regulators and supervisory authorities and the market.

The biggest advantages of using ratios are:

 They help analysts project cash flows and determine creditworthiness

 They help ascertain a bank’s financial flexibility, including its ability to acquire assets when needed.

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 They help evaluate the management.

The disadvantage of using ratios is that they can be made to look favourable. Ratios must always be verified by a deeper study of the operations and activities. Graphs and Charts

Graphs are powerful tools for analysis because they can provide a wide range of information.

They permit comparison of numbers across units and over time, giving an indication of trends.

They offer the bank’s management a high-level overview of its performance.

Graphs can show:

 Asset and liability position

 Income

 Profitability

 Capital adequacy

 Investment portfolios

 Credit risk exposures

 Exposure to interest rates

 Liquidity, market and currency risk

Graphs are useful as a starting point for on-site reviews, where they can be used to illustrate details of performance to the senior management.

Chapter Summary

You have completed the chapter, `Framework for Risk Analysis in Islamic Banks’. The key points are as follows.

 Risks for banks may be classified into:

o Financial risks.

o Operational risks.

o Business risks.

o Events risks.

 Risk management strategies generally include:

o Identification of risks.

o Setting risk management targets.

o Measures to check over exposure to risk.

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 A formal risk management process must include:

o A line-function for risk management at the highest level of management.

o Risk management strategy corresponding to operational targets.

o A formal decision-making process.

o Quantitative and qualitative analysis of risk factors.

o Systematic and timely collection relevant financial data.

o Use of quantitative modelling tools for analysis.

 Evaluation can be conducted by:

o Supervisory authorities.

o External auditors.

o Third party evaluators.

o Central bank.

 In assessing Islamic banks, care must be taken to account for the contractual nature of transactions.

 Another important aspect of financial analysis is conducting sectoral analysis to understand risk in the light of the changes in the industry as a whole and its impact on other related sectors.

 For effective risk analysis, analysts must be able to draw information from financial statements as well as from the industry and economy.

 Accounting practices differ from country to country and from one organization to another. There must be a standard norm in conformity with the International Financial Reporting Standards (IFRS).

 Appraisal methods must evolve all the time to keep pace with the changes in the industry and the market.

 Banks must be evaluated individually and as a consolidated enterprise with subsidiaries because each subsidiary may have its own risk profile that might affect the overall risk profile of the bank.

 Every analysis must study not just `what happened’ but also `why it happened’ and what else it will impact.

 There are several analytical tools available for such in-depth analyses. Some of them are:

o Questionnaires

o Data Input tables

o Output Summary Reports

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o Ratios

o Charts and Graphs

Chapter 3: Credit Risks with Assets and Their Management

Chapter Introduction

Credit Risks with Assets and Their Management.

Credit risk is the probability that the debtor or an issuer of a financial instrument will default on the payment of the principal or any other investment related cash flow that were to be paid to the lender mentioned and specified in the credit terms of the agreement. Credit risk needs to be effectively managed as it affects the bank’s liquidity and causes cash flow problems.

There are very few Islamic credit-rating agencies or conventional agencies rating Islamic finance instruments or borrowers. According to Van Gruening and Iqbal (2007), even the Sharī‘ah quality rating provided by the International Islamic Rating Agency (IIRA) does not aim to give a Sharī‘ah opinion on Islamic financial products.

Islamic banks rely mainly on the individual or organisation’s track record to judge their creditworthiness. They get this information from local community networks and other informal sources.

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The board of directors lay down formal policies for lending. These must be followed by the bank supervisors and other administrative staff. A lending policy should define scope and allocation of credit and guidelines for managing credit portfolio, yet it should allow flexibility in lending terms. This will ensure the consideration of proposals that otherwise would not meet the rigid guidelines.

On completing this chapter, you will be able to:  Distinguish between three types of risk management policies based on their goal.  Describe measures that aim to reduce credit risk for Islamic banks.  Describe credit risk issues specific to Islamic banks in the context of Murabahah, Mudarabah and Bai’ Salam contracts.  Describe credit risk issues specific to Islamic banks and measures used to mitigate them.  Identify the parameters to be included in a risk analysis of the asset portfolio.  Identify the parameters and objectives of credit review of individual customers.  Identify the parameters of review of interbank lending.  Identify the parameters of review of off-balance-sheet commitments.

Standards and Types of Policies

Principles of Credit Risk of the Islamic Financial Standards Board (IFSB) The credit risk principles of the IFSB cover the following areas:  Identifying existing and potential risks,  Determining policies that reflect the bank’s risk management approach and  Establishing parameters for controlling credit risk.

Principles 2.1 to 2.4 relating to credit risk are stated on Pages 1 and 6 of the IFSB document GUIDING PRINCIPLES OF RISK MANAGEMENT FOR INSTITUTIONS (OTHER THAN INSURANCE INSTITUTIONS) OFFERING ONLY ISLAMIC FINANCIAL SERVICES published December 2005. The document also describes other principles of risk management for institutions offering only Islamic financial services. Click the Resources button at the top of the screen to access and read this document.

Principle 2.1 states that “Islamic financial institutions (IFIs) shall have in place a strategy for financing, using the various Islamic instruments in compliance with the Sharī‘ah, whereby they recognise the potential credit exposures that may arise at different stages of the various financing agreements.”

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Principle 2.2 states that “IFIs shall carry out a due diligence review in respect of counterparties prior to deciding on the choice of an appropriate Islamic financing instrument.”

Principle 2.3 states that “IFIs shall have in place appropriate methodologies for measuring and reporting the credit risk exposures arising under each Islamic financing instrument.”

Principle 2.4 states that “IFIs shall have in place Sharī‘ah-compliant credit risk– mitigating techniques appropriate for each Islamic financing instrument.” Islamic Banks use mainly three types of policies.

The first type of policies aims to reduce the credit risk. An example of this includes lending to connected parties, diversifying and overexposing to some sectors.

The second type of policies aims to classify assets. An example of this includes periodically evaluating the collectibility of credit instruments.

The third type of policies aims to provide for losses. An example of this includes making allowances for anticipated losses.

Policies to Reduce Credit Risk

In order to mitigate and effectively manage the credit risk exposure, the regulators watch three issues:

First issue is single customer exposure. Second issue is related party financing and the third issue is overexposure to a geographic area or economic sector.

Let’s understand each of these issues in detail.

Single Customer Exposure

Banking regulations generally do not allow banks to extend credit to a single party beyond a certain limit. The threshold credit limit is specified as a percentage of bank’s capital and reserves.

In most countries, exposure to a single customer cannot exceed between 10 and 25 percent of the bank’s capital.

Any single customer exposure beyond the threshold limit should serve a warning for the banks to take the necessary precautionary measures.

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There are two difficulties while defining the single customer exposure. The first one is how to quantify the less direct forms of credit exposure and the second difficulty is how to define the term “single customer”.

 Credit exposure to a number of clients may represent a cumulative credit exposure risk for banks if all these clients are financial interdependent and access the same source of funds for repayment of debt.  In order to effectively manage large exposures, banks need to have thorough information about the debtor.  Banks should be able to identify common or related ownership.  Banks should continuously monitor the performance of the group, regardless of payment status.  Concerns should be raised if there is any doubt about the repayment of the loan.

Related Party Financing

Extending loans to parties that are connected with the bank in some way can increase a bank’s credit risk exposure. Connected parties include bank’s parent companies, its major shareholders, subsidiaries, affiliate companies, directors and executive officers.

These parties can control and influence the bank’s credit decisions.

The concern is whether the related parties are offered credit on the same terms as the ones that are offered to the general public.

In order to manage this exposure, the regulators stipulate that the credit extended to related parties should not exceed a certain percentage of Tier 1 capital.

Overexposure to Geographic Areas or Economic Sectors

Sometimes a bank can be overexposed to a particular economic sector or to a narrow geographic area. This risk is very prevalent for banks in agrarian economies or countries which are single commodity exporter. In many cases, banks do not have or generate data pertaining to the magnitude of exposure banks are exposed to any of the economic sectors. Banks giving loans to foreign parties have to face additional risks. There are mainly two types of risks. A country (sovereign) specific risk is associated with a country’s social, economic and political factors that might affect the client’s performance. A transfer risk is a risk that due to foreign exchange controls, a client will have difficulties in acquiring the essential foreign exchange to meet the bank’s debts. Foreign loans should usually factor in both country risk and transfer risk. A bank may be allowed to provide international loans based primarily on the merits of each case. In this approach, more funds are provisioned to hedge against additional risk. Alternatively, a bank may ascertain total exposure to country and transfer risks for each country and provide special funds to manage the exposure.

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Credit Risks Specific to Islamic Banks

Islamic banks face specific credit risks arising from the characteristics of contracts used. They arise in three types of contracts:  Murabahah,  Bai’ al-Salam and  Mudarabah.

Let’s understand each of these contracts in detail. Murabahah In Murabahah contracts, when a client refuses to make a payment, the bank is exposed to a credit risk. The risk increases in case of non-binding Murabahah transactions, in which a client can refuse the goods delivered by the bank. In such case, the client will not make the payment and the bank is exposed to credit risk and also market risk.

Bai’ al-Salam In Bai’ al-Salam, credit risk arises when banks fail to supply the goods either on time or as per the contract. Such a failure can cause delay or default in the payment, or in the delivery of the product, and can lead to Islamic banks losing income and capital.

Mudarabah In Mudarabah, the bank acts as a principal (Rabbul-māl) with an external agent (Mudarib). In this case, the bank is vulnerable since over and above the typical principal-agent problems, bank faces an additional credit risk, since it has very little or no control over the activities of the Mudarib. This problem is further aggravated by the fact that there is very little information available and the transparency is low.

More Credit Risk Specific to Islamic Banks

There are additional credit risks that Islamic banks have to face. First, Islamic banks cannot charge extra interest or penalize the client in case of non- payment of interest or principal. Islamic banks face higher credit rate risk since clients are aware of this fact and can take advantage of this situation by defaulting on the payment.

Second, share capital of the bank that is invested through a Mudarabah or Musharakah contract will be changed to a debt if the Mudarib is negligent or is guilty of misconduct. Then the rules to govern this debt obligation will be different than that from the original rules of Mudarabah contracts.

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Finally, difficulties arise when collateral is used as a security against credit risk such as non-payment of loan, which is a norm among Islamic financial institution. There are some problems when collateral is involved. They are:  Liquidity of collateral.  Difficulty in selling the collateral.  Difficulty in determining a fair market price for the collateral.  Difficulty in claiming the collateral due to rigid legal framework.

Analysis of Credit Risk in Asset Portfolio

Asset analysis is an important function of the Islamic banks, in which the primary objective is to summarise the assets with their composition and the risk associated with the assets. More specifically, asset analysis should provide answers to these key questions:

- What are the products in which the bank has invested? To whom has the bank lent money? - For how long has the money has been lent? The charts on screen are an example of the breakdown of investment for an Islamic bank.

We now describe how the portfolio analysis should be done in detail.

First, the Islamic bank should generate a summary of investments such as loans and assets, and various statistics that show the customer profiles.

Then, the bank should create a detailed description of its portfolio, and classify the assets based upon different criteria. Examples are: classification based upon currency, maturity duration, economic sectors, nature of ownership etc. Then the bank should account for government guarantees and calculate the risk associated with various accounts. Finally, the bank should also create a detailed report on non performing accounts, such as losses incurred by the bank.

Credit Review of Individual Customers

For an Islamic bank, a thorough portfolio analysis is required as it reflects the bank’s market position and helps determine its risk and credit strategies. Sometimes it is not possible to do an exhaustive study of all the portfolios. At such time a random sample of few portfolios is selected. The selection is done in such a way that a major chunk of the portfolio and a statistically significant number of accounts are taken into consideration. There are some points that should be taken into consideration while conducting a portfolio review. These points are as follows:

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 All the customers that have a total exposure of more than five percent of bank’s capital.

 All exposures to shareholders and connected parties.

 All investments and other financing assets for which the financing schedule have been changed after such investments were made.

 All investments and financing assets that are declared as substandard, doubtful or cannot be recovered.

The objectives of a detailed portfolio credit review are manifold. The important objectives are to calculate the probability that a particular loan will be repaid and to see whether classification of the loan proposal is sufficient. Other considerations are quality of the collateral held by the bank and client’s ability to generate the necessary cash.

Interbank Deposits

Interbank deposits constitute a significant part of a bank’s asset portfolio.

They are particularly important where citizens and other economic agents are allowed to hold foreign exchange deposits. There are two main advantages of having interbank deposits in a bank’s portfolio.

First, interbank deposits facilitate fund transfer and buying and selling securities between banks.

Second, by keeping these deposits, banks can take advantage of other banks’ ability to perform certain services at a lower cost due to their bigger size or strategic geographic location.

One needs to review interbank deposits in detail. The review needs to be done on things like the formulation and observation of counterparty credit limits, any interbank loans granted that need special provision, how well nostro and vostro accounts are reconciled, terms of pricing of any interbank loan granted that is not consistent with the terms prevalent in the market and finally a detailed listing of banks that contribute toward interbank exposure. Interbank credit increases banks credit exposure. Therefore a bank should review its correspondent bank on its exposure limit and adequacy of collateral.

Generally banks that are from highly regulated countries are considered to be safe to deal with.

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Review of Off- Balance Sheet Items

The objective of an off-balance sheet item review is to make sure that a customer repays the loan in a timely manner.

One needs to assess whether the procedures that analyse the credit risk are sufficient and whether there is periodic evaluation of the administration for off-balance sheet credit instruments like guarantees.

Chapter Summary

You have completed the chapter, Credit Risks with Assets and Their Management. The following points were covered:

The Standards issued by IFSB and the scope of these standards  Three types of risk management polices based on goals

 The measures Islamic banks can take to reduce their credit risk exposure

 Credit risks that only Islamic banks incur due to the characteristics of Islamic contracts and the nature of business

 The parameters to be included while analysing the extent of credit risk in Islamic banks’ asset portfolio

 Main parameters and objectives of credit review of individual customers

 Parameters for review of interbank lending

 Parameters for review of off-balance sheet items

Chapter 4: Managing Nonperforming Assets

Chapter Introduction

Managing Nonperforming Assets.

Nonperforming assets are assets that are not generating income. For example, if the principal or interest on a loan is overdue for 3 months or more, then the loan is said to be nonperforming.

To determine if an asset is a nonperforming asset, view the principal balance outstanding of an asset rather than the delinquent payments. This will indicate the quality of both the overall loan portfolio and the bank’s credit decisions. The bank’s collection ratio is another indicator of a nonperforming asset.

Although the repayment is a matter of concern, the more serious issues are the investment cash flow and the overall ability of the borrower to repay. In order to be fully prepared for these defaults, the banks classify assets depending on the level of risks. Based on the asset classification, level of loss provisions and workout strategies are determined.

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On completing this chapter, you will be able to:

 Identify the parameters of review of nonperforming assets.  Describe the reasons for an increase in nonperforming assets of a bank.  Explain the concept of asset classification.  Explain the rules of asset classification.  Describe the factors that determine adequate level of provisioning for losses.  Identify the levels of provisioning in different types of economies.  Describe alternative approaches for managing asset losses.  Describe parameters to assess workout procedures and typical workout strategies.

Review of Nonperforming Assets

Analysis of a nonperforming asset helps in determining the problem and identifying a solution. While analysing a nonperforming portfolio, the following factors should be considered.

 Classification of portfolios based on the type of customers and the bank branch: This will help determine the overall trend and whether all portfolios have been affected equally.  Causes for the deterioration in portfolio quality: This will help determine the possible measures to reverse a given trend.  Individual evaluation of other nonperforming portfolios: This will help decide if the performance status can be reversed, if there are any steps to improve the repayment capacity and if workout or collection plans have been implemented.  Provision levels: This will help assess the bank’s ability to survive defaults.  Impact on profit and loss sharing accounts: This will help determine the extent to which the bank will be affected due to the deterioration in asset quality.

Reasons for an Increase in Nonperforming Assets

Two common reasons that lead to an increase in nonperforming assets are:

 Mistakes in judgement by the bank and  Distortion in a bank’s credit culture. Of these reasons, the distortion in a bank’s credit culture is the primary cause.

The U.S. Federal Reserve system provides a list of problems that lead to a poor credit culture. These problems apply to not just any commercial bank but also to any Islamic financial institution.

Let’s look at each one of them in detail.

Self-dealing Self-dealing is a key problem that affects most banks. Self-dealing happens when influential parties pressurise the banks to compromise on their credit principles and lend too much credit to large shareholders, directors or their related interests.

Anxiety Over Income

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Loans are the primary source with which banks make their revenue. Hence, there are times when the banks become anxious over their earnings and tend to hope that risks will not materialize or that loans will be repaid.

Incomplete Credit Information There are times when loans are granted without proper assessment of the borrower and the borrower’s ability to repay. This leads to a lot of problems.

Complacency Complacency leads to a lot of problems. A complacent bank:

 Does minimal or no review of old or known debtors,  Depends on verbal information instead of reliable, documented and full economic data,  Ignores any adverse indicators about the borrower, economy, region, industry or other relevant factors,  Ignores known credit weaknesses in a loan because the borrower survived a distressed situation in the past or  Does not enforce repayment agreements, including avoiding immediate litigation.

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Lack of Effective Monitoring Constant monitoring of the debtor’s affairs during the lifetime of the loan is important. Lack of effective supervision leads to little or no insight into the debtor’s dealings and subsequently, loans that were once healthy may develop problems and losses.

Technical Incompetence Loan officers may not be technically sound. They may not possess the ability to evaluate credentials and assess financial statements.

Poor Selection of Risks Banks select risks in the following ways:

 Extending loans to a level beyond what the debtor can repay. This occurs commonly in unsound economies that have fluctuating interest rates.  Financing a huge portion of a project compared to the equity investment of the owners, especially in the case of real estate transactions where equity ownership is narrow.  Granting loans based on the projected outcome of an individual business deal instead of on the debtor’s ability to repay.  Granting loans based on size of deposits rather than projected net value of collateral.  Extending loans for speculation insecurities or goods.  Granting loans to businesses functioning in economically distressed communities.  Extending loans based on collateral that has uncertain resale value or collateral loans without sufficient security margins.

Compromise of Credit Principles When banks sanction loans that carry unnecessary risks or are granted under inadequate terms, then the banks are said to compromise their credit principles.

