View source for Risk Management By Tariq Ullah Khan

         ISLAMIC DEVELOPMENT BANK

  ISLAMIC RESEARCH AND TRAINING INSTITUTE

RISK MANAGEMENT

  AN ANALYSIS OF ISSUES IN

ISLAMIC FINANCIAL INDUSTRY

             TARIQULLAH KHAN

               HABIB AHMED

              OCCASIONAL PAPER

                     NO. 5

           JEDDAH - SAUDI ARABIA

                 1422H (2001)



© Islamic Research and Training Institute, 2001

    Islamic Development Bank

    King Fahd National Library Cataloging-in-Publication data

    Khan, Tariqullah

    Risk Management: An Analysis of Issues in Islamic Financial Industry

    Tariqullah Khan and Habib Ahmed - Jeddah

    183 P; 17 x 24 cm

    ISBN: 9960-32-109-6

    Risk Management - Religious Aspects

    Business Enterprises; Finance - Religious Aspects

    I-     Ahmed, Habib (j.a.)                    II-Title

           658.155 dc                             2113/22

    Legal Deposit No. 2113/22

    ISBN: 9960-32-109-6

______________________________________________________________________________

The findings, interpretations and conclusions expressed in this paper are entirely those of the

authors. They do not necessarily represent the views of the Islamic Development Bank, its member

countries, and the Islamic Research and Training Institute.

References and citations from this study are allowed but must be properly acknowledged.

First Edition

1422H (2001)

                                                                                               1


                                ABOUT THE AUTHORS

         TARIQULLAH KHAN                                      HABIB AHMED

  Born in Chitral, Pakistan (1954), is a          Born in Chittagong, Bangladesh (1959) is an

  member of IRTI’s research staff since           Economist at the Islamic Research and

  Muharram 1404H (October 1983). Before           Training Institute (IRTI) of the Islamic

  joining IRTI, he was in the faculty of the      Development Bank. He has an M.A.

  Economics Department, Gomal                     (Economics) from University of Chittagong,

  University, Pakistan (1976-81), and             Bangladesh, Cand. Oecon. (M.Econ.) from

  International Institute of Islamic              University of Oslo, Norway, and Ph.D. from

  Economics, International Islamic                University of Connecticut, USA. Before

  University, Pakistan (1981-83), teaching        joining IRTI in February 1999, he taught at

  in particular, monetary, development and        the University of Connecticut, USA, Eastern

  international economics. He has an M.A.         Connecticut State University, USA, National

  (Economics) degree from the University          University of Singapore, and University of

  of Karachi, Pakistan, and a Ph.D. degree        Bahrain. He taught various courses on

  from the Loughborough University,               Economics including Business Cycles and

  United Kingdom. At IRTI, his research           Forecasting, Economic Development,

  interest has been in the area of theoretical    International Finance, Macroeconomics,

  developments in Islamic finance and its         Money and Banking, and Quantitative

  practical challenges in an international,       Economics. He has published articles in

  mixed and competitive market and                international refereed journals such as

  regulatory environments. In this area,          Applied Economics, Applied Economics

  some of his recent research works               Letters, Contemporary Economic Policy,

  published by IRTI include: “Demand for          Economics Letters, Journal of Economics

  and Supply of Mark-up and PLS Funds in          and Business, Journal of International Trade

  Islamic Banks” (1995), Performance and          and Economic Development, and Savings and

  Practices of Modaraba Companies With            Development. His current research interests

  Special Reference to Pakistan (1996),           are Islamic Economics and Finance. Couple

  Interest-free Alternatives for External         of his recent publications in Islamic

  Resource Mobilization with Special              Economics and Finance include Exchange

  Reference to Pakistan (1997), Regulation        Rate Stability: Theory and Policies from an

  and Supervision of Islamic Banks (2000)         Islamic Perspective and “Incentive

  with M. Umer Chapra and “Islamic Quasi          Compatible Profit-Sharing Contracts: A

  Equity (Debt) Instruments” (2000).              Theoretical Treatment”.

  E-mail: tariqullah@isdb.org.sa                  E-mail: hahmed@isdb.org.sa

                               ISLAMIC DEVELOPMENT BANK

                    ISLAMIC RESEARCH AND TRAINING INSTITUTE

                          Postal Address: P.O. Box 9201, Jeddah 21413

                                     Kingdom of Saudi Arabia

                 Cable Address: BANKISLAMI-Jeddah Telephone: 6361400

                     Telex: 601137/601945 Facsimile: 6378927 / 6366871

                 E. Mail: ibfd@isdb.org.sa Home Page: http://www.irti.org/

                                                                  Legal Deposit no.2113/22

                                                                  ISBN: 9960-32-109-6

2


                                 CONTENTS

                                                                        Pages

ACKNOWLEDGEMENTS                                                        7

FOREWORD                                                                9

GLOSSARY                                                                11

ABBREVIATIONS                                                           15

EXECUTIVE SUMMARY                                                       17

I. Introduction                                                         21

    1.1 Unique nature of Islamic banking risks                          21

    1.2 Systemic importance of Islamic banks                            22

    1.3 Objectives of the paper                                         23

    1.4 Outline of the paper                                            24

II. Risk Management: Basic Concepts and Techniques                      25

    2.1 Introduction                                                    25

    2.2 Risks faced by financial institutions                           27

    2.3 Risk management: background and evolution                       28

    2. 4 Risk management: the process and system                        30

         2.4.1 Establishing appropriate risk management environment

               and sound policies and procedures                        30

         2.4.2 Maintaining an appropriate risk measurement, mitigating,

               and monitoring process

                                                                        31

         2.4.3 Adequate internal controls

                                                                        32

    2.5 Management processes of specific risks

                                                                        32

         2.5.1 Credit risk management

                                                                        32

         2.5.2 Interest rate risk management

                                                                        34

         2.5.3 Liquidity risk management

                                                                        36

         2.5.4 Operational risk management

                                                                        38

    2.6 Risk management and mitigation techniques

                                                                        39

         2.6.1 GAP analysis

                                                                        39

         2.6.2 Duration-gap analysis

                                                                            3


         2.6.3  Value at risk (VaR)                                     40

         2.6.4  Risk adjusted rate of return (RAROC)                    41

         2.6.5  Securitization                                          42

         2.6.6  Derivatives                                             44

                 2.6.6.1 Interest-rate swaps                            46

                 2.6.6.2 Credit derivatives                             47

    2.7 Islamic financial institutions: nature and risks                49

         2.7.1 Nature of risks faced by Islamic banks                   49

         2.7.2 Unique counterparty risks of Islamic modes of finance    51

               2.7.2.1 Murāba ah financing                              53

               2.7.2.2 Salam financing                                  54

               2.7.2.3 Isti nā‘ financing                               54

               2.7.2.4 Mushārakah - Muārabah (M-M) financing           55

III. Risk Management: A Survey of Islamic Financial Institutions        56

      3.1 Introduction                                                  59

      3.2 Risk perceptions                                              59

         3.2.1 Overall risks faced by Islamic financial institutions    60

         3.2.2 Risks in different modes of financing                    61

         3.2.3 Additional issues regarding risks faced by Islamic       62

                 financial institutions

      3.3 Risk management system and process                            65

         3.3.1 Establishing appropriate risk management environment     66

                 and sound policies and procedures

         3.3.2 Maintaining an appropriate risk measurement, mitigating,

                 and monitoring process                                 66

         3.3.3 Adequate internal controls                               67

      3.4 Other issues and concerns                                     71

      3.5 Risk management in Islamic financial institutions: an         72

         assessment

IV. Risk Management: Regulatory Perspectives                            75

      4.1 Economic rationale of regulatory control on bank risks        77

         4.1.1 Controlling systemic risks                               77

         4.1.2 Enhancing the public’s confidence in markets             77

4


         4.1.3 Controlling the risk of moral hazard                         79

     4.2 Instruments of regulation and supervision                          81

         4.2.1 Regulating risk capital: current standards and new           82

                proposals                                                   82

              4.2.1.1 Regulatory capital for credit risk: present standards

              4.2.1.2 Reforming regulatory capital for credit risk: the     83

                      Proposed New Basel Accord

              4.2.1.3 Treatment of credit risk under the Proposed New

                      Accord                                                84

              4.2.1.4 Regulatory treatment of market risk                   86

              4.2.1.5 Banking book interest rate risk                       91

              4.2.1.6 Treatment of securitization risk                      92

              4.2.1.7 Treatment of operational risks                        93

         4.2.2 Effective supervision                                        93

         4.2.3 Risk disclosures: enhancing transparency about the future    94

     4.3 Regulation and supervision of Islamic banks                        98

         4.3.1 Relevance of the international standards for Islamic banks   102

         4.3.2 The present state of Islamic banking supervision             102

         4.3.3 Unique systemic risk of Islamic banking                      103

              4.3.3.1 Preventing risk transmission                          105

              4.3.3.2 Preventing the transmission of risks to demand        106

                      deposits

              4.3.3.3 Other systemic considerations                         109

V. Risk Management: Fiqh Related Challenges                                 112

   5.1 Introduction                                                         113

       5.1.1 Attitude towards risk                                          113

       5.1.2 Financial risk tolerance                                       113

   5.2. Credit risks                                                        115

       5.2.1 Importance of expected loss calculation                        116

       5.2.2 Credit risk mitigation techniques                              116

              5.2.2.1 Loan loss reserves                                    117

              5.2.2.2 Collateral                                            117

              5.2.2.3 On-balance sheet netting                              118

                                                                                5


             5.2.2.4 Guarantees                                         121

             5.2.2.5 Credit derivatives and securitization              121

             5.2.2.6 Contractual risk mitigation                        123

             5.2.2.7 Internal ratings                                   125

             5.2.2.8 RAROC                                              126

             5.2.2.9 Computerized Models                                128

   5.3 Market risks                                                     129

      5.3.1 Business challenges of Islamic banks: a general observation 129

      5.3.2 Composition of overall market risks                         129

      5.3.3 Challenges of benchmark rate risk management                131

             5.3.3.1 Two-step contracts and GAP analysis                132

             5.3.3.2 Floating rate contracts                            133

             5.3.3.3 Permissibility of swaps                            135

      5.3.3 Challenges of managing commodity and equity price risks     135

             5.3.3.1 Salam And commodity futures                        137

             5.3.3.2 Bay‘ al -Tawrīd with Khiyār al-shar                138

             5.3.3.3 Parallel contracts                                 139

      5.3.4 Equity price risks and the use of Bay‘al‘arboon             140

      5.3.5 Challenges of managing foreign exchange risk                143

             5.3.5.1 Avoid transaction risks                            143

             5.3.5.2 Netting                                            144

             5.3.5.3 Swap of liabilities                                144

             5.3.5.4 Deposit swap                                       144

             5.3.5.5 Currency forwards and futures                      145

             5.3.5.6 Synthetic forward                                  145

             5.3.5.7 Immunization                                       146

   5.4 Liquidity risk                                                   146

VI. Conclusions                                                         146

   6.1 The environment                                                  151

   6.2 Risks faced by the Islamic financial institutions                151

   6.3 Risks management techniques                                      152

   6.4 Risk perception and management in Islamic banks                  152

6


   6.5 Regulatory concerns with risks management                    152

   6.6 Instruments of risk-based regulation                         153

   6.7 Risk-based regulation and supervision of Islamic banks       154

   6.8 Risk management: Sharī‘ah -based challenges                  154

                                                                    155

VII. Policy Implications

   7.1 Management responsibility                                    157

   7.2 Risk reports                                                 157

   7.3 Internal ratings                                             157

   7.4 Risk disclosures                                             158

   7.5 Supporting institutions and facilities                       158

   7.6 Participation in the process of developing the international 158

      standards

   7.7 Research and training                                        159

                                                                    159

Appendix 1: List of financial institutions included in the study

Appendix 2: Samples of risk reports                                 161

Appendix 3: Questionnaire                                           163

Bibliography                                                        167

                                                                    177

                                                                        7


                    ACKNOWLEDGEMENTS

         A number of people have contributed with comments, suggestions, and

input at different stages of writing of this paper. We would like to thank the

members of the Policy Committee of Islamic Development Bank (IDB) and our

colleagues of the Islamic Research and Training Institute (IRTI) who gave

valuable suggestions on the proposal of the paper.

       The study surveyed risk management issues on Islamic financial

institutions. We are grateful to all Islamic banks that have responded to our

questionnaires. These banks include AlBaraka Bank Bangladesh Limited,

ALBaraka Turkish Finance House, Turkey, Meezan Investment Bank Limited,

Pakistan, Badr Forte Bank, Russia, Islami Bank Bangladesh Limited, Kuwait

Turkish Evkaf Finans House, Turkey, and Tadamon Islamic Bank, Sudan. We

had also visited several Islamic financial institutions in four countries to

interview the officials and collect information on risk management issues in

these institutions. We gratefully acknowledge their cooperation and assistance in

providing us with all the relevant information. Among the banks and officials

who deserve special mention are the following:

       ABC Islamic Bank, Bahrain: Mr. Hassan A. Alaali (Executive Director).

       Abu Dhabi Islamic Bank, UAE: Abdul-Rahman Abdul-Malik (Chief

       Executive), Badaruzzaman H. A. Ahmed (Vice President, Internal Audit

       Dept.), Ken Baldwin (Manager, ALM), Ahmed Masood (Manager

       Strategic Planning) and Asghar Ijaz (Manager Special Projects).

       AlBaraka Islamic Bank, Bahrain: Abdul Kader Kazi (Senior Manager,

       International Banking).

       Bahrain Islamic Bank, Bahrain: Abdulla AbolFatih (General Manager),

       Abdulla Ismail Mohd. Ali (Credit Manager), Jawaad Ameeri (Credit

       Department Supervisor), and Adnan Abdulla Al-Bassam (Internal Audit

       Department Manager).

       Bahrain Monetary Authority, Bahrain: Anwar Khalifa al Sadah (Director,

       Financial Institutions Supervision Directorate).

       Bank Islam Malaysia Berhad, Kuala Lumpur, Abdul Razak Yaakub,

       Head, Risk Management Department.

       Citi Islamic Investment Bank, Bahrain: Aref A. Kooheji (Vice President,

       Global Islamic Finance).

8


       Dubai Islamic Bank, UAE: Buti Khalifa Bin Darwish (General Manager).

       Faisal Islamic Bank Egypt, Cairo, Tag ElDin. A. H. Sadek, Manager

       Foreign Department.

       First Islamic Investment Bank, Bahrain: Alan Barsley and Shahzad Iqbal.

       Investors Bank, Bahrain: Yash Parasnis (Head of Risk Management).

       Islamic Development Bank, Jeddah, Saudi Arabia.

       Shamil Bank of Bahrain, Bahrain: Dr Saad S. AlMartaan (Chief

       Executive) and Ghulam Jeelani (Assistant General Manager, Risk

       Management).

       Earlier drafts of this paper were presented at the IRTI seminar and IDB’s

Policy Committee meeting. We would like to thank Mabid Ali al-Jarhi, Boualem

Bendjilali, M. Umer Chapra, Hussien Kamel Fahmy, Munawar Iqbal, and M.

Fahim Khan from IRTI and the members of the Bank’s Policy Committee for

their valuable comments and suggestions. We are also grateful to Sami

Hammoud, Consulting Expert on Islamic Banking and Finance, Zamir Iqbal,

World Bank, Professor Mervyn K. Lewis, University of South Australia, and

David Marston, International Monetary Fund (IMF), who as external referees

gave thoughtful comments and suggestions on the paper. We are also thankful to

Mr. Syed Qamar Ahmad for proof reading the final version of the paper.

       The comments and suggestions of these scholars were helpful in revising

the paper. The views expressed in the paper, however, do not reflect their views,

nor of IRTI or IDB. Views expressed and any remaining errors in the final draft

are those of the authors only.

Jumada' II 29, 1422H                                     TARIQULLAH KHAN

September 17, 2001                                               HABIB AHMED

                                                                               9


                                 FOREWORD

          The Islamic financial industry is growing continuously ever since the

first institutions started operating during the early Seventies. At the present, most

Islamic financial services are being provided in almost all parts of the world by

different financial institutions. Standards for financial reporting, accounting and

auditing have already been put in place. Progress is being made in establishing

an Islamic capital and inter-bank money market, an Islamic rating agency and an

Islamic financial services supervisory board. These developments imply that the

Islamic financial industry has become systemically important for the

international financial system.

          Due to its special treatment of different risks, asset-based nature and the

strong concerns of clients for Islamic values, the concept of Islamic finance

contains inherent features that enhance market discipline and financial stability.

However, due to the relatively new microstructures of the Islamic modes of

finance and the unique risk characteristics of liabilities and assets, the Islamic

financial industry also poses a number of systemic risks. Research studies can be

instrumental in strengthening its stabilizing features and in mitigating the

potential sources of instability. As a result, the stability of financial markets can

be enhanced along with attaining the objective of growth. This is important for

the industry's sustained growth and its contribution to the stability and efficiency

of the international financial markets.

          With such a background, the Board of Executive Directors of the

Islamic Development Bank (IDB), asked IRTI to conduct a research dealing

with risk management issues of the Islamic financial industry. As a result,

Tariqullah Khan and Habib Ahmed - researchers at the Institute have prepared

the present paper. Indeed, the subject is very important and the authors have

attempted to undertake a comprehensive stock taking and analysis of some of the

relevant issues. Standard setters, Sharī‘ah scholars, policy makers, practitioners,

academia and researchers may find the work relevant. It is hoped that the study

will be instrumental in motivating to conduct more research in this important

area.

                                                             Mabid Ali Al-Jarhi

                                                             Director, IRTI

10


11
                               GLOSSARY

                  (ARABIC TERMS USED IN THE PAPER)

al khirāju bi al-  :  These are the two fundamental axioms of Islamic finance

amān and al          implying that entitlement to return from an asset is

ghunmu bi al          intrinsically related to the liability of loss of that asset.

ghurm

‘arboon, bay‘      :  A sale contract in which a small part of the price is paid

al-                   as an earnest money (down payment), the object and its

                      remaining price are exchanged in a future date. In case

                      the buyer rescinds from the contract he has to forego the

                      earnest money compensating the seller in causing a delay

                      in sale.

Band al-I sān      :  Beneficence clause in a Salam contract used in the Sudan.

                      It is aimed at compensating the party to the contract that

                      is adversely affected due to changes in prices between

                      signing the contract and its final settlement.

Band al-Jazāa      :   Penalty clause in an Isti nā‘ to ensure contract

                      enforceability.

Bay‘               :  Stands for sale and has been used here as a prefix in

                      referring to the different sale-based modes of Islamic

                      finance, like Murāba ah, Ijārah, Isti nā‘ and Salam.

Fiqh               :  Refers to the whole corpus of Islamic jurisprudence. In

                      contrast with conventional law, Fiqh covers all aspects of

                      life, religious, political, social or economic. In addition to

                      religious observances like prayer, fasting, Zakāh and

                      pilgrimage, it also covers family law, inheritance, social

                      and economic rights and obligations, commercial law,

                      criminal law, constitutional law and international

                      relations, including war. The whole corpus of Fiqh is

                      based primarily on interpretations of the Qur’an and the

                      Sunnah and secondarily on Ijmā‘ (consensus) and Ijtihād

                      (individual judgement). While the Qur’an and the Sunnah

                      are immutable, Fiqhī verdicts may change due to

                      changing circumstances.

Gharar             :  Uncertainty of outcome caused by ambiguous conditions

                      in contracts of deferred exchange.

12


Ijārah, bay‘ al- : Sale of usufructs (operating lease).

Isti nā‘ , bay‘  : Refers to a contract whereby a manufacturer (contractor)

al-                agrees to produce (build) and deliver a certain good or

                   premise at a given price on a given date in the future.

                   This is an exception to the general Sharī‘ah ruling which

                   does not allow a person to sell what he does not own and

                   possess. As against Salam, the price here need not be

                   paid in advance. It may be paid in installments, in steps

                   with the preferences of the parties or partly at the front

                   end and the balance later on as agreed.

Ju‘ālah          : Service contract, performing a given task for a fee.

Khiyār al-shar   : The option to rescind from a sale contract based on some

                   conditions stipulated by one party without fulfilling,

                   which a party can rescind from the contract.

Muārabah        : An agreement between two or more persons whereby one

                   or more of them provide finance, while the others provide

                   entrepreneurship and management to carry on any

                   business venture whether trade, industry or service, with

                   the objective of earning profits. The profit is shared by

                   them in an agreed proportion. The loss is borne only by

                   the financiers in proportion to their share in total capital.

                   The entrepreneur’s loss lies in not getting any reward for

                   his/her services.

Murāba ah,       : Sale at a specified profit margin. The term is, however,

bay‘ al-           now used to refer to a sale agreement whereby the seller

                   purchases the goods desired by the buyer and sells them

                   at an agreed marked-up price, the payment being settled

                   within an agreed time frame, either in installments or

                   lump sum. The seller bears the risk for the goods until

                   they have been delivered to the buyer. Murāba ah is also

                   referred to as bay‘al mu‘ajjal.

                                                                             13


Mushārakah      : An Islamic financing technique whereby all the partners

                  share in equity as well as management. The profits can be

                  distributed among them in accordance with agreed ratios.

                  However, losses must be shared according to the share in

                  equity.

Qar asan       : A loan extended without interest or profit sharing.

Rahn            : Collateral.

Ribā            : Literally means increase or addition, and refers to the

                  ‘premium’ that must be paid by the borrower to the

                  lender along with the principal amount as a condition for

                  the loan or an extension in its maturity. It is regarded by

                  a predominant majority of Muslims to be equivalent to

                  interest.

Salam, bay‘ al- : Sale in which payment is made in advance by the buyer

                  and the delivery of goods is deferred by the seller. This

                  is also, like Isti nā‘, an exception to the general Sharī‘ah

                  ruling that you cannot sell what you do not own and

                  possess.

Sharī‘ah        : Refers to the divine guidance as given by the Qur’an and

                  the Sunnah and embodies all aspects of the Islamic faith,

                  including beliefs and practices.

Tawrīd, bay‘    : Contractual sale in which known quality and amount of

al-               an object is supplied by a supplier for a known price to be

                  paid on an agreed upon periodic schedule.

Wakālah         : Agency - appointment of someone else to render a work

                  on behalf of the principal for a fee.

14


15
                  ABBREVIATIONS

AAOIFI  Accounting & Auditing Organization for Islamic Financial

        Institutions

BCBS:   Basel Committee for Banking Supervision

BIA:    Basic Indicator Approach

BIS:    Bank for International Settlements

BMA:    Bahrain Monetary Agency

CA:     Capital Arbitrage

CAMELS: Capital, Assets, Management, Earnings, Liquidity, and

        Sensitivity to risk

CAPM:   Capital Asset Pricing Model

DGAP:   Duration Gap

EAD:    Exposure at Default

EL:     Expected Loss

FIs:    Financial Institutions

FTSE:   Financial Times Stock Exchange

G10:    Group of Ten

GDP:    Gross Domestic Product

HSBC:   Hong Kong Shanghai Banking Corporation

IAIB:   International Association of Islamic Banks

IAIS:   International Association of Insurance Supervisors

IASC:   International Accounting Standards Committee

IASs:   International Accounting Standards

IDB:    Islamic Development Bank

IMA:    Internal Management Approach

IMF:    International Monetary Fund

IOSCO:  International Organization of Securities Commissioners

IRB:    Internal Rating Based

IRTI:   Islamic Research and Training Institute

ISDA:   International Swap & Derivatives’ Association

JFFC:   Joint Forum on Financial Conglomerates

LDA:    Loss Distribution Approach

LGD:    Loss Given Default

LIBOR:  London Inter-bank Offered Rate

LLR:    Lender of Last Resort

LR:     Leverage Ratio

16


LTCM:  Long Term Capital Management

MCM:   Murāba ah Clearing Market

MDB:   Multilateral Development Banks

M-M:   Muārabah - Mushārakah

MOF:   Maturity of Facility

ODS:   Object Deferred Sale

OECD:  Organization for Economic Co-operation and Development

OIC:   Organization of Islamic Conference

OTC:   Over the Counter

PD:    Probability of Default

PLS:   Profit-and-Loss Sharing

PPFs:  Principal Protected Funds

RAROC: Risk Adjusted Rate of Return on Capital

RSA:   Rate Sensitive Assets

RSL:   Rate Sensitive Liabilities

RWA:   Risk Weighted Assets

SA:    Standard Approach

SPV:   Special Purpose Vehicle

UAE:   United Arab Emirates

UL:    Unexpected Loss

VaR:   Value at Risk

WL:    Worst Loss

                                                              17


                     EXECUTIVE SUMMARY

         Islamic financial industry has come a long way during its short history.

The future of these institutions, however, will depend on how they cope with the

rapidly changing financial world. With globalization and informational

technology revolution, scopes of different financial institutions have expanded

beyond national jurisdictions. As a result, the financial sector in particular has

become more dynamic, competitive, and complex. Moreover, there is a rapidly

growing trend of cross-segment mergers, acquisitions and financial

consolidation, which blurs the unique risks of the various segments of the

financial industry. Furthermore, there has been an unprecedented development in

computing, mathematical finance and innovation of risk management

techniques. All these developments are expected to magnify the challenges that

Islamic financial institutions face particularly as more well established

conventional institutions have started to provide Islamic financial products.

Islamic financial institutions need to equip themselves with the up-to-date

management skills and operational systems to cope with this environment. One

major factor that will determine the survival and growth of the industry is how

well these institutions manage the risks generated in providing Islamic financial

services.

         Studying risk management issues of the Islamic financial industry is an

important but complex subject. The present paper discusses and analyzes a

number of issues concerning the subject. First, it presents an overview of the

concepts of risks and risk management techniques and standards as these exist in

the financial industry. Second, the unique risks of the Islamic financial services

industry and the perceptions of Islamic banks about these risks are surveyed

through a questionnaire and analyzed. Third, the main regulatory concerns with

respect to risks and their treatment with a view to draw some lessons for Islamic

banks are discussed. Fifth, a number of Sharī‘ah related challenges concerning

risk management are identified and discussed. Finally, conclusions and policy

implications are summarized.

         The study concludes that financial markets liberalization is associated

with an increase in risks and financial instability. Risk management processes

and techniques enable financial institutions to control undesirable risks and to

take benefit of the business opportunities created by the desirable ones. These

18


processes are of important concern for regulators and supervisors as these

determine the overall efficiency and stability of the financial systems.

         The study shows that the Islamic financial institutions face two types of

risks. The first type of risks they have in common with traditional banks as

financial intermediaries, such as credit risk, market risk, liquidity risk and

operational risk. However, due to Sharī‘ah compliance the nature of these risks

changes. The second type is of new and unique risks that the Islamic banks face

as a result of their unique asset and liability structures. Consequently the

processes and techniques of risk identification and management available to the

Islamic banks could be of two types – standard techniques which are not in

conflict with the Islamic principles of finance and techniques which are new or

adapted keeping in view their special requirements.

         Due to their unique nature, the Islamic institutions need to develop more

rigorous risk identification and management systems. The paper identifies a

number of policy implications the implementation of which can be instrumental

in promoting a risk management culture in the Islamic financial industry.

     i.  The management of all banks need to create a risk management

         environment by clearly identifying the risk objectives and strategies of

         the institution and by establishing systems that can identify, measure,

         monitor, and manage various risk exposures. To ensure the effectiveness

         of the risk management process, Islamic banks also need to establish a

         proficient internal control system.

    ii. Risk reporting is extremely important for the development of an efficient

         risk management system. The risk management systems in Islamic

         banks can be substantially improved by allocating resources for

         preparing a number of periodic risk reports such as capital at risk

         reports, credit risk reports, operational risk reports, liquidity risk reports

         and market risk reports.

    iii. An Internal Rating System (IRS) is highly relevant for the Islamic

         banks. At initial stages of its introduction the IRS may be seen as a risk

         based inventory of individual assets of a bank. Such systems have

         proved highly effective in filling the gaps in risk management systems

         hence in enhancing external rating of institutions. This contributes to

         cutting the cost of funds. Internal rating systems are also very relevant

         for the Islamic modes of finance. Most Islamic banks already use some

                                                                                    19


        form of internal ratings. However, these systems need to be strengthened

        in all Islamic banks.

   iv. Risk-based management information, internal and external audit, and

        asset inventory systems can greatly enhance risk management systems

        and processes.

    v. Substantial risks faced by the Islamic banks can be reduced if a number

        of supporting institutions and facilities are provided. These include a

        lender of last resort facility, deposit protection system, liquidity

        management system, legal reforms to facilitate Islamic banking and

        dispute settlement, uniform Sharī‘ah standards, adoption of AAOIFI

        standards and establishing a supervisory board for the industry.

   vi. The Islamic financial industry being a part of the global financial

        markets is effected by the international standards. It is thus imperative

        for the Islamic financial institutions to follow-up the process of standard

        setting and to respond to the consultative documents distributed in this

        regard by the standard setters on a regular basis.

   vii. Risk management systems strengthen financial institutions. Therefore,

        risk management needs to be assigned a priority in research and training

        programs.

20


21
                                          I

                            INTRODUCTION

         Islamic financial institutions were established three decades ago as an

alternative to conventional financial institutions mainly to provide Sharī‘ah

compatible investment, financing, and trading opportunities. During its short

history, the growth in the nascent banking industry has been impressive. One of

the main functions of financial institutions is to effectively manage risks that

arise in financial transactions. To provide financial services at low risk,

conventional financial institutions have developed different contracts, processes,

instruments, and institutions to mitigate risks. The future of the Islamic financial

industry will depend to a large extent on how these institutions will manage

different risks arising from their operations.

1.1 UNIQUE NATURE OF ISLAMIC BANKING RISKS

         A distinction between theoretical formulations and actual practices of

Islamic banking can be observed. Theoretically, it has been an aspiration of

Islamic economists that on the liability side, Islamic banks shall have only

investment deposits. On the asset side, these funds would be channeled through

profit sharing contracts. Under such a system, any shock on the asset side shall

be absorbed by the risk sharing nature of investment deposits. In this manner,

Islamic banking offers a more stable alternative to the traditional banking

system. The nature of systemic risks of such a system would be similar to the

risks inherent in mutual funds.

         The focus of this study is on the actual practices of Islamic banks. The

practice of Islamic banking, however, is different from the theoretical

aspirations. On the assets side, investments can be undertaken using profit

sharing modes of financing (Muārabah and Mushārakah) and fixed-income

modes of financing like Murāba ah (cost-plus or mark-up sale), installment sale

(medium/long term Murāba ah), Isti nā‘/ Salam (object deferred sale or pre-

paid sale) and Ijārah (leasing). The funds are provided only for such business

activities which are Sharī‘ah compatible. On the liability side, deposits can be

made either in current accounts or in investment accounts. The former is

considered in Islamic banks as Qar asan (interest-free loan) or Amānah

(trust). These have to be fully returned to depositors on demand. Investment

depositors are rewarded on the basis of profit and loss sharing (PLS) method and

22


these deposits share the business risks of the banking operations. Using profit

sharing principle to reward depositors is a unique feature of Islamic banks. This

feature along with the different modes of financing and the Sharī‘ah compliant

set of business activities change the nature of risks that Islamic banks face.

1.2 SYSTEMIC IMPORTANCE OF ISLAMIC BANKS

          The Islamic financial services industry comprises of Islamic commercial

and investment banks, windows of conventional banks offering Islamic financial

services, mutual and index funds, leasing and Muārabah companies and

Islamic insurance companies. The present paper specifically deals with the risks

facing the Islamic commercial and investment banks.

          Since its beginning in the early 1970s, the growth of the Islamic

financial industry has been robust. While some countries have introduced

Islamic financial services along with conventional ones, three countries (Iran,

Pakistan, and Sudan) have opted for comprehensive reforms with the objective

of transforming their financial systems to an Islamic one. According to the

International Association of Islamic Banks (IAIB), the number of Islamic

financial institutions stood at 176 at the end of 1997.1 These financial institutions

had a combined capital of US$ 7.3 billion and assets and liabilities worth US$

147.7 billion. In 1997, Islamic banks managed funds worth US$ 112.6 billion

making a net profit of US$ 1.2 billion. The historical data on these financial

variables is given in Table 1.1.

                                          Table 1.1

                          Size of Islamic Financial Institutions

                Some Financial Highlights (Amount in US$ Million)

   Year        No. of      Combined         Combined             Combined          Combined

               Banks         Capital          Assets                Funds              Net

                                                                 Managed             Profits

  1993        100          2,309.3       53,815.3              41,587.3           N.A.

  1994        133          4,954.0       154,566.9             70,044.2           809.1

  1995        144          6,307.8       166.053.2             77,515.8           1,245.5

  1996        166          7271.0        137,132.5             101,162.9          1,683.6

  1997        176          7333.1        147,685.0             112,589.8          1,218.2

Source: Directory of Islamic Banks and Financial Institutions-1997, The International Association

        of Islamic Banks, Jeddah.

      ١

        The data collected by the IAIB is available only up to 1997 and the IAIB is no more

     operational.

                                                                                               23


          During a short history of its existence, the Islamic banks have performed

reasonably well. A recent study on the performance of Islamic banks shows that

these institutions are well capitalized, profitable and stable2. Furthermore, this

paper indicates that Islamic banks have not only grown at a faster rate than their

conventional counterparts, but have also outperformed them in other criteria. On

the average, Islamic banks have larger capital-asset ratios and have used their

resources better than conventional banks. Furthermore, the Islamic institutions

have yielded profitability ratios that are superior to those of traditional banks.

          Linear and exponential forecasts from the data in Table 1.1 indicate that

the estimate of capital of Islamic financial institutions is valued between US$ 13

billion and US$ 23.5 billion in 2002.3 The corresponding projections for assets

held by these institutions are US$ 198.6 billion and US$ 272.7 billion

respectively in the same year. Given the performance and the potential market of

Islamic financial services, Islamic banking sector has grown at a fast pace and

rapidly gained global dimension. This is witnessed by the involvement of many

multinational financial institutions like ANZ Grindlays, Chase Manhattan,

Citicorp, Commerzbank AG, HSBC, and Morgan Stanley Dean Witter & Co. in

Islamic products. Major world stock exchanges like Dow Jones and FTSE

having introduced Islamic indices.

1.3 OBJECTIVES OF THE PAPER

          While Islamic banks being commercial enterprises would be more

concerned with growth of assets and profitability, regulators would prefer the

banks to be more stable and have growth as secondary concern. Due to the

unprecedented developments in the areas of computing, information and

mathematical finance, the financial services markets have become extremely

complex. Moreover, cross-segment mergers, acquisitions, and financial

consolidation have blurred the risks of various segments of the industry.

          Given this complexity, dynamism, and transformation in the financial

sector there are several questions that can be raised related to Islamic banks.

How do the Islamic banks perceive their own risks and these various

developments? How regulators expect to respond to the new risks inherent in

Islamic banks? What possible Sharī‘ah compatible risk management instruments

      ٢

        For details, see Iqbal (2000).

     ٣

        While linear projections are estimated assuming constant growth rate, the exponential

     forecasts are the optimistic figures estimated by assuming exponential growth. Note that

     given the small number of observations, these forecasts should be taken as indicative only.

24


are available at the present? What are the prospects of exploring new

instruments in the future? What are the implications of all these for the

competitiveness of Islamic banks? How is stability of the Islamic financial

institutions going to be affected? The objective of the present paper is to address

some of these questions. Specifically the paper aims at the following:

     i.  Presenting an overview of the concepts of risks and risk management

         techniques and standards as these exist in the financial industry.

    ii. Discussing the unique risks of the Islamic financial services industry and

         the perceptions of Islamic banks about these risks.

    iii. Reviewing the main regulatory concerns with respect to risks and their

         treatment with a view to draw some lessons for Islamic banks.

    iv. Discussing and analyzing the Sharī‘ah related challenges concerning

         risk management in the Islamic financial services industry and

     v. Presenting policy implications for developing a risk management culture

         in Islamic banks.

1.4 OUTLINE OF THE PAPER

         In section two, we discuss the basic concepts of risks and their

management as practiced in the conventional financial sector. This section also

provides details of the various processes to manage different risks. The section

ends with identifying the nature of risks found in Islamic financial institutions

and instruments. Section three, reports results from a survey on risk management

issues in Islamic financial institutions. The survey covered 17 Islamic

institutions from 10 different countries. The results covers the perspectives of

Islamic bankers towards different risks, the process of risk management in these

institutions, and some other aspects related to Islamic financial institutions.

Section four discusses the risk management aspects from the regulatory

viewpoints. Based on, among others, the proposals of Basel Committee, the

section touches on the regulatory aspects for Islamic financial institutions.

Among others, it covers issues related to capital requirements in Islamic

financial institutions and different approaches to manage various risks. Section

five covers some Fiqhī issues related to risk management. Other than pointing

out the Sharī‘ah viewpoints towards different techniques and instruments used

for risk mitigation, proposals are made on developing new techniques. Some

suggestions are also given for consideration of Sharī‘ah experts to deliberate on.

The last section concludes the paper and presents policy implications for

developing risk management culture in Islamic banks.

                                                                                 25


                                               II

                           RISK MANAGEMENT:

        BASIC CONCEPTS AND TECHNIQUES

         In this section we discuss the basic risk concepts and issues related to

risk management. After defining and identifying different risks, we describe the

risk management process. Risk management process is a comprehensive system

that includes creating an appropriate risk management environment, maintaining

an efficient risk measurement, mitigating, and monitoring process, and

establishing an adequate internal control arrangement. After outlining the basic

idea of the risk management process and system, we discuss the main elements

of the management process for specific risks. The latter part of the section

examines the risks involved in Islamic financial institutions. We review the

nature of traditional risks for Islamic financial institutions and point out some

specific risks that Islamic banks face. We then discuss the risks inherent in

different Islamic modes of financing.

