Pre-Examination Session Class Review IB2002 Risk Management for IFIs

1. Pre-Examination SessionClass ReviewIB2002 Risk Management for IFIs Prof. Saiful Azhar Rosly, Banking Department INCEIF

2. Risk Management

3. Business risk • Potential loss in the world of business due to uncertainty about: • Demand for products • The price that can be charged for those products • The cost of producing and delivery the products

4. Risk is potential loss • Risk itself is not an evil thing • Avoiding risk with zero profit is allowed – WadiahYadDhamanah deposit • Avoiding risk with positive profit is not allowed – interest from loans. • Avoiding risk is an evil action if it injures the counterparty –interest from loans

5. Risk Management in Islamic Banking • Fundamental principle in Islamic business : • no reward without risk – al-ghorm bil ghonm • With profit comes liability – al-kharaj bil daman. • Risk taking behaviour – as the above – risk > 0, profit > 0 permissible • Risk avoiding behaviour – risk =0, profit >0 - not permissible

7. Profitability vs Financial Stability • Banks as profit-maximizing firms cannot be left alone without proper regulations by authorities. • Banks may take excessive risks and overlooked safety of depositors’ fund, eroding capital and thus jeopardizing public confidence. • Thus in making profit, banks may introduce financial instabilities. • The purpose of regulation is to instill financial stability by controlling bank’s behaviour.

10. 5 Basic Shariah Principles in Financial Transactions #1 Prohibition of Riba

11. Islamic Bank Risk Management Process

12. Risk Management Take Position: Risk-Taking Impact on Firm OPTIONS OF RISK MANAGEMENT Risk Avoidance Risk Prevention/Reduction/ Mitigation Risk Transfer Insurance Derivatives

14. Failures of Risk Management

15. Islamic Bank’s Average Balance Sheet

16. Income Statement‘Reward comes with Risk”

17. Rate of Return Risk Shariah Risk Displace Commercial Risk

20. Profit Equalization Reserve Displaced Commercial Risk Rate of Return Risk Market Risk (Negative Income gap)

21. SHARIAH RISK Foreclosure & civil court decision concerning validity of Islamic banking products Default Credit Risk

23. Risks in BBA Financing Credit Risk Low credit scoring for Islamic customers, higher probability of default (PD) Market Risk Negative Gap can mean losses as Interest rate increases Shariah Risk Recent Court Judgement on murabaha/BBA as non bona fide sale Operational Risk Conventional solution/system not able to accomodate Islamic accounting principles leading to overcharging and undercharging customers. High NPF and Write-Offs Capital Depletion Earning at risk (EAR) Capital at risk (EAR) Litigation Costs Erosion of earnings Increase Overheads Litigation costs

24. Risk-taking • Once the bank accepts the risk, it must manage it. • What are the risks faced by an Islamic bank? • The Islamic bank’s shareholders face the following risks: • Credit risk • Market risk • Liquidity risk • Operational risk • Commercial displacement risk • Rate of return risk • Shariah risk • Losses arising from risky financing facilities will adversely affect deposits and shareholders’ capital. • The objective of banking regulation (Basel II) is to protect deposits. • When losses wiped out bank’s capital, the bank becomes insolvent.

25. Risk Management in Islamic Banking • Concept of risk in Islam Risk in trading and commercial transactions (al-bay) Risk in loans • Types of risk Systematic , pure and speculative risk Unsystematic • Islamic Banking business Operates under Basel II Basel II – to protect depositors’ fund Capital adequacy requirement • Risk management – Before bank approves financing facilities, it: Identify risk Measure risk Pricing • Risk mitigation collateral risk transfers via derivatives

26. Islamic Banking Balance Sheet Capital ratio = Eligible Capital / Risk-Weights Assets (RWA) = $?m/RWA Eligible Capital = Capital ratio x RWA = 0.1 / (6000 x 1) + (2000 x 1.5) + (1000 x 2.0) + ($1000 x 2.5) + ($500 x 0.5) =______? Highly risky assets carry high conversion factor (Risk Weight) Islamic bank must carry more capital in order to conduct risky business.

27. Risk / Potential losses • Murabaha : sale with installment payments Credit risk Shariah risk • Ijarah: financial leasing – leasing ending with sale Credit risk Market risk Shariah risk • Partnership: profit-sharing Market risk Operational risk

29. Credit Risk

30. Credit risk • Credit risk is the risk that a change in the credit quality of a counterparty will affect the value of a security or portfolio. • When counterparty defaults, the bank loses either all of the market value of the position or, the part of the value that it cannot recover. • Expected loss (LGD loss given default) – covered by provisions • Unexpected loss – covered by capital

32. Basel II and Credit Risk

34. Credit Risk Management • Adverse selection and moral hazard • Moral hazard exists because borrowers may have incentive to engage in activities that are undesirable from lender’s point of view • In such situations, it is more likely that the lender will be subject to the hazard of default • Banks have to overcome the adverse selection and moral hazard problem that make loan defaults more likely.