Bank compromise typically due to reasons such as:

 Self-dealing,  Uncertainty about income,  Competitive pressures or  An individual’s conflicts of interest.

What is Asset Classification?

In order to manage risks efficiently, a bank must classify all assets for which it is taking a risk. Assets include advances, accounts receivable, investment and financing assets, equity participation, and contingent liabilities.

Asset classification involves assigning a grade to an asset based on the credit risk.

The grade is decided based on the probability that debts will be serviced and repaid according to the terms of the contract.

Assets are classified when the loan is initiated. Then, in a year, assets are periodically reviewed and reclassified. While secured assets are usually reviewed every six months, assets classified as critical are reviewed at least every three months.

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The review of an asset considers:

 Service performance to the loan,  The client’s financial situation  Economic trends and  Changes in the market prices of goods.

There have been different approaches to asset classification. Some of the approaches are listed below:

 Some jurisdictions insist that all credits granted to the same client be assigned the same risk classification, while other jurisdictions propose that risk in each asset must be evaluated based on its own merits.  At times, when assets are classified objectively or subjectively, the more stringent classification should be used. If supervisory authorities or external auditors assign more stringent classification, the bank should modify its classification.

Rules of Asset Classification

International standards recommend assets to be classified in the following categories.

Standard or Pass An asset is classified as standard or pass when the capacity of the borrower to service the debt is beyond any doubt. For example, assets that are fully secured by cash or cash substitutes, such as certificates of deposit, treasury bills and notes, are classified as standard assets regardless of whether they possess arrears or other adverse credits.

Specially Mentioned or Watched An asset is classified as specially mentioned or watched if the asset has potential weaknesses that may weaken the asset as a whole or put at risk the borrower’s capacity to service the debt in the future. These assets should be watched and corrected.

Examples of these assets are listed on screen.

Substandard An asset is classified as a substandard asset only if the primary sources of repayment are insufficient. In such cases, banks will look for secondary sources such as refinance, collateral, sale of fixed assets or fresh capital. Examples of substandard assets include:

 Assets whose cash flow may be inadequate to meet current cash flow requirements.  Short-term assets to borrowers whose inventory-to-cash cycle is insufficient to repay the debt when it matures.

 Nonperforming assets that are at least three months overdue.

 Renegotiated loans for which the borrower has paid delinquent interest from his own funds before renegotiating terms and until the asset shows sustainable performance.

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Doubtful An asset is classified as doubtful if:  The full collection of the credit is doubtful given current facts. Although there is chance of a loss, this asset can still not be classified as a loss as there may be certain factors that may strengthen the asset performance.

The asset is at least six months past due, unless it is sufficiently secured.

Loss An asset is classified as a loss if:  The credit cannot be collected or can no longer be defined as bankable due to its minor value. Being classified as a loss does not necessarily mean that the asset cannot be recovered at all but that partial recovery may be possible in the future.

 The nonperforming asset is at least 12 months past due, unless it is very well secured.

Loss Provisioning

Asset classification is a key tool not only to manage risks but also to decide sufficient level of provisions for potential loss. These funds together with the general loss reserves or Tier 2 capital that are not linked to specific assets enhance the bank’s ability to survive the losses.

To determine an adequate level of reserve, factors influencing the probability of loss in a portfolio should be evaluated. These include:  Quality of policies and procedures related to granting credit,  Past losses,  Quality of management,  Procedures for collecting and recovering dues,  Shifts in domestic economic environment and  General economic movements.

After determining an adequate level of reserve, periodic, systematic and objective assessment of the asset value should be performed. This should be supported by adequate documentation.

It is interesting to note that loss provisioning is not mandatory at all banks. Some banking systems make loss provisioning discretionary.

Similarly, different countries treat tax provisions differently, although most banks treat the mass tax-deductible business expenses. However, tax implications should not determine the level of provisions and risk management policies.

Standards for Level of Provisioning

The best method to determine an adequate level of reserve is to estimate each asset on individual merit. However this is not a practical solution. Hence, it is recommended that each classification category is assigned a level of required provisions.

Let’s now look at the provision levels in developed countries and developing countries.

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In highly developed countries, such as the United States, the legal infrastructure for recovering debt is mature and sophisticated. It is, therefore, expected that substandard assets face a 10 percent of loss. Debt recovery success rate for doubtful assets is approximately 50 percent while that for loss assets is almost 100 percent.

In emerging or nascent markets, the legal framework and collection practice is less effective. Hence, substandard assets show loss in the range of 10 to 30 percent. The graph presents the level of provisions in nations with nascent legal infrastructure.

These estimates of loss provisions are based on a matter of subjectivity. Hence, it is best to exercise management discretion aligned with the bank’s set policies and procedures.

Click the Resources button to view the Islamic Financial Services Board or IFSB standard on risk management.

The banks must take into account the following aspects of the overall loss allowance while estimating loss provisions.

 The bank’s provisioning policy and its implementation process: This includes determining the projected value of collateral and the ability to enforce the policy legally and operationally.  The asset classification procedures and the review process: This includes the time allotted for review.  Any loss-causing factors associated with a bank’s portfolio: This involves identifying how these factors changed from the past losses. These factors include changes in the economic conditions of the bank or of its clients, external factors or changes in bank procedures.  A trend analysis over a longer period: This will help identify any increase in past due debts and its impact.  An evaluation of how adequate the current policy is based on the loans reviewed: This includes estimating additional funds needed to align a bank’s loan-loss provision with the International Accounting Standards or IAS.

Approaches for Managing Asset Losses

The approaches for dealing with loss assets are:  Retaining them on the books until all collection strategies have been tried: In this approach, which is typical of British banking system, the level of loss reserve is unusually large.  Writing off all loss assets promptly against the reserve: In this approach, which is typical of the U.S. banking system, the level of the reserve looks small in relation to the outstanding portfolio. This is a more conservative approach as the loss assets though not bankable may still be recoverable.

Workout Procedures

Workout procedures help in credit risk management. Work out procedures help banks take timely action against problem accounts. They ensure that these problem accounts are either strengthened or collected. Workout procedures prevent the accumulation of losses to an extent that it can threaten a bank’s solvency.

While determining the best workout procedures for an asset, consider the following factors:

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 The organisation, including units and relevant staff  The number of attempts and volume of successful recoveries by the workout units  The mean recovery time  The workout strategies previously used and  The engagement of top managers Although a workout procedure is specific to each account and client based on the specific requirements, the typical workout strategies include:

 Reducing the credit risk of a bank by requiring the client to provide additional funds.  Working with the client to find solutions by: o Providing advice, o Proposing a plan to reduce operating costs or enhance income, o Divesting assets, o Developing a restructuring program or o Modifying account terms.  Arranging for an acquisition or merger.  Taking legal action to liquidate exposure, calling on guarantees, foreclosing or liquidating collateral.

Chapter Summary

You have completed the chapter, Managing Nonperforming Assets. The key points of this chapter are as follows:

 Review of a nonperforming asset involves classification of portfolios, causes for the deterioration, other nonperforming portfolios, provision levels and impact on profit and loss sharing accounts.  Nonperforming assets are a result of mistakes in judgements made by the bank and a distortion in a bank’s credit culture.  Asset classification involves assigning a grade to an asset based on the credit risk.  Assets are classified as standard, watched, substandard, doubtful and loss.  Loss provisioning is a process in which adequate level of provisions for possible losses is determined.  Provision levels vary for developed countries and developing countries.  There are two approaches for dealing with loss assets: British approach and American approach.  Workout procedures help banks take timely action against problem accounts.

Chapter 5 – Operational and Specific Risks for Islamic Banks

Chapter Introduction

Operational and Specific Risks for Islamic Banks.

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Operational risk is one of the key aspects in risk management domain. It is the risk of loss arising from ineffective internal process, human resources and infrastructure or from daily activities.

Islamic banks face operational risks as well as the risks arising from business nature, business functions and processes, business environment, competition and rules and obligations to the Islamic law.

According to Khan and Ahmed (2001), managers of Islamic banks regard operational risk as the most important risk next to mark-up risk. The survey reveals that operational risk is lower in the fixed-income contracts of Murabahah and Ijarah and higher in the deferred sales contract of Salam and Istisna’a. The higher level of operational risk in these contracts is because of the complexity and difficulty in implementing these contracts.

Several risks specific to the Islamic Banking include displaced commercial risk, withdrawal risk, fiduciary risk, Sharī‘ah risk, and reputational risk, which are discussed in detail in this chapter. On completing this chapter, you will be able to:

 Identify the types of operational risks to which Islamic banks are exposed.  Identify the risks arising from Islamic banking principles.  Describe displaced commercial risk and its impact on practices in the Islamic banking industry.  Describe fiduciary risk in the context of Islamic banking.  Describe reputational risk.

Operational Risks for Islamic Banks

Specific aspects of Islamic banking that enhance operational risks for Islamic banks include cancellation risk in the nonbinding Murabahah or partnership and Istisna’a or manufacturing contracts; inefficiency of internal control systems to identify a flaw in operational process, back-end operations, and technical risks; difficulty in implementing Islamic contracts in a wider legal environment, necessity of providing and managing commodity inventories in absence of liquid markets; non-compliance with Sharī‘ah requirements; risks and expenditure in monitoring equity-type contracts. In addition to the mentioned aspects which enhance operational risks, People risk and Technology risk are different types of operational risks.

People risk is the result of incompetence or lack of domain knowledge of human resources or fraud. For example, one of the most popular banks in the UAE incurred an extra cost of $50 million in the late 1990s, when the bank official violated the bank’s credit terms. It caused a one-day run on the bank’s deposits to the tune of $138 million, accounting to seven percent of the total bank deposits.

The quality and knowledge of management process poses specific risks in the emerging industries like Islamic banking, which has to abide by Islamic laws. Managers who are fully acquainted with conventional as well as Islamic finance are scarce and losing them involves a greater risk.

Technology risk is the result of usage of Management Information Systems which are not customised to the needs of Islamic Banks.

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Finding individuals having skills in both financial and Sharī‘ah rules is hard and customised management information systems which comply with Sharī‘ah rules are scarce.

Adapting Basel III Measures for Islamic Banks

Using gross income as an indicator of operational risk in Islamic banks is inefficient because of large volumes in commodities trading and structured finance raise operational exposures were not added in gross income.

The three methods proposed in Basel III to measure the operational risk may need to be customised to the needs of Islamic banks. However, the standard approach, which suits different business lines, may be better for Islamic banks.

In this method, services offered under Mudarabah and commodity inventory management should be considered clearly to measure operational risks.

Note that Basel III norms are now replacing Basel II measures worldwide.

Risks Arising from Islamic Banking Principles

In addition to the operational risk, Islamic banks face unique challenges and are exposed to various risks arising from Islamic banking principles such as, Displaced commercial risk, Withdrawal risk, Fiduciary risk, Transparency risk, Sharī‘ah risk and Governance risk.

Let’s look at each one of them in detail.

Displaced Commercial Risk This risk arises when an Islamic bank disburses a higher rate or larger amount to its investors and depositors than the amount mentioned in the investment contract. Banks suffer this risk, when the bank operations are not efficient and when the bank does not yield enough profits to pay the account holders.

Alleviation of this risk can be done by giving up a portion of the bank’s profits and thus dissuading depositors from withdrawing funds.

Example of such alleviation include the most popular banks in Egypt allocated all of its profits from the middle to late 1980s to the account holders with nothing left to the shareholders. Later in the year 1988, the bank distributed an amount more than the profits incurred which then appeared as ‘loss carried forward in the bank’s account. This operation affected bank’s capital which can led to bankruptcy in extreme cases.

Withdrawal Risk

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This risk arises when the bank faces competition from both Islamic banks and the conventional banks with Islamic windows.

An example of this risk is when the depositors withdraw their funds due to the inefficiency of the bank and when the depositors receive lower returns when compared to the other banks.

Governance Risk

This risk occurs due to the lack of proper management by the bank administrators leading to violation of contract rules, missing deadlines, legal risks and a weak internal and external institutional environment.

These weak institutional environments are causing banks to fail in implementing their contracts.

Fiduciary Risk

This risk arises when the institution fails to execute the fiduciary responsibilities in accordance to the related explicit and implicit standards. This risk leads the bank to face the legal consequences upon violation of fiduciary responsibilities towards depositors and shareholders. To avoid this risk, banks must adhere to the interests of investors, depositors and shareholders. Deviation of the shareholders objectives from the actions of bank also leads to the exposure of the fiduciary risk.

Transparency Risk

This risk occurs due to the usage of non-standard conventions while disclosing the Islamic financial contracts and also due to the lack of uniform reporting standards among Islamic banks.

According to the Basel Committee on Banking Supervision (1998), transparency is defined as “the public disclosure of reliable and timely information that enables users of that information to make an accurate assessment of a bank’s financial condition and performance, business activities, risk profile, and risk management practices.” To mitigate the transparent risk, Islamic banks should disclose complete and clear information with special emphasis on disclosure of risk profile, risk-return mix, and internal governance.

Sharī‘ah Risk

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It occurs due to non standard interpretation of contract rules and failure to comply with Sharī‘ah rules.

According to van Greuning and Iqbal (2007), some Sharī‘ah scholars make the Murabahah or Istisna’a contract binding on the buyer, but there are others who argue that the buyer can decline to honour the contract even after placing the order and paying the commitment fee.

This risk is also mainly related to the composition and working of general and institutional Sharī‘ah boards. For example, some Sharī‘ah scholars believe that the buyer should be bound to the Murabahah and Istina’a contracts where as some scholars argue that buyer can decline the contract even after placing an order and paying the commitment fees.

Understanding and complying with the Sharī‘ah rules helps in financial reporting, auditing, and accounting treatment, where as not complying with the Sharī‘ah rules will cause the banks to be exposed to Sharī‘ah risk and may lead to lawsuits if there are unsettled transactions.

To mitigate the Sharī‘ah risk, banks should maintain transparency in compliance with the Sharī‘ah rules and act as necessary to ensure compliance. Also, the relationship between the Islamic bank and its investors or depositors should not be like a relationship between an agent and principal as in conventional banks, but should be trustworthy and fully complied with the Sharī‘ah.

Some scholars suggest that the transactions that do not comply with the Sharī‘ah rules should be considered as invalid.

Practices to Manage Displaced Commercial Risk

Various experiments to alleviate the displaced risk in the industry led to two standard practices such as Profit Equalisation Reserve or PER and Investment Risk Reserve or IRR.

PER is a certain amount of money set aside by the bank from its gross income prior to taking its own share as the agent. This reserve in the bank serves as a back up money to run the smooth returns in future and to increase the owners’ equity for bearing future shocks.

IRR is a certain amount of money set aside from the income of investors or depositors after allocating the bank’s share as the agent. This reserve reduces the risks caused by the investment loss.

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It has been suggested that banks should predefine and disclose the reasons for authorising the funds.

The Use of PER & IRR

Risk faced by the banks is the result of uncertain events which might occur in future. It is the discrepancy between the actual return on investments and the expected return on investments.

Risk could be caused by a variety of factors, which include systemic or the sudden collapse of certain markets and idiosyncratic, that is, bank-specific factors.

Islamic banks use PER to mitigate the risks by offering the returns on investments equal to the market rates of conventional deposits.

In addition, banks also use IRR to allocate the accumulated funds to the investors.

Managing Risk for Mudarabah Accounts

Investors can manage risks for Mudarabah accounts by measuring Profit At Risk or PAR for holding an investment account.

Profit at risk can be calculated by multiplying Zwhich provides a suitable one-tailed confidence interval with a probability of 1 – for the standard deviation, with σp or the standard deviation of the monthly profit as a percentage of assets, and further multiplied with the square root of T or holding period. If the specific risk factors affecting the Mudarabah accounts are recognised, PAR can be refined by analyzing the standard deviation.

The aggregate PAR obtained can be used not only as a preliminary estimate of the risks in unrestricted Mudarabah accounts, but also for the individual business unit within the bank.

Nevertheless, Islamic banks make use of PER funds, which are mutually related with the net returns and assets.

Mutual relationship between PER funds and net returns and assets will protect the investment accounts, thereby viewed as process of mitigating the displaced commercial risk.

As a result, banks assimilate the risk caused from the returns on investments.

Governance Issues in PER & IRR

It is known that PER and IRR funds are used to alleviate the risks faced by the bank in future. Even though having these reserves is a discreet way of managing risk from the bank’s perspective, this action has created governance issues which need to be addressed.

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The first issue is that the investors are not happy with the limited disclosure of the reserves.

The second issue pertains to the fact that the investment account holders do not have rights to influence the use of such reserves and to verify the exposure of overall investments.

The third issue is that the short-term investors believe they are the long-term investors with their investments.

The fourth issue is that the certain banks require the investment account holders to forego all rights to these reserves.

To address these issues, banks should clearly state and explain the reserve rights to investment holders. It has been suggested that profits should be deducted only from the long-term investors who are more prone to the risks when compared to the short- term investors.

Fiduciary Risk

The Accounting and Auditing Organisation for Islamic Financial Institutions or AAOIFI (1999) defines fiduciary risk as being legally liable for a breach of the investment contract either for noncompliance with Sharī‘ah rules or for mismanagement of investors’ funds. Examples of fiduciary risk:

Whenever Mudarabah and Musharakah investments are on partnership basis on the assets side, banks should examine and monitor these projects continuously. Being negligent while monitoring these projects will lead the bank to be exposed to fiduciary risk. To avoid these situations, it is mandatory for the management to pay attention prior to committing to the funds of investors- depositors.

In general Islamic banks use the investment funds of the current accounts without sharing the profits with them. However, when the bank incurs heavy loss, investors lose trust in the bank and may sue, leading to fiduciary risk.

Mismanagement of Amanah funds invested by the current holders leads to fiduciary risk.

Incurring unnecessary expenses to the investment account holders by the governance is a violation to the contract rule and should act in transparency way.

Consequences of Fiduciary Risk

Consequences of fiduciary risk are dreadful causing the bank to be exposed to both indirect and direct losses.

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First consequence is that it will cause reputational risk, making people lose their confidence even in rich banks, which in turn leads to withdrawal of funds from the banks.

Second consequence is that, banks have to pay penalties for being liable towards the fiduciary responsibilities, which will cause financial loss.

Third consequence is that, it can drive down the share price. Fourth consequence is that it will affect the bank’s costs and cause a liquidity crisis.