2.1. INTRODUCTION

         Risk arises when there is a possibility of more than one outcome and the

ultimate outcome is unknown. Risk can be defined as the variability or volatility

of unexpected outcomes.4 It is usually measured by the standard deviation of

historic outcomes. Though all businesses face uncertainty, financial institutions

face some special kinds of risks given their nature of activities. The objective of

financial institutions is to maximize profit and shareholder value-added by

providing different financial services mainly by managing risks.

         There are different ways in which risks are classified. One way is to

distinguish between business risk and financial risks. Business risk arises from

the nature of a firm’s business. It relates to factors affecting the product market.

Financial risk arises from possible losses in financial markets due to movements

in financial variables (Jorion and Khoury 1996, p. 2). It is usually associated

with leverage with the risk that obligations and liabilities cannot be met with

current assets (Gleason 2000, p. 21).

     ٤

       This definition is from Jorion and Khoury (1996, p. 2).

26


         Another way of decomposing risk is between systematic and

unsystematic components. While systematic risk is associated with the overall

market or the economy, unsystematic risk is linked to a specific asset or firm.

While the asset-specific unsystematic risk can be mitigated in a large diversified

portfolio, the systematic risk is nondiversifiable. Parts of systematic risk,

however, can be reduced through the risk mitigation and transferring techniques.

         To understand the underlying principle of risk management, we use

Oldfield and Santomero (1997) classification of risks. Accordingly, financial

institutions face the following three types of risks: risks that can be eliminated,

those that can be transferred to others, and the risks that can be managed by the

institution. Financial intermediaries would avoid certain risks by simple business

practices and will not take up activities that impose risks upon them. The

practice of financial institutions is to take up activities in which risks can be

efficiently managed and shift risks that can be transferred.

         Risk avoidance techniques would include the standardization of all

business-related activities and processes, construction of diversified portfolio,

and implementation of an incentive-compatible scheme with accountability of

actions. Some risk that banks face can be reduced or eliminated by transferring

or selling these in well-defined markets. Risk transferring techniques include,

among others, use of derivatives for hedging, selling or buying of financial

claims, changing borrowing terms, etc.

         There are, however, some risks that cannot be eliminated or transferred

and must be absorbed by the banks. The first is due to the complexity of the risk

and difficulty to separate it from asset. The second risk is accepted by the

financial institutions as these are central to their business. These risks are

accepted because the banks are specialized in dealing with them and get

rewarded accordingly. Examples of these risks are the credit risk inherent in

banking book activities and market risks in the trading book activities of banks.

         There is a difference between risk measurement and risk management.

While risk measurement deals with quantification of risk exposures, risk

management refers to “the overall process that a financial institution follows to

define a business strategy, to identify the risks to which it is exposed, to quantify

those risks, and to understand and control the nature of risks it faces” (Cumming

and Hirtle 2001, p. 3). Before we discuss the risk management process and

                                                                                   27


measurement techniques, we give an overview of the risks faced by financial

institutions and the evolution of risk management.

  2.2. RISKS FACED BY FINANCIAL INSTITUTIONS

          The risks that banks face can be divided into financial and non-financial

ones.5 Financial risk can be further partitioned into market risk and credit risk.

Non-financial risks, among others, include operational risk, regulatory risk, and

legal risk. The nature of some of these risks is discussed below.

          Market Risk is the risk originating in instruments and assets traded in

well-defined markets. Market risks can result from macro and micro sources.

Systematic market risk result from overall movement of prices and policies in

the economy. The unsystematic market risk arises when the price of the specific

asset or instrument changes due to events linked to the instrument or asset.

Volatility of prices in various markets gives different kinds of market risks. Thus

market risk can be classified as equity price risk, interest rate risk, currency risk,

and commodity price risk. As a result, market risk can occur in both banking and

trading books of banks. While all of these risks are important, interest rate risk is

one of the major risk that banks have to worry about. The nature of this risk is

briefly explained below.

          Interest Rate Risk is the exposure of a bank’s financial condition to

movements in interest rates. Interest rate risk can arise from different sources.

Repricing risk arises due to timing differences in the maturity and repricing of

assets, liabilities and off-balance sheet items. Even with similar repricing

characteristics, basis risk may arise if the adjustment of rates on assets and

liabilities are not perfectly correlated. Yield curve risk is the uncertainty in

income due to changes in the yield curve. Finally instruments with call and put

options can introduce additional risks.

     ٥

       This classification of risk is taken from Gleason (2000).

28


         Credit Risk is the risk that counterparty will fail to meet its obligations

timely and fully in accordance with the agreed terms. This risk can occur in the

banking and trading books of the bank. In the banking book, loan credit risk

arises when counterparty fails to meet its loan obligations fully in the stipulated

time. This risk is associated with the quality of assets and the probability of

default. Due to this risk, there is uncertainty of net-income and market value of

equity arising from non-payment and delayed payment of principal and interest.

         Similarly, trading book credit risk arises due to a borrower’s inability or

unwillingness to discharge contractual obligations in trading contracts. This can

result in settlement risk when one party to a deal pays money or delivers assets

before receiving its own assets or cash, thereby, exposing it to potential loss.

Settlement risk in financial institutions particularly arises in foreign-exchange

transactions. While a part of the credit risk is diversifiable, it cannot be

eliminated completely.

         Liquidity Risk arises due to insufficient liquidity for normal operating

requirements reducing the ability of banks to meet its liabilities when it falls due.

This risk may result from either difficulties in obtaining cash at reasonable cost

from borrowings (funding or financing liquidity risk) or sale of assets (asset

liquidity risk). One aspect of asset-liability management in the banking business

is to minimize the liquidity risk. While funding risk can be controlled by proper

planning of cash-flow needs and seeking newer sources of funds to finance cash-

shortfalls, the asset liquidity risk can be mitigated by diversification of assets

and setting limits of certain illiquid products.

         Operational Risk is not a well-defined concept and may arise from

human and technical errors or accidents. It is the risk of direct or indirect loss

resulting from inadequate or failed internal processes, people, and technology or

from external events. While people risk may arise due to incompetence and

fraud, technology risk may result from telecommunications system and program

failure. Process risk may occur due to various reasons including errors in model

specifications, inaccurate transaction execution, and violating operational control

limits.6 Due to problems arising from inaccurate processing, record keeping,

system failures, compliance with regulations, etc., there is a possibility that

operating costs might be different from what is expected affecting the net-

income adversely.

     ٦

       For a list of different sources of operational risk see Crouhy et.al. (2001, p. 487).

                                                                                             29


         Legal Risks relate to risks of unenforceability of financial contracts.

This relates to statutes, legislation, and regulations that affect the fulfillment of

contracts and transactions. This risk can be external in nature (like regulations

affecting certain kind of business activities) or internal related to bank’s

management or employees (like fraud, violations of laws and regulations, etc.).

Legal risks can be considered as a part of operational risk (BCBS, 2001a).

Regulatory risk arises from changes in regulatory framework of the country.

2.3. RISK MANAGEMENT: BACKGROUND AND EVOLUTION

         Though business activities have been always exposed to risks, the

formal study of managing risk started in the later half of the last century.

Markowitz’s (1959) seminal paper first indicated that portfolio selection was a

problem of maximizing its expected return and minimizing the risks. A higher

expected return of a portfolio (measured by the mean) can result only from

taking more risks. Thus, investors’ problem was to find the optimal risk-return

combination. His analysis also points out the systematic and unsystematic

components of risk. While the unsystematic component can be mitigated by

diversification of assets, the systematic component has to be borne by the

investor. Markowitz’s approach, however, faced operational problems when a

large number of assets are involved.

         Sharpe’s (1964) Capital Asset Pricing Model (CAPM) introduces the

concepts of systematic and residual risks. Advances in this model include

Single-Factor Models of Risk that estimates the beta of an asset. While residual

(firm specific) risk can be diversified, beta measures the sensitivity of the

portfolio to business cycles (an aggregate index). The dependence of CAPM on

a single index to explain the risks inherent in assets is too simplistic.

         Arbitrage Pricing Theory proposed by Ross (1976) suggests that

multiple factors affect the expected return of an asset. The implication of the

Multiple Factor Model is that the total risk is the sum of the various factor-

related risks and residual risk. Thus, a multiple of risk-premia can be associated

with an asset giving the respective factor-specific betas. Though the Multiple

Factors Model is widely accepted, there is however, no consensus regarding the

factors that affect the risk of an asset or the way it is estimated. There are three

approaches in which this model can be implemented. While the Fundamental

Factors model estimates the factor specific risk- premia assuming the respective

factor-specific betas as given, the macroeconomic model assumes the risk-

30


premia as given and estimates the factor-specific betas. Statistical models

attempt to determine both the risk-premia and betas simultaneously.

          Modern risk management processes and strategies have adopted features

of the above mentioned theories and adopted many tools to analyze risk. An

important element of management of risk is to understand the risk-return trade-

off. Investors can expect a higher rate of return only by increasing the risks. As

the objective of financial institutions is to increase the net income of the

shareholders, managing the resulting risks created to achieve this becomes an

important function of these institutions. They do this by efficiently diversifying

the unsystematic risks and reducing and transferring the systematic risk.

          There are two broad approaches to quantify risk exposures facing

financial institutions. One way is to measure risks in a segmented way (e.g.,

GAP analysis to measure interest rate risk and Value at Risk to assess market

risks). The other approach is to measure risk exposure in a consolidated way by

assessing the overall firm level risk (e.g., Risk adjusted rate of return, RAROC

for firm level aggregate risk).7

2. 4. RISK MANAGEMENT: THE PROCESS AND SYSTEM

          Though main elements of risk management include identifying,

measuring, monitoring, and managing various risk exposures,8 these cannot be

effectively implemented unless there is a broader process and system in place.

The overall risk management process should be comprehensive embodying all

departments/sections of the institution so as to create a risk management culture.

It should be pointed out that the specific risk management process of individual

financial institutions depends on the nature of activities and the size and

sophistication of an institution. The risk management system outlined here can

be a standard for banks to follow. A comprehensive risk management system

should encompass the following three components.9 We outline the basic

concept of the risk management process and system in this section.

      ٧

        For a discussion on adopting consolidated risk management from the supervisors’ and the

     banks perspectives see Cumming and Hirtle (2001).

      ٨

        See (Jorion 2001, p. 3) for a discussion.

      ٩

        These three components are derived from BCBS’s recommendations of managing specific

     risks. See BCBS (1999 and 2001b).

                                                                                            31


2.4.1. Establishing Appropriate Risk Management Environment and Sound

       Policies and Procedures

         This stage deals with the overall objectives and strategy of the bank

towards risk and its management policies. The board of directors is responsible

for outlining the overall objectives, policies and strategies of risk management

for any financial institution. The overall risk objectives should be communicated

throughout the institution. Other than approving the overall policies of the bank

regarding risk, the board of directors should ensure that the management takes

the necessary actions to identify, measure, monitor, and control these risks. The

board should periodically be informed and review the status of the different risks

the bank is facing through reports.

         Senior management is responsible to implement these broad

specifications approved by the board. To do so, the management should establish

policies and procedures that would be used by the institution to manage risk.

These include maintaining a risk management review process, appropriate limits

on risk taking, adequate systems of risk measurement, a comprehensive

reporting system, and effective internal controls. Procedures should include

appropriate approval processes, limits and mechanisms designed to assure the

bank’s risk management objectives are achieved. Banks should clearly identify

the individuals and/or committees responsible for risk management and define

the line of authority and responsibility. Care should be taken that there is

adequate separation of duties of risk measurement, monitoring and control

functions.

         Furthermore, clear rules and standards of participation should be

provided regarding position limits, exposures to counterparties, credit and

concentration. Investment guidelines and strategies should be followed to limit

the risks involved in different activities. These guidelines should cover the

structure of assets in terms of concentration and maturity, asset-liability

mismatching, hedging, securitization, etc.

2.4.2. Maintaining an Appropriate Risk Measurement, Mitigating, and

        Monitoring Process

         Banks must have regular management information systems for

measuring, monitoring, controlling and reporting different risk exposures. Steps

that need to be taken for risk measurement and monitoring purposes are

establishing standards for categorization and review of risks, consistent

32


evaluation and rating of exposures. Frequent standardized risk and audit reports

within the institution is also important. The actions needed in this regard are

creating standards and inventories of risk based assets, and regularly producing

risk management reports and audit reports. The bank can also use external

sources to assess risk, by using either credit ratings, or supervisory risk

assessment criterion like CAMELS.

         Risks that banks take up must be monitored and managed efficiently.

Banks should do stress testing to see the effects on the portfolio resulting from

different potential future changes. The areas a bank should examine are the

effects of downturn in the industry or economy and market risk events on default

rates and liquidity conditions of the bank. Stress testing should be designed to

identify the conditions under which a bank’s positions would be vulnerable and

the possible responses to such situations. The banks should have contingency

plans that can be implemented under different scenarios.

2.4.3. Adequate Internal Controls

         Banks should have internal controls to ensure that all policies are

adhered to. An effective system of internal control includes an adequate process

for identify and evaluating different kinds of risks and having sufficient

information systems to support these. The system would also establish policies

and procedures and their adherence are continually reviewed. These may include

conducting periodic internal audits of different processes and producing regular

independent reports and evaluations to identify areas of weakness. An important

part of internal control is to ensure that the duties of those who measure,

monitor, and control risks are separated.

         Finally, an incentive and accountability structure that is compatible with

reduced risk taking on part of the employees is also an important element to

reduce overall risk. A prerequisite of these incentive-based contracts is accurate

reporting of the bank’s exposures and internal control system. An efficient

incentive compatible structure would limit individual positions to acceptable

levels and encourage decision makers to manage risks in a manner that is

consistent with the banks goals and objectives.

2.5. MANAGEMENT PROCESSES OF SPECIFIC RISKS

         As mentioned above the total risk of an asset can be assigned to different

sources. Given the general guidelines of risk management process above, in this

                                                                                 33


section we give details of risk management processes for specific risks faced by

banks.

2.5.1. Credit Risk Management10

         The board of directors should outline the overall credit risk strategies by

indicating the bank’s willingness to grant credit to different sectors, geographical

location, maturity, and profitability. In doing so it should recognize the goals of

credit quality, earnings, growth, and the risk-reward tradeoff for its activities.

The credit risk strategy should be communicated throughout the institution.

         The senior management of the bank should be responsible to implement

the credit risk strategy approved by the board of directors. This would include

developing written procedures that reflect the overall strategy and ensure its

implementation. The procedures should include policies to identify, measure,

monitor, and control credit risk. Care has to be given to diversification of

portfolio by setting exposure limits on single counterparty, groups of connected

counterparties, industries, economic sectors, geographical regions, and

individual products. Banks can use stress testing in setting limits and monitoring

by considering business cycles, interest rate and other market movements. Banks

engaged in international credit need to assess the respective country risk.

         Banks should have a system for ongoing administration of various credit

risk-bearing portfolios. A proper credit administration by a bank would include

an efficient and effective operations related to monitoring documentation,

contractual requirements, legal covenants, collateral, etc., accurate and timely

reporting to management, and compliance with management policies and

procedures and applicable rules and regulations.

         Banks must operate under a sound, well-defined credit-granting criteria

to enable a comprehensive assessment of the true risk of the borrower or

counterparty to minimize the adverse selection problem.                           Banks need

information on many factors regarding the counterparty to whom they want to

grant credit. These include, among others, the purpose of the credit and the

source of repayment, the risk profile of the borrower and its sensitivity to

economic and market developments, borrowers repayment history and current

capacity to repay, enforceability of the collateral or guarantees, etc. Banks

should have a clear and formal evaluation and approval process for new credits

     ١٠

        This section is based on the credit risk management process discussed in BCBS (1999).

34


and extension of existing credits. Each credit proposal should be subject to

careful analysis by a credit analyst so that information can be generated for

internal evaluation and rating. This can be used for appropriate judgements

about the acceptability of the credit.

         Granting credit involves accepting risks as well as producing profits.

Credit should be priced so that it appropriately reflects the inherent risks of the

counterparty and the embedded costs. In considering the potential credit, the

bank needs to establish provisions for expected loss and hold adequate capital to

absorb the unexpected losses. Banks can use collateral and guarantees to help

mitigate risks inherent in individual transactions. Note, however, that collateral

cannot be a substitute for comprehensive assessment of a borrower and strength

of the repayment capacity of the borrower should be given prime importance.

         Banks should identify and manage credit risk inherent in all of its assets

and activities by carefully reviewing the risk characteristics of the asset or

activity. Special care is needed particularly when the bank embarks on new

activities and assets. In this regard, adequate procedures and controls need to be

taken to identify the risks in new asset or activity. Banks must have analytical

techniques and information systems to measure credit risk in all on- and off-

balance sheet activities. The system should be able to provide information on

sensitivities and concentrations in the credit portfolio. Banks can manage

portfolio issues related to credit through loan sales, credit derivatives,

securitization, and involvement in secondary loan markets.

         Banks must have a system for monitoring individual credits, including

determining the adequacy of provisions and reserves. An effective monitoring

system would provide the bank, among others, the current financial condition of

the counterparty. The system would be able to monitor projected cash-flow and

the value of the collateral to identify and classify potential credit problems.

While monitoring the overall composition and quality of the portfolio, a bank

should not only take care about the concentrations with respect to counterparties

activities but also the maturity.

         Banks should develop internal risk rating systems to mange credit risk.

A well-structured internal rating system can differentiate the degree of credit risk

in different credit exposures of a bank by categorizing credits into various

gradations in risk. Internal risk ratings are important tool in monitoring and

controlling credit risk as periodic ratings enable banks to determine the overall

                                                                                  35


characteristics of the credit portfolio and indicates any deterioration in credit

risk. Deteriorating credit can then be subject to additional monitoring and

supervision.

          A bank should have independent ongoing credit reports for the board of

directors and senior management to ensure that the bank’s risk exposure are

maintained within the parameters set by prudential standards and internal limits.

Banks should have internal controls to ensure that credit policies are adhered to.

These may include conducting periodic internal audits of the credit risk

processes to identify the areas of weakness in the credit administration process.

Once the problem credits are identified, banks should have a clear policy and

system for managing problem credits. The banks should have effective workout

programs to manage risk in their portfolio.

2.5.2. Interest Rate Risk Management11

          The board of directors should approve the overall objectives, broad

strategies and policies that govern the interest rate risk of a bank. Other than

approving the overall policies of the bank regarding interest rate risk the board

of directors should ensure that the management takes the necessary actions to

identify, measure, monitor, and control these risks. The board should

periodically be informed and review the status of interest rate risk the bank is

facing through reports.

          Senior management must ensure that the bank follows policies and

procedures that enable the management of interest rate risk. These include

maintaining an interest rate risk management review process, appropriate limits

on risk taking, adequate systems of risk measurement, a comprehensive interest

rate risk reporting system, and effective internal controls. Banks should be able

to identify the individuals and/or committees responsible for interest rate risk

management and define the line of authority and responsibility.

          Banks should have clearly defined policies and procedures for limiting

and controlling interest rate risk by delineating responsibility and accountability

over interest rate risk management decisions and defining authorized

instruments, hedging strategies and position taking opportunities. Interest rate

risk in new products should be identified by carefully scrutinizing the maturity,

      ١١

         This section is based on the interest rate risk management process discussed in BCBS

     (2001).

36


repricing or repayment terms of an instrument. The board should approve new

hedging or risk management strategies before these are implemented.

         Banks should have a management information system for measuring,

monitoring, controlling and reporting interest rate exposures. Banks should have

interest rate risk management systems that assess the effects of rate changes on

both the earnings and economic value. These measurement systems should be

able to utilize generally accepted financial concepts and risk management

techniques to assess all interest risk associated with a bank’s assets, liabilities,

and off-balance sheet positions. Some of the techniques for measuring a bank’s

interest risk exposure are GAP analysis, duration, and simulation. Possible stress

tests can be undertaken to examine the effects of changes in the interest rate,

changes in the slope of the yield curve, changes in the volatility of the market

rates, etc. Banks should consider the “worse case” scenarios and ensure that

appropriate contingency plans are available to tackle these situations.

         Banks must establish and enforce a system of interest rate risk limits and

risk taking guidelines that can achieve the goal of keeping the risk exposure

within some self-imposed parameters over a range of possible changes in interest

rates. An appropriate limit system enables the control and monitoring of interest

rate risk against predetermined tolerance factors. Any violation of limits should

be made known to senior management for appropriate action.

         Interest rate reports for the board should include summaries of the

bank’s aggregate exposures, compliance with policies and limits, results of stress

tests, summaries of reviews of interest rate risk policies and procedures, and

findings of internal and external auditors. Interest rate risk reports should be in

details to enable senior management to assess the sensitivity of the institution to

changes in the market conditions and other risk factors.

         Banks should have adequate system of internal controls to ensure the

integrity of their interest rate risk management process and to promote effective

and efficient operations, reliable financial and regulatory reporting, and

compliance with relevant laws, regulations, and institutional policies. An

effective system of internal control for interest rate risk includes an adequate

process for identify and evaluating risk and having sufficient information

systems to support these. The system would also establish policies and

procedures and their adherence are continually reviewed. These periodic

reviews would cover not only the quantity of interest rate risk, but also the

                                                                                 37


quality of interest rate risk management. Care should be taken that there is

adequate separation of duties of risk measurement, monitoring and control

functions.

2.5.3. Liquidity Risk Management12

         As banks deal with other people’s money that can be withdrawn,

managing liquidity is one of the most important functions of the bank. The

senior management and the board of directors should make sure that the bank’s

priorities and objectives for liquidity management are clear. Senior management

should ensure that liquidity risk is effectively managed by establishing

appropriate policies and procedures. A bank must have adequate information

system to measure, monitor, control and report liquidity risk. Regular reports on

liquidity should be provided to the board of directors and senior management.

These reports should include, among others, the liquidity positions over

particular time horizons.

         The essence of liquidity management problem arises from the fact that

there is a trade-off between liquidity and profitability and mismatch between

demand and supply of liquid assets. While the bank has no control over the

sources of funds (deposits), it can control the use of funds. As such, a bank’s

liquidity position is given priority in allocating funds. Given the opportunity cost

of liquid funds, banks should make all profitable investments after having

sufficient liquidity. Most banks now keep protective reserves on top of planned

reserves. While the planned reserves are derived from either regulatory

requirements or forecasts, the amount of the protective reserve depends on the

management’s attitude towards liquidity risk.

         Liquidity management decisions have to be undertaken by considering

all service areas and departments of the bank. Liquidity manager must keep track

and coordinate the activities of all departments that raise and use funds in the

bank. Decisions regarding the banks liquidity needs must be analyzed

continuously to avoid both liquidity surplus and deficit. In particular, the

liquidity manager should know in advance when large transactions (credit,

deposits, withdrawals) would take place to plan effectively for resulting liquidity

surpluses or deficits.

     ١٢

        The discussion on Liquidity Risk Management is derived from BCBS (2000).

38


         A bank should establish a process of measuring and monitoring net

funding requirements by assessing the bank’s cash inflows and outflows. The

bank’s off-balance sheet commitments should also be considered. It is also

important to assess the future funding needs of the bank. An important element

of liquidity risk management is to estimate a bank’s liquidity needs. Several

approaches have been developed to estimate the liquidity requirements of banks.

These include the sources and uses of funds approach, the structure of funds

approach, and the liquidity indicator approach.13 A maturity ladder is a useful

device to compare cash inflows and outflows for different time periods. The

deficit or surplus of net cash flows is a good indicator of liquidity shortfalls and

excesses at different points in time.

         Unexpected cash flows can arise from some other sources. As more and

more banks are engaged in off-balance sheet activities, banks should also

examine the cash flows on this account. For example, contingent liabilities used

in these accounts (like financial guarantees and options) can represent

substantial sources of outflows of funds. After identifying the liquidity

requirements, a series of worse case scenarios can be analyzed to estimate both

possible bank specific shocks and economy-wide shock. The bank should have

contingency funding plans of handling the liquidity needs during these crises.

Possible responses to these shocks would include the speed with which assets

can be liquidated and the sources of funds that banks can use in the crisis. If the

bank is dealing with foreign currency, it should have a measurement, monitoring

and control system for liquidity in active currencies.

         Banks should have adequate internal controls over its liquidity risk

management process that should be a part of the overall system of internal

control. An effective system would create a strong control environment and have

an adequate process of identifying and evaluating liquidity risk. It should have

adequate information system that can produce regular independent reports and

evaluations to review adherence to established policies and procedures. The

internal audit function should also periodically review the liquidity management

process to identify any problems or weaknesses for appropriate action by the

management.

     ١٣

        For a discussion on these methods see Rose (1999).

                                                                                  39


2.5.4. Operational Risk Management14

         The board of directors and senior management should develop the

overall policies and strategies for managing operational risk. As operational risk

can arise due to failures in people, processes, and technology, management of

this risk is more complex. Senior management needs to establish the desired

standards of risk management and clear guidelines for practices that would

reduce operational risks. In doing so, care needs to be taken to include people,

process, and technology risks that can arise in the institution.

         Given the different sources in which operational risk can arise, a

common standard for identification and management of these needs to be

developed. Care needs to be taken to tackle operational risk arising in different

departments/organizational unit due to people, process, and technology. As such

a wide variety of guidelines and rules have to be spelled out. To do so, the

management should develop an ‘operational risk catalogue’ in which business

process maps for each business/ department of the institution are outlined. For

example, the business process for dealing with client or investor should be laid

out. This catalogue will not only identify and assess operational risk but also can

be used for transparency by the management and auditors.

         Given the complexity of operational risk, it is difficult to quantify it.

Most of the operational risk measurement techniques are simple and

experimental. The banks, however, can gather information of different risks

from reports and plans that are published within the institution (like audit

reports, regulatory reports, management reports, business plans, operations

plans, error rates, etc.). A careful review of these documents can reveal gaps that

can represent potential risks. The data from the reports can then be categorized

into internal and external factors and converted into likelihood of potential loss

to the institution. A part of the operational risk can also be hedged. Tools for

risk assessment, monitoring, and management would include periodic reviews,

stress testing, and allocation of appropriate amount of economic capital.

         As there are various sources of operational risk, it needs to be handled in

different ways. In particular, risk originating from people needs effective

management, monitoring, and controls. These include establishing an adequate

operating procedure. One important element to control operational risk is to have

clear separation of responsibilities and to have contingency plans. Another

     ١٤

        This part is based on BCBS (1998) and Crouhy, et.al. (2001, Chapter 13).

40


significant element is to make sure that reporting systems are consistent, secure,

and independent of business. The internal auditors play an important role in

mitigating operational risk.

2.6. RISK MANAGEMENT AND MITIGATION TECHNIQUES

         Many risk measurement and mitigation techniques have evolved in

recent times. Some of these techniques are used to mitigate specific risks while

others are meant to deal with overall risk of a firm. In this section we outline

some contemporary techniques used by well-established financial institutions.

2.6.1. GAP Analysis

         GAP analysis is an interest rate risk management tool based on the

balance sheet. GAP analysis focuses on the potential variability of net-interest

income over specific time intervals. In this method a maturity/repricing schedule

that distributes interest-sensitive assets, liabilities, and off-balance sheet

positions into time bands according to their maturity (if fixed rate) or time

remaining to their next repricing (if floating rate) is prepared. These schedules

are then used to generate indicators of interest rate sensitivity of both earnings

and economic value to changing interest rates.

         GAP models focus on managing net interest income over different time

intervals. After choosing the time intervals, assets and liabilities are grouped into

these time buckets according to maturity (for fixed rates) or first possible

repricing time (for flexible rates). The assets and liabilities that can be repriced

are called rate sensitive assets (RSAs) and rate sensitive liabilities (RSLs)

respectively, and GAP equals the difference between the former and the latter.

Thus for a time interval, GAP is given by,

                 GAP = RSAs – RSLs                                           (2.1)

         Note that GAP analysis is based on the assumption of repricing of

balance sheet items calculated according to book value terms. The information

on GAP gives the management an idea about the effects on net-income due to

changes in the interest rate. For example, if the GAP is positive, then the rate

sensitive assets exceed liabilities. The implication is that an increase in future

interest rate would increase the net interest income as the change in interest

income is greater than the change in interest expenses. Similarly, a positive

GAP and a decline in the interest rate would reduce the net interest income. The

                                                                                   41


banks can opt to hedge against such undesirable interest rate changes by using

interest rate swaps (outlined in Section 2.6.6.1).

2.6.2. Duration-GAP Analysis

          Duration model is another measure of interest rate risk and managing net

interest income derived by taking into consideration all individual cash inflows

and outflows. Duration is value and time weighted measure of maturity of all

cash flows and represents the average time needed to recover the invested funds.

The standard formula for calculation of duration D is given by,

                   n

                ∑ CF × t × (1 + i )

                                       −t

                          t

           D=    t =1

                       n

                                                                               (2.2)

                    ∑ CF × (1 + i )

                                    −t

                            t

                     t =1

where CFt is the value of cash flow at time t, which is the number of periods the

cash flow from the instrument is received, and i is the instrument’s yield to

maturity. The duration analysis compares the changes in market value of the

assets relative to its liabilities. Average duration gaps of assets and liabilities are

estimated by summing the duration of individual asset/liability multiplied by its

share in the total asset/liability. A change in the interest rate affects the market

value through the discounting factor (1+i)-t. Note that the discounted market

value of an instrument with a longer duration will be affected relatively more

due to changes in the interest rate. Duration analysis, as such, can be viewed as

the elasticity of the market value of an instrument with respect to interest rate.

          Duration gap (DGAP) reflects the differences in the timing of asset and

liability cash flows and given by,

          DGAP = DA - u DL                                                     (2.3)

where DA is the average duration of the assets, DL is the average duration of

liabilities, and u is the liabilities/assets ratio. Note that a relatively larger u

implies higher leverage. A positive DGAP implies the duration of assets is

greater than that of liabilities. When interest rate increases by comparable

amounts, the market value of assets decrease more than that of liabilities

resulting in the decrease in the market value of equities and expected net-interest

income. Similarly, a decline in the interest rate decreases the market value of the

equity with a positive DGAP. Banks can use DGAP analysis to immunize

portfolios against interest rate risk by keeping DGAP close to zero.

42


2.6.3. Value at Risk (VaR)15

         Value at Risk (VaR) is one of the newer risk management tools. The

VaR indicates how much a firm can lose or make with a certain probability in a

given time horizon. VaR summarizes financial risk inherent in portfolios into a

simple number. Though VaR is used to measure market risk in general, it

incorporates many other risks like foreign currency, commodities, and equities.

VaR has many variations and can be estimated in different ways. We outline the

underlying concept of VaR and the method of estimating it below.

         Assume that an amount A0 is invested at a rate of return of r, so that after

a year the value of portfolio is A= A0 (1+r). The expected rate of return from

the portfolio is µ with standard deviation σ. VAR answers the question of how

much can the portfolio lose in a certain time period t (e.g., month). To compute

this, we construct the probability distribution of the returns r. We then choose a

confidence level c (say 95) percent. VaR tells us what is the loss (A*) that will

not be exceeded c percent of the cases in the given period t. In other words, we

want to find the loss that has a probability of 1-c percent of occurrence in the

time period t. Note that there is a rate of return r* corresponding to A*.

Depending on the basis of comparison, VaR can be estimated in the absolute and

relative sense. Absolute VaR is the loss relative to zero and relative VaR is the

loss compared to the mean µ. The basic idea of estimating VAR is shown in

Figure 2.1 below.

         A simpler parametric method can be used to estimate VaR by converting

the general distribution into a standard normal distribution. This method is not

only easier to use but also gives more accurate results in some cases. To use the

parametric method to estimate VaR, the general distribution of the rates of return

are converted into a normal distribution in the following way

         -α= (-r*-µ)/σ                                                     (2.4)

         Note that α represents the standard normal distribution equivalent loss

corresponding to confidence level of 1-c of the general distribution (i.e., r*).

Thus, in a normal distribution, α would be 1.65 (or 2.33) for a confidence level

c=95 (or c= 99 percent). Expressing time period T in years (so that one month

would be 1/12), the absolute and relative VaRs using the parametric method are

then given as

     ١٥

        For an extensive discussion on VaR, see Jorion (2001).

                                                                                   43


         VaR( zero) = A0 (ασ T − µT )                                      (2.5)

and

         VaR(mean) = A0ασ T                                                (2.6)

respectively. Say, for a monthly series the VaR (zero) is estimated to be ‘y’ at 95

percent confidence level. This means that under normal market conditions, the

most the portfolio can lose over a month is an amount of y with a probability of

95 percent (see Box 1 for an example).

                                      Figure 2.1

                        Basic Concept of Value at Risk

                          VAR (0)

                                                     Distribution of Returns

5 percent loss         VAR (µ)

probability

              r*                    0      µ               Monthly Return, r (%)

2.6.4. Risk Adjusted Rate of Return (RAROC)

         Risk adjusted rate of return (RAROC), developed by Bankers Trust in

the late 1970s, quantifies risk by considering the tradeoff of risk and reward in

different assets and activities. By the end of the 1990s, RAROC was considered

a leading edge methodology to measure performance and a best practice

standard by financial institutions. It gives an economic basis to measure all the

relevant risks consistently and gives managers tools to make the efficient

decisions regarding risk/return tradeoff in different assets. As economic capital

protects financial institutions against unexpected losses, it is vital to allocate

capital for various risks that these institutions face. RAROC analysis shows how

much economic capital different products and businesses need and determines

the total return on capital of a firm. Though RAROC can be used to estimate the

44


capital requirements for market, credit and operational risks, it is used as an

integrated risk management tool.16

                                             Figure 2.2

                         Estimation of Risk Capital for RAROC

                               Distribution of Loss

                                                                        5 percent

  0                    EL                                              WL

   Loan Loss                             Risk Capital Provision

          From a loss distribution over a given horizon (say a year) expected

losses (EL) can be estimated as average losses of the previous years. Worst case

loss (WL) is the maximum potential loss. The worst case loss is estimated at a

given level of confidence, c (e.g., 95 or 99 percent). The unexpected loss (UL) is

the difference between the worst case and expected loss (i.e., UL=WL-EL). Note

that while the expected loss is included as costs (as loan loss provision) when

determining the returns, the unexpected losses arising from random shocks

require capital to absorb the loss. The unexpected or worst case loss is estimated

at a given level of confidence, c, as it is too costly for an organization to have

capital for all potential loss. If the confidence level is 95 percent then there is a

probability of 5 percent that actual losses will exceed the economic capital. The

part of the loss that is not covered by the confidence level is the catastrophic risk

that the firm faces and can be insured. Estimation of risk capital from a loss

distribution function is shown in Figure 2.2. RAROC is determined as,

      ١٦

         For a discussion of the use of RAROC to determine capital for market, credit and

     operational risks, see Crouhy, et.al. (2000, pp. 543-48).

                                                                                       45


          RAROC = Risk-adjusted Return / Risk Capital,

where risk-adjusted return equals total revenues less expenses and expected

losses (EL), and risk capital is that reserved to cover the unexpected loss given

the confidence level. While the expected loss is factored in the return (as loan

loss provision), the unexpected loss is equivalent to the capital required to

absorb the loss. A RAROC of x percent on a particular asset means that the

annual expected rate of return of x on the equity is required to support this asset

in the portfolio. Note that RAROC can be used as a tool of capital allocation by

estimating the expected loss ex ante, and used for performance evaluation by

utilizing realized losses ex post.

2.6.5. Securitization

          Securitization is a procedure studied under the systems of structured

finance or credit linked notes.17 Securitization of a bank’s assets and loans is a

device for raising new funds and reducing bank’s risk exposures. The bank pools

a group of income-earning assets (like mortgages) and sells securities against

these in the open market, thereby transforming illiquid assets into tradable asset-

backed securities. As the returns from these securities depend on the cash flows

of the underlying assets, the burden of repayment is transferred from the

originator to these pooled assets. The structure of securitization process in

shown in Figure 2.3 below. The bank, the originator of the securities, packages

its assets into pools of similar assets. These assets are passed on to a special

purpose vehicle (SPV) or issuer of securities. Note that the SPV is a separate

entity than the originator so that the viability of the bank does not affect the

credit status of assets in the pool. The issued securities are sold to the investors.

A trustee ensures that the SPV fulfills all aspects of the transaction and provides

all services. These include transfer of assets to the pool, fulfilling guarantees and

collateral requirements in case of default. The trustee also collects and transfers

the cash flows generated from the pooled assets to the investors.

      ١٧

         For a detailed discussion of structured finance and credit linked notes related to

     securitization see Caouttee et.al (1998, Chapter 23) and Das (2000, Chapter 4) respectively.

46


                                         BOX 1:

                      Examples of Estimating VaR and RAROC

Estimating VaR: An Example

Assume an investment portfolio marked to the market is valued at SR 100 million has

expected rate of return of 5 percent and standard deviation of 12 percent. We are

interested to estimate VaR for holding period of one month at 99 percent confidence

interval. Using the symbols in the text, this information can be written as follows:

A0=100 million, µ = 5 percent, σ = 12 percent, c=99, α=2.33, and T=1/12.

Note that 99 percent confidence interval yields α=2.33 in a normal distribution. Given

the above we can estimate the two variants of VaR as:

          VaR(mean) = A0ασ T

                   = 100 × 2.33 × 0.12 × (1/12)0.5 = 8.07

and,

          VaR( zero) = A0 (ασ T − µT )

                   =100[2.33 × 0.12 × (1/12)0.5 – 0.05× (1/12)] = 8.07-0.42= 7.65

The result in the relative sense (i.e. relative to mean) implies that under normal

conditions there is a 99 percent chance that the loss of the portfolio will not exceed SR

8.07 million over a month. In the absolute sense (i.e. relative to zero) this amount is

SR 7.65 million.

