A common perception about Islamic banking is that it is safer since it is not based on interest rates. Also, there is an argument that several of its products are using a mark-up arrangement, and hence they carry less risk. Both these points of view are not entirely correct and are understatements.
IDENTIFYING RISKS IN ISLAMIC FINANCE www.esaac.com.pk
IDENTIFYING RISKS IN ISLAMIC FINANCE • A common perception about Islamic banking – It is safer since as it is not based on interest rates – Products use mark-up arrangement, and hence less risk
• Both the points are not entirely correct and are understatements • Islamic banks are not affected – directly by interest rates fluctuations – rather indirectly affected through • lease • mark-up • deferred sale www.esaac.com.pk
IDENTIFYING RISKS IN ISLAMIC FINANCE • As discussed earlier, Islamic financing relies more on equity financing rather than debt financing and hence inherently is riskier. • There are several reasons why Islamic banking can be riskier than conventional banking • Lack of standardization • Availability of a large number of Financing ways • No legal caveat to control the entrepreneur – Especially Mudaraba financing – Bank can exercise some control through Musharaka. www.esaac.com.pk
IDENTIFYING RISKS IN ISLAMIC FINANCE • Islamic banking more vulnerable due to added unfavorable events like – Scarcity of hedging instruments – Underdeveloped inter-bank money markets – Underdeveloped market for Shariah-compliant government securities – Liquidity management in the absence of a short-term money market for Islamic finance
IDENTIFYING RISKS IN ISLAMIC FINANCE â€˘ Liquidity risk faced by IBIs at present seems to be low, because of several reasons but it may lead to liquidity problems in future. 1. 2. 3. 4.
They rely largely on a current account for liquidity There is a restriction on the sale of debts Market for short term Islamic instruments is not developed Lender of last-resort facilities is not available.
1. Another dimension to the high risk is due to the nature of PLS contracts; they are based on the profitability of the project rather than the credit-worthiness of the borrower www.esaac.com.pk
IDENTIFYING RISKS IN ISLAMIC FINANCE • The three major risk categories as discussed above are all present in Islamic financing in differing degrees, as compared to conventional financing – credit risk – market risk – operational risk
IDENTIFYING RISKS IN ISLAMIC FINANCE • A quick comparison of different risks in Islamic finance with conventional finance reveals that credit risk, commodity risk, liquidity risk, market risk, legal risk, and regulatory risks are higher in Islamic financing. • These risks in Islamic finance exist with different intensities and have several dimensions • Since the bulk of Islamic financing goes to trade finance and mark-up arrangements, it is susceptible to the adverse fluctuations of the commodity prices. • Also, Islamic banks do not have access to cheap credit and hence have to manage their own liquidity. www.esaac.com.pk
IDENTIFYING RISKS IN ISLAMIC FINANCE • In its efforts to manage the liquidity, banks may adopt an over-cautious approach by following a conservative route to investments and funds management which will undermine the efficient allocation of available funds to the profitable channels. • On the other hand, in the case of ill managing the liquidity, there can be a banking crisis, which may even result in sudden cash flight and liquidation. • There are no universally accepted standards for reporting for Islamic finance, except AAOIFI (the Accounting & Auditing Organization for Islamic Financial Institutions), which is still under refinement and is not mandatory and hence still not used by several institutions. www.esaac.com.pk 9
IDENTIFYING RISKS IN ISLAMIC FINANCE • This renders the reports by Islamic financial institutions noncomparable. • An entrepreneur having a financially sound project will generally not come to an Islamic bank due to a PLS contract; his preference in this case will be a conventional bank. • Thus, entrepreneurs having projects which are less profitable will approach Islamic banks to finance. • Some of the unique risk factors relating to the Islamic mode of financing are – liquidity-originated market risk, – transformation of credit risk to market risk and market risk to credit risk during different stages of the contract, www.esaac.com.pk
IDENTIFYING RISKS IN ISLAMIC FINANCE – bundling of credit risk and market risk – market risk arising from ownership of non-financial assets – treatment of defaults
• Some of the factors affecting credit risk in Islamic banks are: – Less sophistication in risk management practices – Incentive to unscrupulous clients to default due to leniency towards default – Lower risk due to short-term financing – No (except in Malaysia) trading book exposure – No access to credit derivatives – According to OIC Fiqh Academy, Murabaha is binding only to the seller
IDENTIFYING RISKS IN ISLAMIC FINANCE – The usual counterparty risks, such as • failure to supply/deliver on time, • failures regarding the quality and quantity
– That Istisna poses dual risk • The default of clients • and non-performance of sub-contractors,
– Some Fiqh does not allow Ijarah ending in ownership.
IDENTIFYING RISKS IN ISLAMIC FINANCE Type of risk
Attributed to delayed, deferred, and default in payments by counterparties. Covers profit-sharing contract (Mudaraba and Musharaka), receivables and lease (Murabaha, Diminishing Musharaka, and Ijarah), and working capital financing (Salam, Istisna, and Mudaraba). Covers different stages of a contract.