Fifth consequence is that, it will expose the investment depositors and account holders to the risk of financial losses as they will have to forego their profits.

Finally, fiduciary risk sometimes may lead to bankruptcy, if the bank is not able to satisfy the requirements of current investment holders.

To mitigate the fiduciary risk, banks should disclose its financial condition, which enables stakeholders to protect their rights, investors to withdraw their deposited funds, and other shareholders to sell their shares, in case of bank’s misconduct or mismanagement.

Reputational Risk

Reputational risk is the risk that the irresponsible action or management misbehaviour will damage the trust of the bank’s clients.

Even though fiduciary and Sharī‘ah risk originates from negligence, reputational risk is the risk caused due to the negligence and irresponsibility of one Islamic bank that will affect the other Islamic banks in the finance industry. Negative publicity about these kinds of Islamic banks will have considerable effect on the institution’s market share, profitability and liquidity.

Sometimes, Islamic banks which do not indulge in misbehaviour also lose their reputation because of the negative publicity.

To mitigate the reputation risk, banks should follow the practice of maintaining standards contracts, self-examination and maintaining proper industrial links with all other banks in the industry.

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Chapter Summary

You have completed the chapter, Operational and Specific Risks for Islamic Banks. The key points of this chapter are as follows:  Operational risk is the risk of loss arising from ineffective internal process, human resources and infrastructure or from mundane affairs.  Managers of Islamic banks regard operational risk as the most important risk next to markup risk.  People risk and the technology risks are the two types of operational risks.  The three methods proposed in Basel II to measure the operational risk may need to be customised to the needs of Islamic banks.  Risks specific to the Islamic Banking include displaced commercial risk, withdrawal risk, fiduciary risk, Sharī‘ah risk, and reputational risk.  PER reserve and IRR reserves are used to mitigate the displaced commercial risk.  Consequences of fiduciary risk are dreadful causing the bank to be exposed to both indirect and direct losses.  Reputational risk is the risk that the irresponsible action or management misbehaviour will damage the trust of the bank’s clients.

Chapter 6 – Asset Liability Management and Liquidity Risk

Chapter Introduction

Asset-Liability Management and Liquidity Risk.

In today’s world, financial instruments offered by banks have become more complex and have more features. Due to their complicated nature, the scope of treasury management has increased.

Treasury management encompasses many functions. They are as follows:

 Overall banking policy guidelines need to be laid down including effective asset-liability management, strategic asset allocation and benchmark approval.  Funding requirements, for example, listing the sources though which it will obtain funds.  Management of investments and cash flow.  Measurement and analysis of risk and performance.  Compliance with guidelines and regulations of investment.  Effective research on risk and strategies.

The Main Risks for Islamic Banks

Islamic banks are exposed to certain risks associated with treasury management. They are:

ALM mismatch risk arises when the maturity profile of the bank’s asset portfolio differs from the maturity profile of bank’s liability portfolio.

Liquidity risk is associated with banks having either too low or too high funds.

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Market risk arises when banks are exposed to unforeseen movements in price fluctuations.

Rate of return risk arises when banks cannot get a desired rate of return on their investment. Due to this banks’ investment might not be profitable.

Equity investment risk is when the shares of companies that the bank has invested in will become less valuable.

Hedging risk arises when bank takes offsetting and opposite positions in related assets so as to profit from relative price movements. However Islamic banks cannot hedge the risk due to absence of financial derivatives

Islamic banks are not exposed to interest rate risk like conventional banks. Instead they face mark up risks. Mark up is cost-plus margin charged in trade financing contracts. Due to this, Islamic banks are also exposed to risks of changes in the benchmark indexes used to determine markup rates and other rates on return.

ALM and Islamic Banks

An asset denotes how a bank puts its funds to use. A liability denotes how a bank raises funds.

Banks needs to have a proper framework for asset-liability management. This ensures a steady flow of net interest income.

A bank is exposed to asset-liability mismatch risk when the maturities of assets are different from that of liabilities.

Theoretically, Islamic banks are supposed be less exposed to ALM mismatch risk than their conventional counterparts. There are two main reasons for this.

Let us understand each of these reasons in detail.

Pass Through

Islamic banks essentially act as agents for their deposit holders and pass on both profits and losses to them. However, most Islamic banks are listed companies, not co- operatives. Therefore, the shareholders can benefit from capital gains or suffer losses.

Depositors in conventional banks receive interest at a predefined rate plus get back their guaranteed principal. This happens regardless of how profitable the assets are for the bank.

However, in the Islamic system, holders of profit-sharing investment accounts share the bank’s profits and losses with the shareholders. Account holders face the risk of losing part of their initial investment or sometime all of it. Shareholders and investor- depositors together absorb negative shocks to an Islamic bank’s assets.

Risk Sharing

Islamic banks participate in the risk of other banks, and the deposit holders share the risks of the banking business.

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This principle incorporates direct market discipline, which has been emphasised by the Basel Committee on Banking Supervision as a factor for improving the stability of the international financial market.

The Risk of ALM for Islamic Banks

Even though theoretically, Islamic banks are supposed to be less exposed to the ALM mismatch risk, in reality Islamic banks are largely exposed to ALM mismatch risk. There are primarily two reasons for this.

Let’s understand each of these reasons in detail.

Instead of sharing profits with the deposit holders of the bank, banks actually distribute profits even in little or no profit situations. This puts pressure on the returns to equity shareholders. There is potential for conflicts of interest between the investment account holders and the shareholders. Only a sound governance structure in the bank can help resolve such conflicts.

Islamic banks rely heavily on short-term trade financing and use partnership-based agreements to a very limited extent.

Due to this, the asset portfolio of Islamic banks is dominated by short-term, low profit and fixed-income assets instead of longer-term, more profitable and riskier assets.

Deviations That Increase the ALM Risk

The asset side of the balance sheet of Islamic Banks is a lot different from the one in theory. Basically, there are three significant deviations.

The first deviation is the trend towards short term assets that are less risky.

The second deviation is low limited interest in profit-and-loss sharing or PLS arrangements.

The third deviation is the lack of clarity between investor-depositors and shareholders.

All these deviations don’t let the banks function to its full potential and expose the banks to more risks.

Let’s understand each of these deviations in detail.

Less Risky Short term Assets

Islamic banks believe in the policy of “Lower risk and lower return”. Because of this, their asset portfolio consists of instruments that have low risk profile, yield lower returns and have a short maturity profile.

Islamic banks’ asset portfolio predominantly consists of sales or trade related instruments or leasing-based securities because these carry low risk and more certain returns.

A study on durations of asset maturities of Islamic banks assets revealed that 54 percen t of their assets had a maturity of less than 1 year and 39 percent had a maturity of less than 6 months.

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Fewer PLS Arrangements

Theoretically, Islamic banks are supposed to participate in instruments involving profit- and-loss sharing arrangements. However, due to their reluctance to take risks, they refrain from participating in such agreements.

Lower transparency leads to loss of confidence among depositors. They avoid risk as much as possible, which makes banks less willing to risk taking on such arrangements. This is a vicious cycle.

Islamic banks justify their lack of participation in profit and loss sharing instruments by claiming that no supporting institutions are available to maintain good-quality information on credit standing of borrowers and entrepreneurs and few credible trade associations exist to monitor and share information on debtors.

Lack of Clarity Between Investor-depositors and Shareholders

If the contractual agreement between the banker and the deposit holder is based on a “pass-through” mechanism, then there would not have been any risk associated with Asset-Liability mismatch. There is no distinction between the shares of a deposit holder and shares of equity shareholders. Policies and procedures for computing and declaring profits and losses are poorly defined. Investment account holders receive profits despite the losses incurred on the assets.

Liquidity Risk

Banks are exposed to liquidity risk if the maturity profile of their assets does not match with the maturity of its liabilities.

When the two sides of the balance sheet do not match, it can lead to a cash surplus that needs to be invested or lead to a cash deficit that needs to be financed.

The liquidity position of a bank:

a. Represents the bank’s ability to redeem deposits and other liabilities. b. Covers the demand for funds in the loan and investment portfolio.

Liquidity is vital for the survival of a bank because it needs sufficient liquidity to protect itself against balance-sheet fluctuations and to ensure that the funds are available when needed.

A bank is said to have adequate liquidity potential when it is in a position to raise funds by either increasing liabilities, securitising, or liquidating assets when it is required promptly and in a reasonable manner.

A bank’s liquidity position is essentially the extent to which it holds readily marketable assets, cash being the most liquid form of asset. The bank needs to calculate its liquidity needs and accordingly can decide upon the composition of its marketable asset portfolio.

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Banks need to have a stable deposit structure and potentially be able to expand the asset portfolio. A bank may need to increase its liquidity level if its liability portfolio consists of loans of higher amounts and higher durations.

Approach to Liquidity Management

The bank’s top management and the board of directors should outline clear goals and objectives of its liquidity management.

The essence of liquidity management stems from the fact that there will always be trade-off between liquidity and profitability.

That means if the bank decides to have more liquid asset in its portfolio, then it has to forgo the interest income that it would have earned had they been invested in long- term high return assets. In this situation, profitability is compromised. This is known as the opportunity cost of liquid funds.

The decision of how many liquid assets should be kept in bank’s asset portfolio over and above the required reserves is guided by bank’s liquidity management philosophy.

A bank needs to lay down formal policies on liquidity management. These policies describe the maximum extent to which banks can be exposed to liquidity risk.

The policies also describe how the liquidity limits are set under different scenarios. For example, what should be the liquidity level in a crisis?

These policies are generally based on a decision making structure. The decision making structure on liquidity management reflects the importance attached by the management to liquidity. If the management thinks that liquidity management is vital for bank’s stability, then it assigns the ultimate responsibility for setting liquidity limits to its highest level of management.

Determining and Fulfilling Liquidity Needs

The bank first needs to determine its liquidity needs and fulfil them accordingly. This two step process is as follows:

First, the bank has to calculate its liquidity requirements.

Second, the bank has to fulfil the calculated liquidity requirements.

Let’s understand each of these processes in detail.

Calculation of Liquidity Requirements

Banks generally calculate their liquidity needs by constructing a maturity ladder that consists of expected cash inflows and outflows over a series of time specified bands.

The difference between cash inflows and outflows that will result in either cash surplus or cash deficit. This can act as a starting point to measure bank’s future liquidity at any given time.

Based on any situation, banks can determine whether there is excess liquidity or whether there is liquidity shortfall.

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Fulfilment of Liquidity Requirements

Once bank’s liquidity needs are set, it will need to act towards fulfilling these needs.

A bank can either increase or decrease its liquidity by asset or liability management or by combining both.

Liquidity will increase with decrease in assets or increase in liability. Similarly liquidity will decrease with an increase in assets or decrease in liability.

On the asset side, banks can increase its liquidity by selling highly liquid assets or selling illiquid assets like property.

On the liability side, banks can increase its liquidity by increasing short-term borrowings or increasing the maturity of liabilities or ultimately increasing the share capital of the bank.

Liquidity Risk for Islamic Banks

Islamic banks have to primarily face two types of risks. The first type of risk is lack of liquidity in the market and the second type of risk is their access to funding is impaired.

In the first type of risk, banks are not able to dispose of the assets because they are illiquid. This results in a situation where bank is unable to honour its financial obligations.

There are five major factors affecting the liquidity of Islamic banks.

First, Sharī‘ah -compatible money market and intra bank market is rare. Furthermore, the Sharī‘ah prohibits borrowing on interest.

Second, the secondary markets are not mature enough. Also the range of financial instruments available for trading in a secondary market is limited.

Third, means such as using interbank market, mature market for debt products, lender of last resort facility that are necessary to manage liquidity management that are readily available to other banks are not available to Islamic banks.

Fourth, Islamic banks are additionally exposed to liquidity risk due to certain characteristics of their typical financial instruments. E.g. Murabahah contracts cannot be cancelled and Bai’ al-Salam contracts can be only traded at par.

Fifth, some Islamic banks are able to invest less of current-account holders’ funds so needlessly hold huge amounts of idle cash.

Liquidity Risk Mitigation by IFIs

IFSB has set principles for liquidity risk and they are:

1. Islamic Financial Institutions shall have in place a liquidity management framework (including reporting) taking into account separately and on an overall basis, their liquidity exposures in respect of each category of current accounts, unrestricted investment accounts and restricted investment accounts.

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2. Islamic financial institutions shall undertake liquidity risk commensurate with their ability to have sufficient recourse to Sharī‘ah -compliant funds to mitigate such risk. Many initiatives have been taken internationally to mitigate liquidity risk and promote growth of Islamic banking.

These include the introduction of Sukuk or Islamic bonds and other national Sharī‘ah - compatible securities.

Also included is the establishment of institutions such as International Islamic Financial Markets and the Liquidity Management Center.

In 1994, the Malaysian central bank, Bank Negara Malaysia, introduced the Islamic Interbank Money Market (IIMM).

Click the Resources button to learn more about IIMM.

Chapter Summary

You have completed the chapter, Asset-liability Management and Liquidity Risk. We can summarise the chapter as follows:

 Islamic banks are exposed to certain risks which are associated with treasury management  A bank is exposed to ALM mismatch risk when the maturities of assets are different from that of liabilities.  Theoretically, Islamic banks are supposed to be less exposed to ALM mismatch risk than their conventional counterparts because of pass through and risk sharing reasons. But in reality, Islamic banks are largely exposed to ALM mismatch risk.  Trend towards less risky short term assets, low participation in profit-and- loss sharing arrangements and lack of distinction between investor-depositors and shareholders are the three major deviations from the basis of Islamic banking contributing to Islamic risk.  Banks are exposed to liquidity risk if the maturity profile of their assets does not match with the maturity of its liabilities.  Formal policies on liquidity management must describe the maximum extent to which banks can be exposed to liquidity risk.  Banks should calculate the liquidity requirements and fulfil the liquidity requirements as a process of liquidity management.  In general, lack of liquidity in the market and lack of access to funding when required are the two types of risks faced by the Islamic banks.  IFSB has defined principles to mitigate the liquidity risk.

Chapter 7: Market Risk

Chapter Introduction

Market Risk.

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Banks experience losses because of unfavourable movements or fluctuations in the market prices of securities. This is known as market risk.

There are two ways in which a bank can expose itself to market risk. One way is if a bank deliberately takes a speculative position or engages in proprietary trading. The other way is when a bank engages in market-making or dealer activities.

The Islamic Financial Services Board (IFSB) realised the significance of market risk and in December 2005, it issued a comprehensive document on the standards for risk management.

Principle 4.1 of this document, “Islamic financial institutions shall have in place an appropriate framework for market risk management (including reporting) in respect of all assets held, including those that do not have a ready market or are exposed to high price volatility.”

On completing this chapter, you will be able to:  Explain how market risks are connected to price volatility.  Describe the different types of market risks affecting IFIs.  Describe how the Mudarabah and Musharakah contracts affect market risk for IFIs.  Describe market risks for IFIs derived from basic market risks.  Explain the need for accurate measurement of market risk and the approaches to measurements.  Explain the VAR model for measuring market risk.  Explain the table-based measurement model and its limitations.  Identify the adjustments required for calculating market risk for IFIs.  Explain the importance of managing rate-of-return risk for IFIs.  Explain the need for and policies in effective management in IFIs of market risks.  Explain the importance of marking to market for IFIs.  Explain the critical requirements for an effective market measurement and management system.

Market Risk

Market Risk Let’s learn a little more about Market Risk. Changes in the prices of standard instruments like equity instruments, commodities, fixed-income securities and currencies result in market risk.

Options, currency derivatives, equity derivatives and interest rate derivatives carry market risk as well. An option is a financial derivative instrument that represents a contract sold by one party to the other, to buy a certain commodity at the agreed price.

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The major components of market risk include commodities risk, currency risk, rate-of- return risk and equity position risk.

Each component comprises a common aspect and a particular aspect that may arise in a bank’s portfolio.

Now that you know about market risks, let’s learn about price volatility.

Price Volatility

When discussing volatility of assets, it is important to note that trading and investment portfolios have significant price volatility. Both mature markets and emerging markets are volatile, but the latter are more volatile. Large institutional investors, such as pension funds, investment funds and insurance companies, adjust their trading portfolios and investments through large-scale trading. In markets with rising prices, large purchases tend to drive up prices. Alternatively, when investors sell large lots of securities, markets with downward trends become more volatile. In turn, this causes prices to vary more and enhances market risk. This has had significant impact on the structure of markets and market risk.

As banks diversify to market-making and proprietary trading activities, they are exposed to greater market risks. They provide for some “risk capital”, which they use for taking risk. Banks usually maintain two portfolios, a proprietary trading portfolio and an investment portfolio.

The proprietary trading portfolio seeks to benefit from market opportunities with leveraged funding such as repurchase agreements.

Banks hold and trade the investment portfolio as a buffer because its liquidity is comparatively steady.

It is important to remember that both portfolios face market risk.

Types of Market Risks for IFIs

For a financial institution, market risk arises as unfavourable price movements. These risks affect the asset’s financial value over the duration of the contract.

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There are different risks that affect Islamic Financial Institutions (IFIs). These include markup, price, leased asset value, currency, securities price, rate-of-return and equity investment risks.

Let’s learn about each one in detail. Markup Risk Islamic banks face markup risk. This is because for the duration of the contract they use a fixed markup rate in Murabahah and other trade-financing instruments, while the benchmark rate may change.

This rate is fixed for the period of the contract; however the benchmark rate may change.

If the prevailing markup rate is higher than the contractual rate agreed by the bank, the bank will not benefit from higher rates.

Islamic banks use the London Interbank Offered Rate or LIBOR as the benchmark, when an Islamic index of rate-of-return doesn’t exist. This aligns their market risk closely with the movement in LIBOR rates. Price Risk Another type of risk an Islamic bank is exposed to is price risk. This risk occurs because of volatility in commodity prices in the case of Bai’ al-Salam or forward sale. Prices tend to be volatile in the time between the delivery of the commodity and its sale at the prevailing market price. If not hedged correctly, the price risk is similar to the “market risk of a forward contract”. To hedge its position, the bank enters into a parallel off-setting Bai’ al-Salam contract. Even if there is default on the first contract, the bank is still bound by the second contract. As a result, the bank is exposed to price risk. Leased Asset Value Risk Ijarah is a contract where the financier leases or rents equipment or any other assets to the entrepreneur for a fee.

