Economic Capital and Risk Management in Islamic Finance (Islamic Business and Finance Series) [1 ed.] 1032567724, 9781032567723

Table of contents :
Cover
Half Title
Series
Title
Copyright
Dedication
Contents
Preface
About the Authors
List of Figures
List of Tables
List of Boxes
Part I Capital under Mudarabah and Musharakah Contracts
1 Introduction
1.1 Overview of Islamic Banking
1.2 Basic Concept of Capital
1.3 Capital for Islamic Banks
1.4 Supervisory Capital Framework
1.5 Rate of Profit
1.5.1 Reasons for Profit
Part II Economic and Regulatory Capital
2 Concept of Capital
2.1 Accountant’s View on Capital
2.2 Regulators’ View on Capital
2.3 Economic Capital
2.4 Regulatory and Economic Capital: What’s the Difference?
2.4.1 Formula
2.4.2 A Hypothetical Example
2.5 Expected Loss and Unexpected Loss
2.6 Economic Capital and Risk Measurement
2.6.1 A Hypothetical Example
2.7 Volatility and Capital
3 The Significance of Economic Capital to Islamic Banks
3.1 Role of Capital and Shareholder Wealth Creation
3.2 Risk Management and Wealth Creation
3.3 Capital Allocation and Cost of Capital
3.4 Economic Profit
3.5 Risks by Type of Contracts
3.5.1 Credit Risks in Sales-Based Contracts
3.5.2 Equity Risks in Profit-Sharing Contracts
3.5.3 Specific Risk Features in Islamic Banks
3.6 Economic Capital for Equity Financing and Sale Receivables
3.7 Shari’ah-Compliant Instruments
3.7.1 Asset-Based Instruments
3.7.2 Profit-Sharing Instruments
Part III Capital under Mudarabah, Musharakah and Other Related Contracts
4 Capital under Mudarabah Contract and Musharakah Contract
4.1 Concept of Property Rights and Trust
4.2 Elements of Mudarabah Contract
4.2.1 Wordings (Sighah)
4.2.2 Distribution of Profits and Capital
4.3 Types of Mudarabah and Termination of Mudarabah
4.3.1 Unilateral Termination
4.3.2 Types of Termination
4.4 The Concept of Musharakah
4.4.1 Different Schools of Islamic Jurisprudences
Part IV Economic Capital and Risk Management
5 Market Risk
5.1 Definition of Market Risk
5.2 Characteristics of Market Risk
5.2.1 Salam Contract
5.2.2 Istisna’ Contract
5.3 Type of Market Risk
5.3.1 Benchmark Rate Risk
5.3.2 Foreign Exchange Risk
5.3.3 Equity Market Risk
5.3.4 Commodity Risk
5.4 Policies and Procedures for Market Risk Management
5.5 Significance of Market Risk Measurement
5.6 Basel Accord and Market Risk
5.6.1 Standardised Measurement
5.7 Measuring Market Risk Exposure
5.7.1 Variance-Covariance Approach (The Risk-Metric™ Model)
5.7.2 Historical Simulation Approach
5.7.3 Monte-Carlo Simulation Approach
5.8 Volatility Forecasting
5.9 Market Factors, Market Risk and Stress Testing
5.10 Capital Requirement for Market Risk
5.10.1 Implementing VaR into Capital Requirement for Market Risk
5.10.2 Standardised Approach into Capital Requirement for Market Risk
5.10.3 An Extension of Economic Capital for Market Risk
6 Credit Risk
6.1 Definition of Credit Risk
6.2 Nature of Credit Risk
6.3 Sources of Credit Risk
6.3.1 External and Internal Risk Factors
6.4 Credit Risk Assessment and Basel III
6.4.1 Standardised Model
6.4.2 Advanced Internal Rating-Based Model
6.5 Credit Risk Management
6.5.1 Role of the Board of Directors and Senior Management
6.5.2 Risk Identification, Measurements and Monitoring
6.5.3 Risk Controlling and Risk Mitigation
6.6 Credit Risk: The Challenge for Financial Market
6.7 Measurement of Loss Given Default
6.7.1 Loss Given Default under Basel III and IFSB
6.7.2 Calculation of Loss Given Default
6.7.3 Loss Given Default under Asymptotic Single Factor Models
6.8 Exposure at Default
6.8.1 Exposure at Default under Basel III
6.8.2 Principles of Estimation of Exposure at Default (EAD)
6.8.3 Guidance on Calculation of Exposure at Default
6.8.4 Estimation of Exposure at Default
6.9 Capital Requirements for Credit Risk
6.9.1 Risk Weights for Assets
6.9.2 Capital Requirement for Credit Risk under Basel III
6.9.3 Implementing VaR Approach
6.9.4 Capital Requirement for Islamic Bank
7 Operational Risk
7.1 Definition and Sources of Operational Risks
7.2 Categorisation of Operational Risks
7.3 Operational Risk: Islamic Banks’ Perspective
7.3.1 Sources of Shari’ah Non-compliance Risk
7.3.2 Profile of Operational Risk
7.3.3 Impact of Shari’ah Non-compliance Risk
7.4 Operational Risk Management
7.4.1 Elements in Risk Management
7.4.2 Multi-Discipline and Process of Operational Risk Management
7.5 Capital Requirements for Operational Risk
7.5.1 New Standardised Measurement Approach
7.5.2 Calculation of Business Indicator Component
7.5.3 Calculation of Loss Component and Capital Requirement
7.5.4 Data Requirements
Part V Strategic Planning and Economic Capital
8 Displaced Commercial Risk and α-Factor
8.1 Displaced Commercial Risks
8.2 α-Factor and Risk
8.3 Mitigation of Displaced Commercial Risk
8.3.1 Profit-Equalisation Reserve
8.3.2 Investment Risk Reserve
8.4 Measuring α-Factor – An Example
9 Stress Testing in the Presence of Shari’ah Non-compliance Risks
9.1 Shari’ah Non-compliance Risks
9.2 Material Risks: Operational and Shari’ah-Compliance
9.3 Criteria of Good Key Risk Indicators
9.4 Selecting the Key Risk Indicators for SNC Risks
9.5 Stress Testing – An Example
Glossary of Arabic Terms
Index

Citation preview

Economic Capital and Risk Management in Islamic Finance

Economic capital is the subject of great debate among academics and professionals in the field of risk management. Conceptually, Islamic finance’s encouragement of risk-sharing eliminates the debt burden encountered by the conventional banking sector. The majority of the Islamic banking system is based on equity-based financing. To be effective in practice, a variety of well-functioning institutions are required to translate Islamic banking concepts into a ‘real-world’ financial system. In spite of this, the regulatory, legal, product and operational requirements specific to Islamic banks may necessitate a distinct strategy for managing capital-related risks. This book provides a comprehensive review of the theoretical and practical aspects of Islamic economic capital in relation to contemporary Islamic finance. Drawing on the risk-sharing concept, this book delves into the core concept of economic capital from an Islamic perspective, including comparisons to conventional finance theory. Furthermore, it introduces alternative models and offers practical examples to strengthen the regulation and supervision of the Islamic banking system. It also addresses critical policy challenges concerning economic capital in Islamic finance, especially in dual banking countries. This book seamlessly integrates new theory with empirical insights and discusses emerging themes, including stress testing and Shari’ah compliance issues. Most of the chapters are illustrated with real-world cases and practical examples. This book is intended for advanced degree students in finance, and investment professionals, as well as financial practitioners and advisors, particularly those who are pursuing Islamic economics and finance courses. Abdul Ghafar Ismail is the chairperson of the Malaysian Organization of Islamic Economic Studies and Thoughts and a professor of Islamic Economics at Universiti Kebangsaan Malaysia. Muhamed Zulkhibri is a senior research economist at the Islamic Research and Training Institute, Saudi Arabia.

Islamic Business and Finance Series Series Editor: Ishaq Bhatti

There is an increasing need for western politicians, financiers, bankers, and indeed the western business community in general to have access to high quality and authoritative texts on Islamic financial and business practices. Drawing on expertise from across the Islamic world, this new series will provide carefully chosen and focused monographs and collections, each authored/edited by an expert in their respective field all over the world. The series will be pitched at a level to appeal to middle and senior management in both the western and the Islamic business communities. For the manager with a western background the series will provide detailed and up-to-date briefings on important topics; for the academics, postgraduates, business communities, manager with western and an Islamic background the series will provide a guide to best practice in business in Islamic communities around the world, including Muslim minorities in the west and majorities in the rest of the world. Shariah Governance in Islamic Banking Institutions Edited by Shafiullah Jan and Muhammad Ismail The Future of Islamic Banking and Finance in Indonesia Performance, Risk and Regulation Romi Adetio Setiawan Money, Interest and Debt in Monotheistic Religions An Etymological Approach Murat Ustaoğlu Islamic Microeconomics An Introduction Lukman Hanif Arbi and M. Ishaq Bhatti Higher Education Finance and Islamic Endowments Nurul Adilah Hasbullah and Asmak Ab Rahman Economic Capital and Risk Management in Islamic Finance Abdul Ghafar Ismail and Muhamed Zulkhibri For more information about this series, please visit: www.routledge.com/Islamic-Business-andFinance-Series/book-series/ISLAMICFINANCE

Economic Capital and Risk Management in Islamic Finance Abdul Ghafar Ismail and Muhamed Zulkhibri

First published 2024 by Routledge 4 Park Square, Milton Park, Abingdon, Oxon OX14 4RN and by Routledge 605 Third Avenue, New York, NY 10158 Routledge is an imprint of the Taylor & Francis Group, an informa business © 2024 Abdul Ghafar Ismail and Muhamed Zulkhibri The right of Abdul Ghafar Ismail and Muhamed Zulkhibri to be identified as authors of this work has been asserted in accordance with sections 77 and 78 of the Copyright, Designs and Patents Act 1988. All rights reserved. No part of this book may be reprinted or reproduced or utilised in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying and recording, or in any information storage or retrieval system, without permission in writing from the publishers. Trademark notice: Product or corporate names may be trademarks or registered trademarks and are used only for identification and explanation without intent to infringe. British Library Cataloguing-in-Publication Data A catalogue record for this book is available from the British Library ISBN: 978-1-032-56772-3 (hbk) ISBN: 978-1-032-56773-0 (pbk) ISBN: 978-1-003-43708-6 (ebk) DOI: 10.4324/9781003437086 Typeset in Times by Apex CoVantage, LLC

This book is dedicated to all professionals, academics, researchers and students throughout the world who have contributed their valuable time and efforts to increasing knowledge in Islamic economics and finance and development in Islamic finance industry for the benefit of the Ummah (humankind).

Contents

Preface About the Authors List of Figures List of Tables List of Boxes PART I

xii xiv xv xvi xviii

Capital under Mudarabah and Musharakah Contracts

1

1

3

Introduction 1.1 Overview of Islamic Banking 3 1.2 Basic Concept of Capital 4 1.3 Capital for Islamic Banks 5 1.4 Supervisory Capital Framework 6 1.5 Rate of Profit 7 1.5.1 Reasons for Profit 9

PART II

Economic and Regulatory Capital

11

2

13

Concept of Capital 2.1 Accountant’s View on Capital 13 2.2 Regulators’ View on Capital 14 2.3 Economic Capital 14 2.4 Regulatory and Economic Capital: What’s the Difference? 14 2.4.1 Formula 17 2.4.2 A Hypothetical Example 21 2.5 Expected Loss and Unexpected Loss 22

viii Contents 2.6 Economic Capital and Risk Measurement 25 2.6.1 A Hypothetical Example 27 2.7 Volatility and Capital 29 3

The Significance of Economic Capital to Islamic Banks 3.1 Role of Capital and Shareholder Wealth Creation 32 3.2 Risk Management and Wealth Creation 35 3.3 Capital Allocation and Cost of Capital 36 3.4 Economic Profit 41 3.5 Risks by Type of Contracts 42 3.5.1 Credit Risks in Sales-Based Contracts 43 3.5.2 Equity Risks in Profit-Sharing Contracts 44 3.5.3 Specific Risk Features in Islamic Banks 45 3.6 Economic Capital for Equity Financing and Sale Receivables 46 3.7 Shari’ah-Compliant Instruments 50 3.7.1 Asset-Based Instruments 51 3.7.2 Profit-Sharing Instruments 55

32

PART III

Capital under Mudarabah, Musharakah and Other Related Contracts 4

Capital under Mudarabah Contract and Musharakah Contract 4.1 Concept of Property Rights and Trust 61 4.2 Elements of Mudarabah Contract 62 4.2.1 Wordings (Sighah) 63 4.2.2 Distribution of Profits and Capital 66 4.3 Types of Mudarabah and Termination of Mudarabah 68 4.3.1 Unilateral Termination 72 4.3.2 Types of Termination 72 4.4 The Concept of Musharakah 73 4.4.1 Different Schools of Islamic Jurisprudences 77

PART IV

59 61

Economic Capital and Risk Management

87

5

89

Market Risk 5.1 Definition of Market Risk 89 5.2 Characteristics of Market Risk 90

Contents

5.3

5.4 5.5 5.6 5.7

5.8 5.9 5.10

6

ix

5.2.1 Salam Contract 91 5.2.2 Istisna’ Contract 91 Type of Market Risk 92 5.3.1 Benchmark Rate Risk 93 5.3.2 Foreign Exchange Risk 99 5.3.3 Equity Market Risk 101 5.3.4 Commodity Risk 105 Policies and Procedures for Market Risk Management 108 Significance of Market Risk Measurement 110 Basel Accord and Market Risk 111 5.6.1 Standardised Measurement 111 Measuring Market Risk Exposure 112 5.7.1 Variance-Covariance Approach (The Risk-Metric™ Model) 112 5.7.2 Historical Simulation Approach 118 5.7.3 Monte-Carlo Simulation Approach 121 Volatility Forecasting 122 Market Factors, Market Risk and Stress Testing 125 Capital Requirement for Market Risk 128 5.10.1 Implementing VaR into Capital Requirement for Market Risk 128 5.10.2 Standardised Approach into Capital Requirement for Market Risk 131 5.10.3 An Extension of Economic Capital for Market Risk 140

Credit Risk 6.1 Definition of Credit Risk 144 6.2 Nature of Credit Risk 145 6.3 Sources of Credit Risk 146 6.3.1 External and Internal Risk Factors 146 6.4 Credit Risk Assessment and Basel III 149 6.4.1 Standardised Model 153 6.4.2 Advanced Internal Rating-Based Model 156 6.5 Credit Risk Management 157 6.5.1 Role of the Board of Directors and Senior Management 158 6.5.2 Risk Identification, Measurements and Monitoring 159 6.5.3 Risk Controlling and Risk Mitigation 162 6.6 Credit Risk: The Challenge for Financial Market 163

144

x

Contents 6.7 Measurement of Loss Given Default 164 6.7.1 Loss Given Default under Basel III and IFSB 166 6.7.2 Calculation of Loss Given Default 168 6.7.3 Loss Given Default under Asymptotic Single Factor Models 170 6.8 Exposure at Default 174 6.8.1 Exposure at Default under Basel III 175 6.8.2 Principles of Estimation of Exposure at Default (EAD) 176 6.8.3 Guidance on Calculation of Exposure at Default 177 6.8.4 Estimation of Exposure at Default 177 6.9 Capital Requirements for Credit Risk 180 6.9.1 Risk Weights for Assets 180 6.9.2 Capital Requirement for Credit Risk under Basel III 183 6.9.3 Implementing VaR Approach 190 6.9.4 Capital Requirement for Islamic Bank 190

7

Operational Risk 7.1 Definition and Sources of Operational Risks 196 7.2 Categorisation of Operational Risks 199 7.3 Operational Risk: Islamic Banks’ Perspective 203 7.3.1 Sources of Shari’ah Non-compliance Risk 204 7.3.2 Profile of Operational Risk 206 7.3.3 Impact of Shari’ah Non-compliance Risk 207 7.4 Operational Risk Management 209 7.4.1 Elements in Risk Management 211 7.4.2 Multi-Discipline and Process of Operational Risk Management 214 7.5 Capital Requirements for Operational Risk 219 7.5.1 New Standardised Measurement Approach 219 7.5.2 Calculation of Business Indicator Component 219 7.5.3 Calculation of Loss Component and Capital Requirement 221 7.5.4 Data Requirements 222

196

Contents PART V

Strategic Planning and Economic Capital

xi

227

8

Displaced Commercial Risk and α-Factor 8.1 Displaced Commercial Risks 229 8.2 α-Factor and Risk 230 8.3 Mitigation of Displaced Commercial Risk 233 8.3.1 Profit-Equalisation Reserve 233 8.3.2 Investment Risk Reserve 235 8.4 Measuring α-Factor – An Example 237

229

9

Stress Testing in the Presence of Shari’ah Non-compliance Risks 9.1 Shari’ah Non-compliance Risks 240 9.2 Material Risks: Operational and Shari’ah-Compliance 241 9.3 Criteria of Good Key Risk Indicators 242 9.4 Selecting the Key Risk Indicators for SNC Risks 245 9.5 Stress Testing – An Example 249

240

Glossary of Arabic Terms Index

252 257

Preface

Islamic finance emerged along with mainstream finance. The global Islamic finance market is valued at over US$3 trillion in 2023, encompassing not only the Middle East and Southeast Asia but also other countries beyond these regions. On the product front, the industry has made substantial gains in establishing a diversified array of Islamic financial products that appeal to a vast array of economic subsectors (i.e., international trade, housing, infrastructure and energy, agriculture and rural communities). Despite the fact that each economic sector possesses distinct characteristics, the Islamic finance industry is capable of supporting a diverse range of needs and demands. Islam prohibits all types of interest in business dealings while encouraging the sale of products for mutual benefit. In addition, Islam forbids the use of the term ‘gharar’, which refers to the purposeful creation of ambiguity in contracts and commercial transactions. Therefore, Islamic money is based on Shari’ah principles and directed by Islamic economics. Islamic finance is founded on two tenets: profit sharing and the prohibition of interest collection and payment, both of which are prohibited by Islamic law. However, a deeper investigation of Islamic modalities of finance reveals that they are inextricably linked to actual economic activity. Based on Islamic principles, Islamic banking requires a coherent theoretical and practical knowledge of economic capital. The conventional banking system is a fractional reserve banking system that mainly depends on debt financing, as opposed to the Islamic banking system, which heavily relies on equity financing. Due to the prohibition of riba (interest), Islamic banks may require a distinct risk management strategy due to their specific regulatory, legal, product and operational limitations. The fundamental purpose of this work is to contribute to the creation of a thorough understanding of economic capital. This book addresses the specific risks associated with the practical implications of Islamic economic capital. As a consequence of a variety of real-world situations and case studies, readers will be able to comprehend and practice key Islamic economic capital ideas. This book, we believe, will motivate a wide spectrum of readers, including

Preface xiii academics, practitioners, students and policymakers, to continue their study in this subject. Finally, but not least, we would like to thank Allah for bringing this book to a close. In addition, we would like to extend our gratitude to everyone who directly or indirectly contributed to the drafting of this important book.

About the Authors

Abdul Ghafar Ismail is both the Chairperson of the Malaysian Organization of Islamic Economic Studies and Thoughts and an economics professor at University Kebangsaan Malaysia. He was formerly a professor at the University Sains Islam Malaysia, University Islam Sultan Sharif Ali and University Kebangsaan Malaysia. He was a member of the Shari’ah committees of Citibank Malaysia and the Ambank Group, and a resident fellow at Malaysia Perdana Leadership Foundation. He has also worked at the Islamic Research and Training Institute of the Islamic Development Bank, Saudi Arabia. He has extensive experience teaching Islamic economics and finance, such as Islamic economic systems, Islamic financial systems, money and banking, financial economics, advanced macroeconomics, Islamic economic systems, Islamic money and capital markets, international finance and Islamic banking. He received his PhD in economics from the University of Southampton in the United Kingdom. Muhamed Zulkhibri works as a senior research economist at the Islamic Research and Training Institute, Saudi Arabia. He has extensive experience in central banks and development institutions, where he worked on a wide range of international high-impact strategic initiatives, policy advisory services, capacity building and research projects. He formerly worked as the Head of Finance and Socioeconomic at the ASEAN Secretariat, where he pioneered regional economic research and surveillance for ASEAN member states. He has taught at the University of Nottingham and University Putra Malaysia and has written numerous publications for journals of economics and finance. His research interests include monetary policy, macroeconomics and financial market development, as well as Islamic economics and finance. He has a PhD in economics from the University of Nottingham in the United Kingdom.

Figures

1.1 2.1 3.1 5.1 6.1 6.2 7.1 7.2 7.3 7.4 7.5 7.6 7.7 8.1

The Framework of Rate of Profit as Shari’ah Reference Rate Comparison of Minimum Regulatory Capital with Economic Capital Risk Profile of an Islamic Bank The Variance-Covariance Method LGD and Default as a Function of Risk Factor Z Two Distribution of LGD Relation between Sources and Events in Operational Risk Unique and Generic Risk Profiles of Islamic Bank Impact of Shari’ah Non-Compliance Risk Shari’ah Risk Governance Operational Risk Management Cycle Shari’ah Risk Management Process Logical Flow of New SMA Theoretical Framework for Earnings Management in IBIs with Income Smoothing

8 18 45 113 172 173 200 207 208 212 216 217 220 236

Tables

1.1 2.1 2.2 2.3 3.1 3.2 3.3 3.4 3.5 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8

Comparison between Conventional and Islamic Banking Example of Risk-Adjusted Performance Measures Risk-Adjusted Return Default Outcomes Risk Weights Based on Counterparty’s Rating Maturity Ladder Approach for Commodities Risk Standard Supervisory Haircuts Specific Risk Provision for Sukuk General Market Risk Provision for Sukuk Risk Perception-Risks in Different Modes of Financing The Banking Book and Trading Book of Islamic Bank Position Inputs in Variance-Covariance Approach Estimation Results of GARCH (1,1) Model Cash Flows of Islamic Profit Rate Swap Plus Factor in Back Testing Framework and Multiplicative Factor Capital Charge for General Market Risk Duration Method Based on Time Bands and Assumed Changes in Yield 5.9 Specific Risk Capital Charge under Benchmark Rate Risk 5.10 Time Band for Commodity Risk 5.11 Capital Adequacy for Market Risk Based on Standardised Approach 5.12 Capital Requirement for Market Risk 6.1 The System of Credit Ratings Employed by Standard & Poor’s 6.2 Total Capital Requirements on Sovereigns Obligations under the Standardised Model of Basel III 6.3 Total Capital Requirements on Islamic Bank under the Standardised Model of Basel III 6.4 Total Capital Requirements on Corporate Obligations under the Standardised Model of Basel III 6.5 Distinction between Foundation and Advanced Approach under IRB 6.6 Standard Supervisory Haircuts 6.7 Example of the Risk Weights 6.8 Example of Capital Adequacy Requirements for Bank’s Assets

3 22 22 24 52 53 54 56 56 90 110 114 125 126 130 132 133 135 137 138 139 150 153 154 154 167 168 181 182

Tables 6.9 6.10 6.11 6.12 6.13 6.14 6.15 7.1 7.2 7.3 7.4 7.5 7.6 7.7 8.1 8.2 8.3 8.4 8.5 8.6 8.7 9.1 9.2

Example of Capital Adequacy Requirements for Islamic Bank’s Off-Balance-Sheet Exposures Dependence of WCDR on PD and ρ Relationship between WCDR and PD for Corporate, Sovereign and Bank Exposures Relationship between WCDR and PD for Retail Exposures Risk-Weight on Individual Claims Based on External Credit Assessments FCF for the Various Types of Off-Balance Sheet Items Example of Calculation of Risk-Weighted Asset for Credit Risk in an Islamic Bank Source of Bank’s Operational Risks Categories of Loss Events Approaches and Tools of Risk Management BI Buckets in the BI Component Income, Operating Lease and Dividend Component Service Component Financial Component Capital Structure of an Islamic Bank IFSB Standard Formula for CAS IFSB Supervisory Discretion Formula for CAS Hypothetical Income Statement of Conventional Bank vis-à-vis Islamic Bank Panel Regression Results Redundant Fixed Effects Test – Likelihood Ratio Correlated Random Effects – Hausman Test Criteria for Good KRIs Key Risk Indicators for SNC

xvii 182 185 185 187 191 193 193 199 200 210 220 223 224 224 230 231 232 233 238 238 239 244 246

Boxes

2.1 4.1 4.2 4.3 4.4 5.1 5.2 6.1 6.2

Balance Sheet of an Islamic Bank Essence of Mudarabah in AL-MAJALLA AL AHKAM AL ADALIYYAH Model of Mudarabah Financing Agreement Proportion of Profits Definition of Partnership in Common Law Example of Future Contract Monetary Policy Statement as on 24 August 20X7 Evolution in Credit Risk Modelling Case Studies

16 62 63 67 74 92 93 151 153

Part I

Capital under Mudarabah and Musharakah Contracts

1

1.1

Introduction

Overview of Islamic Banking

The main principles of Islamic finance can be generally stated as follows (Table 1.1): the rule of uncertainty (risk sharing) principle, which states that profits or losses must be shared by both parties and agreed upon in a contract; a prohibition on paying or receiving interest (riba); the exclusion of speculative and gambling transactions (gharar); and the use of asset-backed financial transactions, which state that a financial transaction must relate to an identifiable and/or tangible underlying asset, requiring parties to share profits or losses. The Islamic banking model is more stable and performs better than the traditional banking approach (Bourkhis and Nabi, 2013; Čihák and Hesse, 2010). The Islamic banking concept is founded on Shari’ah-compliant products that appeal to individuals in search of religiously consistent financial services. Although Shari’ah-compliant financial assets represent a small share of overall banking assets, their significance is expanding, especially in Muslim-majority countries. The worldwide Islamic finance industry has expanded dramatically during the past three decades, with global Islamic finance assets valued at US$3.25 trillion in 2023, with an annual growth rate of 6.2% between 2021 and 2022 (IFSB, 2023). In addition, Islamic financial institutions have a large market share in a number of emerging economies, such as Malaysia, Saudi Arabia and other Middle Eastern countries. Table 1.1 Comparison between Conventional and Islamic Banking

Law Income Risk Ethical Values Customer Relationship

Islamic Bank

Conventional Bank

Islamic banking law Profit-based and Fee-based Risk shared between Islamic bank and customers Compliant with ethical and moral values Seller-Buyer

Secular banking law Interest-based and Fee-based Entrepreneurial risk borne by customers Not subject to any ethical and moral framework Debtor-Creditor

Source: Authors DOI: 10.4324/9781003437086-2

4

Capital under Mudarabah and Musharakah Contracts

In its business model offer, the ideal Islamic banking system separates commercial and investment banking operations in line with Islamic contract law. In this method, demand deposits are supported by 100% reserves and are solely held for safekeeping. On the other side, investment banks continue to fulfil the traditional function of intermediary. Banks absorb surplus money on a profit-and-loss sharing basis (mudarabah) and invest them in real economy initiatives that correspond to depositors’ risk and return profiles. However, since the principle is not covered under profit-and-loss sharing contracts, no reserve is required in this area of banking. Theoretically, this intensifies their monitoring incentives and increases the risk of disciplinary withdrawal for banks. The issue of moral hazard associated with the latter is almost probably resolved. The prevalence of residual claims may reduce the likelihood of unfavourable wealth transfer, rendering risk shifting ineffective. These characteristics, together with the Shari’ah mandated link to the actual economy, limits on the issue of debt and prohibitions on short selling, keep the excessive leverage of Islamic banks in check. Therefore, the risk-shifting incentives of Islamic banks will be weakened. The mechanism of interest payment is a key contrast between Islamic and conventional financing (riba). Islamic banking is centred on Shari’ah-compliant items, whereas conventional banking is focused on interest rate spreads (the difference between lending and borrowing interest rates). Shari’ah compliance necessitates that all transactions made under the Islamic banking model include tangible and real assets. Typically, Islamic banks provide two distinct deposit options. Current accounts (qard hassan) are redeemable at any moment, and the funds placed are guaranteed but not paid out. Current account customers are not exposed to the bank’s risk and are not compensated. Equity investment accounts (profit-sharing investment accounts, PSIA), such as the mudarabah contract, are based on the profit-sharing principle: neither the principal nor the return is guaranteed, and account holders share in bank profits proportionate to their financial contribution, according to a predetermined sharing ratio. 1.2

Basic Concept of Capital

Capital has traditionally been described as the following: (a) financial assets or the financial worth of assets such as cash; and (b) factories, machinery and equipment held by a firm and used for production. However, capital can have several connotations. Its precise definition is context-dependent. Therefore, enterprises and societies with more capital are more successful than those with less capital. Capital is an essential concept in finance, but it is one of the hardest things to define. For example, the capital of a bank is equal to the difference between the value of its assets and liabilities. It refers to the available financial resources to withstand unplanned losses. Because an insolvent bank lacks it, investors and regulators are concerned about capital. The bigger the ratio of a bank’s capital to its assets, the stronger the bank and the greater the trust of its stakeholders that it will

Introduction 5 fulfil its financial obligations. However, capital alone does not guarantee solvency, as a bank with adequate capital might fail due to a lack of liquidity. In this context, what is the function of bank capital, why do banks retain capital and why are regulators so worried about the capital position of the banking sector? Furthermore, how do banks expose themselves to risk? It is essential to specify further what constitutes a capital asset. Capital, like money, is the subject of several controversies among economists. In an ideal Islamic economy, all financial assets are constituted or linked to real assets. Capital assets are a distinct real asset in the economy, regardless of its real or financial form. 1.3

Capital for Islamic Banks

The basic role of capital is to protect a bank against losses that are unexpected, unpredictable and even relatively remote. A bank’s capital must be adequate to safeguard depositors and holders of subordinated debt from losses, while also allowing it to satisfy the demands of its customers. Banks must maintain capital proportional to the risks they assume and bear in order to withstand sometimes catastrophic financial storms. A robust banking industry with a solid capital base is better equipped to finance enterprises and promote investment opportunities, thus contributing to the creation of employment and the expansion of the economy. A fragile banking system, in which banks are unable to operate as effective financial intermediaries, inevitably results in inadequate funding and liquidity in financial markets. Banks increasingly compete for capital not just with domestic and foreign counterparts but also with investment funds, asset management firms, investment banks and insurance organisations. Bankers, regulators and shareholders are concerned with more than capital preservation. Important consumers, especially those with long-term financial relationships with their banks, take this element into account. When an organisation or a corporation engages with letter of credit guarantees or swap contracts, it must assure that the bank will continue to exist for three to five years after the contract’s expiration. A bank with sufficient capital may credibly guarantee its capacity to pay customers and clients. Notably, the risk-to-capital relationship described earlier applies equally to Islamic financial institutions. Islamic banks are expected to keep large amounts of capital for a variety of reasons. It must be conscious that Islamic banks in a number of jurisdictions, including its own, are now facing global competition. Islamic banks and supervisors in many jurisdictions have been challenged to, among other things, increase capital levels and consider the creation of a level playing field across all jurisdictions due to the increasing interconnectedness of Islamic banking systems in the global capital market, as well as the inclusion of more and more emerging market players as active participants. As the number of emerging market banks that participate in the international financial system increases, they face increased competition in their domestic markets from globally active banks. When it comes to global competition and recruiting

6

Capital under Mudarabah and Musharakah Contracts

foreign capital and clientele, Islamic banks in developing economies recognise that adequate capitalisation is a necessary but insufficient condition. In the future, it will be especially challenging for these Islamic banks, which may have high-risk profiles and opaque financial records, to show to their clients and other stakeholders that they do business in a safe and sound manner. The financing and investment cycles provide a unique set of risks for Islamic banks in emerging areas that their counterparts in established markets do not face. If huge fluctuations in currency rates and market volatility make it difficult for Islamic banks to maintain access to funding sources, they may be especially susceptible to liquidity risk. 1.4

Supervisory Capital Framework

Islamic banks are under pressure to strengthen their capital management and risk assessment procedures in order to account for all of their businesses’ associated risks. Several of these Islamic banks make commercial and risk management decisions utilising analytic techniques. Nevertheless, many of these tools and procedures are in their infancy and require further development, and risk management at Islamic banking institutions will continue to prioritise capital adequacy review. As their risk identification and quantification skills improve, Islamic banks should be in a position to enhance risk disclosures and inform investors more thoroughly. Investors in Islamic banks ultimately bear the institution’s risks, as they are inadequate to make informed business decisions on the institution’s prospects. In economics, this is referred to as an ‘information asymmetry’. Accounting and disclosure laws are troublesome in jurisdictions that do not provide consumers of financial statements with appropriate information to analyse risks and make prudent financial decisions. In times of economic turbulence, a lack of transparency exacerbates the crisis. Positively, several governments have taken steps to improve openness and transparency, for instance in respect to non-performing loans. In collaboration with other national and international organisations, the Islamic Financial Services Board (IFSB), the Central Banks, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOFI) and the International Accounting Standards Committee (IAS) have taken steps to improve the relevance, reliability and comparability of information disclosed by the financial sector. The most crucial actions will be those done by each jurisdiction to adopt these principles of openness and encourage Islamic financial institutions to self-disclose. Disclosures that help market decision-making include better asset price information, risk management strategies and controls. Developing capital standards that more comprehensively encompass the whole range of risks to which Islamic banks are exposed is a considerable challenge for regulators. These rules should differentiate between high- and low-risk exposures, risk types, and weak and strong Islamic banks (Zulkhibri and Ghazal, 2014). The minimum capital ratios set in 1988 by the Basel Committee on Banking Supervision (BCBS), an international conference of bank regulators, and updated

Introduction 7 by the Islamic Financial Services Board (IFSB) in 2005 are currently the primary basis for capital regulation. They were codified in the Basel Accord and implemented for two primary reasons. The minimum ratios were first intended to counterbalance the ten-year decrease in foreign capital levels. Second, they were intended to harmonise the different capital requirements and processes of the G-10 countries. Although these ratios were very simple, they have been extraordinarily effective in boosting capital levels over the past decade. The majority of bank regulators believe that the private sector should play a stronger role in regulating Islamic institutions. There is already some marketbased monitoring, but the collection and application of this data is typically neither systematic nor exhaustive. The fundamental goal is to increase market access to information. These perspectives are quickly reflected in the stock prices of Islamic banks and the ease with which Islamic institutions can get capital. A set of criteria that does not considerably impair incentives is necessary for this purpose. The ongoing pressure on supervisors to stay up with financial innovation and advances in risk management methods needs a programme of frequent monitoring and maintenance for the present and future Accord. In whatsoever actions are taken, efforts to update the capital adequacy criterion and improve the entire capital framework must be cognizant of the primary supervisory goals. Promoting the safety and soundness of financial systems is the primary purpose. The second objective is to improve the competitive playing field while allowing for variances in risk profiles amongst institutions. These are the objectives of the original capital adequacy criterion. The third objective is to define fundamentally applicable criteria for banks with varied degrees of complexity and sophistication. 1.5

Rate of Profit

A significant concept in Islam is the notion of profit rate as an alternative to interest. Islam permits the pursuit of profit, but strictly forbids the practise of charging or receiving interest (riba). Calculating the profit rate for Islamic financial products and Islamic bonds is essential to ensuring economic equity, consistency in investment returns and overall societal welfare. The Quran allows for the freedom to engage in trade, while also imposing restrictions on usury. Islam promotes the practice of rationality in one’s endeavour for financial gain and acquiring only what is morally permissible. The drive for maximum wealth must be secondary to the principles of Islamic ethical conduct. Despite the fact that there are different definitions for profit, profit is defined as the net revenue that remains after subtracting all expenses and allocations. Islamic legal schools have provided a jurisprudential basis for asserting entitlement to income and financial gain. A distribution model drawing upon the principles of economic justice rooted in Islamic teachings. The most critical aspect to evaluate is the legality or ethical entitlement to revenue or profit. Therefore, it is normative rather than positive. As illustrated in Figure 1.1, profit is one of the key challenges in both conventional economics and Islamic economics due to the fact that pricing

Rate of Profit (˘˙)

Discourses

˜°˛˝˙ ˇ ˘˙

Islamic Economist

Conventional Economist

Conventional Economist Pre- Determined

The Pure Rate of Interest Theory based on Goods Market (IS) Time Preference • Bohm Bawerk • Nassau Capital Productivity • Marshall • Thornton • Wicksell • Samuelson

The Monetary Interest rate Theory based on Money Market (LM) Loanable Funds A Lerner Liquidity Preference J.M. Keynes

Modern Rate of Interest Theory Both Market (IS=LM) Equilibrium Rate A.H. Hansen Hicks

Karl Marx (ROE) J. Von Neumann (˜) Kalecki (ROI) Piero Sraffa (GNP) Schumpeter Phillip Kotler

Benchmark based on markup in real sector

Benchmark based on Interest

Baqr al-Sadr Kadim al-Sadr Salman Sheikh Mohsin S. Khan Abbas Mirakhor etc

M. Taqi Usmani Mahmoud El Gamal etc

Macro Economy

Stability in Financial System Measured by Equitable Wealth and Income for Investor

Figure 1.1 The Framework of Rate of Profit as Shari’ah Reference Rate Source: Zulkhibri et al. (2019)

Post-Determined

Rate of Profit as a Reference

Profit Sharing Scheme

Muhammad Uzair M. A. Choudhury Umar Chapra Metwally Nejatullah Siddiqy Fahim Khan Iraj Toutounchian Muhamed Zulkhibri etc

Micro Economy

Stable Asset Pricing and Sound Asset-Liability Management in Islamic Financial Market

Capital under Mudarabah and Musharakah Contracts

Rate of Interest ()

˛˝˙ 

8

Al-Baqarah 275, 27/ Annisa’ 29/ Ali Imran Ayat 130

Introduction  9 theory is founded on the concept of ‘profit maximisation’ and the legal foundation for the right to income. 1.5.1  Reasons for Profit

The application of the concept of rate of profit as a substitute for the rate of interest in Islamic banking and capital markets often poses challenges because there is no standard reference benchmark for determining the profit margin on the contract of sale, that is, Murabahah, and the leasing costs on the contract of leasing, that is, ijarah. In Islam, a product must possess three components to generate a lawful profit: (1) the product must have added value resulting from effort (kasb), (2) there must be a risk taking (ghurm) associate with the risk of price variations in the exchanged products and (3) there must be underwriting obligation to compensate for any faults in the supplied goods (daman). Profiteering is permissible, according to jurists. Islamic law schools have endeavoured to establish the basis (mabda’) for generating wealth after it has been created. Due to their diverse analytic approaches, they created concepts with varying perspectives. 1 The Shafi’es school of thought restricts economic activities to firms that are built on capital. By employing a strict interpretation of scriptural evidence, they determined that only money serves as the basis for company profits. Therefore, entrepreneurial activity is exclusively viable for individuals who own capital. The term ‘mal’ is employed by classical jurists to denote capital (money and goods). Other modern scholars have interpreted the phrase as ‘milk’ (property) and argue that capital and goods should generate profit while under the authority of their owner’s control (Khattab, 2001). Money and goods are fundamental basis of economic development and the primary commodities exchanged in commercial transactions. They are essential elements of partnership (sharikah) and one of the foundational aspects of a mudarabah agreement. Real estate, farms and plantations, can be leased or obtained through partnerships. 2 The Malikis have adopted a more flexible methodology. Partnerships can be established based on either financial or labour contributions. Consequently, they granted authorisation for partnerships based only on labour, such as sharikah al-abdan or partnerships between labourers or craftsmen. The exertion of work and labour directly impacts the increase in output and profit growth, which is self-evident. Work and labour have a significant impact on various sectors of industrial (including the transformation of raw materials into finished goods), agricultural, commercial and service activities. Work is compensated in two ways: a fixed wage and a proportional share of the profit (such as through the mechanisms of musharakah or mudarabah). 3 The Hanafis were the first to develop a complete methodology that allowed for a wide range of non-monetary partnerships. Thus, there are three legitimate reasons for making a profit: capital investment (mal), labour (‘amal; as a substitute for wages) and liability for damages (daman) (Qaisi, 2008, p. 58;

10

Capital under Mudarabah and Musharakah Contracts Zuhayli, 2003, p. 465; Haqeel, 2011, p. 91). Contemporary judgements, such as the AAOIFI Shari’ah Standards (AAOIFI, 2015), have adopted the Hanafi perspective because of its allowance of a wider array of economic and commercial dealings. The core concept of Hanafis is daman. This approach enables the development of a thorough framework for analysing profit and revenue, which is proficient in categorising rights and obligations and may be utilised to identify legal and illegal contracts in the present day.

Mukhatarah is a concept in Islamic law that is broader and more universally applicable concept than daman. Islamic law categorises mukhatarah into two distinct groups: those that are legal and those that are prohibited. Legally justifiable mukhatarah is accepting the risks associated with potential loss or damage in contractual agreements. For example, in mudarabah contract, the rabb-ul-mal risks his money, whereas the mudarib risks his life. An entrepreneur invests in goods with the aim of subsequently selling them at a higher price for a profit. The imposition of the non-permitted mukhatarah is not justified by any permissible transaction or business. This category includes mukhatarah transactions involving gharar (gambling or betting) or riba (usury or interest). References AAOIFI. (2015). Shari’ah Standards. Manama: Dar Al-Maiman Publishing. Bourkhis, K. & Nabi, M. S. (2013). Islamic and conventional banks’ soundness during the 2007–2008 financial crisis. Review of Financial Economics, 22, 68–77. Čihák, M. & Hesse, H. (2010). Islamic banks and financial stability: An empirical analysis. Journal of Financial Services Research, 38(2), 95–113. Haqeel, M. (2011). Ribh ma lam yudman. Riyad: Dar al-Mayman. Ibn al-Qayyim, M. (1994). Zad al-Maad. Beirut: Muassasat al-Risalah. IFSB. (2023). Islamic Financial Services Industry Stability Report 2023. Kuala Lumpur: Islamic Financial Services Board. Khattab H. S. (2001). Asbab istihqaq al-ribh. Cairo: Itrack Publication. Qaisi, K. (2008). Maayir al-ribh wa dawabituh fi al-tashri al-Islami. Dubai: Daira al-Shuun al-Islamiyyah. Zulkhibri, M. & Ghazal, R. (2014). Standardization of Islamic banking practices: A regulatory perspective. Afro-Asian Journal of Finance and Accounting, 4(1), 1–25. Zulkhibri, M., Muneeza, A., & Manap, T. A. A. (2019). Islamic Monetary Economics and Institutions: Theory and Practice. Springer. Zuhayli, W. (2003). Financial Transaction in Islamic Jurisprudence. (El-Gamal, M. A., Trans). Damascus: Dar al-Fikr.