Attributed to adverse movements in interest rates, commodity prices, and foreign exchange rates. Covers commodity risks existing in Murabaha and Ijarah contracts
Attributed to adverse changes in market value (and liquidity) of equity held for investment purposes. Covers all equity instruments (Mudaraba and Musharaka).
Attributed to adverse cash flow in situations arising mainly out of changing market risk exposures, credit risk exposures, and operational risk exposures.
Rate of Return
Attributed to changes in account holdersâ€™ expectations of the risk return on investments. Also related to fluctuations in returns due to changes in underlying factors of the contract.
Attributed to the inadequacy of failed processes, people, and systems. Also includes risks arising from Shariah non-compliance.
Attributed to the inadequate legal framework, conflict of conventional and Islamic laws, and conflict between Shariah rulings and legal decisions.
IDENTIFYING RISKS IN ISLAMIC FINANCE â€˘ The role of information in the risk management of Islamic financial institutions can be more critical compared to conventional financial institutions. â€˘ The nature of contracts in Islamic finance involves more integration with the activities of the entrepreneur.
IDENTIFYING RISKS IN ISLAMIC FINANCE • The PLS contracts are heavily biased towards availability of information for managing the risks. • In the case of Musharaka and Mudaraba contracts, there is a heavy bias towards availability of information for risk management.
IDENTIFYING RISKS IN ISLAMIC FINANCE â€˘ Whilst using Istisna, a bank needs to maintain a steady flow of information about the contractors. â€˘ Similarly, the sustainability of the activities of the Islamic financial institution depends on the sharing of information with the shareholders and their approval of these activities through Shariah. www.esaac.com.pk
IDENTIFYING RISKS IN ISLAMIC FINANCE • Sharing of Shariah rulings with the shareholders is an integral part of activities. • Islamic finance has a special emphasis on transparency in the conduct of activities, calculation of profits and losses, as well as the nature of activities.
IDENTIFYING RISKS IN ISLAMIC FINANCE • Transparency depends on information. • Due to the focus on social responsibilities, information management acquires a special dimension in Islamic financial institutions, more than a mere statutory compliance. • Hence, special efforts are required for efficient information management.
The risk of non-compliance with Shariah rules is referred to as Shariah risk.
RISK OF NON-COMPLIANCE WITH SHARIAH RULES www.esaac.com.pk
RISK OF NON-COMPLIANCE WITH SHARIAH RULES • The risk of non-compliance with Shariah rules is referred to as Shariah risk • This can be included in Operational Risk – As non-compliance can lead to reputational damage, which can trigger an exodus of funds from Islamic investors, causing failures and systemic risks – There are several variations possible in Shariah rulings, which give rise to a high degree of uncertainty – A constraint of Islamic finance has been the non-availability of parallel products as compared to conventional finance
• The conventional financial market is reasonably matured in terms of availability of products for financing • A large number of highly matured products are available for retail and corporate financing
RISK OF NON-COMPLIANCE WITH SHARIAH RULES • With the growing market for Islamic finance, innovative products are being launched • Some of these products may not fully comply with Shariah rules • These products pose a special risk in terms of being rejected under the scrutiny of Shariah rules • As interpretations can differ, utmost precaution needs to be taken before entering into any contract • An approval from the Shariah council should be obtained • There should not be any deviations in the contract once the Shariah council has approved a particular contract
There are four main elements (as illustrated in Figure 2.4) that should be well defined and considered in financial risk analysis for both conventional and Islamic financial products
MAIN ELEMENTS USED IN FINANCIAL RISK ANALYSIS www.esaac.com.pk
MAIN ELEMENTS USED IN FINANCIAL RISK ANALYSIS â€˘ The four main elements that should be that should be well defined and considered in financial risk analysis for both conventional and Islamic financial products are: 1. The construction of the financial contracts 2. The identification of the markets 3. The identification of the counterparties 4. The behavior and interaction of the above two within a time period (pastcurrent-future), mapped into the financial contracts www.esaac.com.pk
MAIN ELEMENTS USED IN FINANCIAL RISK ANALYSIS • The construction of the financial contracts is mainly based on the cash flows (ins and outs) • The ins and outs cash flows are illustrated in the representation of the lifecycle of the contracts, as arrows with down and up directions respectively • The identification of the markets and the counterparties is a complex process that is based on many tangible and nontangible factors that affect their associated behaviors • This chapter is mainly focused on the Islamic financial contracts, where their construction is based on the characteristics of markets, counterparties and operations www.esaac.com.pk
MAIN ELEMENTS USED IN FINANCIAL RISK ANALYSIS • The aim of this chapter is to show to the reader how to identify and analyze the different types of risks that arise within the lifetime or type of the Islamic financial contracts • Therefore, the guides illustrated in the following paragraphs can be applicable to any new or integrated types of Islamic products by focusing on the financial events and the inflows and outflows expected cash