When the bank is the financer, it faces market risk. This is because over the contract duration, the asset’s residual value drops.

Under this type of risk, the bank will have to bear the risk at the time the lease expires or if the contract is terminated prematurely.

Currency Risk It arises from a discrepancy “between the value of assets and that of capital and liabilities denominated in a foreign currency or vice versa.”

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When the difference “between foreign receivables and foreign payables is expressed in a domestic currency,” it also gives rise to this type of risk.

Currency risk, which is speculative, leads to either a gain or a loss based on the direction in which the exchange rate changes. It also depends if the bank is net long or net short in the foreign currency. If a bank is net long and the currency depreciates, the bank will benefit; if it appreciates, the bank will lose. If the bank has a net short position, exchange rate movements will have the opposite effect. Movement in foreign exchange rates is another risk occurring due to the deferred trading nature. This risk arises if the value of the currency of payable dues appreciates and the value of the currency of receivables depreciates. Islamic financial institutions face higher currency risk because there are no tradable derivatives with which to hedge currency risk. Security Price Risks Islamic banks invest in marketable securities as the market for Sukuk or Islamic bonds grow.

The prices of these securities are exposed to current market yields. As the yields go up, the prices go down and the reverse is also true.

Banks that hold such securities risk volatile yields, unless they hold on to the securities until maturity. In addition, Islamic banks may be exposed to distorted prices “since the secondary market for such securities may not be very liquid.”

Rate-of-Return Risk The rate-of return risk is associated with mismatches that arise between the bank assets and the depositor’s balances. If an Islamic bank expects to earn more than what it anticipated initially, the investors may also expect the same rate-of-return. To understand how the rate-of-return risk differs from interest rate risk, let us compare conventional and Islamic banks. First, in conventional banks, there is lesser uncertainty in the rate-of-return on investments held until maturity since their model is of ‘fixed interest on income securities’. Islamic banks offer a combination of markup-based and equity-based investments, making the rate-of-return more uncertain. Second, conventional banks define the return on deposits in advance. However, in Islamic banks it is anticipated, but not agreed in advance. Also, returns on some investments like equity partnerships are not known accurately until the period of investment ends. During this period, if the anticipated rates of return change, investors may expect to receive these improved rates from the bank.

Equity Investment Risk Islamic financial institutions are exposed to equity investment risks in profit- and loss- sharing investments. These include partnership-based Mudarabah and Musharakah investments.

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Other investments that carry this equity investment risk include holdings of stock market shares, private equity investments, equity participation in specific projects and syndication investment. Regular commercial banks do not invest in equity based assets as Islamic banks do, making this risk unique to Islamic financial institutions. The liquidity, credit and market risks arising from holding equity investments leads to volatility in the financial earnings of the institution. Equity based assets have credit risk, but there is also a considerable amount of financial risk, which means loss in business could lead to loss in capital.

Market Risk from Mudarabah and Musharakah

Both Mudarabah and Musharakah are equity-type facilities that carry a significant investment risks. Hence, they constitute a miniscule share of all assets.

Research results have shown that that in Islamic banks, the share of Mudarabah and Musharakah facilities and traded equities varied from 0 to 24 percent, with a median share of about three percent.

The recommendations made in Basel III (paragraph 50) can be used to measure the potential loss in equity exposures that are not traded.

Note that Basel III norms are now replacing Basel II measures worldwide.

Expected and unexpected loss can be estimated using given net equity exposures. This is done by “using the probability of default corresponding to a debt exposure to the counterparties whose equity is being held” and a high loss due to default, for example 90 percent, could be applied. These parameters help in computing both expected and unexpected loss.

Islamic banks must closely monitor Mudarabah projects since those who provide the finance cannot interfere in the management of these projects.

The extent of adjustment for operational risk depends on how well internal control systems of the bank can monitor Mudarabah facilities. It is necessary to assign additional unexpected loss due to such operational risk factors on the asset side.

In the case of Musharakah, as far as the bank exercises control over its management, operational risk adjustment required may be less.

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A different supervisory treatment and a lower loss for default could be considered if the bank’s equity interest in a counter party is based on regular cash flow instead of capital gains, is a long term interest or if it is connected to a customer relationship.

As proposed in Basel III, if equity interest is short term and relies on capital gains as in the case of traded equity, a value-at-risk approach can be used to measure capital at risk, subject to a minimum risk weight of 300 percent.

Issues due to Mudarabah and Musharakah

There are issues in Mudarabah and Mushrakah contracts that increase risk for Islamic banks, as a result of which Islamic banks tend to allocate limited funds to these assets.

Let us learn what these problems are and how they can be addressed.

Mudarabah Issues There are some issues in Mudarabah contracts, which make them risky for Islamic banks. Let’s learn about them.

When Mudarabah is used on the asset side of the balance sheet in Islamic banks, it gives rise to moral hazards. For instance, if the partnership fails, the bank bears all the losses. It cannot expect the fund user or Mudarib to return it and fund users could exploit such situations, as shown by research results.

The bank does not have the right to monitor or manage the project. If the entrepreneur shows a loss, then the bank loses its principal investment and its share in the profits, as shown by research results.

There could be principal-agent problems when an Islamic bank enters into a contract as a principal or Rabbul-māl and the user of funds is the agent.

A Mudarabah contract may provide incentives to the user of the fund to increase expenditure on the project or to increase consumption of monetary benefits at the expense of monetary returns.

The bank bears a part of this increased consumption, but the entrepreneur enjoys the benefits entirely. Similar problems arise on the liabilities side, if investment account holders invest their money with the Islamic bank through a Mudarabah contract.

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Musharakah Issues There are some issues in Musharakah contracts, which make them risky for Islamic banks.

In these contracts, the moral hazard problem is reduced because the capital of the partner is also at stake. There is equal partnership and an Islamic bank is permitted to manage the project in which it is investing. Therefore, this type of partnership reduces the problem of informational asymmetry.

The Musharakah requires extensive screening, information gathering, and monitoring. Therefore, if a wrong asset class is selected, it has an associated cost. The cost of intermediation is higher, because each Musharakah contract requires careful analysis and negotiation of profit and loss-sharing arrangements.

More Market Risks for IFIs

There are some other types of market risks for IFIs; these are hedging, benchmark and business risks.

Hedging Risk Hedging risk occurs when a bank fails to mitigate and manage different types of risks. It exposes a bank to even greater risk.

With no derivatives products to hedge risks, nonexistent secondary markets become sources of the higher hedging risk for Islamic banks.

Benchmark Risk Benchmark risk is the loss that is incurred because of the change in the margin between domestic and benchmark rates of return.

Many Islamic banks don’t have a reliable domestic benchmark rate-of-return and use the LIBOR, an external benchmark, to price the markup in Murabahah contracts. Return on assets can be impacted if domestic monetary conditions change and if the margin between the external benchmark and domestic rates of return shifts.

This risk must be considered when calculating the rate-of-return and market risks. The fact that benchmark risks exists indicates that countries with Islamic banking must construct a domestic rate of-return benchmark so that deposits and assets can be both aligned to it.

Business Risk

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Business risk is associated with a bank’s business environment. It includes macroeconomic and policy concerns, legal and regulatory factors, payment systems and auditors and the risk of insolvency due to inadequate capital to continue operations.

IFIs face the normal business risks, but in particular they are exposed to rate-of-return risk.

Measuring Market Risk

A bank must take timely and accurate measurement of market risk as its involvement in investment and trading activities increases and the market environment becomes more volatile.

This can be done by measuring the exposures on a bank’s investment and trading portfolios and its balance sheet positions.

There are two approaches to assessing market risks; the simplistic approach and the comprehensive approach.

The simplistic approach treats every market as a separate entity. It does not consider the possible inter-market relationships that may exist among various markets and measures each risk individually.

The comprehensive approach proposes evaluation of risk from an integrated viewpoint. It considers the relationships among markets and how a movement in one market may affect other markets too. For example, the approach considers that any fluctuation in the exchange rate may alter the price of bonds issued in a specific currency.

For more reading on the measurement of market risk, please refer to Khan and Ahmed (2001).

Click the Resources button at the top of the screen to view a table comparing the two approaches.

Value at Risk (VAR) Model

Value at Risk or VAR is a modeling technique to measure a bank’s aggregate risk. It helps to estimate a bank’s loss if it holds on to certain assets for a certain duration, given a certain level of probability.

This model uses input data, such as the bank’s positions, prices, volatility, and risk factors, such as markup risk, equity, currency and commodity positions intrinsic to the bank’s portfolio for on and off-balance sheet positions.

The VAR-based model combines the changes in the value of each underlying risk factor with the probability of such movements occurring. It sums up the changes in value across all trading activities and markets.

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Value at Risk (VAR) Model – Calculation

There are many methods to measure Value at Risk. The parameters used to measure VAR and allow for the prudent assessment of the magnitude of protection include a holding period, a period during which risk factor prices are observed, and a confidence interval.

There are four areas that have to been considered when using this model. Let’s learn about them.

Holding Period Value at Risk is first broken down by type of risk or asset class. All aggregate values are estimated for one-day and two-week holding periods. Finally, Value at Risk is reported as high, median, and low values over the reporting interval and at the end of the period.

Aggregate Risk Information about aggregate risk and return is also taken into account. It includes a comparison of risk estimates with actual outcomes, such as a histogram of daily profit or loss divided by daily value at risk. It could also be an alternative depiction of the relationship between daily profit or loss and daily value at risk.

Other Factors Other factors that are taken into account include the qualitative discussion and the comparison of profit or loss and value at risk. Differences between the basis of the profit or loss and estimates of value at risk are also included.

Quantitative Measures of Exposure A quantitative measure of exposure to market risk is broken down by type of risk for a given period. It is reported at the end of that period in terms of high, medium and low values.

The Table-based Measurement Model

Assessing and measuring risk systematically and managing the net open position are important. Methods like calculating the net open position or market factor sensitivity to value at risk provide more sophisticated risk estimates.

The standard or table-based tool method offers a simple and practical way of measuring market risk. It totals the assets to arrive at a net open position. The results are reflected on the balance sheet.

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Let’s see how this is done.

Forward and unsettled transactions are considered determine a projected position at book value, This is translated into market value and finally represented as a common denominator representing an equivalent position in the cash markets.

On the basis of the net open position, it is possible to estimate the potential earnings or capital at risk by multiplying the net open position by price volatility. It is important to note that the standard or table-based tool is a simple, single-factor value at risk estimate. It does not consider correlation between positions.

Other Measurement Tools

Risk is based on the probability of events. To capture market risk correctly, a single tool will not help. The market risk is always higher if a bank does not have an adequate portfolio system.

Another measure banks use is called marking to market to protect its capital. The investment portfolio and the trading book should be marked to market on a daily basis to maintain the real value of positions.

In Islamic banks, instruments used in techniques for measuring market risk are limited to traded equities, commodities, foreign exchange positions and various forms of Sukuk.

Islamic banks carry a large share of cash and liquid assets. These assets exceed short- term liabilities significantly. In this case, market risk can be measured using traditional indicators like net open position in foreign exchange and net positions in traded equities and commodities.

Measuring Market Risk for IFIs

In Islamic banks, techniques for measuring market risk are limited to traded equities, commodities, foreign exchange positions and various forms of Sukuk. Islamic banks carry a large share of cash and liquid assets and they exceed short-term liabilities significantly.

In this case, market risk can be measured by the traditional indicators of exposure like:  net open position in foreign exchange,  net positions in traded equities,

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 net positions in commodities,  rate-of-return gap, measured by denominated currency and  various duration measures of assets and liabilities in the trading book.

Liquidity and Duration Gap Measures

Liquidity gap is the gap between assets and liabilities at various periods. Most Islamic banks calculate and publicise their liquidity gap. Identifying this gap makes it easy to compute the rate-of-return or repricing gap.

The duration gap is considered to be a core indicator of financial soundness, but it is not disclosed in various banking systems.

These liquidity and duration gaps indicate if a bank is financially sound.

A change in exchange rate, equity price, commodity price, or rates of return can impact a bank’s earnings. This impact can be computed as the appropriate gap or other indicators of exposure, times the corresponding price change.

Liquidity and duration gap measures are a simple approach and may not be adequate to compute the impact of interest rate variances on fixed maturity, equity-type exposures such as Mudarabah and Musharakah.

For these equities, the effect of variations in the rates of return on the expected profits or income must be computed first, or prior to calculating the gaps in each maturity period, the equity exposures should be calibrated using a multiplicative factor.

In the case of assets and liabilities with a longer-maturity period, a more accurate measure of market risk is the change in the present value of these assets. This is because shifts in rates of return more accurately measure market risk than an estimated change in earnings for a particular period.

Rate-of-Return Risk for IFIs

In most Islamic banks, the rate-of-return risk is more important than market risk. Rate-of-return gap and duration gap when applied to the banking books measure exposure to changes in benchmark rates of return and impact on bank earnings of the present value.

The stress test is applied at various maturity periods. This test is applied for maturing instruments or for reprised instruments.

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Suppose a simple stress test of one percent increase is applied to both maturing assets and liabilities or those being reprised, at various maturity periods. It will yield a measure of loss or gain because of the shift in the structure of the rate or return. This shift is uniform for a particular term.

Alternatively, the impact of changes in the rate of return can be calculated directly from duration measures. It is the difference between the Duration of Assets and the Duration of Liabilities multiplied by the change in the rate of return.

Islamic banks are responsible for managing investors-depositors expectations, making rate-of-return risk a strategic risk. In addition, rate-of-return risk has two subcategories, displaced commercial risk and withdrawal risk.

Displaced commercial risk and withdrawal risk is covered in detail in Chapter 5 of this course.

Managing Market Risk for IFIs

Banks can manage its market risk in different ways. Let’s start by learning why managing market risk is necessary and then go on to learn about the different ways of managing this risk.

To manage market risk, managers must be vigilant of how a bank’s exposure to market risk relates to its capital.

Every bank has objectives and related policy guidelines to protect its capital from the negative impacts of unfavourable price movements. A bank’s market risk management policies should reflect these objectives and policy guidelines. The bank formulates these guidelines within the applicable limits of its legal and prudential framework.

The ways in which banks manage their market risk vary. Some ways of managing this risk include marking to market, positions limits, stop-loss provisions and limits to new market presence. Let’s learn about each in detail.

Mark-to-Market

Marking to market refers to the “repricing of a bank’s portfolio to reflect changes in asset prices due to market price movements.”

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According to this policy, the assets must be repriced at the market value of the asset to comply with International Accounting Standard (IAS) 39. How often the bank reprices will depend on the volume and nature of the activities. Ideally banks should evaluate and (re)price positions related to their investment portfolio at least monthly.

Assets in a bank’s trading portfolio are traded on an ongoing basis. Therefore, their price positions in relation to a bank’s trading portfolio should be assessed and marked to market at least once daily.

All related reports must be reviewed by the senior bank executives responsible for the bank’s investment, asset-liability and risk management.

Position Limits

A bank’s market risk policy should provide limits on its long, short or net positions and should relate to the capital available to cover market risks. These position limits are set keeping in mind that risks could arise when unrealised transactions like open contracts or commitments to purchase and sell securities are executed. Some examples of open contracts include option contracts or repurchase agreements.

When setting these limits several factors are taken into consideration. These include the specific organisation of investment or trading functions and the technical abilities of individual dealers or traders.

Apart from these, other factors taken into consideration include the quality of analytical support provided to the dealers or traders, specific characteristics of a bank’s investment or trading portfolios and the level and quality of its capital. It is important that the bank’s policy on position limits must specify how often position valuations and limit controls should be calculated.

Stop-Loss Requirements

The risk management policy must include instructions for a stop-loss sale or must require consultation related to a predefined risk budget.

The stop-loss exposure limit is calculated by taking into account a bank’s capital structure, earning trends and its overall risk profile.

When losses on a bank’s positions cross acceptable levels, the bank can do one of the following:

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 Consult with risk management professionals or the asset-liability committee in order to establish or affirm the stop-loss strategy or  Make sure that all positions are closed automatically.

Limits to New Market Presence

The key factor behind innovation is profit. In a highly competitive market, innovation pressurises competitors to engage in a new businesses in an effort to make profits or not to lose market presence.

There are risks involved with innovation. For example, a bank must be willing to invest in or trade a new instrument even if its return and variance has not yet been tested in the market or even if an appropriate market for the instrument has not developed yet.

This involves a certain amount of risk for which they must have risk management policies in place. These policies must address the newness of the market or the instrument.

Banks must also often review limits related to a new market and make necessary adjustments. New markets attract more competitors due to the higher profits and therefore the overall market grows faster.

When a bank transacts with a new instrument, it helps deepen and broaden secondary markets and improves their liquidity. As a market establishes itself and liquidity increases, a bank should readjust its limits in line with the requirements of mature markets.

Marking to Market for IFIs

Traditionally Islamic banks trading portfolio has been very small or nonexistent. However, this trend has been changing with the emergence of Islamic bonds or Sukuk. Now more Islamic banks are maintaining trading portfolios. This portfolio should be assessed and marked to market at least once daily.

This strategy has several difficulties and challenges for Islamic banks.

Let’s examine what these are more closely

Shallow Secondary Market

The trading portfolio of Islamic banks is either very small or nonexistent because of shortages of marketable Sharī‘ah -compliant securities. However, with the introduction of Islamic bonds or Sukuk, more banks now maintain trading portfolios.

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Many banks hold on to their investment until maturity, this is because there is a shallow secondary market for Islamic bonds.

Financing Assets Using Murabahah and Salam Financing assets using Murabahah and Salam makes marking to market difficult because once they are sold they are not negotiable or tradable.

If a client refuses to take delivery of underlying assets, Islamic banks will be exposed to price risks. In such cases, Islamic banks should mark to market these assets and regularly monitor their risks.

Marking to market gets more difficult in the case of other financing assets based on Ijarah and Istisna’a because they are not negotiable and not liquid.

Commingling of Funds Islamic banks invest their equity capital along with the assets of investment account holders. This makes it difficult for them to conduct an accurate analysis of equity’s exposure to market movements. Since such analysis is crucial, it is recommended that equity funds should be kept separate from funds deposited by investment account holders.

Pricing Methods

The marking to market policy should address the bank’s responsibilities with regards to pricing and methods to determine a new market price for assets.