Estimating RAROC: An Example

Assume that a bank has funds of SR 500 million, of which SR 460million are deposits

and the remaining SR 40 million equity (Step 2 below shows how this amount is

determined). Say the bank pays an interest rate of 5 percent to the depositors. As

capital is used for unexpected losses, it is invested in risk-free asset (like government

bonds) that has a return of 6 percent. The institution invests its remaining liability in

projects that yields an expected return of 10 percent. The average loss per annum is

estimated at SR 5 million with the worst case loss of SR 45 million at 95 percent

confidence interval. The annual operating costs of the bank is SR 10 million. Given

this information, we can estimate the RAROC for the portfolio in the following steps.

1. Estimate Risk Adjusted Return (= Total Revenue – Total Cost – Expected Loss)

     Total Revenue = Income from Investment + Income from Bonds

                   =460 × 0.10 + 40 × 0.06 = 46 + 2.4 = 48.4

     Total Cost = Payment to Deposits + Operating Costs

          =460 × 0.05 + 10 = 23 + 10 = 33

     Expected Loss = 5

     Risk Adjusted Return = 48.4 -33 – 5 = 10.4

2. Estimate Risk Capital (=Worst Case Loss – Expected Loss)

          = 45 – 5 = 40

3. Estimate RAROC (=Risk Adjusted Return/Risk Capital) ×100

          =10.4/40 ×100 = 26 percent

A RAROC of 26 percent means that the portfolio has an expected rate of return on

equity of 26 percent.

                                                                                         47


                                                Figure 2.3

                                   Securitization Process

                                                   Bank

                                              (Originator)                 Bank Assets

                                                                             Pool of Assets

                                             Trustee

                                                                         Special Purpose

                                                                          Vehicle (SPV)

                                          Asset-backed Securities           or Issuer

                         Investors

         By pooling assets through securitization, a bank can diversify its credit

risk exposure and reduce the need to monitor each individual asset’s payment

stream. Securitization also can be used to mitigate interest rate risk as a bank can

harmonize the maturity of the assets to that of the liabilities by investing in a

wide range of available securities. The process of securitization enables banks to

transfer risky assets from its balance sheet to its trading book.

2.6.6. Derivatives

         In recent years derivatives have been increasingly taking an important

role not only as instruments to mitigate risks but also as sources of income

generation. A derivative is an instrument whose value depends on the value of

something else. The major categories of derivatives are futures, options, and

swap contracts.18 Futures are forward contracts of standardized amounts that are

traded in organized markets. Like futures, options are financial contracts of

standardized amounts that give buyers (sellers) the right to buy (sell) without

any obligation to do so. Swap involves agreement between two or more parties

to exchange set of cash flows in the future according to predetermined

specifications.

     ١٨

        For a discussion on derivatives see Hull (1995) and Kolb (1997).

48


          Recent years have witnessed the explosion of the use of derivatives. To

understand the size of the derivatives in some perspective, we compare it with

the global GDP. In 1999, when the world GDP stood at USD 29.99 trillion, the

notional amount of global over-the–counter derivatives was USD 88.2 trillion.

Of these, USD 60.09 trillion (or around 68 percent) were interest rate

derivatives. Interest rate swaps accounted to USD 43.94 trillion or 73 percent of

the interest contracts and around 50 percent of total notional value of

derivatives.19 In this section we briefly outline the structure of two derivatives

that have relevance to risk management in banking.

2.6.6.1. Interest-Rate Swaps

          As mentioned above, interest rate swaps constitute almost half of the

notional value of all derivatives. Interest rate swaps are used to mitigate the

interest rate risk. Though interest rate swaps can take different types, we outline

formats of two basic ones here.

          The simplest of the interest rate (plain vanilla) swap involves two

counterparties, one having an initial position in a fixed debt instrument and the

other in a floating rate obligation. To understand why the two counterparties

would be interested to swap their interest payments, assume that counterparty A

is a financial institution that has to pay a floating interest on its liability (say it

pays LIBOR+1 percent on its deposits). The counterparty, however, is locked in

an asset that pays a fixed rate of interest for a certain number of years (say 10

percent on a 5-year mortgage). An increase in LIBOR can affect the income of

the financial institution adversely. The counterparty B with the floating rate asset

of LIBOR+3 percent is exposed to interest rate risk and wants to eliminate it. By

swapping the interest payments on their assets, the counterparties can immune

their earnings from movements in the interest rate. Note that at the end of the

contract period, only the net difference of the interest payments takes place

between the counterparties, as the principal involved on both sides of a swap is

usually the same amount. The structure of an interest rate swap is shown in

Figure 2.4.

      ١٩

         Data on world income is taken from World Development Indicators (2001) and on

     derivatives from BCBS (2001c).

                                                                                    49


                                      Figure 2.4

                                Interest Rate Swap

                                   Fixed interest: 10%

         Counterparty A                                         Counterparty B

                             Floating interest: LIBOR+3%

         The other example of interest rate swap we provide is the one where

parties raise funds at different rates. The swap is beneficial to parties even if one

party can raise funds at higher rates than the other for different types of funds.

The underlying concept of this swap contract is similar to that of theory of

comparative advantage of trade. The objective of the swap is to exchange the

costs of raising funds on the basis of comparative advantages. Table 2.1 shows

an example. We observe that party B can raise both short and long-term funds at

lower rates than party A. Party A, however, can raise short-term funds 0.50

percent cheaper than long-term funds and party B can raise long-term funds 0.25

percent cheaper than short-term funds. Say due to the asset structures, party A

needs long-term funds and party B short-term. Party B can raise long-term funds

at 2.5 percent (11.5%-9%) lower than party A. Party B can pay its own cost of

raising short-term funds 9.25 percent less 0.25 percent (i.e., 9 percent) to party

A. In this way B saves 0.25 percent on the cost of the funds of its own choice.

Party A also saves 0.25 percent if it raises short term funds at (9.25%+ 1.75%)

and pays 0.25 percent to party B (adding up to 11.25 percent), instead of paying

11.50 percent for raising long-term funds by its own. Both end up with a net

financial gain as well as paying in consistency with their own asset and liability

structures. Thus the principle of a swap is similar to that of free trade on the

basis of comparative advantages. Since swaps are arranged in trillions of US

dollars in real life, they are hence the practical manifestation of the theory of

gains from comparative advantages under free trade.

50


                                             Table 2.1

                       Comparative Advantages in Fund Raising

                           Cost of raising      Cost of raising      Cost difference %

                           long-term            short-term

                           fixed rate           floating rate

                           funds %              funds %

   Party A                 11.50%               Benchmark            Can raise short-term funds

                                                rate                 .50% cheaper than long-

                                                (9.25%)+1.75         term funds

   Party B                 9%                   Benchmark            Can raise long-term funds

                                                rate i.e.,           .25% cheaper than short-

                                                9.25%                term funds

   B competitive in        2.5%                 1.75%

   both by

2.6.6.2. Credit Derivatives

          Credit derivatives are instruments used to trade credit risk. Credit

derivatives may take different forms such as swaps, options, and credit linked

notes.20 The basic model involves the banks finding a counterparty that assumes

the credit risk for a fee, while the bank itself retains the asset on its book. We

outline the nature of a simple credit swap here. The purpose of the derivative is

to provide default protection to the bank (risk seller) and compensation to the

risk buyer for taking up the bank’s credit risk. By paying a premium, the default

risk of an asset is swapped for the promise of a full or partial payment if the

asset defaults. Credit derivative can be implemented to deal with any part of the

credit risk exposure, like the amount, maturity, etc. The structure of a credit

swap is illustrated in Figure 2.6.

                                            Figure 2.6

                                          Credit Swap

                                         Pays a fixed premium

          Bank (risk seller)                                                   Risk Buyer

                              Makes payment in case of default

2.7. ISLAMIC FINANCIAL INSTITUTIONS: NATURE AND RISKS

      ٢٠

         For a discussion on different types of credit derivatives, see Caouette et.al (1998, pp. 307-

     309) and Crouhy et.al (2001, pp. 448-61).

                                                                                                   51


           In order to understand the risks that Islamic financial institutions face,

we first briefly discuss the nature of these institutions. To have the discussion in

some perspective, we outline the types of conventional institutions. Financial

intermediaries are broadly classified as depositary institutions, investment

intermediaries, and contractual intermediaries. Commercial banks, forming bulk

of the depositary institutions, specialize in intermediation obtaining most of its

loanable funds from deposits of the public. Investment intermediaries offer

liquid securities to the public for long-term investment. Investment

intermediaries are mutuals, with customers being the owners who receive

income in form of dividends and capital gains. Investment intermediaries

typically invest in secondary markets and, as such, avail investors opportunities

to hold securities of private and public institutions. Contractual intermediaries

constitute insurance firms and pension funds.21

           Iqbal et.al. (1998) distinguish two models of Islamic banks based on the

structure of the assets.22 The first is the two-tier Muārabah model that replaces

interest by profit-sharing (PS) modes on both liability and asset sides of the

bank. In particular, in this model all assets are financed by PS modes of

financing (Muārabah). This model of Islamic banking will also take up the role

of an investment intermediary, rather than being a commercial bank only

(Chapra 1985, p. 154). The second model of Islamic banking is the one-tier

Muārabah with multiple investment tools. This model evolved because Islamic

banks faced practical and operational problems in using profit-sharing modes of

financing on the asset side. As a result, they opted for fixed-income modes of

financing. As mentioned earlier, fixed-income instruments include Murāba ah

(cost-plus or mark-up sale), installment sale (medium/long-term Murāba ah),

Isti nā‘/ Salam (object deferred sale or pre-paid sale) and Ijārah.23

      ٢١

         Depending on the regulatory framework of a specific country, financial institutions may

     perform different functions. For example, universal banks are consolidated institutions

     providing different financial services that may include intermediation, investment

     management, insurance, brokerage, and holding equity of non-financial firms (Heffernan

     1996). A simple case of universal bank is in which the liability is the same as commercial

     banks, but the asset side differs. While the assets of commercial banks are in form of loans

     only, universal banks can hold equity along with loans. By holding equity positions, universal

     banks can essentially get involved in the decision making and management of the firm.

      ٢٢

         Iqbal, et.al. (1998) mention three models, the third one being the case where Islamic

     banks work as agent (wakeel), managing funds on behalf of clients on basis of fixed

     commission.

      ٢٣

         For a discussion on these modes of financing see Ahmad (1993), Kahf and Khan (1992),

     and Khan (1991).

52


          Islamic banking offers financial services by complying with the

religious prohibition of Ribā. Ribā is a return (interest) charged in a loan (Qar

 asan) contract. This religious injunction has sharpened the differences between

current accounts (interest free loans taken by owners of the Islamic bank) and

investment deposits (Muārabah funds). In the former case, the repayment on

demand of the principal amount is guaranteed without any return. The owners of

current accounts do not share with the bank in its risks. In case of investment

deposits, neither the principal nor a return is guaranteed. Investment accounts

can be further classified as restricted and unrestricted, the former having

restrictions on assets that the funds can be used for and on withdrawals before

maturity date. The owners of investment accounts participate in the risks and

share in the bank’s profits on pro rata basis. The contracts of Qar asan and

Muārabah are thus the fundamental pillars of Islamic banking and their

characteristics must fully be protected for the preservation of the uniqueness of

Islamic banks.

          The Islamic bank described above appears to have characteristics of

both an investment intermediary and a commercial bank. The ownership pattern

of the Islamic bank resembles that of a commercial bank as the depositors do not

own the bank and do not have voting rights. In Islamic finance parlance, this

means while Mushārakah contract characterizes the equity owners, deposits take

the form of Muārabah contracts.24 An Islamic bank, however, has similarities

with an investment intermediary as it shares the profit generated from its

operations with those who hold investment accounts. After paying the depositors

a share of the profit, the residual net-income is given out to the shareholders as

dividends.

          Using profit-sharing modes in Islamic banks changes the nature of risks

these institutions face. The returns on saving/investment deposit are state

contingent. As the depositors are rewarded on a profit-loss sharing (PLS)

method, they share the business risks of the banking operations of the bank. The

profit/loss sharing feature of these depositors introduces some other risks.

Furthermore, the use of Islamic modes of financing on the asset sides changes

the nature of traditional risks. We outline the nature of risks that Islamic banks

face and risks inherent in different modes of financing below.

      ٢٤

         One difference between Mushārakah and Muārabah is that while in the former case the

     financier also has a role in management of the project, it does not in the latter case.

                                                                                             53


2.7.1. Nature of Risks faced by Islamic Banks

         Credit Risk: Credit risk would take the form of settlement/payment risk

arising when one party to a deal pays money (e.g. in a Salam or Isti nā‘contract)

or delivers assets (e.g., in a Murāba ah contract) before receiving its own assets

or cash, thereby, exposing it to potential loss. In case of profit-sharing modes of

financing (like Muārabah and Mushārakah) the credit risk will be non-payment

of the share of the bank by the entrepreneur when it is due. This problem may

arise for banks in these cases due to the asymmetric information problem in

which they do not have sufficient information on the actual profit of the firm. As

Murāba ah contracts are trading contracts, credit risk arises in the form of

counterparty risk due to nonperformance of a trading partner. The non-

performance can be due to external systematic sources.

         Benchmark Risk: As Islamic banks do not deal with interest rate, it

may appear that they do not have market risks arising from changes in the

interest rate. Changes in the market interest rate, however, introduce some risks

in the earnings of Islamic financial institutions. Financial institutions use a

benchmark rate, to price different financial instruments. Specifically, in a

Murāba ah contract the mark-up is determined by adding the risk premium to

the benchmark rate (usually the LIBOR). The nature of fixed income assets is

such that the mark-up is fixed for the duration of the contract. As such if the

benchmark rate changes, the mark-up rates on these fixed income contracts

cannot be adjusted. As a result Islamic banks face risks arising from movements

in market interest rate.

         Liquidity Risk: As mentioned above, liquidity risk arises from either

difficulties in obtaining cash at reasonable cost from borrowings or sale of

assets. The liquidity risk arising from both sources is critical for Islamic banks.

As interest based loans are prohibited by Sharī‘ah, Islamic banks cannot borrow

funds to meet liquidity requirement in case of need. Furthermore, Sharī‘ah does

not allow the sale of debt, other than its face value. Thus, to raise funds by

selling debt-based assets is not an option for Islamic financial institutions.

         Operational Risk: Given the newness of Islamic banks, operational risk

in terms of person risk can be acute in these institutions. Operational risk in this

respect particularly arises as the banks may not have enough qualified

professionals (capacity and capability) to conduct the Islamic financial

operations. Given the different nature of business the computer software

54


available in the market for conventional banks may not be appropriate for

Islamic banks. This gives rise to system risks of developing and using

informational technologies in Islamic banks.

         Legal Risk: Given the different nature of financial contracts, Islamic

banks face risks related to their documentation and enforcement. As there are no

standard form of contracts for various financial instruments, Islamic banks

prepare these according to their understanding of the Sharī‘ah, the local laws,

and their needs and concerns. Lack of standardized contracts along with the fact

that there are no litigation systems to resolve problems associated with

enforceability of contracts by the counterparty increases the legal risks

associated with the Islamic contractual agreements.

         Withdrawal Risk: A variable rate of return on saving/investment

deposits introduces uncertainty regarding the real value of deposits. Asset

preservation in terms of minimizing the risk of loss due to a lower rate of return

may be an important factor in depositors' withdrawal decisions. From the bank’s

perspective, this introduces a ‘withdrawal risk’ that is linked to the lower rate of

return relative to other financial institutions.

         Fiduciary Risk: A lower rate of return than the market rate also

introduces fiduciary risk, when depositors/investors interpret a low rate of return

as breaching of investment contract or mismanagement of funds by the bank

(AAOIFI 1999). Fiduciary risk can be caused by breach of contract by the

Islamic bank. For example, the bank may not be able to fully comply with the

Sharī‘ah requirements of various contracts. While, the justification for the

Islamic banks’ business is compliance with the Sharī‘ah, an inability to do so or

not doing so willfully can cause a serious confidence problem and deposit

withdrawal.

         Displaced Commercial Risk: This risk is the transfer of the risk

associated with deposits to equity holders. This arises when under commercial

pressure banks forgo a part of profit to pay the depositors to prevent withdrawals

due to a lower return (AAOIFI 1999). Displaced commercial risk implies that

the bank though may operate in full compliance with the Sharī‘ah requirements,

yet may not be able to pay competitive rates of return as compared to its peer

group Islamic banks and other competitors. Depositors will again have the

incentive to seek withdrawal. To prevent withdrawal, the owners of the bank

                                                                                  55


 will need to apportion part of their own share in profits to the investment

 depositors.

 2.7.2. Unique Counterparty Risks of Islamic Modes of Finance

          In this section we discuss some of the risks inherent in some Islamic

modes of financing.

 2.7.2.1. Murāba ah Financing

          Murāba ah is the most predominantly used Islamic financial contract. If

the contract is standardized its risk characteristics can be made parable to

interest-based financing. Based on similarity in risk characteristics of the contract

with the risk characteristics of interest-based contracts, Murāba ah is approved

to be an acceptable mode of finance in a number of regulatory jurisdictions.

However, such a standardized contract may not be acceptable to all Fiqh

scholars. Moreover, as the contract stands at present, there is a lack of complete

uniformity in Fiqh viewpoints. The different viewpoints can be a source of

counterparty risks as a result of the atmosphere of an ineffective litigation.

          The main point in this regard stems from the fact that financial

 Murāba ah is a contemporary contract. It has been designed by combining a

 number of different contracts. There is a complete consensus among all Fiqh

 scholars that this new contract has been approved as a form of deferred trading.

 The condition of its validity is based on the fact that the bank must buy (become

 owner) and after that transfer the ownership right to the client. The order placed

 by the client is not a sale contract but it is merely a promise to buy. According to

 the OIC Fiqh Academy Resolution, a promise can be binding on one party only.

 OIC Fiqh Academy, AAOIFI, and most Islamic banks treat the promise to buy

 as binding on the client. Some other scholars, however, are of the opinion that

 the promise is not binding on the client; the client even after putting an order and

 paying the commitment fee can rescind from the contract. The most important

 counterparty risk specific to Murāba ah arises due to this unsettled nature of the

 contract, which can pose litigation problems.

          Another potential problem in a sale-contract like Murāba ah is late

 payments by the counterparty as Islamic banks cannot, in principle, charge

 anything in excess of the agreed upon price. Nonpayment of dues in the

 stipulated time by the counterparty implies loss to banks.

 56


2.7.2.2 Salam Financing

        There are at least two important counterparty risks in Salam. A brief

discussion of these risks is provided here.

     i.   The counterparty risks can range from failure to supply on time or even

          at all, and failure to supply the same quality of good as contractually

          agreed. Since Salam is an agricultural based contract, the counterparty

          risks may be due to factors beyond the normal credit quality of the

          client. For example, the credit quality of the client may be very good but

          the supply may not come as contractually agreed due to natural

          calamities. Since agriculture is exposed to catastrophic risks, the

          counterparty risks are expected to be more than normal in Salam.

    ii. Salam contracts are neither exchange traded nor these are traded over

          the counter. These contracts are written between two parties to a

          contract. Thus all the Salam contracts end up in physical deliveries and

          ownership of commodities. These commodities require inventories

          exposing the banks to storage costs and other related price risk. Such

          costs and risks are unique to Islamic banks.

2.7.2.3 Isti nā‘ Financing

     While extending Isti nā‘ finance the bank exposes its capital to a number of

specific counterparty risks. These include for example:

     i.   The counterparty risks under Isti nā‘ faced by the bank from the

          supplier’s side are similar to the risks mentioned under Salam. There

          could be a contract failure regarding quality and time of delivery.

          However, the object of Isti nā‘ is more in the control of the counterparty

          and less exposed to natural calamities as compared to the object of

          Salam. Therefore, it can be expected that the counterparty risk of the

          sub-contractor of Isti nā‘ although substantially high, is lesser severe as

          compared to that of the Salam.

    ii. The default risk on the buyer’s side is of the general nature, namely,

          failure in paying fully on time.

    iii. If the Isti nā‘ contract is considered optional and not binding as the

          fulfillment of conditions under certain Fiqhī jurisdictions may need,

                                                                                   57


          there is a counterparty risk as the supplier maintains the option to

          rescind from the contract.

    iv. Considering that like the client in the Murāba ah contract, if the client

          in the Isti nā‘ contract is given the option to rescind from the contract

          and decline acceptance at the time of delivery, the bank will be exposed

          to additional risks.

        These risks exist because, an Islamic bank while entering into an Isti nā‘

contract assumes the role of a builder, a constructor, a manufacturer and

supplier. Since the bank does not specialize in these traits, it relies on

subcontractors.

2.7.2.4. Mushārakah - Muārabah (M-M) Financing

          Many academic and policy oriented writings consider that the allocation

of funds by the Islamic banks on the basis of the Mushārakah and Muārabah is

preferable as compared to the fixed return modes of Murāba ah, leasing and

Isti nā‘. But in practice the Islamic banks’ use of the M-M modes is minimal.

This is considered to be due to the very high credit risk involved25.

          The credit risk is expected to be high under the M-M modes due to the

fact that there is no collateral requirement, there is a high level of moral hazard

and adverse selection and banks’ existing competencies in project evaluation and

related techniques are limited. Institutional arrangements such as tax treatment,

accounting and auditing systems, regulatory framework are all not in favor of a

larger use of these modes by banks.

          One possible way to reduce the risks in profit sharing modes of

financing is for Islamic banks to function as universal banks. Universal banks

can hold equity along with loans. In case of Islamic banks this would imply

financing using Mushārakah mode. Before investing in projects on this basis,

however, the bank needs to do a thorough feasibility study. By holding equity

positions, universal banks can essentially get involved in the decision making

and management of the firm. As a result, the bank will be able to monitor the use

of funds by the project more closely and reduce the moral hazard problem.

          Some economists however, argue that banks by not opting for these

modes are actually not benefiting from portfolio diversification and hence taking

     25

        Credit risk in context of these modes is similar to the common notion of not receiving

     the funds back on time or fully.

58


more risks rather than avoiding risks. Moreover, the use of M-M modes on both

sides of the banks’ balance sheets will actually enhance systemic stability as any

shocks on the asset side will be matched by an absorption of the shock on the

deposit side. It is also argued that incentive compatible contracts can be

formulated which can reduce the effect of moral hazard and adverse selection.

However, these arguments ignore the fact that banks basically specialize in

optimizing credit portfolios not optimizing in credit and equity portfolios.

Furthermore, since the Islamic banks’ use of current accounts on the liability

side is very high, the shocks on the assets side cannot be absorbed by these

accounts on the liability side. Hence greater use of M-M on the asset side could

actually cause a systemic instability given the large current accounts utilized by

the Islamic banks.

                                                                                59


60
                                                 III

                           RISK MANAGEMENT:

           A SURVEY OF ISLAMIC FINANCIAL

                                  INSTITUTIONS

3.1. INTRODUCTION

          This chapter examines different aspects of risk management issues in

Islamic financial institutions (FIs). Results from a survey based on

questionnaires and field level interviews with Islamic bankers are reported.

Questionnaires were sent to 68 Islamic financial institutions in 28 countries and

the authors visited Bahrain, Egypt, Malaysia and the UAE to discuss issues

related to risk management with the officials of the Islamic financial institutions.

A total of 17 questionnaires were received from 10 countries. The financial

institutions that responded and included in the study are given in Appendix 1.

          Before discussing risk management related issues, we report averages of

some basic balance sheet data on Table 3.1. The average value of assets of 15

Islamic financial institutions stands at US$ 494.2 million with a capital of US$

73.4 million.26 The average capital/asset ratio of these institutions stands at 32.5

percent. This ratio is relatively large due to the inclusion of investment banks

that have higher capital/asset ratio. The lower section of the table shows the term

structure of assets. A large percentage of the assets (68.8 percent) of the

financial institutions have short-term maturity (of less than a year), 9.8 percent

have maturity between 1 to 3 years, and the remaining 31.4 percent are invested

in assets that are invested assets that mature after three years.

                                             Table 3.1

                          Basic Balance Sheet Data (1999-2000)

                                                               Number of            Average

                                                              Observations

   Assets (Million US$)                                             15                494.2

   Capital (Million US$)                                            15                 73.4

   Capital/Asset Ratio (Percentage)                                 15                 32.5

   Maturity of Assets

   Less than 1 year(Percentage of Assets)                           12                 68.8

   1-3 yearsa                                                       12                  9.8

   More than 3 years                                                12                 21.4

  a-One financial institution reports term structure for 1-5 years.

     ٢٦

        The data for the IDB was not included in these estimations, as given its size and nature, it

     would bias the results.

                                                                                                61


         The questions related to risk management issues in the questionnaire can

be broadly divided into two types. The first set of questions relates to

perceptions of the bankers related to different issues. They were asked to

identify the severity of different problems that their institutions faced on a scale

of 1 to 5, with 1 indicating “Not Serious” and 5 implying “Critically Serious”.

We report the average ranks of the available responses. Note that these rankings

are indicative of the relative risk perceptions of the bankers and do not mean

anything in the absolute sense. The second type of questions had either

affirmative/negative answers or are marked with an × if applicable. In these

cases we report the number of institutions in our sample that were marked to be

affirmative answers. The remaining answers were either negative or left

unanswered. One possible reason for abstention is that the question might not

have been relevant to the institution. For example, FIs not engaged in certain

modes of financing (like Salam and diminishing Mushārakah) may not have

responded to questions related to these instruments. Similarly, banks that are

operating only in the domestic economy are not exposed to exchange rate or

country risks and may have ignored questions related to these issues. For some

questions, however, multiple answers are possible. In these cases, it is possible

that the percentage of affirmative responses may add up to be greater than 100.

         The results from the survey are discussed into three sections. The first

section examines the risk perceptions of the Islamic financial institutions. Given

the different nature of Islamic banks, the risks faced by these institutions are

identified and ranked according to their severity. The second section scrutinizes

different aspects of the risk management system and process in Islamic financial

institutions. To do so, we divide discussion into the three constituents of risk

management process outlined in Chapter 2. The third section discusses some

other issues related to risk management in Islamic financial institutions.

3.2. RISK PERCEPTIONS

         The nature of Islamic banks is different from that of conventional

interest-based banks, mainly due to the profit-sharing features and modes of

financing used. This changes the kind of risks that these institutions face. In this

section, we report some perspectives of Islamic bankers regarding the risks that

their institutions face.

62


3.2.1.Overall Risks faced by Islamic Financial Institutions

         Table 3.2 reports the average rankings of different kinds to risks faced

by Islamic FIs. Note that the rank has a range of 1 to 5, the former indicating

“Not serious” and the latter implying “Critically Serious”. It appears that Islamic

bankers rank the mark-up (interest rate) risk as the most critical risk they face

(3.07) followed by operational risk (2.92), and liquidity risk at 2.71. While credit

risk is the risk that most FIs deal with, they do not rank this risk as severe as

these risks (2.71). Among the risks listed, Islamic FIs consider market risk to be

the least risky (2.50).

         The reasons for considering mark-up risk the highest may be that

Islamic debt contracts (like Murāba ah) cannot be repriced and cannot use

swaps to transfer this risk. Operational risk may have been ranked high because

given the new nature of Islamic banking a lot of the issues related to the

operations need to be instituted. These include training of employees, creating

computer programs and legal documents, etc. Liquidity risk is also ranked higher

than credit risk due to the lack of money market instruments to manage liquidity.

One reason of a relatively low credit risk may be that with asset or commodity

based financing that most Islamic FIs use, this risk is minimized as the

asset/commodity serves as collateral.

                                         Table 3.2

    Risk Perception-Overall Risks Faced by Islamic Financial Institutions

                          Number of Relevant                 Average Rank*

                                Responses

    Credit Risk                     14                             2.71

    Mark-up Risk                    15                             3.07

    Liquidity Risk                  16                             2.81

    Market Risk                     10                             2.50

    Operational Risk                13                             2.92

*The rank has a scale of 1 to 5, with 1 indicating ‘Not Serious’ and 5 denoting ‘Critically

  Serious’.

         Market risk is incurred on instruments like commodities and equities

traded in well-traded markets appears to be least risky. This risk arising from

movements in the prices of goods/securities are usually a part of the trading

book of a bank. On the banking book, conventional banks trade in bonds to keep

                                                                                        63


a part of their assets in liquid money-market instruments. As the majority of the

Sharī‘ah scholars forbid the sale of debt, trading in bonds almost nonexistent in

Islamic FIs.27 Islamic banks, however, can trade in commodities and assets

backed securities. The later securities are scant, leaving only trading in

commodities that can be as a source of market risk for Islamic FIs. As not too

many banks are involved in commodity trading, this may be a reason for a low

ranking of market risk by Islamic FIs.

3.2.2. Risks in Different Modes of Financing

          Table 3.3 reports the Islamic bankers’ viewpoints on different kinds of

risks inherent in various Islamic modes of financing. The results of these risks

are discussed below.

                                            Table 3.3

              Risk Perception-Risks in different Modes of Financing

                       Credit         Mark-up Risk      Liquidity    Operational Risk

                       Risk                               Risk

  Murāba ah               2.56               2.87         2.67              2.93

                           (16)              (15)         (15)              (14)

  Muārabah               3.25                3.0         2.46              3.08

                           (12)              (11)         (13)              (12)

  Mushārakah              3.69                3.4         2.92              3.18

                           (13)              (10)         (12)              (11)

  Ijārah                  2.64               2.92          3.1               2.9

                           (14)              (12)         (10)              (10)

  Isti nā‘                3.13               3.57          3.0              3.29

                            (8)               (7)          (6)               (7)

  Salam                   3.20               3.50         3.20              3.25

                            (5)               (4)          (5)               (4)

  Diminishing             3.33                3.4         3.33               3.4

  Mushārakah                (6)               (5)          (6)               (5)

Note: The numbers in parentheses indicates the number of respondents.

*The rank has a scale of 1 to 5, with 1 indicating ‘Not Serious’ and 5 denoting ‘Critically

  Serious’.

Credit Risk

          Credit risk appears to be the least in Murāba ah (2.56) and the most in

Mushārakah (3.69) followed by diminishing Mushārakah (3.33) and Muārabah

      ٢٧

         A form of debt-based bonds exists in Malaysia.

64


(3.25). It appears that profit-sharing modes of financing are perceived to have

higher credit risk by the bankers. Note that credit risk in case of profit-sharing

modes of financing arises if the counterparties do not pay the banks their due

profit-share. Furthermore, this amount if not known to banks ex ante. Ijārah

ranks as second (2.64) after Murāba ah as having the least credit risks. Like the

Murāba ah contract, Ijārah contract gives the banks a relatively certain income

and the ownership of the leased asset remains with the bank. Isti nā‘ and Salam

ranked at 3.13 and 3.20 respectively are relatively more risky. These product-

deferred modes of financing are perceived to be riskier than price-deferred sale

(Murāba ah). This may arise as the value of the product (and hence the return)

at the end of the contract period is uncertain. There are chances that the

counterparty may not be able to deliver the goods on time. This may arise to

different reasons like natural disasters (for commodities in a Salam contract) and

production failure (for products in Isti nā‘ contract). Even if the good is

delivered, there can be uncertainty regarding the price of the good upon delivery

affecting the rate of return.

          The results on credit risk give some insight to the composition of

instruments in Islamic banks. We have noted earlier, Islamic banks’ assets are

concentrated in fixed-income assets (like Murāba ah and Ijārah). The results

from the survey indicate that one explanation for the concentration of assets in

fixed income assets may be that these instruments are perceived as having the

least credit risk among the Islamic modes of financing. As banks business is to

take up and manage credit risks, Islamic banks do not opt for other profit-sharing

modes of financing (like Muārabah and Mushārakah) as they regard these

instruments to be relatively more risky.

Mark-up Risk

          Table 3.3 shows that mark-up risk ranked highest in terms of severity in

product-deferred contracts of Isti nā‘ (3.57) and Salam (3.5), followed by profit-

sharing modes of financing of Mushārakah and diminishing Mushārakah

(ranked at 3.4) and Muārabah (3.0).28 Murāba ah is considered to have the

least mark-up risk (2.87) followed by Ijārah (2.92). Mark-up (interest rate) risk

tends to be higher in long-term instruments with fixed rates. One reason for

higher concern of mark-up risk in Isti nā‘ may be that these instruments are

     ٢٨

         Mark-up risk can appear in profit sharing modes of financing like Muārabah and

     Mushārakah as profit-sharing ratio depends on, among others, a benchmark rate like LIBOR.

     For a discussion on the determining profit-sharing ratio see Ahmed (2002).

                                                                                            65


usually of long-term nature. This is particularly true for real estate projects. The

contracts are tied up to a certain mark-up rate and changes in the interest rate

expose these contracts to risks. Murāba ah shows the least risk as this mode of

financing is usually short-term. After Murāba ah, Ijārah is conceived to have

relatively less mark-up risk. Even though Ijārah contracts may be of long-term,

the return (rent) on these contracts can be adjusted to reflect market conditions.

Among the profit-sharing modes of financing, the Islamic bankers rank

Mushārakah and diminishing Mushārakah relatively higher as these are usually

longer-term engagements. Muārabah is usually used for short-term financing

and has a lower mark-up risk than these two instruments.

Liquidity Risk

         Liquidity risk of instruments will be smaller if the assets can be sold in

the markets and/or have short-term maturity. The bankers consider Muārabah

to have the least liquidity risk (2.46) followed by Murāba ah (2.67). Note that

both of these instruments are usually used for short term financing. Other

instruments are perceived as relatively more risky, with diminishing

Mushārakah showing the highest liquidity risk (with a rank of 3.33) and

product-deferred instruments of Salam and Isti nā‘ closely following at 3.2 and

3.0 respectively. Ijārah is also perceived to have a relatively higher liquidity risk

(3.1).

Operational Risk

         As mentioned above, operational risk can arise from different sources.

Some aspects relevant to operational risk in Islamic banks are the legal risk

involved in contracts, the understanding of the modes of financing by

employees, producing computer programs and legal documents for different

instruments, etc. The rankings showing the operational risk for different

instruments should include these concerns. It appears that operational risk is

lower in fixed income assets of Murāba ah and Ijārah (2.93 and 2.9

respectively) and one of the highest in product-deferred sale contracts of Salam

and Isti nā‘ (3.25 and 3.29). Profit-sharing modes of financing of Muārabah

and Mushārakah follow close with ranks of 3.08 and 3.18 respectively.

Operational risk is highest in diminishing Mushārakah (3.4). The relatively

higher rankings of the instruments indicate that banks find these contracts

complex and difficult to implement.

66


3.2.3. Additional Issues regarding Risks faced by Islamic Financial

        Institutions

          Table 3.4 shows the Islamic bankers’ viewpoints on some specific risk

related issues related to Islamic FIs. Given that the Islamic banking is a

relatively new industry, the Islamic bankers are of the view that there is a lack of

understanding of the risks involved in Islamic modes of financing. They rank the

gravity of this problem at 3.82. As the rates of returns on deposits in Islamic

banks are based on profit sharing, this imposes certain risks on the liability side

of the balance sheet. Even though returns on deposits can vary, Islamic banks are

under pressure to give the depositors return similar to that of other banks. They

rank this concern at 3.64. This factor is important as a lower return than that

given by other banks leads to two additional risks. First, the withdrawal risk that

can result from a lower rate of return is considered serious as shown by its

ranking of 3.64. The banks also regard fiduciary risk, in which the depositors

blame the bank for a lower rate of return, serious with a rank of 3.21.

                                         Table 3.4

     Risk Perception-Additional Issues regarding Risks faced by Islamic

                                 Financial Institutions

                                                                   No. of      Average

                                                                 Relevant       Rank*

                                                                Responses

  1.   Lack of understanding of risks involved in Islamic           17           3.82

       modes of financing.

  2. The rate of return on deposits has to be similar to            14           3.64

       that offered by other banks.

  3. Withdrawal Risk: A low rate of return on deposits              14           3.64

       will lead to withdrawal of funds

  4. Fiduciary Risk: Depositors would hold the bank                 14           3.21

       responsible for a lower rate of return on deposits

*The rank has a scale of 1 to 5, with 1 indicating ‘Not Serious’ and 5 denoting ‘Critically

  Serious’.

          Note that most of the rankings in Table 3.4 that Islamic bankers assign

to specific risks faced by their institutions are higher than all the rankings of

traditional risks that financial institutions face (as reported in Table 3.2). To

have some indication of this we compare the averages of these specific risks

faced by Islamic banks (Table 3.4) with that of the traditional risks (Table 3.2).

The average for the former is 3.58 while it is 2.80 for the latter. Thus, Islamic

banks not only face some risks that are different from conventional banks, but

                                                                                        67


there is a feeling that these risks are more serious and not well understood. This

calls for more research in risk related issues in Islamic FIs to understand and

manage these risks.

         Islamic financial institutions have also identified other risks that they

face. At the government level, these include legal aspects and taxes (e.g., taxes

on interest, leases, Murāba ah profit, and services). At the central bank level,

additional risks include those arising central bank regulations and legislation, no

Islamic window for borrowing in terms of need. Other risks pointed are those

arising from Sharī‘ah, non-availability of short-term funds foreign exchange,

natural disasters, specific industries, domestic economy and politics, and

international financial and market environment.

3.3. RISK MANAGEMENT SYSTEM AND PROCESS

As discussed in Chapter 2, the system and process of risk management has three

main constituents. We discuss the risk management practices of Islamic financial

institutions under these three heads below. As mentioned above, we report the

affirmative answers given to different questions by the institutions in the sample.

