Assessing Risk Profiles of Islamic banks
From HodHood
Assessing Risk Profiles of
Islamic Banks
SEMINAR ON ISLAMIC DEPOSIT INSURANCE, KUALA LUMP
18-19 AUGUST 2008
Key Question
What are the differences
between Islamic banking
and conventional bankin
from risk perspective?
2
Scope of Presentation
1. Characteristics of Islamic Banking
2. Risk Matrix
3. Issues and Challenges
3
Characteristics of Islamic ban
4
Salient Features of Islamic Banking
Islamic financial transactions are base
Shariah principles (Islamic jurispruden
� No element of usury
� No element of uncertainty
� No element of gambling
� No trading/investment in prohibited
commodities
5
Contractual Relationship
Islamic contracts in Islamic banking operation …
Shariah Principles Islamic contracts R
� Cost-plus (Murabahah)
Free from Usury � Future delivery (Salam) In
de
No Uncertainty � Purchase by order oth
(Istisna’)
No element of � Leasing (Ijarah) le
gambling
� Profit sharing
(Mudharabah) ent
b
No prohibited
� Joint-venture
commodities (Musharakah)
� Wadiah (safe custody)
6 � Others
Contractual Relationship
Islamic banking Conventi
Relationships in sources and
Application of funds
Savings/demand deposits Custodian
Investment deposits Buyer-seller � Debtor-creditor Debtor-credit
Capital Investor-entrepreneur
• Financing Investor-manager Investor-man
• Securities
• Others
Ownership and risks 100% owned by the bank 100% owned
Co-ownership of asset Risk
• Fully borne
Risk
• Fully transfer to depositor
• Partially transfer to depositor
• Fully borne by bank
7
Balance Sheet Components
Islamic banking Conventional
ASSETS ASSETS
Cash and cash equivalents Cash and cash
Sales receivables Securities portf
Investment in securities Loan and advan
Investment in leased assets and real estates Other assets
Equity investment in joint ventures Statutory depo
Equity investment in capital ventures Investment in s
Inventories Investment in a
Other assets Fixed assets
Fixed assets
LIABILITIES LIABILITIES
Current account Deposits
Other liabilities Other liabilities
Profit sharing investment accounts
Profit equalisation reserve
Investment risk reserve
OWNERS’ EQUITY OWNERS’ EQUI
8
Management of Funds
While conventional banking funds are managed on pool b
Islamic banking funds are managed on pool or separate b
ISLAMIC BANKING CONVENTIONAL B
Management
Sources of funds Sources of funds
of funds
Demand deposits Demand deposits
Savings deposits
General Savings deposits
General investment
pool
deposits
Other deposits Fixed deposits
or Other deposits
Capital Specific account I
Specific investment
Specific account II Capital
deposits
9
Risk Matrix
10
Risk Matrix
Islamic banking Conventi
Credit Risk �
Equity Investment Risk �
Market Risk �
Inventory Risk �
Liquidity Risk �
Rate of Return Risk �
Operational Risk �
Interest Rate Risk �
A number of risks unique to Islamic banks.
11
Credit Risk
Counterparty � Generally similar to conventio
fails to meet banking
its obligations � Credit risk prevalent across th
in accordance Islamic financing contracts -
with agreed whether sale-based, leasing o
terms profit-and-loss sharing (“PLS”
contracts.
