RISK MANAGEMENT IN ISLAMIC/CONVENIONAL BANKING

Risk entails both vulnerability of asset values and opportunities of income growth. Successful firms take advantage of these opportunities (Damodaran, 2005).

An important element of management of risk is to understand the risk–return trade-off of different assets and investors. Investors can expect a higher rate of return only by increasing their exposure to risks. As the objective of financial institutions is to create value for the shareholders by acquiring assets in multiples of shareholder-owned funds, managing the resulting risks faced by the equity becomes an important function of these institutions.

As Islamic banking is relatively new, the risks inherent in the instruments used are not well comprehended. Islamic banks can be expected to face two types of risks: risks that are similar to those faced by traditional financial intermediaries and risks that are unique owing to their compliance with the shari’a.

Furthermore, Islamic banks are constrained in using some of the risk mitigation instruments that their conventional counterparts use as these are not allowed under Islamic commercial law.

Risks in Islamic banks

The asset and liability sides of Islamic banks have unique risk characteristics. The Islamic banking model has evolved to one-tier mudaraba with multiple investment tools. On the liability side of Islamic banks, saving and investment deposits take the form of profit sharing investment accounts. Investment accounts can be further classified as restricted and unrestricted, the former having restrictions on withdrawals before maturity date.

Demand deposits or checking/current accounts in Islamic banks take the nature of qard hasan (interest-free loans) that are returned fully on demand. On the asset side, banks use murabaha (cost-plus or mark-up sale), instalment sale (medium/long-term murabaha),bai-muajjal (price-deferred sale), istisnaa/salam (object deferred sale or pre-paid sale) and ijara (leasing) and profit-sharing modes of financing (musharaka and mudaraba).1 These instruments on the asset side, using the profit-sharing principle to reward depositors, area unique feature of Islamic banks.Such instruments change the nature of risks that Islamic banks face. Some of the key risks faced by Islamic banks are discussed below.

Credit risk

Credit risk is the loss of income arising as a result of the counterparty’s delay in payment on time or in full as contractually agreed. Such an eventuality can underlie all Islamic modes of finance. For example, credit risk in murabaha contracts arises in the form of the counterparty defaulting in paying the debts in full and in time. The non-performance can be due to external systematic sources or to internal financial causes, or be a result of moral hazard (wilful default). Wilful default needs to be identified clearly as Islam does not allow debt restructuring based on compensations except in the case of wilful default.

 In the case of profit-sharing modes of financing (like mudaraba and musharaka) 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 because of the asymmetric information problem where they do not have sufficient information on the actual profit of the firm.

Market risk

Market risks can be systematic, arising from macro sources, or unsystematic, being asset or instrument-specific. For example, currency and equity price risks would fall under the systematic category and movement in prices of commodity or asset the bank is dealing with will fall under specific market risk. We discuss a key systematic and one unsystematic risk relevant to Islamic banks below.

Mark-up risk

Islamic financial institutions use a benchmark rate to price different financial instruments. For example, in a murabaha contract the mark-up is determined by adding the risk premium to the benchmark rate (usually the LIBOR). The nature of a murabaha is such that the mark-up is fixed for the duration of the contract. Consequently, if the benchmark rate changes, the mark-up rates on these fixed income contracts cannot be adjusted.

Commodity/asset price risk

The murabaha price risk and commodity/asset price risk must be clearly distinguished. As pointed out, the basis of the mark-up price risk is changes in LIBOR. Furthermore, it arises as a result of the financing, not the trading process. In contrast to mark-up risk, commodity price risk arises as a result of the bank holding commodities or durable assets as in salam, ijara and mudaraba/musharaka.

 Note that both the mark-up risk and commodity/asset price risk can exist in a single contract. For example, under leasing, the equipment itself is exposed to commodity price risk andthe fixed or overdue rentals are exposed to mark-up risks.

As a result Islamic banks face risks arising from movements in market interest rate. Markup risk can also appear in profit-sharing modes of financing like mudaraba and musharakaas the profit-sharing ratio depends on, among other things, a benchmark rate like LIBOR.

