Risks Underlying Islamic Modes of Financing (I) Islamic Development Bank

Summary of the Previous Lecture We studies the following topics in todays lecture; Popular Sukuks Salam Sukuk Istisna Sukuk Murabaha Sukuk Sukuk Growth Controversies in different types of Sukuks Differences between Sukuk and Bonds

Sukuk versus Conventional Bonds Sukuk 1.Income is generated from assets 2.Return is expected 3.Negotiability is restricted to specific types of Sukuk Conventional Bonds 1.Income is derived from debt instrument. 2.Return is interest and pre-determined. 3.Negotiable financial paper

Sukuk versus Conventional Bonds Sukuk 4.Sukuk issueR is a seller of assets 5.Sukuk holder is an owner of assets 6.Seller-Buyer relationship 7.Business risk-return relationship Conventional Bonds 4.Bond issuer is a borrower 5.Bond holder is a lender 6.Lender-borrower relationship 7.Issuer guarantees the payment of face value and periodic interest

Sukuk versus Conventional Bonds Sukuk 8.Major risk lays with underlying assets 9.Return is expected from the underlying assets 10.Return of investor’s capital cannot be guaranteed Conventional Bonds 8.Major risk is with issuer – credit risk 9.Interest payment is an obligation 10.Issuer is obligated to return investor’s capital (face value)

Controversies in Sukuk Sukuk al Musharakah some Shariah Boards approved the structure or allowed their respective institutions to invest in such business deals, others have prevented institutions under their respective supervision to invest in such Sukuk viewing them Shariah non-compliant.

Controversies in Sukuk Sukuk al Musharakah Disagreement arises on the permissibility for one of the Musharakah partners to give an undertaking to purchase the shares or units of the second partner of the Musharakah, at the maturity of the Sukuk, at face value and predetermined price.

Criticism against the Ijarah Sukuk 1. Guarantee in Sukuk issuance: A third party who is normally the originator of the Sukuk provides a guarantee for the principal capital of the Sukuk. The originator benefiting from the Sukuk proceeds establishes a Special Purpose Vehicle (SPV) that issues the Sukuk while the originator stands by to provide a guarantee against any shortfall.

Criticism against the Ijarah Sukuk 1. Guarantee in Sukuk issuance: The first collective resolution issued by the Islamic Fiqh Academy in its resolution 30(5/4) pertaining to Ijarah Sukuk: "There is no Shariah objection to mention in the prospectus of the issue or in the document of Sukuk the promise of a third party, who is independent personally and in term of financial liability from the two parties to the contract,…………

Criticism against the Ijarah Sukuk 1. Guarantee in Sukuk issuance: The AAOIFI Shariah Standards No.17. on Investment Sukuk states the following: "The prospectus must not include any statement to the effect that the issuer of the certificates accepts the liability to compensate the owner of the certificates up to the nominal value of the certificates in situations other than torts and negligence nor that he guarantees a fixed percentage of profit. It is, however, permitted to an independent third party to provide a guarantee free of charge…………..

Criticism against the Ijarah Sukuk 1. Guarantee in Sukuk issuance: Whereas guaranteeing of capital is prohibited by all schools of Islamic law. Even if the third party guaranteeing the capital is government, it shall be declared non-permissible as the government treasury is the property of the whole community and should not be exposed to financial risk of some individuals or entities.

Criticism against the Ijarah Sukuk 2. The Sale and Lease Back Structure: Renting an asset to the party who sold it, has been questioned by scholars. 3. Pricing of Sukuk Muslim economists and Shariah scholars have not come up with an alternative to the interest rate as a readily available indicator of profitability. Hence the use of LIBOR/KIBOR as a benchmark has become part of the practice in Islamic financial institutions.

Criticism against the Ijarah Sukuk 3. Pricing of Sukuk However, in practice this return is not at all reflecting the rental of the underlying asset but the prevalent interest rate. For example, if there are two real assets which are totally different from each other, then based on market realities we expect to have different rental income on them. However, it is observed that same rate of return, as reflecting the prevailing interest rate, is paid on them if they are used as underlying assets for two different Sukuk issues

Learning Outcomes After this lecture you will be able to understand The basic concept of risk and its classification into different types. Risks faced by the financial institutions. Uniqueness of risk in Islamic banks. Risks in Islamic Financial instruments. How to mitigate in Islamic financial instruments.

