Download risk management in musharakah

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Risk Management in Islamic
Financial Institutions
Associate Prof Rifki Ismal
Sesric Training Program
National Bank of Tajikistan
Tajikistan, 11-12 July 2012
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DAY TWO
Session 1:
Risk Management in
Islamic Banking Contracts
RISK MANAGEMENT IN MUSHARAKAH
• Musharakah is a partnership (joint venture) contract
where two parties (Islamic bank and business partner)
combine their capital in an investment to share profit and
loss whereby they have similar right and liabilities.
• There are permanent and diminishing Musharakah.
Loss - 4
Profit - 3
Islamic
Projects
Depositors
1
Islamic Bank
2
Entrepreneur
RISK MANAGEMENT IN MUSHARAKAH
• Credit, Operational, Market and Liquidity risk
exposes both permanent and diminishing
Musharakah.
• Permanent Musharakah faces operational risk
in determination of profit and loss sharing. Profit
is shared related/unrelated to capital
contribution while loss sharing is precisely
based on capital contribution.
• When business fails to produce income, it
bears credit risk. This might interrupt payment
of PLS to depositors and invite liquidity risk.
RISK MANAGEMENT IN MUSHARAKAH
• Finally if the business can not be
continued, value of final capital
faces market risk.
• Diminishing Musharakah exposes
operational risk when business
partner fails to buy share of
diminishing capital.
• Since expected income can’t be
fulfilled, credit risk appears.
RISK MANAGEMENT IN MUSHARAKAH
• When it disturbs payment of PLS to
depositors, liquidity risk comes into the
bank.
• At the end of diminishing Musharakah,
when value of total equity investment
is different with market value, banks
bears market risk.
• To handle both operational risk and
credit risk, bank must take part in
company’s management, do
monitoring and insure the business.
RISK MANAGEMENT IN MUSHARAKAH
• Bank may have right to sale its share
to third party in diminishing
Musharakah contract to avoid credit
risk.
• Stop the loss of a business is one of the
solutions to mitigate market risk.
• Gradually selling bank’s share to
business partner is also another
solution for credit and market risk.
Finally, reserving capital might hinder
bank from liquidity risk.
RISK MANAGEMENT IN MUDARABAH
• Mudarabah is a partnership where one party
provide capital and another party provide skill.
Any profit will shared but loss will be borne by
owner of capital only.
1
Depositors
PLS
2
Islamic Bank
Profit
PLS
Entrepreneur
4
3
Islamic Project
Loss
5
RISK MANAGEMENT IN MUDARABAH
• External events like catastrophic and internal
business failure might invite operational risk
ending with business losses which should be
covered by the bank.
• Following it, liquidity of the bank is disturbed
(failure to provide cash to depositors) which is
liquidity risk.
• Specifically, if mudarib is not capable (skillful)
enough to run the business, it can cause credit risk
to the bank and because value of the project
dropped in the market equity price risk appears.
• Because management of the project can’t be
controlled by bank, transparency risk exists.
RISK MANAGEMENT IN MUDARABAH
• To mitigate, bank should be sure the
eligibility and capability of the mudarib
(business partner).
• Monitoring business performance and
balance sheet of company might lessen
credit risk.
• Accurately measuring, predicting and
anticipating market risk are some ideas to
tackle market risk issue in this case.
• Providing capital adequacy and internal
reserve are also tools to prevent liquidity
risk in Mudarabah contract.
RISK MANAGEMENT IN MURABAHAH
• Mudarabah stands for a sale of good on a mutually
agreed profit and deferred payment. The seller was
obliged to declare his cost and the profit to the buyer
(transparency) .
1b
Bank's Client
3
4
1a
Islamic Bank
2
Vendor
(Owner of
the Asset)
RISK MANAGEMENT IN MURABAHAH
• Client promises to buy asset under
wa’ad contract (unbinding) so it
might lead to operational risk or asset
risk if he/she declines to buy.
• Before asset being sold to client,
bank is responsible for any risk of the
asset such as market risk, risk of loss,
damage, etc.
• If mark up price is not accurately
determined, it may cause mark up
risk.
RISK MANAGEMENT IN MURABAHAH
• At the end or during payment period
of Murabahah, the bank faces
commodity price risk and market risk.
• When client (buyer) fails to pay the
installment, credit risk comes and if
he/she is default, price and market
risk bear the bank when the asset is
sold to market.