3.3.1. Establishing Appropriate Risk Management Environment and Sound

       Policies and Procedures

         Table 3.5 reports some aspects of establishing a risk management

environment. While 13 institutions (76.5 percent) of the institutions have a

formal risk management system in place, 16 (94.1 percent) institutions have a

section/committee responsible for identifying, monitoring and controlling

various risks. The same number of institutions (16) have internal guidelines,

rules and concrete procedures related to risk management. In the sample, 13

(76.5 percent) banks have a clear policy of promoting asset quality and 14 (82.4

percent) of them have guidelines that are used for loan approvals. Only 12 banks

(70.6 percent) determine the mark-up rates on loans by taking account of the

loan grading or the risks of the counterparty.

68


                                       Table 3.5

 Establishing an Appropriate Risk Management Environment, Policies and

                                      Procedures

                                                          No. of     Percentage

                                                        Affirmative   of Total

                                                        Responses

1.  Do you have a formal system of Risk                      13          76.5

    Management in place in your organization?

2.  Is there a section/committee responsible for             16          94.1

    identifying, monitoring, and controlling various

    risks?

3.  Does the bank have internal guidelines/rules and         16          94.1

    concrete procedures with respect to the risk

    management system?

4.  Is there a clear policy promoting asset quality?         13          76.5

5.   Has the bank adopted and utilized guidelines for a      14          82.4

    loan approval system?

6.  Are mark-up rates on loans set taking account of         12          70.6

    the loan grading?

3.3.2. Maintaining an Appropriate Risk Measurement, Mitigating, and

       Monitoring Process

         Table 3.6 shows the number of affirmative responses to some issues

related to risk measurement and mitigating process. A relatively small number of

Islamic banks in the sample (41.2 percent) have a computerized support system

to estimate the variability of earnings for risk management purposes. The main

risk faced by banks is credit risk. To mitigate this risk majority of the banks

(94.1 percent) has credit limits for individual counterparty and 13 institutions

(76.5 percent) have a system for managing problem loans. Most banks have a

policy of diversifying investments across sectors and industries (88.2 percent

and 82.4 percent respectively). A smaller number of banks (64.7 percent)

diversify their investments across countries. This lower number may reflect the

fact that some banks operate only domestically. To measure and manage

liquidity risk, 12 institutions (70.6 percent) compile maturity ladder chart to

monitor cash flows and gaps. To measure benchmark or interest rate risk, a small

fraction of the institutions (only 29.4 percent) use simulation analysis. Around

three-quarters of the banks (76.5 percent) have a regular reporting system on risk

management for senior management.

                                                                                69


                                         Table 3.6

 Maintaining an Appropriate Risk Measuring, Mitigating, and Monitoring

                                           Process

                                                                 No. of     % of

                                                              Affirmative   Total

                                                               Responses

   1.  Is there a computerized support system for                   7        41.2

       estimating the variability of earnings and risk

       management?

   2. Are credit limits for individual counterparty set            16        94.1

       and are these strictly monitored?

   3. Does the bank have a policy of diversifying investments across:

   a) Different countries                                          11        64.7

   b) Different sectors (like manufacturing, trading               15        88.2

       etc.)

   c) Different Industries (like airlines, retail, etc.)           14        82.4

   4 Does the bank have in place a system for                      13        76.5

       managing problem loans?

   7. Does the bank regularly (e.g. weekly) compile a              12        70.6

       maturity ladder chart according to settlement date

       and monitor cash position gaps?

   8. Does the bank regularly conduct simulation                    5        29.4

       analysis and measure benchmark (interest) rate

       risk sensitivity?

   9. Does the bank have in place a regular reporting              13        76.5

       system regarding risk management for senior

       officers and management?

         Table 3.7 shows the different risk reports that the banks in the sample

produce. Note that a few institutions have indicated that they may not have

separate risk reports as indicated in the table, but may prepare report(s) that may

include information on some of these risks. The table shows that the most widely

used report in the Islamic banks is liquidity risk report with 13 banks (76.5

percent) producing these, followed by credit risk report (70.6 percent). The

operational risk reports are least used with only 3 institutions (17.6 percent)

producing these. Few institutions produce interest rate reports (23.5 percent) and

aggregate market risk report (29.4 percent). While11 Islamic banks in the sample

(64.7 percent) have capital at risk report 10 banks (58.8 percent) produce

commodities and equities position risk reports, relatively fewer institutions

prepare foreign exchange and country risk reports (41.2 percent and 35.3 percent

respectively). One reason for these low numbers may be that some countries

operate domestically only and as such are not exposed to either foreign exchange

or country risks.

70


                                            Table 3.7

 Maintaining an Appropriate Risk Measuring, Mitigating, and Monitoring

                                    Process-Risk Reports

                                                                   No. of          Percentage

                                                               Affirmative           of Total

                                                                Responses

 1.   Capital at Risk Report                                        11                 64.7

 2.   Credit Risk Report                                            12                 70.6

 3.   Aggregate Market Risk Report                                   5                 29.4

 4.   Interest Rate Risk Report                                      4                 23.5

 5.   Liquidity Risk Report                                         13                 76.5

 6.   Foreign Exchange Risk Report                                   7                 41.2

 7.   Commodities & Equities Position Risk Report                   10                 58.8

 8.   Operational Risk Report                                        3                 17.6

 9.   Country Risk Report                                            6                 35.3

          Some financial institutions produce other specific risk reports not

included in Table 3.7 above. These include Compliance Risk Report, Bad and

Doubtful Receivables Report, Monthly Progress Report, Defaulting Cases

Report, and Related Party Exposure Report.

          Table 3.8 exhibits different risk measuring and mitigation techniques

used by Islamic banks. There may be a variety of formats in which these

techniques can be used, ranging from very simple analysis to sophisticated

models. The most common risk measuring and managing technique is the credit

ratings of prospective investors used by 76.5 percent of the institutions in the

sample. Around 65 percent of the institutions use internal rating system for these

ratings.29 Maturity matching analysis to mitigate liquidity risks is used by 10

institutions (58.8 percent). While more than half of the institutions (52.9 percent)

estimate worst case scenarios, 47.1 percent of them use duration analysis to

estimate interest rate risk and risk adjusted rate of return on capital (RAROC) to

determine the overall risk. Seven banks (41.2 percent) in the sample use

different types of Earnings at Risk, Value at Risk. Only 29.4 percent of the

banks use simulation techniques to assess different risks.

     ٢٩

        The internal rating system is used by large commercial banks to determine the economic

     capital they should hold as insurance against losses. BIS (2001) is trying to introduce the

     internal rating system to determine the capital requirements of banks in its new standards

     (see, section four). The internal rating system which the Islamic banks have reported using

     can be considered as a simple listing of assets in accordance with their quality particularly,

     for provisioning loan loss reserves.

                                                                                                71


                                           Table 3.8

 Maintaining an Appropriate Risk Measuring, Mitigating, and Monitoring

                   Process-Measuring and Management Techniques

                                                        No. of Affirmative        Percentage

                                                            Responses               of Total

  1.    Credit Ratings of Prospective Investors                  13                    76.5

  2.    Gap Analysis                                              5                    29.4

  3.    Duration Analysis                                         8                    47.1

  4.    Maturity Matching Analysis                               10                    58.8

  5.    Earnings at Risk                                          7                    41.2

  6.    Value at Risk                                             7                    41.2

  7.    Simulation techniques                                     5                    29.4

  8.    Estimates of Worst Case scenarios                         9                    52.9

  9.    Risk Adjusted Rate of Return on Capital                   8                    47.1

        (RAROC)

  10. Internal Rating System                                     11                    64.7

          The banks indicate the use of some other techniques not listed in Table

3.8 above. These include analysis of the collateral, sector and market exposure

of debtors, lending, risk analysis, measuring the effect of price of a particular

commodity (like oil) and global stock market on borrower.

          Table 3.9 focuses on the monitoring aspects of risk management. Note

that there can be more than one answer to the questions so the sum of the

percentages (given in parenthesis) may exceed 100.30 Almost 70 percent of the

banks reappraise the collateral regularly and 29.4 percent of them do so

occasionally. A large percentage of the banks (82.4 percent) also confirm a

guarantor’s intention to guarantee loans regularly. One institution reviews such

guarantee occasionally. For institutions engaged in international investments, 8

(47.1 percent) review the country ratings regularly, 3 (17.7 percent) do so

occasionally and 1 bank does not review these ratings at all. Note that specific

question on reserve provision for losses was omitted in the questionnaire.

Though most Islamic banks have excess reserves, the information on RAROC

indicates about half of these institutions estimate risk capital to account for

unexpected losses.

      ٣٠

         Five institutions had more than one answer. The bank can have more than one answer as

     they may take different approaches depending on the asset type and the tenure of the contract.

72


          While a significant number of banks (76.5 percent) use international

accounting standards, only 64.7 percent of them use AAOIFI standards. Five

institutions report using other accounting standards, mainly national ones. The

frequency of assessing profit and loss positions is daily for 7 (41.2 percent)

institutions, weekly for 4 (23.5 percent) banks and monthly for almost 70

percent of the banks.

                                         Table 3.9

 Maintaining an Appropriate Risk Measuring, Mitigating, and Monitoring

                                Process- Risk Monitoring

                                              Regularly   Occasionally     Never

 1.   Does the bank periodically                  12            5

      reappraise collateral (asset)?           (70.6%)      (29.4%)

 2.   Does the bank confirm a                     14            1

      guarantor’s intention to guarantee       (82.4%)       (5.9%)

      loans with a signed document?

 3.   If loans are international, does the        8             3             1

      bank regularly review country            (47.1%)      (17.7%)        (5.9%)

      ratings?

 4.   Does the bank monitor the                   12            2

      borrower’s business performance          (70.6%)      (11.8%)

      after loan extension?

                                            International  AAOIFI          Other

 5.   Does the accounting standards               13           11             5

      used by the bank comply with the         (76.5%)      (64.7%)       (29.4%)

      following standards?

                                                Daily       Weekly       Monthly

 6.   Positions and Profits/Losses are            7             4            12

      assessed?                                (41.2%)      (23.5%)       (70.6%)

3.3.3. Adequate Internal Controls

          Table 3.10 points out some aspects of internal controls that Islamic FIs

have in place. Eleven banks (64.7 percent) indicate that they have some form of

internal control system in place that can promptly identify risks arising from

changes in the environment. The same number of banks have countermeasures

and contingency plans against disasters and accidents. A large percentage (82.4

percent) of the banks has separated duties of those who generate risks and those

who manage and control risks. Thirteen banks (76.5 percent) indicate that

internal auditor reviews and verifies the risk management systems, guidelines,

                                                                                 73


and risk reports. A high of 94.1 percent of these institutions have backups of

software and data files.

                                      Table 3.10

                             Adequate Internal Controls

                                                         No. of       Percentage

                                                      Affirmative      of Total

                                                      Responses

  1.  Does the bank have in place an internal              11            64.7

      control system capable of swiftly dealing with

      newly recognized risks arising from changes

      in environment, etc.?

   2. Is there a separation of duties between those        14            82.4

       who generate risks and those who manage

       and control risks?

  3. Does the bank have countermeasures                    11            64.7

      (contingency plans) against disasters and

      accidents?

  4. Is the Internal Auditor responsible to review         13            76.5

      and verify the risk management systems,

      guidelines, and risk reports?

  5. Does the bank have backups of software and            16            94.1

      data files?

3.4. OTHER ISSUES AND CONCERNS

         In recent times there has been an exponential growth in the use of

derivatives by conventional financial institutions for both risk mitigation and

income generating purposes. There are, however reservations regarding use of

derivatives from the Sharī‘ah perspectives. As such, with an exception of a few,

most Islamic financial institutions do not use derivatives. This is revealed in

Tables 3.11 and 3.12. Table 3.11 shows the institutions using derivatives for

hedging (risk mitigation) purposes and Table 3.12 points out the number of

banks using these instruments for income generating purposes. These tables

show that while there is only one case of use of forward contracts for income

generating purposes, there are several cases of use of derivatives for risk

mitigation purposes. Specifically, there are three cases of currency forwards, and

one case each of commodity forwards, currency swaps, commodity swaps, and

mark-up swaps. The case of mark-up swap (or profit rate swap) is interesting.

74


                                          Table 3.11

     Use of Derivatives for Hedging (Risk management) Purposes (No. of

                                         Institutions)

                       Forwards             Futures        Options           Swaps

  Currency                  3                    -             -                1

  Commodity                 1                    -             -                1

  Equity                     -                   -             -                -

  Mark-up Rate               -                   -             -                1

                                          Table 3.12

    Use of Derivatives for Income Generation Purposes (No. of Institutions)

                      Forwards             Futures       Options             Swaps

 Currency                  1                  -              -                  -

 Commodity                 -                  -              -                  -

 Equity                    -                  -              -                  -

 Interest Rate             -                   -             -                  -

                                          Table 3.13

          Lack of Instruments/Institutions related to Risk Management

                                                            No. of Relevant    Average

                                                               Responses        Rank*

  1.   Short-term Islamic financial assets that can be             15             3.87

       sold in secondary markets

  2.   Islamic money markets to borrow funds in case               16             4.13

       of need.

  3.   Inability to use derivatives for hedging.                   14             3.93

  4.   Inability to re-price fixed return assets (like             16             3.06

       Murāba ah) when the benchmark rate changes.

  5.   Lack of legal system to deal with defaulters.               15             4.07

  6.   Lack of regulatory framework for Islamic banks.             15              3.8

*The rank has a scale of 1 to 5, with 1 indicating ‘Not Serious’ and 5 denoting ‘Critically

Serious’.

          Table 3.13 sheds light on the seriousness of some constraints that

Islamic financial institutions face in managing risks. The first two concerns

relate to the lack of financial instruments/institutions for liquidity risk

management. Lack of Islamic financial assets that can be bought/sold in

secondary markets is ranked at a high of 3.87 and the absence of Islamic money

markets to borrow funds in case of need at 4.13. The banks rank inability to use

derivatives to transfer risks at 3.93. Among the concerns listed in the table,

                                                                                        75


inability to reprice assets is considered the least serious (ranked at 3.06). This

may be due to the fact that the most of the assets in Islamic banks use have

short-term maturity and interest rate risk is relatively small. The bankers,

however, have worries about legal and regulatory risks. These are ranked at 4.07

and 3.8 respectively. Note that these constraints identified by Islamic banks are

ranked much higher than the traditional risks (like credit risk, interest rate risk,

etc. listed in Table 2) that these institutions face.

          Table 3.14 reports the responses of Islamic banks to some issues related

to their operations. Ten banks (58.8 percent) in the sample are actively engaged

in research to develop Islamic compatible risk management instruments and

techniques. When a new risk management product or scheme is introduced, a

significant number of Islamic banks (76.5 percent) get clearance from the

Sharī‘ah board. Only three banks (17.7 percent) have used securitization to raise

funds and transfer risks. A relatively small number of banks (41.2 percent) have

a reserve that is used to increase the profit share of depositors in low performing

years. This is done mainly to mitigate the withdrawal and fiduciary risks that

Islamic banks face. Note that investment banks and the only development bank

(IDB) do not have depositors in the traditional sense and this question does not

apply to them.

                                         Table 3.14

               Other Issues related to Islamic Financial Institutions

                                                     No. of Affirmative Percentage

                                                         Responses        of Total

 1.   Is your bank actively engaged in research to           10             58.8

      develop       Islamic      compatible    Risk

      Management instruments and techniques?

 2. When a new risk management product or                    13             76.5

      scheme is introduced, does the bank get

      clearance from the Sharī‘ah Board?

 3. Does the bank use securitization to raise                 3             17.7

      funds for specific investments/projects?

  4. Do you have a reserve that is used to                    7             41.2

       increase the profit share (rate of return) of

       depositors in low-performing periods.

 5. Is your bank of the view that the Basel                  10             58.8

      Committee standards should be equally

      applicable to Islamic banks?

 6. Is your organization of the view that                     9             52.9

      supervisors/regulators are able to assess the

      true risks inherent in Islamic banks?

 7. Does your organization consider that the                  9             52.9

76


      risks of investment depositors and current

      accounts shall not mix?

          The final set of questions in Table 3.14 relates to the regulatory aspects

of Islamic banks. Only 9 banks (52.9 percent) are of the view that

supervisors/regulators are able to assess the risks inherent in Islamic banks and

10 (58.8 percent) of them conclude that the Basel Committee standards should

be equally applicable to Islamic banks. Nearly half of the banks (52.9 percent)

believe that risks of investment deposits and current accounts should not mix.

The views of Islamic financial institutions regarding the capital requirements is

shown in Table 15.3. As is seen, the views given are different. Seven banks

(41.2 percent) are of the view that the capital requirements for Islamic banks

should be less than conventional banks, 6 banks (35.3 percent) think it should be

equal to that of their conventional counterparts, and only three institutions

acknowledge this should be less.

                                       Table 3.15

  Capital Requirement in Islamic Banks compared to Conventional Banks

                                            Less            Same          More

    Do you think that the capital            7                6             3

    requirements     for   Islamic        (41.2%)          (35.3%)       (17.7%)

    banks as compared to

    conventional banks should be

3.5. RISK MANAGEMNET IN ISLAMIC FINANCIAL INSTITUTIONS:

      AN ASSESSMENT

          The above analysis has touched on different aspects of risk management

in Islamic FIs. It first identifies the severity of different risks and then examines

the risk management process in Islamic banks. Among the traditional risks

facing Islamic banks, mark-up risk is ranked the highest, followed by operational

risk. The results show that Islamic financial institutions face some risks that are

different from that faced by conventional financial institutions. These banks

reveal that some of these risks are considered more serious than the conventional

risks faced by financial institutions. Profit-sharing modes of financing

(diminishing Mushārakah, Mushārakah and Muārabah) and product-deferred

sale (Salam and Isti nā‘) are considered more riskier than Murāba ah and

Ijārah. Other risks arise in Islamic banks as they pay depositors a share of the

profit that is not fixed ex ante. The Islamic banks are under pressure to give

returns similar to other institutions, as they believe that the depositors will hold

                                                                                   77


the bank responsible for a lower rate of return and may cause withdrawal of

funds by the depositors.

         In order to get an overall assessment of the risk management system of

Islamic FIs, we report averages of the three constituents of this process. The

average score represents the sum of affirmative answers as a percentage of the

total possible answers in each component. For example, the average score for

“Establishing an Appropriate Risk Management Environment, Policies, and

Procedures” (Table 3.5) is 82.4 percent. We arrive at this number by taking the

sum of all affirmative answers given by financial institutions in Table 3.5 (i.e.

84) as a percentage of all possible affirmative answers (i.e. 17×6=102). The

corresponding figures for “Maintaining an Appropriate Risk Measuring,

Mitigating, and Monitoring Process” (Table 3.6) and “Adequate Internal

Controls” (Table 3.10) are 69.3 percent and 76 percent respectively.

         These figures indicate that Islamic banks have been able to establish

better risk management policies and procedures (82.4 percent) than measuring,

mitigating, and monitoring risks (69.3 percent), with internal controls

somewhere in the middle (76 percent). We note two points from these results.

First, the overall averages are relatively high. One reason of this may be that

there is an upward bias of the banks included in the sample. We believe that the

banks that have relatively better risk management systems have responded to the

questionnaires giving these higher averages. Second, the relative percentages

indicate that Islamic financial institutions have to upgrade their measuring,

mitigating, and monitoring process followed by internal controls to improve

their risk management system.

         The results also point out that the lack of some instruments (like short-

term financial assets and derivatives) and money market hampers risk

management in Islamic financial institutions. There is a need for research in

these areas to develop instruments and their markets that are compatible with

Sharī‘ah. At the government level, the legal system and regulatory framework of

the Islamic financial system needs to be understood and appropriate policies

undertaken to cater to the needs of Islamic banks.

         It should be noted that the views expressed in this chapter are those of

Islamic bankers. As pointed out in the Introduction, the view of risks and their

management of the bankers will differ from the perspectives of the regulators

and the members of Sharī‘ah board. Given the different objectives, regulators

78


and Sharī‘ah experts may take a more conservative approach towards risk and

its management. These perspectives are discussed in the following chapters.

                                                                            79


                                         IV

                       RISK MANAGEMENT:

               REGULATORY PERSPECTIVES

4.1 ECONOMIC RATIONALE OF REGULATORY CONTROL ON

      BANK RISKS

         Banks generate assets by using depositors’ funds. Since the rate of

return on the banks’ equity depends on the volume of assets accumulated, banks

have the natural inclination to mix little amount of their own equity with as

much of depositors’ money as possible. Hence banks’ assets exceed their

equities several times. If assets are far larger than equities, even a small loss on

assets could be enough to wipe out a bank’s equity and cause it to collapse and

loss to depositors. As a result of the contagion effects and disruptions in the

payments and settlement processes, the collapse of even a small bank can be a

source of a big systemic instability. The Islamic banks are no exception to this

systemic phenomenon. Liberalization, electronic banking and clearance and

settlement processes, availability of diverse financial assets, financial

consolidation and emergence of highly leveraged institutions have added to the

fragility of financial systems. The primary concern of regulatory standards and

supervisory oversights is to ensure systemic stability, protect the interest of

depositors and enhance the public’s confidence on the financial intermediation

system. However, due to the rapidly changing nature of financial markets,

regulatory and supervisory standard setting appears to always remain as a “work

in progress”. In this section we discuss regulatory and supervisory concerns with

risk management at the level of individual banks. We also present an overview

of the recent supervisory trends in aligning bank capital with asset risks and the

implications of this for Islamic banks.

4.1.1. Controlling Systemic Risks

       Systemic risk is the probability that failure of even a small bank could

result in the contagion effect and the whole payments system could be disrupted.

This could lead to a financial crisis, decline in the value of assets in place,

impairing growth taking capabilities of the economy, creating unemployment,

decreasing economic welfare and even causing social and political instability.

80


For a number of reasons banks are the only institutions having such significance

for systemic stability.

     i) Banks are not only business firms but are also agents of the payments,

          clearance and settlement system.

    ii) Banks are highly leveraged and exposed to financial risks and instability.

    iii. Regulatory interference is not always perfect. Particularly, deposit

          protection schemes and lender of last resort facilities create moral hazard

          on the part of both banks and depositors.

    iv. Due to financial liberalization, technological and computing revolution,

          and electronic banking, clearing and settlements systems have enabled

          banking to cross-geographic boundaries and regulatory jurisdictions.

     v. The extent of mergers, financial consolidation and cross-segment

          activities – banks writing insurance contracts, insurance companies

          undertaking investment activities and investment banks mobilizing

          deposits etc., is on the rise leading to the mixing of the risks of these

          different segments. The systemic importance of a bank is different

          compared to an investment firm or an insurance company. The failure of

          a bank creates a severe contagion effects due to the disruption of the

          payments and settlement processes. Compared to this the failure of an

          insurance or investment firm will have a more isolated effect on the firm

          itself. Moreover, insurance firms and investment banks are not covered

          by lender of last resort or deposit insurance schemes; hence they do not

          face moral hazard and adverse selection problems as such. Furthermore,

          the nature of liabilities and assets of banks and the other firms are

          different. Cross-segment activities blur all these functional differences

          and mix the different types of risks, making regulation and supervision

          more important.31

    vi. An important source of systemic risk is the relationship of banks with

          highly leveraged firms. Banks are not only highly leveraged themselves,

     31

        Banks are prone to “runs” for a number of reasons: (i) Banks owe to depositors and other

     creditors fixed obligations irrespective of the quality of their assets (this feature, however

     does not exist in Islamic banks), (ii) The value of bank assets is not known to depositors –

     bank runs thus are psychological and confidence matter rather than a true assessment of asset

     values of banks (iii) depositors are paid on the basis of first come first served if bank run

     happens leading to a run in case of problems and (iv) banks are much more interconnected

     through the payments and settlement process – depositors know that. See (Llewellyn 1999).

                                                                                                81


          but are also a source of creating leverage. Leverage increases financial

          risks and creates financial instability. Banks themselves being highly

          leveraged can be severely destabilized if they keep large exposures to

          other highly leveraged firms. Therefore banks need to be aware about

          the risks and risk management systems of their counterparties.32

    vii. Banks undertake large amounts of off-balance sheet activities.

          Particularly, due to an increase in securitization and derivative activities

          these off-balance sheet activities have increased disproportionately.

          These activities although useful are a source of disguise leverage of

          banks.

4.1.2 Enhancing the Public’s Confidence in Markets

        The efficiency of financial markets depends on the confidence of the

public in the financial intermediaries, which in turn depends on the integrity of

these institutions. Public confidence in financial institutions strengthens the

financial intermediation system and the society as a whole benefit from these in

terms of financial efficiency and stability. Some of the benefits of financial

intermediation which need to be strengthened by the regulatory process are

given here:

     i.   Due to economies of scale, specialization and technical expertise,

          financial intermediaries are more suited to evaluate the risks of

          counterparties as compared to individual savers. Thus financial

          intermediation reduces information cost, moral hazard and adverse

          selection and consequently the cost of finance. Due to lack of

          confidence on the financial intermediation system the public could

          withdraw from it. As a result, the cost of funds in the economy will

          increase leading to an inefficient allocation of resources.

     32

        A classical real world case of a relatively small firm potentially causing a meltdown of

     global financial markets happened in September 1998 when Long-Term Capital Management

     (LTCM), a US Hedge Fund with a capital of $ 4.8 billion and assets of $ 200 billion was

     rescued by regulators. Collapse of the LTCM could have caused a serious systemic

     instability. This incident triggered a series of regulatory guidelines and standards regarding

     banks’ relationship with highly leveraged firms and counter party risk management. See, for

     example, Report of the (US) Presidents’ Working Group on Hedge Fund, Leverage and the

     Lessons of Long-Term Capital Management (1999), BCBS, Sound Practices for Banks'

     Interaction with Highly Leveraged Institutions (1999). All BCBS publications can be

     accessed at: www.bis.org.

82


    ii. Financial intermediaries reduce a number of mismatches between the

         preferences and needs of savers and investors. These are maturity

         mismatches, size of fund mismatches and liquidity mismatches. As a

         result of confidence problem these mismatches could increase,

         increasing the frictions in the process of resource allocation.

    iii. Financial intermediaries are much more capable of assessing the risks of

         alternative investment opportunities in comparison to individual savers.

         As a result of a confidence problem this comparative advantage cannot

         be utilized.

    iv. Efficiency in processing the transactions of the payments system is

         extremely important for reducing the transaction costs. Electronic

         systems have made the process even more critical for the competitive

         efficiency of an economy. Lack of public confidence in the financial

         institutions can impair the utilization of the payments facilities and the

         economy can be inefficient as compared to its competitors.

         In order to enhance the public’s confidence on the financial

intermediation system, the interests of depositors and other users of financial

services need to be protected. Depositors of banks in particular and users of

financial services in general are not in a position to protect their own interests

like the shareholders of banks and other firms. There are a number of reasons for

this that require regulatory and supervisory oversight.

     i.  Depositors and other customers of the financial services industry are

         numerous and often have short-term relationships with banks and other

         financial institutions. As a group and individually, they are not able to

         monitor the activities of financial institutions, which always involve

         complex long-term contracts.

    ii. Financial institutions play important fiduciary role. The financial

         contracts at the time of selling to the clients may be of a particular

         nature. These contracts may later be changed due to genuine needs or

         merely due to moral hazard on the part of the institutions. Customers

         cannot effectively monitor the enforcement of the contracts in their own

         best interest overtime.

                                                                                 83


    iii. Customer protection has become even more important in the new regime

           of e-banking, rising trends of money laundering and other acts of deceit

           on the part of some elements.

           For these and other reasons the regulatory and supervisory authorities

have to safeguard and protect the interests of customers. Without such a

protection and safeguard the integrity of markets cannot be ensured and the

confidence of customers on the financial institutions cannot be strengthened. As

a result, inefficiency, systematic instability and financial crisis can grip the

markets effecting economic development and welfare adversely.

4.1.3 Controlling the Risk of Moral Hazard

           Some of the policies and safety nets introduced by regulatory authorities

to protect the integrity of markets, to safeguard the interests of depositors and to

avoid systemic risks often become the source of moral hazard on the part of

depositors as well as banks. Regulation and supervision is also required to

safeguard these safety net arrangements.

      i.   The lender of last resort (LLR) facility of central banks aims at

           preventing bank runs by providing liquidity facility to banks in times of

           crisis. Many studies indicate that since central banks are there to rescue

           banks, particularly, banks which are “too big to fail”, they behave

           imprudently. In addition to the regulatory oversight, it is often

           recommended that the LLR facility shall be provided at a very high cost

           and that the private sector shall participate in overcoming any financial

           crisis by taking direct responsibility for financial losses.

     ii. The deposit insurance schemes aim at providing protection to depositors

           in case of bank failure. Since the depositors have to lose nothing as the

           deposits are insured, banks undertake risky activities. Since the rate of

           interest on deposits is fixed, in case of success of their risky operations,

           all the high return are accrued to the owners of banks and in case of

           losses deposits are protected in any way. Since deposits are protected,

           depositors also have no incentive to monitor the activities of banks. Thus

           a number of studies have found that financial instability is high in

           countries where deposits are fully protected33. An effective regulatory

           and supervisory oversight is thus required to prevent or at least minimize

       ٣٣

          See, Demirguc and Enrica (2000).

84


         the adverse consequences of the safety net schemes put in place by the

         public authorities.

4.2 INSTRUMENTS OF REGULATION AND SUPERVISION

         The regulation of financial institutions is generally classified into

conduct of business regulation and prudential regulation. The former type of

regulation is required to protect the interests of customers. The interests of

customers can be protected by requiring banks to put certain minimum amount

of their own capital at stake and ensuring timely disclosure of accurate

information. Establishing a satisfactory level of competence and integrity in

supplying banking services, maintaining a leveled playing field for competition

and ensuring the production and supply of fair financial contracts and products

are also the primary requirements in this regard. To achieve these objectives of

conduct of business regulation, uniform sets of standards, rules and guidelines

are required. Prudential regulation is directed at systemic safety by ensuring the

soundness of individual financial institutions through the application of the set

standards and guidelines across institutions. The instruments used for the

regulation and supervision of financial institutions can broadly be classified into

three categories:

         a) Ensuring the maintenance of a minimum level of risk-based capital,

         b) Putting in place an effective system of risk-based supervision and

         c) Making certain the timely disclosure of correct information about

             risk management systems and processes.

4.2.1 Regulating Risk Capital: Current Standards and New Proposals

         Bank capital is the most effective source of protection against risks. It is

also an effective means of regulation because capital standards can be enforced

uniformly across institutions and jurisdictions. In general, capital refers to

shareholders’ equity. Capital is required to support the risks of assets and for its

stabilization and confidence building role, particularly, against the eventuality of

any crisis and in fact when it arises. Traditionally, adequacy of capital in a

banking firm is gauged by the capital/asset ratio i.e., the leverage ratio (LR). The

LR does not cover the relative risks of different assets. In addition, it does not

take into account the stabilization role of funds, which due to their long-term

maturity as compared to deposits have the potential to relieve the pressure on

shareholders’ equity in case of a crisis. Therefore, the 1988 Basel Capital

                                                                                  85


Accord34 introduced the concept of risk weights for assets and it distinguishes

between tier-1 and tier-2 capital35. The Accord requires that internationally

active banks in G-10 countries shall maintain at least 3% leverage ratio, at least

4% tier-1 capital against risk weighted assets (RWAs) and at least 8% total

capital (tier-1 plus tier-2) against RWAs36. In this section we briefly overview

the salient features of the existing and proposed regulatory capital standards.

4.2.1.1 Regulatory Capital for Credit Risk: Present Standards

         Credit risks are so much important for banks and from regulators’

perspective that the 1988 Capital Accord requires capital only against credit

risks for on-balance sheet and off-balance sheet assets of banks. Banks are in

the business of borrowing money to lend. As a result of lending, receivables

from clients make an overwhelming part of their total assets. The quality of

these assets, therefore, depends on the timely and full repayment by the clients.

A failure to do so, i.e. default, is always probable depending on the credit quality

of the client. The primary concern of regulators is, therefore, that banks should

be aware of their credit risk and maintain a minimum level of capital to

overcome any instability caused by default by a client. Total assets of a bank are

put into five risk categories (0%, 10%, 20%, 50% and 100%). Summary

     ٣٤

        The Basel Committee for Banking Supervision – an international standard setting body

    was established by the Central Bank Governors of the Group of Ten Countries at the end of

    1974. The Committee's members now come from Belgium, Canada, France, Germany, Italy,

    Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom and

    United States. In 1988, the Committee decided to introduce a capital measurement system

    commonly referred to as the Basel Capital Accord. This system provided for the

    implementation of a credit risk measurement framework with the aim to establish a minimum

    capital standard of 8% of total risk-weighted assets by the end of 1992. In 1996 the Accord

    was amended also to require capital for market risks. The Accord is expected to remain

    effective till 2005 when the New Accord is expected to be implemented.

     ٣٥

        The capital standards differentiate between Tier - 1 capital or core capital (pure capital or

    basic equity), Tier – 2 capital or supplementary capital, tier-3 capital recognized by the 1996

    amendment and leverage ratio in the following form. A. Supervisors shall ensure that Tier – 1

    (core) capital, i.e., a) basic equity + b) disclosed reserves from post-tax bank earnings minus

    a) good will, and b) investment in subsidiaries, shall not fall short of 50% of a bank's total

    capital. B. Supervisors shall also ensure that Tier – 2 (supplementary) capital, i.e., a)

    undisclosed reserves, + b) revaluation reserves, + c) general loan loss reserves, + d) hybrid

    debt instruments, + e) subordinated term debt of 5 years’ maturity (maximum limit 50% of

    tier – 1 capital), shall not exceed 50% of a bank's total capital. C. In some countries

    subordinated debt having a maturity of less than 5 years is classified as tier - 3 capital in

    accordance with the 1996 amendment of the Accord covering market risks.

     ٣٦

        These standards are also maintained in the proposed New Basel Accord too, see the

    discussion below.

86


composition of each risk bucket for on-balance sheet items is given in Table

4.137.

         Total capital requirement for on-balance sheet assets is reached by

putting all assets into their respective buckets and deriving RWAs of the bucket

as a first step. For example, assets in 0% risk weight category are default risk

free assets. These assets do not need any capital for their protection. Assets in

100% risk weight category are very risky and all such assets need minimum 4%

tier-1 and 8% total capital protection. If the assets in this category are $100

million, a minimum of $ 8 million ($100m*.08) total capital is required for this

category of assets. In the second step the required capital for all categories is

added up to calculate the minimum capital requirement for the on-balance sheet

items.

                                           Table 4.1

Summary of Risk Capital Weights by Broad On-Balance-Sheet Asset Categories

     Risk Weights                                 Asset Category

          (%)

  0                      Cash and gold bullion claims on OECD governments such as

                         Treasury bonds or insured residential mortgages.

  0, 10, 20, or 50%      Claims on national public sector entities excluding central

  at         national    government and loans guaranteed by them

  discretion

  20                     Claims on OECD banks and OECD public sector entities such

                         as securities issued by US government agencies or claims on

                         municipalities. Claims on multilateral banks or claims

                         guaranteed by them

  50                     Loans fully secured by mortgage on residential property.

  100                    All other claims such as corporate bonds and less-developed

                         country debt, a claim on non-OECD banks, equity, real estate,

                         premises, plant and equipment.

         For the non-derivative off-balance sheet exposures a credit conversion

system and a set of risk weights is provided. Using these guidelines the off-

balance sheet exposures are converted into their on-balance sheet equivalents

and capital requirement is determined. Capital requirement for the off-balance

sheet derivative positions is calculated separately, again using the standards set

for this purpose. The over all credit risk capital requirement according to the

     ٣٧

        For explanations and details see, BCBS (1988).

                                                                                     87


1988 Accord is the sum total of the on-balance sheet and off-balance sheet

capital requirements.

4.2.1.2 Reforming Regulatory Capital for Credit Risk: The Proposed New

          Basel Accord

          Although the 1988 Accord was meant for application in the G10 and

other OECD countries, it has become a standard benchmark for determining the

capital adequacy of banks worldwide. For the first time, it provided a systematic

framework for aligning bank capital with the risks of their assets. A number of

studies confirm that since the introduction of the Accord, bank capital has been

strengthened in almost all countries. However, for a number of reasons, the 1988

Accord is under review and will be replaced by the proposed New Accord

during 200538. Some of the reasons, which have prompted the review of the

Accord, are given here.

     i.   The Accord was meant for internationally active banks of G10 and other

          OECD countries. But the non-G10 and non-OECD countries have also

          embraced it and it has assumed the position of an international

          benchmark to measure capital adequacy of banks. From the non-OECD

          country perspective, it is, hence, desirable to make adjustments in it to

          enable it to fulfil the needs of the developing countries as well.

    ii. Default risk also depends on maturity of the facility, longer maturity

          assets being more risky as compared to the shorter maturity. Therefore,

          regulatory capital requirements, which give lesser risk weight to assets

          of short-term maturity, could have encouraged the flow of such capital

          as compared to the more stable source of longer-term capital. This

          consideration needs to be built-in the regulatory standards.

    iii. At the time of its adoption, the Accord was truly revolutionary in

          aligning capital with the relative risks of assets. During the past decade a

          number of new risks have arisen, new methods of risk management have

          been innovated and put into practice. There has been an unprecedented

      ٣٨

         The Basel Committee issued a consultative document on the New Accord in June 1999.

     After consultations the documents of the proposed New Accord was launched in January

     2001. The Committee initially planned to finalize the agreement on the Accord during 2001

     and its implementations from 2004. But, the response to the invitation for consultations was

     so overwhelming that the Basel Committee now plans to finalize the agreement on the

     document during 2002 and the agreement is supposed to become effective from 2005. The

     New Accord comprises of three pillars, namely, capital adequacy, supervisory review process

     and market discipline.