12
Equity Investment Risk
Risk arising � Risks inherent in holding of e
from entering instruments or investment
into purposes
partnership � Risk profile of potential partn
� Under PLS contracts, the capi
invested by the provider of
finance (the bank) does not
constitute a fixed return, but
explicitly exposed to impairm
in the event of losses (capital
impairment risk)
Mush Muda
13
Market Risk
Arising from � Relates to current and future
movement in volatility of market values of
market prices specific assets
� Additional issues to consider f
Islamic banks:
� Importance of asset-liability
management
� Limited hedging instruments
against the market risks
14
Inventory Risk
Where � Some Islamic financing contra
ownership of involves Islamic banks taking
assets lies ownership of assets
with the � The bank is exposed to invent
banks risk in the event the custome
does not buy the asset (credit
risk)
� Holding of the inventory also
exposes the bank to price
volatility (market risk)
15
Liquidity Risk
Loss arising � Limited liquidity managemen
from inability instruments
to meet � Limited interbank and money
obligations market
� Limited secondary debt mark
which may hamper liquidity o
Islamic debt instruments
� Lender of last resort facilities
� Use of Commodity Murabahah
manage liquidity
16
Rate of Return Risk
Rates of � Returns to profit-sharing
return risks is investment account holders a
potential not fixed up-front – theoretic
impact on the investors will accept profit or
returns caused
on investment
by
unexpected � Practically, Islamic banks are
change in the of potential withdrawal of fun
rate of return due to uncompetitive profit r
� Displaced commercial risk
� Profit Equalisation Reserves a
Investment Risk Reserves
17
Operational Risk
Risk of losses � Crucial for Islamic banks
resulting from � Compliance with local legal
inadequate or framework
failed � Compliance with Shariah rule
internal � Reputation risk
processes, � For an Islamic bank - Reputat
people and even more important
systems or
from external
events
18
MDIC’s Risk Assessment
� Common methodology but two diffe
applications
� For Islamic banks, the additional ris
perspectives are considered and
analysed
� Additional financial indicators identi
and developed
� Currently developing new benchmar
Islamic banks in terms of financial r
19
Issues & Challenges
20
Issues & Challenges
� Islamic banking fairly new
� New products being developed and
introduced
� Information disclosure
� To monitor changes and develop
new financial indicators where
necessary
21
Conclusion
� There are differences in terms of risk
faced by Islamic banks compared to
conventional banks
� As a result, the risk assessment
techniques need to consider these ri
� The fast-paced development of Islam
banking means that risk assessment
approach needs to be continuously
refined
� Are Islamic banks more risky?
22
Thank you …
MURABAHAH (Cost Plus)
Murabaha refers to contract in which FI purchases goods upon request
makes deferred payments that cover costs and an agreed profit margin f
Transfer of title Transfer of title
to bank to customer
Islamic
Vendor Cu
Bank
Payment of Payment of
purchase price marked up price
(P) (P + X)
The responsibilities of various parties to a Murabaha contract are set out
• Bank buys asset from vendor for P
• Customer then buys asset from bank at a marked up price (P+X), whi
on a deferred payment basis
• The period covering the deferred payment is effectively the period of f
• Title to assets is transferred to customer at time of purchase but usua
provides same or other assets as collateral to the bank for the period
24
ISTISNA’
Istisna is primarily a deferred delivery sale contract. It is similar to conven
in progress financing for Capital project. In practice it is usually used for c
and trade finance such as pre-shipment export finance.
Delivery of asset Delivery of asset
at future date at future date
Entrepreneur Financier Ma
Payment of purchase Progress payment
price on delivery of purchase price
25
IJARAH (Leasing) MUNTAHIA BITTAMLEEK
An Ijarah is a lease purchase contract in which FI purchases capital equ
property and leases it to an enterprise. FI may rent equipment through it
Assets leased to custome
Transfer of title title does (not) pass at the
to bank end of lease term
Islamic Cu
Vendor
Bank (l
Payment of Ijarah installments
purchase price
The responsibilities of various parties to a Ijarah contract are set out bel
• Bank buys asset from the vendor and then leases asset to custome
• Periodic rentals are collected by the bank
• Title of asset remains with bank under an operating Ijarah
• Title passes to the customer under an IMB at the end of contract.
26
MUSHARAKAH (Joint-venture)
Musharakah is a partnership between a FI and an enterprise in which FI
working capital. Notes of participation sold to investors provide the fundin
P
Islamic Bank (Cu
Musharakah
60% ownership 40% owner
The responsibilities of various parties to a Musharakah contract are set out
• Both customer and bank contribute toward the capital of the enterprise
• Under diminishing musharakah, customer buys out bank’s share over a
• Customer and bank share in profits according to agreed proportions, w
different from proportions of capital contributed. Any losses of enterpris
by customer and bank according to their capital contributions.
27
MUDHARABAH (Profit Sharing)
Mudharabah is a contract between investors and FI that acting as a silent p
in a commercial activity that earns each partner an agreed portion of profits
Mudharabah investments may be made for fixed terms and arranged throug
instruments and thus may have characteristics similar to those of shares.
Periodic profits and
return of capital Inve
Islamic Bank tr
a
Entrepreneur
Payment of Mudharabah (mudharib)
capital
The responsibilities of various parties to a Mudharabah contract are set out be
• Bank provides to customer (mudharib) the capital to fund a specified ente
• Customer does not contribute capital but contributes management experti
entrepreneurship)
• Customer is responsible for day-to-day management of enterprise and is
deduct its management fee (mudharib fee) from the enterprise’s profits
• If28 the enterprise make a loss, bank has to bear all losses unless resulted f
