Islamic modes of financing like Murabaha, Musharaka, Mudaraba, Ijara, Salam, Istisna’a and other Islamic modes of financing pose unique risk factors to Islamic Banks, which may be summarised as:
Liquidity originated market risk; transformation of credit risk to market risk and market risk to credit risk at various stages of a contract; bundling of credit risk and market risk, market risk arising from owning the underlying non-financial asset until maturity of a contract or until the ownership is transferred to customer and treatment of default As a result, there are unique balance sheet features of Islamic Banks from a Market risk perspective. For example, in traditional banks, market risk is mostly in the trading book, whereas in Islamic banks, market risk is concentrated in the banking book due to Murabaha, Ijara, Salam, Musharaka and Mudaraba in the asset portfolio. Hence, it is unique for Islamic banks that market risk and credit risk are bundled together.
Credit (default) risk
Credit risk is defined as an unexpected loss in a bank’s income due to delay in repayment or non-repayment in full by a client as contractually agreed. Default risk covers over 80 per cent of risks in an average bank’s banking book asset portfolio. It is the cause of over 80 per cent of cases of bank failures. Default risk also causes market risk and liquidity risk. Re-scheduling of default that is compensation-based restructuring of credit is the most well-known form of Riba, namely, Riba Al Jahiliyah in Islam. Therefore, this highly necessitates proper credit risk management in Islamic Banks. There are also moral issues in loan loss reserves; collateral quality (restrictions on use of sovereign bonds); use of Insurance – clients’ insurance and facilities insurance and issues relating to diverse modes of financing and bundled risks for Islamic Banks.
More specifically, for Mudaraba and Musharaka modes of financing, the default event is undefined and collateral is not allowed by the Sharia’ Boards of Islamic Banks. Similarly, for Salam and Istisna’ modes of financing, there is a strong element of counter-party performance risk, as well as the separation of market risk from default risk is quite difficult, given the nature of construction and real estate industries. Consequently, the catastrophic risk is also quite high. In Murabaha mode of financing, there is always the baseline default risk, but additionally, the counter-party risk due to embedded option (Murabaha, binding or non-binding) also exists, making it more complicated than a simple loan under conventional banking.
Challenge: How to capture the unique risks of IBs
The answer is to develop Internal Rating Systems in IBs. IRSs can be considered as risk-based inventories of individual assets of banks, either based on the loss given default (LGD) of the facility or probability of default (PD) of the obligor, or both. Unfortunately to-date, most IRSs are “judgmental” and not “statistical” or based on actuarial/statistical data.
Uses of IRS
IRSs differ from bank to bank and from use to use. They can be used for a number of purposes, including for guiding credit origination process, portfolio monitoring and management reporting, analysis of adequacy of loan loss reserves and capital, profitability and loan pricing analysis, input to formal mathematical modes of risk management and to facilitate prudential bank supervision.
Desirability of IRS for Islamic Banks
IRSs can be used effectively to capture the diverse nature of the Islamic modes of financing. We have to keep in mind that IRSs are based on the profile of individual assets, not on a bucket of assets. Internal ratings can help the development of a systematic database of critical financial variables; they supplement and may even enhance external credit assessment and ratings. They also improve the quality of MIS for Islamic Banks.
Formal internal ratings are normally used by large and sophisticated banks. The size of most Islamic banks is very small and, therefore, their capacity to develop internal rating systems is limited, in general. Also, this method cannot be utilised for supervisory assessment of individual Islamic banks’ risks. However, initiation of IRS is imperative to develop risk management culture consistent with the Islamic modes of financing.
Sources and inputs of Internal Rating Systems
Client-oriented system generates the probability of default (PD), whereas a Facility-oriented system -value of an asset expected to be lost in the event of a default generates (loss given default: LGD). In both cases, balance sheet value of total asset i.e., Exposure-at-Default (EAD) can be measured. Other data, such as the Maturity of facility as well as the Concentration of credit to the specific client as a percentage of total portfolio, add meaningful input for more effective data output.
Building judgmental default probabilities
Several inputs may be used effectively to develop judgmental (PDs) including an analysis of financial statements of the client to assess its future cash flow and its ability to meet its contractual obligations; debt service capacity of the client; liquidity of the clients’ balance sheet; historical earnings; access to sources of funds; leverage ratio; peer group analysis; audit reports and external credit assessment reports.
Conclusion
Unique features of both asset and liability sides of Islamic banks can strengthen linkages between financial and non-financial sectors and enhance financial stability in the industry.
The unique balance sheet features of Islamic banks, however, also give rise to significant unique risks. Proper management of these risks can strengthen the Islamic banking industry’s role in financing development and enhancing financial markets’ efficiency and stability.
The existing standards, which are meant for traditional banks, need to be complemented with standards covering the unique risks of Islamic banks. This challenging role is currently being played by the Malaysia-based Islamic Financial Services Board (IFSB).
Finally, the implementation and use of Internal Rating Systems are most suitable for addressing the unique risks in Islamic Banks.
*Khalid Yousaf is the Director-Islamic Finance Advisory Services, KPMG.
**This article by Khalid Yousaf was published in Times of Oman. Read the original article here.