Market Efficiency and Systemic Stability in Global Islamic Finance: Challenges of Asymmetric Information and Instrument

1. Market Efficiency and Systemic Stability in Global Islamic Finance: Challenges of Asymmetric Information and Instrumental Deficits Prof. Dr. Volker Nienhaus Presented at the University of Malaya Graduate School of Business 7 June 2011 Kuala Lumpur

2. Structure of Basel II Source: Kross 2009, p. 251.

3. Risks and Banks risk in thefinancial sector (price volatility of financial assets) risks in price bubbles(of real assets) finance for the real economy productive resources entrepreneurial risks • mitigation • dispersion • absorption • mobilisation • employment • allocation banks assume and manage risks additional risk dimensions for Islamic banks • credit risk • operational risk • liquidity risk conventional risks, Basel II + III major issue for IFSB 1 efficient markets: risk reflected in returns to financier 2

4. Risks in Islamic Instruments (1 of 3)

5. Risks in Islamic Instruments (2 of 3)

6. Risks in Islamic Instruments (3 of 3)

7. Change of Risk Characteristics in Islamic Financial Transactions (1 of 3) Murabaha for the Purchase Orderer bank and customer: Agreement to Purchase (binding or non-binding) bank sells and deliversgoods to customer bank purchasesgoods from supplier bank takes possession of goods maturity of contract price risk if customer cancels AP (IIFS has to sell in the open market, price may be less than purchase price) risks associated with goods, liable for defects settlement /default risk: customer is unable to honour the payments (loss of receivables) customer settlesfull amount • risk mitigation: • purchase on 'sales return' basis • security deposit from customer • risk mitigation: • customer as agent • minimize holding period • risk mitigation: • urboun (earnest money), third party guarantees, pledgeof assets • penalty, blacklisting Market risk Credit risk

8. Change of Risk Characteristics in Islamic Financial Transactions (2 of 3) Salam (and Parallel Salam) advancepayment ofprice by bank time of delivery delivery as per agreement Maturity of contract delivery not as per agreement or no delivery at all settlement /delivery risk: customer is unable to deliver as agreed upon (specification, time, etc.) commodity price risk (future pricemay be less; decrease of asset value) commodity price risk (salam without parallel slam) asset replacement risk for parallel salam: need to purchase from open market to meet delivery obligation, maybe at higher price cancellation of delivery, repayment of salam capital capital recovery risk: (no full recovery, insufficient guarantees, etc.) • risk mitigation: • performance guarantee • risk mitigation: • parallel salam Market risk Credit risk

9. Change of Risk Characteristics in Islamic Financial Transactions (3 of 3) Operating IjarahandIjarahMuntahiaBittamleek purchaseof asset by bank Maturity of contract IMB: transfer of ownership to lessee agreement to lease(binding?) ijarah contract(binding) asset returnedto IIFS price risk when customer opts out before leasing contract (lease/sell at lower rental/price) benchmark risk fixed rental in long-term ijarah susceptible to changes in market conditions settlement risk: no rental payments when due residual value risk fair value of asset below initially estimated residual value • risk mitigation: • renewable short-term leases with price re-fixing (in consent) • rentals linked to benchmark • risk mitigation: • urboun (deduct for damages); also advance rental payment • repossess the assets • risk mitigation: • security deposit Market risk Credit risk

10. Information Requirements in Conventional and Islamic Banking

11. Disclosure Practices of Islamic Banks (1/3)

12. Disclosure Practices of Islamic Banks (2/3)

13. Disclosure Practices of Islamic Banks (3/3)

14. Risk Related Disclosures as Recommended by IFSB (1 of 8)

15. Risk Related Disclosures as Recommended by IFSB (2 of 8)

16. Risk Related Disclosures as Recommended by IFSB (3 of 8)

17. Risk Related Disclosures as Recommended by IFSB (4 of 8)

18. Risk Related Disclosures as Recommended by IFSB (5 of 8)

19. Risk Related Disclosures as Recommended by IFSB (6 of 8)

20. Risk Related Disclosures as Recommended by IFSB (7 of 8)

21. Risk Related Disclosures as Recommended by IFSB (8 of 8)

22. Risk Control and Regulation Risk Control: pre-emptive, creating disincentives for taking too much risk; regulators should minimize risk of failure instead of managing failures once they have occurred • Provision: rules aiming at limiting risks • liquidity ratios (e.g. short-term assets > short-term liabilities, minimum ratio of long-term lending to long-term debt)  limiting mismatch risk – gradually disappeared • capital adequacy (capital level in line with risk, capital as buffer for unexpected losses(beyond expected losses as recorded in loan loss provisions) Identification Quantification Measurement Mitigation Management risk bearing capital in IF specific types of risk in IF Risk Insurance: passive ('after the fact') deposit insurance -- moral hazard specific types of 'deposits in 'IF