A bank’s risk management policy should state that officers who are not connected to the dealer or trader and his or her managers should determine prices and execute marking to market.

Independent, third-party price quotes must be considered if pricing positions have to be effective. One way of doing this is to acquire the latest information on the price and performance of assets held in its portfolios from external sources.

Effective Market Risk Measurement and Management

Banks engaged in trading must have systems in place to measure and manage market risk. These systems should be sound and implemented with a great amount of value. The Basel Committee has specified a set of qualitative criteria for market risk measurement.

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A bank must meet these criteria to be eligible to apply the minimum multiplication factor for market risk capital charges. Let’s learn about these criteria in more detail.

Independent Risk Control Unit A risk control unit should be appointed. This unit would be independent from business trading units and should report directly to senior management of the bank.

The unit would be responsible for designing and implementing a bank’s market risk management system.

It should produce daily reports on and analyse the connections between the measures of risk exposure and trading limits.

Senior Management’s Involvement The board and senior management must get actively involved in the risk control process. They should review the daily reports prepared by the independent risk control unit and reduce the positions taken by individual traders and the bank’s overall risk exposure.

Integration with Daily Risk Management The market risk measurement system should be integrated into the daily risk management process. It should be used together with trading and exposure limits.

Stress Testing A bank’s risk measurement system should be able to compare measures generated by the bank’s internal model against daily changes in value of portfolio as well as against hypothetical changes based on static positions.

The ultimate test of a bank’s risk measurement system is to compare actual profits or losses with budgeted profits. Routine and rigorous stress testing is required to support the model’s risk analysis.

The senior management should review the results of stress testing. These results should be factored into the bank’s policies and limits regarding market risk exposure, especially in situations and circumstances where stress tests reveal specific vulnerability.

Compliance Process

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Finally, a compliance process should be in place. This will ensure that the trading activities and operation of the risk measurement system are in keeping with the bank’s documented policies, controls and procedures.

Chapter Summary

You have completed the chapter, Market Risk. In this chapter, you have learnt that:

o A bank experiences market risk, which are losses, because of fluctuations in the market prices of securities.

o The major components of market risk include equity position risk, commodities risk, rate-of-return risk and currency risk. o Large institutional investors adjust their investment and trading portfolios through large-scale trading. o Banks maintain two portfolios, a proprietary trading portfolio and an investment portfolio which are subjected to market risk. o Market risks are of different types. These include markup, price, leased asset value, currency, securities price, rate-of-return and equity investment risks. o Islamic financial institutions face equity investment risks in profit- and loss- sharing investments like Mudarabah and Musharakah investments. Other types of market risks for IFIs are hedging, benchmark and business risks. o There are two approaches to assessing market risks, the Simplistic approach, which treats every market to which the bank is exposed as a separate entity and the Comprehensive approach, which proposes risk assessment from an integrated perspective. o Value at Risk or VAR is a modelling technique that measures a bank’s risk by estimating a bank’s loss if it holds on certain assets for a certain duration, given a certain level of probability. o The standard or table-based tool method measures market risk by totalling the assets to arrive at a net open position and the results are reflected on the balance sheet. o In the marking to market method, the investment portfolio and the trading book should be marked to market daily to maintain the real value of positions. o Some other techniques Islamic banks use include traded equities, commodities, foreign exchange positions, and various forms of Sukuk for measuring market risks. o Since Islamic banks carry a large share of cash and liquid assets which exceed short-term liabilities significantly, they use traditional indicators to measure market risk. o Islamic banks calculate and publicise their liquidity gap at various periods, which helps to compute the rate-of-return or repricing gap. o The rate-of-return risk is more important than market risk in Islamic banks. o Banks manage their market risk in different ways like marking to market, positions limits, stop-loss provisions and limits to new market presence. o The mark-to-market strategy has several difficulties and challenges for Islamic banks. o The Basel Committee has specified some guidelines for market risk measurement like appointing an independent risk control unit, which would have several responsibilities. o The board and senior managers should be actively engaged in the risk control process. o The market risk measurement system should be integrated into the daily risk management process. o A strong compliance process will ensure that trading activities and operation of the risk measurement system are in keeping with the bank’s documented policies, controls and procedures.

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Chapter 8: Governance in Islamic Banks

Chapter Introduction

Governance in Islamic Banks.

The governance in Islamic banks is similar to the corporate governance structure of any other bank in the world. The corporate governance structure of a bank is centred on the needs of the shareholders of the bank. In addition to this role, the Islamic banks need to perform two other functions.

Firstly, stakeholders in Islamic banks want their finances to be managed according to Sharī‘ah principles. Islamic banks need to assure these stakeholders that the bank’s operations are aligned with the Sharī‘ah principles.

Secondly, stakeholders also need to be assured that their Islamic bank is a trustworthy, financial services provider. Islamic banks need to assure stakeholders that they will invest their time and effort on assets that are competitive and provide acceptable risk- return tradeoffs to their clients.

To cater to these needs, Islamic banks constitute Sharī‘ah boards and internal review units to check Sharī‘ah compliance and satisfy stakeholders.

On completing this chapter, you will be able to:

 Explain the difference in approach to governance between the conventional and Islamic financial systems,  Recognise the Basel II Core Principles regarding bank supervision and the enabling factors for implementing them,  Recognise the need for IFIs to conform to Basel II Core Principles for banking and financial services,  Identify the theoretical responsibilities of an IFI’s Sharī‘ah Board and the practice in some Islamic countries,  Describe the five main issues with Sharī‘ah boards in IFIs and

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 Describe other types of entities that can be tasked with ensuring Sharī‘ah compliance.

Basis for the Governance Model in Islamic Finance

In comparison to the conventional model of corporate governance, the Sharī‘ah-based stakeholder model of corporate governance is a more comprehensive approach.

This is because the Sharī‘ah-based corporate governance model is based on the following principles of Islam:  Preservation of the property rights of individuals, organisations and communities  Importance of both explicit and implicit contractual obligations  Creation of incentive schemes to enforce the rules of Sharī‘ah

Let’s now see in more detail how the Sharī‘ah-based stakeholder model differs from the conventional shareholder model.

While the conventional model of corporate governance is centred on the shareholder or owner, the Islamic Sharī‘ah-based model is centred on protecting the interests of all members of society, both individually and collectively.

Secondly, unlike the conventional model, the Islamic Sharī‘ah-based model requires public policy institutions, regulatory and supervisory authorities and Sharī‘ah authorities to take an active role in evaluating the performance of the bank and ensuring its commitment to explicit and implicit contracts.

Although this Sharī‘ah-based model of corporate governance imposes banks to protect stakeholders’ rights through contractual obligations, it is important to note that it does not negate the rights of the shareholders. This model provides a balance among both the sections.

Basel III Core Principles Regarding Bank Supervision

Let’s now discuss the Basel Committee’s recommended Core Principles of effective banking supervision.

The Basel III Core Principles encourage supervisors to ensure that the overall health and stability of the banking system is maintained, governance of banks is improved and legal requirements are complied with.

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The Basel III Core Principles emphasises that supervisors review the following factors:  Lending and investing procedures of the bank  Adequacy of licensing and capital  Classification of different types of risks  Risk management strategies of the bank  Procedure to evaluate the quality of banks’ assets  Loss provisioning procedures  Level of exposure permissible to directors and related persons and individual borrowers  The type of internal supervision and external audit to enforce fairness and accuracy in bank operations There are certain qualities that supervisors need to have while reviewing the factors mentioned by the Basel Committee. A supervisor should:  Have a proper understanding of the banking industry and the problems that banks face,  Have undergone training to perform their job,  Be capable of recognising the risks involved in the bank’s operations and determine suitable risk mitigation strategies and  Possess the legal authority to implement corrective steps before it is too late.

Note: Basel III norms are now replacing Basel II measures worldwide.

Basel III Core Principles and IFIs

The Core Principles recommended by the Basel Committee applies to not just conventional banks but also to Islamic financial institutions or IFIs.

When the investment depositors participate in the risk that the bank faces, why should Islamic banks be subjected to regulations any more than normal corporations?

This is because of the following reasons. (Chapra and Khan, 2000).  Systemic Considerations  Protection of Depositors  Sharī‘ah Compliance  International Acceptance

Let’s look at each of the reasons in detail.

Systemic Considerations

While the failure of a corporation may affect primarily its own shareholders, who are expected to be on guard, the failure of a bank has implications for the health and stability of the whole payments system as well as the development of the economy.

If depositors lose confidence in the system, they will withdraw their deposits, which will not only destabilise the financial system but also jeopardise their availability for financing development.

Protection of Depositors

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The interest of the demand depositors needs to be safeguarded. However, investment depositors also need greater safeguards than those enjoyed by shareholders in non- bank corporations. This is because of the significantly higher leverage in banking business. Such leverage would come from demand deposits. The higher the proportion of demand deposits, the higher would be the leverage.

This would necessitate the banks to adopt certain procedures that would prevent arbitrariness in investment decisions, mismanagement and excessive risk exposure, and manage prudently whatever risks they take. They would also have to build adequate reserves to avoid excessive erosion of investment deposits.

Sharī‘ah Compliance It is necessary to ensure the faithful compliance of banks with the teachings of the Sharī‘ah.

International Acceptance It is essential that Islamic banks are accepted in the inter-bank market of the international financial system. This will not happen unless they conform to international regulatory standards.

The Role of the Sharī‘ah Board

The Sharī‘ah boards that form part of a bank perform the following tasks:  Design, develop, and issue Sharī‘ah-compliant financial products and legal instruments  Conduct ex ante Sharī‘ah audit and ex post Sharī‘ah audit. Ex ante Sharī‘ah audit involves the certification of permissible financial instruments through Fatwas and ex post Sharī‘ah audit involves checking transactions’ compliance with issued Fatwas  Estimate and pay Zakah or alms.  Discard earnings that are not compliant with Sharī‘ah  Issue an annual report on Sharī‘ah compliance of transactions  Counsel shareholders and investment depositors on the distribution of income among them

Sharī‘ah boards can also belong to an external institution such as the central bank. All Islamic countries have Sharī‘ah boards.

The only Islamic country that does not have a Sharī‘ah board is the Islamic Republic of Iran where the central bank also performs the role of the Sharī‘ah board and monitors compliance of the banks with Sharī‘ah.

All Sharī‘ah supervisory boards are provided with ex ante monitoring to ensure that all operations are in compliance with Sharī‘ah. Although the overall functions of all Sharī‘ah

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boards are the same, the internal tasks of each Sharī‘ah board vary. These tasks are determined by the Islamic bank’s articles of association. Apart from this association, national and international regulators also impose guidelines for Sharī‘ah boards. These guidelines primarily discuss rules on compliance of transactions with Sharī‘ah.

Click the Resources button at the top of the screen to view the following:  Countries that implement Sharī‘ah boards and Islamic rating agencies  Salient features of Islamic banking and supervisory systems in some Islamic Development Bank (IDB) member countries (Chapra and Tariqullah, 2000)  Guidelines imposed by the national and international regulators related to the functioning of Sharī‘ah boards

Issues for Sharī‘ah Boards

Although the Sharī‘ah-based stakeholder-centred model of governance has proved to more effective than the conventional model, the functioning of the Sharī‘ah board faces the following problems:  Conflict of interest  Multiple membership  Lack of competence  Inconsistency  Disclosure of information

Conflict of Interest The members of the Sharī‘ah board are selected by the bank’s shareholders and are employed by the bank. While the Sharī‘ah members need to assess and provide an unbiased opinion on the bank’s operations, their employment status can create a conflict of interest and a loss of their independence. The Sharī‘ah board members may be under the influence of the management and may produce false assessments.

This problem can be mitigated to an extent by appointing members who are scholarly, have high ethical values and are aware of the implications of losing the confidence of the bank’s stakeholders. This may however not be a viable measure.

Multiple Membership Since Sharī‘ah scholars belong to more than one Sharī‘ah board at a time, there is a problem of confidentiality, especially if they belong to boards of competing banks. They will have access to proprietary information and will face a potential conflict of interest.

The Malaysian government has suggested scholars to work with only one bank at a time. However, most board members in Malaysia can only work part-time because their main occupation is academic research and teaching.

Although this step may eliminate the problem of confidentiality, there are some practical problems such as:  Alack of competence in areas that already has shortage of Sharī‘ah experts,

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 A decline in the number of people opting for the profession of Sharī‘ah audit due to a small income generated from only one bank and  An increase in partiality caused due to a symbiotic relationship formed between the auditor and the Islamic bank.

Lack of Competence

The Sharī‘ah board members need to be well-versed not only in Sharī‘ah but also in the day-to-day commercial, banking and accounting practices of the bank. There are very few people who are talented in all these disciplines.

This problem has been overcome by appointing members from different backgrounds as part of the Sharī‘ah board. But, this measure causes a lot of conflicting opinions among the members.

Secondly, initiatives taken through public policy and cross-disciplinary training will help produce new talent with multitalented skills.

Inconsistency The members of the Sharī‘ah board determine the permissibility of a financial instrument based on their interpretation of Sharī‘ah rules and legal sources. Since interpretations differ, it is found that there is a lot of conflicting opinions on permissibility of instruments and financial transactions across Islamic banks or across jurisdictions within the same Islamic bank.

This conflict in opinion will lower the confidence of the customer and create problems in the enforceability of contracts. Hence, efforts need to be taken to standardise the process of permissibility of instruments.

Disclosure of Information Disclosure of information is a problem related to the Sharī‘ah board. Several measures have been taken to ensure that there is no disclosure of information of the Sharī‘ah advisory. Some of the measures include:  Implementation of guidelines by regulators,  Creation of stable corporate governance systems and  Establishment of public rating agencies to help check compliance. The private rating agencies however have not yet nurtured the necessary Sharī‘ah talent or incentives to monitor Sharī‘ah compliance.

Other Agencies Monitoring Sharī‘ah Compliance

In addition to the Sharī‘ah boards implemented in the bank, the other agencies that monitor Sharī‘ah compliance are:  Internal Sharī‘ah Review Units  Centralised Sharī‘ah Boards  Rating Agencies

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The challenges faced by IFIs during Sharī‘ah compliance and the solutions are described in more detail in Chapter 6 of the course Maqāsid al-Sharī‘ah.

Internal Sharī‘ah Review Units

In addition to the Sharī‘ah board, most Islamic banks have an internal Sharī‘ah review unit that will perform tasks similar to the Sharī‘ah board. They will check transactions for Sharī‘ah compliance through ex post monitoring and act as a complementary unit to the Sharī‘ah board. These units however face the same challenges as the Sharī‘ah board.

Banks that comply with the standards of the Accounting and Auditing Organisation for Islamic Financial Institutions or (AAOIFI) set up these internal Sharī‘ah review units. These units function either as a separate unit of the bank or as a subunit of the audit and control department.

Centralised Sharī‘ah Boards In addition to the internal regulations set up in the bank, centralised Sharī‘ah boards have a role to play in the broader framework of Sharī‘ah governance. The centralised Sharī‘ah boards perform the following functions:  Conducting ex ante monitoring which involves standardising the way Sharī‘ah is interpreted  Conducting ex post monitoring of Sharī‘ah compliance  Ensuring Sharī‘ah compliance at all times  Provide arbitration and settlement of Sharī‘ah disputes among members of the same Sharī‘ah board

A centralised Sharī‘ah board may be an arm of the central bank or may be a private organisation with capabilities in both the Sharī‘ah and modern finance and possessing sufficient research facilities.

Once it establishes a reputation for integrity and professionalism, a private company with well-known experts may:  Command better respect than individual boards whose members may not be famous.  Help reduce duplication of efforts.  Reduce conflicting verdicts on similar issues.

A Sharī‘ah board in a central bank provides all these benefits and can guide a consensus on Fiqhi issues provided it doesn’t impose its own views.

Rating Agencies

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Government sponsored organisations such as the International Islamic Rating Agency and the Malaysian Rating Corporation have always rated Islamic banks on Sharī‘ah compliance.

However there are no private credit rating agencies in Muslim countries that can provide banks information about the credit rating of counter-parties.

Chapter Summary

You have completed the chapter, Governance in Islamic Banks. The key points of this chapter are as follows:  The Sharī‘ah-based corporate governance model protects the financial interests of the stakeholders by preserving property rights and enforcing contracts.  The Basel II Core Principles ensures that the overall governance of banks is improved by advising supervisors to review the policies and practices of the bank.  Islamic banks should also be subjected to the regulations stated by the Basel Committee due to the following reasons: o Systemic considerations o Protection of depositors o Sharī‘ah compliance o international acceptance  The role of the Sharī‘ah boards is to ensure that the bank’s operation are aligned with Sharī‘ah principles.  Sharī‘ah boards face the following challenges: o Conflict of interest o Multiple membership o Lack of competence o Inconsistency o Disclosure of information  The other agencies that monitor Sharī‘ah compliance other than the Sharī‘ah boards in the bank are: o Internal Sharī‘ah review units, which act as a complementary unit to the Sharī‘ah board o Centralised Sharī‘ah boards, which ensures effective Sharī‘ah-based governance and o Rating agencies, which rate Islamic banks based on Sharī‘ah compliance.

Chapter 9 – Improving Sharī‘ah-based Governance for Bank Accounts

Chapter Introduction

Improving Sharī‘ah-based Governance for Bank Accounts.

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Corporate governance arrangements of Islamic banks are guided and regulated by Sharī‘ah principles.

Sharī‘ah boards of Islamic banks have scholars on their panel who ensure that the Islamic bank’s financial operations comply with Islamic jurisprudence and that the bank’s shareholder’s interests are safeguarded.

There are five types of issues that Sharī‘ah boards have to deal with in respect of Islamic banks’ corporate governance.

 Independence of Sharī‘ah board from the management so that there is no conflict of interest  Sharī‘ah board members should keep the information pertaining stakeholders confidential and should not reveal it to unauthorised parties.  Sharī‘ah board members should preferably be experts on both Islamic law and commercial, banking, and accounting practices.  Sharī‘ah board members should be consistent in their judgment across banks and across jurisdiction.  Sharī‘ah board members should disclose all information regarding a Sharī‘ah advisory.

The Sharī‘ah corporate governance process can be made more efficient and uniform.

The Islamic Financial Services Board (IFSB) has issued standards for corporate governance of Islamic financial institutions. These standards provide a framework for Islamic banks to formulate and implement corporate governance.