88


        advancement in computing and information. E-banking and other

        information and technology intensive services have bypassed regulatory

        jurisdictions. Rapid consolidation has taken place in the financial

        services industry. All these changes need to be taken into account while

        measuring the real capital adequacy requirement of banks.

    iv. The Accord has also encouraged capital arbitrage opportunities,

        particularly by encouraging off-balance sheet and trading activities. The

        merits of this have been tremendous, however it has provided an

        opportunity for “capital arbitrage” (CA) and “cherry picking”. Through

        securitization good quality assets have been taken away from the

        balance sheets of banks and sold for raising additional funds without

        removing the corresponding liabilities from the balance sheets. As a

        result, additional funds are raised with the same amount of capital,

        thereby reducing the overall quality of assets and making the banks

        riskier.

    v. The proposed New Accord by covering some of these and other

        pertinent considerations aims at aligning bank capital and risk

        management systems more strongly. It aims to encourage and give

        incentives for risk management systems by keeping the capital

        requirement under the Internal Rating Board (IRB) approach lesser than

        the standardized approach. It also aims at enhancing disclosures about

        risk management systems and other important information so that

        market discipline can be strengthened. The proposed Accord also aims at

        making bank supervision more risk-based and dynamic.

4.2.1.3 Treatment of Credit Risk under the Proposed New Accord

        The consultative document for the proposed New Accord offers three

approaches to determine risk-weighted capital for credit risk, namely the

standardized approach, foundation IRB approach and advanced IRB approach.

        The objective of offering alternative approaches is to encourage risk

management culture in banks by requiring lesser regulatory capital from those

banks which have put in place standard risk management systems. The risk

management systems of banks who will opt to adopt the IRB approaches will be

verified by supervisors. Depending on the supervisory risk assessment, banks

can graduate from the standard approach to the foundation IRB approach and

                                                                               89


from there to the advanced IRB approach taking benefit from the regulatory

capital relief offered.

Treatment of Credit Risk under the standardized approach

         The main proposal is to replace the risk weighting method of the 1988

Accord with a risk weighting of assets based on the ratings of external credit

assessment agencies according to the risk weights given in table 4.2.

90


                                          Table 4.2

             External credit assessment based risk weighting system

                                                      Assessment39

Claims on                  AAA        A+     to    BBB+ to       BB+ to       Below    Not

                           to AA-     A-           BBB-          B-           B-       rated

Sovereigns                 0%         20%          50%           100%         150%     100%

          Option 11        20%        50%          100%          100%         150%     100%

          Option 22

                           20%        50%3         50%3          100%3        150%     50%

Banks     Long-term

          Option       2

                     3     20%        20%          20%           50%          150%     20%

          Short-term

Corporations               20%        100%         100%          100%         150%     100%

1 Risk weighting based on risk weighting of the sovereign in which the bank is incorporated.

2 Risk weighting based on the assessment of individual banks.

3 Claims on banks of a short original maturity, for example, less than six months.

Source: Taken from BCBS 2001 (The New Basel Accord).

         This risk weighting system implies, for example, that if the sovereign

counterparty of an asset, which is worth $ 100 million, is rated for example,

AAA+ to AA-, the asset will be treated as default risk-free and it will not require

any capital. But if the rating of the sovereign is BB+ to B-, the asset requires

100% capital protection (i.e. minimum 4 %, $ 4 million tier–1 capital and 8%, $

8 million total capital shall be kept by the bank against the asset). If the

sovereign counterparty is rated below B-, for capital requirements, the $ 100

million asset will be treated as $ 150 million and total capital requirement will

be 8% of $ 150 million.

         Collateral, guarantee, credit derivatives and netting arrangements are the

most important instruments to mitigate credit risk. Based on the quality of these,

supervisors can give relief in the capital requirements under certain conditions

and subject to the satisfactory utilization of standard risk management

     ٣٩

        Risk weights for claims secured by residential property 50%, commercial real estate

    100%. Claims on multilateral development banks, case by case approach based on minimum

    0% for AAA - AA- with very strong shareholder structure, paid in and callable capital. For

    risk weights of off-balance sheet items, the risk weights of the 1995 modified Accord are

    maintained with some modifications for maturity of the facility.

                                                                                             91


techniques and systems by banks. These are treated uniformly in the

standardized approach and in the foundation approach of internal rating.

     i.  Collateral is most important among the four techniques to control credit

         risks. Cash, debt securities, equities, mutual fund units and gold can be

         used as collateral. The actual strength of collateral depends on the loss in

         the collateral value due to various risks. The estimate of this loss is

         called ‘haircut’. Normally, the haircut of treasury bills is 0%, if the

         collateral is equity, the haircut is 30%, if the collateral is an asset under

         default, the haircut is 100% - total loss. Therefore, the proposed New

         Accord provides the possibility of a supervisory relief of risk capital

         allocation subject to the quality (haircut) of collateral. A methodology

         for determining the haircut under various approaches is provided in the

         New Accord.

    ii. In addition to collateral, on-balance sheet netting, credit derivatives and

         guarantees are recognized by the Accord as credit risk mitigants and

         eligible for supervisory relief for risk capital allocation. These are,

         however, subject to a number of conditions and existence of risk

         management systems, disclosures and subject to other details given in

         the Accord document.

Treatment of Credit Risk under the IRB Approach

         An internal rating system, in the simplest form, can be considered as an

inventory of all assets of a bank keeping in view the future value of these assets.

In this way an IRB maps all assets of a bank in accordance with the risk

characteristics of each asset. All banks have some systems of internal ratings in

place for provisioning loan loss reserves, but an increasing number of banks are

putting in place formal systems of IRB often based on computerized models.

Internal rating systems can be instrumental in filling the gaps in the existing risk

management systems of a bank. Therefore, these are expected to enhance the

risk assessment of an institution by the external credit assessment as well as

supervisory risk assessment agencies leading to lesser capital requirements and

reducing the cost of funds.

         The IRB approach to credit risk management has a number of

advantages. First, it makes the regulatory capital requirement more risk sensitive

- riskier banks will need more capital, less risky ones lesser capital. The IRB

approach is expected to be effective in this regard. Second, it is expected that the

92


IRB approach will provide incentives for risk management systems. As an

incentive for banks to develop their own internal system of risk management, the

New Accord recognizes internal ratings for credit risk capital allocation. The

Accord offers two alternative types of approaches to internal rating, namely, a

foundation approach and an advanced approach

         The foundation approach is suitable for less sophisticated institutions

and the advanced one is open for use by the sophisticated institutions. Under

both approaches, the exposures of an institution are classified into corporations,

banks, sovereigns, retail, project finance and equity. These exposures are

specifically defined in the foundation and advanced approaches, but both the

approaches are based on five key concepts as determinants of credit risk. These

are probability of default (PD), loss given default (LGD), exposure at default

(EAD), maturity of facility (MOF) and granularity. Each one is briefly described

here.

    i.   Probability of Default (PD): The PD of a client is the measure of credit

         risk faced by the bank. The works of rating agencies provide the vital

         information about the PD of counterparties. The results of the S&P’s

         default studies40 provide a number of factual information about the

         historical characteristics of PDs. First, the higher the ratings, the lower

         the probability of default, lower ratings always correspond to higher

         default rates. Second, the lower the initial rating of a party, the sooner

         the party faces default. An initial B rated company defaults in a period

         of 3.6 years, AA company defaults in a period of 5 years from the

         initial rating. A company downgraded to CCC defaults in an average

         period of less than 6 months. Third, higher ratings are longer-lived. A

         company rated AAA has the 90.3% chance to be rated AAA+ a year

         later. This chance for the same initial rating is 84.3% for a BBB and

         53.2% for a CCC. Thus, ratings provide reliable and systematic

         information about credit risk. Financial institutions can measure their

         credit risk by calculating a PD information and maintaining it overtime.

         In all approaches individual banks must calculate their PDs for

         corporate, bank and sovereign categories. In addition bank supervisors

         will also calculate the PDs of clients of individual banks in order to

         verify the accuracy of the PDs provided by banks.

     ٤٠

        See, Standard & Poor S (2001).

                                                                                   93


   ii. Loss Given Default (LGD): The LGD is a measure of the dollar value

        of loss to the portfolio given a particular default. The PD is specific to a

        given borrower, the LGD is specific to a given credit facility. Together,

        the PD and the LGD make a better measure of the credit risk. Some

        banks may not be able to calculate the LGDs of their facilities reliably

        while others may be able to do so. After reviewing the individual

        banks’ risk management systems, supervisors have the discretion to

        decide whether to allow banks to use their own LGD calculations or to

        assign their facilities supervisory LGD characteristics. Those banks,

        which qualify for the use of their own LGD calculations will graduate

        to the advanced IRB approach and those banks which are required to

        use the supervisory assigned LGDs will be put in the foundation IRB

        approach. Under the foundation IRB approach, supervisors will decide

        the LGDs of various facilities with a supervisory benchmark of 50%

        LGD for an unsecured facility, and with a 75% LGD value for

        subordinated exposures (Table 5.1 provides the regulatory risk weights

        given the benchmark LGD of 50%). For secured collateralized

        transactions, supervisors will decide the LGD values using the

        collateral haircut standards set under the standardized approach to the

        capital allocation for credit risk. Under the advanced IRB approach,

        banks will be allowed to use their own LDG estimates for various

        facilities in allocating capital for credit risk. Banks are expected to use

        scientific and verifiable processes for LGD calculation across facilities,

        across collateral, across borrowers and across exposures. Supervisors

        have the discretion to decline the use of their own LGDs by banks, i.e.

        forcing them to follow the basic IRB approach.

   iii. Exposure at Default (EAD): Like the LGD, EAD is also facility

        specific. It is the measure of the total exposure of the facility at the time

        of default. If the commitment is for example, for a $100 facility to be

        utilized in two years drawn in 4 equal amounts and if the default

        happens at the end of the first year, the EAD is $50. Indeed, the default

        event will also have an impact on future exposures of the remaining

        $50 of the facility. Like the LGD, under the basic IRB approach,

        supervisors will calculate EADs, for individual banks, using set

        supervisory rules. Under the advanced IRB approach, banks are entitled

        to calculate their own EAD values for various facilities. The qualitative

94


          characteristics of the system will be the same as described under the

          LGD.

    iv. Maturity of Facility (MOF): MOF is an important determinant of credit

          risk. As shown in the above S&P default studies, a longer maturity

          facility has higher probability of default for all rating classes. Banks are

          required to provide a complete information about maturity of their

          facilities.

    v. Granularity: Granularity is the measure of a single borrower

          concentration in the banks’ credit portfolio. The more spread is the

          credit portfolio among borrowers, the more the non-systematic risks of

          the borrowers are diversified and the less the credit risk and capital

          requirement is. The benchmark granularity is the average for the

          market. Granularity above the benchmark will require more capital and

          below the benchmark less capital. This evaluation of granularity is

          required to make each facility’s credit risk different for each other

          facility so that capital can be allocated for each facility differently. The

          IRB approach requires that the risk of each facility shall be measured

          separately. The bank’s credit portfolio should not be exposed too much

          to the non-systematic risk of a borrower by loan concentrations.

4.2.1.4 Regulatory Treatment of Market Risk

          As discussed above market risks include interest rate, commodity price,

exchange rate risk and equity price risks faced by the banks’ asset portfolios as a

result of their trading positions. As mentioned earlier, the original 1988 Basel

Accord does not require capital for these risks. The risks were brought under the

regulatory umbrella by the 1996 amendment to the Accord and the amendment

became effective in 1998. The amendment introduces two approaches41 to

regulatory assessment of market risks:

      i) The standardized approach; and

      ii) The internal ratings-based approach.

      ٤١

         The amendment in fact brought three fundamental changes to the original Accord, namely,

     the market-risks are brought under the regulatory capital requirements, tier-3 capital was

     introduced to cover market risks; and two approaches standardized and internal ratings

     approaches were introduced.

                                                                                             95


         The choice of an approach is a supervisory discretion based on review

and understanding of risk management systems and processes existing in banks.

Supervisors may also encourage banks to use both approaches simultaneously.

Capital requirements of banks in the first category are meant to be higher than

the second category. The objective of these alternative approaches is to

introduce an effective incentive system for better risk management by setting

lower capital requirements opting for internal ratings and relatively higher

capital requirements for the standardized approach. In fact this incentive system

proved to be successful and has triggered a revolutionary enhancement of risk

management culture in banks in a short period of time. Impressed by the benefits

of the alternative approaches, as discussed in case of credit risk, the New Accord

suggests adopting the internal ratings approach for credit risk as well. Therefore,

the New Accord, in some sense is an extension of the approaches of 1996

Accord to cover credit risks. In other words as far as market risks are concerned,

the 1996 amendments to the 1988 Accord will continue beyond 2005 with minor

modifications.

         In the standardized approach the capital charge for each market risk is

first determined separately following standardized methods for each risk. After

that these capital charges are added to determine the total capital requirements.

Interest rate risk is subdivided into specific and general risks. Specific capital

charges are designed to capture the risk underlying any net position due to the

non-systematic risks of the counterparty and hence more specific to positions in

individual instruments. General risk refers to the risk of loss arising from the

changes in the market interest rates. Two methods: “maturity ladder” and

“duration” are allowed to banks to choose for allocating risk weights. The

underlying principle of the more commonly practiced maturity ladder approach

is the fact that longer maturity requires higher risk weights and short maturity

lower risk weights. For this specific general principle, it is alleged that the

regulatory framework is biased against long-maturity systemically stable sources

of funding and favors short maturity unstable sources of funding. As a result,

the system might have contributed to the flow of short-term of funds and the

resultant financial instability. The internal ratings approach is essentially based

on value at risk technique as briefly discussed in section two of this paper.

4.2.1.5 Banking Book Interest Rate Risk

96


          The banking book42 interest rate risk refers to income or asset value loss

due to a change in the market rates of interest. This is recognized to be an

important risk, which warrants allocation of capital. However, the risk greatly

varies from bank to bank, therefore, it is not possible to set uniform standards for

capital allocation. Therefore, the New Accord keeps the allocation of capital for

this risk in the discretion of bank supervisions under pillar-2 of the Accord that

gives the framework for the supervisory review process. Supervisions are in

particular required to be attentive to the problem of “outlier” banks – banks

whose interest rate risk can lead to the decline in its asset value equal to 20% or

more of its tier-1 and tier-2 capital. Supervisors also need to carefully assess and

review bank’s internal risk assessment and management systems.

4.2.1.6 Treatment of Securitization Risk

          Since securitization takes away assets from the balance sheet of a bank

and puts them in the balance of a special purpose vehicle as discussed in section

two, its risks need to be regulated at balance sheets of the two entities. The 1988

Accord is widely known to have caused capital arbitrage by giving capital relief

to securitized assets, particularly first ignoring market risks and afterwards

assigning lower risk weights on the trading book positions. The New Accord

while appreciating the benefits of securitization tries to minimize capital

arbitrage by trying to ensure that:

     i.   The securitizing (originator) bank must reach a “clean break” which is: a)

          the asset transfer must be through a legal and transparent sale and b) the

          bank shall not hold any control on the assets securitized.

    ii. If the originator is obliged for first credit losses enhancement, it must do

          so by deducting from its capital and

    iii. If the originator is obliged for a second credit loss enhancement, the

          position to be treated as a direct credit substitute.

4.2.1.7 Treatment of Operational risks

      Operational risks are considered to be important in banking organizations.

However, it is only in the New Accord that a specific capital charge is proposed

to cover operational risk. Alternative methodologies are suggested for measuring

this risk:

      ٤٢

         Banking book in this case covers also all those positions which due to any reason cannot

     be sold.

                                                                                              97


         a) Basic Indicator Approach (BIA);

         b) Standardized Approach (SA);

         c) Internal Management Approach (IMA), and

         d) Loss Distribution Approach (LDA).

         This menu of approaches is given in order of the level of sophistication

of a bank – starting from a simple bank using the BIA and the most advanced

banks opting for IMA or LDA in the future. Under the BIA, banks will be

required to maintain capital for operational risk equal to a fixed percentage of

gross income set by supervisions. Under the SA banks’ activities will be divided

into business lines. Capital charges will be set as Beta fractions for each line as

given in table 4.3. The same set of business lines and beta fractions are further

refined in the IMA, adding additional indicators by the supervisors such as

exposure indicators, loss event probability, given the expected loss etc. Suitable

approaches will be assigned to banks by supervisors after reviewing the

preferences as well as the state of risk management processes existing in banks.

                                      Table 4.3

            Proposed operational risk indicators in the New Accord

       Business     Business Lines        Indicator                  Capital

       Units                                                         factors

       Investment   Corporate finance     Gross income               β1

       banking      Trading and sales     Gross income (or VAR)      β2

       Banking      Retail banking        Annual average assets      β3

                    Commercial            Annual average assets      β4

                    banking

                    Retail banking        Annual average assets      β5

                    Payment          and  Annual settlement through  β5

                    settlement            put

       Others       Retail brokerage      Gross income               β6

                    Asset management      Total     funds     under  β7

                                          management

         Source: The New Basel Accord Document

4.2.2 Effective Supervision

         Effective bank supervision is the key to achieve financial efficiency and

stability. The objectives of bank supervision can be summarized in a few

sentences.

98


     i.   The key objective of supervision is to maintain stability and confidence

          in the financial system, thereby reducing the risk of loss to depositors

          and other creditors.

    ii. Supervisors should encourage and pursue market discipline by

          encouraging good corporate governance (through an appropriate

          structure and set of responsibilities for a bank’s board of directors and

          senior management) and enhancing market transparency and

          surveillance.

    iii. In order to carry out its tasks effectively, a supervisor must have

          operational independence, the means and powers to gather information

          both on and offsite, and the authority to enforce its decisions.

    iv. Supervisors must understand the nature of the business undertaken by

          banks and ensure to the extent possible that the risks incurred by banks

          are being adequately managed.

     v. Effective banking supervision requires that the risk profile of individual

          banks be assessed and supervisory resources allocated accordingly.

    vi. Supervisors must ensure that banks have resources appropriate to

          undertake risks, including adequate capital, sound management, and

          effective control systems and accounting records; and

   vii. Close cooperation with other supervisors is essential, particularly where

          the operations of banking organizations cross national boundaries.43

          Effective supervision of banks ensures that banks function safely and

soundly, so that the financial system can attain the full confidence of savers and

investors. This enables the removal of the constraints imposed by the self-

financing system and increases the monetization of transactions. An increased

level of savings efficiently put into investments ensures economic development

and welfare. Supervisory systems are expected to depend on the socio-political

and legal frameworks prevailing in different countries. Hence there cannot be a

standardized supervisory system to be followed in all jurisdictions. Different

countries use different method and approaches to assess bank risks. These

approaches are however, converging on one important point, namely, risk-based

formal and systematic supervision shall gradually be adopted in order to make

     43

        Core Principles' document, pp.8-9.

                                                                                 99


supervision effective. The approaches to supervisory risk assessment as used in

different countries can be grouped into four.

   a) Supervisory bank rating systems (such a CAMELS)

   b) Financial ratio and peer group analysis systems

   c) Comprehensive bank risk assessment systems and

   d) Statistical models

            The generic features of each approach are summarized in table 4.4.44

                                               Table 4.4

           Salient Features of Bank Supervisory Risk Assessment Systems

                         Assessment of                                               Specific focus

  Approaches                             Forecasting   Use of

                                                                      Inclusion of                    Links with

                         current                       quantitative

  to Bank

                                         future        analysis and   qualitative    on risk          formal

                         financial       financial     statistical                                    supervisory

  supervision            condition       condition     procedures     assessments    categories       action

  Supervisory

  Ratings

  On-site               ***              *             *              ***            *                ***

  Off-site              ***              *             **             **             **               *

  Financial ratio

  and peer group

  analysis              ***              *             ***            *              **               *

  Comprehensive

  bank risk

  assessment            ***              **            **             **             ***              ***

  systems

  Statistical

  models                **               ***           ***            *              **               *

* Not significant ** significant *** very significant

          Despite the prevalence of different approaches to supervision in

different jurisdictions, a broadly acceptable framework of some of the core

principles for effective supervision can be equally relevant across different

countries. Such principles provide a widely recognized benchmark for effective

      ٤٤

           See Sahajwala and Bergh (2000).

100


supervision, provide for a recognition for the minimum precondition for

effective supervision, define supervisory role in identifying risks and mitigating

them, and increase cooperation between supervisors of different countries to

enhance consolidated supervision. Due to these and other considerations, the

BCBS issued the Core Principle for Effective Banking Supervision document in

1997. The main features of these core principles are highlighted in table 4.5.

                                                                               101


                                            Table 4.5

    Core Principles and Assessment Methodology of Banking Supervision

 CLASSIFICATION                      COVERAGE*                         ASSESSMENT OF

 OF CORE                                                               COMPLIANCE**

 PRINCIPLES*

 Principle – 1             Existence of sound economic         Are the roles and duties of

 Preconditions for         policies, public infrastructure,    different      agencies       clearly

 Effective Banking         market discipline, procedures for   defined? Is there a coordination of

 Supervision               effective resolution of problems,   activities? Is there suitable legal

                           sound public safety nets.           framework for banking? Are

                                                               supervisors empowered?

 Principles 2-5            Permissible activities to be        Is the term bank clearly defined in

 Licensing and             licensed to banks, powers of        laws? Are banking activities

 Structure                 licensing authorities, methods of   clearly defined in laws? Are

                           procedures of licensing owners,     licensing authorities competent,

                           plans to operate and manage         honest and well informed? Are

                           risks, competence and integrity     they empowered to block any

                           of senior management, financial     subsequent ownership control,

                           matters      including      capital activity changes, mergers, etc.?

                           required other approvals, transfer  Are they in full contact with such

                           of control, major acquisition or    authorities in other jurisdictions?

                           investment by banks.

 Principles 6-15           Adequacy of risk-based capital,     Are the authorities empowered to

 Prudential Regulations    credit risk management, asset       set        regulatory         capital

 and Requirements          quality      assessment,      large requirements and to implement

                           exposures and risk concentration,   these fully? Have they the

                           connected lending, country and      required rules, regulations in

                           transfer risks, market risks, other place? Have they the required

                           risk (interest rate, liquidity,     technical expertise to evaluate the

                           operational risk), internal control risk existing in banks? Are they

                           systems.                            empowered to take prompt

                                                               corrective measures?

 Principles 16-20          Supervisory risk assessment Have they the conceptual and

 Methods of on-going       systems (offsite surveillance and technical          expertise        for

 Banking Supervision       on-site inspection), external audit supervisory risk assessment? Do

                           reports,              consolidated they have the resource for onsite

                           supervision.                        inspection? Do they have

                                                               information        for        offsite

                                                               supervision?

 Principle 21              Information             disclosure, Are accounting and auditing

 Information               accounting standards periodicity systems in place? Are banks using

 Requirements              and     accuracy     of    reports, valuation methods, which are

                           confidentiality of information.     reliable?     Is    the     required

                                                               information properly disclosed? Is

                                                               confidentiality kept?

 Principle 22              Prompt corrective measures, Are supervisors equipped with the

 Formal Powers of          liquidation procedures.             power and resources for prompt

 Supervisors                                                   corrective measures? Are laws in

                                                               place to enforce liquidation?

 Principle 23-25           Responsibilities of law and host Is consolidated supervision in

 Cross Border Banking      country supervisors.                place? Is there cooperation with

                                                               supervisors from outside?

*This information is extracted from the Core Principles (1997) document of the BCBS.

102


**This information is based on the Core Principles Methodology (1999) document of the BCBS.

                                                                                         103


         If the main objective of the Core Principles of effective banking

supervision is enhancing financial stability, technical assessment of the

compliance with these principles can provide useful insight in increasing the

effectiveness of various policies. A recent study conducted by the IMF staff

concludes that indicators of credit risks and bank soundness are primarily

influenced by macroeconomic and macro-prudential factors and that the direct

influence of the compliance with the Core Principles is insignificant in this

regard. The study suggests that the compliance could indirectly influence risk

through the transmission mechanism of effecting the macroeconomic variables45.

However, it may be noted that the existence of sound macroeconomic policies

and conditions is considered as one of the important pre-conditions for effective

banking supervision.

4.2.3 Risk Disclosures: Enhancing Transparency about the Future

         The market mechanism functions efficiently with complete information.

Information cannot be considered complete unless it is transparent and timely.

There are many channels of disclosing such information to clients, shareholders,

debtors, supervisors and regulators and above all to the market. These channels

are annual reports, supervisory and regulatory review reports, external credit

assessment reports whenever available, periodic regulatory reports, reports of

market intelligence, stock market information and debt-market information etc.

The set of information provides a critical input to investors for allocating their

investment in accordance with their appetite for risk adjusted returns.

Transparency reduces moral hazard and adverse selection and enhances

efficiency and integrity of the markets and strengthens market discipline. Market

discipline is strengthened not only by the timely availability of appropriate

information about the risk level of a firm, but it is also effected by the

information about the firm’s risk management processes. Hence disclosure of

information is effective only if (a) it provides information about the risk of the

firm and (b) it provides information about the risk management processes of the

firm.

         The traditional channels of information have been effective in providing

information about the levels of risks faced by a firm in the past as accounting

standards can largely cover these risks. However, due to a number of reasons, it

is difficult to set standards for disclosure of future risks and risk management

     ٤٥

        See, Sundrarajan, Marston and Basu (2001).

104


    processes across firms, across market segments and overtime. Some of these

    factors are:46

a. The risk management technologies are changing rapidly due to

   innovations making it difficult to set rigid standards.

b. The financial services industry is itself changing fast and financial

   conglomerations are emerging blurring the difference between the risk of

   various segments of the industry - insurance companies, investment

   banks, commercial banks, etc.

c. Financial instruments are also changing fast due to the financial

   engineering process, making standardized valuation of these instruments

   almost impossible.

d. Due to e-banking, a totally new scenario has developed particularly in

   relation to the control of the banks on their own banking infrastructure.

   The Internet-based banking networks surpass regulatory jurisdictions.

   The infrastructure providers practically control all the e-banking

   information. Above all, the technology changes very fast.

e. There are borrower incentives for not disclosing full information. These

   incentives range from hiding information from competitors, tax evasion,

   and conflict of interests among shareholders and providers of funds, etc.

   These factors are so strong that a recent survey of risk disclosure by

   leading international banks found that the quality of disclosures provided

   in the annual reports about risk management practices is far short of the

   expectations. The survey recommends that there must be standardized

   framework for disclosure of risks to enhance comparability of systems

   across firms. Disclosures can be improved in almost all areas, but a lot

   more improvement is needed in non-trading activities as well as credit

   risk in trading activities. Disclosures also need improvement in the use of

   models, internal rating system and safety procedures of using

   computers.47

                Since “one size fits for all” standards are not possible due to the fast

    pace of innovation, management of financial institutions can be most effective in

        46

           See, Ribson, Rajna, “Rethinking the Quality of Risk Management Disclosure Practices”

        http///newrisk.ifci.ch/146360.html

        47

           See, IFCI-Arthur Andersen, "Risk Disclosure Survey", http///newrisk.ifci.ch/ifci-

        AASurvey.html

                                                                                               105


integrating the risk management systems with their annual reports. This requires

the evolution and adoption of:

           One) risk-based accounting systems,

           Two) risk-based auditing systems,

           Three)            risk-based       management          information

                systems, and

           Four) risk-based inventories of all assets of banks.

         The common goal of these processes is to disclose information about the

risks that the firm is expected to face in the future in addition to the traditional

information which relates to the past risks. Once these processes are developed,

the annual reports will not only provide information about the risks faced by

financial institutions in the past but will also disclose sufficient information

about the risk management processes of the institutions and their risks in the

future.

         Disclosures about risk in an institution and the risk management

processes adopted by the institution are so important that the international

regulatory standard setters have produced several reports and guidelines on the

subject.48 Keeping in view the increasing nature of cross-segment activities in

the financial industry, the risks which such activities are bound to pose,

regulators of various sectors need to enhance coordination of their activities to

enhance disclosure and strengthen market discipline. Keeping this consideration

in view a Multidisciplinary Working Group on Enhanced Disclosure was

established in June 1999 jointly by the BCBS, IOSCO, IAIS and Committee on

the Global Financial System of the G-10 Central Banks. The report of the

Working Group was released on April 26, 2001.

         The report makes it clear that there are two complementary types of

disclosures: disclosures about the risks of the institution as given in the

traditional statistical information provided in annual reports about the current

    48

         These reports include: BCBS (1999a) Sound practices for Loan Accounting and

    Disclosure, BCBS (1999b) Best Practices for Credit Risk Disclosures, BCBS (1998),

    Enhancing Bank Transparency, Euro-Currency Standing Committee (1994) Public Disclosure

    of Market and Credit Risks by Financial Intermediaries, BCBS & IOSCO (1999)

    Recommendations for Public Disclosure and Derivative Activities of Banks and Securities

    Firms, BCBS (1997) Core Principles of Effective Banking Supervision, BCBS (1999) the

    New Basel Accord (Pillar-3 Market Discipline). In addition to the www.bis.org most

    resources can be accessed from http://newrisk.ifci.ch/DocIndex/.

106


   health of the institutions, and disclosure about the risk management processes of

   the institution. The second type of disclosure, which is the subject matter of the

   report, is classified into these groups.

     a. A specific minimum level of disclosure must be a part of the

           traditional periodic reports provided by the institution to its

           shareholders, investors, creditors and counterparties.

     b. Disclosure that could be useful, but their costs and benefits are yet

           to be settled.

     c. Certain statistical information could be disclosed which can fill the

           gaps in disclosures of risk management systems. Again this type of

           information needs to be studied further before making it a part of

           the disclosure requirements.

              The study concludes that in order to make disclosures transparent and

   supportive to enhanced market discipline there should be:

        a. A balance between quantitative and qualitative disclosures,

b. Disclosures should basically aim at reflecting the firm’s own true risk.

    To achieve this the comparability (with other firms) may at times be

    sacrificed, and

c. Appropriate disclosure of risk management system can be achieved by

    providing information about intra-period risk exposure instead of the

    traditional system of period-end data.

              The report also recommends to the international standard setters to

   consider enhancement of guidelines on disclosures on risk concentration, credit

   risk mitigation and the evolution of overall risk management systems in financial

   institutions. These recommendations increase the role of supervisors in

   enhancing such disclosures in the framework of risk-based supervision49.

              To achieve financial stability, disclosure requirements for banks can be

   effective only if other agents participating in the economic and financial system

   also comply with the respective standards. The set of international standards

   cover a wide range of important areas such as monetary and financial policy

        49

            For more details see, Working Group (2001), Multidisciplinary Working Group on

        Enhanced Risk Disclosures; Final Report to BCBS, CGFS, IOSCO and IAIS.

                                                                                       107


transparency, fiscal policy transparency, data dissemination, accounting,

auditing, payments settlements, market integrity etc50.

4.3 REGULATION AND SUPERVISION OF ISLAMIC BANKS

         There could be no disagreement on the statement that the risk

management systems in the Islamic banks shall meet the required international

standards. However, as mentioned above a number of risks faced by the Islamic

banks are different as compared to the risks of traditional banks. Therefore,

some international standards meant for traditional banks may not be relevant for

the Islamic banks due to their different nature. Hence the effective supervision of

Islamic banks requires the study of the risks of Islamic banks and formulating

suitable guidelines for the effective supervisory oversight of Islamic banks.

Chapra and Khan (2000) undertake a survey of regulation and supervision of

Islamic banks. Some pertinent conclusions of that study are presented here.

4.3.1 Relevance of the International Standards for Islamic Banks

  a. The Core Principles document sets pre-conditions for effective

      banking supervision. In addition to these pre-conditions, there are

      also a number of other pre-conditions specific for effective Islamic

      banking supervision. One set of these preconditions has to be

      fulfilled by bank regulators and supervisors. These include

      providing a leveled playing field for competition, licensing

      facilities, lender of last resort facility acceptable to the mandate of

      Islamic banks, proper legal framework, proper Sharī‘ah

      supervision, etc. The other set of preconditions has to be met by

      the Islamic banks themselves. These include development of inter-

      bank market and instruments, resolution of a number of unresolved

      Fiqh related issues, development of proper internal control and risk

      management systems, etc.

  b. As for as the Core Principles for effective banking supervision and

      the disclosure and transparency requirements are concerned, these

      are equally relevant for the Islamic banks. Due to the risk sharing

     ٥٠

        For international standards see, Financial Stability Forum, International Standards and

    Codes to Strengthen Financial Systems, (www.fsforum.org/standards/keystds.htm). In

    addition, the Accounting and Auditing Organization for the Islamic Financial Institutions

    (AAOIFI) needs to be mentioned specially as it is the sole standard setter for the Islamic

    financial industry.

108


     nature of Islamic banks, these banks need even more effective

     systems of supervision and transparency.

c. The difficulty in applying the international standards to Islamic

     banks lies in applying capital adequacy standards. First, due to the

     risk sharing nature of their modes of finance, Islamic banks need

     more not lesser capital as compared to traditional banks. Second,

     there is a need to separate the capital of current and investment

     accounts. Third, the need to adapt the international standards for

     the Islamic banks has prompted efforts towards establishing the

     establishment of the Islamic Financial Services Supervisory Board.

     Finally, the supervisory risk assessment systems like CAMELS51

     are equally relevant for Islamic banks and these can be adapted

     without difficulty.

d. A number of advantages of the IRB approach discussed in the

     previous section are relevant for the Islamic banks. First, the

     approach allows mapping the risk profile of each asset

     individually. Since the Islamic modes of finance are diverse, the

     IRB approach suits these modes more than the standardized

     approach. Second, the IRB approach aligns the actual risk

     exposure of banks with their capital requirements. This is

     consistent with the nature of Islamic banks. Third, the IRB

     approach is expected to encourage and motivate banks to develop a

     risk management culture and thereby reduce the risks in the

     banking industry and enhance stability and efficiency. Fourth, it is

     expected to generate reliable data and information and enhance

     transparency and market discipline. Fifth, it will use external credit

     assessment as benchmark, and thus truly integrate internal and

     external information to generate more reliable data. This is

     important because external credit assessment may not have the full

     set of reliable information that an internal-ratings system can have,

     and internal-rating systems may lack the objectivity of external

     ratings. This information, used in harmony with incentives for risk

  51

      The CAMELS rating system refers to capital adequacy, assets quality, management

  quality, earnings, liquidity, and sensitivity to market risks (in some countries also systems

  for internal controls).

                                                                                             109


      management, will be instrumental in controlling moral hazard and

      capital arbitrage.

4.3.2 The Present State of Islamic Banking Supervision

     Most Islamic banks are located in the member countries of the IDB. The

study mentioned above identifies a number of issues regarding the present state

of Islamic banking supervision.

    a. A growing number of these countries are in the process of adopting and

        effectively implementing the international standards, namely, Core

        Principles, minimum risk-weighted capital requirements and the

        international accounting standards. In applying the risk-weighting

        methodologies to Islamic banks, there are difficulties reported due to the

        diverse nature of the Islamic modes of finance. Compliance with the

        standards set by the Accounting & Auditing Organization for Islamic

        Financial Institutions (AAOIFI), has not yet fully materialized. Only

        Bahrain and Sudan have so far adopted these standards.

    b. Some countries including Iran, Pakistan and Sudan are undertaking

        financial sector reform programs. Strengthening the capital of banks is

        an important part of these programs. Since most Islamic banks are very

        small, some countries have announced a program of mandatory merger

        of Islamic banks to strengthen their capital base.

    c. An increasing number of countries where there are Islamic banks

        located, are putting in place both Off-site and On-site supervisory

        systems. The famous On-site supervisory risk assessment system,

        namely, CAMELS is also being used in some countries. Islamic banks

        are generally being supervised within the framework of the prevailing

        international commercial banking supervisory systems. In some

        countries special laws have been introduced to facilitate Islamic

        banking, while in others no such laws exist. Islamic banking operations

        in the latter group of countries are performed under the guidelines issued

        by their respective central banks.

    d. In almost all those countries where Islamic banks are operating,

        commercial banking functions are segregated from securities and

        insurance businesses, and distinct authorities are assigned the

        supervisory task. Malaysia is the only exception, where banks and

110


         insurance companies are supervised by the central bank. However, the

         global trend is inclined towards the concept of universal banking with

         emphasis on supervision by a single mega-supervisor. Moreover,

         commercial banks in these countries are supervised by central banks.

         However, the emerging trend in the world is to segregate the monetary

         policy framework of macroeconomic management from the

         microeconomic considerations of bank soundness. As a result of this

         segregation, banking supervision is being separated from monetary

         policy and being assigned to a specialized authority. In cases where

         different supervisory authorities specialize in supervising different

         banking and non-banking financial institutions, the need for cooperation

         and coordination between these authorities increases.

    e. In some countries conventional banks are allowed to open Islamic

         windows, while in other countries this is not allowed.

    f. Most private banks have their own Sharī‘ah supervisory boards.

         However, in Malaysia, Pakistan and Sudan the central banks have a

         central Sharī‘ah board. In Pakistan the Council of Islamic Ideology and

         the Federal Shariat Court are empowered to review all laws in the light

         of the Sharī‘ah. The Federal Shariat Court has declared interest to be a

         form of Ribā.

    g. A number of characteristics of Islamic banks require that the existing

         international standards need to be properly adapted to apply these to

         Islamic banking supervision effectively. The risk sharing nature of

         investment deposits, the risks of various Islamic products, the

         availability of risk management instruments, the presence of institutional

         support such as lender of last resort facility and deposit protection are

         some of the most important among these factors.

4.3.3 Unique Systemic Risk of Islamic Banking

         Transmission and mixing of risks between different segments of the

financial services industry can be a source of improper identification of risks and

lack of their effective mitigation. Each segment of the financial services industry

is specialized in specific types of risks. For example, the insurance industry in

general deals with risks, which are of long-term in nature. Banks on the other

hand are good in managing short-term risks. The banking book of a bank

constitutes those risks, which profile the risk appetite of its depositors. The

                                                                                111


trading book and fund management activities cater for the risk preferences of

investors. Hence specialization by financial institutions in different types of risks

enhances efficiency in identifying, pricing and mitigating the various risks.