23. Commercial Status of UPSIA in Competitive Markets UPSIA tend to be assimilated to conventional deposit accounts which are “capital guaranteed” and have a contractually determined rate of return. Thus, in practice, IIFS may find themselves virtually obliged to practise the smoothing profit payouts to UIAH. Stabilising payoutsof UPSIA by Cusheninglosses Smoothening profits • Reducing Mudarib share of profits on investments financed by UIAH funds • Donating part of profits on investments financed by shareholders funds IRR2 PER1 Note: Losses must be borne by the UIAH if IRR are insufficient transfer of risk to shareholders, DCR no risk transfer 1 formed out of profits before their allocation between shareholders and UIAH, and therefore having two components, one that is part of the shareholders’ funds and another that is attributable to UIAH funds 2 formed by retaining part of the profit attributable to the UIAH UPSIA = Unrestricted Profit Sharing Investment Accounts UIAH = Unrestricted Investment Account Holders PER = Profit Equalisation Reserve IRR = Investment Risk Reserve

24. Legal Status of UPSIA in Case of Bank Default • PSIA in Shari'ah perspective: profit-sharing and loss-bearing. • UPSIA not treated as liabilities of the IIFS (although reported on the liability side of balance sheet) • in the case of liquidation of the bank: no claims of UPSIA as creditors over the assets of the IIFS (as do conventional depositors)., but • claim to the assets financed by UPSIA (plus share of undistributed profits minus any losses), including • share of assets financed by commingled funds (claims of USIA paripassu with shareholders [after taking account of the fact that the latter are liable for amounts deposited by current account holders and other creditors]).

25. Supervisory Discretion Formula for the Calculation of CAR Total Risk-weighted Assets1(Credit2+ Market2Risks) EC : { ´ - Operational Risks + Risk-weighted Assets funded by Restricted PSIA3(Credit2+ Market2 Risks) - - (1 – α)4[Risk-weighted Assets funded by Unrestricted PSIA3 (Credit2 + Market2 Risks)] α [Risk-weighted Assets funded by PER and IRR of Unrestricted PSIA5 (Credit2 + Market2 Risks)] - } 1 Total RWA include those financed by both restricted and unrestricted Profit Sharing Investment Accounts (PSIA). 2 Credit and market risks for on- and off-balance sheet exposures. 3 Where the funds are commingled, the RWA funded by PSIA are calculated based on their pro-rata share of the relevant assets. PSIA balances include PER and Investment risk reserve (IRR) or equivalent reserves. 4 α refers to the proportion assets funded by unrestricted PSIA which is to be determined by the supervisory authorities. The value of α would therefore vary based on supervisory authorities’ discretion on a case-by-case basis. 5 The relevant proportion of risk-weighted assets funded by the PSIA’s share of PER and by IRR is deducted from the denominator. The PER has the effect of reducing the displaced commercial risk and the IRR has the effect of reducing any future losses on the investment financed by the PSIA.

26. Commercial Character of Unrestricted Investment Accounts Minimized Yes Yes Maximum ~1 deposit Risk bearing Profit smoothening Loss cushening DCR α Full No No No 0 Investmentproduct

27. Underestimated Systemic Risk Potentials return on investment of IAHs funds (commingled with sharholders‘ funds) low profits moderate losses considerable losses heavy losses deposit insurance to protect the principal [in case of a bank default] smoothing techniques to protect expected returns too large for smoothing, too small for bank default • investment risk reserve • profit equalisation reserve • adjusting mudaribshare of profit • transfers from shareholders‘ funds customers consider investment accounts to be risk-free [savings/term]deposits rumours that losses must be passed on to IAHs bail-out by recapitalization? (not to be taken for granted + Shari‘ah concerns) massive withdrawals avoidance of withdrawalsthat may cause systemic risk can cause a bank run systemic riskactually underratedand not well reflected in IFSB standards consideration in capital adequacy requirements; mitigation of displaced commercial risk (DCR) establishment of a Shari‘ah compliant lender of last resort (next step after IILM)

28. Market Inefficiencies: Risk-Ignorant Returns higher risk = higher return? shareholders' return (profit) returns on investment accounts conceptually exposed to higher risks than conventional deposits comparison conventional/Islamic: only for standalone Islamic banks because Islamic windows without separate shareholders' equity observation: returns on IAH are not systematically higher than interest on conventional accounts (decisive empirical test still lacking) [also for Islamic windows] • higher specific risks may beoffset by • disproportionately largeshare of current accounts • less than risk-equivalent returns for IAH possible explanations:  focus primarily on IAH returns

29. Risk Ignorance and Deposit Illusion? inadequate valuation of (additional) risk no awareness of (additional) risk • practice of Islamic banks: announcement of expected returns, ex post = ex ante [smoothening techniques], no allocation of losses • deposit guarantee schemes • (explicit/implicit) bail-out guarantees • lack of awarenessin principle? • lack of relevant information (e.g. on smoothening, levelof reserves, risk profile ofassets)  deposit illusion  risk ignorance? v issues for discussion and further analysis: • implications for • prudential regulation • effectiveness of market discipline (pillar 3 of Basel II) • capital adequacy requirements (IFSB alpha) • incentives for risk taking / risk appetite (esp. in 'dual banks') • allocation of real and financial risks through the banking system

30. Contact Details Prof. Dr. Volker Nienhaus Dachsfeld38a 45357 Essen – Germany Tel.: +49 (0) 201 8695750Fax: +49 (0) 201 8695752Mobile: +49 (0) 176 63755466 Mobile: +60 (0) 19 3040970 (Malaysia)volker.nienhaus@gmx.net