• Further, such difficult situation will end
up with credit liquidity risk, withdrawal
risk and bank rush.
RISK MANAGEMENT IN MURABAHAH
• Bank may require client to put collateral to minimize
operational risk, credit risk and moral hazard risk.
• Complete documents should follow this complicate
contract such as guarantee, collateral, value of the
asset, installment period, etc.
• Total payment of Murabahah uses formula of :
n
R   ri  pi 
i 1
• Hence, total repayment should be greater that the
above formula or :
n
R    ri  pi 
i 1
RISK MANAGEMENT IN SALAM
• In Salam, a bank buys a specific good from a producer
to be delivered in the future (known) date. The bank
later on sales that good to an agreed buyer for profit.
1b
Bank's Client
(Producer)
1a
2
Islamic Bank
3
Good's
Market
RISK MANAGEMENT IN SALAM
• External events may cause the seller fail to
deliver the good in an agreed date.
Operational risk occurs.
• Mismatching between specification of the
good requested and the one being made
may lead to delay of the finished good.
This brings business risk and reputation risk.
• Even though salam price is fixed but the
final price of the good still has mark up risk
and market risk because of fluctuation in
price of commodity.
• In the selling time, if buyer delay/fail to buy
the salam good from bank, credit risk and
liquidity risk hamper the bank.
RISK MANAGEMENT IN SALAM
• To avoid operational risk, bank may ask the seller
to follow standard procedure in making the good
and insures the salam object.
• Choosing the respected, well-performed, skillful
seller can also be adopted by bank.
• Using quantitative and qualitative approaches to
predict probability of seller’s default to deliver the
good in agreed time.
• Predicting future market price can minimize mark
up risk, price risk and market risk. Technically Value
at risk can be employed for such purpose.
• To minimize asset risk (damage risk, loss, etc), bank
can (i) ask the seller to directly deliver the good to
buyer or; (ii) ask the seller to find candidate buyer.
RISK MANAGEMENT IN ISTISHNA
• Istishna has the same mechanism with Salam except it
applies mainly for manufacturing/industrial goods; no
obligation to pay full cash in advance by bank and
having specific quality/quantity to be fulfilled by seller.
1b
Bank's Client
(Producer)
1a
2
Islamic Bank
3
Good's
Market
RISK MANAGEMENT IN ISTISHNA
• During the construction, it is possible to have
disruption in supply of raw material, undesirable
construction, wrong construction, etc. This is
operational risk which may end up with credit risk.
• In such case, when seller asks for a extra time,
bank faces business risk, reputation risk and
liquidity risk.
• If seller finally can not make the ordered good,
default risk, credit risk, liquidity risk are some
potential risks to be borne.
• When actual price of the ordered good
fluctuates, it causes price and market risk when
the bank receives the good and want to resell it
to the buyer.
RISK MANAGEMENT IN ISTISHNA
• Carefully and precisely choose the contractor
(seller) is one possible action to prevent
operational risk, default risk, moral hazard risk, etc.
• Insuring the manufactured good can also be
taken into account.
• During the construction process, coordination,
intensive monitoring, effective communication,
and cooperation are among activities which can
minimize risk of product defect, failure, etc.
• Reserving some capital (internal liquidity) for the
sake of managing liquidity withdrawal from
depositors is another policy to solve liquidity risk.
• Join contract among Islamic banks to order a
good under Istishna basis will also lessen risk of
default, etc.
RISK MANAGEMENT IN IJARAH
• Ijarah is hiring or leasing physical asset. The
bank owns the asset and leases it for a fee.
There are operational ijarah and financing
ijarah.
1b
Bank's Client
3
4
1a
Islamic Bank
2
Vendor
(Owner of
the Asset)
RISK MANAGEMENT IN IJARAH
• Any default of payment by the lessee may
generate credit risk and operational risk.
• There is also commodity price risk and market
risk to the asset being rented.
• Any damage/defect in the asset is under
responsibility of the bank. It can invite moral
hazard risk and personal risk.
• Rate of return risk appears when determination
of ijarah fee is not appropriately calculated.
• In ijarah muntahia bitamlik/ ijarah tumma al
baik/ijarah wa iqtina, the lessee and lessor bear
market risk when settling the asset at the end of
ijarah period.