Part II

Economic and Regulatory Capital

2

Concept of Capital

2.1 Accountant’s View on Capital Capital is a central concept in mu’amalat. Moreover, it is among the most intriguing. The worth of an Islamic bank is its capital, which equals the total of its assets and liabilities. As such, it signifies the available financial resources to absorb unplanned losses. Investors and regulators value capital because an Islamic bank without capital is bankrupt. The bigger the capital-to-asset ratio of an Islamic bank, the greater the trust of its stakeholders that the bank will fulfil its responsibilities. Indeed, capital alone cannot guarantee financial stability. Even a well-capitalised Islamic bank might fail owing to a lack of liquidity. On occasion, capital might be viewed as the liquidation value of an Islamic bank. How much cash would remain for equity investors if an Islamic bank liquidated all of its assets and liabilities? In fact, because liquidating an Islamic bank may be expensive, the majority of Islamic banks are more valuable to equity owners when they are operating than when they are dissolved. Such complications add to the enigmatical nature of capital. It is difficult to define capital in a precise and relevant manner. Accountants define capital as book value of assets less book value of liabilities, often with adjustments for off-balance-sheet items. Although this accounting word is precise, it is not always relevant. A bank’s assets may consist of non-depreciated investments in obsolete technology or ‘goodwill’. A significant mark-to-market loss may have been sustained by an Islamic bank over a period of ten years. Even if liquidation expenses are disregarded, many Islamic banks may have a liquidation value that is much less than the accounting value of their capital. The market value of the Islamic bank’s equity is a distinct form of capital measurement. This is similar to the number of outstanding shares multiplied by the current stock price for a single-class stock Islamic bank. In the absence of accounting requirements, market value of equity reveals the market’s evaluation of the Islamic bank’s worth. The stock market is influenced by human emotions and herd behaviour. The stock price of an Islamic bank may vary dramatically without affecting its business prospects greatly. If the stock market soars on a speculative bubble or plunges in a panic, this says little about the Islamic bank’s intrinsic worth.

DOI: 10.4324/9781003437086-4

14

Economic and Regulatory Capital

2.2

Regulators’ View on Capital

Regulators and risk managers perceive capital as financial resources that can be utilised to absorb unanticipated losses. In this sense, capital refers to the funding sources that protect parties having claims on an Islamic bank’s assets against such losses. It might be controversial to choose which items to include in this definition. Examples include owners’ equity, retained earnings and long-term subordinated debt. 2.3

Economic Capital

Economic capital is an indicator of risk, not a measure of retained capital. Conceptually, economic capital may be viewed as insurance against unforeseen future losses at a certain degree of confidence. Although the term ‘economic capital’ was developed relatively recently, the notion it represents dates back to the 1980s. To do this, regulators must establish capital and required capital formulae for banks. These were meant for regulatory purposes but were not always compatible with internal business aims, resulting in a split of regulatory and economic capital. In general, economic capital is ‘the amount of a person’s property that he expects to create income’, either via circulating capital and reselling it for a profit or through land development with usable equipment and instruments of trade, known as fixed capital (Smith, 1776, p. 177). It is the production of excess when a person’s profit from his own labour surpasses his needs (Khaldun, 1377, p. 297). Economic capital in the banking sector is the amount of risk capital required by a bank to cover the risks it is running or collecting in finance, primarily for Islamic banks’ financial services. Typically, this is estimated by establishing the amount of capital required to ensure that the Islamic bank’s realistic balance sheet remains solvent over a certain time period with a predetermined likelihood. Then, Islamic banks and regulators of financial services should endeavour to maintain risk capital that is at least equal to economic capital. Economic capital is the most accurate estimate of necessary capital that Islamic banks use internally to manage their own risk and spread the cost of regulatory capital maintenance among their many business divisions. The objective of regulatory capital is to establish minimum capital standards for financial organisations. This is achieved by employing capital ratios or risk-based capital. Islamic banks utilise economic capital largely to support business line and transaction selection decisions. 2.4

Regulatory and Economic Capital: What’s the Difference?

Two distinct risk management frameworks are used to quantify economic and regulatory capital. Firstly, a 1980s approach emphasises external risk supervision and regulatory reporting. The regulatory capital model defines regulatory capital as the minimum number of shares or other funds a financial firm must hold to

Concept of Capital 15 comply with central bank regulatory requirements. Tier-1, Tier-2 and extra capital comprise regulatory capital. The objective of regulatory capital is to guarantee that banks can withstand substantial potential losses without triggering a financial crisis. It contributes to the soundness and stability of the banking industry, as well as depositor safety. Secondly, a 1990s-era model emphasises risk and capital management. In this concept, economic capital is the amount of capital an institution feels is necessary to support its business activities and related risks. Economic capital functions as a single currency for risk, thus resolving the disparity between statutory capital adequacy frameworks. In this new dimension, economic capital refers to everything that can withstand economic losses without impacting the debtor. Economic capital is not restricted to intangible or concealed reserves or fees. It must absorb all possible losses associated with risks accepted or to be assumed. In addition to assisting in the identification of value-creating firm operations, it also facilitates compliance with investor information demands and regulatory obligations. Economic capital is combined with regulatory capital in order to ‘aggregate risks’. This strategy, despite its unpopularity, may be advantageous for incorporating frequent disciplinary feedback into risk-related decision-making. Thus, economic capital assessment is a determination of the amount of capital necessary to withstand a given set of hazards. There are two unique ways to acquire material riches. First, utilising statistical methods, it determines the needed capital to sustain losses up to a specified probability. Second, they employ techniques like stress testing and scenario-based development. Bank regulators throughout the world have traditionally expected financial businesses to follow the same standards and practises as conventional banks. In the absence of a welfare-relevant precautionary externality, banks will choose the socially optimum capital structure in the absence of government intervention. Banks determine the optimal capital structure; if government pushes banks to increase capital ratios, the economy will suffer. This condition exists only in the absence of asymmetric information, such as moral hazard and adverse selection. In the context of moral hazard, debt finance may be associated with risk shifting. Capital adequacy regulation is meant to reduce banks’ risk-taking motive. Using Basel III’s single risk factor model, economic capital (chosen by shareholders without respect to regulation) may be differentiated from regulatory capital (the bare minimum needed by regulation) and real capital (chosen with respect to regulation) in terms of the key factors. However, other factors, such as intermediation margin and cost of capital, might account for significant deviations from the required capital. Regulatory capital is effectively the minimum capital required by regulators, which they associate with capital charges under the Internal Rating-Based (IRB) system of Basel III. Economic capital is the amount of capital necessary to cover a bank’s losses with a specific probability or degree of certainty, as specified by the desired grade. When the cost of capital is low, economic capital exceeds regulatory capital; when it rises, economic capital falls below regulatory capital. The chance of default and loss on default have a positive influence on both capital levels for

16

Economic and Regulatory Capital

appropriate values of both variables. When they reach critical levels, they have a detrimental impact on economic capital, widening the gap between economic and regulatory capital. Actual capital is the capital that bank shareholders choose to put in their institutions notwithstanding legal constraints. Two regulations are accounted for. First, at the beginning of each period, banks must have a capital base equivalent to or greater than statutory capital. Second, banks whose capital levels fall below minimal (positive) standards at the end of a period are deemed to be severely undercapitalised and closed. Actual capital equals the total of economic capital and regulatory capital upon application of the first rule. The second rule is likely to explain the disparity whenever real capital exceeds regulatory capital. Given the set of distinctions between economic and regulatory capital concepts, the Basel Accord III’s applicability to Islamic banks is called into question. While Basel III is only concerned with capital adequacy risks, it appears that Pillar 1 (calculation of the minimum capital requirement) did not place a high premium on certain external risks, namely changes in the benchmark (i.e., London Interbank Offered Rate (LIBOR)-benchmark risk for fixed income instruments) and liquidity risk, on the grounds that these types of risks are inherent to management’s primary role and must be managed by its daily operations.

Box 2.1 Balance Sheet of an Islamic Bank Liabilities

Assets

Demand/Transactions/Current Account: – Amanah

Asset-Backed Transaction/Trade Finance: – Murabahah – Bay Mu’ajjal – Bay Salam Collateral-Based Product: – Ijarah – Istisna Syndication: – Mudarabah (special purpose) – Musharakah

General Investment Account: – Mudarabah Specialised Investment Account: – Mudarabah – Musharakah Equity

Source: El-Hawary et al. (2004)

Fee-Based Services (e.g., letter of credit): – Ju’ala – Qard al-Hassan

Concept of Capital 17 Islamic banks face not just the same risks as conventional banks but also risks unique to their asset and liability structures (see Box 2.1: Balance Sheet of an Islamic Bank). Islamic banks require a different risk identification process, distinct risk management methodology and strategies, and unique oversight (except for market risk, where it has a similarity with market conventional banks). As a result, applying Basel III on Islamic banks looks to be inadvisable and nonsensical. The capital adequacy requirements of the Basel Committee for Islamic financial institutions must be completely rewritten. This is a small detail, but one of the key purposes of the framework is to ensure a high degree of uniformity in its application to banks in different jurisdictions. One may argue, however, that because Islamic banks are fundamentally distinct, problems of competitive neutrality and ‘Islamic windows’ are not technically applicable. In the next section, the contrasts between economic and regulatory capital under the new capital structure (Basel Accord III) are discussed. Under the revised framework (The First Pillar-Minimum Capital Requirement), the computation of minimum regulatory capital is predicated mostly on information derived from the bank’s risk profile assessment. In determining the capital charge for credit risk, for instance, the bank’s individual credit exposures are categorised according to their internal PD (Probability of Default) and LGD (Loss Given Default) ratings. This demand for uniformity invariably leads to disparities between a bank’s internal capital allocations and the minimum statutory capital charge. Figure 2.1 illustrates some potential differences between regulatory capital under the new Basel framework and economic capital for a hypothetical bank. The second pillar establishes a regulatory criterion for assessing the capacity of banks to estimate their own capital needs. 2.4.1

Formula

A bank’s economic capital is defined as the sum of its owners’ equity, retained earnings and subordinated debt, among other factors. Economic capital charges are assigned using formulas to certain company lines or transactions. The objective is to determine which business lines or transactions make the best use of the bank’s limited economic capital. Banks conduct such reviews using risk-adjusted performance criteria (RAPMs). A RAPM is a performance metric that is derived from a normal accounting performance indicator but adjusted to represent ‘true’ or ‘economic’ risk. RAPMs are derived from the accounting concept of return on assets (ROA), which was long utilised as a performance metric for Islamic banks: ROA =

revenue − expenses assets

(2.1)

The widespread usage of structured products and other off-balance-sheet items has rendered the accounting concept of assets completely irrelevant as a proxy for a

Capital ($ billion)

Bank Model

Regulatory Model

18

35

Model Drivers Funding sources and uses stress scenario analysis

25

Business Risk 4

Measure of poten˜al earnings vola˜lity

Market Risk 4

20 15

Capital $21

Opera˜onal Risk 5

10

5

Credit Risk 12

Interest Rate Risk 4

Model Drivers 10-day Value-at-Risk plus specifc risk charges Frequency and severity loss distribu˜ons and other factors

Capital $25

PD and LGD bands, EAD and some maturity data as inputs, regulatory risk curves used to capture correla˜on; credit losses related default

Market Risk 5

Value at risk over a liquida˜on period plus stress scenario analysis

Opera˜onal Risk 5

Frequency and severity loss distribu˜ons and other factors

Credit Risk 10

0 -5

Other Model Di˛erences: -Di˛erent confdence levels used -Varia˜ons in input data

Diversifca˜on Benefts -7

-10

Minimum Regulatory Capital

Economic Capital

Figure 2.1 Comparison of Minimum Regulatory Capital with Economic Capital Source: Authors’ illustration based on Federal Deposit Insurance Corporation

Economic value of equity (EVE) results

PD, LGD, EAD and maturity as inputs; observed correla˜ons used; credit considera˜on considered; credit losses related to changes in economic value

Economic and Regulatory Capital

30

Liquidity Risk 4

Concept of Capital 19 bank’s risk or financial resources deployed. Return on equity (ROE) has largely been phased out as a success metric for Islamic banks. ROE =

revenue − expenses equity

(2.2)

ROE has two drawbacks that limit its use for internal purposes: (1) the accounting concept of equity might be a poor predictor of an Islamic bank’s risk; and (2) while ROE is defined Islamically for the entire bank, it is not defined for specific business lines or transactions. Return on capital (ROC) can be expressed as follows by substituting capital for equity in formula (2.2): ROC =

revenue − expenses capital

(2.3)

Economic capital is our first example of a RAPM since it reflects ‘real’ or ‘economic’ risk. When applied to specific business lines or transactions, the formula is somewhat modified: ROC =

revenue − expenses + income from capital capital

(2.4)

where capital is defined as the cost of capital for a particular business line or transaction and income from capital equals capital (risk-free rate). The income from capital term is included in equation (2.4) because allocating capital to a business line or transaction is distinct from investing in the business line or transaction. As a result, it gets assigned risk-free income. Occasionally, an Islamic bank will invest the money allocated to that business line or transaction in that business line or transaction. Equation (2.4) is still true in this scenario as long as the costs term in the numerator includes a transfer pricing charge for the capital’s financing cost. When ROA, ROE and ROC are used to evaluate a bank’s (actual or predicted) performance, they are typically applied to one year’s results. The same principle applies to the remaining RAPMs described below. They devised a bank-wide RAPM they dubbed risk-adjusted return on capital (RAROC). This is because Islamic banks have divested themselves of their retail deposit and loan activities. It was actively involved in the securitisation of assets and was developing an off-balance-sheet company. The names were primarily keywords. Today, the majority of RAPMs developed from ROC are simply referred to as RAROC. Perhaps the most frequently used definition of RAROC is simply ROC with an expected loss adjustment: RAROC =

revenue − expenses − expected loss + income from capital capitaal

(2.5)

20

Economic and Regulatory Capital

When expected loss is defined as the mean of the loss distribution associated with some activity – most commonly, it refers to the expected loss connected with defaulted funding or operational risk. Equation (2.5) is equivalent to: RAROC =

gross earning − expected unit costs − expected losses bookk value of equity capital

(2.6)

Equation (2.6) can be simplified as: RAROC =

Risk Adjusted Return book value of equity capital

(2.7)

where adjusted return is equal to total income minus expenses and anticipated losses (EL). To compute RAROC, the following metrics are required: 1 Risk. There are two categories of risks: anticipated and unanticipated loss. The expected loss is the mean or average loss that a portfolio is expected to incur. Assume a bank provides financing for home purchases. The risk premium on the loan, together with the costs, should be sufficient to cover anticipated losses. A bank will reserve funds to meet these anticipated losses. Simultaneously, a bank must set aside capital as a buffer against unanticipated losses, which are quantified in terms of the volatility (standard deviation) of home improvement (or other forms of financing) losses. 2 Intervals of confidence. Although capital is set aside to protect against unexpected losses, it begs the question of how much capital should be set away. Typically, banks estimate the amount of capital required to ensure their solvency using a 95% or 99% confidence interval. If management develops a 99.97% confidence level, this implies that they are willing to tolerate a 3 in 10,000 chance that the bank will go insolvent during the following 12 months. 3 Time frame for risk exposure measurement. In an ideal world, risk would be quantified over a five- or ten-year horizon, but acquiring the requisite data presents challenges. Generally, no inverse relationship exists between the confidence interval chosen and the time horizon. A traditional bank that specialises in lending will typically choose a year as the time horizon for both expected and unforeseen losses, realising that financing cannot be easily unwound. 4 Distribution of possible outcomes’ probabilities. Additionally, one must understand the probability distribution of a possible outcome, such as the probability of default (PD) or the chance of portfolio loss. Additionally, financing losses are significantly skewed, with a large downside tail, as the distribution of financing returns demonstrates. The skew on the left is due to defaults, showing that there is a high probability of earning very little returns with a very small chance of experiencing extremely large losses. If a bank has a significant portfolio of funding, these two explanations account for the skewed distribution.

Concept of Capital 21 RAROC is not devoid of limitations. Each category is allocated a risk factor based on the historical volatility of its market price, which is often between two and three months and one year. First, there is no assurance that the past accurately predicts the present or the future. Second, it is less precise when used to non-tradable assets such as debt, which are incredibly challenging to value. The third factor to consider is the selection of a hurdle rate or benchmark. The returns on the screened activity are evaluated apart from the return structure of the bank. The hurdle rate can be calculated in a variety of ways. If it is defined as the cost of equity (the shareholder’s minimum necessary rate of return), then shareholders receive value for their investment if the RAROC of a business unit exceeds the cost of equity, but if it is less than the cost of capital, shareholders lose value. In general, the hurdle rate is the least rate of return on risk capital that a transaction, a business line or the bank must earn on its risk position to meet investor expectations. (For a discussion of the hurdle rate in greater detail, see Appendix 1: Hurdle Rate.) RAROC is a cost-loss ratio that accounts for anticipated expenses and losses but not for unanticipated losses. In banking operations, RAROC analysis provides a significant advantage over gross margin analysis, as it incorporates predicted losses (standard risk costs). However, the capital amount employed in this formula (book value of equity capital) is not risk-adjusted. As a result, unanticipated losses are disregarded. Risk-adjusted return on risk-adjusted capital (RARORAC) is a forward-looking performance metric that considers both expected and unexpected costs and losses. It is determined using the following formula: RARORAC=

s expected gross earning −expected unit costs −expected losses (2.8) amount of the risk

Unlike RAROC, RARORAC adds a metric for unexpected losses by utilising the denominator ‘amount of risk’. The term ‘amount of risk’ is frequently used to refer to a specific metric (e.g., actual economic capital) that is to be assigned to the firm and against which risk-adjusted performance is to be judged. The same type of data could be quantified using a well-defined absolute measure (e.g., the shareholder value-added). In contrast to relative performance measures (ROE, ROI, RAROC and RARORAC), shareholder value added (SVA) is an absolute and forward-looking metric that, like RARORAC, may account for both expected and unforeseen costs and losses. It is determined using the following formula: SVA = expected gross earning − expected unit costs − expected lossses − cost of capital

(2.9)

2.4.2 A  Hypothetical  Example

Assume that an Islamic bank is evaluating the performance of two financial portfolios: Portfolios X and Y, with Portfolio X being assumed to be riskier and yielding

22

Economic and Regulatory Capital

Table 2.1 Example of Risk-Adjusted Performance Measures

Portfolio Balances Net Income before Losses* Financing Parameters: – PD (Probability default) – LGD – EL (in bps) Expected Losses Income after Expected Losses Economic Capital (credit only)** RAROC Economic Profit (10% hurdle rate)

Portfolio X

Portfolio Y

$100,000,000 $1,400,000

$100,000,000 $1,100,000

0.50% 50% 25 $250,000 $1,150,000 $4,640,000 24.78% $686,000

0.25% 40% 10 $100,000 $1,000,000 $2,460,000 40.65% $754,000

Note: *Net income before losses = financing income + fees – funding costs – operating costs; **Determined from the economic capital charges shown in Box 2.1: Economic Capital Allocation for Credit Commercial Risk

Table 2.2 Risk-Adjusted Return

Income after Expected Losses Flat Capital Charge (e.g., 8%) Return on Equity

Portfolio X

Portfolio Y

$1,150,000 $8,000,000 14.4%

$1,000,000 $8,000,000 12.5%

a larger return than Portfolio Y (see Table 2.1). The example in Table 2.1 takes only credit risk into account. Islamic bank management would include additional risks while calculating risk-adjusted performance. Initially, Islamic bank management may have been tempted to choose Portfolio X, as illustrated in Table 2.2, due to its simple return characteristics. While Portfolio X generates a greater predicted book and economic net income, the volatility of its return (i.e., risk) is not appropriately compensated for in contrast to Portfolio Y. Portfolio Y has a higher RAROC and hence generates a larger economic profit with a much lower economic capital allocation. 2.5

Expected Loss and Unexpected Loss

The term ‘expected loss’ refers to the projected average loss over a specified time period. Expected losses are a necessary component of doing business and are often absorbed by operational income. For example, in the event of financing losses, the anticipated loss should be factored into profit-loss sharing and a suitable charge added to the allowance for financing and leasing losses. As a result,

Concept of Capital 23 Basel III provides banks with substantial freedom when implementing Advanced Measurement Approaches (AMA). Islamic banks should also create significantly different methodologies for calculating credit risk capital, placing a greater focus on the predicted loss calculation compared to total capital. Bank risk assessment entails an element of unanticipated loss. These unexpected losses can occur as a result of lower-than-expected asset returns or needing to pay more for obligations than anticipated. This will result in volatility in the bank’s earnings. Expected losses, on the other hand, are changes in values that can be determined from currently anticipated information, whereas unexpected losses are possible deviations from the expected losses. Expected losses may emerge as a result of anticipated market value fluctuations (e.g., share price due to dividend payments, movement in bond and option prices due to changes in residual maturity). Additionally, it could arise from the anticipated number and quantity of financing defaults, as well as anticipated credit rating downgrades (rating migration). Predicted losses may also be influenced by the expected amount of processing errors resulting in normal levels of damage. The identification of all material hazards as well as their quantification using established techniques includes back testing (confirmation of risk assessments by comparing prior unexpected losses or profits to actual results) and stress testing (measurement of risks for specified extreme events). Due to the fact that the bank engages in a variety of various types of business, unanticipated losses may also vary. In general, economic capital formulas incorporate a limited number of risk kinds. Interest rate risk, company risk, pricing risk, credit risk, equity market risk, liquidity risk and operational risk are only a few of the risks. Numerous studies, on the other hand, concentrated only on credit risk, market risk and operational risk. The equity of the bank serves as a buffer or cushion against unforeseen losses. Over the last four decades, enormous amounts of work have been done in retail and commercial banking to create methods for quantifying credit risk. Different types of bank assets provide unique modelling issues; however, the majority of asset classes have a set of models that compute (to varying degrees of precision) the credit risk associated with particular assets. While modelling methodologies differ, the majority of models are econometric in nature, examining historical trends in customer behaviour and assuming they will persist. For instance, businesses with a consistent turnover rate over multiple years are likely to pose fewer credit problems than those with fluctuating growth. Customers who have recently changed jobs or residences are more likely to be at risk than those who have not. In each situation, the factors that have previously been able to distinguish between high and low credit risk will be included in the credit risk prediction model. Islamic banks have refined their credit risk measurement techniques as a result of regulatory changes brought about by the forthcoming capital adequacy standard (CAS). According to CAS, credit risk calculations will typically yield three components for each exposure: probability of default (PD), indicating the likelihood of a

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Economic and Regulatory Capital

customer defaulting (without regard for the severity of the loss); loss given default (LGD), indicating the amount the bank is likely to recover; and exposure at default (EAD), indicating the amount the customer is likely to owe if he defaults. As an illustration, consider that an unsecured revolving credit line with a $250,000 limit is 1.24% likely to default. If it defaults, it will forfeit 95% of the exposure – the projected default exposure is $275,000. Given the significant number of clients who default, it is highly probable that the EAD exceeds the limit. On the basis of this information, the following expected loss figure can be calculated: EL = PD × LGD × EAD = 1.24% × 95% × $275,000 = $3,239.50 (2.10) This value can then be used to estimate the overall portfolio’s expected loss. However, because International Accounting Standards (IAS) differ, this number may differ from the real provisions charged for that loan. While risk measurement at the exposure level is advantageous for pricing and managing individual facilities, it is insufficient to explain the dynamics of a bank’s whole portfolio. Portfolio management approaches come into play here. Portfolio management entails examining several exposures concurrently and attempting to understand their interactions in order to predict what might happen in a stressed environment. For instance, if a bank wishes to maintain its present BBB grade, it must have adequate capital to withstand any severity scenario up to BBB. Consider the following example: Example 1: To illustrate the concepts, consider a portfolio with simply two exposures. Assume that both facilities have the same risk profile as the $250,000 scenario above, but with exposures of $250,000. As a result (as illustrated in Table 2.3), there are four possible outcomes for this portfolio of two financings. Calculating the cost in each of these eventualities is straightforward; the tough part is calculating the probability of each outcome. If the two financings were completely independent, it could simply multiply the relevant odds to obtain their combined probabilities, but businesses are rarely truly independent. As a result, portfolio management is inextricably tied to the problem of determining the correlation between default probability. Once this region is completely understood, Islamic banks will be able to comprehend their extreme risk scenarios, allowing them to more precisely calculate economic capital and move towards strategic financing in order to mitigate extreme risk exposures. Table 2.3 Default Outcomes Outcome

Total Loss

Neither financing defaults Financing 1 defaults; financing 2 does not Financing 2 defaults; financing 1 does not Both financing default

$0 $ 261,250 $ 522,500 $ 783,750

Concept of Capital 25 2.6

Economic Capital and Risk Measurement

While economic capital can be quantified in a variety of ways, the most typical method includes developing a statistical distribution of the potential losses associated with a given set of risks. This distribution can be used to calculate the probability that a predefined percentage of the time a loss threshold will be exceeded (the confidence level). There are several fundamental methods for generating a statistical distribution of potential losses (value at risk – VaR), including the following: (1) analytical method, in which historical data is fitted to a mathematical distribution formula and that formula is used in the analysis; (2) historical data method, in which actual outcomes are ordered by size and a desired percentile of the result is selected; and (3) simulation method, in which a large number of simulations is performed and the results are raised. Each technique offers a number of pros and disadvantages in terms of accuracy, relevance, data availability, the requirement to fill in data gaps, computational ease and resource requirements. These three techniques are applicable to all major risk categories. In practice, the bank may employ a variety of strategies depending on its management objectives, available resources and data availability. Along with these statistically based methodologies, many banks incorporate stress testing into their economic capital framework. The most often used method of stress testing is to create one or more particular adverse situations that are evaluated to fall within the specified confidence level. These may or may not be based on true incidents from history. Economic capital is stressed through a scenario-based approach that focuses on the losses that would occur under the various scenarios. How these possible stress test loss amounts are converted to economic capital is a judgement call based on the various stress scenarios and will vary between Islamic banks. The time horizon and definition of loss are critical factors when developing an economic capital framework. Trading activities typically have a short time horizon (a few hours to a few days); credit activities have a longer time horizon (a few months to a few years); operational risk and takaful activities have a very longtime horizon (several years). Additionally, when a loss is recognised, accounting standards, regulatory guidance and management policy all come into play. In some cases, such as when trading assets that are regularly marked-to-market or when operational losses arise, loss recognition is straightforward. In these cases, there is usually little doubt about the economic capital’s role. In other circumstances, management has more discretion. For instance, when it comes to credit exposures, management may opt to measure economic capital exclusively against financing defaults or against both defaults and deterioration in financing quality. The time horizon and loss definition options can be coupled. Thus, the approaches to economic capital that are most frequently utilised for distinct risk kinds can be quite diverse. It is common to utilise value at risk (VaR) approaches to assess market risk associated with trading portfolios. VaR is essentially the statistical technique discussed

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above. Its purpose is to determine the level of loss that will be exceeded only x% of the time, where x is often 1% or even less. Due to the shifting nature of the trading portfolio, Islamic banks may tend to use short time horizons (e.g., days or weeks) when performing such analyses; however, this can occasionally miss the non-linear risks associated with swap positions. However, Islamic banks may take into account the possibility of long-term losses by scaling up one-day VaR results. Additionally, Islamic banks incorporate stress testing into their VaR methods. Each bank determines the relative importance of VaR and uses the findings of stress testing to determine the amount of economic capital required to protect against market risk. Take credit risk into account while financing. If capital is retained solely to protect against defaults, it is logical for the horizon to be the duration of the financing. If capital is held against depreciation, a period is chosen that is independent of the life of the underlying financing. Market risk results in loss as a result of market risk’s volatility. As a result, estimation utilising VaR should be based on the assumption of market price variability. Concerning credit risk, the recent decade has seen a significant increase in the popularity of so-called credit VaR models, which are based on the generation of a statistical distribution of prospective credit losses. This risk arises as a result of default, downgrade or counterparty risk. These models largely rely on three major components: probabilities of default (PD), loss given default (LGD) and exposure at default (EAD) estimates for individual credit exposures. Additionally, assumptions about the relationships between exposures (e.g., their correlations) are significant drivers inside these models. Credit VaR models frequently use a one-year horizon to measure the risk of loss; however, longer horizons are occasionally used as well. Internal data adequate to construct a probabilistic model are less likely to be accessible for operational risk than for other risk kinds. As a result, external data, expert opinion, scorecards and benchmarking are commonly augmented (or replaced) by internal data. Scorecards and benchmarking are particularly prevalent in Islamic banks as a technique of allocating economic capital across business divisions. Economic capital approaches to operational risk are a fast-expanding field, and each specific implementation requires considerable judgement. Economic capital metrics are difficult to aggregate for a variety of reasons. First, the majority of businesses inside an Islamic bank are exposed to many types of risk; for instance, a trading firm is exposed to both market and credit risk. Second, an Islamic bank engages in a variety of business activities. Third, in the majority of circumstances, the risk (economic capital) connected with two activities is not equal to the simple sum of the hazards (economic capital) associated with each activity separately. This is true both within and across risk categories. Banks must make decisions on how to aggregate risks and economic capital in practice. Probably the most used strategy relies on risk type aggregation. Each business activity is examined for its susceptibility to the fundamental risk indicators associated with each risk class using this approach. This strategy has the advantage of allowing these risk factor inputs to be aggregated across business lines.

Concept of Capital 27 For instance, each business line may be evaluated based on its sensitivity to currency exchange rate fluctuations. These sensitivities can be added together to obtain an assessment of the aggregate sensitivity of Islamic banks to this currency rate. Such sensitivities might be entered into a VaR or stress test model at both the business unit and aggregate levels to assess the amount of economic capital required to cover this risk. Notably, if certain business units are favourably exposed to dollar appreciation while others are negatively exposed, the aggregate economic capital required to mitigate this risk will be less than the sum of the individual business unit computations. Following through on this strategy often results in the assignment of a set of risk factor inputs to each business activity, some of which will relate to market risk, some to credit risk, some to operational risk and so on. These can then be combined together, and economic capital procedures implemented across the Islamic bank. In theory, all risk factor inputs might then be incorporated into a unified conceptual economic capital framework; however, this is more of an aspiration than a reality at the moment. In practice, risk factor inputs for market risk are often plugged into a market risk economic capital model, risk factor inputs for credit risk into a credit risk economic capital model and so on. As a result, a bank-wide measure of economic capital is established for market risk, a bank-wide measure of economic capital is established for credit risk and so forth. Similar computations can be conducted at the business unit level, but the outcome will be distinct estimates of economic capital for each risk type. Thus, the final stage in the aggregation problem is to determine how to aggregate economic capital metrics across risk kinds. This is where correlations play a vital role. When confronted with this issue, the majority of Islamic banks address it by treating individual economic capital estimates as measures of volatility and examining the statistical question of what the aggregate volatility across all risk types is under certain assumptions about risk type correlations. This is a simple statistical computation, albeit one that is significantly influenced by the correlation assumptions applied. 2.6.1 A  Hypothetical  Example

To illustrate the general methodology and, particularly, the potential diversification benefits, let us assume that a hypothetical bank decides to create an economic capital model based on the following concepts. The bank separately estimates its economic capital requirements for its market, credit and operational risks. Because it wishes to earn ‘AA’ rating from the external credit rating agencies, the bank chooses a common one-year time horizon and the 99.97% level of confidence.1 The bank calculates its VaR for market risk every business day. Its trading department uses an analytical model to estimate VaR over a one-day horizon at a 99% confidence level. The amount of capital needed over a one-day horizon is converted to that needed over a full year by using a multiplicative factor.2 It is possible to convert the 99% confidence level to 99.97% by using another

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multiplicative factor.3 Using these factors introduces assumptions that may or may not correspond to actual experience. For example, use of the time conversion factor, with no adjustments, implies that no account will be taken of any optionality effects. In addition, the selection of a 99.97% confidence level means that a loss greater than the estimated amount would occur 0.03% of the time, or once in 3,333 years. The reliability of the resulting estimate would obviously be difficult to verify empirically.4 For simplicity, let us assume that the bank’s market risk calculation includes all asset/liability risks. Additionally, because this estimate is generated from a VaR framework, it will automatically account for diversification impacts across all important types of market risk factors, such as interest rates, foreign currency rates and equities prices. Assume the net outcome is a $1 billion market risk economic capital estimate. Following that, suppose the bank has created a statistical model for credit risk. This model is based on internal ratings of the bank’s clients, which provide estimates of the risk of default, the amount the bank can recover in the case of default, and the likelihood that lines of credit will be run down in the event of default. Additionally, the model makes assumptions about the variables’ interrelationships. For instance, the model determines the association between loan default rates in various commercial sectors. The bank will almost certainly use one methodology for larger commercial financings and another for retail financings. In general, a bank may employ a variety of different financing methods for a variety of different financing segments. If financing areas are modelled individually, the economic capital amounts projected for each area must be added together. The bank integrates numerous correlation assumptions into the combination, either implicitly or explicitly. Assume that the bank’s entire economic capital for credit risk is estimated to be $3 billion. Finally, assuming the bank has estimated economic capital for operational risk based on the frequency of substantial losses experienced by Islamic banks engaged in comparable operations, with some adjustment for changes in management controls and procedures. Economic capital for operational risk is estimated to be $2 billion. After estimating the economic capital required for market, credit and operational risks, the bank must combine the individual requirements into a single amount. The hypothetical bank aggregates these numbers using a typical statistical approach based on correlation assumptions. Consider now the effect of various correlation hypotheses. In one scenario, the bank makes a conservative assumption about the perfect correlation of its market, credit and operational risks. If it requires $1 billion in economic capital to protect against market risk, $3 billion to protect against credit risk and $2 billion to protect against operational risk, its total economic capital requirement is equal to the sum of these amounts, or $6 billion. Alternatively, the bank might assume that the three risks are fully uncorrelated, with zero correlations between any two of them. The aggregate economic capital estimated under this assumption is only $3.74 billion. This implies a nearly 40% reduction in comparison to the $6 billion projection based on perfect correlation.

Concept of Capital 29 The bank forecasts a 0.8 connection between market and credit risk in a third scenario, a 0.4 correlation between market and operational risk and a 0.4 correlation between credit and operational risk in a fourth scenario. According to these assumptions, the bank’s overall economic capital requirement is estimated to be $5.02 billion. Thus, even under these greater correlation assumptions, recognising the benefits of diversification would result in a 16% capital reduction – a sizable sum. The preceding example explains the practical implications of the cross-risk correlation assumptions. This idea is underlined further by examining the differences in the calculated rate of return on economic capital that would arise from these various assumptions. 2.7 Volatility and Capital Once we’ve agreed on a definition of capital,5 the next step is to calculate the minimum capital requirement for an Islamic bank. Historically, this question was answered in terms of a financial institution’s capital ratio, which is defined as the ratio of capital to assets. capital ratio =

capital assets

(2.11)

Financial institutions often have capital ratios of between 4% and 10%, depending on the definition of capital utilised. During the 1970s and 1980s, financial institutions were exposed to heightened risk as a result of deregulation. Capital becomes increasingly critical in this context as a hedge against losses. The more the risk taken by an Islamic bank, the more capital it required. Because assets are a poor predictor of risk, regulators and practitioners began changing or eliminating the standard capital ratio. Modifications took the form of risk-adjusted capital ratios: resk − adjusted capital ratio =

capital resk − adjusted assets

(2.12)

where risk-adjusted assets are calculated by applying risk-based weights to specific assets and summing the results. Somewhat crudely, it applied weights, including: • 0% for G-10 government debt • 20% for G-10 bank debt • 100% for corporate debt and the debt of non-G-10 governments These contain stated rules for calculating the capital and appropriate capital charges of an Islamic bank. The objective is to ensure that an Islamic bank has adequate capital to remain solvent in the event of losses incurred as a result of the Islamic bank’s risk taking. This type of analysis is referred to as regulatory capital calculations. They were used in both the 1996 Basel Accord modification and Basel III.

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Economic and Regulatory Capital

Risk-based capital calculations have been utilised to aid in the performance assessment and decision-making processes of financial Islamic banks. The objective is to weight capital charges according to the risk associated with different business lines or transactions. Performance is determined by comparing a business line’s or transaction’s profitability to its capital charge. The return on capital for a particular business line or transaction can then be determined. A financial institution will pursue enterprises or transactions that provide the highest rate of return on capital under this paradigm. Senior management takes on the role of venture capitalists, determining where to invest their limited capital. This is referred to as capital allocation. Islamic banks might theoretically make such capital allocations using the capital and capital charges formulas prescribed by applicable rules. While some Islamic banks have taken this step, the vast majority have not. The issue is that regulatory capital and regulatory capital charges are intended to accomplish broader objectives than assessing specific business lines or transactions. They frequently make imprecise judgments between the riskiness of similarly structured but marginally different transactions. For instance, the 1988 Basel Accord established a consistent capital charge of 8% on all corporate loans. As a result, banks would be required to hold the same amount of capital for debt issued to an AA-rated borrower as they would for a BB-rated borrower. As a result, financial institutions have created their own proprietary capital and capital charge algorithms. To differentiate them from regulatory capital calculations and to underline their objective of more precisely reflecting the economic impact of certain business lines or transactions, these are referred to as economic capital calculations. Volatility might come from unexpected banking losses. These unexpected losses are the result of unexpected market value fluctuations (e.g., share prices, the five-year euro swap rate), unexpected credit rating downgrades and a higher-thananticipated rate of loan defaults (e.g., the economic crisis), and an unusually high number of processing errors resulting in especially severe damage (e.g., loan processing, payment). Unanticipated losses may also vary due to the bank’s involvement in a number of different forms of business. Risk, which is defined as the volatility or standard deviation (square root of the variance) of an Islamic bank’s net cash flows, threatens the institution’s existence. Risk management focuses on unexpected losses, which often arise from lower-than-anticipated returns on assets or having to pay more for obligations than projected. This causes earnings volatility, ranging from decreased profits to balance sheet losses and, perhaps, bank failure. The bank’s equity (capital) acts as a buffer or cushion against unexpected losses. In addition to book capital, economic capital also includes projected future earnings or losses, as well as additional reserves and provisions. Therefore, banks must implement economic capital management, which assesses the total capital adequacy associated with business risk and devises a plan for maintaining capital levels. The allocation of capital to particular business units will depend on their contribution to the bank’s total risk. It will also depend on the degree of correlation between the unit’s earnings and the bank’s earnings. Certain units will demonstrate market

Concept of Capital 31 volatility that is inverse to that of the rest of the Islamic bank, hence decreasing the total amount of equity capital necessary for setup. Consider, for example, a ‘universal bank’ with a liquidation business that handles bankruptcies. Its market value is almost probably negatively related to the bank’s overall value. Notes 1 This is the confidence level associated with the one-year AA default probability. 2 If the distribution is normal, the multiplicative factor is the square root of the number of trading days in the year, i.e., about 15.5. 3 If the probability distribution takes a normal shape, then VaR is simply the standard deviation times a constant that depends on the confidence level chosen. VaR at the 99.97% level of confidence is about 1.5 times VaR at the 99% level. 4 Although it conducts stress testing, the hypothetical bank chooses not to include the results in its economic capital framework. Other financial institutions may use only stress test results and not VaR. Still other institutions may use a weighted combination of the amounts of economic capital implied by VaR and stress testing. Even when economic capital is estimated at a 99.97% confidence level, not all the components would necessarily be estimated at this level. For example, market risk VaR may be measured at a 99% level, with stress test results increasing the level of confidence to 99.97%. 5 According to the definition proposed by the 1988 Basel Accord.

References El-Hawary, D., Grais, W. & Iqbal, Z. (2004). Regulating Islamic financial institutions: The nature of the regulated. World Bank Policy Research Working Paper No. 3227. Washington, DC: World Bank. Khaldun, I. (1377). The Mukaddimah: An Introduction to History (Rosenthal, F., Trans., 1967). Princeton, NJ: Princeton University Press. Smith, A. (1776). An Inquiry Into the Nature and Causes of the Wealth of Nations. London: Strahan and Cadell.

3

3.1

The Significance of Economic Capital to Islamic Banks

Role of Capital and Shareholder Wealth Creation

Supervisors are extremely concerned about the banking sector’s capital position. They believe that capital, particularly the minimum capital requirement, can protect banks from shocks or significant potential losses without precipitating a banking crisis. Banks are obligated to capture not only projected losses but also unexpected losses under Basel III. Supervisors expect banks to operate over the Basel Accord’s minimum regulatory capital ratios, and sensible assessments can assist in determining how much. According to some, the minimum capital level is insufficient to assure a bank’s performance. This concept stems from the belief that losses, whether anticipated or unanticipated, can deplete the bank’s shareholder equity. As a result, capital as a buffer or shield must capture and reduce the maximum amount of losses incurred by the bank. The greater the loss reduction, the greater the wealth creation for the bank’s shareholders. Economic capital has the potential to capture and absorb all bank losses, thus directly increasing shareholder wealth growth. Nonetheless, it is critical to remember that capital plays a critical role in both economic capital and the minimal requirement standard approach. Fundamentally, capital serves as a protection against future, unidentified and even somewhat remote losses incurred by a bank. A bank’s capital must be sufficient to protect both depositors and senior lenders (under the qard facility) against loss. Bank executives who can concentrate on the banking business, strategy and competitiveness, rather than on financial challenges, may create and innovate, thereby increasing shareholder wealth. Additionally, the problem of shareholder wealth is becoming increasingly significant to bankers as they compete for capital resources against an expanding field of competitors. Banks now compete for money not just with local and overseas peers but also with investment funds, asset management organisations, investment banks and insurance companies. Not only bankers, regulators and shareholders care about a robust capital base. It is becoming increasingly important to critical clients, particularly those who have long-term financial obligations with their banks. Clients are more aware of this and use it to differentiate between various financial market participants. A more critical point to emphasise is the breadth of risks to which banks are exposed and how DOI: 10.4324/9781003437086-5

The Significance of Economic Capital to Islamic Banks 33 certain of these risks have grown in prominence in recent years. The public has witnessed this cycle multiple times in the high-yield bond and leveraged buyout financing markets in the United States and elsewhere. Clearly, turmoil in the fixed income markets resulted in liquidity and solvency concerns for hedge fund market participants. The risk-capital structure stated earlier applies equally to Islamic financial institutions in emerging markets. Islamic banks in these countries require increased capital for a variety of reasons, as previously discussed. Additionally, it is necessary to recognise that foreign competition has reached Islamic banks in developed and emerging market countries equally, even in areas formerly considered to be exclusively domestic. The increasing interconnectedness of Islamic banking systems in a global capital market, coupled with the inclusion of an increasing number of emerging market participants as active participants, has pushed Islamic banks and supervisors in developed and developing countries alike to strengthen capital levels and consider a level playing field for all nations. As an increasing number of emerging market Islamic banks participate in the international financial system and compete in their domestic markets with internationally active conventional banks, the critical role of strong capital as the bedrock of a safe and sound Islamic banking system in these countries becomes clear. Emerging market Islamic banks acknowledge that adequate capital is a necessary but insufficient requirement for global competitiveness and the attraction of foreign investors and clients. Islamic banks operating in emerging nations are often exposed to a particular mix of risks due to their countries’ finance and investment cycles, as well as the underlying contracts for their products and services. Additionally, the majority of developing countries are actively committed in promoting the practice of Islamic banking. This assumption is based on the notion that the majority of Islamic countries or countries with a majority of Muslims are considered underdeveloped countries. Thus, the existence of a distinct set of hazards in Islamic banks necessitates a distinct approach to risk evaluation. Fortunately, capital can be assigned to absorb losses associated with certain risk characteristics. Islamic banking institutions are being pressed to create more sophisticated methods for managing and measuring capital that fully account for the numerous interrelated risks they must assume. Numerous Islamic banks are increasingly concentrating their efforts on assessing their own risk profiles and determining the amount of capital required to weather adverse outcomes in normal times and under tolerable stress scenarios. Islamic banks that are more advanced are creating internal systems and techniques, including formal analytical models, to enable them to do so more effectively. Several of these Islamic banks make business and risk management choices in part using analytical methodologies. Islamic banks’ top management can take this a step further by assessing not only their existing capital levels but also the suitability of their capital structure. Islamic banks should be well-positioned to strengthen risk disclosures and better inform investors as they improve their risk identification and quantification capabilities. While investors in Islamic banks ultimately carry the institution’s

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Economic and Regulatory Capital

risks, they are typically ill-equipped to make informed business judgments about an Islamic bank’s prospects. Without a doubt, investors are less knowledgeable than bank management. This is referred to as a ‘information imbalance’ in economics, but the issue is plainly not academic. Inadequate transparency hinders money from flowing efficiently, hence reducing or even eradicating prosperity. In times of financial turmoil, insufficient openness adds to increased disaster. However, various countries’ efforts to enhance disclosure and transparency, for example, about non-performing loans, are the first step toward increasing the Islamic banks’ wealth. The Basel Committee on Banking Supervision, the Euro-Currency Standing Committee, the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and the International Accounting Standards Committee have all taken steps to improve the relevance, reliability and comparability of information disclosed by the financial sector, in collaboration with other national and international organisations. The most significant actions will be those taken by national governments to implement these transparency rules and financial firms’ voluntary disclosures. Improved information on asset wealth and risk management plans and controls are among the disclosures designed to aid market decision-making. The bank’s primary purpose is to maximise shareholder wealth. Shareholders’ claims on an Islamic bank’s assets take precedence over all other claims. Their return will vary according to the volatility of the Islamic bank’s earnings and the predicted rise in earnings. As a result, they are willing to tolerate increased default risk on the part of the Islamic bank if they can expect a long-run return proportional to the bank’s risk and are reasonably confident that the Islamic bank will continue to be a viable economic entity capable of realising future expected earnings. As residual claimants of an Islamic bank, shareholders seek cash dividends and the promise of future payments, which is represented in the stock’s market price. If an Islamic bank fails to meet its shareholders’ financial demands, and earnings fall below the Islamic bank’s required return on capital (or cost of equity), the shareholder will withdraw its capital investment. Investors will only part with their money on the promise of a bigger return. They would undoubtedly anticipate a larger rate of return than they would receive by investing their money in a non-productive fund. This fundamental, however, imposes the requirement of a minimum acceptable rate of return on investment. In other words, it is not just debt capital that is expensive but also equity capital. The cost of equity capital is an opportunity cost, which complicates its expression in simple words. It is, however, no less ‘real’ for that: if shareholders do not receive the desired rate of return on their investment, they will eventually invest elsewhere. Islamic banks may utilise a system of calculating shareholder wealth because it is the only comprehensive metric available and hence beneficial for decisionmaking. Management can optimise wealth for other stakeholders (employees, consumers and government) by boosting shareholder wealth (through zakat paid). Furthermore, stockholders are the only stakeholders in an Islamic bank who maximise everyone’s claim while simultaneously aiming to maximise their own. Finally, Islamic banks that fail to generate shareholder wealth will see capital flow away from them and toward their competitors who do.