On completing this chapter, you will be able to:  Explain two ways in which Sharī‘ah-based governance can be improved,  Describe the need for improving governance to safeguard the interests of three types of account holders in an Islamic bank,  Describe ways to protect the interests of unrestricted investment account holders,  Describe the issues arising from the treatment of reserves by banks,  Describe the challenges in corporate governance of Islamic companies,  Describe the key principles of the standard on corporate governance issued by the IFSB and  Describe the challenges for regulatory and legal infrastructures in Islamic banks.

Improving Sharī‘ah Governance

Sharī‘ah governance in Islamic banks can be further improved by making it more consistent and easier to follow. It can be done in two ways.

The first method is creation of an international, standards-setting, self-regulatory association.

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The second method is creation of system-wide Sharī‘ah board.

Let us understand each way in detail.

International Standards Association Establishing an international, self-regulatory association would ensure clear interpretation of standards and harmonise the standards and practices. This will improve public and shareholder’s understanding of corporate governance based on Sharī‘ah law.

Stakeholders will be encouraged to play a more effective role in the activities of the institution.

Setting up a self-regulatory association will also enhance the enforceability of contracts before the civil courts.

System-wide Sharī‘ah Board A system-wide Sharī‘ah board should contain members who are knowledgeable in principles of Islamic economics and finance.

Countries like Sudan and Malaysia have followed this structure. They have teams of scholars that are competent in the fields of finance, banking, accounting etc.

The system wide structure of governance is more efficient and cost-effective than that of internal Sharī‘ah boards structure because each shareholder is not subjected to duplicate monitoring and because each institution does not need to appoint its own Fatwa-issuing board.

Concerns of Account Holders in Islamic Banks

In addition to safeguarding shareholder’s interest, banks also have to protect the rights of its investment deposit holders. Typically there are three types of accounts in Islamic banks. They are current account, restricted investment accounts and unrestricted investment accounts.

Each type of account has its unique issues with respect to corporate governance.

Let us understand each account and its issues in detail.

Current Accounts There are three variations of a current account:

 The Amanahor “trust deposits,” where the Islamic bank is a trustee and promises to pay back the deposit in full,  The Qard al-Hasan, or goodwill loan, where the bank receives a loan from depositors and owes only the principal and

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 The Wadiah, or safe deposits and guaranteed banking, with the amount of principal payable on demand.

Islamic banks get implicit or explicit permission to use the deposited money of current account holders for any purpose permitted by the Sharī‘ah.

The bank pays no fixed interest or profit with the exception of distribution of gifts (Hiba) at the bank’s discretion.

Current account holders need to be protected from:

 Exposure to high-risk investments and  Unwarranted use of their funds for improving the performance of overall investments or for unlimited investments.

Restricted Investment Accounts The bank acts as fund manager or more appropriately an agent or Mudarib who isn’t participating in the contract.

The bank cannot merge its funds with those of investors without their prior approval.

The Islamic bank operates restricted investment accounts under the principle of Mudarabah. This entails customising investments and distributing profits to suit the needs of the client.

Restricted account holders comprise savvy high-net-worth investors, whose stakes are large enough so they can monitor the agent’s behavior directly.

Restricted account holders are keen on seeing full disclosure of information about returns and risks.

Bank management is responsible for ensuring that there is transparency in identifying eligible recipients and distributing profits and losses.

Unrestricted Investment Account The unrestricted investment account is the most important and most popular type of account in Islamic banks.

These accounts are based on a Mudarabah contract between account holders and the Islamic bank. The Islamic bank manages account holders’ funds. In return, it pays the account holders only according to a predetermined profit-and loss-sharing ratio.

The whole risk of performance of the investment pool lies with the unrestricted account holders, except when misconduct by the Islamic bank can be proven. In this sense, they are like shareholders, except that the agent is appointed by another principal, which is the shareholder.

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Unrestricted account holders are thus a unique category of depositors. Neither their capital nor their returns on their investment are guaranteed.

Islamic banks do not separate the funds of unrestricted account holders from shareholder funds. This raises concerns that interests of investment account holders are secondary to those of shareholders.

Therefore, these accounts pose distinctive challenges for corporate governance.

Protection for Unrestricted Investment Accounts

There are three ways to protect the interests of unrestricted accountholders. They are:

 Avoiding commingling of funds.  Giving equal rights to restricted and unrestricted account holders and  Initiating a Sharī‘ah-compliant version of deposit insurance.

Let us understand the ways in more detail.

Avoiding Commingling of Funds There is a need to stop the practice of commingling funds of investors with that of the shareholders. This creates a bad impression because investment mandates are not honoured.

Giving Equal Rights to All Account Holders Banks can give unrestricted accountholders rights that normally belong to equity holders. This might increase the involvement of such account holders in the strategic management of banks. Alternatively banks can also grant unrestricted account holders full debt-holding status and the protection that goes with it.

Initiating Sharī‘ah-Compliant Insurance A Sharī‘ah-compliant version of deposit insurance could be started. This would cover current accounts under all circumstances of bank insolvency and unrestricted accounts only in cases of insolvency resulting from fraudulent mismanagement. Banks should aim to create a permanent institutional channel to facilitate the flow of information from and to unrestricted account holders.

Issues Relating To Treatment of Fund Reserves

Islamic banks need to maintain consistent and smooth profits over time.

The objective of a profit equalisation reserve (PER) is to hedge against the risk of low income in future for distributions by retaining apart of current profits to pay investment account holders in the future. This is a very prudent risk management practice.

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There are certain issues that need to be discussed:

First, minimal disclosure about such funds and their use makes investment account holders uncomfortable.

Second, investment account holders don’t have rights to change avenues where the reserves can be used. They also cannot verify the extent to which their investments are exposed to risk.

Third, an account holder who aims at holding the investment over a long term may be interested in adding the profits to the reserves. But short-term investors may want their profits paid to them immediately, though the profits may vary or even be zero for certain periods.

Challenges in Islamic Corporate Governance

Internal corporate governance is reinforced by the external arrangements such as legal and regulatory prudential framework that are necessary to govern business activity and provide necessary information for official and private monitoring. They also help in governing Islamic bank activities.

IFIs hold assets based on the partnership contracts that convert them into stakeholders in the enterprises which they are financing. This is quite similar to the “insider” system of governance in the German banking, where bankers represent the board of directors. This kind of practice poses two challenges for corporate governance.

1. Asymmetry of information with respect to contracts and costs of monitoring An Islamic bank’s assets consist of both profit and loss sharing instruments, similar to those of Mudarabah and Musharakah. Because there is a high degree of inequality in information available in equity and profit and loss sharing contracts, a complete monitoring by the Islamic bank is required. In addition, institutional arrangements are also required to minimise the costs.

2. Importance of participation of banks in governance and the impact on accountability IFIs place more emphasis on partnership-based instruments and their participation in corporate governance is critical through the augmentation of the accountability and responsibility of the management and decision makers.

Simply adapting international standards and practices to Islamic banks is not enough for sound corporate governance. Most of the countries with an emerging Islamic finance industry have weak contractual environments. Moreover, in such countries, regulators

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lack powers to enforce the rules, private entities are nonexistent, and courts lack funds, motivation, clarity about the laws and familiarity with economic issues or are even corrupt. Thus, a law-abiding culture needs to be rooted in the society. To develop an effective regulatory framework, the regulatory enforcements should be coupled with transparent legislation, regulation of development process, private monitoring initiatives and investments in the rule of law.

IFSB Principles for Corporate Governance

The Islamic Financial Services Board (IFSB) issued a set of standards for corporate governance of Islamic financial institutions. These standards provide a framework for Islamic banks to formulate and implement corporate governance.

Click the Resources button to learn more about IFSB’s guiding principles on corporate governance for institutions offering only Islamic financial services.

The Standard on Corporate Governance defines principles dealing with general governance principles, rights of investment account holders, Sharī‘ah governance and transparency in reporting.

Principle 1.1 Establish a governance policy framework that establishes for balancing Islamic bank’s accountabilities to stakeholders.

Principle 1.2 Ensure that financial and nonfinancial information is reported according to international accounting standards, is Sharī‘ah-compliant and applies to Islamic financial services.

Principle 2.1 Acknowledge the right of investment account holders to monitor the performance of their investments and the risks associated with it. Also ensure that these rights are observed and exercised.

Principle 2.2 Adopt an effective investment strategy that is aligned tithe risk and return expectations of investment account holders and transparent in smoothing returns.

Principle 3.1 Provide an appropriate mechanism to obtain rulings from Sharī‘ah scholars, apply Fatawa and monitor Sharī‘ah compliance for their products, operations and activities.

Principle 3.2 Comply with the Sharī‘ah rules and principles and make them available to the public.

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Principle 4 Provide adequate and timely disclosure of material and relevant information on the investment accounts that they manage to the account holders and public.

Challenges for Regulatory and Legal Infrastructures

IFSB has promulgated a number of standards and guidelines that cater to the unique characteristics of Islamic banks to assist the relevant authorities in supervising them. The IFSB standard and guidelines are based on the contractual relationship between the Islamic bank and the PSIA holder.

IFSB has promulgated a number of standards and guidelines that cater to the unique characteristics of Islamic banks to assist the relevant authorities in supervising them. The IFSB standard and guidelines are based on the contractual relationship between the Islamic bank and the PSIA holder.

IFSB standards take into consideration the regulatory practices of its member jurisdictions. For example, in its Capital Adequacy Standard, the IFSB introduced an alpha factor in the ‘supervisory discretion’ formula whereby PSIA are not necessarily treated as pure investors.

The inconsistencies between the contractual relationship and regulatory practices need to be ironed out as they tend to create uncertainty as to how Islamic banks would be regulated. They also create a lack of a level playing field between Islamic banks across jurisdictions and hamper the growth of Islamic banks.

Treating PSIA as investors as per their contracts would not only require supervisory authorities to depart from their usual measures for enhancing financial stability and reducing systemic risk, but also educate holders of unrestricted PSIA of the implications of their contractual relationship with the bank. The holders of unrestricted PSIA need to understand that they risk losing their capital and the returns on their investments could also be both volatile and even negative.

Departing from their regulatory challenges to cater for the specificities of PSIA could be a challenging task for central banks. This is because the regulatory measures are geared to protect depositors and enhance financial stability, and mitigating systemic risk. For example, allowing Islamic banks to pass losses to unrestricted PSIA could trigger systemic risk, if such losses lead holders of PSIA to withdraw their funds.

Subjecting unrestricted PSIA to Takaful-based deposit insurance schemes to enhance financial stability and reduce systemic risk could lead to regulatory arbitrage. Therefore, such investments enjoy a protection denied to investors in otherwise fairly similar capital market products. However, while such arbitrage possibilities might possibly

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create tension between the banking and securities regulators, it is debatable whether this would be a problem in practice, insofar as unrestricted PSIA are seen to be a Shari’ah-compliant substitute for conventional deposits rather than as a capital market product.

The legal infrastructures in the jurisdictions that host Islamic banks need to be adapted to cater for the specificities of these banks. There should be a high degree of certainty in the implementation of the Shari’ah-compliant contracts in case of dispute.

There may be merit in the claim that those jurisdictions which have national Shari’ah boards tend to provide more certainty in the implementation of Shari’ah contracts, especially the national Shari’ah boards that have the legal banking in courts. This does not guarantee the absence of a discrepancy between the de facto capital certainty afforded to unrestricted PSIA by the regulator in some jurisdictions and the absence of de jure capital certainty for them in those same jurisdictions, with the resultant risk of legal conflicts arising from this discrepancy.

Chapter Summary

You have completed the chapter on Improving Sharī‘ah based Governance for Bank Accounts. In this chapter, you learned that:  Sharī‘ah governance can be improved for Islamic banks by creation of an international standard setting self-regulatory association and creation of system- wide board of Sharī‘ah members.  The three types of accounts are current account, restricted investment account and unrestricted investment account.  Current account holders need to be protected from exposure to risky investments and improper use of their funds.  The three ways to protect the interest of unrestricted account holders are by avoiding commingling of funds, giving shareholder rights to unrestricted account holders and using a Sharī‘ah-compliant version of deposit insurance.  The objective of a Profit Equalisation Reserve or PER is to hedge against the risk of low income in future for distributions by retaining a part of current profits to pay out to investment account holders in the future.  Issues pertaining to treatment of fund reserves are limited disclosure, lack of rights for investment account holders, and periodic pay of profits.  Internal corporate governance is reinforced by the external arrangements to govern business activity and provide necessary information for official and private monitoring. They also help in governing Islamic bank activities.  The Islamic Financial Services Board (IFSB) issued a set of standards for corporate governance of Islamic financial institutions. These standards provide a framework for Islamic banks to formulate and implement corporate governance.

 IFSB has promulgated a number of standards and guidelines that cater for the specificities of Islamic banks to assist the relevant authorities in supervising them. They are based on the contractual relationship between the Islamic bank and the PSIA holder.

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Chapter 10: Transparency in Islamic Banks and Other FIs

Chapter Introduction

Transparency in Islamic Banks and Other FIs.

In the world of Islamic banking, there is a growing need for a culture of transparency. The corporate governance rules for Islamic banks must focus on creating this culture in order to provide a safe environment for stakeholders.

So how does one go about creating such a culture? The answer lies in understanding what transparency, disclosure and accountability mean.

Transparency, in principle, refers to an environment in which any information on decisions, existing conditions and actions is made accessible, visible, and understandable to all market players.

Disclosure is process driven and refers to the methodology of providing the existing information and letting the players know of policy decisions by disseminating them in a timely and open manner.

Accountability requires all market participants and relevant entities to explain and justify their actions and policies. This also includes taking ownership of their decisions and outcomes.

You will learn more about these principles in the following pages.

On completing this chapter, you will be able to:

 Recognise the importance of transparency in a financial system.  Describe the relationship between transparency and accountability in a financial system.  Recognise the importance of disclosure to the stability and effectiveness of a financial system.  Identify the two key aspects of disclosure in a financial system.  Explain the importance of the quality of information disclosed.  Explain the limitations of and concerns about transparency in financial reporting.  Recognise how transparency and clarity in financial statements help improve decision-making and governance.

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Benefits of Transparency

A transparent system lays the foundation for accountability.

The parties accountable in the system are borrowers and lenders, issuers and investors, national authorities and international financial institutions.

If private sector entities are to understand and accept policy decisions easily, especially those that influence their behaviours, the banking system needs to be more transparent and accountable.

The benefits of having a transparent and accountable system are many.  Greater transparency and accountability translates to improved economic decisions by financial institutions and other agents in the economy. It also results in improved policy-oriented decision making.  Transparency and accountability fosters internal discipline and better governance of Islamic banks.  When the actions and decisions taken by the concerned parties are accessible and understandable, the cost of monitoring automatically reduces.  Transparency and accountability can successfully expose the incompetence of policy makers who prefer secrecy in order to exercise power.

Reinforcing Transparency and Accountability

Transparency and accountability mutually reinforce each other.

Transparency sets the stage for accountability by facilitating monitoring efforts by concerned players.

Accountability, on the other hand, enhances transparency by encouraging the entities to ensure that their actions are correctly disseminated and interpreted.

Transparency and accountability together can improve the functioning of the markets and influence the policy making process.

Due to greater transparency, market players place less emphasis on the nature of news thereby making financial markets less volatile.

Quality of decision making in the public sector also improves as transparency and accountability, when taken together, impose the required discipline on market players.

This improves the private sector’s insight on how policy makers may respond to certain future events– resulting in the creation of efficient policies.

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Transparency makes officials act more responsibly, especially when they know that they will be held accountable for their decisions and actions.

Importance of Disclosure

To be efficient, the market requires transparency in information sharing and dealings from market participants. This transparency is also essential for imposing market discipline.

As bank managements and supervisory agencies increasingly adopt a risk-based approach, every key market participant must receive useful information for such an approach to be effective.

These market players include supervisors, depositors and other creditors, correspondent and other banks, counterparties, current and prospective shareholders and bondholders and the general public.

Left to themselves, markets alone cannot ensure that adequate information is being provided. Therefore, legislation is necessary to ensure disclosure.

Traditionally, disclosure involved not only providing prudential information needed by bank managers but also compiling statistics for monetary policy purposes.

Though it did not provide information that would help to evaluate financial risks, the imperfect information has improved the functioning of markets.

Key Aspects of Disclosure

The two key aspects of disclosure in a financial system are:  Utility vs. cost of provision and  Timelines of disclosure

Let’s learn more about these key aspects.

Utility Vs. Cost

Quality accounting standard and a sufficient disclosure process are necessary for financial information to be disclosed publicly.

Public disclosure of information involves publishing qualitative and quantitative information in annual financial reports as well as in biannual or quarterly financial

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statements. As the process of disclosure is expensive, financial institutions and policy making bodies must measure the usefulness of such information for the public against the cost of provision.

Timeliness The second key aspect of disclosure is the timely introduction of information. When negative information is disclosed to the public that is not sophisticated enough to understand it, it can have grave repercussions on the bank or the banking system. In situations when either the information is negative or of low quality, or the recipients cannot interpret the disclosed information, public disclosure standards should be phased in cautiously. This helps the recipients to interpret the information accurately. Even if the banking system experiences immediate problems, a full disclosure is always essential and beneficial in the long run. This is because in a financial system, in the long run, the cost of not being transparent is higher than the cost of disclosing information.

Importance of Quality of Disclosure

Apart from timely disclosure of information, equal emphasis has been placed on the quality of information disclosed.

Following the financial and capital market liberalisation of the 1980s, the financial markets became increasingly volatile. This necessitated an increase in information to stabilise the markets. As the financial and capital markets are liberalised further, there is increasing pressure to define minimum disclosure requirements. These focus on improving the quality and quantity of information made available to the public as well as market participants.

To achieve this, the regulatory authorities have prioritised improving the quality of disclosure to help stabilise the banking system. Providing high quality information is also the responsibility of banks that must work towards improving their internal information systems.

The 1990s changed the structure of financial intermediation.

Tradable debt securities were substituted for bank lending.

Financial instruments were increasingly used to transfer risk.

These changes expanded the role of market and market prices in capital and risk allocation, thereby reducing the importance of banker-client relationships. This further strengthened the need for disclosing high quality information.

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Limitations of Transparency

Despite what transparency can achieve, it is important to understand its limitations.

By its very nature, transparency assists market participants to make informed decisions, thereby improving the performance of the overall working of the international financial markets.

