Presentation on theme: "Risk profile of Islamic banks"— Presentation transcript:
1Risk profile of Islamic banks Claudio Porzio & M. Grazia StaritaUniversity of Naples “Parthenope”
2Agenda A taxonomy of Islamic contracts Islamic bank contracts: their typical risk profileLiabilitiesAssetsMurabahaSalamIjaraIstisnaMudarabaMusharakaRisk profile of Islamic banksConclusions
3A taxonomy of Islamic contracts Liability side: short-term (liquidity management) and long-term (investment) funding; banking book mobilisation (ijara, especially).Asset side: contracts with or without Profit and Loss Sharing (P&LS)P&LS contracts can be subdivided according to the different needs (financial, insurance and asset management) satisfied.No P&LS contracts allow short and long term financing.Asset finance requires the lender to purchase the asset and to sell it on to the borrower at a higher price with instalment payments.Partnership finance requires the lender to participate in the equity of the transaction.Lease finance involves the lender acquiring the asset, leasing it to the borrower in exchange for rental payments.
4A taxonomy of Islamic contracts Liability side FundingLiquidity managementInvestmentDemand depositsIslamic funds(mudaraba)SecuritisationaccountsSukukOutside the conventional bank’s boundary
5A taxonomy of Islamic contracts Asset side P&LS contractsFinancialneedsInsuranceMusharakaMudarabaTakafulAssetmanagementIslamicfundPartnership finance
6A taxonomy of Islamic contracts Asset side No P&LS contractsShort-term financingLong-term financingMurabahaSalamIjaraIstisnaLease financeAsset financeAsset finance
7A taxonomy of Islamic contracts The parallel with “conventional” finance SalamHouseholders lendingMurabahaMortgage with bank’s ownership(in the first step of contract)IjaraRenting / LeasingIstisnaSale of real estate under contructionMusharakaJoint venture / investment depositsMudarabaLimited partnership / Investment accountsMutual funds / bank’s performance bondsQardh hasanDemand deposits 11(current accounts)TakafulInsurance contractSukukAsset Backed SecuritiesAsset sideLiability sideOther
8Islamic bank contracts - Liabilities Losses’ absorption+P S Investment accounts(unrestricted)Equity-(restricted)Demanddeposits(non interest bearing)StabilityHaving both debt and equity features, are PSIAs to be accounted for as off-balance-sheet ?
9PSIAs holders’ cash flow rights Islamic bank contracts - LiabilitiesThere is a commercial pressures on Islamic banks to offer market-based returns and repay in full on due date to ensure PSIAs continue to be funded (displaced commercial risk).What is the boundary between shareholders’ claims and investment account holders’ claims? What happens in a liquidation scenario?What relationship between control rights and cash flow rights?PSIAs holders’ cash flow rightsReturn in line with market interest rates (after PER’s depreciation against the displaced commercial risk)No control rightsShareholders’ claimsDividend (after PER’s depreciation and IRR’s depreciation)Control rights
10Islamic bank contracts - Liabilities Profit smoothing Profit Equalization Reserve (PER)Unexpected loss against displaced commercial risk Investment Risk Reserve (IRR)Capital adequacy? Is a different approach to its calculation and accounting standards necessary?Capital ratio in case of profit smoothingwhere:RWA = Risk Weighted Assets OR = Operational RiskRWA PSIAr = RWA funded by Restricted PSIAs RWA PSIAunr = RiWA funded by Unrestricted PSIAsRWA PERIRRPSIAunr = Risk Weighted Assets funded by Profit Equalisation Reserve and Investment Risk Reserve of Unrestricted Profit Sharing Investment Accountsα = percentage of assets financed with PSIAunr
11Islamic bank contracts - Murabaha Short-term financingMurabaha (purchase and resale) involves three parties: the purchaser/importer, the seller/exporter, the bank. The last provides finance by purchasing the desired commodity and reselling it to the purchaser at a prefixed higher price (mark-up) payable in installments.The key risk is that the bank must have title to the goods at some point in the transaction. The main risk drivers are linked to:the contract structure: with or without customer’s promise to pay; with or without customer’s appointment ;the enforcement of customer’s promise;The mitigation techniques (collateral or deposit).Compare with the IFSB’s requirement
12Islamic bank contracts - Murabaha Counterparty monitoring+with customer’s appointment and instalment payment (“revolving” murabaha)without customer’s promise-with customer’s appointmentwith customer’s promiseKnowledge of the underlying marketCredit riskrisk due to the existing implicit option to buyMarket risk
13Islamic bank contracts - Salam Short-term financingSalam (purchase and resale) involves two parties: the bank as purchaser and his borrower as seller. It is an agreement to purchase, at a prefixed price, a specific kind of commodity not available with the seller. The commodity will be delivered on a specified future date.The risk profile of Salam depends on:bank’s role;the presence of parallel contract (parallel salam);the standardization of the underlying asset.counterpart performance risk