RISK MANAGEMENT IN IJARAH
• Accurately measuring the value of the asset
and rental rate. Since rental rate can be
adjusted, bank has to determine it precisely.
• Insuring the asset and monitoring the usage of
the asset might be lowering moral hazard risk,
credit risk, operational risk, etc.
• Estimating future market price may allow
Islamic bank to anticipate market risk.
• Financing lease by mechanism prevents
Islamic bank from asset risk (damage, loss,
defect, etc) but it needs more effort
compared to operational lease.
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DAY TWO
Session 1:
Liquidity Risk in
Islamic Banking
Characteristics of IB Facing Liquidity Risk
• Liquidity risk in IB is theoretically a reflection of the
real economic condition.
• The probability of liquidity risk is reduced internally
throughout sharia principles and externally
through Islamic financial market mechanism,
spurred by regulators and connected with real
sector under sharia compliance.
Characteristics of IB Facing Liquidity Risk
• Islamic bank ties its financing contract
with real asset and this is typically another
unique attribute of its operation.
• As a result, they face commodity risk such
as price risk, asset loose, amortization, etc
that could all interrupt asset side and end
up with asset liability imbalances.
• Therefore, in Islamic banking, liquidity risk
can happen as a result of attaching
financing contract with real asset, which
is not a typical conventional business
transaction.
IB Risk Related to Liquidity Risk Management
• IB is expected to see its liquidity risk from
holistic perspective (IFSB) due to current
economic condition and interconnection
among financial and business risk.
• Financing risk in IB exposes direct loss to
asset or liabilities followed by asset liability
mismatch risk and liquidity run risk.
• As Islamic bank replaces lending with
investment and partnership terminology.
Credit risk (part of financing risk) becomes
another problem to be anticipated.
IB Risk Related to Liquidity Risk Management
• Market risk and commodity risk such as
mark up risk, price risk, leased asset value
risk, securities price risk and foreign
exchange risk.
• Business risk, which incorporates rate of
return risk, displaced commercial risk,
withdrawal risk and treasury risk.
IB Risk Related to Liquidity Risk Management
• Liquidity run risk is partly triggered by asset and liability
imbalances; and another part from uncontrollable factors
: (1) Macroeconomic imbalances; (2) Low trust on banks
by investors leading to redemption and; (3) Abnormal
financial market behavior.
FINANCIAL AND BUSINESS RISK
Financing Risk
Market Risk
Liquidity Risk
Asset Liability
Mismatch Risk
Asset Side
Sharia Compliance Risk
Certainty Income
Default Risk
Commodity Risk
Asset Value Volatility
Uncertainty Income
Business Life Cycle
Moral Hazard Risk
Non Economic Risk
Credit Risk
Business Risk
Liquidity Run Risk
Liability Side
Sharia Compliance Risk
Under Developed
Product Risk
Deposit Concentration
Risk
Depositor Dependence
Risk
Rational Depositor Risk
Operational Risk
Economic Crisis
Lower Trust on Banks
External Shock
Huge & Sudden Demand
of Liquidity
Followed by
Insolvency Risk
Gov't Take Over Risk
Reputation Risk
Religious Consequences
Over Capital
Commitment Risk
Inaccurate Financial
Analysis Risk
IB Risk Related to Liquidity Risk Management
• Reputation risk arising from failure in
governance, business strategy and
process; government takes over risk;
up into the risk of religious
consequences .
• Persistent asset liabilities mismatches
should be traced seriously. On the
liability side, it emerges in:
– under developed banking products;
– specific time deposit concentration;
– reliance on big investors;
– rational depositors consequences.
IB Risk Related to Liquidity Risk Management
• On the asset side, if there are
disturbances in both certainty and
uncertainty financing.
• Certainty income, for example:
– Murabahah financing is very sensitive
to its long term deferred payment;
– Ijarah has problems of assets being
leased;
– Bay Salam and Bay Istisna have
problems of non-deliverable objects or
drop of objects’ price risk.
IB Risk Related to Liquidity Risk Management
• Uncertainty income is determined by
business risk such as changes in market,
counter parties, product and
economic/political environment.
• Fortunately, sharia equips Islamic bank
with the profit and loss sharing concept
that potentially reduces a deep loss of
liquidity risk when it occurs (Alsayed,
2007:1).