However, transparency neither removes the risks present in the financial system nor does it change the nature of banking.

Even though transparency cannot prevent financial crisis, it can help to make the markets predictable.

This allows market participants to assess negative information appropriately. This helps to mitigate panic among players. But on the other hand, transparency can also be an area of concern for financial institutions, especially in the context of confidentiality of information.

Release of proprietary information may be used by competitors to their advantage. Likewise, any confidential information belonging to financial institutions that are obtained by regulatory bodies may have market implications.

Considering these concerns, financial institutions do not easily share sensitive information unless assured of confidentiality.

However, this is a short term perspective where individual entities are bound to experience problems and discomfort. But in the long run, having a culture of full disclosure and unilateral transparency would ultimately benefit all market participants.

Transparency in Financial Statements

Various financial statements provide information about an entity to its stakeholders. The balance sheet gives details of the entity’s financial position, the income statement talks about its performance, the cash flow statement mentions the changes in its financial position and the notes contain detailed information, including any applicable risk management practices, which have aided the management in drafting financial statements.

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When the information contained in these financial statements is transparent and fully disclosed to the stakeholders, they are equipped to make better economic decisions.

They are in a better position to privately and officially monitor the business’s financial performance as the financial information is easy to interpret.

Such widely available and affordable financial information improves market discipline and promotes corporate governance due to higher levels of stakeholder scrutiny.

Transparency and Disclosure Issues

According to their contractual relationship with the Islamic bank, which is based on the Mudarabah contract, holders of profit sharing investment accounts (PSIA) should be treated as investors because they bear the risk of loss on their investment provided it is not due to misconduct and negligence.

Consequently, holders of PSIA are exposed to the risk of impairment of the assets financed from their funds such as absent misconduct and negligence, by the Mudarib.

Holders of PSIAs should have adequate information in order to be aware of the risks to which they are exposed in the asset portfolio in which their funds are invested.

This information should assist holders of PSIA in assessing whether or not the risk to which they are exposed matches their risk appetite.

Such disclosure of information would also help holders of PSIA to ascertain whether or not the risk to which they are exposed is commensurate with the expected returns on their investment.

The disclosure of information should also include whether or not the bank has smoothened the returns of the PSIA using Profit Equalisation Reserve (PER) and/or absorbed losses relating to the PSIA investments using Investment Risk Reserve (IRR). The use of either reserve could also be factored into the decision made by holders of PSIA as to whether or not to continue placing their funds with the bank.

However, the above analysis assumes that holders of PSIA will behave in a manner similar to investors when making their decisions.

This assumption could be challenged on the grounds that holders of unrestricted PSIA tend to behave in a manner similar to depositors rather than investors.

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Challenges With Respect to Disclosure Issues

Let’s look at some of the challenges with regards to the supervision of Islamic banks.

The challenges include regulatory, market, behavioural and legal challenges.

Regulatory Challenges Accordingly, as with depositors, Islamic banks may not be allowed by their central banks to pass losses on to holders of unrestricted PSIA, as doing so might trigger large numbers of withdrawals by holders of these accounts entailing a danger of a bank run and hence systemic risk.

However, this would put the Islamic bank’s shareholders at a disadvantage because they bear the risk of losses on assets funded by the PSIA, which is not consistent with the shareholders’ contractual relationship with the bank.

Market Challenges All Islamic banks operate in a mixed banking environment.

The resultant market pressures force Islamic banks to distribute to unrestricted PSIA a return that matches the rate of interest paid on interest bearing deposits.

This treats unrestricted PSIA much like conventional deposits, in spite of the fundamental contractual differences between conventional deposits and PSIA, whether managed under Mudarabah or Wakalah contracts.

Such a practice masks the investor’s true contractual relationship with the bank, which differs from that between conventional depositors, who are creditors entitled to a contractual rate of interest and the bank.

In addition, the supervisors in several countries do not accept the passing of losses by Islamic banks on to their unrestricted PSIA holders, because of their concern for systemic risk, if the fear of losses leads unrestricted PSIA holders to make mass withdrawals.

While the use of PER and IRR raises issues of corporate governance (transparency and moral hazard) at the micro level with implications at the macro level, at the latter level their formation by Islamic banks has helped to mitigate systemic risk.

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Competition, conventional banks or among Islamic banks appears to have forced the latter to develop the practice of “smoothing of PSIA profits” or, more exactly, payouts. Initially, Islamic banks used to finance the smoothing of the PSIA profits from their Mudarib share.

Later, Islamic banks started to created a reserve known as a PER, which is funded from the profits of both PSIA and shareholders before paying the latter’s Mudarib share of profit.

Islamic banks have recourse to this reserve to smooth the returns distributed to PSIA holders, as well as the returns of the shareholders. Islamic banks developed Investment Risk Reserve, which is funded solely from the PSIA profits, that is after paying the Mudarib share.

IRR is used by Islamic banks to absorb any losses relating to the investments of PSIA holders and thus to avoid showing such losses by writing down the equity of PSIA holders.

Behavioural Challenges The Mudarabah contract, which Islamic banks generally use to mobilise funds in PSIA, specifies that the holder of PSIA bears the risk of loss provided it is not due to misconduct and negligence.

However, holders of unrestricted PSIA tend to behave in a manner similar to conventional depositors. They neither expect to bear losses nor receive returns that are volatile.

This tends to pose a major challenge to both regulators and Islamic banks.

As noted above, not matching unrestricted PSIA holders’ expectations could leave an Islamic bank facing withdrawal risk, which given the relatively illiquid nature of most of its assets.

In turn this could lead to a liquidity crisis, resulting in the bank’s insolvency, triggering a run on other banks.

Legal Challenges In many jurisdictions in which Islamic banks operate legal disputes involving Islamic banks, subject to the same legal system as that which governs conventional banks.

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The legal infrastructures in the majority of countries that host Islamic banks tend not to recognize unrestricted PSIA as a type of equity investors and part owners, rabbul mal of the bank’s assets, but rather as creditors of the bank.

For example, in liquidating an Islamic bank, PSIA may be treated not as equity investors but as unsecured creditors, thus may be denied their contractual rights according to the Shari’ah.

In case of liquidation, current account holders and other creditors should not be paid from the residual value of the assets funded by PSIA. They only have a first claim on the residual value of the shareholders’ portion of the assets.

Islamic banks also face legal risk as to how courts in the jurisdictions in which they operate would construe the transaction contract between the bank and its client.

Many judges are also unskilled in Shari’ah, and the link between Islamic and secular law is unclear.

For example, the courts treated client defaults in deferred payment sale contract as loans rather than sales on credit.

This adds to the uncertainty faced by Islamic banks in legal issues.

Scenarios to Address Transparency Issues

Scenarios to Address Transparency Issues One way to address the above regulatory side effects of PSIA is the suggestion that PSIA funds should be mobilised in a separate fund management company owned either by the Islamic bank as a subsidiary or by the same group. This would make it clear that PSIA, whether restricted or unrestricted, are not ‘banking’ products as normally understood, but investment products.

In this scenario, there would be no unrestricted PSIA with funds commingled with other funds of the bank, including those of current accounts.

Instead, there would be a form of PSIA designed for savers unwilling to risk their capital, but seeking only a modest return.

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Such PSIA could benefit from Takaful cover to protect the capital, the premiums being paid by the PSIA holders. All investment products offered by the fund management company would be regulated by the securities market regulator.

The only logical alternative to this scenario seems to be that adopted by the FSA (Financial Services Authority) in London, namely the transformation of the Mudarabah or Wakalah contracts underlying unrestricted PSIA into a form of contract that provides “capital certainty” and hence does not conform to the Sharī‘ah as generally understood.

The approach whereby unrestricted PSIA holders enjoy de facto (but not de jure) capital certainly as a regulatory requirement would not withstand a lawsuit by shareholders of an Islamic bank who would insist on their legal right not to bear losses on PSIA funds, absent misconduct and negligence.

Chapter Summary

You have completed the chapter, Transparency in Islamic Banks and Other FIs. A summary of the key points of this chapter is as follows:

 Transparency refers to an environment where any information that exists on current decisions, conditions, and actions is accessible by, visible to, and comprehensible to all market players.  Transparency sets the stage for accountability by facilitating monitoring efforts by concerned players. Accountability enhances transparency by encouraging the participants to ensure that their actions are properly communicated and interpreted.

 Left to themselves, markets alone cannot ensure that adequate information is being provided. Therefore, there is a need for legislation to ensure that disclosure provides useful information to key market players.

 As the process of disclosure is expensive, financial institutions and policy making bodies must measure the usefulness of such information for the public against the cost of provision.

 Minimum disclosure requirements focus on improving the quality and quantity of information made available to the general public as well as the market participants.

 Transparency neither removes the risks present in the financial system nor does it change the nature of banking. However, in the long run, all market participants would eventually benefit from a culture of full disclosure and unilateral transparency.

 When the information contained in the financial statements is transparent and fully disclosed to the stakeholders, they are equipped to make better economic decisions.

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 Consequently, holders of PSIA are exposed to the risk of any impairment of the assets financed from their funds.

 Holders of PSIA should have adequate information in order to be aware of the risks to which they are exposed in the asset portfolio in which their funds are invested.

 While the use of PER and IRR raises issues of corporate governance (transparency and moral hazard) at the micro level with implications at the macro level, at the latter level their formation by Islamic banks has helped to mitigate systemic risk.

 The Mudarabah contract, which Islamic banks generally use to mobilise funds in PSIA, specifies that the holder of PSIA bears the risk of loss provided it is not due to misconduct and negligence.

 One way to address the above regulatory side effects of PSIA is that PSIA funds should be mobilised in a separate fund management company owned either by the Islamic bank as a subsidiary or by the same group.

Chapter 11 – International Financial Reporting and IFIs

Chapter Introduction

International Financial Reporting and IFIs.

Financial statements of a business entity, such as balance sheets, cash flow statements and income statements indicate the financial position of the entity along with details of its income, cash flow and risk management techniques. This information is essential for stakeholders as well as the public to take investment decisions. Moreover, being transparent about the financial status is also a key aspect of corporate governance.

Although business entities tend to be transparent about their financial position, a clear definition of the extent of disclosure is not prevalent in the market. Therefore, a need to standardise the disclosure requirements and outline the financial aspects that should and should not be disclosed came up.

On completing this chapter, you will be able to:

 Explain the need for and objectives of a framework for disclosing financial information,

 Describe the qualitative characteristics required in financial information,

 Describe the key aspects of a process of reporting financial information,

 Identify the types of information required to be disclosed by companies and financial institutions,

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 Describe each of the three main standards on reporting financial information,

 Identify the key reasons for inadequate and poor quality of information disclosed,

 Explain the emergence of specific reporting and accounting standards for IFIs,

 Describe the efforts made to encourage transparency in IFIs and

 Describe the three main issues regarding transparency in IFIs.

Need for International Financial Disclosure Standards

As already mentioned, the extent of disclosure of financial information needs to be standardised. This regularisation process must be evaluated using certain key principles, laid down by a committee called the Basel Committee. The principles have been documented as “Basel Committee on Banking Supervision 2000”.

The standard commonly used today to facilitate disclosure and elucidation of financial information is International Financial Reporting Standards, or IFRS.

IFRS has constantly been updated to include new rules. One such addition in 1989 was the Framework for the Preparation and Presentation of Financial Statements. The purpose of this section was to explain the basic concepts of financial statements to all users, help the development of accounting standards and support auditors, users and developers to understand IFRS.

All standards and policies described so far have been outlined based on certain assumptions. Two such assumptions are that the business entity for which financial information is reported continues to function with stability and the business continues to receive further investments. The effects of transactions are reported immediately and reflected in the reports.

Qualitative Characteristics of Financial Information

In addition to being transparent about financial information, the information presented to the public and the stakeholders must be comprehensive.

Supply of incorrect data could mislead the stakeholders and direct them towards making inappropriate business decisions. Therefore, it is crucial to present qualitative financial data.

Let’s now look at some important qualitative parameters.

Relevance The first key qualitative parameter is relevance. It is important to present relevant information to the user because it helps them to analyse the past, present and future

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scenarios enables them to correct or reuse past assessments and aids them towards making appropriate business decisions. Presenting irrelevant and excess information makes interpretation difficult.

Faithful Representation Another key qualitative parameter is faithful representation. Due to the crucial nature of the information, it is essential that the presented financial data is accurate, reliable, complete, neutral and free from any opinion or bias.

Comparability Yet another key qualitative parameter is the information being comparable. Users should be able to line the data to older versions and align them against parallel information.

Understandability One more qualitative parameter is the understandable nature of financial information. Users with average knowledge of business, finance and economics should be able to comprehend easily.

Process of Reporting Financial Information

In addition to the nature of financial information reported the process that is used to report information should also be carefully designed. There are three aspects that should be considered.

One is the timeliness with which information is reported. This is the most crucial aspect because any delay in reporting can make the information irrelevant.

Another aspect is the trade-off between benefit and cost. The benefit in reporting information should always be less than the cost incurred. Due to a substantial cost factor, banks in developing countries may not have an efficient accounting reporting system. However, this cannot be a justification for non-disclosure of financial information.

One more aspect in the process of financial reporting is balancing the qualitative parameters. This is again crucial because one parameter outweighing another might result in presentation of misleading information.

Apart from the aspects mentioned so far, the reporting process works with an underlying principle that it is better not to report any information rather than reporting inaccurate information. However, when a system is not found complying with the IFRS standards or exhibit partial compliance, IFRS demands complete disclosure and reason for non-disclosure.

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Type of Information Required

The regulations laid down by the corporate governance framework of a bank have always considered disclosure requirements to be a crucial aspect. Disclosure helps present quality data to the public and manage any financial risks involved. However, despite constant supervision, not all banks present confidential information to the regulatory authorities all the time. This is not a recommended practice.

Disclosure of financial information should be comprehensive so that it can be consumed by all users. Increased transparency leads to reduction of systemic banking crisis and effects of financial contagion. It also guides shareholders and creditors make informed decisions.

The three aspects of financial information that are mandatory when disclosing information to users are:

 Realistic valuation of assets along with substantial recognition of expenses and income.  Evaluation of the bank’s complete risk profile including components in the balance sheet, capacity to handle short-term risks, capability to generate additional revenue and the capital to risk assets ratio.  Special characteristics of the bank’s operations especially liquidity and solvency.

The Main International Standards on Reporting

The erstwhile standards for banking, Generally Accepted Accounting Practices, or GAAP, did not lay down strict policies on transparency. However, IFRS has a comprehensive set of policies that emphasizes on full disclosure.

IFRS has also developed several standards for international markets with time. It included several new topics such as the International Accounting Standard, or IAS, 30, IAS 32 and IAS 39. IAS 30 has been cancelled with the advent of IFRS 7 and has been replaced by IAS 32. However, IAS 32 and IAS 39 are used together within IFRS 7.

Let’s now look at these international standards in detail.

IFRS 7 IFRS is a framework that supplies disclosure, international and other accounting standards to banks. It is applicable to any bank that executes borrowing and deposit operations.

The earlier versions of IFRS revealed several gaps in terms of standards for financial risk disclosure. These were addressed by IFRS 7 by including new requirements to disclose:

 Loans and other receivables,

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 Changes to financial liabilities that are not affected by market trends,

 Methods used to identify the changes from standardised interest rates,

 Value attributing to the lack of impact on profit or loss due to cash flow hedges and

 Net gain or loss due to loans, financial liabilities and held-to-maturity investments.

IAS 32  IAS 32 standards when combined with IFRS 7 add on to the other global accounting standards applicable to banks.

 Apart from the disclosures specified by IFRS 7, IAS 32 specifies certain requirements such as disclosure of the financial position due to commitments to extend credit and letters of credit. This information is crucial because it affects the cash flow of banks.

IAS 39 IAS 39 standards include disclosure requirements for recognising and measuring financial instruments. These standards are still undergoing review and changes. The effect of IAS 39 is that it has increased fair value accounting in the market. However, the Basel committee fears that in the process of carrying out fair value accounting using IAS 39, banks should not deviate from the Basel-supported best-practices for global risk management.

Deficiencies in Accounting Practice

Since late 1990s, a popular opinion that inadequate disclosure of financial information in a bank’s annual reports is due to the lack of sound accounting practices. This works out to be a significant disadvantage for banks because without adequate transparency, market participants are unable to make any informed decisions. Moreover, they tend to react negatively to partial disclosure.

However, in reality, inadequate disclosure is not due to improper accounting standards, but a few other reasons.

Let’s look at these reasons in detail.

Non-enforcement of Complete Disclosure The key reason behind insufficient disclosure is that the accounting principles and regulatory authorities do not enforce comprehensive disclosure.

Therefore, to ensure sufficient transparency, disclosure standards should be designed in such a manner that they enforce complete disclosure in a timely manner, while avoiding misleading reporting.

Lack of Incentives for Full Disclosure

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Another important reason leading to insufficient disclosure is the lack of incentives to banks and external auditors for disclosing more than the required information. However, the truth is that investors and depositors are willing to invest in sufficiently transparent banks only.

To overcome this limitation, market participants and rating agencies must demand for full disclosure and reinforce that investor confidence is directly affected by transparency.

Disinclination to Reveal Negative Information Yet another key reason in banks not revealing all the financial information as per regulatory requirements is the fear of losing business by disclosing disadvantageous information. Negative information is often disclosed at the last minute and is incomplete.

International Standards and IFIs

We have already seen that insufficient disclosure of financial information in banks is not due to inadequate accounting standards. Islamic Financial Institutions, IFIs for short, suffer from the difficulty in application of these standards. Several standards stated in IFRS are not applicable to Islamic banks. In addition, the IFRS standards do not account for several specific issues that arise in Islamic banks.

To deal with these issues, Accounting and Auditing Organization for Islamic Financial Institutions, AAOIFI for short, was formed. This board laid down stipulated standards that were relevant to Islamic banks and ensured that the banks showcased sufficient financial transparency.

This standardisation of financial reporting by Islamic banks enables analysts and investors to compare the performance of various banks within and between jurisdictions consistently and regularly. AAOIFI has put down standards for two broad sections, namely Financial Accounting Statements and Financial Accounting Standards.

Over a period of few decades, many countries in the Middle East adopted the AAOIFI standards. Between 1998 and 2002, Bahrain, Jordan and Sudan adopted AAOIFI. Qatar later joined this list by reporting financial statements complying with AAOIFI standards.