14Islamic bank contracts - Jiara Long-term financingIjara (leasing): due to the asset-backed nature of the operation, the bank retains ownership of the asset until maturity, helping to reduce the credit risk of the counterparty. The bank shares in the risk through its responsibility for maintenance and insurance.The main risk drivers are:the customer’s appointment,the sale of underlying asset at the end of the contract (the customer’s promise to buy the underlying asset);the mitigation instruments (collateral or takaful contract).Compare with the IFSB’s requirement
15Islamic bank contracts - Jiara Counterparty monitoring+with customer’s appointment and promise to buy the underlying assetwithout customer’s promise to buy the underlying asset-with customer’s appointmentwithout customer’s appointmentKnowledge of the underlying assetCredit riskThe full collateral can mislead in creditworthiness assessmentMarket risk
16Islamic bank contracts - Istisna Long-term financingIstisna: the bank finances work in progress or construction of a building or an installation and then sells it to the customer; it is payable in instalments.The main risk drivers are linked to:the type of contract: customer’s (full version)/underlying asset’s cash flows (limited version);the presence of parallel contract (parallel istisna):the underlying business risk.counterpart performance risk
17Islamic bank contracts - Mudaraba Partnership financingMudaraba (PL&LS agreement): a contract between a bank (acting as a silent partner) and one or more entrepreneurs (the bank and the depositor in case of PSAs): The bank provides the entrepreneur with the funding for a specific commercial activity. The entrepreneur does not contribute any funding himself, but contributes management expertise. The entrepreneur earns an agreed portion of the profits (‘management fee’). The profit balance is payable to the bank.The default event is indefinite and collaterals (or guarantees) are not allowed
18Islamic bank contracts - Mudaraba Bank pay off in tipycal mudarabaFirm’s cash flowBank’s pay-offIn the example, if the firm’s cash flow is positive the bank’s participation is 50%
19Islamic bank contracts - Mudaraba Bank pay off in mudaraba with maximum profitFirm’s cash flowStrikePrefixed levelBank’s pay-offAccording to several Islamic schools it is possible to determine a prefixed level of bank’s partecipation on firm’s cash flow against the moral hazard of the counterpart.It’s similar to pay-off’s put option (short position) on firm’s cash flow
20Islamic bank contracts - Musharaka Partnership financingMusharaka: partnership between a bank and an entrepreneur: both contributing capital to a project and sharing in its risks and its rewards. A formal contract is normally in place, outlining the obligations and rights of both parties: profits can be allocated in any pre-agreed ratio, and losses are borne in proportion to the capital of each partner.The risk profile of musharaka depends on:the underlying asset;the goal of contract such as the link withother contracts (diminishing musharakafor householders, for example).It is the purest Islamic contract thanks to the sharing of risk
21Islamic bank contracts – Risk unbundling Contract / RiskCreditMarketLiquidityOperationalSalamMurabahaIjaraIstisnaMusharakaMudarabaMarket and credit risks are more ntensely interdependent and connectedhignmediumRelevant market risks are strictly connected to liquidity riskslow
22Islamic bank contracts - Asset and liability Typical Islamic bank’s balance-sheetMurabahaSalamIjaraIstisnaMudarabaMusharakaDemand deposits(qardh hasan)Investment accounts(mudaraba)Islamic fundsNo P&LS contracts with high operational riskP&LS contracts inside the commercial bank’s boundaryLosses’ absorption of investment depositsMudaraba on both asset and liability sides
23Risk profile of Islamic banks Even though Islamic scholars consider mudaraba and musharaka as preferable Sharia-compliant financing vehicles, Islamic banks concentrate on selling the lucrative murabaha markup financing.The most common activities (trade and commodity finance, leasing, fund/asset management, etc) of dedicated Islamic banks are essentially no different to similar activities practised by many conventional banks.HoweverCertain risks are of greater significance compared to conventional banks.Creditworthiness, solvency and profitability are influenced by their unique characteristics.Higher profitability, cheaper and more stable deposits, and higher customer loyalty than for conventional peers tend to be offset by weaker liquidity; greater concentration; and more heterogeneous and less rigorous regulatory, accounting and disclosure frameworks.