The Significance of Economic Capital to Islamic Banks 35 It is critical to highlight here that the bank’s management objectives may differ from those of the bank’s shareholders in certain circumstances. Managers can occasionally act in their own self-interest. When principals (e.g., shareholders) have imperfect control over their agent (e.g., management), these agents may not always behave in the principals’ best interest. This is referred to as the agency cost. Agents have their own ambitions, and it may occasionally benefit them to put their own interests ahead of the interests of their principals. The difficulties are exacerbated in large Islamic banking institutions, because it is difficult to discern the interests of a broad group of stockholders, ranging from institutional investors to people with tiny shares. The fundamental premise of shareholder wealth management is that the cost of capital must be considered. That is, an Islamic bank earns a real (economic) profit only after recouping the cost of capital required to establish it. Calculating the cost of capital is critical because bank management is concerned with whether earnings exceed the statutory return on capital for an Islamic bank. This minimum required rate of return, or cost of capital, is referred to as a hurdle rate, or the minimum required rate of return for stockholders. The question is specifically if RAROC exceeds the Islamic bank’s cost of capital. Traditional bank performance metrics such as ROA and ROE are obsolete due to their disadvantages. However, it also raises the question of the optimal strategy for increasing shareholder wealth in the event of unanticipated losses. Thus, we analyse whether economic capital via RAROC is a more effective means of achieving shareholder wealth development than capital adequacy requirements. 3.2

Risk Management and Wealth Creation

Bank management’s primary purpose is to enhance shareholder value. However, shareholder maximising is contingent upon the Islamic bank taking on risk. If the Islamic bank’s management fails to generate a return commensurate with the risks assumed, shareholders will sell their investments and replace them with more efficient risk-return assets, thereby depressing the share price. Additionally, such failure will result in the bank being acquired by other competitors. This failure will erode shareholder wealth and jeopardise the institution’s viability. Risk-adjusted performance metrics (RAPMs) are used to quantify the rate of return obtained by Islamic banks on economic risk exposures. Capital structuring identifies how to alter the composition of an Islamic bank’s rise or decrease in risk-weighted leverage and how to maximise the Islamic bank’s cost of capital in relation to its intended likelihood of default. The debt-to-equity ratio has an effect on the cost of capital of an Islamic bank. Capital allocation is to quantify the risk in an Islamic bank and to keep it within the Islamic bank’s economic capital targets. Capital budgeting establishes the required rate of return on money for shareholders and then makes investment and divestment decisions to allocate capital to the highest risk-adjusted return activities. To determine whether wealth is created or destroyed in an Islamic bank on a systematic basis, the return on investment must be weighed against the risk. The

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traditional methods for valuing a conventional bank’s debt and equity establish the wealth of these instruments by assessing the projected cash flows to investors and then discounting these cash flows for time wealth and risk.1 Credit spreads are the major risk factor used to value a bank’s debt. Credit spreads are determined by a bank’s probability of default, which is determined by its capital structure and the adequacy of its equity to shield debt holders from the bank’s risk of default. Return on equity (ROE) is an alternative to this strategy. As previously demonstrated, ROE is calculated using return on book or regulatory equity rather than economic capital, which is the underlying risk indicator. As a result, it would not be a perfect measure of economic wealth generation. As a result, financial industries have shifted their focus to modified ROE-based measurements that incorporate risk through the calculation of economic capital. These are referred to as risk-adjusted performance indicators (RAPMs). By comparing the anticipated risk-adjusted return on an activity, transaction or investment to a goal or benchmark risk-adjusted return, such as the hurdle rate, RAPMs can assist management in determining if an activity, transaction, or investment adds wealth. However, two requirements must be met before an Islamic bank can employ this strategy. First, the amount of economic capital necessary to safeguard the Islamic bank from unexpected losses resulting from risk exposures on the transaction is determined. Second, the amount of losses anticipated as a result of transaction risk exposures associated with the activity. Typically, Islamic banks generate the expected and unexpected loss information required to generate RAPMs. The majority of institutions employ wealth-at-risk (VaR) frameworks to quantify and manage economic risk associated with unexpected losses. Economic capital allocations based on these VaR metrics can be combined with internal performance measurements within the bank to generate RAPMs such as RAROC/RORAC and Economic Profit (EP). Chapter 4 examined the application of economic capital allocation via RAROC/RORAC. 3.3

Capital Allocation and Cost of Capital

Wealth creation in Islamic banking requires a high level of risk management involvement in the following areas: (1) determining risk-adjusted performance, (2) determining the optimal capital structure of the Islamic bank’s balance sheet, (3) allocating economic capital against risk in order to keep the Islamic bank’s probability of default and cost of debt within acceptable parameters and (4) setting minimum returns on economic capital in order to direct scarce economic capital to businesses. Chapter 6 will address risk-adjusted performance measures (RAPMs). The emphasis is on capital structure, which defines how to alter the composition of capital, thereby increasing or decreasing the Islamic bank’s leverage in relation to risk and optimising the cost of capital in relation to the bank’s desired likelihood of default. Any combination of debt-to-equity ratios will affect the cost of capital of an Islamic bank. Again, shareholder value generation will be contingent upon the success of all of these processes.

The Significance of Economic Capital to Islamic Banks 37 There are numerous ways for calculating the total required economic capital and determining the method that maximises shareholder wealth. The Islamic bank may employ one of the following strategies: pure-play, internal betas, regulatory, shareholder, debt-holder or financial crisis. However, many have criticised the regulatory approach as the dominant focus of discussion. Certainly, the pure play, internal beta, regulatory and debt holder techniques of capital allocation are ineffective at determining if shareholder wealth is created. Capital allocation sets the amount of capital that a business unit requires based on its risk profile. Economic capital, on the other hand, is superior to regulatory capital. Thus, RAROC is the optimal technique for capital allocation because it takes risk into account. However, determining whether shareholder wealth was created or destroyed needs an understanding of the cost of the economic capital employed to support the risk associated with the activity. Indeed, investing in an Islamic bank’s equity is riskier than investing in its debt, as loan holders have a first claim on the Islamic bank’s assets. As a result, the cost of capital must exceed the cost of debt. Estimating precisely how much more return equity holders require than debt holders is the primary impediment to determining an Islamic bank’s cost of capital. Additionally, any RAROC study that aims to assess whether shareholder wealth is created or lost must consider the opportunity cost of capital. The decision of an investor to invest in the stock of an Islamic bank is influenced by the rate of return (Islamic banks offer profit as a return). They would anticipate obtaining it by investing their money in a company with equivalent risk. If the Islamic bank’s predicted return is higher than their next best but equally risky choice, they will invest in the Islamic bank’s equity. The Capital-Asset Pricing Model (CAPM) can be used by an Islamic bank to assess its cost of capital: K i = ˜ f + °iM (Κm − ˜ f )

(3.6)

where r f is the return on a risk-free asset, Km is the expected return on the market and biM is a measure of the expected specific risk of an Islamic bank or asset in relation to the bank. CAPM is criticised as untestable (Roll, 1977), not showing close relationship between return and risk (Fama and French, 1992) and inaccurate method to measure opportunity cost of capital (Froot and Stein, 1998). Despite these limitations, no other tractable financial theory has been developed that convincingly explains why investors demand premium over debt for investing in low price/earning ratio stocks and low market/book ratio stocks. Therefore, CAPM is the best model to estimate the opportunity cost of capital. The CAPM framework places a premium on beta, a measure of a bank’s stock price’s volatility relative to the broader market. The assumption is that historical returns are the best indicators of future predicted returns. The returns on the stock are regressed on the returns on an index in equal time increments and over the same time interval. The index that serves as the independent variable is a proxy for the returns on the entire market. The slope of such a regression line is referred to

38

Economic and Regulatory Capital

as the stock’s beta. Internal risk-adjusted performance measurement of divisions, business units or products within a bank requires the bank to know the Beta for each division, business unit or product in order to estimate the division, business unit or product’s unique cost of equity capital. This strategy is very dependent on whether the evaluating unit is organised by product line or geography. If business units are defined by product lines, betas can be approximated using publicly traded enterprises in the same or similar industries. If the business units are geographically organised, the conventional technique is to estimate the cost of equity while disregarding the business unit’s Beta. To calculate the bank’s risk-adjusted performance, it is important for the bank to know its overall beta. As previously stated, CAPM has numerous limitations, including the possibility that the opportunity cost of equity obtained from regular CAPM underestimates the true economic costs of illiquid Islamic bank investments. Shareholders can diversify illiquid, unhedgeable risks, but the Islamic bank cannot. As a result, investors would need the Islamic bank to maintain a higher level of equity capital in the face of illiquid, unhedgeable risks. Thus, capital allocation for a position, and thus the Islamic bank’s acquisition price for that position, should prioritise unhedgeable risk, as hedgeable risks can be laid off in the market at a fair market price compatible with the risk being hedged. Furthermore, capital allocation to the position should be based on the diversified contribution of that unhedgeable risk to the total risk of the Islamic bank’s portfolio, not on the position’s stand-alone unhedgeable risk. For instance, if an Islamic bank already has a portfolio of highly correlated credit risks and the position in question will be highly correlated with that portfolio, the Islamic bank should allocate more capital to that position and, as a result, set a higher hurdle price for that credit, all other factors being equal. Other market players for whom the position helps for their credit portfolio diversification should charge the position a lower marginal capital charge and hence bid more aggressively for the position. The fact that markets are not fully symmetrical, that not all risks can be hedged in the capital market at the same price, underpins this thesis. The capital charge and opportunity cost of capital, and therefore any RAROC calculation, should take into account the covariance of the business unit’s or portfolio’s returns with those of the Islamic bank’s portfolio. Froot and Stein (1998) propose an amendment to CAPM. Following significant research on the one-factor model, they created a two-factor model in which the normal needed rate of return is entirely a function of the portfolio under analysis’s covariance (Beta) with the market portfolio. The original CAPM model’s premise of no financing frictions in the market is no longer valid in the real world. As a result, when financing frictions exist, the needed rate of return on capital for a portfolio is shown to contain a second element, resulting in the following CAPM equation: K n = ˜ f + ° NM (˜m − ˜ f ) + ° NP Z define ˜ NP = cov (°NN , °PN ) / var(°PN )

(3.1)

The Significance of Economic Capital to Islamic Banks 39 where Z is the bank’s price of un-hedged risk, and b NP is the covariance of the non-tradable risk of the portfolio under analysis (eNN ) with Islamic bank’s overall non-tradable portfolio divided by the variance of Islamic bank’s total non-tradable portfolio (ePN ) . b NM , rm and r f are the Beta of Islamic bank’s portfolio with the market portfolio, the expected return of the market portfolio and the risk-free rate just as they are defined in the standard CAPM. Kn is Islamic bank’s required return on the portfolio under analysis. The effect of the second factor b NP is to change the hurdle rate by an amount that is proportional to the new portfolio’s ‘internal portfolio Beta’ if the portfolio being analysed is small with respect to Islamic bank’s total portfolio. This second Beta is driven by the correlation of the new portfolio’s un-hedgeable risks with the un-hedgeable risks of Islamic bank’s existing portfolio. Islamic bank’s price of un-hedged risk (Z) is the result of its risk aversion and the overall variance of its unhedged portfolio. Islamic bank’s risk aversion is determined by the amount of capital it holds. If it has infinite capital, then its risk aversion is zero, as the likelihood of having to go to the market to raise costly external financing is zero, regardless of the variance of the un-hedged portfolio. In this situation, Islamic bank becomes risk-neutral. The overall variance of the un-hedged portfolio is determined through the conventional VaR analysis. If this variance is high and Islamic bank’s risk aversion is high because internal capital is constrained, the price of increasing Islamic bank’s exposure to un-hedged risk will be high. This leads to the intuitive conclusion that a capital-constrained Islamic bank would be relatively risk-averse and seek to maintain a diversified portfolio. The impact of this model is that Islamic banks that have capital constraints will hold additional capital if they undertake investments that contribute un-hedgeable risks that are positively correlated with those of the Islamic bank’s pre-existing portfolio. This additional capital will come from increasingly costly external financing, in which case existing shareholders will suffer a cost in the form of lower dividends arising from higher financing and cost of funds. If an Islamic bank that does not have constraints on its capital undertakes risky investment, this will incur costs to shareholders. If this cost is not predicted under CAPM, then capital is costly because of tax effects and other deadweight costs. Consequently, the cost of capital charged to those investments should be higher than those predicted by the CAPM alone. The two-factor model is appropriate for a small portfolio. If a portfolio is large enough, then investing in it creates a risk concentration in the Islamic bank’s total portfolio and reduces the diversification of the portfolio. Therefore, a risk-averse Islamic bank would need to evaluate that project’s capital allocation and cost more stringently. A large investment that reduces the diversification of the portfolio by creating a risk concentration should be allocated more economic capital, because the cost of capital may be higher if the effect of the investment were to increase the Islamic bank’s cost of capital by making it a riskier investment from the shareholder’s perspective,

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For multiple investments, the correlation between investments matters. Under normal scenarios, the appeal of one investment opportunity does not depend on whether another investment opportunity is undertaken. However, when multiple large investments can be made, the investment decision in the two-factor model framework is affected by covariance of risk between the multiple investment opportunities and the impact the investments will have on Islamic bank’s capital level and, subsequently, its risk aversion. Holding Islamic bank’s risk aversion fixed, an investment in any one opportunity will be less attractive if another investment opportunity is also undertaken that is positively correlated in terms of its un-hedgeable risks with the first opportunity. Conversely, an investment in any one opportunity will be more attractive if another investment opportunity is also undertaken which is negatively correlated in terms of its un-hedgeable risks with the first opportunity. The two-factor model is criticised because of its application. As size increases, risk-averse Islamic banks may want their capital charges to increase more steeply than the second factor allows. The covariance of the Islamic bank’s existing portfolio does not rise fast enough with the size of incrementally risky positions. Positions need to become unacceptably large before they receive a capital charge from the second factor that would alter the capital charge enough to create an incentive for line management to alter their behaviour. The three-factor model is shown as: K i = ˜ f + °iM (km − ˜ f ) + °ib Z b + °il Z l

(3.2)

where Ki is the hurdle rate for the ith risk exposure, r f is the risk-free rate, biM is the Beta of the ith exposure and (km − r f ) is the market equity premium, bib is the Beta of the ith exposure and Islamic bank-wide portfolio, Z b is the risk tolerance with respect to bank-wide risks, bil is the Beta of the ith exposure and the line-specific portfolio, l, and Z l is the risk tolerance with respect to the business line l risks. The first factor contributes to capital costs through the product of market risk’s price and quantity. Market risk can be defined as the market equity premium multiplied by the correlation between the given position and the market. The second component affects capital costs by calculating them on the basis of the product of the price and amount of bank-wide portfolio risk. The price of bank-wide risk can be viewed as a proxy for bank-wide risk aversion, and the quantity of bank-wide risk as the correlation between the portfolios of individual business units and the overall bank-wide portfolio. The third element contributes to capital charges by calculating the product of the price and quantity of portfolio risk unique to business units. The price of this risk can be viewed as its risk aversion, whereas the quantity of risk can be interpreted as the correlation between a certain position and a particular portfolio. With this third element, increasing size results in a faster increase in capital charges, as covariance with the business unit-specific portfolio develops with size. Due to the fact that these portfolios are far smaller than bank-wide portfolios, capital costs scale much more quickly with size. As a

The Significance of Economic Capital to Islamic Banks 41 result of the third covariance-based element, large un-hedged positions become more expensive to hold than their contribution to bank-wide risk alone would imply. The fundamental point of the three-factor is that, to create shareholder wealth, Islamic bank should require that returns on risk exceed those required by the basic CAPM equation by bib Z b +bil Z l . Such a required return reinforces the idea that risk warehousing should be limited to illiquid un-hedgeable risk that cannot be passed to the market or to risks which reduce the risk of Islamic bank’s pre-existing portfolio because they are negatively correlated and in which Islamic bank consequently has a competitive advantage. Determining an Islamic bank’s opportunity cost of capital is critical for calculating the capital charge in any risk-adjusted performance evaluation framework and establishing whether a business unit generated economic profit or loss. Similarly, establishing an Islamic bank’s opportunity cost of capital is important in order to establish the threshold rate for risk-adjusted return on capital from business units. 3.4

Economic Profit

Economic profit (EP) is a sophisticated modification of cash flow that looks at the cost of economic capital and the incremental return above that cost as a way of separating businesses that truly generate economic wealth from ones that do not. Economic Value Added™ (EVA) is popularised version of the concept of economic profit. Economic Profit = (dC – dO) K

(3.3)

where dC is the rate of return on economic capital and dO is the opportunity cost rate of economic capital and K is the amount of economic capital used by a business unit or activity being measured. Islamic bank’s management can improve the economic profit in two ways: by increasing dC, risk-adjusted return; or by reducing dO, the opportunity cost rate of capital. However, every change to one element in the economic profit equation is likely to have an effect on the others. Management must assess and manage the inherent risk-reward trade-offs between the critical factors. The amount of economic capital allotted to an activity should equal the amount of capital statistically required to cover the activity’s worst-case net-asset value, assuming a particular degree of confidence in the distribution of net-asset values. Economic capital provided to a business should be sufficient for an Islamic bank to sustain a significant loss in that operation while remaining confident that it will not default on its other obligations. The required confidence interval is determined by the Islamic bank’s desired cost of debt, which is determined by the debt holders’ tolerable risk of default given the risk premium received on the debt. The confidence interval should be the inverse of the acceptable probability of default for debt holders prepared to hold an Islamic bank’s debt at an acceptable cost to the Islamic bank. The opportunity cost of equity capital is the rate of return required to entice shareholders to take on the risk of owning the equity of an Islamic bank.

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The most broadly accepted approach for determining a shareholder’s required return is the Capital Asset Pricing Model (CAPM) or the Arbitrage Pricing Theory (APT). Assuming that investors and the market have an asymmetric information consequence, the CAPM states that shareholders will require a return more than the risk-free rate (assume that the shareholders are risk-averse) to compensate them for non-diversifiable risk only. CAPM formulates a simple linear relationship between required return and Beta, where Beta is a function of the volatility of the Islamic bank’s equity value and its correlation with the market portfolio. Once the shareholder’s required return is determined by CAPM, its inherent wealth can be calculated by discounting the expected cash flows using a dividend discount model or cash-flow model. Fundamentally, wealth is created when the economic rate of return surpasses the equity cost of capital, as defined by the fundamental economic-profit strategy. Economic capital is a function of risk. Calculating the quantity of economic capital utilised by an activity involves an accurate assessment of the risk associated with the activity. VaR may be used by Islamic banks to manage market, credit and operational risks. VaR approaches enable the quantification of risk at any given confidence level. Additionally, it is the marginal contribution of an activity to an Islamic bank’s VaR on a diversified basis that most exactly calculates the required economic capital for that activity and provides the most precise information for Islamic banking strategic decision-making. Internal risk management is able to contribute to the maximisation of returns since it offers precise information about the level of risk and may attach a cash value to it. The ability of Islamic bank risk management to accurately measure risk enables efficient allocation of economic capital, determination of the optimal capital structure through an assessment of the default risk that depositors and debt holders face at any level of economic capital and the use of RAPM measures such as economic profit and RAROC. Equity holders should be worried about Islamic bank’s risk management capabilities due to risk management’s essential role in these wealth-creating operations. 3.5

Risks by Type of Contracts

Types of risks can be categorised by contracts that are offered by Islamic banks. Islamic financial contracts such as mudarabah, musharakah, murabahah, ijarah, istisna’ and salam are compatible financing arrangements. The business of Islamic banking differs from conventional banks in terms of basic principles. As a result, the assets of Islamic banks are distinct from those of their conventional counterparts. These generally consist of cash and cash equivalents; receivables relating to murabahah, salam and istisna’; investments in securities; mudarabah investments; musharakah investments; investments in other entities; inventories (including goods purchased for murabahah contract); investments in real estate; assets acquired for ijarah; and fixed and other assets. The risks associated with each contract will be combined into generic risks, namely, credit, market, operational and liquidity risks.

The Significance of Economic Capital to Islamic Banks 43 3.5.1 Credit  Risks   in Sales-Based  Contracts

Credit risk exists in murabahah and other sales-based contracts due to the possibility of loss in the event of customer default or degradation of the customer’s repayment capacity. Calculating loss in an individual financing, both expected and unforeseen, requires estimations of the following: (1) risk of default, (2) potential credit exposures at default and (3) loss-given default. Using the option pricing technique to predict bankruptcy, the observed market value of a firm’s stock and the estimated volatility of equity prices can be utilised to estimate the likelihood of default. Numerous techniques can be integrated during the risk management process to derive a credit rating and related probability of default based on previous experience. Probability estimation and rating accuracy, on the other hand, require previous data on finance structure and performance, customer characteristics, and the broader industry and macroeconomic climate. As a result, the rating will fluctuate over time in response to changes in financial conditions and the external environment. Losses will undoubtedly vary according to the credit exposures that exist at the time of default (exposure at default, EAD). In general, exposure to default would be contract-specific, based on the amount to which the client has discretion over drawing down lines of credit, prepaying already drawn accounts or any other specific occurrences affecting the value of contingent claims (i.e., guarantee to third parties). In most murabahah and salam contracts, EAD is just the contract’s nominal value. EAD will be determined by contract-specific environmental parameters in long-term ijarah and istisna’ contracts. Losses will ultimately be determined by the rate of recovery following a default or by the decrease in the value of the financing due to a change in the rating (in a market-to-market model). The loss-given default (LGD equals one minus the recovery rate multiplied by the EAD) is likely to be determined by the ease with which the collateral may be collected, the collateral’s value and the enforceability of any assurances, if any. Most notably, it is contingent upon the legislative environment that governs creditors’ rights and the insolvency regime’s characteristics. Similarly, this is true for salam contracts used to calculate counterparty credit risk. However, these contracts include an additional commodity price risk that should be added to the credit risk. Even if the counterparty does not default, the commodity price risk will exist, and in the event of a default (i.e., delivery of a substandard good, delayed delivery of a good etc.), the commodity price risk, taking into account any offsetting parallel salam positions, may be included as part of the loss due to default. Thus, the potential loss in a salam contract is equal to the sum of the credit risk and the commodity price risk, if delivery occurs in accordance with the contract (i.e., there is no credit risk loss). There may be a correlation between these two types of risks (e.g., as a result of similar variables such as drought, which affect both commodity price risk and counterparty credit risk), which may be evaluated using historical data. In the absence of liquid commodity markets and Shari’ah-compliant hedging solutions, commodity price risk can be quantified by estimating the value at risk of commodity exposures

44  Economic and Regulatory Capital across various maturity buckets using historical pricing data. While commodities exposures can be included in the calculation of market risk for capital allocation purposes, it is critical to compute market risk independently for each salam contract or portfolio of salam contracts and to add it to credit risk in order to accurately measure and price each contract. Additionally, the projected commodity price risk should be reviewed on a frequent basis, as price volatility can fluctuate over time as macroeconomic and market conditions change. Finally, depending on the degree of diversity or concentration in specific credit categories, the credit risk of a portfolio of exposures and contracts may be lower or higher. Credit risk measurement can take diversification into account by computing the joint distribution of default events based on correlations between different classes and segments of the portfolio, that is, correlations between counterparty defaults, and then estimating the joint probability of default for any pair or group of counterparties. This can be used to determine the value of the financing portfolio and the predicted loss on the financing portfolio, based on the portfolio’s joint distribution of components. Default rates and transition probabilities can be considered to be a function of macroeconomic variables in some models. The probability distribution of the financing portfolio’s gains and losses, or the financing contract’s gains and losses, may therefore be used to calculate both expected and unexpected losses (at a given probability level). Supervisors and banks may classify financings to a diverse range of consumers and small enterprises, with routine payments and commodities leases, as a retail exposure with a lower risk weight. Simultaneously, credit concentrations by industry and rating class should be tracked as a proxy for credit risk. 3.5.2  Equity Risks in Profit-Sharing Contracts

Profit-sharing arrangements are typically used in commercial transactions and do not cover participation in another entity’s share capital. Trading transactions are typically not permitted in regular banks. Musharakah is a type of profit-sharing arrangement that entails the acquisition and sale of commodities, real estate or other similar products. The risk weighting attributed to these assets varies considerably depending on the asset category. For example, if the musharakah is on a commodity, some central banks may add a risk rating to the commodity based on its life. Musharakah on real estate would impose a risk weighting of 100% on the capital given by the Islamic bank. Apart from this, and because the fundamental legal principle governing musharakah contracts is that neither the bank nor the client may guarantee the capital of the other partners, the risk will vary according to the parties’ capital shares. Musharakah may also be structured as equity-based contracts. Unexpected losses in such equity-type arrangements will vary according to the operations of the underlying firm or venture in which the Islamic bank takes an equity stake. The equity position risk in a venture founded to trade commodities or foreign exchange originates from the venture’s underlying transactions. A possible loss in equity exposures in untraded commercial operations can be calculated using the Basel III

The Significance of Economic Capital to Islamic Banks  45 standard and the Islamic Financial Services Board’s (IFSB) standard for equity position risk in the Islamic banking book. A mudarabah contract may require additional unexpected losses to be assigned owing to operational risk factors, the level of which will rely on the quality of internal control systems monitoring mudarabah contracts on the asset side. Musharakah may require less operational risk adjustment, insofar as the Islamic bank exercises some management control. If an Islamic bank’s equity interest in a counterparty is based on regular cash flow rather than capital gains and is long term in nature tied to a customer relationship, a different regulatory procedure and a smaller loss on failure may be applied. 3.5.3  Specific Risk Features in Islamic Banks

In addition to the above risk, Islamic banks also face five broad risk categories, as shown in Figure  3.1, that are transaction, business, treasury, governance and systemic risks. The following focuses on risks specific to Islamic banks: (1) displacement risk, (2) quality of management, (3) harmonisation of the institutional environment, (4) liquidity management and (5) counter-party risk. Islamic banks have a higher risk profile than traditional interest-based banks for the following reasons: first, an Islamic bank’s investments are profit-and-loss oriented; the volatility in the rate of return on its investments is greater. Second, there is increased liquidity risk, as a significant amount of an Islamic bank’s assets are in illiquid form. Third, Islamic banks are vulnerable to foreign currency exposures against which they have limited options for hedging. Finally, Islamic banks

Risk Profile of An Operating Islamic Financial Institution

Transaction risks

Mark-up risk

Business risks

Treasury risks

Governance risks

Systemic risks

Credit risk

Displaced Commercial risk

ALM risk

Operational risk

Business environment risk

Market risk

Withdrawal risk

Liquidity risk

Fiduciary risk

Institutional risk

Solvency risk

Hedging risk

Transparency risk

Regulatory risk

Foreign exchange risk

Figure 3.1  Risk Profile of an Islamic Bank Source: Authors’ illustration

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are more vulnerable to fiscal and monetary policy changes than traditional banks, as they share in the profits and losses of their economic businesses. There are substantial disparities in how Islamic banks absorb such risk elements. Displacement risk is defined as the danger that an Islamic bank’s returns to equity holders will deteriorate in order to retain its appeal to investment account holders. It occurs when an Islamic bank gives account holders a larger rate of return than what the investment contract’s ‘real’ requirements require. For Islamic banks, the quality of management and operational processes creates unique risks. While expertise in either finance or Shari’ah is not a requirement, the combination of the two is less common. Additionally, Shari’ah compliance requires Islamic banks to follow operational processes that necessitate the use of management information systems that are not readily available in the market. Due to gaps in the harmonisation of the institutional environment controlling Islamic banks’ financial intermediation, they face performance risks. The institutional risk associated with the consensus among Fiqh academics on contractual agreements is at the forefront of these constraints. For example, while some Fiqh scholars believe that the provisions of a murabahah or istisna’ contract are binding on the buyer, others argue that the customer retains the right to terminate the deal even after placing an order and paying the commitment fee. Lack of standardisation, combined with the absence of competent litigation and dispute resolution processes, exposes Islamic banks to counter-party default and delinquency risks. Islamic banks have liquidity risk as a result of their inability to use traditional money market instruments, which are not Shari’ah-compliant. An Islamic bank’s liquidity excess must be invested, while its shortfall must be funded. Borrowing is prohibited under Shari’ah legislation, and there is no active interbank market. Islamic banks’ liquidity management choices are constrained by the Shari’ahcompliant money market. Near-term trade financing enables Islamic banks to invest their excess cash in the short term. However, there is currently no efficient mechanism for funding a cash shortfall in an emergency. Islamic banks are exposed to counter-party risk as a result of certain modalities of Islamic finance (Zulkhibri, 2018; Zulkhibri and Sukmana, 2017). It is present in deferred payment and delivery contracts. The former is a surcharge on murabahah finance. In a deferred delivery, bay’ salam, as well as in production orders (istisna’ contract), an Islamic bank is subject to the risk of not supplying goods on time or at all, or of not supplying items in the quality stated in the contract. The mudarabah contract may subject an Islamic bank to increased counter-party risk. If an investor books an asset through a mudarabah contract, the investor is responsible for any losses in the event of a negative outcome. In a mudarabah, the Islamic bank has no right to monitor or participate in the administration of the project and risks losing both its main investment and any prospective profit sharing if the entrepreneur’s books reveal a loss. 3.6

Economic Capital for Equity Financing and Sale Receivables

Both partners participate in the management and provision of capital and share in the profit or loss in musharakah contracts. As a result, this strategy is appropriate

The Significance of Economic Capital to Islamic Banks 47 for joint venture investments and can be used to package portfolios of assets whose returns, such as real estate lease payments, are then split among the partners. Enterprise capital is a type of equity financing in which the investor has an active role in the venture that is being financed. Investor funds will be directed toward the most promising businesses, particularly in the form of equity. The venture capitalist, as manager of the investors’ cash, will support the receiving company financially and strategically. Additionally, they take an active role in its management. From an Islamic perspective, venture capital is classified as equity financing and hence falls under the umbrella of Islamic finance. Thus, the discussion of venture capital serves as a springboard for further exploration of equity financing in Islamic institutions. The musharakah contract serves as the basis for the equity financing. Equity financing has been a viable option for Islamic banks due to its economic feasibility. After establishing a venture capital fund, the venture capitalist must discover investment possibilities, monitor the success of their investment and earn a profit on their investment. The financing process is staged, with each stage providing sufficient funds to proceed to the next stage. Venture capitalists also play a role in the management of recipient firms by serving on their boards of directors. Venture capitalists are banks that are directly involved in risk management and mitigation. The venture capitalist provides operational support to the venture until it succeeds. Finally, an outside investor may be interested in acquiring a stake in the recipient company, allowing it to become a public enterprise. The proceeds from the sale of the business are subsequently distributed to the limited partners, and the venture capitalist begins work on a new venture capital fund proposal. Islamic banks may also use mudarabah to finance equities. Profits are split between the two parties in the ratio agreed upon at the time of the contract. The capital owner bears the financial loss, whereas the manager bears the opportunity cost of his own effort, which generates no money for him. The manager makes an exception for violation of contract or default; the manager does not guarantee the capital or profit production. The capital supplier has the power to impose certain mutually agreed-upon requirements on the manager, but these restrictions do not include capital management. As a manner of financing used by Islamic banks, deposits serve as rabb-ulmal and the Islamic bank as mudarib on the liabilities side. On the asset side, the Islamic bank acts as the rabb-ul-mal (financial provider), while the businessperson acts as the mudarib (manager). Credit risk is predicted to be high under the musharakah and mudarabah modes due to the absence of collateral, a high level of moral hazard and adverse selection, and the Islamic bank’s current competencies in project evaluation and related approaches. The equity-type profit and loss sharing (musharakah) contract retains an element of human error in the management of the funds due to the fund manager’s negligence or incompetence (venture capitalist). As a result, it may be classified as an operational risk. If an Islamic bank’s equity interest in a counterparty is based on regular cash flow rather than capital gains and is long-term in character and tied to a customer relationship, a different supervisory procedure and a lesser loss on

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failure may be applied. However, if the equity interest is short-term and dependent on capital gains (e.g., traded stock), a VaR approach could be employed to calculate capital at risk (however, for some reason, for example, imprecise estimation of the amount that will be lost, the VaR approach must be complemented by a stress testing approach). Additionally, the possibility of unanticipated losses in such equity-type arrangements is contingent on the operations of the underlying firm or venture in which the Islamic bank gets an ownership stake. For instance, in a venture engaged in commodity or foreign exchange trading, the equity position risk derives from the venture’s underlying activities. Market risk exists within an Islamic bank’s trading book. Equity investments can be made through long-term participations, joint ventures or equity mudarabah funds. mudarabah, on the other hand, are subject to market risk as a result of price fluctuation. Because market risk is composed of two components: specialised risk and general risk. Individual equities are exposed to issuer and liquidity risk, which can be mitigated by portfolio diversification. Additionally, an Islamic bank could mitigate this risk by trading directly or through a fund manager using the mudarabah contract. Indeed, some central banks may view equity funds granted on a mudarabah basis as being vulnerable to market risk, but others may not. Market risks are typically quantified using several VaR metrics. This is especially critical considering the expected importance of equities and commodities on the balance sheets of Islamic banks, which have the potential to generate significant losses. The discussion of equity financing’s risk characteristics (musharakah and mudarabah) has implications for the formulation of economic capital for equity financing. Once the risk characteristics of equity financing are defined, we may classify these modalities of financing into one of three major risk groups. musharakah and mudarabah are classified as market risk, credit risk and operational risk, respectively, based on the underlying enterprise’s or venture’s functions. We can quantify and compute maximum expected and unexpected losses over a specific time period, confidence interval, risk exposure time horizon and probability distribution of possible outcomes using VaR, stress-testing and other statistical techniques. Calculating and quantifying these risks enables us to create particular economic capital for the unique risks inherent in any contract (e.g., operational and market risk in this example) utilising RAROC or RARORAC. By assessing the risk-return variables associated with various asset classes and business units, RAROC is used to allocate capital between them. In Islamic finance, RAROC could be used to allocate resources to various kinds of financing. Islamic financial instruments have a range of risk characteristics. Murabahah, for example, is believed to be less dangerous than mudarabah and musharakah. Using historical data on various types of investment financing, one can estimate the expected loss and maximum loss for various financial instruments over a specified time period with a certain degree of confidence. Then, using this information, risk capital can be assigned to various modalities of financing via Islamic financial instruments. The murabahah (cost-plus-sales) contract is the most prevalent example of this type of debt-based structural arrangement. Murabahah (cost-plus sales)

The Significance of Economic Capital to Islamic Banks 49 refers to a transaction in which the buyer is aware of the price at which the seller acquired the financed item and agrees to pay a premium over that initial price. The Islamic bank must own the item at the time the consumer purchases it from them with the set profit margin in this contract. A murabahah contract may comprise either the sale-purchase agreement of a customer-held asset (‘negative short selling’) or the purchase of a tangible asset by an Islamic bank on behalf of the customer from a third party (‘back-to-back sale’). The resale price is equal to the original purchase price plus a pre-specified profit margin imposed by the Islamic bank to ensure that the clients’ repurchase of the assets is a ‘loss-generating contract’. Different instalment rates, repayment schedules and timetables for asset delivery all contribute to deviation from the basic murabahah cost-plus sale. Salam (delayed delivery sale), bai bithaman ajil (deferred payment sale), istisna’ (buy order), qard al-hassan (benevolent finance) and musawamah are the most significant examples (negotiable sale). In general, the sale of non-existent property is prohibited under gharar. However, adjustments were made for salam and istisna’s contract in order to facilitate certain types of commerce. These contracts provide for the full payment of the trading price and the delivery of the well-defined item of the sale after a set time period. These two contracts are permissible by way of exception from the general principles of sale. As such, certain requirements must be satisfied in order for salam or istisna’s contracts to be legal. An istisna’ contract provides pre-delivery (project) financing for future assets, such as long-term projects that the customer agrees to fulfil within the life of the lending arrangement. On the asset side, sales receivables frequently introduce market and credit risk. Credit risk may develop, for example, when one party to a transaction pays money (e.g., in a salam or istisna’ contract) or delivers assets (in a murabahah contract) prior to receiving its own assets or cash, exposing it to possible loss. Additionally, murabahah contracts are considered to be trading contracts. Credit risk manifests itself as counter-party risk as a result of a trading partner’s non-performance. The failure to perform may be a result of external systemic factors.2 Credit risk is also present in salam contracts, which include an additional commodity price risk that needs to be added to the credit risk. Commodity price risk exists even if the counterparty does not default and even if the counterparty does default (i.e., delivery of a substandard good, delayed delivery of a good etc.). Commodity price risk exists when commodity prices are volatile. Thus, the potential loss in a salam contract is equal to the sum of the loss owing to credit risk and the loss due to commodity price risk, assuming delivery occurs as agreed. On the other hand, changes in market interest rates pose some hazards to the revenues of Islamic banks. Islamic banks price various financial instruments using a benchmark rate. The mark-up is calculated in a murabahah contract by adding the risk premium to the benchmark rate, such as LIBOR. Fixed-income assets are structured in such a way that the mark-up is fixed throughout the term of the contracts. As a result, Islamic banks incur risks associated with market interest rate fluctuations, commonly referred to as benchmark risk. If domestic monetary conditions change, necessitating adjustments to deposit and financing rates, but

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the spread between the external benchmark and domestic rates of return narrows, asset returns may suffer. This is a type of ‘base risk’ that should be factored into the banking book’s rate of return risk calculation (and market risks). Credit risk is calculated in the case of murabahah and salam sales-based contracts based on the prospective credit risks at the time of default (exposure at default, EAD). In most murabahah and salam contracts, EAD is just the contract’s nominal value. EAD is dependent on contract-specific environmental conditions in long-term ijarah and istisna’ contracts. An Islamic bank may apply a loss-given default (LGD equals one minus the recovery rate multiplied by the EAD), which is contingent upon the ease with which the collateral may be collected, the collateral’s value and the enforceability of any guarantees, if any. The expected and unexpected losses can be easily computed using the estimated probability of default (PD), or probabilities of transitioning from one rating class to another (transition matrix), and the estimated LGD (or change in value of the financing for any given transition from one rating class to another). This reduces the likelihood of experiencing unexpected losses to a predefined level. The consideration of the risk characteristics and risk computations associated with sales receivables (murabahah, istisna’ and salam) has implications for the formulation of economic capital for sale receivables. By identifying risk characteristics, we can classify the modes of sale receivables as market risk or credit risk. We can quantify and compute maximum expected and unexpected losses over a specific time period, confidence interval, risk exposure time horizon and probability distribution of possible outcomes using VaR, stress-testing and other statistical techniques. All computation and measurement are required to employ RAROC or RARORAC as a sophisticated technique for designing economic capital for accounts receivable. In Islamic finance, RAROC could be used to allocate resources to various kinds of financing. Islamic financial instruments have a range of risk characteristics. Using historical data on various types of investment financing, one can estimate the expected loss and maximum loss for various financial instruments over a specified time period with a certain degree of confidence. 3.7

Shari’ah-Compliant Instruments

Compliance with Shari’ah is one of the prerequisites of Islamic banking operation. Failure to adhere to Shari’ah can expose financial institutions to further reputational risks. Both the management of Islamic banks and the supervisory authorities need to ensure that proper measurement and management of such risks are in place. The risk of non-compliance with Shari’ah requirements that may result in nonrecognition of income and resultant losses will also lead to operational risk, which will be discussed at the end of this chapter and in Chapters 8 and 9. In order to understand the implication of Shari’ah-compliant instruments on capital requirement, it is crucial to comprehend the nature of different risks of these instruments since each Shari’ah-compliant instruments will be assigned their own credit and market risks.