Banks in Saudi Arabia had to follow IFRS and some local standards for financial reporting. However, since AAOIFI standards were reviewed and changed in 2001, Saudi Arabian banks also migrated to AAOIFI. Similarly, Islamic banks in Indonesia have been brought under the control of a national body. Its new accounting standards are formulated based on AAOIFI principles. Recently, Kuwait and United Arab Emirates have also started training their staff on AAOIFI.

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The Efforts Towards Transparency in IFIs

The need for financial transparency is more in IFIs than in conventional banks, because of two reasons. One reason is the set of characteristics of some Islamic instruments. Another reason is the assumption that Islamic banks offer better incentives to its depositors.

To satisfy this greater need for transparency, efforts should be taken to:

 Develop an exclusive institution that helps report accurate information,

 Identify agencies that distribute this information and

 Formulate methods to maintain the integrity of the information.

In 2007, the Islamic Financial Services Board, IFSB for short, issued a supplement called Exposure Draft No.4. It stated the disclosure principles to encourage transparency and market discipline among companies offering Islamic financial services. The draft emphasised the fact that transparency is rather crucial for IFIs because it is a Sharī‘ah consideration. Any fraud or camouflage in information is against the justice and fairness mentioned in the Holy Qur’ān.

The exposure draft developed by IFSB is based on the principles of Basel Committee on Banking Supervision and the disclosure standards contained in Pillar 3 of the new Basel Capital Accord.

Key Issues Regarding Transparency in IFIs

Insufficiency in transparency of IFIs is due to some key reasons.

Let’s look at these reasons in detail.

Weaknesses in the Current System of Disclosure The system of disclosure currently prevalent in IFIs lacks uniform reporting standards. This gave rise to the need for a regulatory framework that validated accounting standards and information disclosure regularly. Therefore, several frameworks were formed such as:

 Supervisory framework formed in 1998 by Errico and Farabakash based on the standards of Basel Committee,

 Regulatory framework formed in 2002 by Errico and Sundararajan on the lines of the Capital Adequacy, Asset quality, Management, Earnings and Liquidity, or CAMEL, framework,

 Statement of purpose and calculations on Capital Adequacy Ratio, or CAR, for Islamic banks formulated by AAOIFI as per the IDB research of Dr Chapra and

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 Documentation on features of Islamic finance created by Archer and Ahmed in 2003.

Demarcation of Equity and Depositors’ Funds Due to the nature of operations that Islamic banks execute, they are considered as both commercial and investment banks. This leads to the merging of their investments and revenue generated from their commercial services. Therefore, when financial information is reported, the market participants find it difficult to identify the source of investment.

Transparency in Sharī‘ah Rulings The annual financial reports published by Islamic banks often do not contain information with respect to the duties, components and operations of the Sharī‘ah board. The reports also do not include details on the Fatwas issued by the board. Banks can overcome this by using qualitative methods for reporting.

Chapter Summary

You have completed the chapter, International Financial Reporting and IFIs. The key points of this chapter are as follows:

 The standard commonly used today to facilitate disclosure and elucidation of financial information is IFRS.

 The qualitative characteristics of financial data reported by business entities are relevance, faithful representation, comparability and understandability.

 The three aspects that should be considered when designing the process to report financial data are timeliness, benefit vs. cost balancing and balancing qualitative characteristics.

 The aspects of financial information that users require during disclosure are realistic valuation of assets, evaluation of the bank’s complete risk profile and special characteristics of the bank’s operations.

 IFRS developed several standards for international markets such as IAS 30, IAS 32 and IAS 39.

 IFRS is a framework that supplies disclosure, international and other accounting standards to banks.

 Inadequate disclosure by banks is not due to improper accounting standards, but a few other reasons such as non-enforcement of complete disclosure, lack of incentives for full disclosure and disinclination to reveal negative information.

 AAOIFI has put down standards for two broad sections, namely Financial Accounting Statements and Financial Accounting Standards.

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 IFSB issued a supplement called Exposure Draft No.4 that stated the disclosure principles to encourage transparency and market discipline among companies offering Islamic financial services.

 Insufficiency in transparency of IFIs is due to some key reasons such as weakness in the current system of disclosure, demarcation of equity and depositors’ funds and transparency in Sharī‘ah Rulings.

Chapter 12: Capital Adequacy Norms and Islamic Banking

Chapter Introduction

Capital Adequacy Norms and Islamic Banking.

Capital is a key factor that is considered when evaluating the reliability and potential of a bank. It acts as a safety layer that protects the bank from various risks it is susceptible to during its operations. Capital is also an important element in maintaining the confidence of depositors and stakeholders because it helps manage any business losses.

In addition, the amount of capital is directly proportional to its ability to compete in the market. If a bank faces capital shortage, the public tend to move business to the competitors.

On completing this chapter, you will be able to:

 Describe vital characteristics of capital invested in a bank,  Explain the two perspectives on capital of a bank,  Explain the need for calibrating capital structure and efforts to standardise norms, including for Islamic banks,  Describe the evolution of Basel I and Basel II norms on capital structure and adequacy,  Explain the application of Pillar 1 of Basel II norms to Islamic banks,  Explain how the PLS system of Islamic Banking affects capital adequacy calculation,  Explain the similarities and differences between IFSB standards and Basel II Pillar 1 norms and the considerations regarding capital risks in Islamic banks,  Explain the differences between calculation of risk weights for conventional and Islamic banks,  Explain the two formulas recommended by IFSB for calculating risk weights for Islamic banks,  Describe the methodology for calculating risk weights and CAR for market risk, credit risk and operational risk,  Describe the Basel II guidelines for supervisory review and the application to Islamic banks and  Describe the Basel II guidelines for market discipline and the application to Islamic banks.

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Key Characteristics of Capital

The primary purpose of capital is to provide stability to banks and absorb any losses during the course of business. This helps the bank provide a layer of security to its depositors even in situations of liquidation.

The important characteristics of a bank’s capital: it should be constant, it should not levy any additional charges against earnings and it should allow for legal subordination in favour of depositors and creditors.

In addition to these features, the amount and ownership nature of capital affects the competitiveness of the bank. This is because shareholders expect returns for their equity investments and this obligation affects the pricing of bank products.

It is advisable that the bank’s ownership structure is set up in such a manner that the integrity of capital is maintained and additional capital is supplied whenever needed.

Two Perspectives on Capital

Capital of erstwhile banks usually is the sum of equity capital, retained reserves and some specific non-deposit liabilities. Capital is used primarily for buying assets that help improve business and reserve some buffer funds for emergency situations.

A bank’s capital can be looked at from two perspectives. In the context of efficiency and returns, capital can be used to purchase or acquire assets that directly help earning revenue and benefit shareholders. Another perspective of capital is stability. From this perspective, capital can be treated as a shock absorber that cushions the bank from any risks. Financial Institutions, FIs for short, and regulators are usually sensitive to this dual role of capital. While the FIs are particular about the revenue generating potential of capital, regulators concentrate on the stability aspect.

Importance of Capital Structure and Adequacy

The capital structure of a bank is represented as the ratio of capital to deposits and the ratio of debt capital to equity capital.

With respect to the return on equity capital, the performance of a bank is affected by how well it can calibrate the required level of capital.

As part of the risk management procedure, banks can opt for a capital structure that enables them to:

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 Make profits and maintain stability,  Provide reassurance to public about the quality of their business conduct, and  Get into constructive conversations with regulators.

Because banks usually have a low ratio of capital for externally provided funding, there needs to be strong risk management guidelines that introduce sufficient capital Adequacy Requirements, CAR for short. In order to arrive at the international convergence of all banks active in the international market, several bodies framed different standards. Let’s look at them in detail.

Basel Committee

The Basel Committee on Banking Supervision formulated a risk-based capital adequacy standard in the late 1980s. The two main purposes of this standards framework were to:  Increase the stability of the international banking system and  Ensure that the competitiveness among international banks is constant with the help of a consistent framework.

AAOIFI/IFSB

Later, the Accounting and Auditing Organisation for Islamic Financial Institutions, AAOIFI for short, also realized the differences in the intermediation nature of Islamic banks and hence laid down a basic standard on capital adequacy of Islamic financial institutions. This standard was enhanced further by the Islamic Financial Services Board, or IFSB. To make it more specific, in December 2006, a committee in IFSB issued the first capital adequacy standard only for Islamic financial services.

Basel I and Basel II Norms

The capital adequacy standards introduced by the Basel committee were segregated as Basel I and Basel II standards based on the modifications they underwent over time.

Let’s look at these two standards in detail.

Note that Basel III norms are now replacing Basel II measures worldwide.

Basel I

The standard formulated in the 1980s’ is called the Basel capital Accord of 1988, also known as Basel I. It includes:  Definitions of regulatory capital,  Risk exposure measures and  Rules for maintaining adequate capital to manage risks.

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In practice, Basel I turned out to be the standard for capital adequacy as it is based on the risk-weighted composition of a bank’s assets and off-balance sheet exposures. This was due to its recommendation to maintain adequate capital and buffer to prevent solvency.

Though the Basel I standards were originally formulated for international banks, several national authorities also started using it to introduce formal regulatory capital requirements. After the inclusion of risk-based capital adequacy standards, the capital ratios in all G-10 countries increased from 9.3 percent to 11.2 percent between 1988 and 1996.

Now, the Basel I standard has been adopted by more than 100 countries around the world, with a recommended 12 to 15 percent of adequacy ratio for transitional and developing countries.

Basel II Due to the extensive unsettlement among international banks and their running into severe risks, the Basel I standard required a relook from the risk sensitivity perspective. Therefore, in 1999, after several consultations, a new capital accord standard called Basel II was issued. It was tuned well to most of the modern complexities that international banks were facing.

Basel II underwent continuous changes and was finally consolidated in 2005. It suggested extensive usage of the banks’ internal systems for capital assessment and adequacy calculations. In addition to the existing minimum capital requirements pillar, Basel II Accord now has two new pillars:  Enhanced supervisory review process and  Effective use of market discipline. It was expected that the Basel II standards would be implemented in countries with well-developed financial systems during 2009. However, other countries were expected to take some time for adoption.

Pillar 1 of Basel II for Islamic Banks

The first pillar in Basel II Accord is the capital Adequacy Requirement or CAR. It is based on the proportion of a bank’s capital that should be related to its risk profile. To measure CAR, the components that must be used are:

 Credit risk,  Market risk and  Operational risk. The risk management arrangements of Islamic banks suggest their ability to:

 Calibrate capital and map them on to their business objectives,  Deal with market discipline and  Maintain a dialogue with regulators.

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The banks’ characteristics of arranging funds in the form of risk-sharing deposits and materiality of financing transactions drastically affect the risks in the banks’ balance sheet. Specifically, risk-sharing deposits act as a safeguard during poor investment results.

The components of a capital, although vary, consist of three categories:

 Tier 1: Core capital  Tier 2: Supplementary capital  Tier 3: Unsecured debt For a bank to be considered adequately capitalised it should possess a capital, Tier 1 and Tier 2 put together, that should be at least 8 percent of total assets. The Tier 1 capital for Islamic and conventional banks is the same. However, the reserves in Islamic banks do not include the shareholders contribution.

PLS in Islamic Banking and capital Adequacy

The shareholders of Islamic banks, unlike those of conventional banks, have agreed to share the profit and loss of the bank. Uniquely, they hold only partial liability being neither depositors nor equity holders. Though they do not contribute towards the bank’s capital, they end up sharing in all the losses on the investments made using their money. The implications of this risk-sharing system are:

 Deposits acquired on profit- and loss-sharing basis should not be subject to capital requirements.

 Because investments into current accounts possess commercial risks, they should be applied with sufficient risk weights and capital allocation.

 Financial institutions that possess heterogeneous investments should be subjected to the capital requirements like regular depositors.

 When calculating CAR, the regulatory authorities need to consider the possibility of displaced commercial risk and the practice of smoothening income.

When acting as an intermediary, Islamic banks may face a moral hazard because the bank is not liable for losses but must share the gains with the investment account holder. Therefore, capital requirements in Islamic banks should increase as per the incentive misalignment of depositors.

IFSB Standards and Risk Management in Islamic Banks

The capital requirement standards for Islamic banks had always been based on conventional Basel standards. In December 2006, IFSB issued one such standard based on Basel II with sufficient risk management.

Although the operating modes of intermediation, financial instruments and risks for Islamic and conventional banks are different, the fundamental concepts are the same.

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However, there is a crucial difference in terms of investment accounts. In Islamic banks, any loss incurred is accounted against the income. Therefore, when compared to conventional banks, the risk capital required for absorbing losses is lesser.

As per Islamic bank guidelines, it accepts deposits that are risk-sharing proposals. As an intermediate agent, also called Mudarib, Islamic banks shares it profit from the investment with the depositor. However, the depositor must absorb any losses that are incurred due to market conditions. This helps reduce the overall risks for Islamic banks.

Determining Risk Weights for Islamic Banks

The nature of risks in Islamic and conventional banks is different. This is because all assets in conventional banks are considered liabilities and are based on debts, but in Islamic banks they are a wide variety from trade financing to equity partnerships. Therefore, assigning risk weights to assets can clearly define the contract between Islamic banks and its customers.

There are important differences between the risk weight calculation process of conventional and Islamic banks.

In Islamic banks:  Trade assets are not purely financial assets and hence carry risks,  Non-financial assets such as land, commodities, Ijarah and Istisna’a contracts have special risk characteristics,  Partnership and profit- and loss-sharing assets possess higher risks and  Lack of well-defined instruments for risk mitigation.

The IFSB’s Recommended Methodology for Risk Weights

The IFSB standard for capital requirements elaborates the nature of risks and risk weights in a detailed manner. It specifies the minimum CAR for both credit and market risks for seven Sharī‘ah-compliant instruments:  Murabaha,  Salaam,  Istisna’a,  Ijarah,  Musharakah and Diminishing Musharakah,  Mudharabah and  Sukuk

The calculation of minimum CAR can be done using two formulas. Let’s look at them in detail.

Standard Formula

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This is the standard formula in which capital is divided by risk-weighted assets, minus the assets funded by investment account holders. In this method of calculation, the size of the risk-weighted assets is determined for the credit risk and then adjusted towards market and operational risks. Supervisory Discretion Formula

This is the supervisory discretion formula, which is a modification of the standard formula to account for the reserves maintained by Islamic banks to reduce commercial, withdrawal and systemic risks. As per this formula, in markets where Islamic banks maintain Profit Equalization Reserve, PER for short, and Investment Risk Reserves, IRR for short, the supervisory authorities can use their discretion to adjust the denominator. They can also include a specific percentage of assets financed by investment account holders in the denominator of the CAR formula.

Risk Weights and CAR for Types of Risk

The method to determine CAR using Basel and IFSB standards is similar. However, there are several differences in their application and determination of weights. This is majorly due to differences in intermediation and instruments. Moreover, the risk weights and CAR calculation procedure for different types of risks are also different.

Let’s look at them in detail.

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Credit Risks

To determine the risk weight and CAR required for credit risks of an Islamic bank, there is a standardised approach, which uses the external assessment of credit ratings. For profit- and loss-sharing deposits, the bank can use a simple risk-weight method or a slotting method.

Market Risks

To determine the risk weight and CAR required for market risks of an Islamic bank, the approach is to include market risk of inventories for the measurement of weights and use standardized methods of measurement simultaneously.

Operational Risks

To determine the risk weight and CAR required for operational risks of an Islamic bank, it is recommended to exclude the share of profit-sharing investment accountholders from gross income. This is mandatory because Islamic banks share profits with their depositors-investors.

Pillar 2 of Basel II for Islamic Banks

The second pillar of Basel II Accord is supervisory review. This is the most crucial part of the standards framework and has two objectives:  To evaluate if the banks maintain adequate capital for intrinsic business risks and  To suggest to banks, policies and internal processes for evaluating and managing capital adequacy based on their risk profile, operations, and business strategy.

When implementing the standards of this pillar, the supervisor should:  Review the bank’s internal capital adequacy assessments and management processes,  Ensure that the capital targets and position of the bank are consistent with its risk profile,  Intervene if the bank’s capital does not protect adequately against risks,  Assess compliance with the minimum standards and disclosure requirements,  Identify and intervene during times of falling capital levels and  Take appropriate action if they are not convinced about the bank’s internal processes.

The four principles that must be followed when conducting supervisory review are:  Banks must have a process for evaluating their overall capital adequacy based on their risk profiles,

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 Supervisors should review and evaluate banks’ internal capital adequacy assessments and strategies,  Supervisors must anticipate that the banks could operate above the minimum regulatory capital ratios and  Supervisors should identify and intervene early to prevent the capital from dropping significantly below the minimum requirement levels.

Pillar 3 of Basel II for Islamic Banks

The third pillar of Basel II Accord is the requirement for market discipline. It complements the other two pillars and is based on disclosure requirements. As per this standard, banks must disclose precise information in timely manner so that market participants can evaluate risks well.

The disclosure requirements are based on materiality. This means that banks must disclose all information without omitting or misspelling because it could lead to misleading of the market users. However, proprietary and confidential information are exempted from disclosure.

The key areas of information, from the qualitative and quantitative aspects, that must be disclosed are:  Capital structure,  Capital adequacy and  Risk exposure and assessment.

Chapter Summary

You have completed the chapter, Capital Adequacy Norms and Islamic Banking. The key points of this chapter are as follows:

 The primary purpose of capital is to provide stability to banks and absorb any losses during the course of business.

 A bank’s capital can be looked at from two perspectives: efficiency and returns and stability.

 The capital structure of a bank is represented as the ratio of capital to deposits and the ratio of debt capital to equity capital.

 Capital adequacy standards introduced by the Basel committee were segregated as Basel I and Basel II.

 The first pillar in Basel II is CAR, which is based on the proportion of a bank’s capital that should be related to its risk profile.

 In December 2006, IFSB issued a new standard based on Basel II with sufficient risk management.

 The IFSB standard for capital requirements elaborates the nature of risks and risk weights in a detailed manner.

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 The general method to determine CAR using Basel and IFSB standards is similar. However, there are several differences in their application and determination of weights.

 The second pillar of Basel II Accord is the supervisory review.

 The third pillar of Basel II Accord is the requirement for market discipline and is based on disclosure requirements.

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