24Risk profile of Islamic banks Credit risk peculiaritiesTransformation of credit in risk into market risk and viceversaA different bundling of credit and market risks between the bank and its financed customer.As collateral levels are typically higher than in conventional banks, a significant part of assets must be converted to real assets over a certain period of time.The legal environment is crucial for allowing an efficient loan recovery.Many products tend to carry higher asset and operational risk.Musharaka and mudaraba expose to heightened asset risk and potentially limits the bank’s ability to foreclose on loans and recover bad debts. They carry a fair amount of potential risks, as recognition of impaired transactions can be assessed only at the end of a contract.Overall, may be difficult to judge an Islamic bank's asset portfolio risk.
25Risk profile of Islamic banks Credit risk managementThe credit risk management functioning of an Islamic bank is essentially no different from that of a conventional bank even if some aspects are key: loan sanctioning process, loan book concentrations, loan impairment, collateral valuations and risk appetite.A higher transparency and a clear distinction between the risk management and the Shari’ah board are required. This board provides guidance and supervision in the development of Shari’ah-compliant products to ensure that they meet the requirements of Islamic law. A Shari’ah board should not involve itself with the actual granting of credit, as it is doubtful whether scholars are sufficiently skilled in credit analysis.
26Risk profile of Islamic banks Performance riskReturns achieved in Islamic banking seem to be high and have attracted the attention of conventional banks. This is due to:the benign operating environment that Islamic banks, mainly those based in oil-producing countries, have benefited from;the asset quality remained healthy;the margins on some products tend to be high partly reflecting the lack of pricing transparency but also limited competition (at least until now);as much of an Islamic bank’s funding comes from interest-free customer deposits, its cost of funding is typically lower than that of a commercial bank. This, in turn, boosts its ‘net profit’ margin and ‘net profit from financing activities’ line although it leaves income vulnerable to falling asset yields.
27Risk profile of Islamic banks Governance and complianceGovernance structures are quite peculiar because the institution must obey a different set of rules - those of the Holy Qur'an - and meet the expectations of Muslim community by providing Islamically-acceptable financing modes.Many different interpretations of Sharia law can exist at bank and country level. Although this has hampered product standardisation, the resulting lack of product comparability and pricing transparency has helped to benefit margins. smoother throughout the cycle, as IFIs do not pay fixed interest on debt and because they engage in profit-and-loss
28Conclusions - The concerns for supervisors Market risk: the specific dynamics of underlying market of asset-based contracts (no P&LS contracts) can create several concerns to the banks in case of unexpected price shocks or liquidity crisisCredit risk: the moral value of borrower’s promise and the enforcement’s mechanisms of this promise imply different standards of credit screening and monitoringOperational risk: the endogenous factors of operative risk are under control thanks to the Sharia “deterrent”
29Conclusions - The concerns for supervisors The regulation of Islamic banks in Europe implies several issues (as above mentioned) but what is the degree of growth in Europe?What is the real concern of European supervisors? Is the framework of the existing regulation, adequate for Islamic banks?Islamic banks operating in Europe (Islamic Bank of Britain, for example) have a simple business, mainly retail. In particular, on the asset side they don’t use the P&LS contracts while on the liability side the degree of freedom in managing PSIAs is limited.
30Conclusions - The concerns for supervisors Any regulatory framework has to:recognise the special features of Islamic finance and, in case, find appropriate responses to them rather than simply applying solutions already devised for traditional banksoffer those who use Islamic finance the same degree of protection offered to those who use non Islamic finance.Principles applied (adequate resources, corporate governance, reliable control systems, transparency) are general and cannot be modified. Specific issues relating to Islamic finance (the special position of the Sharia Board, bank’s and customers’ rights under a contract of mudaraba), accounting, …) may require specific solutions. In this case, it is necessary to adjust the domestic fiscal and legal framework to render it friendlier to the development of Islamic banking (and finance).
31Conclusions - The concerns for Italy Are there specific problems of compatibility with the existing Italian regulation?In addition to products offered, typical risks, investors and depositors protection, the assessment of corporate governance is crucial.In fact, in any case:the authorities cannot give any guarantee as to the Sharia compliance of products offered;the role and responsibilities of the Sharia Board vis a vis top management and shareholders are completely delegated to the bank and its management.However, some reflections are necessary about the composition of the Board and its relationships with other stakeholders bank. Although formally independent and separate, the effective influence on management depends on the nature of their relationship with the bank which may take different forms.9