Liquidity risk

Liquidity risk arises from either difficulties in obtaining cash at reasonable cost from borrowing (funding liquidity risk) or sale of assets (asset liquidity risk). The liquidity risk arising from both sources is critical for Islamic banks. For a number of reasons, Islamic banks are prone to facing serious liquidity risks. First, there is a fiqh restriction on the securitization of the existing assets of Islamic banks, which are predominantly debt in nature. Second, because of slow development of financial instruments, Islamic banks are also unable to raise funds quickly from the markets. This problem becomes more serious because there is no inter-Islamic bank money market. Third, the lender of last resort (LLR) provides emergency liquidity facility to banks whenever needed. The existing LLRfacilities are based on interest, therefore Islamic banks cannot benefit from these.

Operational risk

Operational risk is the ‘risk of direct or indirect loss resulting from inadequate or failed internal processes, people, and technology or from external events’ Given the newness of Islamic banks, operational risk in terms of personal risk can be acute in these institutions. Operation 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 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

Legal risks for Islamic banks are also significant and arise for various reasons. First, as most countries have adopted either the common law or civil law framework, their legal systems do not have specific laws/statutes that support the unique features of Islamic financial products. For example, whereas Islamic banks’ main activity is in trading(murabaha) and investing in equities (musharaka and mudaraba), current banking law and regulations in most jurisdictions forbid commercial banks undertaking such activities.

Second, non-standardization of contracts makes the whole process of negotiating different aspects of a transaction more difficult and costly. Financial institutions are not protected against risks that they cannot anticipate or that may not be enforceable. Use of standardized contracts can also make transactions easier to administer and monitor after the contract is signed. Finally, lack of Islamic courts that can enforce Islamic contracts  increases the legal risks of using these contracts.

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

Fiduciary risk can be caused by breach of contract by the Islamic bank. For example, the bank may not be able to comply fully with the shari’a requirements of various contracts. Inability to comply fully with Islamic shari’a either knowingly or unknowingly leads to alack of confidence among the depositors and hence causes withdrawal of deposits. Similarly, a lower rate of return than the market can also introduce fiduciary risk, when depositors/investors interpret a low rate of return as breaching an investment contract or mismanagement of funds by the bank

Displaced commercial risk

This is the transfer of the risk associated with deposits to equity holders. This arises when, under commercial pressure, banks forgo a part of their profit to pay the depositors to prevent withdrawals due to a lower return Displaced commercial risk implies that the bank may operate in full compliance with the shari’a 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.

Bundled risks

It is uncommon for the various risks to be bundled together. However, in the case of most Islamic modes of finance, more than one risk coexists. For example, in salam, once the bank has made an advance payment, it has started to take the counterparty risk concerning delivery of the right commodity on time, the market risk of the commodity, the liquidity risk of its conversion into cash, the operational risk of its storing and movement and so on. The same is the case with istisnaa, financial murabaha, ijara andmusharaka/mudaraba.

Risk mitigation in Islamic banks

The techniques of risk identification and management available to the Islamic banks could be of two types. The first type comprises standard techniques, such as risk reporting, internal and external audit, GAP analysis ,internal rating and so on, which are consistent with the Islamic principles of finance. The second type consists of techniquesthat need to be developed or adapted, keeping in mind the requirements for shari’ a compliance. Hence the discussion of risk management techniques for Islamic banking is a challenging one. While all these challenges cannot be identified and fully discussed in this chapter, we focus on some of the issues that have relevance to shari’a and avoid the details of standard techniques. We discuss the risk mitigation techniques and challenges under the headings of risk avoidance/elimination, risk transfer and risk absorption/management below.

Risk avoidance/elimination

Risk avoidance techniques would include the standardization of all business-related activities and processes, construction of a diversified portfolio and implementation of an incentive-compatible scheme with accountability of actions. Some risks that banks have can be reduced or eliminated by transferring or selling these in well defined markets. The ways in which some risks can be reduced or eliminated in Islamic banks are discussed below.

Contractual risk mitigation

As Islamic banks use unique modes of finance, some risks need to be mitigated by proper documentation of products. 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 examples.

a.       To overcome the counterparty risks arising from the non-binding nature of the contract in murabaha, up-front payment of a substantial commitment fee has become a permanent feature of the contract. To avoid fulfilling the promise made by a client in taking possession of the ordered goods (in the case of murabaha), the contract should be binding on the client and not binding on the bank. This suggestion assumes that the bank will honour the contract and supply the goods as contractually agreed, even if the contract is not binding on it.

Since the murabaha contract is approved on 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 more or less eliminated by the Islamic banks by appointing the client as an agent for the bank to buy the asset.