Risk Existence of uncertainty about future outcomes Difference between expected and actual result Uncertainty can be classified as general and specific General: ignorance of any potential outcome, e.g. after the investment in stocks of a company, the company goes default. Specific: when probabilities can be assigned to potential outcomes—this is usually referred to as risk, e.g. depending upon the financial conditions of the company what are chances of default.

Risks Risk is measured by the variability or volatility of outcomes using statistical tools like variance or standard deviation. Costs involved with higher volatility can lead to bankruptcy

Risk Objectives of risk management To reduce volatility in the probable outcomes. To eliminate costly lower tail outcomes To maintain a certain risk profile The value maximization

Risk Classification of Risks Business risks and financial risks – Business risk relates to uncertainty arising from the nature of firm’s business, e.g. decreased revenues, higher costs, high turnover, etc. – Financial risks relates to movements in the financial market (Interest rates, economic conditions, etc.) Systematic risk and unsystematic risks – Systematic risk is associated with overall market – Unsystematic risk is linked to the specific asset or firm

TotalRisk Unsystematic risk Systematic risk STD DEV OF PORTFOLIO RETURN NUMBER OF SECURITIES IN THE PORTFOLIO Systematic Risk Factors such as changes in nation’s economy, tax reform by the government, or a change in the world economic situation or the exchange rate movements. Total Risk = Systematic Risk + Unsystematic Risk

TotalRisk Unsystematic risk Systematic risk STD DEV OF PORTFOLIO RETURN NUMBER OF SECURITIES IN THE PORTFOLIO Unsystematic Risk Factors unique to a particular company or industry. For example, the death of a key executive or strike by the employees of the company. Total Risk = Systematic Risk + Unsystematic Risk

Risks faced by Financial Institutions 1. Market Risks Interest rate/benchmark risk Equity price risk Asset/Commodity price risk Currency risk (Foreign exchange rates) 2. Credit Risks Trade credit (settlement) risk Counter party risk

Risks faced by Financial Institutions 3. Liquidity risk Funding liquidity risk (risk to meet liabilities) Trading liquidity risk Funding liquidity – Risk that liabilities: Cannot be met when they fall due Can only be met at an uneconomic price Can be name-specific or systemic

Risks faced by Financial Institutions 4. Operational risk People risk (employees turnover) Technology risk (rapidly changing cost efficient technologies) Process risk (Obsolete process) Legal and regulatory risks

Typical Balance Sheet of FI LiabilitiesAssets Deposits & DebtBanking Portfolio EquityTrading Portfolio 28

A Typical Islamic Bank Model Typical IB model—one-tier Mudarabah with multiple investment tools. Liability side – Savings and investment accounts –Mudarabah – Demand deposits—Qard e Hasana Asset side – Fixed income assets (Murabaha, installment sale, Istisna, salam, and Ijarah) – Variable income assets (Mudarabah and Musharakah)

Unique Risks in Islamic Banks 1. Contractual Nature of Deposits PSIA — Mudarabah contracts Demand deposits— Qard-e-Hasana 2. Fiduciary (trust) risk—PSIA are fiduciary contracts Lower rate of return than conventional banks or non- compliance with Sharia can be interpreted as breach of contract – fiduciary risk 3. Withdrawal Risk Lower returns may lead to withdrawal of deposits. To avoid such situations returns (dividends) from shareholders are transferred to depositors-transfer of risks associated with deposits to equity holders.

Unique Risks in Islamic Banks 4. Using PSIA as capital Difference between restricted and unrestricted PSIA 5. Risks in Islamic financial instruments As modes are asset-backed or equity based, market risks are important along with credit risks Market and credit risks intermingle and transform from one kind to another at different stages of transaction

Unique Risks in Islamic Banks 6. Operational Risks Person risk—lack of qualified human resource who understand/manage risks in Islamic banking Technology risk - computer software's and IT for IBs Legal risks  Standardization of contracts  Lack of legislative act and enforcement institutions

Summary of the Lecture In this lecture we covered the following topics; The concept of risk. Objectives of risk management Classification of risk Risks faced by financial institutions Islamic bank model Unique risk in Islamic Banks