The Significance of Economic Capital to Islamic Banks 51 The Islamic financial instruments offered by Islamic banks can be divided into four categories: 1 Asset-based (murabahah and murabahah for the purchase ordered; salam and istisna’), which are based on the sale or purchase of an asset (debt-creating assets) 2 Asset-based-ijarah, which is based on the leasing of such an asset, and ijarah muntahia bittamleek, which is based on the combination of leasing and purchasing of such an asset (debt-creating assets) 3 Profit-sharing, mudarabah; musharakah and diminishing musharakah (non-debt-creating) 4 Sukuk (securities), which may be based on the above assets (debt-creating assets or asset-based) Those instruments may involve exposure to market (price) risk in respect of the asset as well as credit risk in respect of the amount due from the counterparty. For the profit-sharing instruments, namely musharakah and mudarabah, the exposure is of the nature of an equity position not held for trading similar to an ‘equity position in the banking book’, as described in Basel III and is likewise dealt with under credit risk. However, investments (normally on short-term basis) in assets for trading purposes are dealt with under market risk. Therefore, the CAS is structured in a matrix format so that the minimum capital adequacy requirements in respect of both the credit and market risks exposure arising from a given type of financial instrument is discussed under the sub-heading of respective Shari’ah-compliant financing and investment instrument, as indicated below. Additionally, the provisions for operational risk and the treatment of profit-sharing investment account (PSIA) are also justified.3 3.7.1 Asset-Based  Instruments

The instruments are related to murabahah, salam, istisna’ and ijarah contracts. The assignment of risk weight shall take into consideration the following: (i) Credit Risk Rating Based on External Credit Assessment Institutions

The proposed standardised approach as in Basel II distinctly modifies the extent of different capital requirements used to classify borrowers’ credit risk. The current system of a 0% risk weight for members of the OECD and 100% risk weight for all other countries is replaced by six new buckets (columns 2–7, Table 3.1) based on the external credit rating assessment institutions (ECAIs). CAS suggests allocating a 100% risk weight to the unrated entities of these institutions, resulting in a capital adequacy ratio of 8%. Table 3.1 also portrays the suggested risk weights for banks’ claims on sovereign borrowers, banks and securities firms. Table 3.1 implies that in contrast to Basel I, which encompassed a maximum capital requirement of 8%, under Basel II, capital requirements could be as high as 12% for an emerging market economy with a weak sovereign credit rating.

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Table 3.1 Risk Weights Based on Counterparty’s Rating Rating/Risk Score

AAA A+ to BBB to BB+ Below Unrated to AA– A– BB– to B– B−

ECA Country Risk Score

1

Counterparty

2

3

4

4 to 6 7

Risk Weights (RW)

0%(b) 20% 50% Sovereigns and Central Banks(a) 100% 150% 100% Non-Central Government Public Sector Subject to supervisory authorities’ discretion Entities (PSEs)(c) to treat as either Islamic banks, banks and securities firms (Option 1 or Option 2a) or as Sovereigns Multilateral Development Banks 20%(b) 50% 50% 100% 150% 50% (MDBs)(d) Islamic banks, banks and securities firms Option 1* 20% 50% 100% 100% 150% 100% Option 2a** 20% 50% 50% 100% 150% 50% Option 2a**/@(e) 20% 20% 20% 50% 150% 20% Rating/Risk Score (contd.)

AAA to AA−

A+ to A−

BBB+ to Below BB− BB−

Unrated

Corporates(f)

20%

50%

100%

100%

150%

* Credit assessment based on ECAI of sovereigns. ** Credit assessment based on ECAI of the Islamic banks, banks and securities firms. @ Applicable for original maturity ≤ 3 months, which is not rolled over.

Within the proposed standardised approach to credit risk, the IFSB recommends three options to measure risk weights on lending to Islamic banks, banks and securities firms. Table 3.1 indicates that under the first scheme, claims on these institutions would be given risk weights based on their respective governments’ ECAI. Under the second option, claims on these institutions would be designated the risk weights as given in Table 3.1, based on the ratings assigned directly to them by an ECAI. While, under the third option, the risk weight applied to these institutions would be one category less favourable than that assigned to claims on the sovereign, while a ceiling of 20% would be imposed when the exposure is denominated and funded in domestic currency. The proposed CAS framework also differs from Basel I in its treatment of short-term claims on Islamic banks and banks. Furthermore, the IFSB made the decision to lower the threshold for the favoured treatment of short-term debt to three months since the upper maturity bound in the short-term inter-bank market is also three months. (ii) Market Risk

The market risks are due to the risk of losses in on- and off-balance-sheet positions arising from movements in market prices. Islamic banks can use either a Shorthand Method or Internal Models Approach in calculating the risks inherent

The Significance of Economic Capital to Islamic Banks 53 in the Islamic bank’s mix of long and short positions in different currencies. The Shorthand Method is mostly recommended for Islamic banks by (1) converting the nominal amount of the net position (net long or net short positions) in each foreign currency and in gold or silver into the reporting currency using spot rates; (2) aggregate the sum of converted net short positions or the sum of converted net long positions; (3) the larger sum of net short positions or net long positions calculated in (2) is added to the net position of gold/silver, either short or long position regardless of sign to derive at the overall net position. The capital charge is 8% the overall net position. While the use of an Internal Models Approach by an Islamic bank is subject to the supervisory authority’s explicit approval and fulfilment of qualitative standards, specifications of market risk factors being captured into the Islamic bank’s risk management system, quantitative standards, comprehensive stress testing programme and validation of the models by external auditors and/or supervisory authorities. However, those requirements are not covered in the Islamic bank’s IFSB Standard No. 2 (IFSB-2 is superseded by IFSB-15). The minimum capital requirements cover the risks of holding or taking long positions in commodities,4 including precious metals but excluding gold and silver, as well as the inventory risk which results from Islamic banks holding assets with a view to re-selling or leasing them.5 The Islamic banks can use either the maturity ladder approach or the simplified approach for calculating the capital charge for commodities risk. Under both approaches, each commodity position is expressed in terms of the standard unit of quantitative measurement of weight or volume (barrels, kilos, grams etc.). The net position in each commodity will then be converted at current spot rates into the reporting currency. However, positions in different groups of commodities cannot be offset unless6: (1) the sub-categories of commodities are deliverable against each other, (2) The commodities represent close substitutes for each other and (3) a minimum correlation of 0.9 between the price movements of the commodities can be established over a minimum period of one year. The netting of positions for different commodities is subject to the supervisory authorities’ approval. Under the maturity ladder approach, the net positions are entered seven time-bands as shown in Table 3.2.

Table 3.2 Maturity Ladder Approach for Commodities Risk Category

Time-band

1 2 3 4 5 6 7

0–1 month 1–3 months 3–6 months 6–12 months 1–2 years 2–3 years Over 3 years

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As shown in Table 3.2, a bigger time band is assigned for higher category. It implies that the short position could dominate the impact on the risks of holding positions for different commodities. (iii) Mitigation Risk

Islamic banks can employ the credit risk mitigation techniques to adjust or to reduce the exposure with respect to a debtor, counterparty or other obligor. The techniques should investigate security deposits held as collateral (hamish jiddiyyah), earnest money held as collateral (‘urbun), recourse or non-recourse guarantee (guarantee from a third party) and pledge of assets as collateral. The collaterisation under the concept of rahn or kafalah shall be properly documented in a security agreement or in the body of a contract to the extent permissible by Shari’ah and must be binding on all parties and legally enforceable in the relevant jurisdictions. Capital relief against the collateral can be granted based on either simple approach or standard supervisory haircuts (internal haircuts).7 In the former, the Islamic banks can substitute the RW of the collateral for the RW of the counterparty for the collateralised portion of the exposure subject to the collateral to be pledged for at least the duration of the contract. The RW of that collateralised portion shall not be lower than 20%. In the latter, both the amount of exposure to counterparty and the value of collateral received are adjusted by using standard supervisory haircuts as set out in Table 3.3.

Table 3.3 Standard Supervisory Haircuts Types of Collateral

Cash Sukuk Long term: AAA to AAShort term: A−1 Sukuk Long term: A+ to BBBShort term: A−2 to A−3 Sukuk Long term: AAA to AA– Sukuk (unrated) Equities (included in main index) Equities (not included in main index but listed) * @

Residual Maturity (years)

Haircuts (%) Sovereigns@

Others

All ≤1 >1 to ≤5 >5 ≤1 >1 to ≤5 >5 All All All All All

0 0.5 2 4 1 3 6 15 15 25 15 25

0 1 4 8 2 6 12 15 15 25 15 25

Collateral denominated in different currency will also be subject to additional 8% haircut to cater for foreign exchange index includes PSEs and MDBs.

The Significance of Economic Capital to Islamic Banks  55 3.7.2  Profit-Sharing Instruments

These instruments cover the long-term and medium-term investment made under profit-sharing and loss-bearing mode (mudarabah) and profit and loss-sharing mode (musharakah). Both modes are not meant for trading or liquidity purposes, but for earning investment returns. (i) Credit Risk

Long-term and medium-term investments undertaken under profit-sharing and loss-bearing modes (mudarabah) and profit-sharing and loss-bearing modes (musharakah) that are not intended for trading or liquidity are also subject to credit risk in the form of capital impairment risk. Risk weights for such assets should be determined using one of two methods: First, the simple risk-weighted strategy should be used for all equity holdings in private and commercial firms, that is, a 400% risk weight. However, funds invested on a mudarabah basis may be withdrawn by the investor at any time and so may be deemed as liquid as publicly traded shares. The risk weights that apply in this scenario are 300%. Second, the slotting technique, that is, Islamic banks may, at the supervisor’s discretion, use an alternate strategy, namely the supervisory slotting criteria approach. Under this system, an Islamic bank is expected to categorise its internal risk levels for specialised financing into four supervision categories (strong, good, satisfactory and poor), with each category assigned a specified risk weight. In some instances, Islamic banks enter the musharakah financing mode with the goal of transferring ownership to the partner/customer, in which the Islamic bank acts as a joint owner of the asset and the partner promises to purchase the Islamic bank’s share in the asset by making a payment on one or more specified future dates. The Islamic bank’s selling price shall be determined by the fair market value of the partnership share being transferred on the day of each transaction, which may expose the Islamic bank to the risk of selling its ownership interest at a loss. As a joint owner, the Islamic bank is also entitled to a share of the revenue generated by the musharakah’s assets, such as ijarah lease rentals, where the Islamic bank’s rental entitlements are modified annually in accordance with its share of ownership in the asset. Thus, the Islamic bank’s position in a declining musharakah implies two types of risk. (ii) Market Risk

As mentioned in (i), an equity position under ‘equity exposure in the banking book’ is dealt with under the credit risk. However, equity position in the trading position is subject to market risk.8 There are two charges that are separately calculated for the specific and general market risks. The capital charge for specific risk is 8% on the summation of all long equity positions and of all short equity positions and must be calculated on a market-by-market basis (for each national market). The

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Table 3.4 Specific Risk Provision for Sukuk Issuer

Specific Risk Charge

Government Investment Grade

0% 0.25 (residual term to final maturity 6 months or less) 1.00% (residual term to final maturity 6 and 24 months) 1.60% (residual term to final maturity exceeding 24 months) 8%

Others

capital charge can be reduced to 4% for a portfolio that is both liquid and welldiversified, subject to criteria determined by the supervisory authorities. The capital charge for general market risk is 8% on the difference between the summation of the long position and short position, that is, the overall net position. These positions must be calculated on a market-by-market basis. As shown in Table 3.4, in the case of sukuk held for trading, the provision for specific risk charge will depend on the RW of the issuer and the term to maturity of the sukuk. There are two important findings that can be derived from Table 3.5. First, the specific risk charge on investment grade follows the ‘diminishing return to scale’. It would encourage the holding of sukuk with a maturity less than six months. Therefore, the availability of secondary market for this instrument is needed. Second, sukuk other than the ones issued by government and other issuers with grade are given a lower risk charge. It shows that sukuk issuer is encouraged to appoint the ECAI as an incentive to reduce the specific risk charge. The provision for general market risk depends on the residual term to maturity or to the next repricing date, using a simplified form of the Maturity Method on the net positions in each time-band (refer to Table 3.5). The table shows that a higher residual to maturity would be given a higher risk weight. Furthermore, the incremental risk weights increase over a longer residual duration to maturity. Table 3.5 General Market Risk Provision for Sukuk Residual term to maturity

RW

1 month or less 1–3 months 3–6 months 6–12 months 1–2 years 2–3 years 3–4 years 4–5 years 5–7 years 7–10 years 10–15 years 15–20 years > 20 years

0.00% 0.20% 0.40% 0.70% 1.25% 1.75% 2.25% 2.75% 3.25% 3.75% 4.50% 5.25% 6.00%

The Significance of Economic Capital to Islamic Banks 57 In the case of equity investments made by means of a musharakah or a mudarabah contract where the underlying assets are commodities held for trading, the market risk provisions for commodities, as described in (ii), will be applicable. (iii) Mitigation Risk

The mudarabah contract may take the form of a fund placement, an investment in project finance or a deposit with the central bank of liquid funds. A placement made pursuant to a mudarabah contract may be subject to a third-party guarantee. This guarantee is limited to the capital of mudarabah, not to the return. In this situation, the capital should be classified as credit risk with a risk weighting equal to that of the guarantor, provided that the guarantor’s risk weighting is less than the mudarib’s counterparty risk weighting. While the liquid money is held in a central bank or another bank on a shortterm mudarabah basis in order to earn interest on them. These placements act as an interbank market with maturities ranging from overnight to three months, but the money may be withdrawn on demand before maturity, at which point no interest is received. Although the amounts so placed do not constitute debts legally, as mudarabah capital does not constitute a liability for the institution acting as mudarib (in the absence of misconduct or negligence), the operation of this interbank market requires that the latter effectively treat them as liabilities. Thus, an Islamic bank that invests in this manner may treat the funds as cash equivalents and apply the risk weight appropriate to the mudarib as counterparty. Notes 1 Rappaport (1986) popularised this strategy. 2 See counter-party risk 3 The PSIA (commonly referred to as investment accounts and special investment accounts) is a pool of investment funds placed with an Islamic bank on the basis of Mudarabah and can be categorised on unrestricted PSIA or restricted PSIA. 4 A commodity is defined as a physical product, which can be traded on a secondary market, e.g., agricultural products, minerals (including oil) and precious metals. 5 Inventory risk is defined as arising from holding items in inventory either for resale under a murabahah contract or with a view to leasing under an ijarah contract. 6 Commodities can be group into clans, families, sub-groups and individual commodities, e.g., a clan might be Energy Commodities, within which hydrocarbons is a family, with Crude Oil being a sub-group and West Texas Intermediate, Arabian Light and Brent being individual commodities. 7 The term ‘haircut’ refers to a discount on the full value of an asset as collateral after taking into consideration some inherent risks that affect the volatility of the market price or value of the asset. It is commonly expressed in terms of a percentage by which an asset’s value as collateral is reduced. 8 Market risk is defined as the risk of losses in on- and off-balance-sheet positions arising from movements in market prices.

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References Fama, E. & French, K. (1992). Taxes, financing decisions, and firm value. The Journal of Finance, 53(3), 819–843. Froot, K. & Stein, J. (1998). Risk management, capital budgeting, and capital structure policy for financial institutions: An integrated approach. Journal of Financial Economics, 47(1), 55–82. Rappaport, A. (1986). Creating Shareholder Value. New York: Free Press. Roll, R. (1977). A critique of the asset pricing theory’s tests part i: On past and potential testability of the theory. Journal of Financial Economics, 4(2), 129–176. Zulkhibri, M. (2018). Macroprudential policy and tools for dual banking system: insights from Islamic finance literature. Borsa Istanbul Review, 19(1), 65–76. Zulkhibri, M. & Sukmana, R. (2017). Financing channels and monetary policy: Evidence from Islamic banks in Indonesia. Economic Notes, 46(1), 117–143.

Part III

Capital under Mudarabah, Musharakah and Other Related Contracts

4

4.1

Capital under Mudarabah Contract and Musharakah Contract

Concept of Property Rights and Trust

Islam acknowledges and protects the right to private property. In a similar vein, Islam places a premium on an individual’s right to private property. The Quran lacks precision in its pronouncements on individual property, except for providing a theoretical foundation for the concept of ownership and the ontological dimension of wealth possession, which is represented by the trusteeship framework. Islam places a premium on private property and promotes it through the doctrine of maqasid al-Shari’ah. Islamic law, within the context of maqasid al-Shari’ah, not only protects and preserves an individual’s wealth through specific Qur’anic and Sunnah decisions but also actively promotes property ownership. Muslims regard private property as a gift from God. Individuals are born with the ability to access riches as part of the trust bestowed upon them. In Islam, wealth ownership entails a number of moral demands and responsibilities. Similarly, another critical aspect of preserving private property is that Islam vests owners with complete sovereignty over their property, and no authority or administrative force has any valid ability to take or deny ownership. In a more reduced form, the Islamic framework of private property rights also necessitates a restricted state to safeguard the ideal’s integrity. One of the most fundamental frameworks of Islamic property rights is in civil and commercial dealings (mu’amalat), which are regarded as valid and binding on the parties and are subject to enforcement by the courts. This critical fundamental enables the execution of unique contracts. In Islam, the concept of contract transcends the modern conception of contract as a legal entity necessary for the fulfilment of legitimate human demands. In Islamic law, a contract is defined by the principles of justice (adl) and loyalty (amana), of reward and punishment, all of which are inextricably tied to the performance of contractual commitments. In Islam, contractual freedom is a necessary condition for the validity of a contract. Not only does this imply that individuals are capable of making free choices without undue influence but it also emphasises the sacredness of property ownership and the owner’s inalienable rights over his or her property. Contracts governed in this manner promote fairness, create equity and protect the vulnerable and naïve, while also advancing social interests. DOI: 10.4324/9781003437086-7

Capital under Mudarabah, Musharakah and Other Related Contracts

62

Trust is a special kind of partnership where one partner gives money to another for investing it in a commercial enterprise. The trust comes from the first partner who is called ‘rabb-ul-mal’, while the management and work are an exclusive responsibility of the other, who is called ‘mudarib’. This trust is usually known as mudarabah agreement. It means that mudarabah contract is a partnership between principal (rabb-ul-mal), who owns the capital, and agents (mudarib), who have expertise in deploying capital into real economic activities with an agreement to share the profits. In Islamic banks, on liability side of balance sheet, mudarabah contract can take several forms, shareholders (rabb-ul-mal) provide the capital and the managers (mudarib) manage that capital; depositor (rabb-ul-mal) provides the funds and the bank’s staff (mudarib) act as a discretionary fund manager in the investment of these funds. On assets’ side, Islamic banks take on the role of capital provider (rabb-ul-mal) and customer (mudarib) takes on the role of entrepreneur. 4.2

Elements of Mudarabah Contract

The nature of a valid contract is that there must be contracting parties who have legal capacity and express their agreement in terms of a sound ijab (proposal) and qabul (acceptance) on a particular subject matter recognised by Shari’ah. The contract (aqd) is concluded when its essential elements (arkan) and conditions (shurut) are found. An essential element (rukn) is that the existence of a thing depends regardless of whether it is part of its essence or lies outside it. The essential elements of ‘aqd are three: the formula (sighah) or wording by which the contract becomes complete, that is, proposal and acceptance; the contracting parties (‘aqidan), one that entails (majib), that is, proposes, and the other which accepts (qabil); and the object (mahall), that is, the thing which is the subject matter of the contract (ma’qud alayh). Box 4.1 Essence of Mudarabah in AL-MAJALLA  AL  AHKAM  AL  ADALIYYAH The essence of a mudarabah is an offer and acceptance. For example, if the owner of capital says to the person who provides the labour, ‘Take this capital and do the work and labour in return, on the terms that the profits are to be divided between us half and half or as two to one’, or if he says anything else which represents the meaning of a mudarabah like, ‘Take this money and make it capital and let the profit be in common between us in this proportion’, and the mudarib (working partner) accepts, a contract of mudarabah is concluded.

The elements of this partnership are the same as those of the contract, which is proposal and acceptance. The offer or proposal (ijab) is what proceeds first from rabb-ul-mal, and acceptance (qabul) is what proceeds next from the mudarib. The proposal can be done by uttering the terms of mudarabah, muqaradah or mu’amalah or any other term to indicate its meaning or intention. The express form takes place when the rabb-ul-mal says to the mudarib, ‘Take this money in

Capital under Mudarabah Contract and Musharakah Contract 63 mudarabah, and what God gives in profit will be divided between us . . .’ (and he must specify a certain rate, say a half, a quarter or a third). If the partner accepts the offer saying, ‘I accept’ or whatever conveys the same meaning as ‘I agree’, and takes the money, then the partnership contract is confirmed, and the profit is divided in accordance with the agreement. 4.2.1 Wordings  (Sighah)

The wordings (sighah) in a contract are the instruments or means by which the intention of the contracting parties about the conclusion of a contract is expressed. Therefore, it is not a necessity to fix specific words without the utterance of which contracts are not constituted. However, every contract is constituted by that which indicates its meaning and idea clearly, regardless of whether this indication is expressed or by allusion (indirect declaration of legal intent). The general principle is that contracts are constituted by uttering the words in the past tense. For example, the party making the proposal said, ‘I sold this house to you for ten thousand’, and the buyer said, ‘I accepted’. This is because the word in the past tense indicates the creation of the contract immediately. It is definite in declaring one’s desire, and these words have no possibility of meaning of neither bargaining nor promise to make a contract in the future. On the contrary, the contract is not constituted by the words in imperfect tense (mudari’) except if it comes with presumptive evidence, which indicates that the creation of contract is intended immediately, not a promise to create it in future. By having these words, it means future tense figuratively. Therefore, it is necessary that there is presumptive evidence, which removes this possibility. Similarly, contracts are not constituted by interrogative words. For example, if the party who is making the proposal said, ‘Do you buy this house for ten thousand?’ and the other party said, ‘I accepted’, the contract will not be constituted because these words do not indicate the existence of a definite intention. The party does not inform him of his desire to make a contract; he only wants an answer to his question. Box 4.2 Model of Mudarabah Financing Agreement THIS AGREEMENT FOR FINANCING ON THE BASIS OF MUDARABAH is made on the __________day of _________2017 Between [Name of the Client], _____________________________________, having its place of business at/resident of_______________________________ hereinafter referred to as the Client (which expression shall, where the context admits, mean and include its successors in interest and assigns) acting as mudarib of the ONE PART; And [Name of the financial institution], a banking company incorporated under the laws of Malaysia, having its Registered Office at ________________________, hereinafter referred to as the Institution, (which expression shall, where the context admits, mean and include its successors in interest and assigns) acting as rabb-ul-mal of the OTHER PART. Source: Bank Negara Malaysia

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Regarding the object of a contract, it should belong to the things in which transaction is allowed. Otherwise, the contract will be invalid, and the object must be fit for transaction in it. Islamic law gives several guidelines to make sure the object is legal. First, Islamic law prohibits making a transaction in which the object is not property according to Shari’ah. There are several cases, which the transaction is not admissible: (1) when the object of transaction is a free man because the free man is not property. Therefore, depositing it as security and transaction in any of its limbs is not allowed; (2) when the object of contract is impure such as blood. The scholar has attached to them the impure things that cannot be purified such as liquids mixed with impurities. Therefore, the scholar prohibited making transaction in them; and (3) when the object of contract is useless. For example, insects and beasts of prey are not used for eating, game and adornment. Therefore, transaction in all these objects is not allowed since it creates no benefit to human beings. Second, the object of a contract should be valuable. Any transaction in property which is not valuable is not allowed. It is about a thing, which is property according to some, and not property according to others, such as wine and swine. They are property according to non-Muslims living under the protection of Islamic state (zimmi), but they are not property according to Muslims. Therefore, a Muslim is not allowed to make transaction in them. If this object is bartered for some other things, the sale is voidable or vitiated (fasid) with respect to their counter value; even they can be owned and secured by taking their possession. The sale is invalid (batil) with respect to their substance; even they cannot be secured nor taking their possession, because they are not valuable. The object of a contract also should be ownable and exist. According to this condition, making transaction in the property which is not ownable regarding public or common property such as water, highways, markets and canals because they are common property. An individual is not allowed to monopolise their benefit to exclude others from using it, even if water comes out of a well, which is owned by him. Similarly, transaction is not allowed in the things that are ownable before owning them. For example, birds in the air and fish in the water are not allowed for transaction because they are not owned before seizing and acquiring them. Finally, the object of contract does not have a binding right attached to it. The right is divided into the right of Allah and the right of man. When Allah’s right is attached to the property, the transaction is not allowed. For example, transaction in mosques and sacred territory of Mecca is inadmissible. The transaction of an object is prohibited when the transaction violates Allah’s right. The protection of life is Allah’s right and hence every transaction which causes the loss of life is prohibited. Protection of honours and property is Allah’s right and therefore, every agreement violates this right will be considered invalid. Similarly, the transaction is prohibited when there is right of a man attached to the property. Scholars hold that transaction in an object pledged as security is not allowed after taking its possession because of attachment of the right of pledged to it, nor in the property donated for a religious endowment (waqf) because of attachment of the right of beneficiary of the waqf to it.

Capital under Mudarabah Contract and Musharakah Contract 65 Besides all these things, Islamic law hold that the object of the contract must exist (ascertain) at the time of making a contract and its existence must be actual and has the capability by which the contract becomes complete and not in the eyes of the parties. The existence of the object also must have the same quality, which it had at the time of conclusion of a contract. The scholars also agree that the ability to deliver an object of a contract at the time of its conclusion is a condition for its validity. The party to the contract, whether offers or accepts, either concludes it for himself or to someone’s credit. If it concludes it for itself, it must have the capacity of its conclusion, and if it concludes it to someone’s credit, then it must have a capacity to fulfilling the conditions of capacity as the authority or guardianship to conclude this contract. When a party to the contract ventures to conclude it without having an authority of its conclusion, he is known as unauthorised agent (fuduli). In general, both contracting parties must have ahliyyah (capacity) to conclude the contract. The contracting parties must have the capacity of obligation, which is defined as a person’s competency for acquiring right and liabilities. The ground of capacity of obligation is humanity. The capacity of obligation is divided into two: perfect and imperfect. The perfect capacity of obligation is one by which a man acquires all rights and liabilities, such as the capacity of a man after his birth. On the other hand, the imperfect capacity is established for a child in womb before his birth. The imperfection of capacity in respect of a child in womb is that by which he acquires only rights and not liabilities. The contracting parties also must have the capacity of execution. It is defined as man’s competence for issuing of words and deeds from him in a manner that the Shari’ah makes their effects accrue from them or man’s fitness. The capacity of execution consists of three things. First, the capacity of proceeding of words and deeds about the prohibition of which the divine communication has occurred in a manner that the Lawgiver makes their effects accrue from them, such as worldly punishment. This is the capacity of bearing punishment, or capacity of receiving the communication relating to offence. Second, the capacity of issuing of words and deeds about demand of which the divine communication has occurred in a manner that the Lawgiver takes cognizance of them; that is, he makes their effects accrue from them. These effects are meeting one’s obligation in this world and getting reward for it in the hereafter. This is the capacity of doing acts of worship, or the capacity of receiving divine communication relating to acts of worship and rituals. Third, the capacity of proceeding of permissible words and deeds recognised by the Shari’ah; that is, the Lawgiver makes their effects accrue from them. These effects are rights and liabilities which accrue from contracts, dispositions, fulfilment of liabilities, and discharge of duties and other deeds from which the Shari’ah make some effects accrue, because they do not proceed resulting in these effects except when a person who performed them had the capacity of their performance.

66  Capital under Mudarabah, Musharakah and Other Related Contracts 4.2.2  Distribution of Profits and Capital

A mudarabah contract is valid if rabb-ul-mal entrusts his money to the mudarib. Mudarib as an agent implies the huquq (performance of the contract) revert to mudarib as he is the person who is doing the transactions, and he is the person responsible for any outcomes from those transactions. For example, mudarib may use the capital to make buying and selling of goods. The profit that emerges from the above transaction will be shared between mudarib and rabb-ul-mal. This is based on the argument that mudarabah is a partnership in profit, and a mudarib is not entitled to profit based on his work after the emergence of profit, but he becomes a partner here due to the contract of partnership. Therefore, the generated wealth (i.e., assets and profit) may become a joint ownership between mudarib and rabb-ul-mal, and the share of the mudarib is now based on his undivided share in the co-ownership. Therefore, it is not valid to leave profit unsettled at the time of agreement. The ratio divided between mudarib and rabb-ul-mal must be expressed as ratios such as one-half, one-third or one-fourth. The partners can share the profit in equal proportions, or they also can allocate different proportions for both partners. The proportions of profit may be applied differently in different situations. The mudarib cannot claim any periodical salary or a fee or remuneration for the work done by him except from the agreed proportion of the profit. The entitlement of profit is based on wealth (mal) or work or by bearing a liability for losses (daman). These three references enable the establishment of sharikat al-mal (wealth), sharikat al-abdan (work) and sharikat al-wujooh (pure daman). Entitlement of profit based on wealth is obvious because profit is considered growth in wealth and belongs to its owner. It provides the justification for the rabb-ul-mal an entitlement to get profit. In summary, the owner of wealth is entitled to get profit based on wealth under three conditions: first, he must contribute his wealth; second, he must bear the liability for loss; and third, he must continue to retain ownership (milkiyah) in the wealth contributed (or in the things that it is exchanged for after transactions). In the case of daman (liability for bearing losses), if the mudarib were made to bear the liability for losses, he would be entitled to the entire profit. This implies that in such a case there would be nothing for the rabb-ul-mal. However, rabb-ulmal own the original wealth, and the wealth becomes the basis for the entitlement of profit. This raises the question of denying profit to the rabb-ul-mal, while wealth is a basis for profit. The answer to this problem is that wealth is a basis for entitlement to profit, with additional support coming from daman. This shows that daman is always associated with wealth. Entitlement of profit among partners may also be based on the wealth contribution to the partnership. If a partner contributes work along with wealth to a partnership, his work is considered subservient to wealth. This means that work is not valid, or at least independent, basis for entitlement to profit. Therefore, when work is not dependent on wealth, it is considered a valid basis for entitlement of profit. In mudarabah, the labour contributed by the mudarib is not accompanied by wealth.

Capital under Mudarabah Contract and Musharakah Contract 67 However, this raises the question of stipulating a higher ratio of profits for a partner who devotes more of his time and effort to the partnership, or a working partner as against a sleeping partner. This is explained further in Box 4.3.

Box 4.3 Proportion of Profits Two persons participate in a partnership with one of them contributing 100 dirhams and the other 50 dirhams, on the condition that the profit will be shared equally. The owner of the extra 50 dirhams contributes his labour towards 25 of these, because both are working for the additional 50. Thus, the owner of the additional 50 works for 25 of these and his partner too works for the extra 25 out of 50. Therefore, his partner is entitled to reasonable wages for this work. If they do not make a profit and make a loss, the loss is shared by them in proportion to their capitals, but the owner of the 50 dirhams is still entitled to reasonable wages for the work he has done.

A mudarabah partnership is only based on capital (mal). It does not allow either a partnership based on work (sharikat al-abdan) or daman (sharikat al-wujooh). As for mudarabah, which is based upon one side, the former may be considered as a type of ijarah and not as a partnership. In addition, the mudarib is entitled to collect its share of profit only after capital is recovered, because the principle says, ‘profit is protection to capital’. It is necessary for the validity of mudarabah that the parties agree, right at the beginning, on a definite proportion of the actual profit to which each one of them is entitled. In mudarabah contract, it is preferred to provide the capital in absolute currency in circulation. Specifically, the capital must be in the form of gold or silver coins or any accepted currency. It implies that merchandise or goods or ‘urud (tangible property) are not allowed. This facility will help mudarib to do transactions and easily divide the profit among the contracting parties according to their capital contributions. Goods and commodities are not regarded as eligible capital because they render the amount of profit uncertain, which may lead to dispute and litigation among the contracting parties. In addition, it also leads to inequitable advantage and undue improvement for one of the parties and converse disadvantage to the other. This happens because of the fluctuation of the price of goods between the date they are remitted to the agent-principal and the date of their conversation into a ready money. Therefore, any marked rise in the market value of goods serving as the basis for the mudarabah would cancel out any profit for the mudarib. Any drop in the market value would put the rabb-ul-mal at a disadvantage and provide the mudarib with unjustified and, in a sense, unearned profit. The capital must be delivered to the mudarib; that is necessary because failing to deliver it imposes constrictions on the mudarib and restricts its power disposal.

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Mudarib is responsible to do the entire work and leave the rabb-ul-mal as a capital provider. Therefore, according to majority of school, the mudarabah contract stipulated that the rabb-ul-mal must always retain the entire wealth or part of it. The condition is considered detrimental to the contract and hence, invalid. However, if the mudarib takes possession of the entire capital and then decides to leave part of it in the rabb-ul-mal’s hand, it is permitted if there is no condition attached to it and it does not disrupt the process of business. The capital also should be ready in cash and not in the form of debt or money usurped by someone. If the capital is offered as debt, it creates the invalidity of mudarabah contract. However, it can appoint a person to collect the debt and make it as capital. It is also lawful to start mudarabah contract with a capital lying as deposit with the mudarib or someone else. The rabb-ul-mal can appoint an agent to collect the money from the depositor and use it as capital of mudarabah or he may directly arrange with the depositor to change the status of his capital from that of a deposit to that of mudarabah investment. The capital of mudarabah should be known and defined to the parties at the time of the contract in terms of quality and quantity. If the amount of capital is uncertain or unknown, the mudarabah is not valid. 4.3 Types of Mudarabah and Termination of Mudarabah Mudarabah is divided into several types. It can be divided into two: restricted and unrestricted mudarabah. This classification is based on the type of restrictions placed on the work of the mudarib. The unrestricted mudarabah implies the capital is handed over without determination of the type of work that is to be done, nor the location, nor the time, nor the quality of work, or with whom he is to trade. This type of Mudarabah is also called unlimited mandate, perpetual mudarabah or mudarabah al-mutlaqah. The Majallah defines it in the following words: For unrestricted mudarabah, there is no restriction, in terms of time, place, kind of trade, or person from whom he is to buy and to whom he is to sell. Can the rabb-ul- mal gives an incentive to mudarib, if the performance is better than a restricted mudarabah. This definition implies that if a mudarabah is free from restrictions regarding time, place, trade policy and person with whom business is to be done, it is called absolute or unrestricted mudarabah. Mudarib in absolute mudarabah has own prudence and discretion in delivering the work given. His authority may extend from minor issues to major issues in investing the capital for earning profit. Therefore, mudarib has every right to use money in the manner he deems fit. The mudarib possesses the authority to buy and sell, because the mudarabah generates its profit through this authority. If the mudarib does not have this authority, it is impossible to trade and create the profit. However, the transaction to trade with his wife, children or his parents should not be encouraged to avoid the act of self-interest. The right to buy implies that if mudarib buys at very high rates as

Capital under Mudarabah Contract and Musharakah Contract 69 compared to those existing in the market, his purchase is deemed to be for his own account and not for the mudarabah. Does mudarib has the right to buy and sell for credit? The mudarib can buy and sell on credit up to the extent of the capital employed, but he cannot exceed the limit imposed by the capital for such a purchase. If the purchase exceeds that limit, the purchase is from his own account. Sale and purchases on credit may not be permitted except by specific permission (of rabb-ul-mal) and violation of this condition will make the contract of mudarabah void. However, the Maliki scholars permit sale on credit without express permission, but not purchase. The cash and credit sales by the mudarib implies that prices cannot be varied by giving trade discount, but the reason of such rejection is not clear. However, it is permissible to sell on credit for reasonable periods (i.e., usual commercial practice). The right to give goods as bida’ah means giving off one’s goods to another for trading when the person accepting them is not going to share the profit derived. Some types of bailments would be covered in this. This is based on commercial practice, because mudarib has the right to hire such services but it is considered better for him to choose to give them the same purpose free of charge. Conversely, Hanbalis and Malikis prefer the view that the mudarib does not have the right to give the goods of the mudarabah on bida’ah. The mudarib possesses the right to deposit the goods as well as bailment because it is a common commercial practice in the past. Since the mudarib has the right to assign claims and debts based on hawalah, he has the right to pledge property connected to the debts of the mudarabah. He may also accept such pledges or mortgages for the debts owed to the mudarabah. The reason is that these are methods for the transaction of claims. However, the mudarib or any other partner in a partnership is prohibited from using the partnership’s property as mortgage to obtain financing as this would constitute business loan. The mudarib can involve only in one of type of mortgage, that is, credit purchases made by him. The mudarib possesses the authority to appoint helpers as needed for the trade. This implies that if the mudarib has power or capability to manage the transaction he may delegate this power to another person by virtue of the contract of mudarabah. Mudarabah is higher-level contract as compared to agency, and in fact, agency is part of it. Therefore, mudarib has authority to employ a lower-level contract that is included within it (agency). The mudarib can hire services and may let them out on hire. He has the authority to hire workers who labour with the wealth, as this is the commercial practice. This is based on the idea that mudarib is human being who has limitations to perform all works by himself. Therefore, he can hire workers as we found in the contract of ijarah (ijarah al-ashkhas). Further, the mudarib has the authority to buy or rent animals, equipment and building for storing or vehicles for delivery to make his work easier (ijarah al-ashya). The mudarib is authorised to travel with the wealth of the mudarabah. This implies that mudarabah has been concluded independent of a location and mudarabah itself is derived from darb fi al-ard (travelling in the land). Therefore, any transportation cost must be included in it. This is the view of Hanafis and Shafi’es.

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The Hanafis specifically restrict this right of the mudarib only to a situation where he is on a business trip outside his own city. Regarding mingling this capital with mudarabah capital, to give it as mudarabah to a third party and to invest it in a partnership with a third party, Al Sarakhsi wrote that: If the investor says to the agent, ‘act with it as you see fit’, then he may practice all of these things except the loan. For the investor has consigned the control of his capital to the agent’s discretion in a comprehensive way; and we know that his intention is the inclusion of all that is the customary practice of merchants. The agents, thereby, has the right to engage in mudarabah, a partnership and to mingle the capital with his own capital because this is a practice of the merchants. The validity of an agent’s action will be determined by comparing his action with the customary practice of the merchants. If such action is in accordance with practice, then it is legitimate and binding upon the investor. However, the agent is not allowed to commit mudarabah partnership to any sum greater than the capital in hand without the investor’s specific authorisation. Similarly, he is not allowed to borrow money on behalf of mudarabah except he is specifically allowed to do so. In general, if mudarib want to do an extraordinary work, which is beyond the normal commerce practice, they cannot do so without expressing permission from the rabb-ul-mal. If he wants to sell or purchase on credit beyond the limits imposed by the capital, the mudarib needs special permission. As noted, if the mudarib makes such a purchase on credit, which is not allowed, and the excess will be considered a personal debt. This is because he does not have the right of wilayat al-istidanah. Istidanah (rising credit through credit purchase) comes from one side that is, permitted by the rabb-ul-mal alone. Since the mudarib does not possess this right, he also does not have the right to repair, improve or manage the existing assets of the mudarabah through this method. The mudarib does not have the authority to make gift and donation, except he is given specific permission by the rabb-ul-mal to do so. This is because the capital is belonging to rabb-ul-mal not to the mudarib. Therefore, if mudarib decide to make gift or donation, he must have granted special permission from the rabb-ul-mal. Similarly, the mudarib cannot give a loan to another or assign claims to another where they are not offset by other claims, because each is a kind of charitable donation. Some powers may not require to express permission, but may be included in a general provision. Al-Kasani (2000) says: The categories of acts that the mudarib may undertake if he is authorized to act according to his considered opinion, even when these have not been stipulated are: mudarabah, sharikah and khalt. Thus, he has the right to employ

Capital under Mudarabah Contract and Musharakah Contract 71 the assets of the mudarabah for another mudarabah with someone else or to enter into a partnership with someone else by way sharikat al ‘inan. He also has the right to mingle the wealth of the mudarabah with his own wealth when the rabb-ul-mal tells him to act on his considered opinion. He does not have the right to do any of the above things if he has not made this statement. On the other hand, restricted mudarabah (also known as mudarabah almuqayyadah) implies that all these things are determined by rabb-ul-mal. That means the liberty of action of agent (mudarib) is restricted in terms of kind of trade, time and place. In addition, Al Kasani added that the hukm of the restricted mudarabah is the same as that of the absolute mudarabah except the restriction placed on it. The basic rule in this is that if the restriction is beneficial, it is implemented, because the principle for conditions is that they are applied as far as is possible. Thus, when the condition is beneficial, it can be considered, and this is done because of the words of the Prophet (pbuh): Muslims abide by their stipulations. The investor has the right to impose any restriction on things like type of trade, time and place. However, there is disagreement on these. For example, the restriction to purchase from a person is permissible to Hanafis and Hanbalis, but not permissible to Shafi’es and Malikis. Hanafis and Hanbalis allow the restriction to purchase goods from a place, but this is not valid according to Malikis and Shafi’es. The condition to trade merchandise such as books, gold and silver is valid to all the scholars. However, the Maliki and Shafi’e scholars suggest additional conditions that such merchandise should be habitually available in the market. The Shafi’es and Malikis refuse to recognise the validity of restricting mudarabah with a predetermined duration, but Hanbalis and Hanafis consider it valid. When a mudarabah is of predetermined duration, this does not mean that the investor and the agent-principal are precluded from making use of their basic right of withdrawing from mudarabah at will. It only means that the agent-principal is not entitled, after the elapse of the pre-agreed duration, to continue performing the act of commerce on behalf of mudarabah if we accept the liquidation. If the mudarib violates the restriction or contravenes the beneficial condition, it becomes a usurper and guarantees capital to the rabb-ul-mal. This also will be the case if the mudarib neglect when he conducts his duties. An important issue is if when the mudarib violates the conditions stipulated for his work by the rabb-ul-mal, the mudarabah is annulled and the mudarib becomes liable for compensating (loss) whatever he was delivered by way of capital. This implies that if the mudarabah business is restricted by a place, type of goods, time or by the dealing with a certain party, mudarib has no right to trespass it, since there is no trespassing in the partnership. In this case, if there was some profit, it belongs to the mudarib. Therefore, if mudarib trespasses, then he compensates for it and the profit goes to him. In practice, however, this provision will provide a loophole for dishonest person to violate a condition when substantial profit has been emerged. Mudarabah, like any other partnership, is a terminable contract. The contract of mudarabah may be terminated if one of the following situations arises:

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4.3.1 Unilateral  Termination

Unilateral termination happens when the rabb-ul-mal withdraws his capital or when the mudarib is not allowed to perform his act as an agent. Since the contract of mudarabah is an optional not a binding contract, any partner can terminate unilaterally provided the other partner is made known of this decision and the capital is in the cash form. However, if the mudarib has commenced work, some of the scholars hold the view that mudarabah is binding and cannot be dissolved. If the capital is in the form of goods, the termination of the contract and the disengagement of the agent by the investor is not allowed. In such a case, the agent has the right to sell the goods to reconvert them to cash. In general, there are two conditions for the dissolution of mudarabah that will take effect: first, the notice of dissolution is given to the other party. Second, the assets of the partnership are converted to fungibles or cash assets. The first condition implies that the mudarib cannot be deposed from their job by deposing the capital of rabb-ul-mal if he is not aware of it. The second condition is required in cases such as the enemy partnership, insanity, and death that is the assets are converted to cash to give effect to the dissolution. If the contracting parties get separated while there are some credits, the mudarib must collect them, if there is a profit. All other agents, salespersons and mediators are too to be forced to collect the credits. 4.3.2 Types   of Termination

By Expiry of Fixed Time: If the mudarabah is for a fixed time, it will be terminated on the expiry of that period; that is, when the owner of the capital has fixed the duration of mudarabah, the mudarabah is dissolved when the prescribed time elapses. The Hanafi and Hanbali schools view that the mudarabah can be restricted to a term, for example, a year, after which it will come to an end without a notice. On contrary, Shafi’e and Maliki schools give a strict opinion that the mudarabah cannot be restricted to a time. What about setting the minimum time limit fixed by the parties before which the mudarabah contract cannot be terminated? There is no opinion to be found from the books of the Islamic Fiqh, but general principles stated no such limit can be fixed and each party is free to terminate the contract as he wishes. It also involves a very complex procedure and stage. Therefore, no party shall terminate the contract during a specified period, except in specified circumstances as it does not seem to violate any principle of Shari’ah in the light of the famous hadith of the Prophet (pbuh): All the conditions agreed upon by the Muslims are upheld, except a condition, which allows what is prohibited, or prohibits what is lawful By Death of Any of the Partners: If any of the partners in a mudarabah dies, either rabb-ul-mal or mudarib, the contract of mudarabah comes to end as follows:

Capital under Mudarabah Contract and Musharakah Contract 73 ‘If the owner of the capital, or the mudarib (working partner) dies, the mudarabah is dissolved’. Majority scholars agreed on this issue because the contract of mudarabah is like the contract of wakalah. When the wakeel dies, he is still in the contract. In addition, majority of scholars agreed that the contract of mudarabah cannot be continued by their legacy. However, this opinion is rejected by Malikis where, if one of any parties dies, the contract is valid and can be continued by his legacy. By Insanity of Any of the Partners: In the case that any of the partners becomes insane, the mudarabah contract will come to an end as follows: ‘If the owner of the capital, or the mudarib, dies, or becomes continuously mad the mudarabah is dissolved’. Insanity completely negates the ahliyyah al-ada (capacity of execution) due to lack of reason and intellect. Therefore, an insane person has no liability for worship, or punishment and all his transactions are void. By Disregard of Express Direction: The working partner is under the obligation to abide by the direction of rabb-ul-mal in a restricted mudarabah. Thus, if he does not comply with these instructions, the mudarabah will be dissolved by virtue of the breach of trust on which mudarabah stands as follows: ‘If the mudarib goes beyond what he is permitted, or acts contrary to the condition, he becomes a wrongdoer (ghasib)’. In the case that he has done so, the profit and loss from the trading goes to him, and if a property of the partnership is lost, he is responsible. By Destruction of Capital: The mudarabah is also dissolved by the destruction of capital before the initial purchase has taken place. The agent will not be held liable for this destruction if he exercises maximum care. However, if it is destroyed due to his negligence or by some action on his part, he is responsible. The mudarabah in all such cases will stand dissolved. Thus, the mudarabah comes to end when after its possession and before the commencement of the transaction the capital becomes extinct. The Order of the Court: The court may order mudarabah parties to dissolve the contract if one of the parties joins the dar al-harb (non-Muslim state). However, some opinions stated that the mudarabah will not end if the mudarib partner joins the non-Muslim state. That means this condition is valid for rabb-ul-mal. In this case, it would be categorised as an enemy partnership. If rabb-ul-mal chooses to withdraw from Islam (murtad), according to Hanafis, the contract of mudarabah comes to an end. 4.4 The Concept of Musharakah Musharakah is a term commonly referred to in the context of Islamic modes of financing. The connotation of this term is little limited than the term shirkah (corporation) or sharikah, which is more commonly used in Islamic jurisprudence. For clarity in the basic concepts, it will be pertinent at the outset to explain the meaning of each term, as distinguished from the other. Shirkah is similar to sharikah, which means sharing. Literally, the word shirkah is used in two meanings. First, mixing (ikhtilat) means the mixing of the shares, that is, the capital contributed. Ikhtilat

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is described as the attribute of the property that is found in a mixed or mingled state, which is mixing of the shares so that one of them cannot be distinguished from another. This concept must be distinguished from the concept of participation. Second, it is defined as the contract of partnership. It emphasises on the relationship that exists between two or more partners.

Box 4.4 Definition of Partnership in Common Law A partnership is a form of business where there are two or more owners. Legally, a partnership is formed using a partnership agreement, which spells out the responsibility of each partner in the business. Part of the partnership agreement is the financial responsibility of each partner. Sources of financing for a partnership can range from personal money contributed by each partner to obtaining a business loan for the partnership.

In the terminology of Islamic jurisprudence, it has been divided into three kinds: sharikat-ul-ibahah (common sharing of thing), sharikat-ul-milk (coownership) and sharikat-ul-‘aqd (partnership through contract). Sharikat-ulibahah is defined as the common right of the people in ownership by acquisition or gathering of things that are mubah (permissible for such acquisition) and are not originally owned by anyone. This type of partnership means the participation of the people in the common right to own things that are not owned by anyone. However, such partnership would be difficult to form because all things that are not owned by citizens are owned by the government except for things that are free like air and rainwater. Sharikat-ul-milk means joint ownership of two or more persons in a property such as ‘ayn (ascertained property) or dayn (debt not ascertained by weight or measure or other means) that arises through inheritance or through exchange (bay’) or through other means. For example, if two or more persons purchase equipment, it will be owned jointly by both, and the relationship between them with regard to that property is called sharikat-ul-milk. More specifically, this is known as coownership in an ‘ayn, which means the joint and exclusive ownership of two or more persons resulting from one of the causes of ownership, like purchase, gift, acceptance of a bequest, inheritance or by the mixing (khalt) of their property in a manner that does not accept distinction or separation. This is known as co-ownership of a dayn, which occurs when two persons are owed for instance a debt attached to the dhimmah (liability) of another person, a debt that has arisen from a single cause. This is a common debt and is held in co-ownership between them. If the cause is not common, the debt is not in co-ownership. Notice that the term dayn means a debt created through a credit

Capital under Mudarabah Contract and Musharakah Contract 75 transaction, like selling of goods on credit. In any case, if a debt can be sold, then, this would be useful for financing the accounts receivables of a partnership. Whether this would be hit by the principle of prohibition of a dayn bi al-dayn needs to be investigated. Sharikat-ul-‘aqd means a partnership affected by a mutual contract. For brevity, it may also be translated as joint commercial enterprise. Sharikat-ul-‘aqd is further divided into three major types. First, it is known as sharikat-ul-amwal, where all the partners invest some capitals into a commercial enterprise. Second, sharikatul-a’mal, where all the partners jointly undertake to render some services for their customers, and the fee charged from them is distributed among them according to an agreed ratio. Third, known as sharikat-ul-wujooh, where the partners have no investment at all. All they do is purchase the commodities for a deferred price and sell them at the spot. The profit earned is distributed between them at an agreed ratio. Hanafi School defines sharikat-ul-‘aqd as an agreement between two or more persons for common participation in capital and profit. Thus, this definition more precisely refers to sharikat-ul-amwal. However, according to Hanafi School sharikat-ul-a’mal and sharikat-ul-wujooh as well as mudarabah cannot be included in this definition because there is no participation either capital (at the first place) as required. Maliki School defines sharikat-ul-‘aqd as the permission from each of the participants to the others for transactions in his wealth and on their own behalf, while retaining the right to transact personally (in such wealth). This definition is applicable to partnerships with capital (referring to his wealth) and excludes partnership through labour as in mudarabah with the argument that the former does not involve capital and in the latter, the wealth belongs to the rabb-ul-mal and not to the mudarib. However, sharikat-ul-wujooh is still void according to the Malikis. The definition, however, does not include mudarabah for the same reason as the previous one and needs permission from each partner, whereas permission in mudarabah is from one side alone. The Shafi’e School defines Sharikah in its literal meaning: it is mixing and technically it is an established undivided right in a single thing, or it is a contract implying this. This definition does not indicate participation by the partners in the transaction nor does it indicate the purpose of the partnership, which is the acquisition of the profits and participation in them. In addition, this definition is restricted to co-ownership and partnership in wealth, because the other forms of partnership are not valid according to the Shafi’e. Mudarabah is not included in this definition either. The Shafi’e law of partnership is very narrow and highly restricted. All that the Shafi’e law permits by way of business organisation is included in this definition are sharikat-ul-milk and restricted form of ‘inan based on mal. The Hanbali School has defined partnership as ‘participation of two or more persons in transactions’. Here, the scholar has tried to cover mudarabah along with the other types of partnership. The contract of partnership (sharikat-ul-‘aqd), according to the majority of schools, is divided into five types: sharikat-ul-‘inan, sharikat-ul-mufawadah, sharikat-ul-abdan (a’mal), sharikat-ul-wujooh and mudarabah. Recently, the

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contract of partnership is divided into two major categories and then further classified into nine types: 1. The First Category: a) b) c) d) e) f)

Sharikat-ul-amwal by way of mufawadah Sharikat-ul-amwal by way of ‘inan Sharikat-ul-a’mal by way of mufawadah Sharikat-ul-a’mal by way of ‘inan Sharikat-ul-wujooh by way of mufawadah Sharikat-ul-wujooh by way of ‘inan

2. The Second Category: a) Mudarabah b) Muzara’ah c) Musaqah On the foregoing grounds, the contract of partnership is divided into two broad types (according to the Hanafis as a main source of study since it provides a structure for legal analysis that is not available to the classification adopted by the majority school) insofar as there is work from both sides or from one side alone. The former (work from both sides) is divided based on the nature of the governing contracts into types: ‘inan or mufawadah. We divide the ‘inan contract into two sorts based on whether it includes a contract of agency alone or a contract of agency plus surety. Further divisions of ‘Inan are possible on the basis of whether the agency is general or special and whether the partnership is for all types of trades or for a specialised trade, but too much detail will naturally come up within the broad categories. The latter (one side alone) is categorised as mudarabah, muzara’ah and musaqah. 1. The First Category of Partnership (a) ‘Inan Ordinary i. With wealth as its subject-matter ii. With work as its subject-matter iii. With creditworthiness as its subject-matter (b) ‘Inan with the contract of kafalah i. With wealth as its subject-matter ii. With work as its subject-matter iii. With creditworthiness as its subject-matter (c) Mufawadah i. With wealth as its subject-matter ii. With work as its subject-matter iii. With creditworthiness as its subject-matter

Capital under Mudarabah Contract and Musharakah Contract 77 2. The Second Category of Partnership (a) Mudarabah (b) Muzara’ah (c) Musaqah In the Shafi’e view, mudarabah is an analogy of musaqah on the common ground of work as a basis with some capital from rab-ul-mal (owner of capital) in each one of them, along with some jahalah (uncertainty) and compensation (‘iwad). Musaqah in the Shafi’e view is a type of ijarah (hire). Hanbali consider mudarabah to be a contract, and associate muzara’ah and musaqah with the condition that there is rabb-ul-mal and the worker participates in growth. There are four basic contracts that can operate on a partnership: the contract of Amanah (trust), the contract of wakalah (agency), the contract of kafalah (surety) and the contract of ijarah (hire).1 The contracts that underlie the first category of partnership (in the form of ‘inan) are the contract of wakalah and Amanah. The second category of partnership (in the form of mufawadah) can take any form of contract of wakalah, kafalah and Amanah. As for musaqah and muzara’ah, include the contracts of amanah and ijarah. 4.4.1 Different  Schools   of Islamic  Jurisprudences Hanafi School

There are many thoughts on ‘inan and mufawadah under the general condition of ‘inan, where some of them consider both concepts as same, while others consider it as a different concept.2 ‘Inan is different from mufawadah, because ‘inan does not involve personal wealth, while mufawadah involves the entire personal assets. These two terms have different implications for the concept of partnership; thus, it is considered as a different thing. There is no comprehensive definition of the ‘inan partnership in the Hanafi manuals. The only definition for ’inan is for of its types called sharikat-ul-amwal, that is, the ‘inan based on wealth (where all the partners invest some capital into a commercial enterprise). The absence of its definition is due to the method adopted by the jurists for the study of contracts, that is, examining them as individual contracts without building up a theory. The reason, however, appears to be that the rules are meant for traders. Thus, according to jurists, a partnership could be concluded with wealth with work, and with creditworthiness, and then each of these could take the form of the ‘inan or mufawadah for detailed conditions and rules. Sharikat-ul-a’mal is participation in work (e.g., contractor or developer), where there is participation in the form of work from all partners. Sharikat-ul-wujooh is participation without having wealth, but they have creditworthiness among people. However, Hanafis only focus on the contract of ‘inan as a main type of partnership. ‘Inan is a contract, based either on wakalah or on wakalah as well as kafalah, which permits participation from both sides with wealth, work or creditworthiness and the sharing of profits in an agreedupon ratio. The solitary rukn (element) of the ‘inan, according to Hanafi school, is

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sighah (form), that is, offer and acceptance. A defect in the rukn makes the contract batil (void), while one in the conditions makes it fasid (vitiated). If the offer and acceptance just use the term ijarah (trade) and do not specify what type of trade it will be, the ‘inan concluded will be general for all trades, and the contract of agency underlying it will also be general. A concept of conversion of mufawadah happens when the ‘inan partnership is formed by default. These happen when some of the conditions of mufawadah are found lacking. The type of ‘inan that is formed by this conversion is the general ‘inan. The conversion of the mufawadah to ‘inan is conceived in two general situations: first, the lack of equality in wealth of the partners and this applies when the mufawadah is based on wealth, and second, the lack of a condition of equality in the capacity of the parties or the total lack of contractual capacity. This situation applies to all cases of mufawadah, that is, whatever their subject matter. The first general situation has three subcases: first, when the term mufawadah is used in the sighah (offer and acceptance), but an actual equality in wealth of the partners is not found. Here, the partnership formed is ‘inan; second, when the wealth of one of the partners, after the formation of the partnership, grows and becomes more than the wealth of the other partner, before they have started trading with their joint capital. mufawadah in this case is declared vitiated and is converted into ‘inan. When this growth occurs after transactions begin, the mufawadah will continue, because the goal is achieved when they begin transactions with joint capital; third, when one of them inherits wealth in which sharikat is possible, and he takes possession of it, the mufawadah is void and reverts to ‘inan. This rule applies even in the case of hibah, sadaqah and wasiyah to one partner or even in the case of possession of debt by him. There are few things about ‘inan that should be noted. First, when a partner becomes the agent of another, he possesses all the rights of the agent. Further, he also possesses the right to buy and sell for the partnership on credit by virtue of the simple ‘inan contract. Second, a partner in the sharikat-ul-‘inan is not a surety (kafil) for his partner. Therefore, he does not possess the right of istidanah because it arises through express permission or through the contract of kafalah. Third, the wealth in the possession of a partner is a kind of deposit. What is destroyed (or lost) is a loss that is borne by both and falls within their liability. Lastly, the ‘inan contract does not imply or require equality with respect to capital, sharing of profit or other things. The idea of stipulating additional condition, the contract of sharikat based on or like kafalah in ‘inan, implies that the contract of kafalah should not be assumed in an ‘inan contract when it is converted from a mufawadah, because it will make it seem so obscure. For kafalah to be valid in the ‘inan contract, it must be inserted with an express stipulation. The sharikat-ul-‘inan would be valid if the contract of kafalah is stipulated in it, because dealing in unknown products is not the objective of the partnership even if it is so in the nature of the contract. In the Hanafi system, the contract of kafalah is split up into the hukm of the contract and its huquq. This means that the partner who is dealing with a customer is the only person whom the customer can approach for delivery of the goods, for

Capital under Mudarabah Contract and Musharakah Contract 79 payments and the completion of the work. The reason is that he is the agent of the other partners and the only agent who can be approached and not the principal. When the relationship is also established between the partners, the customer can get the right to approach the other partners too. Therefore, liability becomes joint and several. The exception to this rule of huquq is given for the case of an ‘inan partnership formed based on labour. The third part of the first category of partnership, that is, mufawadah, is defined as a contract of participation between two or more persons, with the stipulation of complete equality with respect to capital, profit and status, for working with their own wealth, or with their labour in another’s wealth, or based on their credit worthiness, so that each partner is surety for the other. However, since ‘inan is more important to this discussion, the focus on mufawadah only has little attention. There are few things about mufawadah that should be noted here. First, equality in wealth (capital), profit and work. This equality is also required in contractual capacity and religion. Second, each partner operates according to his opinion. This implies that the mufawadah is general for all types of trade. Third, the contracts that exist between the partners are wakalah as well as the contract of kafalah. There are two ways in which a mufawadah may be terminated. First, it is terminated in all those ways that are mentioned for ‘inan. When one of these methods or events comes into operation, the mufawadah is dissolved, and no new partnership is born out of this termination. Second, the mufawadah partnership may be vitiated and converted into an ‘inan partnership. Maliki School

There are three types of partnership according to Maliki School, which are sharikatul-‘inan, sharikat-ul-mufawadah and sharikat-ul-a’mal. The Maliki school distinguishes between sharikat-ul-wujooh and sharikat-ul-dhimam, considering both to be void in their view. It is important to note that sharikat-ul-a’mal is not a type of ‘inan or mufawadah, but an independent type. One of the Malikis quote that ‘sharikatul-‘inan . . . it means sharikat-ul-‘inan is valid and is derived from the reins of an animal, that is, each one of the partners has stipulated for the other that he should act on his own in any matter pertaining to the sharikat, except with the permission of his partner and with his knowledge’. It is as if he has taken hold of his rein, that is, by his forelock, so that he does not do anything without his permission. This is not a special agency (wakalah khassah) in which a partner is given prior permission to do certain things without consulting his partner every time. The meaning appearing here is that of co-ownership (sharikat-ul-milk), where a co-owner may undertake an act with the permission of the other co-owner and with his knowledge. Hanafis acknowledge that ‘inan implies the minimum authority given to a partner is to undertake sale and purchase and to perform related acts according to his own considered opinion. The partner in ‘inan, according to them, can even sell and purchase on credit. The meaning of ‘inan so far, according to Malikis, is not better than co-ownership. ‘Inan partnership according to the Hanafi School is based on the contract of wakalah as well as kafalah. According to the Malikis, the contract of wakalah is

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included when the ‘inan is included. The Hanafi form of wakalah within an ‘inan provides a broad range of powers to the partner (he can act independently for the partnership). The Maliki form of wakalah, on which the ‘inan is based, places severe restrictions on the partner making him virtually ineffective, he can only act jointly with his partner as in a co-ownership. There are two major disadvantages in this concept of ‘inan, which restrict it to a mere form of co-ownership and do not permit it to become a regular form of partnership. First, this partnership is for acquiring joint ownership alone and the purpose is not the sharing of profits, whereas the goal of any business partnership is the sharing of profits. Second, this partnership is a one-time arrangement. It is restricted to a single transaction. A business partnership requires continuity, if not perpetuity like a corporation. Malikis allows that the principle of proportionality between the capital contributed and share of profits is visible in all categories of partnership except for mudarabah. It also can be concluded that there is no difference between the concept of sharikat-ul-‘inan as conceived by the Malikis and the concept of sharikatul-milk as explained by Hanafis. There are two reasons for this argument. Firstly, a co-owner (partner) in ‘inan, according to the Malikis, is not permitted to undertake transactions in the share of his partner without his permission. Second, the profit in this type of partnership always corresponds with the share of the partner. This is true also in a co-ownership, when profits are generated. The meaning of mufawadah, according to Malikis, has two meanings. First, the term mufawadah is derived from tafwid (delegation) and it is sometimes a delegation for all types of trade and sometimes in one type of trade. In other words, mufawadah is general with respect to trade or is special being confined to a single type of trade. Second, the meaning of tafwid is realised in this form when it is compared to the Maliki ‘inan, because the partner is not in need of seeking authorisation from his companion each time he wishes to enter into a transaction for the partnership. The permission granted at the time of the contract is sufficient. Here is one issue that must be solved. Does the concept of mufawadah require or include kafalah as it does in the Hanafi form of the contract? To answer this question, the partner must have the permission from his partner to buy on credit. In this case, the partner has been authorised by his partners, thus he possesses the authority of istidanah. Istidanah, according to Hanafi School, arises from a special permission in the ordinary ‘inan with wakalah, and in mufawadah, it arises from the underlying contract of kafalah and is, thus, implicit in the partnership contract; no special permission is required. Then, this will raise the question: what is the nature of the istidanah according to the Maliki School, in this contract of mufawadah? To answer this question, we must note that the relationship between the partners with respect to the excess credit purchases (after the authority for istidanah is granted), according to Hanafi, is based on sharikat-ul-wujooh. The problem is sharikat-ul-wujooh is not allowed according to Malikis because of the element of jahalah in the object of the partnership (the purchased commodity). Therefore, the permission of istidanah is based on the idea that the jurist is not about the authority of istidanah but about the credit purchases in general, and the same stipulation should apply to istidanah as well. The conclusion is that credit purchases are not

Capital under Mudarabah Contract and Musharakah Contract 81 allowed by Malikis, except in a situation where the goods have been ascertained. A credit purchase for Maliki partnership requires the following: 1 The goods must have been ascertained whether they are present at the time of the contract. 2 All the partners must be present at the time of the contract, even when one of them has been authorised to buy on credit. 3 When a credit purchase is made by all these partners, they will be considered sureties (kafil) for each other. Furthermore, the contract of kafalah, according to Maliki, does not require distinction between the huquq and the hukm. Thus, if an agent buys for the partnership, both agent and principal can be sued. However, if the agent does not have authority for making credit purchases, a special permission is required. The permission is not istidanah, but a widening of wakalah. istidanah will be required when the credit purchase exceeds the capital employed. In each case of such permission, both agent and principal, that is, all partners, can be sued by the creditors, by virtue of the Maliki wakalah. In other words, the partners do not have to be present at the time of the sale for this to happen. Therefore, the Malikis make an unnecessary stipulation of making all partners are not present. In any case, one thing is so clear: that is, the contract of kafalah is not part of the Maliki mufawadah as it is in the Hanafi mufawadah. When it is inserted for an ordinary credit purchase, the purchase is more likely a special transaction that does not require a partnership relationship to exist and can be undertaken jointly by any group of people who are not partners. Sharikat-ul-mal is also known as sharikat-ul-abdan. It is the participation of two (or more) artisans in joint work and the division of wages in the ratio of work done by each. It is of two types according to the Malikis. We can conclude that the Maliki sharikat-ul-mal is almost similar to the Hanafi ‘inan when its subject matter is labour. These can be explained as follows. When the trade does not depend on the use of tools. This type of partnership is one in which the trade does not depend on the use of tools and implements, or the implement is so insignificant that it is ignored. For instance, in tailoring a needle will not be considered an implement. In such a partnership, the following stipulations are made. Similar or interdependent work. It can be defined as a work that is almost similar or is divided up in a manner that the task is independent. Specifically, it is a form of specialisation of work. In such work, cooperation of some sort is necessary; otherwise, the partnership will be unnecessary. Division of profits is according to work. It is stipulated that they are required to work equally so that they can share the receipts equally as well. No one receives more than what they have completed. This will ensure that every partner is satisfied and proportionally gets their return based on their effort. When the trade involves the use of implements. This is when the trade involves the use of implements. The equality of implements (contributed) either can be made by ownership or through renting (equally). The reason why ownership of

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implements is stipulated is that a joint liability is created in accordance with the principle of liability. Stipulations for labour and liability in both forms. If one of the parties accepts something or some work, his partner is equally liable for performing work on it. However, there is no requirement for joint acceptance of work. If the thing accepted is destroyed, the liability is shared by the parties prior to separation (termination of partnership). Shafi’e School

Shafi’e allows the concept of ‘inan as a form of partnership because it has freedom from all kinds of gharar (uncertainty). ‘Inan, according to Shafi’e, has five elements. There are two parties, the subject matter of the contract, work, and the form (sighah). Shafi’e permits only one form of ‘inan, in which all partners have been accorded transaction authorisation. There is no such thing only a single partner has been authorised. Any ideas that say partnership is valid if one person permits a transaction to another, even if the other person has not granted such permission, can only exist as arrangement within co-ownership. Further, this idea, according to Malikis and Hanafis, is categorised as mudarabah rather than ‘inan. The contract of sharikat, according to the Shafi’e, is based on wakalah and not on kafalah. This is because the objective of sharikat is achieved by the desire to make transaction and profit. In fact, it is not an independent contract, but agency and delegation of powers. If both parties conduct the transactions, the capacity of accepting and granting agency is stipulated for them with respect to wealth, as each one of them is agent for the others as well as his principal. Further, the partnership in which permission has been granted from both sides is converted into the other form if the permission granted for transactions is withdrawn by the other partner. There are two stages in the formation of partnership. First, actual physical mingling of the capitals takes place so that distinction, or separation, of one from the other is not possible. This generates a co-ownership (sharikat-ul-milk). However, Shafi’e never mentions actual physical mingling of the capitals except regarding allowing for mufawadah by mingling of capitals (and sharing the profit). Second, the contract of partnership is created through permission from both sides or at least from one of them, as stated before. Since the Shafi’e ‘inan is based on wealth, it is nothing more than co-ownership with agency for one or for both partners being turned on or off at will and according to need. This is due to the Shafi’e view that ‘inan can be formed through a co-ownership and occasional agency. Contrary to Shafi’e, the Hanafis consider mixing of capitals is not a condition for validity of this partnership. The reason is that Shafi’e consider sharikat-ul-milk (co-ownership) is the sole basis and the contract of partnership is a term depicting ikhtilat (mingling by the partners) and it is realised through milk (joint). From the discussion, the ‘inan partnership based on wealth is quite similar to co-ownership (sharikat-ul-milk) found with the Hanafis. It is not an independent contract and is merely wakalah.

Capital under Mudarabah Contract and Musharakah Contract 83 The distribution of profits and loss, according to Shafi’e, must follow the ratio of ownership with reference to value, not based on parts or based on work. It does not matter, as far as the sharing of profits is concerned, whether the partners contribute equal amounts of work. Any violation of this condition could make this partnership invalid. There are few things that must be followed by partners that has been authorised to undertake the transaction. First, he cannot sell at market rate (i.e., without specifying exact rate). Second, he cannot sell on credit, because of gharar. Third, he cannot sell for other than the local prevailing currency. If this prerequisite is satisfied, the transaction will take effect only against one’s own share. The issue of whether the partner permits to trade in all commodities or only on specific trade seems unrevealed by Shafi’e. However, the contract of wakalah in their view accepts the general form for trade in general but needs special authorisation each time a transaction is made. In other words, unqualified contract of partnership does not grant this right to the partner, meaning it must be stated explicitly in the contract. The Shafi’e considers the other forms of partnership such as mufawadah, sharikat-ul-abdan and sharikat-ul-wujooh to be batil (void). Thus, the only form of partnership approved by Shafi’e is the sharikat-ul-‘inan, incorporating the contract of wakalah and having its subject matter as wealth. Sharikat-ul-mufawadah, according to Shafi’e, is not valid because they believe that each condition that is not in the Qur’an is batil. Moreover, sharikat-ul-abdan is invalid since the stipulation that does not come from Qur’an is batil. Further, because the labour of each person is exclusively his own. Therefore, it is not permitted for others to participate in this type of partnership. Hence, a partnership according Shafi’e is not possible without khalt and hence khalt is considered as the basis for sharikat-ul-milk. As khalt or mingling of physical labour is not possible, this partnership is void. Sharikat-ulwujooh is participation in the profit of what each partner purchases based on creditworthiness. It is void because what each partner purchases goes into his ownership and belongs exclusively to him. Therefore, it is not permitted for him to share with others. Hanbali School

Shirkah, according to Hanbali, is divided into sharikat-fi-ul-mal and sharikat-fiul’aqd. Sharikat-fi-ul-mal is defined as participation in a right to entitlement, by which they mean sharikat-ul-milk or co-ownership. Sharikat-fi-ul’aqd is defined as participation in the right of disposal, which is of five types: sharikat-ul-‘inan, sharikat-ul-mufawadah, sharikat-ul-abdan, sharikat-ul-wujooh and sharikat-ulmudarabah. Each of these is an independent partnership. The meaning of partnership (‘inan) is that two persons should participate with their wealth and work on the condition that the generated profits will be shared by them. The partner is not required to participate with equal capital. The capital, according to Hanbalis, must be ascertained and be present. This partnership is not considered complete and effective unless transactions are made in the contributed

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currencies. For the other things, the Hanafis use different hilahs to contribute the capital. The objective is to create joint liability, to form an operation that is based on the rules of sharikat-ul-milk and to enable the partners to share the profit. The principle behind this is that if the khalt is achieved by the contract itself, the question (destroying capital) of before and after the khalf is irrelevant. The Hanbali ‘inan is based on wakalah and amanah and does not include the contract of kafalah. The partnership is general for all trades or special for one type of trade, if it is specified. A partner in this ‘inan has all the powers that the Hanafi ‘inan constituted with wealth (mal). A partner also has the right to take delivery of goods or the price and to make claims for receivable of the partnership and to accept assignments, as well as to return goods based on defect. Further, each partner may sue and be sued for the debts of the partnership or those due to it. This happens because the distinction between the huquq and hukm of a contract has not been drawn. The partner also cannot mix up his own wealth with that of the partnership. He also does not have the right of istidanah. If he raises credit beyond the limit of the capital of the partnership, he is personally liable. The stipulations for sale and purchase on credit for the ‘inan partnership are also no different from those stipulated by the Hanafis for the ordinary ‘inan based on wealth. For the case that a partner does not have the authority, a transaction (buying) on credit with the type of currency or buying on the basis of fungibles is permitted because any transaction will require the payment to be made and there is not an excess payment situation (over the capital). In the case that the partner has the authority to raise credit beyond the capital employed (istidanah), liability for this istidanah is upon him for any case (loss or profit), unless the partner permits him to do so. There are many disputes on this issue since this is known as sharikat-ul-wujooh in Hanafis as well as in Malikis. It should be put in a separate class for several reasons. Hanbalis failed to do so because they never explain the legal principle that lays down the partnership. More surprisingly, Hanbalis categorised the sharikatul-wujooh as another type of partnership. The authority of istidanah operates in the Hanafi concept by the construction of sharikat-ul-wujooh on the top of ‘inan. There is no such provision in Hanbali’s view since the introduction of istidanah is not possible in the Hanbali’s ‘inan, because doing so would create a different partnership. This new form may quite be similar to the Hanbali mufawadah or the Hanafi’s ‘inan, which includes kafalah. Regarding the power of partners, if one of the partners terminates the agency of the other partner, the authority of this partner is terminated. Thus, he cannot make any transaction except to the extent of his own share. The partner who has terminated his authority may transact in the entire wealth. It means by restricting the rights of one partner, it will negate completely the concept of partnership contract. At the end, it will reduce the partnership to a co-ownership, where one of the co-owners has the right of disposal over the property. Thus, ‘inan, according to Hanbalis, is where the partners are equal in wealth as well as tasarruf (right of disposal). Sharikat-ul-wujooh is defined as the purchase on credit by two persons of something whose profits they share on the condition of half or third or the agreed

Capital under Mudarabah Contract and Musharakah Contract 85 proportion. There are few things to be noted here. First, each partner is the agent of the other in sale and purchase. Second, the partnership is supported by kafalah bi al-thaman, which means that for the liability of their payments, each partner stands surety for the other, while being liable for his own share as well. Third, the ownership of each partner is established in the thing purchased in accordance with the ratio agreed upon, whether the type of commodity to be purchased is determined. Fourth, the profit is shared by partners in accordance with ratios agreed upon, while the loss follows the ratio of ownership in what is purchased. Lastly, the remaining powers of the partners are almost the same as those for the partner of ‘inan. The Hanbali sharikat-ul-wujooh is almost similar to the Hanafi form if it is based on kafalah and wakalah (except for apparent defect). The partnership of sharikat-ul-abdan under Hanbali School is divided into two types. First, the participation of two or more people in what they accept for their physical labour and for which they are responsible as a result of their work. Any work accepted by one or both partners becomes joint liability, and they are liable to perform it. Therefore, if one of them says that he will accept the work and his partner should perform the work, the contract is valid. Furthermore, each one of them has the right to claim wages from the client irrespective of who accepted the work. In case of loss of property, it is a joint liability for both partners except one of them will be made personally liable. Second, the participation in the acquisition of free good. While the Hanbali permits this, the other schools reject this view because they do not permit a partnership in personal physical labour. Mufawadah is divided into two types. First, a partnership for sharing what each one of the partner receives through inheritance, or treasure property. These seem so unrealistic in real world and this partnership is void according to Hanbalis. Second, mufawadah is formed by combining all the other types of partnership, namely, ‘inan, abdan and wujooh. The partnership is valid because all the other types are valid individually. Hence, the partnership is formed on the basis of mal (wealth) based on wakalah. This partnership can include the contract of kafalah either initially in the contract or as part of istidanah. Also, each partner becomes a surety for the other partner and can be sued for debt recovery. Notes 1 For further explanation, please refer to Nyazee (1997), pp. 57–63. 2 Also known as the first category of partnership.

References Al-Kasani, A. B. M. (2000). Bada’i al-Sana’i fi Tartib al-Shara’i. Beirut: Dar Ihya at-Turath al-Arabi. Bank Negara Malaysia. Guidelines on Musharakah and Mudarabah Contracts for Islamic Banking Institution. www.bnm.gov.my/guidelines/01_banking/04_prudential_stds/15_ mnm.pdf Nyazee, I. A. K. (1997). Islamic Law of Business Organization: Partnership. Islamabad: International Institute of Islamic Thought and Islamic Research Institute.

Part IV

Economic Capital and Risk Management

5

Market Risk

5.1

Definition of Market Risk

Islamic bank has various types or lines of business, which significantly increase their profitability. Nevertheless, each line of business is exposed to the movement in current market prices and foreign exchange rate. Efficient risk management will reduce losses due to movement in market variables. In practice, traders are the first people to deal with the market risk and they are responsible to manage the market risk. For example, traders working for Islamic bank are responsible for the exchange rate risk. At the end of each trading day, they are required to ensure that specified risk limits do not exceed, or otherwise, they must execute new hedging trades. The risk managers will ensure that all the residual market risks from their activities are aggregated to determine the total market risks. If the portfolios are well diversified, it is expected to have small exposure to market movements. If the market risk is high, the reason must be found, and corrective action must be taken. According to the Oxford Dictionary of Economics, market risk is defined as ‘the risk taken by any trader on a market who holds either a long or a short position that the price will change’. The holders of stocks of goods, securities or currencies are subjected to the risk of losing if the price falls. The owners of goods, securities or currencies who do not hold the future position may run the risk of losing if the market price rises. Market risk persists regardless of whether the other party fulfils their obligations promptly and completely. This is distinct from counterparty risk, which is the risk that the other party may fail to deliver on time or not at all. Economics dictionary provided by Babylon defines market risk as ‘the risk that the value of an investment will decrease due to moves in market factors’. Market risk, according to Online Dictionary of Financial Term provided by Lightbulb Press,1 is also known as systematic risk that results from the characteristic behaviour of an entire market or asset class. For example, the market prices of existing bonds generally fall as benchmark rates rise because investors are not willing to pay par value to own a bond that pays less benchmark than other bonds available in the marketplace. Therefore, if investors want to sell their existing bonds, they will probably have to settle for less than they paid to buy them. In the simplest way, market risk arises in the form of unfavourable or adverse movement in market prices such as benchmark rates (rate of return risk), foreign DOI: 10.4324/9781003437086-9

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Table 5.1 Risk Perception-Risks in Different Modes of Financing

Murabahah Mudarabah Musharakah Ijarah Istisna’ Salam Diminishing Musharakah

Credit risk

Market risk

Operational risk

2.47 (17) 3.38 (13) 3.71 (14) 2.64 (14) 3.13 (8) 3.2 (5) 3.43 (7)

2.75 (12) 3.56 (9) 3.67 (9) 3.17 (6) 2.75 (4) 3.25 (4) 3.50 (6)

2.80 (15) 2.92 (13) 3.08 (12) 2.90 (10) 3.29 (7) 3.25 (4) 3.17 (6)

Note: The number in parenthesis indicates the number of respondents. Sources: Ahmed and Khan

exchange rates (foreign exchange risk), equity (equity risk) and commodity prices (price risk) which have a significant impact on the financial value of an asset over the life of the contract. Such exposures to market risk are due to the volatility in the values of tradable, marketable or leasable assets. Islamic banks are also exposed to risk based on the underlying contracts. Table 5.1 shows the perceptions of 18 Islamic bankers on some important risks inherent in various Islamic modes of financing. Market risk appears to be the most in musharakah and the least in murabahah and istisna’. The second mode that is highly exposed to market risk is mudarabah, and it is followed by diminishing musharakah. This is followed by salam, and ijarah profit-sharing modes of financing are highly exposed to market risk due to the involvement of such contracts in project financing that are sensitive to market movement. 5.2

Characteristics of Market Risk

From the above definition, market risk can be defined as the risk that the value of on- or off-balance-sheet positions may fluctuate. It declines before the position (item) can be liquidated or offset with other positions. It implies that the value of on- or off-balance-sheet position is exposed to market risk because of movement in price, rates or exchange. Because most asset and liability positions are traded and hedged, the value movement of asset or liability can be connected to market risk. In derivative market, assets and liabilities positions are also exposed to the movement in the price, rates and exchange. In addition, changes in rates and prices may be influenced by factors like as uncertainty and unexpected shifts in demand and supply. These changes result in a decrease in value of assets. At the same time, it is evident that these positions function as derivative instruments that are easily exposed to market risk because the value of derivative itself is driven by the movement in price, rates and exchange. Thus, all traded and hedged instruments are exposed to market risk. However, characteristics of market risk are also reflected by the characteristics of the underlying contract.

Market Risk 91 5.2.1

Salam  Contract

It is a contract in which advance payment is made for goods to be delivered later. It is similar to future contract. The seller undertakes to supply specific goods to the buyer at a future date for an advance price fully paid at the time of the contract. The objects of this sale are goods and cannot be gold, silver or currencies. Bay’al-salam covers almost everything, in terms of quantity, quality and workmanship. The contracting parties in a salam contract are as follows: al-muslam ‘ilayhi (forward sale). Salam is valid if it satisfies six conditions: the object of sale is of known genus, characteristic, amount; the term of deferment is known; the price is known; and that the place of delivery is specified if the object’s transportation is costly. In a second type of bay’ al-salam: ra’s-mal al-salam, or the price of a forward sale, the price must be specified in monetary form, and items must be measured by volume or by weight. If there are multiple types of the specified genus in the area, then the type must be specified. Then, there is of al-muslam fih, or object of a forward sale, where genus and type are known. Thus, it is not valid in the contract to mention that the price will be part of conditions to be agreed upon, because the products are not yet produced. This is to avoid the uncertainty in the supply of products. 5.2.2

Istisna’  Contract

Istisna’ is an order of sale used mainly in financing assets that are under construction. Therefore, it is a contract for the acquisition of goods by specification or order. For example, in the purchases of houses under construction where the payments made to the developer are based on the stages of work completed. It allows Islamic bank to disburse payments according to the stages of completion. As a financier, Islamic bank rarely orders the asset for its own use. Once completed, the asset will be handed over to the customer through a leasing arrangement (ijarah), a deferred sale arrangement (bai bithaman ajil), a cost-plus arrangement (murabahah) or a profit-sharing arrangement (mudarabah or musharakah). In the case of bay’ alsalam, the full payment is made in advance to the seller before delivery of the goods, but in an istisna’ contract, the price is paid progressively according to the job completion. In simplest way, both contracts are considered as future contracts. This contract is a legally binding agreement to buy or sell something in the future. A future contract is a contract that allows the investor to write a contract today at a stated price but pay cash (now or later), for promised future delivery of the underlying item (asset) at a specified time and place in the future. In other words, an investor can buy or sell a certain underlying instrument for cash at a certain date in the future, at a specified price. The investor receives the purchased asset and pays the price (settlement price) at the signing or the delivery date (final settlement date). Futures are typically, but not always, settled by payments of cash or provision of other financial instruments rather than by actual deliveries of underlying items. Any profit (or loss) on the delivery date is the difference between the market value of the asset and the contract price.

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The difference relates to the price, which in salam contract is fixed over the life of the contract. Therefore, actual daily cash settlement occurs between the buyer and seller in response to this marking-to-market process. This can be compared to an istisna’ contract, where the whole cash payment from buyer to seller occurs at the end of the contract period. A typical example of future contract is Islamic profit rate swap. For cross-currency swaps that involve the commodity murabahah and profit rate swaps (PRS), the former utilises the deferred payment of the spot sale of the commodity to the client by an Islamic bank through an agent Islamic bank that will be treated as a placement. The tenor will be the agreed forward date of the deferred payment. Here, the difference between the deferred payment and the spot price is recognised as fixed income. The related impact on earnings at risk in the accrual portfolio will be captured through monitoring of the corresponding earning at risk limits. Liquidity risk can be mitigated by avoiding undue concentration of maturity or market share; that is, limits can be placed on the amount of purchases and sales on any given day by currency, by country, from any one source or in aggregate. Under PRS, the client will pay the fixed rate profit and receive a floating rate profit (or vice versa) and the exchange of profit payments will be made at each rollover period (e.g., six months) between an Islamic bank and the client. If a higher amount is due from the customer, the Islamic bank’s risk on the client will be to the extent of the differential payment. This risk is mitigated via the collateral management agreement. The credit risk on the principal amount is eliminated via a collateral pledge and set-off provisions. In the event of default under long-term murabahah, the Security Trustee may call the collateral invested in the short-term murabahah prior to the deferred payment date of short-term murabahah.

Box 5.1 Example of Future Contract (i) Fixed Profit Rate. Suppose the principal amount intended is $500,000 and the fixed mark-up is 5.75% for two years. The fixed mark-up profit rate amount is payable every six months for two years ($500,000 × 5.75% × 5.75% × 180/365 = $815.24); (ii) Floating Profit Rate. Just prior to six months, Bank W invests in Bank X at a selling price of $500,000 plus a markup based on current profit rate (agreed spread plus current benchmark). The payment of selling price by both Bank W and Bank X is netted off. The net difference is profit and is paid to the receiving party as the case may be spelt out in the settlement agreement.

5.3 Type of Market Risk The major components of market risk include benchmark rate risk, equity risk, foreign exchange risk and commodity risk.

Market Risk 93 5.3.1 Benchmark  Rate  Risk

Islamic bank always tries to meet the demands of their customer and execute business strategies by providing financing, purchase commodities and take deposits with different maturities and rates of return. All these activities may leave an Islamic bank’s earnings and capital exposed to movements in benchmark rates. Benchmark rate risk represents the exposures that the investor must rely on instruments whose values vary with the level of benchmark rates. These instruments (benchmark-bearing assets) include, but are not limited to, financing, investments, sukuk, swaps and other derivative instruments. Benchmark rate risk arises when there is a mismatch between positions, which are subject to benchmark rate adjustment within a specified period. Generally, benchmark rate is the risk to earnings or capital arising from movement of benchmark rates. Specifically, benchmark rate risk occurs due to: (1) differences between the timing of rate changes and the timing of cash flows (repricing risk), (2) changing rate relationships among different yield curves affecting Islamic bank activities (basis risk), (3) changing rate relationships across the range of maturities (yield curve risk) and (4) benchmark rate-related options embedded in products (option risk). Re-pricing or maturity mismatched risk arises from differences in the timing of rate changes and the timing of cash flows that occur in the pricing and maturity of an Islamic bank’s assets, liabilities and off-balance-sheet instruments. Islamic banks intentionally take re-pricing risk in their balance sheet structure to improve earnings. Because the yield curve is generally upward-sloping (long-term rates are higher than short-term rates), Islamic banks can often earn a positive spread by funding long-term assets with short-term liabilities (‘liability sensitive’). However, the bank faces a problem when the benchmark rate raises its cost of funds and affects their earnings. Conversely, an asset-sensitive Islamic bank (asset pricings shorter than liability re-pricing) will generally benefit from a rise in rates of return and be hurt by a fall in rates of return. In the case of an Islamic bank in Malaysia, for example, basis risk occurs when the spread between the three-month Treasury and the three-month Kuala Lumpur Interbank Offered Rate (KLIBOR) changes as a result of monetary policy statements (Box 5.2). Box 5.2 Monetary Policy Statement as on 24 August 20X7 At its meeting today, Bank Negara Malaysia’s Monetary Policy Committee (MPC) decided to leave the Overnight Policy Rate (OPR) unchanged at 3.50%. During the first half of 20X7, growth of the Malaysian economy has remained favourable, with the slower external sector being balanced by stronger growth in domestic demand. In assessing the outlook for the rest of the year, the turbulence in the global financial markets over the recent

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Economic Capital and Risk Management weeks has created a higher degree of uncertainty regarding global economic growth. While the Malaysian economy is not insulated from the volatility in the global financial markets and possible consequential moderation in global demand, strong domestic fundamentals will provide a sound foundation for growth. While rising global food and commodity prices could potentially increase the risk of higher prices, the inflation rate in Malaysia is expected to remain low. Inflationary expectations are also well-contained. The future stance of monetary policy would be determined by Bank Negara Malaysia’s assessment of new data and information and their implications on the medium-term prospects for price stability and economic growth. Bank Negara Malaysia 24 August 20X7

If an Islamic bank uses KLIBOR as a benchmark, it affects the Islamic bank’s current net benchmark margin through changes in the earned/paid spreads of instruments that are being re-priced. At the same time, it also affects the anticipated future cash flows from such instruments, which in turn affects the underlying net economic value of the Islamic bank. Basis risk can also be said to include changes in the relationship between managed rates, or rates established by an Islamic bank, and external rates. For example, basis risk may arise because of differences in the base financing rate and an Islamic bank’s offering rates on various liability products, such as money market deposits and savings accounts. Since return on saving deposit tends to lag an increase in market benchmark rates, Islamic banks may see an initial improvement in their net benchmark margins when rates increase. Whether this behaviour is categorised as basis or option risk is not important, so long as Islamic bank management understands that this pricing behaviour will influence the Islamic bank’s benchmark rate risk exposure. Yield-curve risk arises from variations in the movement of benchmark rates across the maturity spectrum. It involves changes in the relationship between benchmark rates of different maturities of the same index or market (e.g., a threemonth Treasury versus a five-year Treasury). Yield curve variation can heighten the risk of an Islamic bank’s position by magnifying the effect of maturity mismatches. Certain types of structured products can be particularly vulnerable to changes in the shape of the yield curve. For example, the performance of certain types of structured products, such as dual index, is directly linked to basis and yield curve relationships. Sukuk are financial instruments whose returns are determined by the difference between market indices, such as the constant-maturity Treasury (CMT) rate and Kuala Lumpur Interbank Offered Rate (KLIBOR). As an illustration, consider a sukuk whose rate is based on the following formula: the return equals to the ten-year CMT rate plus 300 basis points less the

Market Risk 95 three-month KLIBOR. Since the return on this sukuk is adjusted as benchmark rates change, an Islamic bank may incorrectly assume that it will always bring benefits if benchmark rates increase. If, however, the increase in three-month KLIBOR exceeds the increase in the ten-year CMT rate, the sukuk on this instrument will fall, even if both KLIBOR and Treasury rates increase. Islamic banks, which hold these types of instruments, should evaluate how their performance may vary under different yield curve shapes. Option risk arises when an Islamic bank or an Islamic bank’s customer has the right (not the obligation) to alter the level and timing of the cash flows of an asset, liability or off-balance-sheet instrument. An option gives the option holder the right to buy (call) or sell (put) the underlying commodity at a specified price over a specified period. If Islamic bank has written (sold) options to its customers, the amount of earnings or capital value that an Islamic bank may lose from an unfavourable movement in benchmark rates may exceed the amount that an Islamic bank may gain if rates move in a favourable direction. The option has an explicit price at which it is bought or sold and may or may not be linked with another Islamic bank product. However, Islamic bank does not have to buy and sell explicitly priced options to incur option risk. Indeed, Islamic bank may incur option risk from options that are embedded or incorporated into retail products. On the asset side, prepayment options are the most prevalent embedded option. Most residential mortgage and consumer financing gives the consumer an option to prepay with little or no prepayment penalty. Islamic banks may also permit the prepayment of commercial financing by not enforcing prepayment penalties (perhaps to remain competitive in certain markets). A prepayment option is equivalent to having a written call option to the customer. When rates decline, customers will exercise the calls by prepaying financing, and Islamic bank’s asset maturities will be shortened just when the Islamic bank would like to proceed with an extended period. When rates rise, for example, customers will keep their home financing, making it difficult for the Islamic bank to shorten asset maturities just when it would like to do so. On the deposit side of the balance sheet, the most prevalent option given to customers is the right of early withdrawal. Early withdrawal rights are like put options on deposits. When benchmark rate increases, the market value of the customer’s deposit declines, and the customer has the right to ‘put’ the deposit back to Islamic bank. This option is to the depositor’s advantage. As previously noted, Islamic bank management’s discretion in pricing such retail products as non-maturity deposits can also be viewed as a type of option. This option usually works in the Islamic bank’s favour. For example, Islamic bank may peg its deposits at rates that lag market rates when benchmark rates are increasing and that lead market rates when they are decreasing. The movement of benchmark rates immediately affects an Islamic bank’s reported earnings and book capital by changing the Islamic bank’s net benchmark income, the market value of trading accounts and other benchmark-sensitive income and expenses, such as mortgage servicing fees. The long-term impact is on Islamic bank’s net worth since the economic value of Islamic bank’s assets,

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liabilities and benchmark rate-related, off-balance-sheet exposures is affected by changes in rates because the present value of future cash flows, and in some cases the cash flows themselves, are changed. Based on these effects, there are two common perspectives for the assessment or evaluation of benchmark rate risk exposure, which are earning and economic value perspectives. A well-managed Islamic bank always considers the effect on both its earnings (the earning or accounting perspective) and economic value (the economic or capital perspective) when evaluating the potential impact of benchmark rate on an Islamic bank’s operation. Assessment of benchmark risk exposure from both perspectives enables Islamic bank to determine the full scope of Islamic bank’s benchmark rate risk exposure, especially if Islamic bank has a significant long-term or complex benchmark rate risk position. Evaluating benchmark rate risk solely from an earnings perspective may not be sufficient if an Islamic bank has significant positions that are intermediate-term (between two and five years) or long-term (more than five years) because most earning-at-risk measures consider only a one-year to two-year time frame. Thus, the potential impacts of benchmark rate changes on long-term positions often are not fully captured. The earning perspective focuses on how the benchmark rates’ variation will affect an Islamic bank’s accrual or reported earnings. For example, a decrease in earnings caused by movement in benchmark rates can reduce earnings, liquidity and capital. Fluctuations in benchmark rates generally affect reported earnings through changes in an Islamic bank’s net benchmark income. Thus, this traditional approach allows the Islamic bank to measure the changes in the net benchmark income (NII) or net benchmark margin (NIM), that is, the difference between the total benchmark income and the total benchmark expense. Net benchmark income will vary because of differences in the timing of accrual changes (re-pricing risk), changing rate and yield curve relationships (basis and yield curve risks), and option positions. Changes in the general level of market benchmark rates also may cause changes in the volume and mix of an Islamic bank’s balance sheet products. For example, when economic activity continues to expand while benchmark rates arise, financing for manufacturing activities may increase while residential mortgage financing growth and prepayments slow. Declines in the market values of commodities may diminish near-term earnings when accounting rules require an Islamic bank to charge such declines directly to current income. This risk is known as price risk, as price movement in commodities causes the value of instruments to decline. Islamic banks with large trading account activities generally will have separate measurement and limit system to manage this risk, which will be explained later. On the other hand, the economic perspective provides a measure of the underlying value of the Islamic bank’s current position and seeks to evaluate the sensitivity of that value to change in benchmark rate. In other words, the economic value perspective reflects the impact of fluctuation in the benchmark rates on the economic value of an Islamic bank. Specifically, this perspective focuses on how the economic value of Islamic bank assets, liabilities and off-balance-sheet instruments change with movements in benchmark rates. Economic value of the Islamic bank

Market Risk 97 can be viewed as the present value of future cash flows. This economic value is affected by changes in future cash flows and expected rate of return used for determining present value. By evaluating changes in the present value of the contracts that result from a given change in benchmark rates, one can estimate the change to an Islamic bank’s economic value (known as economic value of equity). The economic perspective takes an approach to identify risk arising from longterm re-pricing or maturity gap, which is more comprehensive than earning perspective because it captures the impact of benchmark rate changes on the value of all future cash flow. The future cash flow projections used to estimate an Islamic bank’s economic exposure provide a pro forma estimate of the Islamic bank’s future income generated by its current position. Because changes in economic value indicate the anticipated change in the value of the Islamic bank’s cash flow, the economic perspective can provide a leading indicator of the Islamic bank’s future earnings and capital values. When immunising earning and economic value from benchmark rate risk, Islamic bank management must take a certain trade-off. The economic value of equity, like other financial instruments, is a function of the discounted net cash flows (profits). Therefore, if an Islamic bank must immunise earnings, such that expected earnings remain constant for any change in benchmark rates, the discounted value of those earnings will be lower if benchmark rates rise. The results would be that its economic value will fluctuate with benchmark rate changes. Conversely, if an Islamic bank fully immunises its economic value, its periodic earnings increase and decline, when benchmark rates rise and fall respectively. Consequently, Islamic banks that limit the sensitivity of their economic value will not set a zero-risk tolerance but rather will set limits around a range of possible outcomes. In general, the Islamic bank’s financing, funding and investment activities give rise to benchmark rate risk. Each completed financial transaction also may affect its benchmark rate risk profile. However, Islamic banks may differ in the level and degree of benchmark rate risk they are willing to assume. Islamic banks may seek to minimise their benchmark rate risk exposure, where they do not deliberately take positions to benefit from a movement in benchmark rate. Islamic banks’ management differs on which portfolios or activities they allow position-taking in. Islamic banks try to centralise management of benchmark rate risk and restrict positiontaking to certain ‘discretionary portfolios’, such as their money market and investment. Here, Islamic banks use a funds transfer pricing system as a medium to isolate the benchmark rate management and positioning in the treasury unit of the Islamic bank. Islamic banks may also choose to confine their benchmark rate positioning to their trading activities, while others may choose to take or leave open benchmark rate positions in non-trading books and activities. Islamic bank can alter its benchmark rate risk exposure by changing investment, financing, funding and pricing strategies and by managing the maturities and re-pricings of these portfolios to achieve a desired risk profile. Islamic bank also can use off-balance-sheet derivatives (swaps and options), such as benchmark rate swaps, to adjust the benchmark rate profile. Before applying such derivatives,

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Islamic banks must understand the cash flow characteristic of the instruments that will be used and have an adequate system to measure and monitor their performance in managing the Islamic bank’s risk profile. Islamic bank should also consider that benchmark rate may consequently generate other risks. The result will be a higher level of financings default. Thus, such increases in benchmark rates might expose Islamic bank with a significant concentration of adjustable rate to credit risk. Increases in benchmark rates cause Islamic bank that are primarily funded with short-term liabilities to experience a drop in net benchmark income and have issues with financing quality. Managing the benchmark rate risk profile and strategy requires the Islamic bank to consider its liquidity and ability to access various funding and derivative market. An Islamic bank with plenty and stable sources of liquidity has extra capability to withstand short-term earnings pressures arising from adverse movement in benchmark rate compared to an Islamic bank that is mainly dependent on wholesale, short-term funding sources that may leave the Islamic bank if its earnings deteriorate. For example, an Islamic bank that mainly depends on wholesale funding may have difficulty in replacing its existing funds or obtaining additional funds if it has an increasing number of non-performing financings. An Islamic bank that can readily access various money and derivatives markets may have better ability to respond quickly to changing market conditions than Islamic banks that rely on customer-driven portfolios to alter their benchmark rate risk positions. Finally, an Islamic bank should consider the fit of its benchmark rate risk profile with its strategic business plan. An Islamic bank that has significant long-term benchmark rate exposures (such as long-term fixed rate assets funded by short-term liabilities) may have less ability to respond to new business opportunities because of depreciation in its asset base. As noted, Islamic banks are required to calculate a capital charge using either the standardised approach or internal model approach, but Islamic banks are immune to this risk factor. However, an Islamic bank would be exposed to benchmark rate risk to the extent that the Islamic bank resorts to debt sales in the secondary market at a price different from the nominal value of the debt and the market continues to use benchmark rates directly or indirectly in investment and financing decisions, as in case of floating-rate ijarah. As will be shown later, the Islamic bank would also expose itself to mark-up risk in the contract of murabahah. We need to bear in mind that Islamic banks are not supposed to be seeking risk-free returns (riba) either through straightforward benchmark-based transactions or indirectly through hedging or complete risk transfer. It is not the attention to emphasise the benchmark rate risk in this text, which is opposite to the spirit of Islamic banks. The only reason to address this risk is to show those Islamic banks that are largely exposed to the benchmark rate risk and, thus, may affect their performance. On the other hand, Islamic banks that are free from the benchmark rate risk (except for basis risk) should have better opportunities to expand their business operation because they are free from this type of risk. It is well understood that the most important earning for Islamic bank is earning that is derived from benchmark rate. Thus, Islamic bank must maximise

Market Risk 99 application of profit-loss sharing contract to compete with conventional banks to get large market share. 5.3.2 Foreign  Exchange  Risk

Foreign exchange risk is the current or prospective risk to earnings or capital arising from adverse movements in currency exchange rates. It is a form of risk that arises from the changes in price of one currency against another. It is a subjective concept and concerns anticipated or forecasted rate fluctuations together with the assessment of the vulnerability of an entity to such fluctuations. The element of uncertainty gives rise to risk and creates an opportunity for profitable action. These risks are also known as translation risk. This risk is applicable to cross-border investing and operating activities. It represents exposures investor has to changes in the values of current holdings and future cash flows denominated in other currencies. Specifically, it arises from holding accrual accounts denominated in foreign currency, including financings, bonds and deposit. It also includes foreign currencydominated derivatives such as structured notes, synthetic investments, structured deposits and off-balance-sheet derivatives used to hedge accrual exposure. As mentioned before, there are many factors that affect the foreign exchange risk exposure. The most important foreign exchange risk exposure relates to open positions taken as a principal by the bank for speculative purposes. Banks create an open position by taking an un-hedged position in a foreign currency in its foreign exchange trading with other financial institutions. Banks can make speculative trades directly with other financial institutions or arrange them through specialist foreign exchange brokers. These speculative trades can be instituted through a variety of foreign exchange instruments such as spot currency, where banks make profit on the difference between buy and sell price. The second dimension of banks’ foreign exchange exposure arises from any mismatches between its foreign financial asset and foreign financial liability portfolio. A bank is long a foreign currency if its assets in that currency exceed its liabilities. In this case, the bank bought more currency than what they sold, and they are exposed to risk if foreign currency falls in value against domestic currency. A bank is short a foreign currency if its liabilities in that currency exceed its assets. In this situation, the firm sold more than it bought and faces risk if the value of the foreign currency rises versus the home currency. The process of assessing risk is an ongoing, dynamic activity extending from the time an initial forecast is made (when the risk concerns the potential for fluctuations between the contract rate and the market rate) right up to the conclusion (when the risk relates to the settlement of the transaction and the resultant variation from that originally contemplated). The existence of a net transaction or translation exposure or the contemplation of a possible net economic exposure requires the use of suitable and practical techniques to measure and evaluate the risks involved. Banks can measure the potential size of foreign exchange exposure by analysing the asset, liability and currency trading mismatches on the balance sheet and the underlying volatility of exchange rate movements. The larger the bank’s net

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exposure in a foreign currency and the larger the foreign currency’s exchange rate volatility, the larger the potential says US dollar loss or gain to bank earnings. As mentioned before, the underlying causes of foreign exchange volatility reflect fluctuations in the demand and supply of a country’s currency. This exchange rate has a similar concept to goods, which the value will appreciate relative to other currencies when demand is high, or supply is low, and will depreciate in value when demand is low, or supply is high. Managing foreign exchange risk is not only about using forward contracts or derivatives but also effective management of cross-currency assets and liabilities. Successful risk management requires an entity to get a handle on what its actual net position is and put an effective policy/framework in place to limit profit/loss volatility as foreign exchange moves. Conventional risk management strategy not only gives structure to protect an entity from adverse movement in foreign exchange but also provides flexibility to take advantage of favourable moves when it happens. As for the Islamic bank, it needs to take critical consideration. As mentioned before, Islam allows trading of currencies on a spot basis. This implies any currency transactions on a deferred basis are not allowed. In practice, the spot exchange cash delivery takes about two days. Some scholars believe the time lag of two days is considered as spot exchange. The delay of two days exposes the two parties to credit and political risk. For example, it exposes to credit risk if the other party fails to deposit the sale price or simply delays it. As for the political risk, it involves government intervention on the exchange rate, such as disallowing its conversion, etc. Indirectly, prohibition on currency transaction on a deferred basis implies Islamic law tries to minimise market risk due to uncertainty if the delivery takes a longer period to be solved. Hence, Islamic law gives a solution to avoid market risk in foreign exchange transactions. Trading of currencies on a spot basis provides simultaneous transfer of the two currencies at the prevailing rates. The Prophet (peace be upon him) did not allow any time lag in the exchange of currencies. The rationale behind this insistence on simultaneous transfer seems to be in the very nature of money. At the first place, such delay will open causes possibility of riba existence. Thus, Shari’ah take the prevention action rather than to solve the problem. The contemporary practice of allowing a two-day lag is criticised by other scholars. An alternative for this practice is the exchange is affected simultaneously by involving correspondent banks or agents at the same station. Even though the foreign exchange transaction is conducted based on a spot basis and thus is safe in terms of transaction, it is still exposed to movement in exchange rate, especially for on-balance-sheet assets held outside the trading book and denominated in a foreign currency. Furthermore, Islamic banks could be exposed to foreign exchange risk because the various hedging techniques available to Islamic banks cannot be used by Islamic banks. As an alternative, Islamic banks should be required to apply capital charges on their foreign exchange exposures based on the market risk methodology, as recommended by Basel Committee. Measurement of the foreign exchange risk would involve the calculation of the net open position

Market Risk 101 in each individual currency. The open position may be either trading positions or simply exposures caused by the bank’s overall assets and liabilities. Foreign exchange also exists in other types of markets such as swap, forward and futures. In the swap market, the dealers conclude two contracts: spot and forward. The spot contract is reversed in the forward contract. The rate differential in the spot and forward contracts are, in fact, the benchmark rate differentials on the two currencies during the period of maturity. From the Islamic point of view, it is a contrivance to earn a benchmark (riba) on one’s currency holdings. The basic idea behind this is that money is a commodity like any other commodity, and one must try to sell it for profit or earn its rent. This basic idea is unfamiliar to the Islamic legal framework, which treats money as a medium of exchange rather than commodity. Thus, this idea becomes fundamental to Shari’ah rejection of swaps contract. In the forward contract, a bank agrees to sell a currency against another currency at an agreed price, but the delivery is made in the future. In the forward contracts in foreign exchange, Shari’ah interprets it as not legally enforceable until the date of their maturity, since neither of the currencies are exchanged until then. At best, the two banks ‘promise’ to transact an exchange business at a future date. Such an agreement is only morally enforceable. No court in the Islamic state would enforce it. Subject to this, there is nothing in Islam which prohibits this type of business. As the element of benchmark in the quoted rate is concerned, this also cannot be legally disallowed as it is only a mental exercise, which cannot be proven by any method. In the futures market in foreign exchange, the dealers merely settle the differences in prices without taking the delivery of any currency. In terms of operation, it is quite similar to commodity futures exchange except that the option to deliver different ‘grades’ is not available. From the Islamic point of view, future market in foreign exchange is similar to commodity exchange. As it does not involve simultaneous and actual delivery of the two currencies involved, it is not allowed in Islam. Thus, we can conclude that Islamic banks do not deal in derivative contracts, such as options, futures and swaps either for trading or for hedging purposes. This is because Islam does not allow activities involving uncertainty that is gharar, especially in return for the portfolios. 5.3.3 Equity  Market  Risk

In the simplest way, equity risk is the risk that one’s investments will depreciate (stock price change) because of stock market dynamics causing one to lose money. Specifically, equity market risk or equity price risk is the risk to earnings or capital that results from adverse changes in the value of equity-related portfolios of a financial institution. Equity market risk arises from exposure to securities that represent an ownership benchmark in a corporation in the form of common stock or other equity-linked instruments. The instruments that would lead to this exposure include, but are not limited to, the following: common stock, listed equity options

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(puts and calls), over-the-counter equity options, equity total return swaps, equity index futures and convertible bonds. Equity price risk could be systematic or unsystematic. Systematic risk refers to the sensitivity of the portfolio’s value to changes in the overall level of equity prices. For example, when the economy is growing, all equities will likely be affected either in a cyclical or countercyclical fashion. The unsystematic risk is associated with price volatility that is determined by entity-specific characteristics. Equity markets can be more volatile than other financial markets and thus equity derivatives can experience larger fluctuations than other financial derivatives. Demand and supply, besides speculative motive, become the major factors to influence the fluctuation in the equity of a firm. If people demand more stock than the amount supplied by the entity, the price of stock will go up. Conversely, the price of stock will go down when the supply is higher than demand. In practice, the current situation of the global economy has a strong influence on the movement in stock exchange prices. Investors sensitively respond in their buying and selling to fundamental economic news, fickle market sentiment and to baseless rumours. For example, conflict between the US and countries like Iraq and Iran will affect the price of crude oil, thus affecting the value of the entity (stock) involved in these industries. Similarly, the ‘sub-prime’ crisis in the US will raise uncertainty in the global economy and thus affect the domestic economy. If the domestic economy has a strong and significant economic relation with such a country (US), the tendency of slow domestic economy activities is high. Slow growth in the domestic economy will affect the domestic entity activities if the economy fundamentally is weak. The entity condition itself will directly influence the level of demand that individuals have for stock. An entity with a strong financial background (higher earning, including sustainable growth opportunities and large firm size) will reflect strong performance. If an entity fails to generate profits, it is not going to stay in business. The exceptional entity has a high stock price because excess demand pushes the price up until the current market share price becomes expensive. Such entity benefits from economies of scale and typically dominates a significant share of the market. Conversely, an entity with a weak financial background experiences little demand for their stock, resulting in a rise in firm-specific risk. This is because such entity is unable to generate higher ‘returns’ (after paying all the claims) for their client’s stock. Thus, a stock price is affected by the entity’s financial performance and overall business environment, along with other relevant factors relating to the entity. In the case of banks, the balance sheet includes many sources of stock market risk first as the bank itself may be involved in stock as investments. Investment in other companies will affect the performance of the bank as stock in other companies may increase or decline depending on the demand and supply of stock. In fact, the stock of the bank itself depends on the demand and supply, which derive from the economic and industry conditions. If the demand is less than the supply of stock, the value of the bank will decline (capital loss) and thus the bank will have difficulties raising the capital.

Market Risk 103 The bank stock market risk also arises from bank activities, which sell products implicitly or explicitly indexed to the stock market level. Also, in many cases, banks get incomes indexed to the stock market indexes. For example, banks may ask their customers for a fee to conserve stocks. The fee is proportional to the stock amount detained in the bank. Therefore, the bank income is somehow proportional to the stock index level. When the stock index increases, the expected future incomes will increase, too. Consequently, corporate stock prices will affect the bank incomes’ level. When assessing price risk arising from equity derivatives, the distinction between systematic and unsystematic risk is a crucial consideration. Unsystematic risk can be eliminated or reduced by diversification. Because the returns of different instruments can be negatively correlated, the total volatility of the portfolio of instruments may be less than the summed volatility of the component instruments. Moreover, in a well-diversified portfolio, any one asset represents a small fraction of the total portfolio and, consequently, an insignificant portion of the total portfolio variance. Systematic risk cannot be eliminated or reduced by diversification, because a market move will affect all securities prices in a similar way. As mentioned before, the impact of inverse movement in stock price causes the value of investment as well as the capital to decline. Thus, in the simplest form, the value of the firm will decline along with the decline in stock price. The bank, for example, experiences capital loss and at the same time loses the opportunity to expand its business activities. In further impact, declining stock prices results in lower stock prices, which forces the shareholder to push the managers to cut costs by laying off workers and scaling back investment. At the same time, the factors dragging down stock prices typically spur investors to demand higher risk premiums, which boosts the cost of financing business investments. Again, the bank loses the business opportunity. From the Islamic point of view, it provides some guidelines for transactions in stock/equity to prevent the problem in the future. The conventional stock exchange permits the sale and purchase of stocks and securities without the physical transfer of these certificates from the seller to the buyer. This implies that one share may be sold several times before an actual delivery takes place. Thus, Islamic law does not allow the sale of an article (e.g., share) until one has actual physical possession of it. In the conventional stock exchange, they use the instrument of business that is called ‘contango’, which is a rate of benchmark paid by a bank on money borrowed with which to pay for stock that one has bought. The money is borrowed from one account day to the next account day, and the bank is said to ‘contango’ the stock or to carry it over. Thus, Islamic law prohibits the transaction that involves riba because it brings injustice to society. The conventional stock exchange also permits ‘option’ sales. The option signifies choice, and in stock exchange, it means the choice to deal or not deal in a share later at today’s price. The person who exercises the option gives option money, usually a fraction of the price of each share he wants to buy (call money) or sell (put money). A giver of call money has the right to purchase shares during the call

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period at today’s price and a giver of put has the right to sell and both can exercise the transaction if they wish, but they do not have to do so. The option sales transaction violates the Islamic law of bay’ al-salam, which regulates credit sales involving advance payment of money. The bay’al-salam only permits the payment of the full price of the product in advance and not a fraction of price. A transaction, which involves both a future delivery and a deferred payment of price is not permitted in Islam in case of option sales in stock exchange, both are deferred. Thus, options that contain uncertainty in terms of put and call bring the risk to seller and buyer. This happens when the price differential opens for speculative activities. In Islamic law, stock exchange would deal in equity capital available in the form of mudarabah and musharakah certificates. Benchmark-bearing financings and securities, and elements of gharar do not exist in Islamic law. Similarly, there would be no preference shares in Islamic economy as it involves a fixed pre-determined guaranteed rate of return, which is akin to riba. Since the equity of Islamic bank is heavily dependent on mudarabah and musharakah, the equity inside the trading book of an Islamic bank is subject to market risk. In practice, many Islamic banks have investments in equity that are long-term participations and joint venture musharakah and in the form of equity mudarabah funds. Specific examples of equity investments are holdings of shares in stock market, private equity investments and equity participation in specific projects or syndication investments. Since Islamic banks invest based on equity-based assets, such investments are exposed to price volatility that causes market risk. It has few distinct features. Both mudarabah and musharakah are profit and loss sharing contracts that are subject to loss of capital despite proper monitoring (such as proper financial disclosure, closer involvement with the project and transparency in reporting and supervision). The degree of risk in equity is relatively higher than in other investment, and thus, Islamic banks should take extreme care in evaluating and selecting the project. As mentioned before, the market risk consists of specific risk and general risk. The specific risk requirements recognise that individual equities are subject to issuer risk and liquidity risk. Observation across the Muslim world shows that equity mudarabah of many Islamic institutions comprises stocks with low levels of liquidity, and they lack developed secondary equity markets. These types of risks may be reduced by portfolio diversification, where the bank may take the trading position directly or through a fund manager based on mudarabah contract. The market risk should be calculated on each position taken by the mudarib or on a portfolio basis to take account of the diversification impact present in the mudarabah portfolio. In practice, the Islamic bank uses the fixed mark-up rate in the contract mudarabah and other trade-financing instruments to price different financial instruments. Therefore, they will be exposed to mark-up risk if the benchmark rate (LIBOR) changes as the market changes. Such risk occurs if the prevailing mark-up rate in the market increases beyond the rate the bank had fixed in a contract and therefore the bank is unable to benefit from increased rates. Specifically, this happens to the contract of mudarabah, where the mark-up rate is fixed at the time of the contract.

Market Risk 105 If an Islamic bank chooses to invest its assets in marketable securities (sukuk) rather than equity, the prices of such marketable securities are exposed to current yield, where the prices go down as yields go up and vice-versa. By holding such securities, Islamic banks will be exposed to volatility in yields, unless they hold the security until maturity. Furthermore, the secondary market for such securities may not be liquid, and therefore Islamic banks are exposed to distorted prices in an illiquid market. 5.3.4 Commodity  Risk

Commodity risk refers to the risk posed by the possibility of price volatility or decreases in commodity prices. The higher and the more unpredictable the price fluctuation, the greater the possibility of incurring losses or realising gains on future sales or purchases of a commodity. Commodity risk represents exposures investor has to products traded in the petroleum, natural gas, power markets, metal, grains etc. Studies have shown that commodity price movements (except for crude oil) have traditionally been negatively correlated to price movements of other financial instruments (such as equities or bonds). Therefore, investment in commodities can provide important portfolio diversification. Equities, bonds and other financial instruments tend to follow the same trend in times of economic crisis. In contrast, commodities goods such as zinc and wheat will rarely rise and fall in parallel, regardless of economic fundamentals, and they reflect the global commodities economy. There are four categories of agents/participants who face the commodities risk. Suppose that world market prices for a commodity fall. First, producers like farmers and mining and plantation companies, who face price risk of not being able to cover the production cost. When prices are low, producers cannot hedge their future production against current expenditure on infrastructure and inputs. Second, buyers like institutional, private and retail investors, who face price risk and buy commodities before reselling them, thus facing the risk of not covering their purchasing costs or not making any profit. Third, exporters, who face the same risk between purchase at the port and sale in the destination market. Finally, the government, who faces the price risk of tax revenues, particularly when tax rates decrease as commodity prices decline. Among these four agents, the buyer or investor is the most exposed to the movement in the price of commodities. Commodity derivative usually exposes an institution to higher levels of price risk than other financial derivatives. With these characteristics, the commodity derivative markets are generally much less liquid than the benchmark rate and exchange markets, and fluctuation in market liquidity often accompanies price volatility. Commodity prices depend on many factors, including weather, economic conditions and political stability, that are exceptionally difficult to forecast. Price volatility is caused by shifts in the supply and demand for a commodity. For example, natural gas and wholesale electricity prices are particularly volatile for several reasons. Demand increases quickly in response to weather, and ‘surge’

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production is limited and expensive. In addition, neither can be moved to where it is needed quickly, and local storage is limited, especially in the case of electricity. Public policy efforts to reduce volatility have focused on increasing reserve production capability and increasing transmission and transportation capability. Recently there has been an emphasis on making prices more visible to users so that they will conserve when supplies are tight, thus limiting price spikes. Daily price volatility is the standard deviation of the percentage change in the commodity’s price. The standard deviation is a measure of how concentrated daily percentage price changes are around the average percentage price change. For a normal distribution, approximately 67% of all the percentage price changes will be within one standard derivation of the average percentage change. Volatility is usually expressed on an annual basis, where a year is understood to be the number of trading days, usually 252, in a calendar year. Annual volatility is calculated by multiplying daily volatility times 15.87, which is the square root of 252. Volatility in commodity prices requires the investor to hedge their investment. When energy prices fall, so do the equity values of producing companies. This is the result of ready cash becoming scarce, and it is more likely that contract obligations for energy sales or purchases may not be honoured. When prices soar, governments tend to step in to protect consumers. Thus, commodity price risk plays a dominant role in these energy industries, and the use of derivatives has become a common means of helping energy firms, investors and customers manage the risks that arise from the high volatility of energy prices. Participants seek to mitigate exposure to the commodity markets with instruments including, but not limited to, options, futures and swaps in the same or similar commodity product, such as over-the-counter (OTC) markets and the commoditylinked bond as well as cash positions. Forward contracts are mostly used to hedge the risk of holding a certain commodity or of having the obligation to deliver it (or the need to acquire it) at a future date. This is called ‘forward cover’ and involves the execution of a set of offsetting transactions simultaneously in the spot and the forward markets. For example, if a trader holds (or purchases in the spot market) a certain commodity, he can insure against adverse price movements by selling the same amount of that commodity in the forward market at the prevailing forward price. In this case, he would be holding a ‘short position’ in the forward market (when a person buys forward or futures contracts, that person is said to have gone ‘long’ or to be holding a ‘long position’). When the forward contract matures, the trader sells the commodity at the specified price, thereby avoiding the risk of a price decline in the intervening period. This enables him to fix the amount of revenue from the future sale of the commodity at the time that the forward contract is signed, therefore locking in the price, and, of course, his profit margin. Futures contracts, like forward contracts, are agreements to purchase or sell a given quantity of a commodity at a predetermined price, with settlement expected to take place at a future date. Futures contracts more or less lock in the price the hedger is going to receive or to pay, but this time the mechanism is indirect. To hedge, a producer planning a future physical sale would, at the time of planning,

Market Risk 107 sell a futures contract (this is called ‘price fixing’). Later, when he sells his physical goods, he must simultaneously buy a futures contract, to close out his position. For the physical sale, he receives the market price prevailing on the day of the sale. If this price is lower than the price in the futures contract, the loss on the physical market is compensated by the higher price on the futures contract. This happens because the futures contract that he had sold earlier should have declined in value enabling him to buy (repurchase) the contract at the lower price. On the other hand, if the price in the physical market is higher than in the futures contract, the gain on the physical market is offset by the loss on the repurchase of the futures contract. Options are risk management instruments that do not lock in prices but protect those who buy them against unfavourable price movements while retaining the possibility of profiting from favourable ones. Options can perform almost the same hedging functions as futures or forward contracts. Compared to forward contracts and futures, apart from setting floor and ceiling prices, options have two benchmarking characteristics: (1) the buyer of an option must pay the premium at the time of purchasing the option. This often requires a significant amount of cash at the outset. However, there is no risk of unexpected margin calls, which, in the case of futures, can result in the cancelling of the contract if the hedger cannot raise the necessary cash within the specified period (normally one to three days). This has been an important reason for the increased use of options. (2) Unless the operation is executed via an exchange, the buyer of an option faces a credit or default risk by the counterpart; the seller of an option does not. The seller has already encashed his premium; the buyer, when he wants to execute his option, is dependent on the seller’s meeting his commitment. The mechanism of swaps is purely financial. In a swap agreement covering a specified volume of a commodity, two prices are involved. One of these prices is variable and is usually expressed in relation to a published price index such as the price of a futures contract. The other is fixed at the time of the swap agreement. As a commodity swap is a purely financial transaction, it has the advantage of allowing the producer and consumer to hedge their price exposure without directly affecting their commodity production, distribution or procurement activities. Thus, the participants have a large degree of flexibility to alter their production or consumption patterns to adapt to changing market needs. However, indirectly, these activities are influenced because a company must generate the cash flows necessary to meet the eventual obligations of the swap agreement. Islamic banks also involve in trade commodities activity through commodity financing and holding durable assets using contracts of murabahah, istisna’, ijarah, salam and partnership. Therefore, their portfolio is also exposed to price commodity risk for holding or taking positions in commodities. While conceptualising commodity price risks in Islamic banking, there is a need to clarify several points. First, the murabahah price risk and commodity price risk must be clearly distinguished. In Islamic banking, there could be a misconception about the treatment of mark-up price risk as commodity price risk. The basis of the mark-up price risk is LIBOR. Furthermore, it arises because of the financing, not trading, process. Therefore, it

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shall conceptually be treated as an equivalent of benchmark (benchmark) rate risk. In contrast, commodity price risk arises because of the bank holding commodities for some reason. Some good examples of such reasons are the Islamic bank (1) developing an inventory of commodities for selling, (2) developing inventories because of salam financing, (3) gold and real estate holdings and (4) holding of equipment particularly for operating leases. Second, commodity price risk arises because of ownership of a real commodity or asset. Mark-up price risk arises because of holding a financial claim, which could be the result of deferred trading. If the lease contract is a long one and the rental is fixed not floating, the contract faces benchmark rate risk. We can conclude that the murabahah and istisna’ transactions are exposed to murabahah (mark-up price) or benchmark rate risk, and salam and leases are exposed to both murabahah price and commodity price risks. Mark-up risk arises from a situation where mark-up used in financing the contract of murabahah is fixed for the duration of the contract, while the benchmark rate may change. Consequently, if a benchmark rate changes and the mark-up rates cannot be adjusted, Islamic banks face risks arising from movements in the market benchmark rate. For istisna’, it is not binding contract (ja’iz) and it is quite similar to the contract of salam. Thus, there is a possibility that the potential buyer breaches the contract. In the contract of bay’ al-salam, Islamic banks are exposed to commodity price volatility during the period between the delivery of the commodity and the sale of the commodity at the prevailing market price. Conventionally, such market risk happens to the commodity in forward contract if it is not hedged properly. A bank can hedge the commodity by entering into a parallel (off-setting) bay’ al-salam contract. In such cases, the bank is exposed to price risk if there is default on the first contract and the bank is obligated to deliver on the second contract (in a spot market). In the case of an operating ijarah, the bank (lessor) is exposed to reduction in the residual value of the leased asset at the expiry of the lease term or in the case of early termination due to default, over the life of the contract. In ijarah muntahia bittamleek, the bank is exposed to market risk on the carrying value of the leased asset (as collateral) if the lessee defaults on the lease obligations. 5.4

Policies and Procedures for Market Risk Management

IFSB via its revised capital adequacy standard requires Islamic banks to calculate the capital charges for benchmark rate-related instruments and equities based on current trading book items. A financial instrument is defined as any contract that gives rise to both a financial asset (any asset that is cash, the right to receive cash or contractual right to exchange financial assets on potentially favourable terms, or an equity instrument) of one entity and a financial liability (the contractual obligation to deliver cash or other financial assets to exchange financial liabilities under conditions that are potentially unfavourable) or equity instrument of another entity. These financial instruments include both primary financial instruments (cash instruments) and derivative financial instruments.

Market Risk 109 Islamic bank is required to have clearly defined policies and procedures for determining which exposures to include in, and to exclude from, the trading book purposes of calculating their regulatory capital. All compliance with these policies and procedures must be documented and requires periodic internal audits. These policies and procedures should, at least, address the following general considerations: 1 The activities must involve trading and be considered as part of the trading book for regulatory capital purposes. 2 The extent to which an exposure can be marked to market daily should be made about an active, liquid two-way market. 3 For exposures that are marked to model, the extent to which Islamic bank can: (i) Identify the material risk of the exposure (ii) Hedge the material risks of the exposure and the extent to which hedging instruments would have an active, liquid two-way market (iii) Derive reliable estimates for the key assumptions and parameters used in the model 4 The extent to which Islamic bank can and is required to generate valuations for the exposure that can be validated externally in a consistent manner 5 The extent to which legal restrictions or other operational requirements would impede Islamic bank’s ability to affect an immediate liquidation of the exposure 6 The extent to which Islamic bank is required to, and can, actively risk-manage the exposure within its trading operations 7 The extent to which Islamic bank may transfer risk or exposures between the banking and the trading books and criteria for such transfers Islamic bank may also need to establish prudence valuation guidance for positions in trading books. This requires Islamic banks to establish and maintain adequate systems and controls sufficient to give management (and supervisors) the confidence that their valuation estimates are reliable. For example, most VaR models depend on statistical analyses of past price movements that determine returns on the assets. In practice, while VaR models provide a convenient methodology for quantifying market risks and are helpful in monitoring and limiting market risk, there are limitations to their ability to predict the size of potential losses. These particularly relate to the possibility of losses in the event of unique market disturbances and the potential for a reduction in overall liquidity. Islamic bank may use stress tests and scenario analyses to complement and to help validate VaR models. Stress tests measure the potential impact of various large market movements on the value of an Islamic bank’s portfolio. These tests can identify market risk exposures that appear to be small in the current environment but grow disproportionately under certain circumstances. Scenario analysis focuses on the potential impact of particular market events on the value of the portfolio. Frequently, large and disruptive events from the past (e.g., stock market crash) are used as potential scenarios.

110 Economic Capital and Risk Management 5.5

Significance of Market Risk Measurement

Market risk is the risk that the value of on- or off-balance-sheet positions (trading book) declines due to unexpected economic changes or other events before the position can be liquidated or offset with other positions (like hedging). As shown in Table 5.2, the market risk arises from movement in market prices, such as benchmark rate (of financing),2 foreign exchange, sukuk market, equity market and commodity market. Islamic bank must measure each of these exposures. Specifically, market risk is inherent in the financial instruments as Islamic bank involves in investment activities, including financing, deposits, sukuk, trading accounts in assets and liabilities, and derivatives. If Islamic bank fails to measure the market risk accurately, they may underestimate the loss due to rate or price movements that affect their portfolios. Consequently, Islamic bank may be unable to accurately calculate capital charges and thus provide capital as a buffer to absorb the unexpected losses. Therefore, measuring market risk is important to Islamic banks. There are at least five reasons that market risk measurement (MRM) is important: 1 Management information. MRM provides senior management with information on the risk exposure taken by their traders. Management can then compare the risk exposure to the Islamic bank’s capital resources. 2 Setting limits. MRM considers the market risk of traders’ portfolios, which will lead to the establishment of economically logical position limits per trader in each area of trading. 3 Resource allocation. MRM involves the comparison of returns to market risks in different areas of trading, which may allow the identification of areas with the greatest potential return per unit of risk into which more capital and resources can be directed. 4 Performance evaluation. MRM relatedly considers the return-risk ration of traders, which may allow a more rational bonus (compensation) system to be put in place. Should we pay higher compensation for traders with lower returns and lower risk exposures? 5 Regulation. Both the Bank for International Settlements (BIS) and financial authority currently regulate market risk through capital requirements; private Table 5.2 The Banking Book and Trading Book of Islamic Bank

Banking Book

Trading Book

Assets

Liabilities

Financing Other liquid assets Sukuk (long term) Commodities (long term) Foreign exchange (long term) Equities (long term) Derivatives in off-balance sheet (short term)

Capital Deposits Sukuk (short term) Commodities (short term) Foreign exchange (short term) Equities (short term) Derivatives in off-balance sheet (short term)

Market Risk 111 sector benchmarks are important, because it is possible that regulators will overprice some risks. MRM conducted by Islamic banks can be used to identify the potential misallocations of resources because of prudential regulation. As a result, in certain cases regulators may allow Islamic banks to use their own models (internal) to calculate their capital requirements. 5.6

Basel Accord and Market Risk

The Basel Accord of 1988 suffered from a major shortcoming, as it did not address the threat to the stability of banks and the financial system, which is posed by the trading book’s market risk. In 1994, the BIS started to release discussion papers dealing with the measurement and disclosure of market risks of financial institutions. Subsequently, in April 1995 the BIS issued a ‘Planned Supplement to the Capital Accord to Incorporate Market Risk’. In this paper the BIS lays down the rules for bank’s capital charges in respect of their market risks (in addition to their credit risks). They also issued guides for calculating banks’ capital charges based on Standardized Measurement Methods and Internal Model Approach, which are discussed in BIS (1995a, 1995b, 1996 and 2006). Based on ‘An Internal Model-based Approach to Market Risk Capital Requirement’ provided by BIS in 1995, banks can apply either the Standardized Measurement Method or the Use of Internal Models to measure market risk. The standardised approach uses a ‘building-block’ approach in which specific risk and the general market risk arising from debt and equity positions are calculated separately. That means financial instruments are grouped in blocks with different market risks (e.g., short-term, medium-term and long-term), and the risks are simply summed across the different classes. Short and long positions in the same issue may be reported on net basis. The process of calculating capital requirement for foreign exchange risk requires the bank to measure the net exposure in a single currency position and the risks inherent in a bank’s mix of long and short positions in different currencies. 5.6.1 Standardised  Measurement

The standardised approach requires the bank to calculate the minimum capital requirement for each of the market exposures. For example, the minimum capital requirement for benchmark rate risk is expressed in terms of two separately calculated charges; the specific risk associated with each security whether short or a long position, and the general market risk, which allows for offsetting long and short positions in different securities. Under specific capital charges, the charges depend on the level of external credit assessment on sukuk and other short-term instruments. Under general market risk, banks can choose a maturity method or duration method. The minimum capital standard for equities is also expressed in terms of two separately calculated charges; those are specific risk of holding a long or short position in an individual equity, and general market risk of holding a long or short position in

112 Economic Capital and Risk Management the market. Two sources of risk in equities are systematic and unsystematic risk. The capital charge for specific risk (systematic or market risk) will be 8%, unless the portfolio is both liquid and well diversified (unsystematic risk), in which case the charge will be 4%. The general market risk charge also will be 8%. The process of calculating capital requirement for foreign exchange risk requires the bank to measure two things; those are the net exposure in a single currency position and the risks inherent in a bank’s mix of long and short positions in different currencies. Under the portfolio of foreign currency position, banks are free to choose between shorthand methods which treat all currency equally and the use of internal models which take account of the actual degree of risk dependent on the composition of the bank’s portfolio. The capital charges would be 8% times the maximum absolute value of the aggregate long or short positions. For the bank, there are two ways for measuring commodities position risk; those are simplified approach and maturity ladder approach. For both methods, long and short position in each commodity may be reported on a net basis for the purposes of calculating open positions. However, positions in different commodities will not be offset-able in this manner. Then, the net position in each commodity will be converted at current spot rates into the national currency. Second, in order to capture forward gap and benchmark rate within a time-band, matched long and short positions in each time-band will carry a capital charge. In the end, a bank will have either only long or only short positions, to which a capital charge of 15% will apply. Under simplified approach, calculation of capital charge for risk is similar to maturity ladder approach. The capital charge will be equal to 15% of the net position, long or short, in each commodity. As the bank uses portfolio strategies involving forward and derivative contract, they are exposed to variety of additional risks such as basis risk, benchmark rate risks and forward gap risk. Thus, to protect the bank against these risks, the capital charge for each commodity will be subject to an additional capital charge equivalent to 3% of the bank’s gross positions, long plus short in that commodity. 5.7

Measuring Market Risk Exposure

Banks have flexibility in applying the precise nature of their models, but the following minimum standards will apply for calculating their capital charge. Individual banks or their supervisory authorities will have the discretion to apply stricter standards. 5.7.1 Variance-Covariance  Approach  (The  Risk-Metric™  Model)

Variance-covariance can be defined as the product of the market value of position exposures and the standard deviation of price changes (σ). This approach involves standard statistical measures based on the normal distribution curve. It calculates from historical time series the variance of price and return, and covariance with other asset prices such as exchange and benchmark rate within and between the

Market Risk 113 Position exposures

Volatilities - × 2.33 = 99%

Correlations

= VaR

Figure 5.1 The Variance-Covariance Method

markets. The combination of the price/rate sensitivities of the individual positions is combined with the variance/covariance matrix of price/return/rate volatilities and correlations. This outcome is an estimate for likely expected losses. Here, concentrate on measuring the market risk exposure daily using the RiskMetrics approach. Measuring the risk exposure for periods longer than a day (e.g., ten days) is under certain assumptions, that is, based on a simple transformation of the daily risk exposure number. Rather than using mathematical/statistical notation, variance-covariance can be explained as follows. The bank is concerned about the potential losses it may incur if there is an adverse movement in market conditions the following day that is: Market risk = Estimated potential loss under adverse circumstances More specifically, the market risk is measured in terms of the bank’s daily earning at risk (DEAR). Daily earning at risk = (Dollar market value of the position) × (Price sensitivity of the position) × (Potential adverse movement in return)

(5.1)

Equation (5.1) has three main components: market value of the position, price sensitivity of position and potential adverse movement in return. The last two terms on the right-hand side of equation (5.1) measure the degree of price volatility of an asset; we can also re-write equation (5.1) as: Daily earning at risk = (Dollar market value of the position) × (Price volatility)

(5.2)

The measurement of price sensitivity and an adverse return movement depends on the bank and its choice of a price-sensitivity model. It also depends on what is exactly the potential adverse price (or return) movement. Note that DEAR is similar to value at risk.3 Thus, we can extend the variancecovariance approach for two-asset (portfolio). Consider banks have portfolios consisting of $10 million of shares in firm A and $5 million of shares in firm B. Assume that the returns on the two assets (e.g., shares) have a bivariate normal distribution with a correlation of 0.3. According to standard results in statistics, if two variables, X and Y, have standard deviations equal to σX and σY with the

114 Economic Capital and Risk Management coefficient of correlation between them being equal to ρ, the standard deviation of X + Y is given by ˜ X +Y = ˜ X2 + ˜Y2 + 2°˜ X ˜Y

(5.3)

Example 1: Market Risk of Equity Market If X is equal to the change in the value of the position in firm A over a one-day period and Y is equal to the change in the value of the position in firm B over a one-day period, then we assume σX = $200,000 and σY = U$50,000. Therefore, the standard deviation of the change in the value of the portfolio consisting of both stocks over a one-day period is given as: 200, 0002 + 50, 0002 + 2× 0.3×200, 000×50, 000 = 220, 227 The mean change is assumed to be zero. Therefore, the change is normally distributed. Hence, the one-day VaR is 220,227 × 2.33 = $513,129 The 10-day 99% VaR is 10 times $220,227, that is, $1,622,657. As a general guideline, the position inputs used in the sensitivity approach are given in Table 5.3. Example 2: The market risk of Sukuk4 Consider that a bank has a $1-million market value position in sukuk murabahah of seven years to maturity with a face value of $1,631,483.5 Today’s return on these sukuks is 7.243% per annum. These sukuks are held as part of the trading portfolio. The bank manager wants to know the potential exposure the bank faces should benchmark rate movement against the bank as the result of an adverse or reasonably bad market movement the next day. How much the bank will lose depends on the sukuk’s price volatility. From the duration model, we know that: Daily price volatility (D) = Price sensitivity to a small change in return (MD) × Adverse daily return movement (R) (5.4)

Table 5.3 Position Inputs in Variance-Covariance Approach Position

Delta Equivalent

Benchmark Rate Position Foreign Exchange, Equity and Commodity Swap

Dollar Value per Basis Point Change in Rate Dollar Value of the Position Dollar Value Adjusted for Swap Delta Plus Gamma Expressed as a Change in Delta

Market Risk 115 The modified duration (MD) of this sukuk is given as:6 MD =

D 7 = = 6.527 1+ R 1.07243

(5.5)

Given that the return on the sukuk is 7.243%. To estimate the price volatility (as in DEAR), we multiply the sukuk’s MD by the expected adverse daily return movement. Suppose that there is only a 5% chance that the return changes will exceed this amount in either direction or if we are concerned only with bad outcomes, and we are holding a long position in sukuks, there is 1 chance in 20 events (or a 5% chance) that the next day’s return increase (or shock) will exceed this given adverse movement. If the return changes are assumed normally distributed, 90% of the area under the normal distribution is to be found within ±1.65 standard deviations (σ) from the mean (that is 1.65σ), and 10% of the area under the normal distribution is found beyond ±1.65σ (5% under each tail, –1.65σ and +1.65σ, respectively). Suppose that during the last year the mean change in daily returns on seven years murabahah sukuk was 0%, while the standard deviation (volatility) was 10 basis points (or 0.001). Thus, 1.65σ is 16.5 basis points (bp). In other words, over the last year daily returns on seven years, murabahah sukuk have fluctuated (either positively or negatively) by more than 16.5bp 10% of the time. Adverse movements in returns are those that decrease the value of the security (i.e., the return increases). These occur 5% of the time or 1 in 20 days. Strictly speaking, only a 5% chance that seven-year rates will the movement up by more than 16.5 basis points (bp) a day. Based on the above information, the potential daily price volatility on sevenyear sukuks is given as: Price volatility = (MD) × (potential adverse movement in return) = (6.527) × (0.00165) = 0.01077 or 1.077% Given the market value position and daily price volatility of the seven-year sukuk portfolio, we can calculate daily earning at risk (DEAR): Daily earning at risk = (Dollar market value of position) × (price volatility) = $1,000,000) × (0.01077) = $10,770 The calculation of potential loss can be extended over 2, 3, . . ., N days. Note that, daily earning at risk (DEAR) is similar to value at risk, and the extension of VaR over N is similar to the following explanation. If we assume that return shocks are independent, daily volatility is approximately constant, and the bank holds this asset for N number of days, then the N-day market value at risk (VaR) is related to daily earnings at risk (DEAR), which is given by: VaR = DEAR× N

(5.6)

116 Economic Capital and Risk Management Equation (5.6) shows that the earnings the bank has at risk, should returns movement against the bank, are a function of the value or earnings at risk for one-day (DEAR) and the (square root of the) number of days that the bank is forced to hold the sukuk because of illiquid market. Specifically, DEAR assumes that the bank can sell all the sukuk tomorrow, even at the new lower price. It may take many days for the bank to unload its position. This relative illiquidity of a market exposes the bank to magnified losses (measured by the square root of N). If N is five days, then: VaR = $10, 770× 5 = $24, 082 If N is 10 days, then: VaR = $10, 770× 10 = $34, 057 In the above example, the price sensitivity is estimated using modified duration. However, the Risk-Metrics model prefers using the present value of cash flow changes as the price-sensitivity weights over modified durations. If we use the direct cash flow calculation, the loss would be $10,771.2.7 Example 3: Market Risk of Foreign Exchange (Dollar US$ versus Ringgit RM) From equation (5.2), suppose the bank has a $ 263,157.9 trading position in spot US dollar at the close of business on a day. The bank wants to calculate the daily earnings at risk (DEAR) from this position. The first step is to calculate the ringgit market value of the position: Ringgit equivalent = (FX position) × ($/RM spot exchange) value of position = ($ 263,157.9) × (RM per unit of foreign currency) (5.7) If the exchange rate is $ 0.263159/RM 1 or RM 3.8/$ 1 at the daily close, then Ringgit market value of position = ($ 263,157.9) × (RM 3.8) = RM 1 million Suppose that, during the last year, the standard deviation (volatility),8 σ, of daily changes in the spot exchange rate was 56.5 bp. However, suppose that the bank is interested in bad movements that will not occur more than 5% of the time, or 1 day in every 20. In other words, if changes in the exchange rate are normally distributed, the exchange rate must change in adverse direction by 1.65σ (1.65 × 56.5 bp). This change is to be viewed as likely to occur only 1 day in every 20 days. Foreign exchange volatility = 1.65 × 56.5 bp = 93.2 bp or 0.932%

Market Risk 117 We can say that during the last year, the US dollar declined in value against the Ringgit by 93.2 bp or 0.932% of a time. Consequently, one-day VaR is: DEAR = (Ringgit value of position) × (FX volatility) = (RM 1 million) × (0.00932) = RM9,320 This is the potential earnings exposure to adverse US dollar to ringgit exchange rate changes for the bank from the $263,157.9 spot currency holdings. Example 4: Market Risk in Equities The application of Capital Asset Pricing Model (CAPM) on equity can be shown as follows. Suppose the bank holds a $1-million trading position in stock. Then β=1 and the DEAR for equities is given as: DEAR = (Dollar value of position) × (Stock market return volatility) = ($1,000,000) × (1.65σm )

(5.8)

If, over the last year, the σm of the daily returns on the stock market index was 2%, then 1.65σm = 3.3% (i.e., the adverse change or decline in daily return on the stock market exceeded 3.3% only 5% of the time). Thus, one-day VaR is given as: DEAR = ($1,000,000) × (0.033) = ($33,000) That is, the bank is going to lose at least $33,000 in earning if adverse stock market returns materialise tomorrow.9 Portfolio aggregation from all portfolios (sukuks, foreign exchange and equity) is not simply the sum of all DEAR ($10,770 + $9,320 + $33,000 = $53,090). It requires banks to estimate correlation among these positions because negative correlation among asset shock can reduce the degree of portfolio risk. If given the correlation matrix along with the individual asset (DEARs), we can calculate the risk or standard deviation of the three assets using this equation: 2  2 2 ( DEARSK ) + ( DEARFX ) + ( DEAREQ )      + ×r ×DEAR 2 ×DEAR ( )   SK ,FX SK K FX DEAR portfolio =   + 2 × r  SK ,EQ ×DEARSK ×DEAREQ )  (    + ( 2 × r  EQ,FX ×DEAREQ ×DEARFX X)  

1

2

(5.9)

118 Economic Capital and Risk Management where subscript SK, FX and EQ denote sukuk, foreign exchange and equity, respectively. The correlation between two assets is characterised by ρ. If we assume that ρSK,FX = −0.2, ρ BD,EQ = 0.4 and ρEQ,FX = 0.1, then DEAR portfolio is equal to RM 39,969. 5.7.2 Historical  Simulation  Approach

There are two types of historical simulation approaches. They are sensitivity analysis of profit and loss (P&L) and full revaluation analysis of P&L.10 However, the central focus of this study is the sensitivity analysis. In this approach, the historical data of price and return (i.e., the last two years) are used to compute the changes in the value of the trading book (mark-to-market) that would have materialised on the position held during the period. This approach calculates the hypothetical value change in the current portfolio based on actual historical movements in prices, returns and correlations (risk factor). The confidence level determines the value at risk. Historical simulation does not require the assumption of a normal distribution of changes in prices, benchmark rate and exchange rates as in the variance-covariance model. The only thing that matters is the market prices of those assets over a sufficient long historic time period. The current market portfolio of assets (foreign exchange, sukuk and equities) is revalued based on the actual historical movement in prices (return) that existed on those assets yesterday, the day before that and so on. The bank will calculate the market or value risk of its current portfolio based on prices (returns) that exist for those assets on each of the last 500 days. Then, it will calculate the 5% worst case (the 25th lowest value out of 500). That is, on only 25 days out of 500, or 5% of the time, would the value of the portfolio fall below this number based on recent historic experience of exchange rate changes, equity price changes, benchmark rate changes and commodity price changes. Consider the following example to calculate the VaR, where an Islamic bank is trading two currencies that are US dollars and pound sterling (can be more than two). At the close day of trading on July 24, 2017, it had a long position in US dollars of 500,000,000 and a long position in pound sterling of 20,000,000. The assessment of VaR implies that if tomorrow is that one bad day in 20 (the 5% worst case), how much does it stand to lose on its total foreign currency? There are six steps to calculate the VaR of its currency portfolio. It should be noted that the same methodological approach can be followed to calculate the VaR of any asset, liability or derivative. • Step 1: Measuring exposure. Convert today’s foreign currency position into ringgit equivalents using today’s exchange rate to find the long position of the ringgit in foreign currency. Assume that the exchange rates are $0.2877/RM1 or RM3.4760/$1 and £0.1627/RM1 or RM6.1475/£1. Step1: Measure Exposures

US Dollar

Pound Sterling

Closing position on July 24, 2017 Exchange rate on July 24, 2017 Ringgit equivalent position on Jul 24, 2017

500,000,000 $0.2333/RM1 2,143,017,259

20,000,000 £0.1795/RM1 111,392,891

Market Risk 119 • Step 2: Measuring sensitivity. Measure the sensitivity of each foreign exchange (FX) position by calculating its delta, where delta measures the change in ringgit value of each FX position if the US dollar or the pound sterling depreciates (decrease in value) by 1% against ringgit (assumed to be the same across all assets and across time-period or day).11 Step 2: Measure Sensitivity

US Dollar

Pound Sterling

1.01 × current exchange rate Revalued position in RM Delta of position (RMs) (measure of sensitivity to a 1% adverse change in exchange rate)

$0.2356 2,122,241,086 −20,776,173

£0.1813 110,314,396 −1,078,494

• Step 3: Measuring risk. Look at the actual percentage changes in exchange rates, US$/RM and £/RM, on each of the past 500 days. Thus, on July 31, 2017, let us say the US dollar declined in value against the RM by 0.4649%, while the pound sterling declined in value against the RM by 1.0711%. (It might be noted that if the currencies were to appreciate against the ringgit, the sign against the number in change in the exchange rate would be negative as it takes fewer units of foreign currency to buy a ringgit than it did the day before.) Step 3: Measuring risk of July 31, 2017, closing position using exchange rates that existed on each of last 500 days.

US Dollar

Pound Sterling

Change in exchange rate (%), July 31, 2017 Risk (delta × change in exchange rate), July 31, 2017 Sum of risks (US$ and pound sterling), July 30, 2017

−0.4649% −7,999,842 −6,696,259

1.0711% 1,303,583

• Step 4: Repeat Step 3 – Step 4 repeats the same exercise for the US dollar and pound sterling positions but uses actual exchange rate changes on July 28, 2017; September 27, 2008 (as 29 and 30 July are weekend); and so on. That is, we calculate the FX losses and/or gains (P&L) on each of the past 500 trading days, excluding weekends and holidays, when the FX market is closed. This amounts to going back in time over two years. These two numbers are summed to attain total risk measures for each of the past 500 days. Step 4: Repeat Step 3 for each of the remaining 499 days

US Dollar

Pound Sterling

July 28, 2017 July 27, 2017 : July 18, 2017 : January 29, 2017 : May 1, 2016 (last day of remaining 499 days)

−4,260,434 −4,024,474 : 751,732 : 466,888 : −467,840

648,317 749,481 : −148,277 : 729,328 : 95,6616

120

Economic Capital and Risk Management

• Step 5: Rank days by risk from worst to best. These risk measures can then be ranked from worst to best. Clearly, the worst-case loss would have occurred in this position on December 1, 2016, with a total loss of RM 31,274,413. However, we are interested in the 5% worst case, that is, a loss that does not occur more than 25 days out of the 500 days (25/500 = 5%). As can be seen, the 25th worst loss out of 500 occurred on November 15, 2016. This loss amounted to RM 9,850,164. Step 5: Rank days by risk from worst to best

US Dollar + Pound

Date 1. Dec 1, 2016 2. July 27, 2016 3. Sept 14, 2016 : 5. Oct 10, 2016 25. Nov 15, 2016 : 56. Sept 30, 2016 : 499. Sept 8, 2016 500. Sept 22, 2016

Risk (RM) −RM 31,274,413 −RM 18,136,448 −RM 17,789,523 : −RM 15,679,520 : −RM 9,850,164 : −RM 6,696,259 : + RM 18,554,228 + RM 21,699,072

• Step 6: VaR (25th worst day out of last 500). The RM 9,850,164 can be viewed as the FX value at risk (VaR) exposure of the bank on November 15, 2016, if it is assumed that the recent past distribution of exchange rates is an accurate reflection of the likely distribution of FX rate changes in the future. That is, if tomorrow (in our case, November 16, 2016) is a bad day in the FX markets and given the bank’s position of long $500 million and long pound sterling 20 million, the bank can expect to lose RM9,850,164 (or more) with a 5% probability. For a more accurate result, we can estimate the 5% VaR based on 1,000 past daily observations (the 50th worst case) or even 10,000 past observations (the 500th worst case). This VaR measure can be updated every day as the foreign exchange position changes and the delta changes. Some banks may choose 99% VaR or 1% worst case, that is, a loss that does not occur more than 5 days out of the 500 days. In our case, the VaR for the fifth worst day out of the last 500 is RM15,679,520 Unlike the variance-covariance approach, the historic simulation sensitivity approach can produce VaR results that fully account for option convexity (gamma). From step 3 above, we know that: VaR ≡ Delta × (Pt – Pt−1)

(5.10)

where delta measure sensitivity to a unit change in price/rate and (Pt – Pt−1) is a historic change in price/rate. The sensitivity P&L with gamma adjustment can be written as:

Market Risk 121 VaR ≡ Delta × (Pt – Pt−1) + ½ Gammai (Pt – Pt−1)2

(5.11)

where the first term of the right-hand side in equation (5.10) multiplies the position by the change in price/rate. This calculates the P&L of the positions for the delta risk only. For assets that are not sensitive to benchmark rate and are not linked to derivatives, the VaR refers to total P&L. In equation (5.11), the third term of the right-hand side represents an adjustment for convexity or gamma effect which can be either added or deleted. If the portfolio is comprised of net long derivatives and benchmark rate sensitive assets, this term may have the potential to either decrease or enhance the profit and consequently the level of risk. When the portfolio has a net short position in benchmark rate sensitive positions and derivatives, the second term increases the loss or reduces the gain, and hence increasing the level of risk. 5.7.3 Monte-Carlo  Simulation  Approach12

The Monte-Carlo simulation methodology has several similarities to the historical simulation approach. A pseudo-random number generator is used to generate thousands or perhaps ten thousand of the hypothetical changes in the market factors. The value at risk is then determined from those distributions. This approach tests the value of the portfolio assuming a large sample of randomly selected price, rate and correlation combinations whose probabilities are based on historical experience. Monte Carlo simulations are suitable especially for measuring the risk of options with their non-linear price relationships. Similar to the historical simulation approach, this approach can be analysed either by sensitivity analysis of profit and loss (P&L) or by full revaluation analysis of profit and loss (P&L). In this approach, the Monte-Carlo simulation method is utilised to generate new observations when the number of actual observations is limited. The generated observations are structured based on the returns that have occurred in previous historical time-periods. Under a single instrument portfolio, there are few steps to be followed to produce VaR: First is to identify the basic market factors and obtain a formula expressing the mark-to-market value of instruments (i.e., forward contract) in terms of the market factors (refer to the discussion on market factors). Second is to determine or assume a specific distribution (i.e., multivariate normal or any relevant other form) for changes in the basic market factors, and to estimate the parameters of that distribution. The ability to pick the distribution is the feature that distinguishes Monte Carlo simulation from the other two approaches, unlike the other two approaches where the distribution of changes in market components is specified as part of the method. Third is to use a pseudo-random generator to generate N hypothetical values of changes in the market factors, where N is almost certainly greater than 1,000 and perhaps greater than 10,000 (S&P index). These hypothetical market factors are then used to calculate N hypothetical mark-to-market portfolio values.

122

Economic Capital and Risk Management

Finally, the market-to-market profit and loss (P&L) are ordered from the largest profit to the largest loss (or vice versa) and the value at risk is the loss, which equals or exceeds 5% of the time (i.e., 500th worst simulated loss out of 10,000). In general, suppose that a bank needs to generate scenarios for an asset whose returns are distributed normally with a mean of μ and a standard deviation of σ2. The simulation requires a random-number generator that draws from a normal distribution with a mean of zero and a standard deviation of one. Denote these N(0,1) draws by z1, z2, . . . ., zNSIM. The NSIM scenarios are, hence, μ + σz1, μ + σz2, . . ., μ + σzNSIM. Since we use continuously compounded returns, the index’s simulated value for a given random normal draw zi is denoted Sn+1,i and can be expressed as: Sn+1,1 = Sn *exp{µ + ° * zi }

(5.12)

For each parameter in equation (5.12), we revalue the entire derivative portfolio. Next, we order the simulated value of NSIM and pick the (1−X/100)×NSIM th value as the X% of VaR. We can extend the Monte Carlo approach to the more relevant case facing realworld risk managers in banking institutions, that is, the case of multiple assets with multiple risk exposures. The extension is conceptually straightforward, although some technical issues arise. Briefly, for K risk factors and NSIM simulations, we need to generate K×NSIM independent variables distributed as N(0,1). These can be stacked as NSIM vectors of size K. Each such vector is distributed as multivariate normal with a mean vector, which is a K×1 vector of zeros, and a variance-covariance matrix, which is an identity matrix of size K×K. Similar to the one-dimensional single factor case, we generate NSIM scenarios for K underlying factors, which are given as: Ln( Sn+1 Sn ) = exp {µ+ A′ ∗ Z n }

(5.13)

where Ln(Sn+1/Sn) is a K×1 vector lognormal returns; μ is a K*1 vector of mean returns; Zn is a K×1 vector of N(0,1)’s; and A′ is the Cholesky decomposition of the factor return covariance matrix ∑, that is, A′A = ∑. 5.8 Volatility Forecasting An important part of the above discussion is to estimate or forecast the volatility of price/rate of return in portfolios. Because VaR is a function of volatility forecasts. Note that daily VaRs of the banks and their internal VaR models are not publicly available information. There are many models used to estimate standard deviations and correlations. These are often referred to as volatility models. The models range from extreme value techniques, two-step regression analysis, to more complicated non-linear modelling, such as GARCH (Generalized Auto Regressive Conditional Heteroscedasticity) and stochastic volatility (SV). Among the researchers, GARCH-type models have gained the most attention due to the evidence that time series realisation of returns often exhibits time-dependent volatility. This idea was

Market Risk 123 first formalised in Engle’s (1982) ARCH model, which is based on the specification of conditional densities at successive periods of time with a time-dependent volatility process. VaR can be interpreted as a function of volatility forecasts. VaR is an estimate of the amount that could be lost on a portfolio of assets. Consider a portfolio of assets whose returns follow a normal distribution. VaR of the portfolio can be expressed as:

{

}

VaR = MV p ⋅ min E ( R p ) − k ⋅ s p , 0

(5.14)

where MVp is the market value of the portfolio, E(Rp) is the expected portfolio return, k stands for the critical value of confidence level, and σp is the volatility forecast of the portfolio return. Equation (5.14) ensures that VaR is a measure of the expected maximum trading loss of the portfolio. The size of the expected maximum trading loss depends on E(Rp), k, and σp. For simplicity, Islamic banks may estimate daily VaRs by assuming daily E(Rp) equal to zero. In this case, daily VaRs can be written as: VaR = MV p ⋅ k ⋅ s p

(5.15)

This is similar to equation (5.2) and footnote 3 of this chapter. Both these equations show that VaR is positively related to forecasted volatility (σp). A larger forecasted volatility results in not only larger VaRs but also more capital charges imposed by central banks. In most circumstances, no Islamic bank wants to have a higher capital requirement. An increase in capital charge will result in an increase of equityasset ratio. As equity tends to have higher required rate of return than debt or other sources of capital, the average cost of capital of Islamic bank will rise. This may result in low profitability of Islamic bank in terms of return on equity (ROE) and exert downward pressure on the Islamic bank’s stock prices. Forecasted VaRs can include simulation-based (non-parametric) approach and parametric approach. These approaches require some inputs of forecasted volatility. Previous studies such as Brooks (1998) and Taylor (1999) forecast volatility by using different time series models. They find that GARCH-type models tend to have better performance in forecasting volatility than other time series models. The generic GARCH model posits a volatility estimator that depends on both lagged value of squared returns and lagged volatility estimates. GARCH (1,1) model was proposed by Bollerslev (1986). The equation for GARCH (1,1) is given as: 2 2 ˜n2 = °VL + ˛µn−1 + ˙˜n−1

(5.16)

where γ is the weight assigned to VL (long-run average variance rate), α is the 2 2 weight assigned to µn−1 , and β is the weight assigned to sn− 1 . Since the weighs must sum to one, hence γ + α + β = 1.

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The ‘(1,1)’ in GARCH (1,1) indicates that sn2 is based on the most recent observation of u2 and the most recent estimate of the variance rate. The more general GARCH (p,q) model calculates sn2 from the recent p observations on u2 and the most recent q estimates of the variance rate. GARCH (1,1) is by far the most popular of the GARCH models. Setting ω = γVL, we can also rewrite the GARCH (1,1) model as: 2 ˜n2 = ° + ˛µn2−1 + ˙˜n−1

(5.17)

This is the form of the model that is usually used for the purposes of estimating the parameters. Once ω, α and β have been estimated, we can calculate γ as 1 – α – β. The long-term variance VL can then be calculated as ω/γ. For the stable GARCH (1,1) process, we require α + β < 1. Otherwise, the weight applied to the long-term variance is negative. Further, we can use GARCH (1,1) to forecast future volatility. The variance rate estimated at the end of day n – 1 for day n is written as: 2 2 ˜n2 = (1− ° − ˛)VL + °µn−1 + ˛˜n−1

(5.18)

Equation (5.18) can be written as: 2 2 ˜n2 −VL = °(µn−1 −VL ) + ˝(˜n−1 −VL )

(5.19)

At day n + t, equation (5.19) can be rewritten as: ˜n2+t −VL = °(µn2+t −1 −VL ) + ˝(˜n2+t −1 −VL )

(5.20)

2 2 The expected value of un+ 1−1 is s n +t −1 . Hence, equation (5.20) can be rearranged as:

E ˜n2+t −VL  = (° + ˛)E ˜n2+t −1 −VL     

(5.21)

where E denotes expected value. The expected sign operator on the right-hand side of equation (5.21) can be eliminated; hence, equation (5.21) can be re-expressed as: E [˜n2+t −VL ] = (° + ˛) L (˜n2 −VL )

(5.22)

E [˜n2+t ] = VL + (° + ˛) L [˜n2 −VL ]

(5.23)

or

Equation (5.23) can be used to forecast the volatility on day n + t using the information available at the end of day n – 1.

Market Risk 125 Table 5.4 Estimation Results of GARCH (1,1) Model Parameters

Coefficient

t-Statistics

Constant ω α β

0.6508E-02 0.6444E-02 0.0377 0.9578

0.3045 3.1661 8.4639 169.1980

Example 1: Asymmetric Variations of GARCH Models An empirical observation will be done to look at the impact of negative price moves on future volatility. The future volatility is different from that of positive price moves. This is particularly true in equity markets. Here, we will produce an example that happens on the changes in volatility during the financial crisis in 2008. Consider the situation that occurred in equity markets. The data for the end of September and beginning of October of 2008 show that the volatility reacted asymmetrically to up and down stock market moves. The returns for the S&P 500 during this period, which measure the weighted average of the implied volatility of short-term S&P 500 options (the Chicago Board Options Exchange (CBOE) Volatility Index (VI)) as a proxy for market expectations about future volatility), show that the market declined sharply, like on 9/29, 10/2, 10/6, 10/9 and 10/15, when the market dropped 8.8%, 4.0%, 5.7%, 7.6% and 9.0%, and the VI rose on each of those days. However, on 10/13, when the market rose 11.6%, which was the largest percentage rise in the stock market since 1933, the VI fell 21.4%, from 69.95 to 54.99. Even on small down days in the market, like 10/1, 10/8, 10/14 and 10/17, when the market dropped by less than 1.2% on each day, the VI rose each time. Example 2: GARCH (1,1) Estimation Using equation (5.17), for cocoa price futures from 1 month to 12 months, sampled daily between 4th January 2015 to 23rd December 2016, the results of GARCH (1,1) are given in Table 5.4. The coefficient α measures the intensity of reaction of volatility to yesterday’s 2 unexpected market return, un−1 , and the coefficient β the persistence in volatility. The results show that the price movement has low reaction and high persistence. It reflects that all variables are very highly correlated. 5.9

Market Factors, Market Risk and Stress Testing

To compute VaR, another input that we need to identify is the basic market rates and prices that affect the value of the portfolio. These basic market rates and prices

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are the ‘market factors’ and are inherent in instruments such as forward contracts, swaps, financing (often with embedded options) and option. Consider the foreign exchange forward contract as an example. The current date is 1 August 2017. The contract requires the Malaysian company to deliver RM15 million in 91 days, and in exchange, it will receive US$10 million. The current ringgit market value of this forward depends on three basic market factors: spot exchange rate expressed in ringgit per dollar (S), the three-month dollar profit margin rate (mUS$) and three-month ringgit profit margin rate (mRM). The cash flows of the forward contract are decomposed into the following equivalent portfolio of profit rate swap. The decomposition returns for the current mark-to-market value (in ringgit) of the position in terms of the basic market factors mUS$, mRM and S are given by the following formula: RM mark-to-market = S ×

i US$ 10 million RM 15 million − 1 + mUS $ (91/360) 1 + mRM (91/360)

(5.24)

In some cases, formula is not available, and instruments’ values must be computed by numerical algorithms. Once such formulas have been obtained, a key part of the problem of quantifying market risk is settled. The remaining steps involve determining or estimating the statistical distribution of the potential future values of the market factors. Thus, we know that measurement of these potential changes in the portfolio’s value is known as value at risk. As mentioned before, the Basel Committee requires market risk measurement based on VaR approach is accompanied by a ‘rigorous and comprehensive’ stress testing programme. Because the VaR models use average historical correlation among asset prices to make statistical assessments, they have limited ability to capture the risks of exceptional circumstances (such as market events), especially those in which asset prices movement in ways that differ sharply from historical norms. Exceptional circumstances occur rarely, and statistical inference is imprecise without enough observations. Stress tests partially fill this gap, and thus complement VaR, by offering a quantitative picture of the exposure associated with a possible extreme event.13 Table 5.5 Cash Flows of Islamic Profit Rate Swap Position Long position in 91-day US$denominated profit rate swap with principal value of US$10 million Short position in 91-day ringgitdenominated profit rate swap with principal value of RM 15 million

Current RM Value of Position

S× −

US $10 million 1+ mUSD (91 360)

RM15 million 1+ mRM (91 360)

Cash Flow on Delivery Date Receive US$10 million Pay RM15 million

Market Risk 127 The asset classes used to classify the scenarios are commodities, equities, foreign exchange rates and financing (including liquidity). Stress tests are designed to answer such questions as ‘If the stock market falls 20%, how much will the value of Islamic bank’s portfolio of sukuk, financing and profit rate swap change?’ or ‘If the central bank increases benchmark rate 100 basis points, how much will the value of Islamic bank’s portfolio rise or fall?’ Stress testing involves estimating how the portfolio would have performed under extreme market movements (large market shock).14 These extreme market movements typically have a very low (virtually zero) probability under most VaR models, but they do happen from time to time. A five-standard deviation daily movement in a market variable is one such extreme event. Under the assumption of normal distribution, it happens about once every 7,000 years, but, in practice, it is not uncommon to see a 5-standard deviation daily movement once or twice every ten years. The concept of stress testing is based on the notion that the value of portfolio depends on market risk factors (risk factor). Let us call the risk factors with an impact on the portfolio r1,r2, . . ., rn and the function determining the value of the portfolio when the values of all risk factors are given, P, the value of the risk factors r1,r2, . . ., rn characterises the market situation as far as it is of relevance to the portfolio. The risk factors may be combined into one single vector r:=(r1,r2, . . ., rn) describing the market situation. In a market situation r, the value of the portfolio is P(r). Below, rMM will stand for the vector representing the current values of the risk factors, that is, the current market situation. If ‘MM’ stands for the ‘current market situation’, P(rMM) represents the current value of the portfolio. The choice of risk factors depends on the portfolio. Not all portfolios are influenced by the same risk factors. The number of risk factors must be chosen so as to include all parameters likely to have an impact on the value of the portfolio. However, one may decide to use an even larger number, which may be wise as it allows the user to restructure his portfolio later without having to add more risk factors. The procedure for selecting risk factors is not clearly defined. The value of the portfolio may be understood as the function of several sets of risk factors. For example, where interest is connected, discount factors or benchmark rates may be chosen as risk factors. The function P depends on the portfolio and thus a different portfolio has a different function. P is frequently not an explicit function of the risk factor. Explaining in this manner, stress tests answer the question of ‘What would happen if a market situation r suddenly occurred?’ the scenario in this case is the sudden emergence of a market situation r. Therefore, scenarios may be identified with market situations and represented by vector r. It represents the possible future market situation. For stress testing, scenarios r1, . . ., rk are selected according to specific criteria and calculations are made to determine the value of the current portfolio under these scenarios. These portfolio values are represented by P(r1), . . ., P(rk). By comparing them with the current value of the portfolio (rMM), one can assess the losses that would be incurred if the market suddenly movements from rMM to r1, . . ., rk without allowing a chance for rebalancing the portfolio.

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Stress tests more often involve making changes to several market variables. A common practice is to use historical scenarios. For example, to test the impact of an extreme movement in US equity prices, a bank might set the percentage changes in all market variables equal to those on 19 October 1987 (Black Monday 1987, when the S&P 500 moved by 22.3 standard deviation). If this is considered too extreme, the bank might choose 8 January 1988 (when the S&P 500 moved by 6.8 standard deviations). The stress tests are applicable to the 1997 East Asian crisis, the sukuk default in 2009 and the ERM crises of 1992–1993. The common approach in stress testing is to choose past events that are known to be periods of financial market volatility as the relevant stress tests. This approach could be problematic since it might miss the true relevant risk sources that may be specific to an Islamic bank. An alternative approach is an approach based on the same intuition of historical simulation. The idea is to let the data decide which scenarios fit the definition ‘extreme stress’. Formally, the two most common types of stress tests are sensitivity stress tests and stress test scenarios. A sensitivity stress test measures the impact on a portfolio’s value of a large change in an asset price or in a small number of tightly linked asset prices. A stress test scenario measures the effect on an Islamic bank’s portfolio of simultaneous extreme movements in several different asset prices such as equity prices, exchange rates, benchmark rate and benchmark rate spreads. The other stress test is contagion analysis, which seeks to take account of the transmission of shocks from individual exposures to the system. 5.10

Capital Requirement for Market Risk

5.10.1 Implementing  VaR  into  Capital  Requirement  for  Market  Risk

This chapter discusses that market risk significantly influences Islamic banks’line of business. Specifically, adverse movement in price and rates affects the trading book positions of an Islamic bank. To cover potential losses resulting from the Islamic bank’s asset risk profile exposure, they must fulfil the capital adequacy requirement. The concept of capital adequacy relates the riskiness of an Islamic bank to the amount of capital, with minimum capital standard being the minimum permissible amount of capital. In this perspective, risk-based capital standard is used to replace depositor pressures to limit bank risk-taking behaviour. On the other hand, regulators would ask an Islamic bank to increase its capitalisation as the Islamic bank’s operations become riskier. Internally, Islamic banks would use the value at risk to capture the risk exposure inherent in their portfolios. Capturing these risk exposures enables the Islamic bank to calculate capital charges and thus provide capital as a buffer to absorb the unexpected losses due to market risk. From the previous discussion, we know that a market VaR model can be used to calculate the Islamic bank’s daily earning at risk (DEAR) for adverse changes in benchmark rates, exchange rates, equity returns and commodity prices. However, certain conditions are imposed on the Islamic bank’s internal model to ensure that the risk estimates are adequate for the purposes of setting minimum capital

Market Risk 129 requirements. First, the stipulated VaR model is set at the 99th percentile rather than the 95th percentile (multiply σ by 2.33 rather than by 1.65 as under RiskMetrics). Thus, this will increase the estimated precision of the DEAR. Moreover, the minimum holding period is set to be two weeks (ten business days), thus requiring the Islamic bank to multiply the DEAR estimate by 10 . The VaR measure used for market risk is the loss on the trading book that can be expected to occur over a ten-day period 1% of the time. For example, if the VaR is $1 million, the Islamic bank is 99% confident that there will not be a loss greater than $1 million over the next ten days. The market risk capital requirement (MRC) for Islamic banks when they use the internal model-based approach is calculated at any time as: MRC = k × VaR + SRC

(5.24)

where k is a multiplicative factor, and SRC is a specific risk charge. The value at risk is the greater of the previous day’s value at risk and the average value at risk over the last 60 days. The minimum value for k as suggested by the Basel Committee is 3. Higher values may be chosen by regulators for a particular Islamic bank if tests reveal inadequacies in the Islamic bank’s value at risk model. Similarly, we can rewrite equation (5.24) as: 1 MRCmt = Smt × max   60

60

∑ VAR i=1

mt−i

 (10,1),VaR mt (10,1) + SR mt 

(5.25)

where MRCmt is market risk capital requirement at time t, and it is based on a mul1 tiple of the larger of VaRmt (10,1) or the average of {VaR mt (10,1)}tt− = t −60 }. The figures of 10 and 1 in bracket denote 10-day holding period and 99% coverage (α=1), respectively. The Smt and SRmt are a regulatory multiplication factor (or denoted by k) and an additional capital charge for portfolio’s specific risk (or denoted by SRC), respectively. In the following discussion, we will be looking at several parameters, that is, k factor, back-testing framework and specific risk charge that may affect the capital charge for market risk. k factor – k depends on the number of times that daily trading losses exceed the corresponding VaR estimates over the last 250 trading days. The use of a multiplicative factor (k) increases the capital charge over the economic capital requirement obtained directly from the VaR model. The size of the multiplicative factor is used as a back-testing device to discipline Islamic banks that systematically underestimate their capital requirements under the so-called ‘traffic light’ system. In other words, Islamic banks systematically underestimate their capital requirements if the change in portfolio value exceeds the value at risk. Specifically, if the Islamic bank’s internal model underestimates market risk less than 4 days out of the past 250 days, then the Islamic bank receives a green light, and the multiplicative factor is set at 3. If the Islamic bank’s internal model underestimates market risk between

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4 and 9 days out of the last 250 days, then the Islamic bank receives a yellow light and the multiplicative factor is set above 3 (set at various increments above 3, but less than 4).15 In the event that the model underestimates market risk on ten days or more out of the last 250 days, it is given a red light and the multiplicative factor is raised to 4. The resulting increases in the Islamic bank’s cost of capital could be high enough to put the Islamic bank out of the trading business. Thus, the regulations offer Islamic banks the incentive to improve the accuracy of their internal model estimates of market risk. Back-testing framework – the plus factor must be added to the multiplicative factor as a penalty to the Islamic bank if back-testing reveals that the internal model incorrectly forecasts risks (see Table 5.6). The purpose of this factor is to give incentives to Islamic banks to improve the predictive accuracy of their models and to avoid overly optimistic projection of profits and losses due to model fitting. Since this penalty factor may depend on the quality of internal controls at the Islamic bank, this system is designed to reward truthful internal monitoring, as well as develop a sound risk-management system. This plus factor ranges from 0 to 1, and it depends on the number of days that Islamic bank underestimates (termed ‘exceptions’) their market risk, and it is shown in Table 5.6. If the back-testing result falls within 0 to 4, Islamic banks are not required to add plus-factor to the multiplication factor. If the results of the Islamic bank’s back-testing fall within 5 to 9 exceptions, Islamic banks are required to add a plus factor in accordance with Table 5.6 (yellow zone). Finally, if the Islamic bank’s back-testing results in ten or more exceptions, Islamic banks are required to add a plus factor of 1 to the multiplicative factor. Within the red zone of ten or more exceptions, the VaR model is deemed to be ‘inaccurate’ for regulatory purposes. Specific risk charge – The specific risk charge (SRC) is a capital charge for the idiosyncratic (specific) risks related to individual securities. For example, a security such as sukuk murabahah may give rise to idiosyncratic risks. There are two components to the risk of this security. They are benchmark rate risk and credit risk. The benchmark rate risk is captured by the Islamic bank’s market value at risk measure, while the credit risk is specific risk. Islamic banks may use internal

Table 5.6 Plus Factor in Back Testing Framework and Multiplicative Factor

Green Zone Yellow Zone Red Zone

Number of exception

Plus factor

Multiplier k

4 or less 5 6 7 8 9 10 or more

0.00 0.40 0.50 0.65 0.75 0.85 1.00

3 3.40 3.50 3.65 3.75 3.85 4.00

Source: www.apra.gov.au (2007)

Market Risk 131 models (discussed in the following section) for arriving at a capital charge for specific risk similarly to the way they calculate a capital charge for market risks.16 Table 5.6 shows the specific risk charge for equity at 4% and the specific risk charge for other benchmark rate-related instrument. Example: The internal model approach suggested by BIS set the minimum capital requirement to be the larger of: (1) the previous day’s VaR (i.e., DEAR × 10 ),17 or (2) the average daily VaR over the previous 60 days times a multiplicative factor of 3 (i.e., capital charge = average DEAR × 10 × 3). For example, suppose the portfolio DEAR was $10 million using the 1% worst case (for the 99th percentile). The minimum capital charge would be given as: Capital Charge = $10 million×( 10 ) × (3) = $94.86 million

(5.26)

As the Islamic bank is permitted to use two types of capital (Tier-1 and Tier-2), the $94.86 million can be raised by any of the two types of capital. Thus, if we know the average daily VaR over the previous 60 days, the multiplicative factor and specific risk charge (if it is considered as specific market risk), then we can calculate risk-weighted asset for market risk straightforwardly. Hence, if the capital charge is equal to $94.86 million, the risk-weighted asset for market risk is equal to $94.86 million × 12.5 = $1,185.75 million. 5.10.2 Standardised  Approach  into  Capital  Requirement  for  Market  Risk

The capital requirement for market risk can be calculated using the standardised approach. It is also known as the building block approach because financial instruments are grouped in blocks with different market risks (for instance, by maturity, such as short-term, medium-term and long-term, or by contract, such as salam, mudarabah and musharakah), and the risks are simply summed across different classes. As an internal approach, standardised approach considers that adverse movement of market price and rate will affect debt securities and equity in trading book and foreign exchange and commodity positions throughout the Islamic bank. Islamic banks are exposed to benchmark rate risk when they hold or take positions in debt securities and other benchmark rate-related instruments in the trading book. Under the standardised approach, the minimum capital requirement for benchmark rate risk is divided into two types of capital charges: general market risk and specific risk. General Market Risk

As for general market risk, Islamic banks can use maturity’ or duration method that estimates the price sensitivity of each security in the portfolio as a response to a benchmark rate shock expected to occur over a time horizon. Maturity Method – The capital charge for general market risk depends on the residual term to maturity or to the next re-pricing date. Table 5.7 shows the

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Table 5.7 Capital Charge for General Market Risk Residual Term to Maturity

RW (%)

Less than 1 month >1–3 months >3–6 months >6–9 months >1–2 years >2–3 years >3–4 years >4–5 years >5–7 years >7–10 years >10–15 years >15–20 years >20 years

0.00 0.20 0.40 0.70 1.25 1.75 2.25 2.75 3.25 3.75 4.50 5.25 6.00

Source: IFSB (2013) – Revised Capital Adequacy Standard for Institutions Offering Islamic Financial Services (Excluding Islamic Insurance (Takaful) Institutions and Islamic Collective Investment Schemes)

simplest way of the maturity method on the net positions in each time band. The risk weighted is given the highest percentage if the remaining maturity is longer. Duration Method – The market risk measurement proposal of IFSB requires Islamic banks to slot their long (Zone 3) and short (Zone 1) positions in securities and debt-related derivatives into a maturity ladder comprising 15 maturity bands as suggested in Table 5.8. Securities are classified according to time bands (columns 2 and 3) and the assumed change in expected yield (column 4). The price sensitivity of each security position (or called as weighted position) can be calculated based on the change in profits which is assumed in the range of 0.6 to 1 percentage points. The price depends on the maturity of the securities. Then, the figures are fitted into the duration method with 15-time bands as reported in Table 5.8. The next step involves a risk weighting procedure. The positions in the maturity bands are weighted by a factor that captures their price sensitivity to price or rate changes. The suggested weights have two components: 1 The duration of the security (column 4). Duration is the appropriate measure of the price sensitivity of security to benchmark rate changes. It depends, besides being primarily influenced by maturity, in an important way, on the coupon rate. For instance, zero-coupon or deep discount securities have much greater price volatility in response to benchmark rate changes than coupon securities. For this reason, each maturity band is broken down for securities with coupons above 3% and those below 3%, which consist of deep discount and zero-coupon securities. For the latter the rugs in the maturity ladder are, in general, narrower and the ladder itself is longer.