Cross-segment transmission of the various risks can thus cause the mixing of

these various risks, and can trigger a conflict in the risk profile of the various

users of financial services and can weaken the customers confidence in the

overall financial intermediation system. This could cause macroeconomic

inefficiency as well as systemic instability. Therefore, most regulatory regimes

attempt to block such transmission of risks either by preventing cross-segment

activities of different institutions or by requiring separate capital and other

firewalls between the risks of activities of a bank in different sectors.

4.3.3.1 Preventing Risk Transmission

         The raisons d’être of Islamic banking is conducting business practices

consistent with the religious prohibition of Ribā. Ribā is a return (interest)

charged in a loan (Qar) contract. This religious injunction has sharpened the

differences between current accounts (interest free loans taken by owners of the

Islamic bank) and investment deposits (Muārabah funds). In the former case,

the repayment on demand of the principal amount is guaranteed without any

return. In case of investment deposits, neither the principal nor a return is

guaranteed. The owners of current accounts do not share with the bank in its

risks. Whereas, the owners of investment accounts participate in the risks and

share in the bank’s profits on pro rata basis. The contracts of Qar and

Muārabah are thus the fundamental pillars of Islamic banking and their

characteristics must fully be protected for the preservation of the uniqueness of

Islamic banks.

         In all Islamic banks sizeable proportion of funds under management are

comprised of current accounts. In some Islamic banks these accounts constitute

more than 75% of total funds under management. Thus current accounts are the

strength of Islamic banks as these are a vital source of their free money. The use

of funds of investment deposits (Muārabah money) along side such huge

proportion of borrowed money is unprecedented in the history of the Islamic

financial system. It poses at least two important challenges to Islamic banks,

namely the challenge of systemic risk and the challenge of barriers to market

entry.

112


         The current account holders need to be fully protected against the

business risks of the bank. The investment account holders need to fully

participate in the business risks of the bank. But the current accounts are

guaranteed only theoretically in the sense that in case of a confidence problem,

the Islamic bank is not in a position to return all the accounts on demand. The

more an Islamic bank relies on these funds the more serious this systemic

problem is. This means that in case of crisis, the risks of the assets of investment

deposits will be borne by the current account holders. Since most Islamic banks

operate in jurisdictions where deposit insurance and lender of last resort facilities

are not available, this systemic risk is serious in nature.

         Even though investment deposits are theoretically assumed to share the

business risks of the bank to the extent that investment deposits finance the

businesses, these deposits are also not immune to the systemic risks posed by the

current accounts. Current accounts tend to increase the leverage of the Islamic

banks, their financial risks and hence adversely affect their overall stability.

Thus in a crisis situation, the risks of one type of deposits cannot be separated

from the risks of the other type of deposits. This is not only systemically

unstable but also against the basic premises of Qar and Muārabah – the two

pillars of the unique nature of Islamic banking. A number of suggestions are

made to prevent the confidence problem, which may arise due to the

transmission of risks between the two accounts.

     a. Some researchers suggest a 100% reserve requirement for current

         accounts. As mentioned earlier current accounts are a vital source of

         strength of Islamic banks. The drastic measure of 100% reserve

         requirement will no doubt enhance systemic stability, but it imposes an

         unreasonable cost on the Islamic banks due to which they may not be

         able to even survive in the competitive markets.

     b. The BMA has introduced prudential rules whereby it is mandatory to

         disclose all assets financed by current accounts separately and all assets

         financed by investment deposits separately.

     c. In some regulatory jurisdictions the reserve requirements for current

         accounts are much higher as compared to investment deposits.

     d. Some other regulatory regimes combine the requirements as mentioned

         in the second and third cases.

                                                                                 113


    e. The AAOIFI has suggested a more elaborate and systematic procedure

         to tackle the subject. The AAOIFI scheme is worth of discussing in more

         detail.

         The AAOIFI’s main concern has been to develop accounting, auditing

and income recognition standards for the Islamic financial institutions so that

transparency and disclosures can be enhanced in these institutions, which is an

Islamic requirement for conducting fair and honest business. In the process of

developing the standards, AAOIFI found that most Islamic banks are reporting

their investment deposits as off-balance sheet items. After a thorough technical

analysis, AAOIFI reached two crucial conclusions.

    a. There is a need to differentiate two types of investment deposits; those

         restricted to a specific use and general-purpose unrestricted deposits.

         The magnitude of the first type of deposits is very small as compared to

         the second type of deposits. While the Islamic banks can continue

         keeping the first type of deposits off-balance sheet, the second type of

         deposits shall be kept on-balance sheet. In all our discussion, investment

         deposits imply this type of deposits.

    b. The bank while managing investment deposits must face fiduciary and

         displaced commercial risks. Fiduciary risk can be caused by breach of

         contract by the Islamic bank. For example, the bank may not be able to

         fully comply with the Sharī‘ah requirements of various contracts. While,

         the justification for Islamic banking is the compliance with the Sharī‘ah,

         an inability to do so or not doing so willfully can cause a serious

         confidence problem and deposit withdrawal. Displaced commercial risk

         implies that the bank though may operate in full compliance with the

         Sharī‘ah requirements, yet may not be able to pay competitive rates of

         return as compared to its peer group Islamic banks and other

         competitors. Depositors will again have the incentive to seek

         withdrawal. To prevent withdrawal, the owners of the bank will need to

         apportion part of their own share in profits to the investment depositors.

         The AAOIFI thus suggests that the Islamic bank’s capital shall bear the

         risks of all assets financed by current accounts and capital. In addition,

         the capital shall also bear the risks of 50% of assets financed by the

         investment deposits. The risks of the remaining half of the assets

         financed by the investment deposits shall be borne by the investment

         depositors.

114


         The results of our survey reported in section three of the paper show that

the risk of withdrawal is in fact a nightmare for the managers of Islamic banks.

This risk is indeed more serious in Islamic banks as compared to conventional

banks. This is because, neither the principal nor a return is guaranteed in Islamic

banks’ investment deposits unlike the deposits of conventional banks. Although

the nature of Islamic banks’ investment deposits does introduce market

discipline, it also causes a potential confidence problem as compared to

traditional bank deposits. Therefore, Chapra and Khan (2000) show reservations

about the AAOIFI suggestion to make capital responsible for the risks of only

50% of assets financed by investment deposits, as this will weaken the capital of

Islamic banks. They argue that due to the confidence problem mentioned above

Islamic banks in fact should need more capital as compared to conventional

banks. A stronger capital base coupled with the market discipline introduced by

the nature of investment deposits can indeed make Islamic banks more stable

and efficient.

4.3.3.2 Preventing the Transmission of Risks to Demand Deposits

         The main concern of AAOIFI namely, the prevention of the

transmission of risks of investment deposits to current accounts is of a

fundamental nature. To strengthen this concern, Chapra and Khan (2000)

suggest for the consideration of standard setters that the capital requirement for

demand deposits must be completely separated from the capital requirement for

investment deposits. Islamic banks can thus have two alternatives with respect to

capital adequacy requirements as given in Figure 4.1. The first alternative would

be to keep demand deposits in the banking book and investment deposits in the

trading book with separate capital adequacy requirements for the two books. The

second alternative would be to pool investment deposits into a securities

subsidiary of the bank with separate capital adequacy requirement. There could

be other subsidiaries, of an Islamic bank but all with separate capital

requirements. These alternatives are expected to introduce a number of benefits

over the existing systems.

    a. These will align the capital requirements of the two different deposits to

         their respective risks. Demand deposits are the main source of leverage

         of the Islamic banks as a source of free money. These depositors

         therefore, need more protection as compared to investment account

                                                                                115


    holders. Therefore, the capital as well as statutory reserve requirements

    must be substantially higher for demand deposits.

116


                            Figure 4.1

Proposed Capital Adequacy Alternatives for Islamic Banks

                 THE EXISTING SYSTEM

                              BANK

                  Capital

                                  Current Accounts

                             Investment Accounts

              PROPOSED ALTERNATIVE - 1

                               BANK

                               TRADING BOOKBANKING BOOK

     Capital                   Capital

     Current Accounts            Investment Accounts (Mutual Fund)

    SUBSIDIARIES

    Capital

              PROPOSED ALTERNATIVE - 2

                             BANK

               Capital

                                    Current Accounts

    INVESTMENT SUBSIDIARY                    OTHER SUBSIDIARIES

    Capital                               Capital

     Investment Accounts (Mutual

                           Fund)

                                                                   117


    b. As for as the risk-return tradeoff is concerned, investment deposits and

         mutual funds are not much different. However, mutual funds are

         considered to be more transparent, liquid, and efficient in the allocation

         of returns to risks. Therefore, several policy oriented writings, judgment

         of courts and research works have called for establishing mutual funds

         of various types. Capital requirements provide a strong incentive to

         establish mutual funds. There is also evidence on this in many regulatory

         jurisdictions. In these regimes, regulatory capital have played an

         important role in creating incentives for securitization by requiring lower

         capital for trading activities as compared to banking book activities of

         financial institutions. As a result, the size of banking book activities of

         banks has declined sharply overtime, and that of trading book activities

         has widened.52 This incentive effect of regulatory capital can be

         replicated in Islamic banks so that the investment accounts of these

         banks get gradually transformed into mutual funds. The relatively lower

         capital adequacy requirement on investment accounts (mutual funds) can

         provide a strong incentive to Islamic banks to develop mutual funds,

         enhance PLS financing and ensure efficient risk sharing, market

         discipline and transparency in the distribution of returns.

    c. As mentioned above, the uniqueness of Islamic banking lies in the fact

         that the owners of Islamic banks raise demand deposits as interest-free

         loans (Qar) and investment deposits as Muārabah funds. Unless the

         transmissions of any risks between the two types of deposits are

         completely prevented, this unique characteristic of Islamic banking

         cannot be preserved. In this regard, separate capital adequacy standards

         will serve the firewalls and safety net requirements of major regulatory

         and supervisory jurisdictions around the world. Furthermore, these

         alternatives will also help eliminate the difficulty of treating investment

         accounts while applying the international capital adequacy standards. In

         addition, segregation of the depository function of Islamic banks from

         their investment function, will make these banks more credible and

         acceptable under almost all jurisdictions, thus enhancing the growth of

         Islamic finance. This will enhance acceptability of Islamic banking in

         majority regulatory regimes and will remove barrier to market entry.

    52

       See for example, European Commission (1999), and Dale (1996).

118


4.3.3.3 Other Systemic Considerations

    a. Transmission of the risk of permissible income and impermissible

        income is a serious systemic risk in conventional banks offering Islamic

        banking windows. This risk can be controlled if the Islamic banking

        windows of these banks are brought under separate capital.

    b. Establishment of specialized subsidiaries with separate capital can also

        enhance the level of diversification of the business of Islamic banks.

        Such a diversification can contribute to proper control of their business

        risks. However, it is also prudent to ensure consolidated supervision of

        the Islamic banks like traditional banks.

    c. The unique risks of Islamic modes of finance, the nonexistence of

        financial instruments, restrictions on sale of debts, and other special

        features of Islamic banking force the Islamic banks to maintain a high

        level of liquidity. This naturally affects their income adversely. As a

        result, the withdrawal risk is strengthened. In this manner, unless these

        risk factors are properly managed, they can culminate into a serious

        systemic instability.

                                                                              119


                                                 V

                       RISK MANAGEMENT:

              FIQH RELATED CHALLENGES

5.1 INTRODUCTION

          The discussion of the previous sections shows that Islamic banks can be

expected to face two types of risks – risks that are similar to the risks faced by

traditional financial intermediaries and risks that are unique due to their

compliance with the Sharī‘ah. Consequently the techniques of risk identification

and management available to the Islamic banks could be of two types. The first

type comprises of standard techniques, such as risk reporting, internal and

external audit, GAP analysis, RAROC, internal rating, etc., which are consistent

with the Islamic principles of finance. The second type consists of techniques

that either need to be developed or adapted keeping in view the requirements for

Sharī‘ah compliance. Hence the discussion of risk management techniques vis-

à-vis Islamic banking is a challenging one. In a study like this, these challenges

can neither be identified fully, nor can these be resolved even partially. The

objective of this section is to initiate a discussion on some aspects of the unique

risks faced by Islamic banks with a view to highlight the challenges and

prospects of mitigating these within the framework of the Islamic principles of

finance. However, in the outset, we briefly discuss the attitude of Islamic

scholars towards risk.

5.1.1 Attitude towards Risk

          Risk is assigned significant importance in Islamic finance. Both the two

foundational Fiqhī axioms of Islamic finance, namely, a) al khirāju bi al-amān

and b) al ghunmu bi al-ghurm are in fact risk-based. Together the two axioms

can be described to mean that entitlement to the returns from an asset is

intrinsically related to the responsibility of loss of that asset53. Interest-based

financial contracts separate entitlement to return from the responsibility of loss

by protecting both the principal amounts of a loan as well as a fixed return on it.

Hence, these contracts transfer the risks of loans to the borrower while the lender

retains the ownership of the funds. Islamic finance prohibits the separation of

     53

        See, Kahf and Khan (1992) for an elaborate discussion of this premises.

120


entitlement to return from the responsibility for ownership. By doing so risk

transferring is discouraged and risk sharing is encouraged.

          This does not however mean that the individual’s attitude towards risk is

subjected to any rigid rules. Due to their natural inclinations, some individuals

may like to take more risks than others do and others may like to avoid risk at

all. The universal principle of risk aversion, that expected return from an

investment depends on the level of the investment’s risk – higher risks warrant

the expectation for higher returns and lower risks warrant the expectation for

lower returns is also accepted by the Islamic scholars.

          However, the rule of non-separation of entitlement to returns from the

ownership risks led Islamic economists to theorize that most needs of an Islamic

economy would be met by the risk sharing arrangements; leaving no role for

debt finance to play54. Hence within the framework of an interest-free (profit and

loss sharing – PLS) economy the effect of leverage on asset growth and the

resultant financial risks were ignored in the initial theoretical literature. If a bank

is financed only by risk sharing, the dollar value of its assets will be equal to the

dollar value of its equity; a dollar of equity capital will bear the burden of risks

of a dollar in assets. For a 100% equity-based firm, this risk can be referred to as

its normal business risk. As soon as the firm inducts debt finance, the dollar

value of its assets start exceeding the dollar value of its equity by the amount of

the debt finance inducted. In this case, a dollar of the equity capital of the firm

faces the risks of assets in excess of a dollar. This excess burden of risks faced

by the equity capital is due to the debt-financed assets and this can be referred to

the firm’s financial risk. The theoretical literature characterizes the Islamic

economy mainly PLS based, hence it ignores the fundamental difference

between the two types of risks and its implications for stability of Islamic

financial institutions.

          It is in the nature of the banking business that assets exceed bank capital

several times. The Islamic banks are not an exception to this general rule

particularly due to their utilization of demand deposits for financing assets.

Islamic scholars agree that under such a condition, banks working on behalf of

depositors need to be very cautious about risks55.

     54

        See, e.g. Siddiqi (1983).

     55

        See, Zarqa (1999).

                                                                                    121


         From this brief discussion we can derive two important conclusions

regarding the attitude of Islamic scholars towards risk. First, liabilities and

returns of an asset cannot be separated from each other. Indeed, this condition

has a far-reaching implication for all Islamic financial contracts. Second,

common people do not like risk; banks working on their behalf must be cautious

and avoid excessive risk taking.

5.1.2 Financial Risk Tolerance

         Is it desirable for the Islamic banks to carry the same level of financial

risks as their peer group conventional banks carry? Or should one expect that

due to the nature of Islamic modes of finance, the Islamic banks should be

exposed to more risks as compared to conventional banks?

         It is hard to bring practice and theory together for an answer to these

questions. From a practical perspective, banks should eliminate their financial

risks if possible. For example, without credit risks they will not be required to

apportion part of their current income in loan loss reserves. They can use their

capital more efficiently to accumulate assets, and maximize their rates of return

on equity. This can enable the Islamic banks to pay higher returns to the

investment deposit holders who take more risks as compared to the depositors of

traditional banks. Hence the Islamic banks can maintain their competitive

efficiency. Therefore, the existence of financial risk is an undesirable cost for the

Islamic banks, exactly in the same manner as it is undesirable for the

conventional banks. If the Islamic banks have to carry the same level of financial

risks as their peer group traditional banks, they require simplifying and refining

the Islamic modes of finance to make the risk profile of these modes exactly at

par with the risk profile of interest-based conventional credits.

         However, from the theoretical perspective, in this regard, the challenge

is that as a result of such an oversimplification and refinement the Islamic modes

of finance can lose their Islamic characteristics and hence their raison d’être.

Thus from the perspective of the mandate of the Islamic banks, such a

refinement and simplification may not be possible. This is because all Islamic

modes of finance are based on undertaking real transactions and banks are

expected to take a certain degree of ownership risks in order to justify a return

on finance. To the extent of the existence of this inevitable level of additional

risks in the Islamic banks as compared to conventional banks, the Islamic banks

122


will need to keep additional capital and develop more rigorous internal control

and risk management techniques.

5.2. CREDIT RISKS

         Credit risk is the most important risk faced by banks, because defaults

can also trigger liquidity, interest rate, downgrade and other risks. Therefore, the

level of a bank's credit risk adversely affects the quality of its assets in place. Do

the Islamic banks face more credit risks as compared to conventional banks or

less? A preliminary answer to this question depends on a number of factors, such

as:

         One)    General credit risk characteristics of Islamic financing,

         Two) Counterparty risk characteristics of specific Islamic modes of

             finance,

         Three) Accuracy of expected credit loss calculation, and

         Four)   Availability of risks mitigating techniques.

         The first two points have been discussed in sections two and three of the

paper. Here we discuss the last two points in more detail.

5.2.1 Importance of Expected Loss Calculation

         The process of credit risk mitigation involves estimating and minimizing

expected credit losses. Calculation of expected credit losses, requires the

calculation of probability of default, maturity of facility, loss given default,

exposure at default and the sensitivity of the assets’ value to systematic and non-

systematic risks. Expected loss calculation is relatively easier for simple and

homogenous contracts as compared to relatively complex and heterogeneous

contracts. Since the Islamic financial contracts are relatively complex as

compared to the interest-based credit, the accurate calculation of expected losses

is supposed to be relatively challenging for the Islamic contracts. The lack of

consensus in dealing with a defaulter, illiquid nature of debts etc., add to the

complexity of this matter.

         This challenge can be overcome by adapting the foundation IRB

approach as suggested in section four of this paper. Although our survey results

in section three reveal that most Islamic banks, who responded to the

                                                                                   123


questionnaire, already use some form of internal rating systems, it is early for the

Islamic banks to qualify for the IRB approach for regulatory capital allocation.

Nevertheless, the presence of some form of internal ratings in these banks

implies they can enhance their systems with an objective to gradually qualify for

the IRB approach. If that happens, these banks will be expected to initially

follow the supervisory benchmark LGD and the risk weights as given in Table-

5.156. Gradually, the banks can develop their own systems of calculating the

LGD and can graduate to the advanced IRB approach.

                                                  Table 5.1

                              Benchmark Regulatory Risk Weights

                                       (Hypothetical, LGD 50%)

        Probability of Default % Corporate Exposures                Retail Exposures

                    0.03                           14                         6

                    0.05                           19                         9

                     0.1                           29                        14

                     0.2                           45                        21

                     0.4                           70                        34

                     0.5                           81                        40

                     0.7                          100                        50

                      1                           125                        64

                      2                           192                       104

                      3                           246                       137

                      5                           331                       195

                     10                           482                       310

                     15                           588                       401

                     20                           625                       479

                     30                             -                       605

      Source: The New Basel Accord

5.2.2 Credit Risk Mitigation Techniques

          A number of standard systems, methods, and procedures for credit risk

mitigation are also relevant for the Islamic banks. In addition, there is also a

need to keep in view the unique situation of these banks. A number of the

standard systems and some additional considerations are discussed here in

relation to the credit risk management of Islamic banks.

5.2.2.1 Loan Loss Reserves

    56

       It needs to be emphasized that at this stage the New Basel Accord is only a proposal. But it

    is expected that the IRB approach will remain as an important part of the final document.

124


       Sufficient loan loss reserves offer protection against expected credit

losses. The effectiveness of these reserves depends on the credibility of the

systems in place for calculating the expected losses. Recent developments in

credit risk management techniques have enabled large traditional banks to

identify their expected losses accurately. The Islamic banks are also required to

maintain the mandatory loan loss reserves subject to the regulatory requirements

in different jurisdictions. However, as discussed above the Islamic modes of

finance are diverse and heterogeneous as compared to the interest-based credit.

These require more rigorous and credible systems for expected loss calculation.

Furthermore, for comparability of the risks of different institutions there is also a

need for uniform standards for loss recognition across modes of finance,

financial institutions and regulatory jurisdictions. The AAOIFI Standards # 1

provides for the basis of income and loss recognition for the Islamic modes of

finance. However, except for a few institutions, banks and regulatory

organizations do not apply these standards.

       In addition to the mandatory reserves some Islamic banks have established

investment protection reserves. The Jordan Islamic Bank has pioneered the

establishment of these reserves. The reserves are established with the

contributions of investment depositors and bank owners. The reserves are aimed

at providing protection to capital as well as investment deposits against any risk

of loss including default. However, investment deposit holders are not

permanent owners of the bank. Therefore, contributions to the reserve by old

depositors can be a net transfer of funds to new depositors and to the bank

capital. In this manner these reserves cannot ensure justice between old and new

depositors and between depositors and bank owners. This problem can be

overcome by allowing the depositors to withdraw their contributions at the time

of final withdrawal of deposits. However, such a facility will not be able to

provide a protection in the case of a crisis.

5.2.2.2 Collateral

         Collateral is also one of the most important security against credit loss.

Islamic banks use collateral to secure finance, because al-rahn (an asset as a

security in a deferred obligation) is allowed in the Sharī‘ah. According to the

principles of Islamic finance, a debt due from a third party, perishable

commodities and something, which is not protected by the Islamic law as an

asset, such as an interest-based financial instruments are not eligible for use as

collateral. On the other hand, cash, tangible assets, gold, silver and other

                                                                                  125


precious commodities, share in equities, etc., and debt due from the finance

provider to the finance user are assets eligible for collateral. We discuss a

number of general characteristics of the collateral, which is available in the

Islamic financial industry.

    a) As discussed in section four, in the proposed New Basel Accord some

        types of collateral are given regulatory capital relief depending on the

        quality of the collateral and subject to the standardized regulatory

        haircuts as given in Table 5.2. These standards show that cash and

        treasury bills are the most valuable collateral and can be given very high

        regulatory capital relief. Suppose two clients offer collateral of dollars

        100 each, e.g., US treasury bills of one-year maturity and the main index

        equities, respectively. The haircut for the first collateral is 0.5% (the

        collateral value after this haircut is dollars 95). In the second case, the

        collateral haircut is 20% (collateral value is dollars 80). In the first case,

        the capital requirement will be lesser as compared to the second case.

        The Islamic banks not being able to take the first type of collateral, will

        be considered more risky.

    b) There may be some assets, which from the Islamic banks’ point of view

        are good collateral and deserve a regulatory capital relief. For example, a

        carefully selected asset financed by the Islamic bank may be at least as

        good a collateral as a 5-year maturity bond issued by a BBB corporate

        entity. Since the Islamic bank’s asset is not in the list of eligible

        collateral, it is subject to a 100% haircut; the BBB-bond in this case is

        subject to only a 12% haircut. For the purpose of regulatory capital

        relief, the Islamic bank’s asset is worth nothing, whereas the bond is

        worth dollars 88 (considering the collateral value as dollars 100).

    c) Due to restrictions on sale of debts, there are no liquid Islamic debt

        instruments. However, in view of their liquid nature debt instruments

        like treasury bills etc., are generally considered as good collateral. These

        assets are not available to the clients of Islamic banks to offer.

    d) The Islamic banks have limited recourse to the assets they finance. As

        compared to this the conventional banks can have unlimited recourse to

        the assets of their clients. On a stand-alone basis, a particular asset

        financed by the Islamic bank may depreciate fast even though during the

        same time the firm’s assets may gain value in general. Thus due to its

126


     limited recourse nature, the quality of the Islamic banks’ collateral may

     in fact be lower as compared to the collateral of the peer group

     conventional banks. Moreover, the value of limited recourse collateral is

     normally highly correlated with the exposure of the credit. If the credit

     goes bad, the collateral value depreciates too. Good quality collateral

     should not have such a characteristic. Furthermore, if stand-alone

     collateral depreciates faster in value as compared to the firm’s other

     assets; there is an incentive to default.

                                         Table 5.2

Standard Supervisory Haircuts for Collateral in % of Collateral Value

Issue rating for debt     Residual Maturity       Sovereigns   Banks/

securities                                                     Corporates

                          ≥ 1 year                0.5          1

AAA/AA                    > 1 year, ≤ 5 years     2            4

                          > 5 years               4            8

                          ≥ 1 year                1            2

A/BBB                     > 1 year, ≤ 5 years     3            6

                          > 5 years               6            12

                          ≥ 1 year                20

BB                        > 1 year, ≤ 5 years     20

                          > 5 years               20

Main index equities                               20

Other equities listed on a recognized exchange    30

Cash                                              0

Gold                                              15

Surcharge for foreign exchange risk               8

   Source: The New Basel Accord

 e) The legal systems in the jurisdictions in which Islamic banks operate do

     not support the qualitative aspects of a good collateral as in most cases it

     is very difficult to obtain control of the asset and convert it into liquidity

     without a high cost. This state worsens further due to the fact that the

     supporting institutional infrastructure for Islamic banking is still in the

     early stages of development. There are no uniform standards to

     recognize a default event, to treat a default event when it happens and to

     litigate disputes.

                                                                               127


         This discussion shows that due to a number of reasons the collateral

available to the Islamic banking industry in general is not eligible for regulatory

capital relief under the proposed international standards. This may be due to the

fact that the Islamic banks are not represented in the standard setting bodies.

They can however, carefully study the consultation documents distributed by the

standard setters and present their own points of view like other institutions.

Furthermore, the industry-wide general quality of collateral depends on a

number of institutional characteristics of the environment as well as the products

offered by the industry. An improvement in the institutional infrastructures and a

refinement of the Islamic banking products can be instrumental in enhancing the

collateral quality and reducing credit risks.

5.2.2.3 On-Balance Sheet Netting

         On-balance sheet netting implies the matching out of mutual gross

financial obligations and the accounting for only the net positions of the mutual

obligations. For example, bank A owes to bank B $ 2 million resulting from a

previous transaction. Independent from this obligation, bank B owes to A $ 2.2

millions. In a netting arrangement, the $ 2 million mutual obligations will match

each other out so that $ 0.2 million will be settled by B as a net amount. There

could be several considerations in this arrangement including the maturity of the

two obligations, and the currencies and financial instruments involved. The

netting process could therefore include discounting, selling and swapping the

gross obligations.

         Carefully prepared, netting overcomes credit risk exposures between the

two parties. With the participation of a third party, playing as a clearinghouse for

the obligations, the arrangement becomes a powerful risk mitigating technique.

Regulators recognize that role but also supervise the netting activities of banks.

The Islamic banks so far have not designed any such mechanism. It can be

considered as an important area for future cooperation between the Islamic

banks particularly, if the market for two-step contracts as discussed in this

section expands in which banks will have more mutual obligations.

5.2.2.4 Guarantees

         Guarantees supplement collateral in improving the quality of credit.

Commercial guarantees are extremely important tools to control credit risk in

conventional banks. Those banks whose clients can provide good commercial

guarantees and who can fulfill other requirements can qualify for regulatory

128


capital relief under the proposed New Basel Accord. Although some Islamic

banks also use commercial guarantees, the general Fiqh understanding goes

against their use. In accordance with the Fiqh, only a third party can provide

guarantees as a benevolent act and on the basis of a service charge for actual

expenses. Due to this lack of consensus, therefore, the tool is not effectively

used in the Islamic banking industry.

         Multilateral Development Banks (MDBs) enjoy special status in the

jurisdiction of their respective member countries. This status has a particular

privilege during times of financial crisis in a member country. Financial crisis

exposes banks’ credit to a country or an institution in its jurisdiction to serious

credit risks. In terms of their foreign exchange reserves some countries are

always in a crisis-like situation. Credit exposure to entities in such jurisdictions

is always risky. This also has an implication for the borrower’s cost of capital in

terms of foreign exchange. The cost of capital in getting finance in local

currency being always lower than the cost of capital in getting finance from

outside.

         Participation in MDB-led syndication provides an automatic guarantee

to a participating commercial bank against the risks as mentioned. Thus it

enhances the finance user’s credit quality often to the extent that the cost

differential between borrowing at home and borrowing abroad is almost

eliminated. This implies that by participating in the MDB-led syndication

schemes, the commercial banks can mobilize funds in foreign currency at the

cost of mobilizing funds in local currency. The syndication generally takes the

form of Figure 5.157.

                                     Figure 5.1

                    Fund Flows in an MDB-led Syndication

   MDB Own Resources

                                   MDB-led

                                    Facility                      Users of

         MDB fund flows                                           funds

             Commercial flows

     57

        See for example, (Hussain 2000), Standards & Poor’s (2001), Asian Development

     Bank (2001).

                                                                                      129


   Commercial Co-financiers

          Based on these arguments, Hussain (2000) suggests that the IDB shall

play a more active role in providing syndicated facilities by strengthening its

existing facilities. By benefiting from the IDB’s preferred status in the member

countries the participating Islamic banks will be able to mitigate their foreign

exchange as well as country risk exposures substantially.

5.2.2.5 Credit Derivatives and Securitization

        As discussed in section two, through credit derivatives the underlying risk

of a credit is separated from the credit itself and sold to possible investors whose

individual risk profile may be such that the default risk attracts their investment

decision. This new mechanism has already been described earlier. It has become

so effective that under certain conditions it is expected to fully protect banks

against credit risks. Therefore, the use of credit derivatives as a risk-mitigating

instrument is on a rapid rise.

          However, at the present, the Islamic banks are not using any equivalent

of credit derivatives. The development of comparable instruments depends on

the permissibility of sale of debts, which is prohibited by almost a consensus

except for Malaysia. In addition to the Malaysian practice, there are a number of

proposals under discussion to overcome the sale of debt issue.

    a. Some studies call for making a distinction between a fully secured debt

          and an unsecured debt. It is argued that external credit assessment makes

          the quality of a debt transparent. Moreover, credit valuation techniques

          have improved drastically. Furthermore, all Islamic debt financing are

          asset-based and secured financing. In view of these developments,

          restrictions on sale of debt may be re-considered (Chapra and Khan

          2000).

    b. Some scholars suggest that although sale of debt is not possible as such,

          but the owner of a debt can appoint a debt collector. For example, if the

          due debt is $ 5 million58 and the owner considers that as a result of

          default 0.5 million may be lost. The owner can offer some amount lesser

          than this estimated loss, say for example 0.4 million to a debt collector.

          The arrangement will be organized on the basis of Wakālah (agency

     58

        See, Al-Jarhi and Iqbal (forthcoming).

130


        contract) or Ju‘ālah (service contract). There seems to be no Fiqhī

        objection to this.

    c. Debt can be used as a price to buy real assets. Suppose, bank A owes

        debts worth $1m to bank B, which are due after 2 years. Meanwhile

        bank B needs liquidity to buy real assets worth $1m from a supplier C

        on deferred basis for 2 years. In this case, subject to the acceptance of C,

        the payments for bank B’s installment purchase can be made by bank A.

        Due to installment sale from C to B, C will charge Murāba ah profit of

        say, 5%. This profit can be adjusted in two ways. First, upon mutual

        agreement the supplier may supply goods worth $0.95 million to bank B

        and the supplier will receive $1m cash from bank A in 2 years. Or as a

        second option, C will receive $1m from A and $0.05m directly from B.

        The implication of this is important. B receives assets worth $1m at the

        present instead of receiving $1m after 2 years, but after paying 5%. As a

        result, in net terms, B receives $0.95m today for $1m after 2 years. Thus

        the arrangement facilitates a Fiqh compatible discount facility. The flow

        of funds and goods resulting from the first case are given in Figure 5.2.

                                     Figure 5.2

                           Sale of Debt for Real Assets

                       Bank A owes to                     Bank B, buys from

                     bank B, $ 1m in 2              supplier C on credit for 2

                                 years                   years worth $ 0.95m

                                          Supplier C, receives

                                             from A, $1m in 2

                                                          years

        The example cited above is based on the permission of the use of debts

in buying goods, services and other real assets. This permission can further be

extended to design quasi debt (equity) financial instruments by embedding

convertibility options. For instance in writing an Islamic debt contract, the user

of funds can inscribe a non-detachable option in the contract that subject to the

preference of the financier the receivables can be used to buy real assets or

                                                                                131


shares from the beneficiary. This option in fact changes the nature of collateral

from a limited recourse to a full recourse as the option can be utilized depending

on the will of the financier. In this manner, it enhances the quality of credit

facility by reducing its risk. The potential of these instruments increases in the

framework of two-step contracts. However, the Islamic banks at the present do

not write such instruments.

5.2.2.6 Contractual Risk Mitigation

         Gharar (uncertainty of outcome caused by ambiguous conditions in

contracts of deferred exchange) could be mild and unavoidable but could also be

excessive and cause injustices, contract failures and defaults. Appropriate

contractual agreements between counterparties work as risk control techniques.

A number of these can be cited as an example.

    a) Price fluctuations after signing a Salam contract may work as a

         disincentive for fulfilling contractual obligations. Hence if the price of,

         for example, wheat appreciates substantially after signing the contract

         and receiving the price in advance, the wheat grower will have an

         incentive to default on the contract. The risk can be minimized by a

         clause in the contract showing an agreement between the two parties that

         a certain level of price fluctuation will be acceptable, but beyond that

         point the gaining party shall compensate the party, which is adversely

         effected by the price movements. In Sudan, such a contractual

         arrangement known as Band al-I sān (beneficence clause) has now

         become a regular feature of the Salam contract.

    b) In Isti nā‘, contract enforceability becomes a problem particularly with

         respect to fulfilling the qualitative specifications. To overcome such

         counterparty risks, Fiqh scholars have allowed Band al-Jazāa (penalty

         clause).

    c) Again in Isti nā‘ financing, disbursement of funds can be agreed on a

         staggered basis subject to different phases of the construction instead of

         lumping them towards the beginning of the construction work. This

         could reduce the banks’ credit exposure considerably by aligning

         payments with the progress of the work.

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    d) In Murāba ah, to overcome the counterparty risks arising from the non-

         binding nature of the contract, up-front payment of a substantial

         commitment fee has become permanent feature of the contract.

    e) In several contracts, as an incentive for enhancing re-payment, a rebate

         on the remaining amount of mark-up is given.

    f) Due to non-presence of a formal litigation system, dispute settlement is

         one of the serious risk factors in Islamic banking. To overcome such

         risks, the counterparties can contractually agree on a process to be

         followed if disputes become inevitable. This is particularly significant

         with respect to settlement of defaults, as interest-based debt re-

         scheduling is not possible.

    g) It can be proposed that to avoid the default by the client in taking

         possession of the ordered goods, the contract shall be binding on the

         client and not binding on the bank. This suggestion assumes that the

         bank will honor the contract and supply the goods as contractually

         agreed, even if the contract is not binding on it. An alternative proposal

         could be to establish a Murāba ah clearing market (MCM) to settle

         cases, which may not be cleared due to the non-binding nature of the

         Murāba ah contract.

    h) Since the Murāba ah contract is approved with the condition that the

         bank will take possession of the asset, at least theoretically the bank

         holds the asset for some time. This holding period is almost eliminated

         by the Islamic banks by appointing the client as an agent for the bank to

         buy the asset. Nevertheless, the raison d’être of approving the contract is

         the responsibility of the bank for the ownership risk. For this risk

         therefore, capital needs to be allocated.

         All these features of contracts serve to mitigate counter party default

risks. Similar features can enhance the credit quality of contracts in different

circumstances. It is desirable to make a maximum benefit of such features

wherever new contracts are being written.

5.2.2.7 Internal Ratings

         All banks undertake some form of internal evaluation and rating of their

assets and clients, particularly, for maintaining the regulatory loan loss

provisions. Depending on the sophistication of banks, these systems can be

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different in different banks. Some banks have recently developed formal internal

rating systems of the client and/or the facility. As discussed above, in a general

sense an internal rating system can be described to be a risk-based inventory of

individual assets of a bank.

          These systems identify credit risks faced by the banks on an asset-to-

asset basis in a systematic and planned manner instead of looking at bank's risk

on an entire portfolio basis. The asset-to-asset coverage of the system makes it

more relevant for banks whose asset structures are less homogenous. The

Islamic modes of finance are diverse and have different risk characteristics. For

example, a credit facility extended to a BBB rated client on the basis of

Murāba ah, Isti nā‘, leasing and Salam will have different not uniform risks

exposures. The risk exposure is expected to be different not only across modes

of finance but also across clients. For example, if there are two clients both rated

as BBB, due to the different nature of the businesses of the two clients, risk

exposure of the same mode can be different for the different clients. In addition,

different maturity can have different implication for risk across modes and

across clients. Therefore, due to the diversity of the Islamic modes of finance, it

is appropriate for the Islamic banks to measure the risk of each asset separately.

Developing a system of internal ratings can be instrumental in doing this.

          Various banks use different systems. For establishing a basic internal

rating system in a bank, two basic information are required - maturity of the

facility and credit quality of the client. Maturity of facility is known in all cases

of funding. Credit quality of the client can be assessed by various means. The

client may have a previous record with the bank, it may be rated by rating

agencies and it must have audited reports. Moreover, the general reputation of

the client, and the type of collateral provided can also be helpful. Putting all

these and other relevant information together wherever available, bank staff can

judgmentally assess the clients’ credit quality.