35. Credit Risk Management This is done by • Screening • Monitoring & enforcing restrictive covenants • Establishment of long term customer relationships • Loan commitment • Specialized lending • Collateral and compensating balance requirements • Credit rationing

37. Credit Risk in BBA • The risk of the facility is characterized by: • The external and /or internal rating attributed to each obligor, usually mapped to probability of default (PD). • The loss rate given default (LRGD) and EAGD of the facilities. LRGD is the loss rate when the borrower defaults. • Exposure at given default (EAGD) : notional value of a loan, or exposure for loan commitment. Amount of credit outstanding at the time of default. • The expected loss (EL) for each credit facility: EL = PD x EAGD x LRGD

38. Example: Expected Loss • Zahidi Bank hold a $500 million BBA portfolio with 15 years tenor. • PD of the portfolio = 10% • BBA defaulted after 5 years • Exposure at given default (EAGD) = $400 • Collateral $300m • Loss rate given default = (EAGD – collateral)/$500m = ($400m - $300m)/$500m = ($100/$500) x 100% = 20% • EL= PD x EAGD x LRGD • EL = 0.1 x $400m x 0.2 = $8 million • Bank will put aside $8 million for NPF provisioning.

39. EXPECTED LOSS = PD x EAGD x LRGD EAGD = $400m Maturity Origination PD = 10% Default BBA PORTFOLIO = $500m

40. Expected Loss is covered by Bank’s Provisioning

41. Credit risk inn BBA • Expected loss (EL) is the basis for the calculation of the bank’s allowance for BBA losses, which should be sufficient to absorb both specific and general credit related losses. • EL can be viewed as cost of doing business. That is, on average, the bank will incur a credit loss amounting to EL. • However ACTUAL credit losses may be higher or lower than EL. • The variation for credit losses beyond EL is called unexpected loss (UL). • UL is the basis for the calculation of economic and regulatory capital.

42. Assessing credit exposure • Compute EL • Compute UL • Determine the volatility of expected loss of a BBA to the whole portfolio. • Calculate the probability distribution of credit loss for the portfolio and asses the capital required to absorb the unexpected losses.

43. Pricing, Credit risk and Expected Loss How does an Islamic bank pass on the cost of non-performing financing provisions to the customers?

44. Pricing of Debt instrument.Profit rate = Cost of deposits + cost of overheads + risk premium

45. Bank’s contractual loan rate is equal to the: • cost of deposits (rd), • operating costs (c), • Statutory profit margin (p) and • a risk premium. • If we take away the risk premium, we get the targeted interest-rate (rt), which is also known as the prime or base-lending rate (BLR). • The BLR is the interest rate charged to bank’s best customers consisting of the interest rate on deposits (rd) operating cost (c) and a profit margin (p).

46. Based on the above rt = rd + c + p. • Let’s say that bank pays depositors 7% and incurred 1% in operating cost and a 2% profit margin. • The targeted interest rate is therefore 10%.

47. Now the bank receives a $180,000 BBA application from Salim. After full assessment of his credit ratings, the bank felt that Salim has a 20% default risk (pd = 0.2). • This also implies that the probability of Salim making full payment is 80% (pf). • Given this information, the question now is how much should the bank charge Salim for the $180,000 BBA? • Or what is the contractual profit rate (rc)?

48. The contractual profit interest rate is the rate set in the BBA contract in arriving at the selling price (SP). • Given that Salim is a risky customer, the bank may not want to charge him the prime rate. The prime rate is the rate the bank charges to its best customer. Certainly now, the contractual profit rate is expected to be higher than the prime rate or BFR.

49. To obtain the contractual profit rate, the bank must first determine how much profits it desires to make from the BBA. Meaning that the expected rate of return (re) must be computed to find (rc). • Since the bank’s targeted rate of return (rt) is equal to the BFR, it also means that expected rate of return (re) must be equal to the targeted rate of return (rt). • rt = re

50. Now given Salim’s 20% probability of default, which is assumed to cause the bank a 10% loss (rd), [also known as loss rate given default LRGD in a BBA portfolio] the expected rate of return (rc) and contractual profit rate are given below: