Risk profile of Islamic banks

1. Risk profile of Islamic banks Claudio Porzio & M. Grazia Starita University of Naples “Parthenope”

2. Agenda • A taxonomy of Islamic contracts • Islamic bank contracts: their typical risk profile • Liabilities • Assets • Murabaha • Salam • Ijara • Istisna • Mudaraba • Musharaka • Risk profile of Islamic banks • Conclusions

3. A 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.

4. Funding Liquidity management Investment Securitisation Demand deposits Islamic funds (mudaraba) Sukuk Investment accounts A taxonomy of Islamic contractsLiability side Outside the conventional bank’s boundary

5. P&LS contracts Financial needs Insurance Asset management Musharaka Takaful Islamic fund Mudaraba A taxonomy of Islamic contractsAsset side Partnership finance

6. No P&LS contracts Short-term financing Long-term financing Murabaha Ijara Salam Istisna A taxonomy of Islamic contractsAsset side Lease finance Asset finance Asset finance

7. A taxonomy of Islamic contractsThe parallel with “conventional” finance Asset side Liability side Other

8. Islamic bank contracts - Liabilities Having both debt and equity features, are PSIAs to be accounted for as off-balance-sheet ?

9. Islamic bank contracts - Liabilities • There 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? Shareholders’ claims • Dividend (after PER’s depreciation and IRR’s depreciation) • Control rights PSIAs holders’ cash flow rights • Return in line with market interest rates (after PER’s depreciation against the displaced commercial risk) • No control rights

10. Islamic 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 smoothing where: RWA = Risk Weighted Assets OR = Operational Risk RWA PSIAr = RWA funded by Restricted PSIAs RWA PSIAunr = RiWA funded by Unrestricted PSIAs RWA PERIRRPSIAunr = Risk Weighted Assets funded by Profit Equalisation Reserve and Investment Risk Reserve of Unrestricted Profit Sharing Investment Accounts α = percentage of assets financed with PSIAunr

11. Islamic bank contracts - Murabaha Short-term financing Murabaha (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

12. Islamic bank contracts - Murabaha Credit risk risk due to the existing implicit option to buy Market risk

13. Islamic bank contracts - Salam Short-term financing Salam (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

14. Islamic bank contracts - Jiara Long-term financing Ijara (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

15. Islamic bank contracts - Jiara Credit risk The full collateral can mislead in creditworthiness assessment Market risk

16. Islamic bank contracts - Istisna Long-term financing Istisna: 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

17. Islamic bank contracts -Mudaraba Partnership financing Mudaraba (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

18. Bank’s pay-off Firm’s cash flow Islamic bank contracts -Mudaraba Bank pay off in tipycal mudaraba In the example, if the firm’s cash flow is positive the bank’s participation is 50%

19. Bank’s pay-off Prefixed level Strike Firm’s cash flow Islamic bank contracts -Mudaraba Bank pay off in mudaraba with maximum profit According 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

20. Islamic bank contracts -Musharaka Partnership financing Musharaka: 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 with other contracts (diminishing musharaka for householders, for example). It is the purest Islamic contract thanks to the sharing of risk

21. Islamic bank contracts –Risk unbundling Market and credit risks are more ntensely interdependent and connected hign medium Relevant market risks are strictly connected to liquidity risks low

22. Islamic bank contracts - Asset and liability Typical Islamic bank’s balance-sheet • No P&LS contracts with high operational risk • P&LS contracts inside the commercial bank’s boundary • Losses’ absorption of investment deposits • Mudaraba on both asset and liability sides

23. Risk 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. However • Certain 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.

24. Risk profile of Islamic banks Credit risk peculiarities • Transformation of credit in risk into market risk and viceversa • A 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.

25. Risk profile of Islamic banks Credit risk management • The 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.

26. Risk profile of Islamic banks Performance risk Returns 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.

27. Risk profile of Islamic banks Governance and compliance • Governance 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

28. Conclusions - 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 crisis Credit risk: the moral value of borrower’s promise and the enforcement’s mechanisms of this promise imply different standards of credit screening and monitoring Operational risk: the endogenous factors of operative risk are under control thanks to the Sharia “deterrent”

29. Conclusions - 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.

30. Conclusions - 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 banks offer 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).

31. Conclusions - 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