          Once this information is available, each client can be assigned an

expected probability of default. After having information about the maturity of

each facility and expected default probability for each client, as a first step, this

information needs to be mapped together as in Table – 5.359. As a second step, a

benchmark credit risk weight is assigned. In Table – 5.3 this benchmark credit

risk weight (100%) is for a probability of default of 0.17% - 0.25% for a facility

     59

        The table is based on ISDA (2000).

134


with a maturity of 3 years. With the same probability of default, the credit risk

weight for a facility of 2 years’ maturity will be 20% less than the benchmark

and for a 4 years’ maturity 18% more than the benchmark.

                                                                             135


                                                                  Table 5.3

                Hypothetical Internal Rating Index Relative to 3 Year Asset with

                     (Default Probability of 0.17% - 0.25% = 100%)

 Probability

 of default %     0.5 Ysr   0.5-1Yrs   1-2Yrs   2-3Yrs   3-4Yrs     4-5Yrs   5-6Yrs   6-7Yrs   7-8Yrs   8-9Yrs   > 9Yrs

 0.00-            6         8          12       17       21          25      28       32       36       40       43

 0.025

 0.025-           9         12         17       23       29          35      40       46       51       56       60

 0.035

 0.165-           48        69         80       100      118         134     149      164      178      191      203

 0.255

 0.255-           72        86         108      130      150         168     186      202      216      230      241

 0.405

         Most Islamic banks are technically capable to initiate some form of

internal credit risk weighting of all their assets separately. In the medium and

longer-run these could evolve into more sophisticated systems. Initiation of such

a system can be instrumental in filling the gaps in the risk management system

and hence enhancing the rating of these by the regulatory authorities and

external credit assessment agencies.60

         At this stage, it is too early for the Islamic banks to qualify for even the

foundation IRB approach for regulatory capital allocation. However, one needs

also to reemphasize that the IRB approach is more consistent with the nature of

Islamic modes of finance. It is with this background that the Islamic banks need

to initiate programs for developing systems of internal rating. Regulatory

authorities will recognize these systems only if these are found to be robust.

5.2.2.8 RAROC

        RAROC is used for allocating capital among different classes of assets

and across business units by examining their associated risk-return factors. An

application of RAROC in Islamic finance would be to assign capital for various

modes of financing. Islamic financial instruments have different risk profiles.

For example Murāba ah is considered less risky than profit-sharing modes of

        60

         Chapra and Khan (2000) recommend the Islamic banks to adopt this system. Bank Nagara

        Malaysia (2001) calls for the BCBS to make this as the primary approach for regulation.

136


financing like Muārabah and Mushārakah. Using historical data on different

modes of financing for investments, one can estimate the expected loss and

maximum loss at a certain level of confidence for a given period for different

financial instruments. Then this information can be used to assign risk capital for

different modes of financing by Islamic financial instruments.

          The concept of RAROC can also be used to determine the rate of return

or profit rate on different instruments ex-ante by equating their RAROCs as

shown below.

          RAROCI = RAROCj ,

or        (Risk Adjusted Return)I /(Risk capital)i =(Risk Adjusted Return)j/(Risk

capital)j

 where i and j represents different modes of financing (e.g., Muārabah and

Mushārakah respectively). Thus if instrument j is more risky (i.e., has a larger

denominator) then the financial institution can ask for a higher return to equate

RAROC of the instrument with that of instrument i.

5.2.2.9 Computerized Models

          Due to the revolutionary developments in the area of mathematical and

computational finance and the use of computers, banks are increasingly using

computerized models of risk management. These models are actually refined

versions of the internal ratings systems. In the internal ratings systems

information can be based on qualitative judgment, models are actually based on

quantitative data. A number of credit risk management models are now available

in the market such as the KMV, CreditMetrics, CreditPortfolioView, CreditRisk

etc. In future these models are going to be more important for risk management.

Therefore, there is a need for the Islamic banks to make planned and conscious

strategies towards developing advanced systems wherever feasible.

5.3 MARKET RISKS

          As mentioned before, market risks comprise of interest rate risks,

exchange rate risks, and commodity and equity price risks. These are briefly

discussed here in perspective of Islamic banks.

5.3.1 Business Challenges of Islamic Banks: A General Observation

          It is generally accepted that the non-availability of financial derivatives

to Islamic banks is a major hindrance in their way to manage market risks as

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compared to the conventional banks. The direct competitors of Islamic banks are

however, Islamic banking windows of conventional banks. Obviously, due to

religious restrictions, the Islamic banks cannot enter the conventional banking

market. But the conventional banks are offering the Islamic products

simultaneously with their own products. Competition no doubt enhances

efficiency and a leveled playing field is a prerequisite for a healthy competitive

environment. A leveled playing field for competition between Islamic and

conventional banks in this regard cannot be ensured without a complete

separation of the risks of the Islamic products from the risks of conventional

banks’ other operations. There are a number of difficulties in separating these

risks effectively.

         As discussed earlier regulators have been trying to bring as many risks

under the cover of capital as possible. Since capital is the ultimate protection

against risks, it is a prudent policy, for banks to manage the risks of the

organization at the group level. Particularly, derivatives for hedging purposes are

used to control the risks of the banking organization at the group level rather

than using these separately for activities of different units. This implies that the

positions of an Islamic banking unit can be left open to comply with the

requirements of the Sharī‘ah supervisors. But at the group level, the bank may

not leave any position open without hedging using interest-rate derivatives. As a

result, controlling the use of derivatives for hedging the group level positions are

beyond the reach of Sharī‘ah supervisors of an Islamic window in a

conventional bank.

         In addition to supervisors, owners, credit assessment agencies and

depositors are expected to influence the activities of banks. Unlike the owners of

Islamic banks, the owners of most conventional banks cannot be expected to

offer Islamic products as a result of their own religious beliefs. These products

are offered as a result of pure business decisions. External rating agencies also

rate banks only on the basis of their financial soundness not on the basis of

religious commitment.

         Clients, directly or through the Sharī‘ah boards can also be expected to

effect the decisions of banks. The prime concern of Islamic depositors is to

avoid any mixing of permissible and impermissible incomes. The clients of

Islamic banking windows of conventional banks are mostly on the asset side. In

most countries where Islamic banking windows are allowed, mutual funds are

offered as an alternative to investment deposits. Islamic depositors in such

138


systems will keep only current accounts. Since current account holders are not

entitled to any income, they will have no incentive in monitoring the

management or income earning activities of banks.

         Thus, there is no effective mechanism to prevent the conventional banks

from using derivatives for managing the risks of their Islamic products. As a

result, Islamic banks competing with the Islamic banking windows of

conventional banks are in a serious competitive disadvantage as for as the use of

derivatives are concerned. This poses to the Islamic banks the most serious

business risk – that of competing on a playing field, which is not leveled. As

discussed in section four, this playing field can effectively be leveled only if

separate capital is required for the Islamic banking operations of a conventional

bank.

          There is a need to distinguish the environment as described above from

an environment where all operations of banks could be subject to the principles

of Islamic finance. If the entire banking system is brought under Islamic

principles, the nature of this risk will change. In the ongoing dialogue in

Pakistan about the introduction of a comprehensive Islamic banking system, the

apprehension of local banks has been that as a result of introducing PLS

deposits, there would be a quick migration of funds from the weaker (local)

banks to the stronger (foreign) banks. This could prompt the collapse of local

banks. The apprehension in fact highlights the potential market discipline which

withdrawal risk of Islamic banking can introduce if the system is applied

economy-wide. In countries where banks are mostly in the public sector, the

subject of market discipline is however, not much relevant.

5.3.2 Composition of Overall Market Risks

         The above discussion necessitates some analysis of the nature of

important risks for which derivatives are used and the types of most dominant

derivatives. There is no statistical information, which can tell us exactly about

the proportion of each of the various risks in the total global financial risk.

However, since derivatives are primarily used for the mitigation of risks, we can

use the data on derivative markets to gauge the actual intensity of the various

risks in the financial markets.

         By end of December 2000, the total notional amount of the outstanding

volumes of OTC traded derivative contracts was US dollars 64.6 trillion for

interest rate derivatives and 15.6 trillions for FX derivatives. This makes the

                                                                              139


interest rate contracts 78% of the total notional amount of derivatives, and FX

contracts 19% of the total. The remaining 2% of the total were in equity-linked

derivatives and 1% in commodity-based derivatives. A further narrowing down

of the composition of the most important derivative market, namely the interest

rate derivatives into its different components shows that 75% of these are in

swaps, 15% in options and 10% in forward rate agreements61.

         From this information we can conclude that interest rate risk and foreign

exchange risk are the most important risks. The event of credit default in

addition to creating an immediate liquidity problem magnifies the risk of the

bank through two more channels. As a result of the delay in repayment, the

effect of changes in the market prices will be adverse for the net income of the

bank. Furthermore, as a result of the default the firm will be downgraded, again

having a negative implication for the bank’s net income. Conventional banks

effectively use this decomposition of credit risk in mitigating the risks through

credit derivatives. Credit derivatives are not available to Islamic banks.

Moreover, due to default, the Islamic banks cannot reschedule the debt on the

basis of the mark-up rate. Hence these banks are also more exposed to default

triggered interest-rate risks as compared to their conventional counterparts62.

5.3.3 Challenges of Benchmark Rate Risk Management

         Among interest rate derivatives, swaps are the most dominant contracts.

Swaps facilitate dual cost reduction role simultaneously. On one hand these

contracts enable financial institutions to utilize their comparative advantages in

fund raising and exchanging the liabilities according to their needs. Thus, the

contract minimizes the funding costs of participating institutions. On the other

hand, they are used as effective hedging instruments to cut the costs of

undesirable risks. Thus, the effective utilization of swaps undisputedly enhances

competitive efficiency. Since swaps are primarily interest-based contracts, these

have not attracted the attention of Islamic scholars.

         Although Islamic banks do not undertake interest-based transactions

they however, use the London inter-bank borrowing rate (LIBOR) as a

benchmark in their transactions. Thus, the effects of interest rate changes can be

transmitted to Islamic banks indirectly through this benchmark. In case of a

    61

       For the year 2000 as a whole, the turnovers of exchange traded derivatives were recorded

    as US dollars 383 trillion (interest 339 trillion, equity 41 trillion, and currency 2.6 trillion).

    62

       The interrelationship between credit and market risk is an important area of current

    research. But there are still no reliable measures of this relationship.

140


change in the LIBOR, the Islamic banks could face this risk in the sense of

paying more profits to future depositors as compared to receiving less income

from the users of long-term funds. Hence it is only more prudent to consider that

the assets of Islamic banks can be exposed to the risk of change in the LIBOR.

          Chapra and Khan (2000) argue that the nature of investment deposits on

the liability side of the Islamic banks adds an additional dimension to this risk.

Profit rates to be paid to Muārabah depositors by the Islamic bank will have to

respond to the changes in the market rate of markup. However, as profit rates

earned on assets reflect the markup rates of the previous period, these cannot be

raised. In other words, any increase in new earnings has to be shared with

depositors, but it cannot be re-adjusted on the assets side by re-pricing the

receivables at higher rates particularly, due to restrictions on the sale of debts.

The implication is that the net Murāba ah income of the Islamic bank is

exposed to the markup price risk. Some techniques to mitigate the Murāba ah

(mark-up) price risk are discussed below.

5.3.3.1 Two-step Contracts and GAP Analysis

          One of the most common and reliable tools to manage interest rate risk

is the technique of GAP analysis63 as discussed in section two. The GAP

analysis technique is used to measure the net income and its sensitivity with

respect to a benchmark. Risk management tools then target at ideally making the

net income immune to any changes in the benchmark rate, i.e., a target net

income is achieved whatever the market benchmark may be. If such an objective

is achieved, an increase in the benchmark will not pose any risks to the targeted

net income. The cash flows of the bank remain stable at a planned level ensuring

stability of net income

          The effectiveness of interest rate risk management depends on the re-

price-ability of assets and liabilities. As for as the Islamic banks are concerned,

investment deposits are perfectly re-price-able as the expected rate of return

increases and decreases depending on the market rate of return. On the other

hand most of the assets of Islamic banks are perfectly non-re-price-able due to

restrictions on sale of debts. The effectiveness of a GAP management strategy

for the Islamic banks requires flexibility from the two extremes on both liability

and assets sides. On the asset side the Islamic banks’ managers need to have

more re-price-able assets. The list of probable financial instruments as given in

     63

        See, Koch (1995).

                                                                                141


Table 5.4 are expected to make the asset side of Islamic banks more liquid in

future.

         The re-price-ability of instruments on the liability side shall be in the

control of asset and liability managers; the re-price-ability of investment

deposits is not in their control. This goal is always very difficult to achieve.

However, the availability of more options is always expected to be helpful. One

of such options is available to Islamic banks in the form of two-step contracts.

         In a two-step contract, the Islamic bank can play the role of a guarantor

in facilitating funds to the users. Since guarantee cannot be provided as a

commercial activity, in a two-step contract, it can be provided by the Islamic

bank’s participation in the funding process as an actual buyer. In the existing

Murāba ah contracts the bank makes an up-front payment to the suppliers on

behalf of the client. In the two-step contract the bank will have two Murāba ah

contracts, as a supplier with the client and as a buyer with the actual supplier

(see Figure 5.3). The bank will hence not make an up-front payment to the actual

supplier. The two-step Murāba ah contract will have a number of implications

for the banks.

                                       Figure 5.3

                                 Two-Step Contracts

     Client                         Bank                        Supplier

        Client-Bank Murāba ah Contract          Bank-Supplier Murāba ah Contract

  a. It can serve as a source of funds. In a longer maturity contract,

      such funds can be considered as tier-2 capital of the bank, based on

      the criteria allocated to such capital by the Basel Accord.

  b. The contracts will enhance the banks' resources under

      management. This will have both good and adverse implications.

      The adverse implications will arise from the increased amount of

      financial risks. If these risks are managed properly, the contracts

      can prove to be instrumental in enhancing the net income and

      hence competitiveness of Islamic banks.

142


  c. This will enhance the liquidity position of Islamic banks. Although

       liquidity is not the immediate problem of Islamic banks, the

       availability of liquidity always enhances stability.

  d. It will provide flexibility in liability management by offering

       different maturity of liabilities. The banks can match the maturity

       of their liabilities and assets more efficiently.

  e. The banks will actually guarantee the re-payment of the funds by

       the clients. Hence guarantee is provided in a more acceptable and

       transparent manner.

   f.      The concept of the two-step contracts is not restricted to

       Murāba ah, it is equally applicable to Isti nā‘, leasing and Salam.

   g.      Finally, the new contracts would be an addition to the available

       financial instruments thus paving the way for developing further

       instruments.

          5.3.3.2 Floating Rate Contracts

          Fixed rate contracts such as long maturity installment sale are normally

exposed to more risks as compared to floating rate contracts such as operating

leases. In order to avoid such risks therefore, floating rate leases can be

preferred. However, leases will expose the bank to the risk of equipment price

risks as discussed below.

5.3.3.3 Permissibility of Swaps

          As mentioned above the basic economic rationale of a swap contract is

to cooperate in minimizing the cost of funds by reducing the borrowing cost and

by reducing the cost of undesirable risks for both parties. In this manner a swap

is a win-win contract for both participating parties. To start with, it is obvious

that one cannot expect any Fiqhī objections to such a cooperative strategy. It is

the process of implementing the swap contract, which may not be permissible.

Particularly, as all swaps are interest-based, there is no possibility for the Islamic

banks to use such contracts. To design Sharī‘ah compatible swaps the following

conditions need to be fulfilled.

     a. There is a party whose credit rating is low because it holds long maturity

          (illiquid) assets and short maturity liabilities. Because, of the shorter

          maturity of liabilities, this party faces uncertainties in the short-run.

                                                                                   143


         Since its assets are long-term it needs to borrow long-term, but its long-

         term borrowing cost is high due to its low rating. Due to non-availability

         of such cheaper and long-term funds, it actually borrows short-term at a

         higher cost.

     b. There is another party whose liabilities are long-term but assets are more

         liquid as a result its credit rating is very good. It has no uncertainties in

         the short-term but has uncertainties in the long run at the time of the

         maturity of liabilities. It can borrow long-term at cheaper cost, but its

         borrowing preference is for short-term to match its asset-liability

         maturity. These two scenarios simplify the real world situation.

         Obviously, the Fiqh cannot have an objection to these quite natural

         situations.

      c. There exists a fixed-income financial instrument, which is used for

         raising long-term funds and there also exists a floating income financial

         instrument, which is used for raising short-term funds.

         The third prerequisite for having an acceptable swap depends on the

availability of suitable Sharī‘ah compatible instruments. At the present, there are

no fixed and floating income Islamic financial instruments available in the

secondary markets. However, ideas have been substantially conceptualized and

efforts are underway to make institutional arrangements for making such

instruments available. Once such instruments become available, the Islamic

banks will be empowered with one of the most powerful tools of market risk

management, namely, swaps.

         As discussed in section two, the objective of a swap is to exchange the

costs of raising funds on the basis of comparative advantages. It has been shown

there that by means of swap both parties end up with a net financial gain as well

as paying in consistency with their own asset and liability structures. Thus the

argument for a swap is exactly the same as the argument for free international

trade on the basis of comparative advantages. Since swaps are arranged in

trillions of US dollars in real life, they are hence the practical manifestation of

the theory of gains from comparative advantages under free trade.

         The last question in evaluating a swap contract from the Islamic finance

perspective is, is it permissible for two parties to pay the funding costs of each

other? As shown, a swap is basically a win-win contract. Both parties are better

off and hence there could not be any objection from the Sharī‘ah point of view.

144


   Thus we conclude that there is a great need for swap contracts. There apparently

   are no Sharī‘ah restrictions in developing swap contracts as such. The limitation

   is that of the availability of Sharī‘ah compatible financial instruments suitable

   for using in swap contracts.

   5.3.3 Challenges of Managing Commodity and Equity Price Risks

            In general, fluctuations in the prices of commodities and equities is not

   of any serious concern for bank asset-liability managers. The statistical

   information on derivatives provided earlier confirms this fact. However, banks

   may consider investment in commodities particularly gold and equities as a

   source of income for their clients and themselves. Banks’ exposures in this

   regard are normally marginal and are included in the trading books. There are

   however, some special considerations involved in conceptualizing these risks,

   particularly commodity price risks, in Islamic banks. First we briefly discuss

   these considerations. After that the challenges of controlling the risks are

   discussed.

            While conceptualizing commodity price risks in Islamic banking there is

   a need to clarify a number of points.

a. The Murāba ah price risk and commodity price risk must be clearly

   distinguished. In Islamic banking there could be a misconception about

   the treatment of mark-up price risk as commodity price risk. The basis of

   the mark-up price risk is LIBOR. Furthermore, it arises as a result of the

   financing not trading process. Therefore, in our understanding it shall

   conceptually be treated as an equivalent of interest (benchmark) rate risk

   as discussed in the previous section.

b. In contrast to mark-up price risk, commodity price risk arises as a result

   of the bank holding commodities for some reason. Some good examples

   of such reasons are: a) The Islamic bank developing an inventory of

   commodities for selling, b) Developing inventories as a result of Salam

   financing, c) gold and real estate holdings and d) holding of equipment

   particularly for operating leases. There is always a possibility that in

   leases ending with ownership, the benchmark rate risk and equipment

   price may not be properly identified and separated. This could be one of

   the reasons due which the Fiqh scholars do not recommend such leases.

                                                                                  145


c. Commodity price risk arises as a result of ownership of a real

   commodity or asset. Mark-up price risk arises as a result of holding a

   financial claim, which could be the result of deferred trading. Therefore,

   under leasing, the equipment itself is exposed to commodity price risk

   and the overdue rentals are exposed to interest-rate risks. Similarly, if

   the lease contract is a long one and the rental is fixed not floating, the

   contract faces interest rate risk. Thus, a fixed rental, based on a long

   operating lease is exposed to dual edged risks – commodity and mark-up

   price. In order to avoid such risks banks shall prefer leases ending with

   ownership possibly price fixed in the beginning and rentals periodically

   re-priced. Such a lease would actually be an installment sale contract

   based on a floating rate mark-up. In this case, the banks can actually

   minimize their exposure to both the mark-up and commodity price risks.

   Our survey results reveal that there is a tendency among Islamic banks

   to prefer such contracts. However, neither such a lease nor such an

   installment sale is compatible with the Sharī‘ah.

            Thus we can conclude that the Murāba ah and Isti nā‘ transactions are

   exposed to Murāba ah (mark-up price) or benchmark rate risk and Salam and

   leases are exposed to both Murāba ah price and commodity price risks. Due to

   Salam, and operating leases, commodity price risk exposure of Islamic banks is

   expected to be higher as compared to their peer group conventional banks. We

   discuss here some of the techniques which may be useful in managing the

   commodity and equipment price risks.

   5.3.3.1 Salam and Commodity Futures

            Futures contracts enable their users to lock-in future prices of their own

   expectations. For example, a wheat grower typically faces price risk - a

   deviation of actual future wheat prices from the expected future wheat prices. A

   farmer whose wheat will be ready for market in six months time may expect its

   price to be some amount per bushel; after six months the price may actually

   turnout to be more or less than that. If the farmer dislikes the uncertainty related

   to the future prices of wheat, he simply has to find a future buyer on the basis of

   Salam who would pay him the expected price per bushel now. If the deal is

   reached, the farmer has removed the uncertainty by selling the wheat at the price

   of his own expectations. Removal of the future wheat price risk enables the

   farmer to project his business forecasts more accurately, particularly, if he had to

   pay significant amount of debts.

   146


         The potential of futures contracts in risk management and control is

tremendous. Conventional banks manage risks by utilizing commodity forwards

and futures contracts. In these contracts, unlike Salam payment of the price of

the commodity is postponed to a future date. In the traditional Fiqh postponing

both the price and the object of sale is not allowed. Therefore, the Islamic banks

at the present do not utilize the commodity futures contracts in a large scale.

Nevertheless, by virtue of a number of Fiqh Resolutions, conventions, and new

research, the scope for commodity futures is widening in Islamic financing64. In

the future these contracts may prove to be instrumental in managing the risks of

commodities.

         5.3.3.2 Bai‘ al-Tawrīd with Khiyār al-Shar

         As mentioned above the objection of Islamic scholars to delaying both

the price and the object of sale is softening. An important reason for this has

been the need and sometimes inevitability of such transactions in the real life.

The classical example given about Bay‘ al Tawrīd as a long-term contract is the

supply of milk by the milkman. At the time of signing the contract, the milk

buyer and the milkman (the two parties) agree on the quantity of milk to be

delivered daily, the duration of the contract, the time of delivery and the price.

The milk is not present at the time of the contract and the price is mostly paid

periodically, normally on monthly basis. Public utilities provide a modern

example for the case. Public utilities are consumed and the bill is paid when it

comes in a future date. In this way, both the price and the service are not present

in the beginning. There are numerous other examples from real life where the

postponement of the two actually enhances efficiency and convenience and

sometimes the postponement becomes in fact inevitable.

         The example of the milkman provides an important basis for extending

the postponement of both the price and the object to banking. Any type of

    64

       The OIC Fiqh Academy in its Resolution # 65/3/7 has resolved that in Isti nā‘ both the

    price and its object of sale can be delayed. Isti nā‘ is the most dynamic mode of Islamic

    finance. Thus, such delayed payment Isti nā‘ are expected to increase in volume. The

    Fiqh Academy has also resolved on the acceptability of ‘arboon. Since, in ‘arboon most

    part of the price is delayed as well as the object of sale is also delayed this also falls in the

    framework of the definition of a forward sale. Islamic banks are using a special variant of

    ‘arboon in which the client pays small part of the price up-front and payment of the price

    and the object of sale are both delayed. For all Resolutions of the Academy see IRTI-

    OICFA (2000). Bay‘ al-tawrīd (continuous supply-purchase relationship with known but

    deferred price and object of sale) is a popular contract among the Muslims of our time,

    particularly in public procurements and finally, some prominent Islamic banks are already

    using currency forwards and futures.

                                                                                                     147


Islamic banking contract with a predetermined price, quantity and long duration

and in which the price and object are both postponed will have an analogy to the

example. In such contracts, both the two parties are exposed to price risk. The

risk is that immediately after the contract, of a fixed price and a fixed quantity,

the two parties may experience a noticeable change in the market price of the

commodity. If the market price declines the buyer will be at a loss by continuing

with the contract. If market price rises, the seller will lose by continuing with the

contract. Thus, in such contracts of continuous-supply-purchase, a Khiyār al-

Shar (option of condition) for rescinding the contract will make the contract

more just and will reduce the risk for both parties. In Figure 5.4, if the agreed

price is P0, and the two parties are uncertain about the future market prices, they

can mutually determine the upper and lower boundaries for the acceptable

movements in market prices. Beyond these boundaries they can agree to rescind

the contracts65.

                                               Figure 5.4

                          Khiyār al-Shar with respect to future prices

   Upper ceiling of

        market price

        appreciation

     beyond which                                          Future market prices

   the supplier can

          rescind the

              contract

                                                                  Price of the

     Lower ceiling                                                    contract

   of market price

    beyond which

     the buyer can                                     Future market prices

         rescind the

             contract

5.3.3.3 Parallel Contracts

     65

        For more detailed discussion, see Obaidullah (1998).

148


         Price risk can either be due to transitory changes in prices of specific

commodities and non-financial assets or due to a change in the general price

level or inflation. Inflation poses risk to the real values of debts (receivables),

which are generated as a result of Murāba ah transactions. However, as a result

of inflation it is expected that the prices of the real goods and commodities,

which the banks acquire as a result of Salam transactions will appreciate. This

divergent movement of asset values created as a result of Murāba ah and Salam

has the potential to mitigate the price risks underlying these transactions.

Although permanent shifts in assets’ prices cannot be hedged against, however,

the composition of receivable assets on the balance sheet can be systematically

adjusted in such a way that the adverse impact of inflation is reduced as

explained in Figure 5.5 (A).

         Suppose that an Islamic bank has sold assets worth $100 on Murāba ah

basis for six months, it can fully hedge against inflation by buying $100 worth

on Salam basis. If for example, 10% of the value of the previous assets is wiped

out by inflation, its Salam-based receivables can become valuable by the same

percentage. Moreover, as for as the Salam is concerned, it can be fully hedged

by the bank by adopting an equivalent parallel Salam contract as a supplier.

Figure 5.5 (B) also explains this possibility.

                                  Figure 5.5 (A):

        Parallel Contracts: Implications for Inflation Risk Mitigation

Panel A. Trader as a Seller                        Panel B. Trader as a Buyer

        Price Deferred Sale                       Object Deferred Purchase

       (Receivables: Debts)                      (Receivables: Real Assets)

                                  (Inflation 10 %)

                                                                               149


 Value of Debts (-10) Value of Real Assets (+10)

150


                                                   Figure 5.5 (B)

                              Managing Receivables as a Hedge Against Inflation

                             Panel A                                                  Panel B

Dollar Value of Price Deferred Sales        Dollar Value of Object Deferred

                                           Purchase

                $100                                                                               $100

                                 Total Receivables: Unadjusted for inflation $ 200

                Inflation adjusted                                                Inflation adjusted

                Value of receivable                                               value of receivables

                $90                                                                        $110

                                                      Value of total receivables

                                                     adjusted for inflation $ 200

                                                                                                       151


5.3.4 Equity Price Risks and the use of Bay‘ al-‘arboon

          Options are another powerful risk management instrument. However, a

Resolution of the OIC Fiqh Academy prohibits the trading in options. Therefore,

the scope for the utilization of options by the Islamic banks, as risk management

tool is limited at the present. Nevertheless, some Islamic funds have successfully

utilized -‘arboon (down payment with an option to rescind the contract by

foregoing the payment as a penalty) to minimize portfolio risks in what are now

popularly known in the Islamic financial markets as the principal protected funds

(PPFs).

          The PPF arrangement roughly works in the following manner; 97% of

the total funds raised are invested in low risk (low return) but liquid Murāba ah

transactions. The remaining 3% of the funds are used as a down payment for

‘arboon to purchase common stock in a future date. If the future price of the

stock increases as expected by the fund manager, the ‘arboon is utilized by

liquidating the Murāba ah transactions. Otherwise the ‘arboon lapses incurring

a 3% cost on the funds. This cost is however, covered by the return on the

Murāba ah transactions. Thus, the principal of the fund is fully protected. In this

way, ‘arboon is utilized effectively in protecting investors against undesirable

down side risks of investing in stocks while at the same time keeping an

opportunity for gains from favorable market conditions

5.3.5 Challenges of Managing Foreign Exchange Risk

          Foreign exchange risk can be classified into economic risk, transaction

risk and translation risk. Economic risk is the risk of losing relative

competitiveness due to changes in relative exchange rates. For instance, an

appreciation of local currency will increase the relative price of exported goods

directly as well as indirectly. There is no better hedge against such a risk except

for having subsidiaries in countries of significant markets. This is a crucial

matter for non-financial firms, but financial firms at the same time cannot ignore

it either. In fact, the dominant Islamic groups of financing have such subsidiaries

in important markets.

          Translation risk occurs only in the accounting sense. If the subsidiary of

a bank is operating in a country, where it may make a 13% profit during a year.

If the currency of these earnings depreciates by 10% during the period against

the home country currency, the earnings translated into the home country

152


currency actually increase by 3%. Hence this risk does not affect the value of

assets in place.

         Transaction risks originate from the nature of the bank’s deferred

delivery transactions. Typically the implication of transaction risk is similar to

that of transitory changes in commodity prices. The currency in which

receivables are due (or assets in general are held) may depreciate in the future

and the currency in which payables (or liabilities in general) are held may

appreciate, thus posing a risk to the overall value of the firm.

         This risk could have adverse and severe consequences for a business.

Therefore, it must be minimized by various techniques. Any remaining risk must

be hedged by using currency futures and forwards. Some of the possible

methods of reducing currency transaction risks are briefly discussed here.

5.3.5.1 Avoid Transaction Risks

         On the banking book, the most sensible method to avoid transaction risk

is to avoid undertaking such transactions, which require dealing in unstable

currencies. However, this is not always possible, as by rigidly following this

strategy market share can be lost. Banks have to decide carefully to find an

optimal trade-off between market shares and possible transaction risks.

5.3.5.2 Netting

         On-balance sheet netting is another method used to minimize the

exposure of risks to the net amount between the receivables and payables to

counterparty. Netting is more suitable for payments between two subsidiaries of

a company. With non-subsidiary counterparties, the currency position of

receivables and payables can generally be matched so that the mutual exposures

are minimized.

5.3.5.3 Swap of Liabilities

         Exchange of liabilities can also minimize exposure to foreign exchange

risk. For instance, a Turkish company needs to import rice from Pakistan, and a

Pakistani company needs to import steel from Turkey. The two parties can

mutually agree to buy the commodities for each other, bypassing the currency

markets. If the dollar amount of the two commodities is the same, this

arrangement can eliminate transaction risk for both parties. If the ratings of the

                                                                               153


two companies are good in their own home countries as compared to the other

country, this swap will also save them some of the cost of finance.

5.3.5.4 Deposit Swap

        Islamic banks have been using the technique of deposit swaps. In this

method, two banks in accordance with their own expected risk exposures agree

to maintain mutual deposits of two currencies at an agreed exchange rate for

agreed period of time. For example, a Saudi bank will open a six months account

for SR 50m in a counterpart Bangladeshi bank. The Bangladeshi bank will open

the TK amount of the SR deposit in the Saudi bank for the same period. The

SR/TK exchange rate will be mutually agreed and will be effective for the

deposit period. After the six months both banks will withdraw their deposits. In

this way the risk exposure for the value of the deposits for the currency involved

are minimized according to the two banks’ own perceptions.

        There are at least two Sharī‘ah objections to this contract. The exchange

rate cannot be any rate except the spot rate. In this case the rate is fixed for a

period during which there could be a number of spot rates not only one. The

exchange of deposits is also questionable. These deposits are supposed to be

current accounts, which are treated as Qar. There cannot be mutual Qar.

Further, Qar in two different currencies cannot be exchanged.

5.3.5.5 Currency Forwards and Futures

        Forwards and futures are the most effective instruments of hedging

against currency risks. Most Islamic banks who have significant exposures to the

FX risk do use currency forwards and futures for hedging purposes as required

by regulators. However, all Fiqh scholars unanimously agree that such contracts

are not allowed in the Sharī‘ah. Keeping this apparent contradiction in view and

the tremendous difference between the stability of the present and past markets,

Chapra and Khan (2000) make a suggestion to the Fiqh scholars to review their

position and allow the Islamic banks to use these contracts for hedging. Such a

change in position will remove the contradiction between the practices of

Islamic banks and the existing Fiqhī positions on one hand and will empower the

Islamic banks on the other hand. Furthermore, it may be noted that hedging is

not an income earning activity. Since Ribā is a source of income and hedging

does not generate income, there is no question of involvement of Ribā. On the

other hand hedging actually reduces Gharar. It is important to note that this a

personal opinion of the two writers. The consensus among Fiqh scholars is that

154


currency futures and forwards are another form of Ribā which have been

prohibited by the Sharī‘ah.

5.3.5.6 Synthetic Forward

          As an alternative to the currency forwards and future, Iqbal (2000)

proposes a synthetic currency forward contract. The purpose is to design a

currency forward without using the currency forward contracts. The synthetic

forward can be designed given a number of conditions. These conditions are the

need for hedging against foreign exchange rate risk, the existence of an equal

tenure local Murāba ah investment and foreign Murāba ah investment. The

existence of a known rate of return on the Murāba ah-based investments is

another condition. Finally, that the foreign bank, which invests in dollar-based

Murāba ah, is willing to collaborate with the local bank, which invests in the

local currency-based Murāba ah. The dollar amount of the two investments

must be the same66.

5.3.5.7 Immunization

          Once the net exposure is minimized the possibility exists that the

exposure can be hedged. Suppose an Islamic bank has to pay in three months

time $1 million for a contract, which it has signed when the exchange rate is

Rs.60/$. The risk is that after three months, the dollar will appreciate as

compared to the initial exchange rate. The bank can protect against this risk, by

raising three months’ PLS deposit in Rupees for the dollar value of 1m and

buying with this amount $1m at the spot rate. These dollars can then be kept in a

dollar account for three months. After the three months and at the time of

making the payment, the PLS deposit will mature and the bank can share the

earning on the dollar deposit with the rupee deposit holders. Thus, the dollar

exchange rate risk for the three months’ period is fully hedged by the bank.

5. 4 LIQUIDITY RISK

          As mentioned earlier, liquidity risk is the variation in a bank's net

income due to the bank's inability to raise capital at a reasonable cost either by

selling its assets in place (asset liquidity problem) or by borrowing through

issuing new financial instruments (funding liquidity problem). All other risks of

a bank culminate into liquidity crunch before bringing a problem bank down.

Operationally, a bank fails when its cash inflows from repayments of credits,

     66

        For details of the arrangement see, Iqbal (2000).

                                                                               155


sale of assets in place and mobilization of additional funds fall short of its

mandatory cash outflows, deposit withdrawals, operating expenses, and meeting

its debt obligations.

         A recent study commissioned by the Bahrain Monetary Agency (BMA

2001) shows that in general Islamic banks are facing the phenomenon of excess

liquidity. The total assets of the Islamic banks in the sample were 13.6 billion

dollars and 6.3 billion dollars were found to be in liquid assets. For Islamic

financial institutions with a combined asset of 40 billion dollars, the liquid assets

are calculated to be 18.61 billion dollars. The study shows that the peer group

conventional counterparts of the Islamic banks in the sample, in average, keep

46.5% less liquidity as compared to the Islamic institutions.

         On the average, conventional banks are expected to maintain the bare

minimum liquidity, which can satisfy regulatory requirements. The liquidity

position of Islamic banks is much in excess of the regulatory requirements. This

means that these liquid funds are either not earning any return at all or earning a

return much lesser than the market rates. Thus the excess liquidity position of

the Islamic banks generates for these banks a serious business risk as it adversely

affects the rates of returns offered by them as compared to their conventional

competitors. Furthermore, in most cases these banks largely rely on current

accounts, which is a more stable source of free liquidity.

         However, for a number of reasons, Islamic banks are prone to face

serious liquidity risks.

     a. There is a Fiqh restriction on the securitization of the existing assets of

         Islamic banks, which are predominantly debt in nature. Thus, the assets

         of Islamic banks are not liquid as compared to the assets of conventional

         banks.

     b. Due to slow development of financial instruments, Islamic banks are

         also not able to raise funds quickly from the markets. This problem

         becomes more serious due to the fact that there is no inter-Islamic banks

         money market.

156


                                                     Table 5.4

                             List of Islamic Financial Instruments

      CERTIFICATE                                          BRIEF DESCRIPTION

Declining participation      Redeemable Mushārakah certificates were designed by the IFC for providing

certificates                 funds to the Modaraba companies in Pakistan.

                             Based on Muārabah principle, the proceeds of these certificates are meant for

Islamic Deposit Certificates

                             general purpose utilization by the issuing institution.

                             Installment sale debt certificate is proposed to finance big-ticket purchases by

Installment sale debt        making a pool of smaller contributions. The certificate represents the principal

certificates                 amount invested plus the Murāba ah income. These are issued mostly in

                             Malaysia as Islamic debt certificates.

Islamic Investment           Similar to Islamic deposit certificates, but the proceeds are meant to be utilized

certificates                 in a specific project.

                             Like the installment sale debt certificate, this certificate represents the investors’

Isti nā‘ debt certificates   principal amount investment in the Isti nā‘ project plus the Murāba ah income

                             and is proposed for financing infrastructure projects.