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DAY TWO
Session 1:
Sharia Approaches on
Liquidity Risk Management
Challenges Related to Liquidity Risk Management
• From liability side: the requirement to maintain
adequate liquidity as a standby reserve. It
contains two modes of reserves, namely cash
reserve requirement in the central bank and
statutory liquidity requirement in the bank itself
• Another type of liquidity reserved for such
purpose is placement in money market
instrument essentially the very short-term basis.
• Usually, the instruments take form of debt
based such as Murabahah inter bank or
equity based such as Musharakah and
Mudarabah inter bank and ready to be
liquidated whenever the bank needs.
Challenges Related to Liquidity Risk Management
• From asset side: Islamic bank tends to
allocate fund in just short-term investment
basis (Gafoor, 1995:8). Even, in the short
investment period, Islamic bank prefers debt
based Islamic financing to equity based.
• The necessary challenge appears in the
case of default by business partners because
Islamic bank is prohibited from charging any
accrued interest or imposing any penalty .
• The other challenges are lack of easily
liquidated long-term investment, immature
financial market, etc.
IFSB Guide on Liquidity Risk Management
• IIFS shall have in place a liquidity management
framework (including reporting) taking into
account separately and on an overall basis
their liquidity exposures in respect of each
category of current accounts, unrestricted and
restricted investment accounts (Principle 5.1).
• IIFS shall assume liquidity risk commensurate
with their ability to have sufficient recourse to
sharia compliant funds to mitigate such risk
(Principle 5.2).
• Best practices in many IB identify involvement
of investors, Islamic bank, business partners and
their stakeholders in dealing with liquidity risk
mitigation.
Best Practices in ISLAMIC BANKS
Investors Involvement in Liquidity Risk Management
• Sharia ties investors of the bank to be
responsible and aware of liquidity risk. Their
engagements are ultimately in forms of
their deep understanding of Islamic
banking principles, operations and business
consequences.
• The most important one is their
unwillingness to entail in the prohibited
business activities such as:
– speculation,
– interest rate return seeking, etc
• besides their willingness to share the risk
and responsibility with the bank.
Investors Involvement in Liquidity Risk Management
• The mature investors will be ready to
accept:
– risk sharing,
– no periodic return in certain types of
the banks’ products, and
– all other following consequences.
• Meanwhile, for business partners, the
understood investors will indirectly
guarantee the availability of fund for
business.
IB Roles in Liquidity Risk Management
• IB develops internal sharia approaches facing
liquidity risk problem :
– Liquidity risk management policy that includes
policy related to liability and asset side. It is
established by Board of Director and followed
up by special task body and continued by
senior management in a very technical level.
– Measuring and monitoring liquidity risk. Islamic
bank is obliged to maintain adequate liquidity
as its standby reserve and regularly review its
limit.
– Prudential and sharia compliance banking
operation that deals with the bank’s financing
decisions, business partners’ selection, and
possibility of join operation with other Islamic
banks.
IB Roles in Liquidity Risk Management
– Sharia based liability management. IB
follows three approaches:
• Adjusting types of deposit products
into projects to be financed;
• Balancing of financing needed and
amount to be collected and;
• Managing maturity date of both
deposit products and projects
financing.
IB Roles in Liquidity Risk Management
– Sharia based asset management. IB
approaches are,
• Fitting characteristics of deposit and
projects financing;
• Matching the flow of projects’ return
with the due date of PLS payment;
• Selecting business partners through
due diligence;
• Employing joint financing with other
Islamic banks to share the risk and;
• Monitoring and conducting
cooperative business
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DAY TWO
Session 2:
Sharia Techniques to
Mitigate Liquidity Risk
Organizational Approaches & Liquid Instruments
• Organizational approaches captures policies of:
–
–
–
–
Regulating redemption time;
Mitigating of default in equity;
Mitigating of default in debt based financing, and;
Determining parent company internal liquidity
agreement.
• Liquid Instruments as follows:
SOURCES OF LIQUIDITY
Internal Sources of Liquidity
Placement through Islamic
Financing
-
Mudarabah Redeemable CD
Islamic Bankers Acceptance
Private Asset Securitization
Commodity Murabahah.
Wakalah
Double Currency Exc Depo
Placement in External
Instruments
- Central Bank's Instrument
- Financing
- Pooling Fund
- Government Securities
- GII and ILIF
- Sukuk
-
External Sources of
Liquidity
Central Bank Facility
Government Intervention
Islamic Money Market
Overseas Investors
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End of the Training