                             Leasing certificate represents ownership of usufructs leased out for a fixed

Leasing certificates         rental income. Since usufructs are marketable, this certificate can be bought and

                             sold.

                             Muārabah certificate represents ownership in the beneficiary company without

Muārabah certificates

                             a voting right issued so far by several institutions.

                             Muqaradah certificate is a hybrid between Muārabah certificate and declining

                             participation certificates to be issued by the government for the development of

Muqāraa certificates

                             public utility projects. A muqāraa certificate law was enacted in Jordan during

                             the early Eighties, but these certificates were never issued.

                             Mushārakah certificates are common stocks of companies doing Sharī‘ah

                             compatible business. In Iran the government for financing infrastructure projects

Mushārakah certificates

                             issues these certificates. In Sudan these are issued as an instrument of monetary

                             policy.

                             National participation certificates are proposed by the IMF staff as an

                             instrument for mobilizing resources for the public sector. These proposed

National participation

                             instruments are based on the concept of Mushārakah certificates are issued in

certificates

                             Iran. The certificates are assumed to represent as an ownership title in public

                             sector assets of a country.

Property income              Property income certificate is a Muārabah income note with a secure stream of

certificates                 income from an ownership in a property without a voting right.

                             Participation term certificates were issued by the Bankers’ Equity Pakistan in

Participation term

                             the Eighties. These had some common characteristics of declining Mushārakah

certificates

                             and Muqarada certificates.

                             The holder of this certificate shares in the rental income of the asset against

Rent sharing certificates

                             which the certificate has been issued.

Revenue sharing              Revenue sharing certificates were issued in Turkey for re-financing the

certificates                 privatized infrastructure projects.

                             The holder of a Salam certificate claims commodities, goods and services in a

Salam certificates

                             specified future date against the payments the holder has made.

Two-step contracts –

                             In these contracts the bank pays to the suppliers in installment and creates a

Leasing, Murāba ah,

                             fixed liability in its balance sheet instead of paying up-front to the suppliers.

Isti nā‘, Salam

                             Hybrid instruments allow the holder of any of the debt certificates to exchange

Hybrid certificates          the certificate for other assets of the issuing entity or in any other entity subject

                             to the offer prescribed on the hybrid certificate.

                                                                                                              157


    c. The specific objective of Lender of Last Resort (LLR) facilities is to

       provide emergency liquidity facility to banks whenever needed. The

       existing LLR facilities are based on interest, therefore, Islamic banks

       cannot benefit from these and,

    d. Due to the non-existence of a liquidity problem at the present, these

       banks do not have formal liquidity management systems in place. Hence

       there is a large potential to develop financial instruments (see Table 5.4

       for a list of potential instruments) and markets, which can utilize the

       excess utility of the Islamic banks for income earning. The project on the

       Islamic Capital Markets sponsored by the IDB, BMA and Bank Nagara

       Malaysia is expected to formally launch a facility for tapping the

       potential.

158


159
                                        VI

                             CONCLUSIONS

         The previous sections of this paper covered a number of important areas

concerning risk management issues in the Islamic financial industry. The

introductory section covered among others, the systemic importance of the

Islamic financial industry. An overview of the various concepts of risks and the

industry standards of risk management techniques were discussed in section two

along with the discussion of some of the unique risks of the Islamic modes of

finance. The perception of the Islamic banks about various risks were surveyed

through a questionnaire and analyzed in section three. In section four the

emerging regulatory concerns with risk management have been discussed and

some conclusions were drawn for the Islamic banking supervision. The Sharī‘ah

related challenges concerning risk management were analyzed in section five. In

the present section we summarize the main conclusions of the paper.

6.1 The Environment

         Islamic financial industry has come a long way during its short history.

The future of these institutions, however, will depend on how they cope with the

rapidly changing financial world. With globalization and informational

technology revolution, activities of different financial institutions have expanded

beyond national jurisdictions. As a result, the financial sector in particular has

become more dynamic, competitive, and complex. Moreover, there is a rapidly

growing trend of cross-segment mergers, acquisitions and financial

consolidation, which blurs the unique risks of the various segments of the

financial industry. As a result, the general premise of universal banking is

becoming more dominant. Furthermore, there has been an unprecedented

development in computing, mathematical finance and innovation of risk

management techniques. All these developments are expected to magnify the

challenges that Islamic financial institutions face particularly as more well-

established conventional institutions have started to provide Islamic financial

products. Islamic financial institutions need to equip themselves with the up-to-

date management skills and operational systems to cope with this environment.

One major factor that will determine the survival and growth of the industry is

how well these institutions manage the risks generated in providing Islamic

financial services.

160


6.2 Risks Faced by the Islamic Financial Institutions

         The risks faced by the Islamic financial institutions can be classified into

two categories – risks which they have in common with traditional banks as

financial intermediaries and risks which are unique due to their compliance with

the Sharī‘ah. Majority of the risks faced by conventional financial institutions

such as credit risk, market risk, liquidity risk, operational risk, etc., are also

faced by the Islamic financial institutions. However, the magnitudes of some of

these risks are different for Islamic banks due to their compliance with the

Sharī‘ah. In addition to these risks commonly faced by traditional institutions,

the Islamic institutions face other unique risks. These unique risks stem from the

different characteristics of the assets and the liabilities. Other than the risks that

conventional banks face, the profit-sharing feature of Islamic banking introduces

some additional risks. In particular, paying the investment deposits a share of the

bank’s profits introduces withdrawal risk, fiduciary risk, and displaced

commercial risks. In addition, the various Islamic modes of finance have their

own unique risk characteristics. Thus, the nature of some risks that Islamic

financial institutions face is different from their conventional counterparts.

6.3 Risks Management Techniques

         Consequent on the common or unique nature of risks faced by the

Islamic financial institutions, the techniques of risk identification and

management available to these institutions are of two types. The standard

traditional techniques that are not in conflict with the Islamic principles of

finance are equally applicable to the Islamic financial institutions. Some of these

are, for example, GAP analysis and maturity matching, internal rating systems,

risk reports, and RAROC. In addition there is a need for adapting the traditional

tools or developing new techniques that must be consistent with the Sharī‘ah

requirements. Similarly, the processes, internal control systems, internal and

external audits as used by the conventional institutions are equally applicable to

Islamic financial institutions. There is, however, a need to develop these

procedures and processes further by the Islamic financial institutions to tackle

the additional unique risks of the industry.

6.4 Risk Perception and Management in Islamic Banks

         Results from a survey of 17 Islamic institutions from 10 different

countries reveals the bankers’ perspectives on different risks and issues related

to the risk management process in Islamic financial institutions. The results

                                                                                  161


confirm that Islamic financial institutions face some risks arising from profit-

sharing investment deposits that are different from those faced by conventional

financial institutions. The bankers consider these unique risks more serious than

the conventional risks faced by financial institutions. The Islamic banks feel that

the returns given on investment deposits should be similar to that given by other

institutions. They strongly believe that the depositors will hold the bank

responsible for a lower rate of return and may cause withdrawal of funds by the

depositors. Furthermore, the survey shows that the Islamic bankers judge profit

sharing modes of financing (diminishing Mushārakah, Mushārakah and

Muārabah) and product-deferred sale (Salam and Isti nā‘) more riskier than

Murāba ah and Ijārah.

         We found the overall risk management processes in Islamic financial

institutions to be satisfactory. We apprehend, however, that this may be because

the banks that have relatively better risk management systems have responded to

the questionnaires. The results from risk management process shows that while

Islamic banks have established a relatively good risk management environment,

the measuring, mitigating and monitoring processes and internal controls needs

to be further upgraded.

       The survey also identifies the problems that Islamic financial institutions

face in managing risks. These include lack of instruments (like short-term

financial assets and derivatives) and money markets. At the regulatory level, the

financial institutions apprehend that the legal system and regulatory framework

is not supportive to them. The results indicate that the growth of Islamic

financial industry will to a large extent depend on how bankers, regulators, and S

Sharī‘ah scholars understand the inherent risks arising in these institutions and

take appropriate policies to cater to these needs. This calls for more research in

these areas to develop risk management instruments and procedures that are

compatible with Sharī‘ah.

6.5 Regulatory Concerns with Risks Management

         The primary concern of regulatory and supervisory oversight standards

is to ensure a) systemic stability, b) protect the interest of depositors and c)

enhance the public’s confidence on the financial intermediation system. The

Islamic banks could not be an exception to these public policy considerations.

Due to the new risks introduced by the Islamic banks, it is expected that

162


   regulatory and supervisory concerns will increase with the expansion of the

   Islamic products.

   6.6 Instruments of Risk-based Regulation

            The instruments used for the regulation and supervision of financial

   institutions can broadly be classified into three categories:

a. Ensuring the maintenance of a minimum level of risk-based capital.

b. Putting in place an effective system of risk-based supervision, and

c. Making certain the timely disclosure of correct information about risk

    management systems and processes.

            These three instruments constitute the three pillars of the New Basel

   Accord, which primarily aims at developing risk management culture in the

   financial institutions by providing capital incentives for good systems and

   processes. By issuing a consultative document and by inviting comments on the

   document all financial institutions are provided an opportunity to participate in

   the process of setting these standards. The Islamic banks must participate in the

   process so that the standards can cater for their special needs.

   6.7 Risk-based Regulation and Supervision of Islamic Banks

          Adopting international standards for the regulation and supervision of

   Islamic banks will increase the acceptance of these institutions in the

   international markets and hence will prove to be instrumental in making the

   institutions more competitive. Some standards could be applied without any

   difficulty. However, there is a difficulty in applying in particular the risk

   weighting standards to Islamic banks due to the different nature of the Islamic

   modes of finance. This limitation is overcome by the internal ratings-based

   approach of the New Basel Accord. It is early for the Islamic banks to qualify

   for using internal ratings for regulatory capital allocation. However, by opting

   for this approach in the future, the Islamic banks will not only be able to comply

   with the international standards but will also be developing risk management

   systems suitable for the Islamic modes of finance. Moreover, the nature of the

   Islamic banks’ current and investment accounts creates a unique systemic risk,

   namely, the transmission of risks of one account to the other. In the Islamic

   banking windows of traditional banks, this systemic risk could be in the form of

   risk transmission between permissible and impermissible sources of income.

                                                                                  163


These two systemic risks can be prevented by requiring separate capital for the

current and investment accounts of an Islamic bank as well as for traditional and

Islamic banking activities of a conventional bank.

6.8 Risk Management: Sharī‘ah -based Challenges

         Risk management is an ignored area of research in Islamic finance. The

present paper is one of the few written in this area so far. Therefore, a number

of challenges are still being confronted in this area. These challenges stem from

different sources. First, a number of risk management techniques are not

available to Islamic financial institutions due to requirements for the Sharī‘ah

compliance. In particular, these are credit derivatives, swaps, derivatives for

market risk management, commercial guarantees, money market instruments,

commercial insurance, etc. Due to lack of research efficient alternatives to these

techniques have not been explored. Second, there are a number of Sharī‘ah

positions which effect the risk management processes directly. Some of these are

lack of effective means to deal with willful default, prohibition of sale of debts

and prohibition of currency forwards and futures. Third, lack of standardization

of Islamic financial contracts is also an important source of the challenges in this

regard.

         A number of ideas have been discussed and analyzed in the paper which

can be considered to constitute an agenda for further research and deliberations

by researchers, practitioners and Sharī‘ah scholars. For their practical relevance

the ideas discussed in the paper must attain the consensus of the Sharī‘ah

scholars. There is a great need to enhance the process of consensus formation on

a priority basis so that the Islamic financial institutions can develop Sharī‘ah

compliant risks management systems as early as possible.

164


165
                                        VII

                    POLICY IMPLICATIONS

        Based on what has been reported in this study, a number of policy

implications can be suggested for the development of risk management culture

in the Islamic financial institutions. Some of these are mentioned here.

7.1 Management Responsibility

         A risk management culture in Islamic banks can be introduced by

involving all the departments/sections in the risk management process discussed.

In particular, the Board of Directors can create the risk management

environment by clearly identifying the risk objectives and strategies. The

management needs to implement these policies efficiently by establishing

systems that can identify, measure, monitor, and manage various risk exposures.

To ensure the effectiveness of the risk management process, Islamic banks also

need to establish a proficient internal control system.

7.2 Risk Reports

         Risk reporting is extremely important for the development of an

efficient risk management system. We consider that the risk management

systems in Islamic banks can be substantially improved by allocating resources

to preparing the following periodic risk reports. The sketches of some of the

reports are given in Appendix-2.

     a. Capital at Risk Report

            b. Credit Risk Report

            c. Aggregate Market Risk Report

            d. Interest Rate Risk Report

            e. Liquidity Risk Report

            f. Foreign Exchange Risk Report

            g. Commodities and Equities Position Risk Report

            h. Operational Risk Report

     i.  Country Risk Report

166


7.3 Internal Ratings

         At initial stages of its introduction an internal rating system may be seen

as a risk-based inventory of individual assets of a bank. Such systems have

proved highly effective in filling the gaps in risk management systems, hence

enhancing the external rating of the concerned institutions. This contributes to

cutting the cost of funds. Internal rating systems are also very relevant for the

Islamic modes of finance. Most Islamic banks already use some form of internal

ratings. However, these systems need to be strengthened in all Islamic banks.

7.4 Risk Disclosures

         Disclosures about risk management systems are extremely important for

strengthening the systems. Introducing a number of risk-based systems as given

here can enhance risk disclosures.

     a. Risk-based Management Information System

    b. Risk-based Internal Audit Systems

     c. Risk-based Accounting Systems and

    d. Risk-based Asset Inventory System

7.5 Supporting Institutions and Facilities

         The risks existing in the Islamic financial industry can be reduced to a

great extent by establishing a number of Sharī‘ah compatible supporting

institutions and facilities such as:

     a. Lender of last resort facility,

    b. Deposit protection system,

     c. Liquidity management system,

    d. Legal reforms to facilitate Islamic banking and dispute settlement etc.,

     e. Uniform Sharī‘ah standards,

     f. Adoption of AAOIFI standards, and

    g. Establishing a supervisory board for the industry.

                                                                                 167


7.6 Participation in the Process of Developing the International Standards

         The Islamic financial industry being a part of the global financial

markets is effected by the international standards. In fact compliance with these

standards wherever relevant and feasible is expected to enhance the endorsement

of the Islamic financial institutions by the international standard setters. This in

turn is expected to enhance the growth and stability of the industry. It is thus

imperative for the Islamic financial institutions to follow-up the process of

standard setting and to respond to the consultative documents distributed in this

regard by the standard setters on a regular basis.

7.7 Research and Training

         Risk management systems strengthen financial institutions. Therefore,

risk management needs to be assigned as a priority area of research and training

programs. Given the nascent nature of the Islamic financial industry there is a

need to develop Sharī‘ah compatible risk management techniques and organize

training programs to disseminate these among the Islamic banks. In the present

research we have made an attempt to cover a number of issues. These and other

issues can constitute an agenda for future research and training in the area. The

training programs need to be designed for Sharī‘ah supervisors, regulators and

managers of the Islamic financial institutions.

168


                   APPENDIX 1: LIST OF FINANCIAL

          INSTITUTIONS INCLUDED IN THE STUDY

         Name                                  Country        Type

         ABC Islamic Bank                      Bahrain        Offshore

         Abu Dhabi Islamic Bank                U.A.E.         Commercial, Investment,

                                                              Retail,     and       Foreign

                                                              exchange dealers

         Al-Ameen Islamic Financial &          India          Non-Banking           Finance

         Investment Corporation                               Company

         AlBaraka Bank Bangladesh Limited      Bangladesh     Commercial

         AlBaraka Islamic Bank                 Bahrain        Commercial, Offshore, and

                                                              Investment

         Al-Meezan Investment Bank             Pakistan       Investment

         Limited

         Badr Forte Bank                       Russia         Commercial

         Bahrain Islamic Bank                  Bahrain        Commercial

         Bank Islamic Malaysia Berhad          Malaysia       Commercial

         Citi Islamic Investment Bank          Bahrain        Investment

         First Islamic Investment Bank         Bahrain        Investment

         Investors Bank                        Bahrain        Investment

         Islami Bank Bangladesh Limited        Bangladesh     Commercial

         Islamic Development Bank              Saudi          Development

                                               Arabia

         Kuwait Turkish Evkaf Finans House     Turkey         Commercial, Investment,

                                                              and Foreign Exchange

                                                              dealers

         Shamil Bank of Bahrain E.C.           Bahrain        Commercial and Offshore

         Tadamon Islamic Bank                  Sudan          Commercial, Investment,

                                                              and Foreign exchange

                                                              dealers

Note: We could not include two banks in the study for reasons mentioned here. Faisal

     Islamic Bank Egypt - because of receiving the questionnaire at a very late stage of

     the study. Al-Barakah Turkish Finance House - because of data gaps.

                                                                                           169


170
                                     APPENDIX 2:

                   SAMPLES OF RISK REPORTS

          We outline some sample risk reports used by financial institutions here.67 While

the actual reports can be complicated, the examples given here represent the basic format

of these reports.

     1.   Bank Level Credit Quality

          In this report, the bank ranks all its receivables (different types of consumer and

commercial loans, leases, etc.) and contingent claims (like unused commitments, stand-

by letters of credit, commercial letters of credit, swaps, etc.) according to an internal risk

rating criterion. The averages of these risk ratings give an indication of the quality of

loans and overall portfolio. Note that internal risk ratings for various institutions are

based on different scales. The example below uses a five-point scale.

                      A Sample of Bank Level Credit Quality Report

                                                             Risk Rating

 Receivables/Commitments                           1                2    3    4    5  Total

 Receivables

 -Consumer Loans

 -Commercial Loans

 -Leases

 .

 .

 Contingent Exposures

 - Unused Commitments

 - Standby Letters of Credit

 - Swaps

 .

 .

 Total

     2.   Credit Risk Exposure by Industry Sectors

          In this report, all assets are categorized according to different industries and the

exposure of these industries are examined by taking some external rating agency’s

ranking of these industries (like Moody’s). This report not only gives an idea of the

concentration of the investments and commitments in different industries, but also

identifies the risks involved in these categories.

                A Sample of Credit Exposure by Industry Groups Report

  Industry Group         Outstanding                            Commitments

                         % of Term to Risk                      % of Term to Risk

                         Total         Maturity Rating          Total      Maturity Rating

  Automobile

  Banking

  Beverage         and

     67

        The basic formats of the risk reports are adapted from Santomero (1997).

                                                                                          171


  Food

     3. Net Interest Margin Simulation

          In this report the effect of changes in the interest rate on the net income is

summarized. The effect of interest changes on net interest income (i.e., interest income

on assets-interest payable on liabilities) is estimated for different scenarios. A limit that

represents the maximum acceptable change in net income is also indicated.

                       A Sample of Interest Rate Simulation Report

                                Rate Scenario

                                Unchanged         +100 +200 Limit          -200      Limit

                                                  bps     bps               bps

  12 Month Net Interest

  Income

  Total Earning Assets

  -Change in Net Interest

  Income

  -%Net Interest Income

  Portfolio Equity

  Market Value

  Change in Market Value

  % Shareholder’s Equity

     4.   GAP Report

          The GAP report estimates interest rate risk by distributing assets and liabilities

in time bands according to their maturity for fixed rate assets and first possible repricing

time for flexible rate assets. For each time bucket the GAP is calculated as the difference

between assets and liabilities. If the financial institution uses interest rate swaps, these

are factored in to find the Adjusted GAP.

                                 A Sample of GAP Report

                         0-3          >3-6         >6-12       >1-5      Non-        Total

                         Months       Months Months Years                Market

  Assets

  -Commercial

  Loans

  -Consumer Loans

  -Lease financing

  .

  .

  Total Assets

  Liabilities

  -Interest-bearing

  Checking

  Deposits

  -Savings Deposits

  -Savings

  Certificates

  .

  .

  Total Liabilities

  GAP          before

  Interest        rate

172


  Derivatives

  Interest-rate

  Swaps

  Adjusted GAP

      5.   Duration Analysis

           Duration analysis compares the market value of assets and liabilities resulting

from changes in the interest rate. The formula for calculating duration is given in

Chapter 2 (Section 6). It is the time-weighted measure of cash flows representing the

average time needed to recover the invested funds. After the duration of assets and

liabilities are estimated the Duration-GAP can be calculated.

                              Sample of Duration Analysis Report

                                               On-Balance Sheet

                                               Balance           Rate     Effective

                                                                          Duration Years

    Assets

    Variable Rate Assets

    .

    Fixed Rate Assets

    .

    Total Assets

    Liabilities

    Variable Rate Liabilities

    .

    Fixed Rate Liabilities

    .

    .

    Total Liabilities

      6.   Operational Risk Report

           Operational risk may arise from different sources and is difficult to measure.

The risk management unit of a financial institution can, however, use judgements

regarding different kinds of operational risks based on all the available information. The

list of sources used to gather information to measure operational risk is given in Table

below. From this information, the risk management unit can classify the different

sources of operational risks as low, medium, and high. A sample of a typical operational

and strategic risk report is shown below.68

                               Sample of Operating Risk Report

Category                                                    Risk Profilea

1. People Risk

- Incompetence

- Fraud

2. Process Risk

1st. Model Risk

-Model/methodology error

2nd. Transaction Error

      68

         These reports are adapted from Crouhy et.al. (2001, Chapter 13).

                                                                                         173


- Execution Error

- Booking Error

- Settlement Error

- Documentation/Contract Risk

3rd. Operational Control Risk

- Exceeding Limits

- Security Risk

- Volume Risk

3. Technology Risk

- System Failure

- Programming Error

- Telecommunication Failure

Total Operational Risk

Strategic Risk

- Political Risk

- Taxation Risk

- Regulatory Risk

Total Strategic Risk

a- Risk Profile can be Low, Medium, and High.

         Sources of Information used as input to Measure Operational Risk

Assessing Likelihood of Occurrence                Assessing Severity

- Audit Reports                                   - Management interviews

- Regulatory Reports                              - Loss history

- Management Reports

- Business plans

- Budget plans

- Operational plans

- Business Recovery plan

- Expert Opinion

174


                                 APPENDIX – 3

                             QUESTIONNAIRE

                          ISLAMIC DEVELOPMENT BANK

                 ISLAMIC RESEARCH & TRAINING INSTITUTE

PROJECT ON “A SURVEY OF RISK MANAGEMENT ISSUES IN ISLAMIC

FINANCIAL INDUSTRY”

Questionnaire for Islamic Banking and Financial Institutions

                                      I. GENERAL

    1. Name and location of the Bank:__________________________

    2. Year of Establishment:       _________________________________

    3. Respondent’s Name:                    __________________

    Position:_____________

    4. Number of Branches:

    5. Number of Employees__________

    6. Legal Status of the Bank:

             Public limited Company ________Private limited company ___________

             Partnership ____________           Other (please specify) __________

7. How many shareholders do you have at present?               ____________

8. What is the largest percentage share of a single share-holder?       ____________

9. Name of the Chief Executive: ________________________________

10. Names of the Sharī‘ah Board:

11. Nature of Activities: (Please mark the appropriate boxes with U)

                Commercial Banking                    F Investment Banking

       F

         Offshore Banking                    F Foreign Exchange dealers        F

         Investment (including funds)        F Stock Brokers                   F

         Insurance                           F Others (please specify)         F

                            II. FINANCIAL INFORMATION

         1. Most Recent Basic Balance Sheet Figures: Year ______________

                                          Local Currency        US Dollars

      Total Assets

      Total Liabilities

      Equity (Capital)

2. Term Structure of the Assets (% Distribution)

        Less that 6 Months %                           6-12 months %

        12-36 months        %                          More than 36 Months %

                                                                                   175


    3. Profit-Sharing ratio between the bank and the depositors

   Depositors Share on:

                             Investment Accounts of                Savings Accounts of

        a)        Less than 6 months             ________                   _______

        b)        6-12 months                    ________                   _______

        c)        12-24 months                   ________                   _______

        d)        More than 24 months            ________                   _______

    4.  Geographical Distribution of Investment

                                                   Foreign

Year    Domestic       Total         US,           Japan        Middle    Asia &      Other

                       Foreign       Canada                     -East     Africa

                                     &

                                     Europe

1996

1997

1998

1999

2000

    5.  Details of Default

Year      Total No. of Total Value             No.            of   Cost     of   Average

          Default Cases of Default             litigation cases    Litigation    time lost in

                                                                                 litigation

1996

1997

1998

1999

2000

6.  Comparative Rates of Return (in percentage) for Depositors and Equity

    Holders

                                            1996        1997      1998       1999       2000

Your Bank’s Equity Holders (dividend

share %)

Deposits of your bank (average)

Deposits of competing Islamic Banks

(average)

Deposits of Competing Commercial

Banks (average)

NOTE: Information on questions 6,7, and 8 can be skipped if you can provide us with the Annual

        Reports of the latest two years (1999 and 2000).

176


     7. Structure of the Assets                                       (US$ Millions)

    Year Total Reserves Debts                  Deposits       Securities Physical Others

                       & Cash due              with other                  Assets

                       in Vaults               banks

    1996

    1997

    1998

    1999

    2000

8. Capital and Structure of the Liabilities                           (US$ Millions)

   Year      Total       Total        Total      Investment Saving       Current      Deposits

             Capital     Liabilities Deposits    Accounts Account        Accounts     of Other

                                                                                      Banks

   1996

   1997

   1998

   1999

   2000

     8.    Modes of Finance:

    Year      Total         Murāba ah       Mushā     Muāra-    Leasing      Isti nā‘/S  Other

              Financial     /Install. Sale  -rakah    bah                     alam        s

              Operations

    1996

    1997

    1998

    1999

    2000

                    III. ISSUES IN RISK MANANGEMENT: A SURVEY

1.         Severity of Various Types of Risks in Different Financial Instruments

           (Can you please rank the seriousness of the following overall and instrument

specific risks in the tables below. Please mark the appropriate boxes with U)

                  Credit Risk                   Not                       Critically

                                                Serious                   Serious

      (The risk that counterparty will          1         2     3     4 5 N. A.

      fail to meet its obligations timely

      and fully in accordance with

      agreed terms)

      1. Overall Risk

      2. Murāba ah

      3. Muārabah

      4. Mushārakah

      5. Ijārah

      6. Isti nā‘

      7. Salam

                                                                                               177


     8. Diminishing Mushārakah

     Markup (Benchmark) Rate Risk            Not                 Critically

                                             Serious             Serious

     (The risk arising from           1        2     3     4     5    N. A.

     changes in the level of

     market interest rate or

     benchmark rate)

     1. Overall Risk

     2. Murāba ah

     3. Muārabah

     4. Mushārakah

     5. Ijārah

     6. Isti nā‘

     7. Salam

     8. Diminishing Mushārakah

                 Liquidity Risk              Not                   Critically

                                             Serious               Serious

     (The risk of insufficient liquidity in  1         2 3   4    5     N.A.

     meeting        normal       operating

     requirements and taking growth

     opportunities)

     1. Overall Risk

     2. Murāba ah /Bai-muajjal

     3. Muārabah

     4. Mushārakah

     5. Ijārah

     6. Isti nā‘

     7. Salam

     8. Diminishing Mushārakah

              Market Risk              Not                     Critically

                                       Serious                 Serious

    (Risk incurred on instruments      1         2   3     4      5     N. A.

    traded in well-traded markets,

    e.g., commodities and equities)

    1. Overall Risk

    2. Murāba ah

    3. Muārabah

    4. Mushārakah

    5. Ijārah

    6. Isti nā‘

    7. Salam

    8. Diminishing Mushārakah

178


           Operational Risk              Not                                Critically

                                         Serious                            Serious

  (The risk of losses from              1        2 3                4     5         N.A.

  inadequate or failed internal

  processes, people, or systems)

  1. Overall Risk

  2. Murāba ah

  3. Muārabah

  4. Mushārakah

  5. Ijārah

  6. Isti nā‘

  7. Salam

  8. Diminishing Mushārakah

 Please list below any other risks that you think affects your institution:

                          Not Serious                                   Critically

                                                                        Serious

  Other Risks             1                 2    3            4         5           N. A.

  1.

  2.

  3.

  4.

  5.

 A Survey of Issues related to Islamic Banking

 (Please mark the appropriate boxes with U)

                                               Not Serious                    Critically

                                                                              Serious

  How would you rate the following             1      2      3       4   5      N. A.

  issues according to their seriousness

1.A low rate of return on deposits will

  lead to withdrawal of funds?

2.Depositors would hold the bank

  responsible for a lower rate of return

  on deposits?

3.The rate of return on deposits has to be

  similar to that offered by other banks.

4.Lack of short-term Islamic financial

  assets that can be sold in secondary

  markets

5.Lack of Islamic money markets to

  borrow funds in case of need.

6.Inability to re-price fixed return assets

  (like Murāba ah) when the benchmark

  rate changes.

7.Inability to use derivatives for hedging.

8.Lack of legal system to deal with

  defaulters.

9.Lack of regulatory framework for

  Islamic Banks.

0.Lack of understanding of risks

  involved in Islamic modes of

  financing.

                                                                                         179


   3. Please Rank the top ten (10) risks faced by your organization in order of severity

   1. _______________________________ 6. ______________________________

   2. _______________________________ 7. __________________________

   2.         ___________________________ 8. ______________________

   3.         ____________________________ 9. _______________________

   4.         ____________________________ 10. ________________________

                        ISSUES IN RISK MANAGEMENT: GENERAL

   Please mark the appropriate boxes with U.

                                                                         YES       NO

 1.         Do you have a formal system of Risk Management

        in place in your organization?

 2.         Is there a section/committee responsible for

        identifying, monitoring, and controlling various risks?

      3. Does the bank have internal guidelines/rules and concrete

            procedures with respect to the risk management system?

 4.         Does the bank have in place an internal control

        system capable of swiftly dealing with newly

        recognized risks arising from changes in environment,

        etc.?

 5.         Does the bank have in place a regular reporting

        system regarding risk management for senior officers

        and management?

            Is the Internal Auditor responsible to review and

rify the risk management systems, guidelines, and risk

 orts?

 7.         Does the bank have countermeasures (contingency

        plans) against disasters and accidents?

 8.         Does your organization consider that the risks of

        investment depositors and current accounts shall not

        mix?

 9.         Is your bank of the view that the Basel Committee

        standards should be equally applicable to Islamic

        banks?

 10.        Is your organization of the view that

        supervisors/regulators are able to assess the true risks

        inherent in Islamic banks?

   11. Positions and profit/losses are assessed:

              Every Business Day F Weekly F                Monthly F

         12. Would you prefer repricing of leased assets?

              Periodically (e.g., monthly) F Continuously (benchmark rate + markup) F

     13. Do you think that the capital requirements for Islamic banks as compared to

         conventional banks should be

                       More F                     Same F                    Less F

   180


    ISSUES IN RISK MANANGEMENT: MEASUREMENT AND MITIGATION

Please mark the appropriate boxes with U.

                                                                        YES    NO

 1. Is there a computerized support system for estimating the

      variability of earnings and risk management?

      2. Is there a clear policy promoting asset quality?

 3.   Does the bank have in place a support system for assessing

      borrowers’ credit standing quantitatively?

 4.   Has the bank adopted and utilized guidelines for a loan approval

      system?

 5.   Are credit limits for individual counterparty set and are these

      strictly monitored?

 6.   Are mark-up rates on loans set taking account of the loan

      grading?

 7.   Does the bank have in place a system for managing problem

      loans?

 8.   Does the bank regularly (e.g. weekly) compile a maturity ladder

      chart according to settlement date and monitor cash position

      gaps?

 9.   Does the bank regularly conduct simulation analysis and

      measure bench-mark (interest) rate risk sensitivity?

      10. Does the bank have backups of software and data files?

 11. Does the bank use securitization to raise funds for specific

      investments/projects?

 12. When a new risk management product or scheme is introduced,

      does the bank get clearance from the Sharī‘ah Board?

 13. Is your bank actively engaged in research to develop Islamic

      compatible Risk Management instruments and techniques?

 14. Is there a separation of duties between those who generate risks

      and those who manage and control risks?

 15. Do you have a reserve that is used to increase the profit share

      (rate of return) of depositors in low-performing periods.

     16. Does the bank produce the following reports at regular intervals?

                                                                       YES    NO

      One)          Capital at Risk Report

      Two)          Credit Risk Report

     Three)         Aggregate Market Risk Report

     Four)          Interest Rate Risk Report

     Five)          Liquidity Risk Report

     Six) Foreign Exchange Risk Report

     Seven)         Commodities & Equities Position Risk Report

     Eight)         Operational Risk Report

     Nine)          Country Risk Report

     Ten)           Other Risk Reports (Please Specify)

     17. Do you use any of the following procedures/methods to analyze risks?

                                                                                 181


                                                                      YES      NO

      One)            Credit Ratings of prospective investors

      Two)            Gap Analysis

     Three)           Duration Analysis

     Four)            Maturity Matching Analysis

     Five)            Earnings at Risk

     Six) Value at Risk

     Seven)           Simulation techniques

     Eight)           Estimates of Worst Case scenarios

     Nine)            Risk Adjusted Rate of Return on Capital

     (RAROC)

     Ten)             Internal Rating System

     Eleven)          Other (Please Specify)

                                                                          YES   NO

 18. Does the bank have a policy of diversifying investments across:

                (a) Different countries?

(b) Different sectors (like manufacturing, trading etc.)

                (c) Different Industries (like airlines, retail,

                       etc.)

      19. Do the accounting standards used by the bank comply with

 a) International standards?

 b) AAOIFI standards?

 c) Other (please specify)

 ___________________________________________

                                                   Regularly  Occasionally   Never

  20. Does         the      bank    periodically

        reappraise collateral (asset)?

  21. Does the bank confirm a guarantor’s

        intention to guarantee loans with a

        signed document?

  22. If loans are international, does the

        bank regularly review country

        ratings?

  23. To keep the rate of return in line

        with other banks, do you transfer

        profit      from      shareholders    to

        depositors?

  24. Does the bank monitor the

        borrower’s business performance

        after loan extension?

182


25. Does the bank engage in the spot market and any of the following derivatives for

    hedging (risk management) purposes?(Please mark the appropriate boxes with U)

                   Spot   Forwards     Futures      Options       Swaps   None

   Currency

   Commodity

   Equity

   Interest Rate

26. Does the bank engage in the spot market and any of the following derivatives for

    income generation? (Please mark the appropriate boxes with U)

                   Spot   Forwards     Futures      Options       Swaps   None

   Currency

   Commodity

   Equity

   Interest Rate

27. We will appreciate if you could share with us any Islamic compatible Risk

    Management instruments and techniques that your institution uses.

                                                                                183


184
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                                                                                    185


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                                                                                       191


                                    ABOUT THE AUTHORS

 TARIQULLAH KHAN                                 HABIB AHMED

 Born in Chitral, Pakistan (1954), is a          Born in Chittagong, Bangladesh (1959) is an

 member of IRTI’s research staff since           Economist at the Islamic Research and

 Muharram 1404H (October 1983). Before           Training Institute (IRTI) of the Islamic

 joining IRTI, he was in the faculty of the      Development Bank. He has an M.A.

 Economics Department, Gomal                     (Economics) from University of Chittagong,

 University, Pakistan (1976-81), and             Bangladesh, Cand. Oecon. (M.Econ.) from

 International Institute of Islamic              University of Oslo, Norway, and Ph.D. from

 Economics, International Islamic                University of Connecticut, USA. Before

 University, Pakistan (1981-83), teaching        joining IRTI in February 1999, he taught at

 in particular, monetary, development and        the University of Connecticut, USA, Eastern

 international economics. He has an M.A.         Connecticut State University, USA, National

 (Economics) degree from the University          University of Singapore, and University of

 of Karachi, Pakistan, and a Ph.D. degree        Bahrain. He taught various courses on

 from the Loughborough University,               Economics including Business Cycles and

 United Kingdom. At IRTI, his research           Forecasting, Economic Development,

 interest has been in the area of theoretical    International Finance, Macroeconomics,

 developments in Islamic finance and its         Money and Banking, and Quantitative

 practical challenges in an international,       Economics. He has published articles in

 mixed and competitive market and                international refereed journals such as

 regulatory environments. In this area,          Applied Economics, Applied Economics

 some of his recent research works               Letters, Contemporary Economic Policy,

 published by IRTI include: “Demand for          Economics Letters, Journal of Economics

 and Supply of Mark-up and PLS Funds in          and Business, Journal of International Trade

 Islamic Banks” (1995), Performance and          and Economic Development, and Savings and

 Practices of Modaraba Companies With            Development. His current research interests

 Special Reference to Pakistan (1996),           are Islamic Economics and Finance. Couple

 Interest-free Alternatives for External         of his recent publications in Islamic

 Resource Mobilization with Special              Economics and Finance include Exchange

 Reference to Pakistan (1997), Regulation        Rate Stability: Theory and Policies from an

 and Supervision of Islamic Banks (2000)         Islamic Perspective and “Incentive

 with M. Umer Chapra and “Islamic Quasi          Compatible Profit-Sharing Contracts: A

 Equity (Debt) Instruments” (2000).              Theoretical Treatment”.

 E-mail: tariqullah@isdb.org.sa                  E-mail: hahmed@isdb.org.sa

                              ISLAMIC DEVELOPMENT BANK

                   ISLAMIC RESEARCH AND TRAINING INSTITUTE

                         Postal Address: P.O. Box 9201, Jeddah 21413

                                    Kingdom of Saudi Arabia

                Cable Address: BANKISLAMI-Jeddah Telephone: 6361400

                    Telex: 601137/601945 Facsimile: 6378927 / 6366871

                E. Mail: ibfd@isdb.org.sa Home Page: http://www.irti.org/

                                                                 Legal Deposit no.2113/22

                                                                 ISBN: 9960-32-109-6

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