Market Risk 133 Table 5.8 Duration Method Based on Time Bands and Assumed Changes in Yield Zone

Time Band (Expected profit 3% or more)

Time Band (Expected profit 3% or less)

Duration Weight (A)

Assumed change in expected yields (%)(B)

Zone 1

Up to 1 month >1 to 3 months >3 to 6 months >6 to 12 months >1 to 2 years >2 to 3 years >3 to 4 years >4 to 5 years >5 to 7 years >7 to 10 years >10 to 15 years >15 to 20 years >Over 20 years

Up to 1 month >1 to 3 months >3 to 6 months >6 to 12 months >1.0 to 1.9 years >1.9 to 2.8 years >2.8 to 3.6 years >3.6 to 4.3 years >4.3 to 5.7 years >5.7 to 7.3 years >7.3 to 9.3 years >9.3 to 10.6 years >10.6 to 12 years >12 to 20 years >20 years

40% 40% 40% 40% 30% 30% 30% 30% 30% 30% 30% 30% 30% 30% 30%

1.00 1.00 1.00 1.00 0.90 0.80 0.75 0.75 0.70 0.65 0.60 0.60 0.60 0.60 0.60

Zone 2

Zone 3

Risk weight (A) × (B)

Source: IFSB (2013) – Revised Capital Adequacy Standard for Institutions Offering Islamic Financial Services (Excluding Islamic Insurance (Takaful) Institutions and Islamic Collective Investment Schemes)

2 The assumed yield change (column 5). The price sensitivity of an Islamic bank’s financial position also depends on the magnitude of the benchmark rate change (column 5). From the distribution of past yield changes, the standard determines the most likely future rate changes as two standard deviations of one month’s yield volatility. Since rates of return on short-term securities fluctuate much more than long-term rates, the two-standard deviation equivalent benchmark rate changes diminish progressively along the yield curve from 1% at the short end to 0.6% for securities with 20 or more years to maturity. Thus, Islamic banks can be sure that in about two out of three cases, the yield change will not exceed 1% for short-term securities and 0.6% for long-term securities. The next step is to compute risk weight (column 6, Table 5.8) by multiplying the computed duration (column 4, Table 5.8) with the assumed change in yields (column 4, Table 5.8) for each maturity band. What is the meaning of this single risk number? For example, consider an Islamic bank has a net exposure consisting of $10 million worth of zero-coupon securities within the 20-year and over maturity band.18 Note that under standardised approach, the risk charge for debt position is calculated by multiplying the current market value of each net long or

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short position by the appropriate risk-weighting factor. From the example, with an overall risk measure of 12.5%, Islamic bank faces over the next month a 68% [two standard deviation, that is, 1 – (2 × 0.165)] chance of a loss of $1.25 million (= $10 million × 0.125) on its net position of zero securities. This loss is due to an expected rise in security yields by 0.6% (column 5, Table 5.8). As we are dealing with a 2-σ-range, a fall in security market rates would generate a similar amount of capital gains. Simply adding the general market risk charges for all long and short positions in the portfolio might underestimate the portfolio’s benchmark rate risk exposure because it assumes that all benchmark rates of ‘similar’ maturity securities move together in lock step, such that the risk exposure on long positions perfectly offsets the risk exposure on short positions for securities of a ‘similar’ maturity. Since all yields across all instruments of the same maturity do not necessarily move together, portfolios are exposed to ‘basis risk’. Thus, the IFSB standardised framework imposes a series of additional capital charges for basis risk called vertical and horizontal offsets or disallowance factors. Vertical disallowance factors limit the risk hedging across instruments of similar maturity. In contrast, horizontal offsets limit the implicit hedging within the portfolio across maturities. Specific Risk

As for specific capital charges, the capital charge is designed to protect against an adverse movement in the price of an individual security owing to factors related to the individual issuer. Benchmark risk – Under specific capital charges, the charges depend on the type of issuer and the level of external credit assessment (based on maturity period) on each financial instrument. Table 5.9 shows specific risk capital charges for different categories of issuers. The specific risk charge is used to calculate the market risk of each security. As shown in Table 5.9, securities are assigned to a specific risk weight ranging from 0% (such as government sukuk, Islamic treasury bills and other short-term instruments) to 8% (for non-qualifying corporate sukuk). The specific risk charge for each individual position is obtained by multiplying the specific risk weight by the absolute values of all long and short positions in fixed income securities such as sukuk murabahah. The portfolio’s specific risk charge is calculated by summing the specific risk charges for each fixed income security held by Islamic bank in the trading book. Equity risk – As the portfolio of equity is exposed to market risk, Islamic banks are required to measure the risk of holding or taking positions in equities in the trading book. The market risk that an Islamic bank has to bear depends on whether it holds a long or short position. It is worth noting that market risk is not dependent on whether the portfolio is well diversified. In the situation where the share market collapses, diversified and non-diversified portfolios are affected equally. In general, the risk charge for equity positions is based on Islamic bank’s gross equity position for each national market. The gross equity position is defined as

Market Risk 135 Table 5.9 Specific Risk Capital Charge under Benchmark Rate Risk Categories

External Credit Assessment

Government

AAA to AA− A+ to BBB−

Investment Grades

Other

Specific Risk Capital Charge

0% 0.25% (residual term to final maturity 6 months or less) 1.00% (residual term to final maturity greater than 6 and up to and including 24 months) 1.60% (residual term to final maturity exceeding 24 months) BB+ to B− 8.00% Below B− 12.00% Unrated 8.00% 0.25% (residual term to final maturity 6 months or less) 1.00% (residual term to final maturity greater than 6 and up to and including 24 months 1.60 % (residual term to final maturity exceeding 24 months) Similar to credit risk charges under the standardised approach of the Basel II BB+ to BB− 8.00% Below BB− 12.00% Unrated 8.00%

Source: IFSB (2013) – Revised Capital Adequacy Standard for Institutions Offering Islamic Financial Services (Excluding Islamic Insurance (Takaful) Institutions and Islamic Collective Investment Schemes)

the sum of all long and short equity positions. The minimum capital standard for equities is divided into two: specific risk of holding a long or short position in an individual equity, and general market risk of holding a long or short position in the market. It is suggested that the long or short position be calculated on a market-by-market basis. (i.e., a separate calculation for each national market in which the Islamic bank holds equities). The general market risk charge is set to be 8%. In capital asset pricing model, we can divide equities risk into systematic and unsystematic risk. The specific risk (systematic) of equities makes it necessary for Islamic bank to set aside 8% of the Islamic bank’s gross equity position in the form of capital. For a well-diversified (unsystematic risk) and liquid, the charge is reduced to 4%. To calculate the capital charge for unsystematic risk, a × factor of 4% is applied to the gross position in each stock (i.e., the aggregated absolute value of both long and short equity positions). Thus, if Islamic bank holds a gross position in Microsoft of $200 million, unsystematic risk charge would be 4% × $200 million = $8 million. In addition, the charge for systematic risk known as the y factor is set to be 8%. If the Microsoft position consisted of $150 million long and $50 million short (for a $200 million gross position), then Islamic bank’s net position in Microsoft

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would be equal to $100 million. By applying the y factor, a systematic risk charge of $8 million is required, calculated as 8% of $100 million. The total capital charge for equity price risk is the sum of the x factor and the y factor risk, which is equivalent to $16 million. This process could be repeated for each individual stock in the portfolio. The portfolio is considered as liquid and well-diversified if: (1) it is characterised by a limited sensitivity to price changes of any single equity or closely related group of equity issues held in a portfolio; (2) the volatility of the portfolio’s value is not dominated by the volatility of any individual equity issue or by equity issues from any single industry or economic sector; (3) it contains a large number of individual equity positions, with no single position representing a substantial portion of the portfolio’s total market value; and (4) it consists mainly of issues traded on organised exchanges or in well-established over-the-counter markets. Foreign exchange risk – Islamic bank’s holding or taking position in foreign currency are exposed to currency risk. Thus, Islamic banks need to measure the risk of holding or taking positions in foreign currencies including gold. The measurement of exchange rate risk covers all the assets and not just for the trading book. They have to measure the net exposure in a single currency exposure that entails summing the net spot position, net forward position, foreign currency guarantees, fully hedged net income/expenses and the delta equivalent of the foreign currency option book. On the other hand, Islamic banks with a portfolio of currencies (in a different currency) must convert all long and short positions into the domestic currency and obtain an overall net open position by aggregating overall net short and net long positions. All net long positions across all foreign currencies are summed separately from all net short currency positions. Then, the capital charge is calculated as 8% of the higher of the aggregate long positions or the aggregate short positions. For example, if an Islamic bank had a net long currency exposure of RM800 million to the Euro, a net long currency exposure of RM500 million to the US dollar, and a short net currency exposure of RM1.4 billion to the pound sterling, then the aggregate shorts would be equal to RM1.4 billion (since the aggregate short RM1.4 billion position exceeds the aggregate long RM1.3 billion position). The IFSB standardised capital charge for foreign exchange rate risk would therefore be 8% of RM1.4 billion or equal to RM112 million. Commodity risk – Islamic banks might also be exposed to commodity risk when they hold or take position in commodities or commodities derivatives such as commodities futures/forwards as well as commodities swaps and options. There are two approaches for measuring commodities position risk. They are simplified approach and maturity approach. In order to calculate the open positions, both approaches specifically require the long and short position in each commodity is reported on a net basis except for positions in different commodities. Nevertheless, this net basis reporting is also applicable for different sub-categories of the same commodity (with supervisory approval), and if they are close substitute against each other and a minimum correlation between the price movements is 0.9 for a minimum period of one year.

Market Risk 137 By employing maturity ladder approach to measure the commodity risk, Islamic banks must express each commodity position in terms of the standardised physical unit of measurement (e.g., barrels or kilos). Subsequently, the net position in each commodity is converted at the current spot rate into the national currency. For example, an Islamic bank that bought oil contract of 20 million barrels and sold contracts of 14 million barrels would have a net long position of 6 million barrels. With a domestic currency price of $60 per barrel, the ringgit amount of the net long position amounts to $360 million. Islamic bank’s net open position is subject to directional price risk. A fall in the price of oil creates a loss in the commodities trading book. Special charge is assigned for matching the long and short positions in each time-band to capture forward gap and benchmark rate risk within a time-band, as shown in Table 5.10. For each time-band, the sum of short and long positions that are matched will be multiplied by the spot price for the commodity. After that, this amount is multiplied by the appropriate spread rate for that band. The residual net positions from nearer time-bands may be carried forward to offset the exposures in the time-bands that are further out. Finally, an Islamic bank will have either only long or only short positions. The capital cover for commodities amounts to 15% of the net position, short or long, in each commodity. The higher capital ratio is due to the fact that the commodities market is less liquid compared to the securities and currency markets. This makes the price risk in commodities more volatile than the two of markets-sensitive instruments. Similarly, the calculation of capital charge for directional risk in maturity ladder approach is applicable for the simplified approach. This includes all commodity derivatives and off-balance-sheet position, which are affected by changes in commodity prices. Still, the capital chargers only cover for commodities amounts up to 15% of the net position, long or short, in each commodity. For the forward and derivative contract that is exposed to additional risks such as basis risk, benchmark rate risks and forward gap risk, the capital charge for each commodity will be subject to 3% as an additional capital charge of Islamic bank’s gross positions, long plus short in that commodity. Table 5.10 Time Band for Commodity Risk No 1. 2 3 4 5 6 7

Time Band 0–1 Month 1–3 Months 3–6 Months 6–12 Months 1–2 years 2–3 years >3 years

Source: IFSB (2013) – Revised Capital Adequacy Standard for Institutions Offering Islamic Financial Services (Excluding Islamic Insurance (Takaful) Institutions and Islamic Collective Investment Schemes)

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Example 1: The market risk charge (MRC) in the arithmetic sum of market risk charges for individual positions is given as: MRC =

∑ MRC i

(5.27)

i

Based on the standardised approach (as well as internal-based approach), we can assign the capital charge as suggested by Basel Committee. Table 5.11 shows the example of capital adequacy for market risk in Islamic bank. Based on the standardised approach, if the net exposure in equity risk is valued at $1,261,449, the general market risk of equities requires Islamic bank to set aside at 8% of gross equity position, and for a well-diversified and liquid (all are assumed unsystematic risk), the charge is reduced to 4%. Therefore, the capital charge is equal to $100,915.92 and $50,457.96, respectively. Note that both capital charges come from the same amount, that is, $1,261,449. Consider an Islamic bank that has net exposure consisting of $2,758,620 worth of zero-coupon securities within 20 years and over maturity band. With an overall risk measure of 12.5%, the Islamic bank faces over the next month a 68% chance of a loss of $344,827.5 (= $2,758,620 × 0.125) on its net position of zero-coupon securities. This loss is due to an expected rise in security yields by 0.6% (column 5, Table 5.8). Similarly, consider the net exposure of $2,758,620 of zero-coupon securities, which is issued by government and rated at BB+ to B−; the special capital charge is 8% and the capital charge amount is $220,689.6. Suppose that the net exposure in commodity is about $5,240,865. The capital charges for commodities amount to 15% of the net position, long or short, in each commodity. Therefore, the capital charge for commodities is equal to $786,129.75. As for the foreign exchange risk, Islamic bank must set aside 8% of the net open position of foreign currency positions. If the calculated foreign exchange risk exposure is equal to $12,072,000, then the amount of capital charge is $965,760.

Table 5.11 Capital Adequacy for Market Risk Based on Standardised Approach Market Risk 1) Equity Risk a) Specific Risk b) General Market Risk 2) Interest Rate Risk a) Specific Risk b) General Market Risk 3) Commodity Risk 4) Foreign Exchange Risk

Amount

MR Weight

Capital charge

1,261,449 1,261,449

4% 8%

50,457.96 100,915.92

2,758,620 2,758,620 5,240,865 12,072,000

8% 12.5% 15% 8%

220,689.60 344,827.50 786,129.75 965,760.00

Total Market Risk Capital Charge Market Risk Capital Charge × 12.5 = Total Market Risk-Weighted Assets Source: Modified from Turk-Ariss and Sarieddine (2007).

2,468,780.73 30,859,759.13

Market Risk 139 The total market capital charges are sum of equity risk, benchmark rate risk, commodity risk and foreign exchange risk. The total market capital charge is $2,468,780.73. The total risk-weighted assets amount to $30,859,759.13 are calculated by multiplying the capital requirements for market risks (12.5, which is the reciprocal of the minimum capital ratio of 8%) by the given value. Under the internal-based approach, we expect the total market risk-weighted assets will differ from the amount produced under standardised approach (column 5, Table 5.8). This is because the amount exposed for each category of market risk (column 4, Table 5.8) depends on the variables such as horizon period and the level of confidence. In addition, this amount also depends on the k (multiplicative factor and SRC (specific risk charge) as shown in equation (5.24). However, in practice, the internal-based approach usually produces smaller capital requirements for market risk than the standardised approach. Figures in Table 5.12 provide an example of capital requirement for market risk based on the internal-based model. Without mentioning the risk weight assigned for each category of market risk, the calculation of capital requirement (capital charge) and risk-weighted assets (RWA) for market risk is quite similar, as explained in Table 5.11. For example, capital requirement is multiplied by 12.5 (up to 2 precision points) to get RWA for each market risk and RWA for overall market risk. There are two ways to measure market risk in trading book and Islamic banking book: VaR and non-VaR (standardised approach). However, our concern is Islamic bank’s trading book using VaR and non-VaR. The sum of these two approaches is shown in the last column, where capital requirement and RWA are 284 and 3,554, respectively.19 Also, the table shows that the largest contribution to the non-VaR capital requirement is benchmark rate risk and equity risk.

Table 5.12 Capital Requirement for Market Risk

EURm Interest rate risk Equity risk Foreign exchange risk Commodity risk Diversification effect Total

Trading book, VaR

Trading book, non-VaR

Islamic banking book, non-VaR

Total

RWA 665 183 103

RWA 2,656 305

CR 213 24

RWA

CR

0**

0**

66

5

3,027

242

0

0

RWA 3,321 488 103 66 −424 3,554

−424 527

CR* 53 15 8 −34 42

CR 266 39 8 5 −34 284

Note: *CR stands for capital requirement; **foreign exchange in the Islamic banking book is less than 2% of the capital base and therefore excluded from the market risk capital. Source: Adapted from Nordea Group (2007)

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The total market risk-adjusted capital requirement for fixed income securities held in the trading book is determined by summing the general market risk charge (incorporating any disallowance factors) for the specific risk charge. 5.10.3 An  Extension   of Economic  Capital  for  Market  Risk

Economic capital in essence is an Islamic bank’s own estimate of the capital needed, whereas regulatory capital is the capital (minimum) mandated by regulator to be maintained.20 However, divergence between regulatory and economic capital (i.e., the Islamic bank’s own privately determined optimal capital level) is costly both on the upside and the downside. That is, if regulatory capital is set too low, then Islamic banks do not consider capital requirement to be binding constraints. Therefore, minimum capital charges cannot be used by regulators to influence Islamic bank portfolio and risk-taking activities. On the other hand, if regulatory capital is set too high, then the cost of providing Islamic banking services increases, thus reducing entry into the industry and encouraging Islamic banks to circumvent (or arbitrage) requirements. Thereby, this will undermine the supervisory function of the Islamic bank regulators and impose welfare losses to Islamic bank customers to the extent that such costs are passed on by the Islamic bank. As discussed in the previous chapter, Islamic bank uses value at risk for estimating the probability distribution of the loss or gain from the market risk. This distribution is usually calculated in the first instance with a one-day time horizon. Regulatory capital for market risk is calculated as a multiple (at least 3.0) of the 10-day 99% VaR, and Islamic bank supervisors may use the 10-day 99% VaR as 10 times the one-day 99% VaR. In calculating economic capital, we may use the same horizon period and confidence level for all risks. The horizon period is usually one year, and the confidence level is often chosen as 99.97% for an AA-rated Islamic bank. The simplest assumptions are (1) that the probability distribution of gains and losses for each day during the next year will be the same as that estimated for the first day and (2) that the distributions are independent. We can then use the central limit theorem to argue that the one-year loss or gain distribution is normal. Assuming 252 business days in the year, the standard deviation of the one-year loss or gain equals the standard deviation of the daily loss or gain multiplied by 252 . The mean loss or gain is much more difficult to estimate than the standard deviation. A reasonable, if somewhat conservative, assumption is that the mean loss or gain is zero. The 99.97% worst-case loss is then 3.43 (which can be calculated using NORMSINV in statistical function of Excel) times the standard deviation of the one-year loss or gain. The 99.8% worst-case loss is 2.88 times the standard deviation of the oneyear loss or gain. For example, if the standard deviation of market risk losses/gains for an Islamic bank is $1 million, the one-year 99.8% worst-case loss is 2.88 × 252 × 1 = 45.7 or $45.7 million. Note that it is not necessary to assume that the daily losses/gains are normal. What we assume is that they are independent and identically distributed. The central limit theorem shows that the sum of many independent identically distributed

Market Risk 141 variables is approximately normal. When the autocorrelation is not too high, it is still reasonable to assume that the one-year loss distribution is normal. If a more complicated model for the relationship between losses on successive days is considered appropriate, then the one-year loss distribution can be calculated using the Monte-Carlo simulation. Notes 1 For details see http://financial-dictionary.thefreedictionary.com/market+risk 2 For Islamic banks, the benchmark is used as replacement for interest rate, because the interest rate is only used as benchmark to determine the profit margin for debt-related instruments. 3 A common assumption is that the change in the portfolio value over the time horizon is normally distributed. The mean change in the portfolio value is usually assumed zero. These assumptions are convenient because they lead to a simple formula for VaR: VaR = σN−1 (X), where X is the confidence level, σ is the standard deviation of the portfolio change over the time horizon, and N−1 (.) is the inverse cumulative normal distribution (which can be calculated using NORMSINV in statistical function of Excel). This equation implies regardless of the time horizon, VaR for a confidence level is proportional to σ. For example, if the change in the value of a portfolio over a 10-day time horizon is normal with a mean of zero and a standard deviation of $20 million (for 10-day time horizon), the 10-day 99% VaR is 20 N−1(0.99) = 46.5 or $ 46.5 million. This example only takes single assets. 4 Benchmark rate is part of market risk. However, in market model, we are concerned with the benchmark rate sensitivity of sukuk held as part of bank active-trading portfolio. 5 The face value of sukuk is $1,631,483, i.e., $1,631,483/(1.07243)7 = $1,000,000 market value. 6 Assuming annual compounding for simplicity. 7 The initial market value of the seven-year sukuk was $1 million or $1,631,483/ (1.07243)7. The (loss) effect on each US$1 (market value) invested in the sukuk of a rise in benchmark rate by 1 basis point (bp) from 7.243% to 7.253% is 0.0006528. However, the adverse rate movement is 16.5 bp. Thus, DEAR = ($1 million) × (0.0006528) × (16.5). 8 Variance is calculated by var (X ) = ˜ 2X = E( X − µ) 2 = E( X 2 ) −[ E ( X )]2 . The square root of the variance is the standard deviation. 9 If beta (β) = 1.25 (i.e., as market return increase (decrease) by 1%, the security’s return increases (decreases) by 1.25%), and 1.65σm = 3.3%, for given RM 1 million equity investment, DEAR = $1,000,000 × 1.25 × 0.033 = $41, 250. 10 See the comparison between these two approaches in Allen et al. (2004), p. 95. 11 In the case of equities, delta would measure the change in the value of those securities for a 1% change in price, while for sukuk, it measures the change in value for a 1% change in the price of sukuk (note that delta measures sensitivity of a sukuk’s value to a change in return, not price). 12 For more discussion, please refer Glasserman et al. (2000). 13 To solve this problem, Aragonés et al. (2001) suggest bringing stress testing into the market risk modelling process by unify stess testing and probabilistic risk estimation. 14 For further discussion, see Berkowitz (2000) in A Coherent Framework for Stress Testing.

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15 Hendricks and Hirtle (1997) report a penalty function that is driven by statistical test on model accuracy. Five underestimates of market risk out of the past 250 days result in a 3.4 multiplicative factor; six underestimates result in a factor of 3.5; seven underestimates result in a factor of 3.65; eight underestimates result in a factor of 3.75; and nine underestimates set the factor at 3.85. This is also shown in Table 5.6. 16 The minimum capital requirement can be expressed in terms of two separately calculated charges, one applying to the ‘specific risk’ of each security, whether it is a short or a long position. The other is related to benchmark rate risk in the portfolio (termed as ‘general market risk’), where long and short positions in different securities or instruments (also based on the underlying contract) can be offset. Or generally, general and specific risk are analogous to systematic and non-systematic risk in a standard assetpricing framework. 17 Islamic banks may calculate market risk as VaR largely over a 1-day or 10-day period and confidence level of mostly 95% or 99%. For the purposes of aggregation, the scale of this value can be set at up to a one-year horizon and the appropriate confidence level for an evaluation of overall risk. By assuming that the portfolio is held constant for one-year, Islamic banks scale the market risk VaR to the time period that they believe is necessary to liquidate their portfolio. 18 From author’s point of view, exposure to various forms of market risk can be measured by traditional exposure indicators, such as net open position in foreign exchange, net position in traded equities, net position in commodities, and various duration measures of assets and liabilities in the trading book. The impact of earning of a change in exchange rate, equity price, commodity price or interest rate can be directly obtained by multiplying the appropriate gap or other exposure indicators by corresponding price change. 19 The total risk-weighted amount for market risk of a reporting institution is equal to the sum of the total market risk capital charge calculated under the standardised approach and that calculated under internal-based model, multiplied by 12.5. 20 We can further use the economic capital to determine RAROC for evaluating Islamic bank’s performance.

References Ahmed, H. & T. Khan, 2007. Risk Management in Islamic Banking, Chapters, in: M. Kabir Hassan & Mervyn K. Lewis (ed.), Handbook of Islamic Banking, Cheltenham: Edward Elgar Publishing. Allen, L., Boudoukh, J. & Saunders, A. (2004). Understanding Market, Credit and Operational Risk: The Value at Risk Approach. Oxford: Blackwell Publishing Ltd. Aragonés, J., Blanco, C. & Dowd, K. (2001). Incorporating stress tests into market risk modeling. Derivatives Quarterly, 7(3), 44–49. Berkowitz, J. (2000). A coherent framework for stress-testing. Journal of Risk, 2(2), 5–15. BIS. (1995a). Planned Supplement to the Capital Accord to Incorporate Market Risks, April. Bank for International Settlements: Basel Committee on Banking Supervision. BIS. (1995b). An Internal Model-Based Approach to Market Risk Capital Requirements, April. Bank for International Settlements: Basel Committee on Banking Supervision. BIS. (1996). Financial Market Volatility: Measurements, Causes and Consequences, March. Bank for International Settlements: Basel Committee on Banking Supervision.

Market Risk 143 BIS. (2006). Guidelines on the Implementation, Validation and Assessment of Advanced Measurement (AMA) and Internal Ratings Based (IRB) Approaches, April. Bank for International Settlements: Basel Committee on Banking Supervision. Bollerslev, T. (1986). Generalized autoregressive conditional heteroskedasticity. Journal of Econometrics, 31(3), 307–327. Brooks, C. (1998). Predicting stock index volatility: Can market volume help? Journal of Forecasting, 17(1) 59–80. Engle, R. (1982). Autoregressive conditional heteroscedasticity with estimates of the variance of United Kingdom. Econometrica, 50(4), 987–1007. Glasserman, P., Heidelberger, P. & Shahabuddin, P. (2000). Variance reduction techniques for estimating value-at-risk. Management Science, 46(10), 1349–1364. Hendricks, D. & Hirtle, B. (1997). Bank capital requirements for market risk: the internal models approach. Federal Reserve Bank of New York Economic Policy Review, 3(4), 1–12. IFSB. (2013). Revised Capital Adequacy Standard for Institutions Offering Islamic Financial Services (Excluding Islamic Insurance (Takaful) Institutions and Islamic Collective Investment Schemes). Kuala Lumpur: Islamic Financial Services Board. Taylor, J. W. (1999). Evaluating volatility and interval forecasts. Journal of Forecasting, 18(2), 111–128. Turk-Ariss, R. & Sarieddine, Y. (2007). Challenges in implementing capital adequacy guidelines to Islamic banks. Journal of Banking Regulation, 9(1), 46–59.

6

Credit Risk

6.1

Definition of Credit Risk

Credit risk is widely known as the most important among many types of risk facing an Islamic bank. Islamic banks are highly exposed to credit risk as their main activity is to provide financing to the customers in the economy. The customers consist of individuals, firms and government that come from various financial backgrounds. The issue of moral hazard has made it difficult for Islamic banks to distinguish good customers from bad customers. To solve this problem, Islamic bank’s management designs many mechanisms, rules and tools. However, it seems that Islamic banks must bear the credit losses that are derived from credit risk as it is naturally embedded in their activities. Therefore, the task of Islamic bank’s management is not to eliminate the credit risk but to control and to minimise the credit risk. The importance of managing credit risk stems from the recognition that credit risk is the primary that can lead to the failure Islamic bank. There are many definitions of credit risk, and they may differ from each other because they depend on the context of application. For example: • Credit risk is the risk when selling goods on credit that the purchaser may fail to make payments when they become due.1 • Credit risk is the possibility that a bond issuer will default, by failing to repay principal and interest in a timely manner. This type of risk is also called default risk.2 • Credit risk is the risk of investing, when the customer of the money would not be able to pay principal or interest from the agreement.3 • Credit risk is the risk of loss due to a customer’s non-payment of a financing or other line of credit either the principal or interest or both.4 • Credit risk arises from the possibility that a firm will experience a loss when the counterparty defaults.5 • Default risk is related to the creditworthiness of the customer and is taken into account when banks set the interest rate on the requested financing.6 In general, credit risk can be defined as the probability that a customer (counterparty) could not meet the repayment obligations, including a chance that the DOI: 10.4324/9781003437086-10

Credit Risk 145 counterparty’s credit risk would be downgraded, which may affect earnings and capital of Islamic bank. Credit risk is very important as it involves the extension of financing, which is a major transaction of Islamic bank. Financings appear on both assets and contingent liabilities of Islamic bank. For example, financing for commercial or industrial acceptance or guarantee arises from financing transactions where Islamic bank may receive the repayments in the future. It also includes financing transactions and transactions where the counterparty has to deliver assets or repayment to Islamic bank (settlement risk). For commercial or industrial financing, credit risk may arise due to downgrading, which may incur losses from the lower mark-to-market value of a financial instrument. Some products also require collateral, most commonly in the form of property. As for the business entity, Islamic bank will trade off the cost/benefits of a financing agreement according to its risks and the profit margin charged. However, profit margin is not the only method to compensate for risk. Protective covenants are written into financing agreements that allow Islamic bank some controls. These covenants may: (1) limit the customer’s ability to weaken their balance sheet voluntarily, for example, by buying back shares, or paying dividends; (2) allow for monitoring through frequent auditing, and monthly reports; and (3) allow Islamic bank to decide whether they can recall the financing based on specific events or when financial ratios, like debt/equity, or benchmark rate coverage deteriorate. 6.2

Nature of Credit Risk

Credit risk arises whenever a customer is expecting to use future cash flows to pay a current obligation. Islamic bank is compensated for assuming credit risk by way of payments from the customer or issuer of an obligation. As mentioned above, credit risk arises whenever the counterparty is unwilling, unable or fails to fulfil their contractual obligations. Hence, the cost of replacing cash flows should be measured, if the other party defaults. Default risk may create losses, if it satisfies two conditions. First, there must be a net claim against the counterparty (or credit exposure), and second, that counterparty must default. Losses due to credit risk can occur before the actual default. More generally, credit risk should be defined as the potential loss in mark-to-market value that may be incurred due to the occurrence of a credit event. A credit event happens when there is a possibility in the counterparty’s ability to perform its obligations. Therefore, changes in market prices of debt, due to changes in credit ratings or in the market’s perception of default, also can be viewed as credit risk, creating some overlap between credit risk and market risk. Based on this argument, credit can be ascribed to two factors: (1) default risk, which is the objective assessment of the likelihood that a counterparty will default, or default probability, combined with loss given default; and (2) market risk, which drives the market value of the obligation, also known as credit exposure. For example, the credit risk of a forward contract on a foreign currency. Credit exposure is the positive value of the contract, whose value depends on movements in exchange rates; therefore, credit risk consists of default and market risk.

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Sukuk, financings and derivatives, including syndicated financings, retail mortgages and asset-back securities, are exposed to credit risk. Traditionally, credit risk only applied to sukuk and financings, for which the exposure is simply the face value of the debt. However, with derivatives such as swaps, the credit exposure is much less because the initial value of the swap is generally zero. Instead, the exposure is the change in the value of the position, if positive when a default occurs. Thus, measuring credit risk on swaps involves a detailed analysis of the relationship between market risk and credit risk. Credit risk also includes sovereign risk. For instance, this occurs when countries impose foreign exchange controls that make it impossible for counterparties to honour their obligations. Whereas default risk is generally company-specific, sovereign risk is country-specific. As financial innovation has progressed, credit risk has changed in many ways. For example, in the case of senior/subordinated securities, credit risk has been segmented and redistributed. To avoid possibility that an entire issuance will be downgraded due to poor performance is a specific segment, these structures are partitioned into distinct classes. The objective is to attract multiple investor classes for a single issuance. This approach to credit risk has turned it from a defensive concern to an offensive opportunity. This means that understanding the credit risk has made it possible to open new channels or funds flow. The new generations of instruments that are funded by assets-backed commercial paper are a prime example of this trend. The number of entities participating in a credit-related transaction has grown. For example, as structured finance transaction may include an originator, a seller, a trustee and a guarantor. Each of these entities faces exposure from or represents exposure to some other participants. This does not mean that it causes total credit risk to increase. However, because multiple parties are involved, it does mean that credit risk must be assessed from more than one perspective. Credit risk of the underlying customer has now been exchanged for counterparty financial institution risk, and in many instances, for market risk. 6.3

Sources of Credit Risk

There are two types of credit risk factors, namely external risk factors and internal risk factors. 6.3.1 External  and  Internal  Risk  Factors

The external factors include economic condition, correlated risk and competition. Economic condition – Change in the macroeconomic level, namely, global, regional and national economy such as change in national income, unemployment, can influence credit risk through a change in the business cycle, exchange rate, interest rate, credit availability and credit quality. In addition, change in the microeconomic level such as liquidity crunch or financial problem will affect customer’s ability to fulfil their obligation. Legal and regulatory change will cause Islamic

Credit Risk 147 bank to change the way the bank manages a transaction, as well as the quality and ability of debt collections. Correlated risk factors – The impacts that risk factors in one market have on another market. The impact groups into direct and indirect correlation. Direct correlation is when an impact on one industry directly affects another industry. Indirect correlations happen when an impact on one industry affects another industry and the effect spills over to another industry, such as in the case of seemingly unrelated industries such as oil and steel. Historically, a decline in global oil price causes deterioration in credit quality of both oil and steel industries. A thorough analysis shows that the oil industry is indirectly related to steel industry as oil companies purchase steel through drilling rigs and pipe. Competition – Competition pressure among Islamic banks in terms of growth, profitability and the desire to be the market leader can cause Islamic banks to lower their underwriting standards or improperly price their financing products. This will result in higher cost from non-performing financings (NPL). Competition comes from domestic Islamic bank, foreign Islamic bank, branches of foreign Islamic bank and specialised finance companies. The internal factors cover the underwriting standards, financing concentration, staff experience, management information system, assessment of credit quality, new financial products, lending excess of the real value of collateral, negligence of business cycle, self-dealing, technical competence and supervision. Underwriting Standards – Underwriting standards is a process to determine what type of, whom, for what purpose and when credit should be granted. Change in underwriting standards should not occur too often. Deviation from the standards should be carefully analysed and received approval from the board of directors or delegated officers; the guideline of such deviation should be sufficient to ensure an effective credit approval process. Lenient credit underwriting can incur losses to Islamic bank, especially when debt repayment cannot be demanded or collateral cannot be seized in time. Many of the problem financings arise from the deficiency in underwriting standards and credit monitoring. Such problems can be reduced by prudent underwriting standards. Financing Concentrations – It can be a major cause of most financing problems as they can affect capital funds and assets of Islamic bank. Concentrations can take several forms, including concentrations on each customer or groups of customers or each economic sector such as real estate, construction, manufacturing and agriculture. Concentrations arise through Islamic bank’s desire to be a leader in a particular market. Typically, Islamic banks are cautious of credit concentrations; however, when faced with intensified competition, such caution may reduce. Staff Experience – Credit officers that lack experience in the activities they are responsible for, be they financing, investment, management of problem assets or new products, can lead to poor financing to poor financing practice, ineffective administration and, eventually, loss to Islamic bank. Management Information System – Risk will increase if the management does not regularly receive accurate and timely reports on credits. The reports shall comprise important information related to the underwriting process, such as economic

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trends, change in the structure of industry, or market share, commodity prices, exchange rates, including past due credits, financing concentrations and analysis of problem financings. Inappropriate Assessment of Financing Quality – This problem may result from competitive pressure and financing growth as they tend to put a time constraint on getting accurate data. Moreover, rapid growth and/or entry into new markets can lure the management to provide financing without sufficient financial and economic analysis. To facilitate quicker decision-making, the management may support financing decisions by using simple indicators of credit quality such as customers’ characteristics, current and expected value of collateral or support of a parent company or affiliated companies. Introduction of New Financial Products or Services Without Proper Risk Assessment – Islamic bank that fails to properly assess risk in launching new products and does not install risk management system prior to launching new products may create another important problem. With rapid financing growth and/or heightened competition, Islamic banks are pressured to introduce new products and services to the market without proper testing. Not in line with the principle of proper credit underwriting, such practice can lead several Islamic banks to serious problems. Islamic bank that practices proper credit underwriting usually test new products and services before introducing them to the general customers. Financing in Excess of the Real Value of Collateral – When financings are granted for purchasing or developing assets that are used as collateral, Islamic bank should be able to assess the correlation between customers’ financial condition and income-generating ability and also price changes and liquidity of collateral. The types of financing such as commercial, hire purchase, factoring and real estate lending are highly correlated between the creditworthiness of customers and the quality of asset placed as collateral. Because the customers’ primary income, the principal source of repayment, is directly related to the quality of the associated asset. When the customers’ income stream deteriorates, due to economic problems, the value of the asset placed as collateral is likely to decline. Negligence of business cycle – Financings granted without taking into account of business cycle can cause an overly optimistic credit analysis. For example, businesses such as retail business, real estate, real estate investment and consumer financing tend to have strong cyclical effects. Nevertheless, the effect of the business cycle is less than the effect of the product cycle, especially new, rapidly growing products such as business related to telecommunication. Effective stress testing that incorporates the effect of business cycle and product cycle is one approach for financing decision process and should induce a clearer understanding of credit risk. Self-dealing – Self-dealing can cause serious problems, resulting in failure of Islamic banks. Such practices can be found in the form of excessive financing to insiders, overriding the specified financing policy and use of authority to improperly obtain financing without proper financing analysis, making it difficult for

Credit Risk 149 financial officers to appropriately assess the financing. Sometimes, insiders may apply for financing in the name of unrelated parties to conceal the self-dealing transactions. Technical competence – Technical incompetence is evident when the management cannot obtain and assess financing information to analyse the viability of financing. Such management weaknesses can eventually lead to financing losses. Supervision – Parts of problem financing arise when Islamic bank’s boards or management cannot manage various units to appropriately comply with the policy or when the supervision is ineffective due to lack of knowledge of customers’ true condition. 6.4

Credit Risk Assessment and Basel III

Assessing credit risk from a single counterparty requires Islamic banks to consider three issues: (1) Default probability – it calculates the likelihood that the counterparty will default on its obligation either over the life of the obligation or over some specified horizon (i.e., a year). If the obligation is calculated for a one-year horizon, this may be called the expected default frequency; (2) Financing exposure – in the event of default, Islamic bank calculates the size of outstanding obligation when the default occurs; and (3) Recovery rate – in the event of a default. The way credit exposure (the second issue) is assessed depends on the nature of the obligation. If an Islamic bank provides financing (as well as subscribing sukuk) to a firm, the Islamic bank might calculate its credit exposure as the outstanding balance on the financing. Suppose instead that the Islamic bank extend a line of financing to a firm, but none of the line has yet been drawn down. The immediate financing exposure is zero. In assessing the financing quality, it includes the assessment on the customers’ assets as collateral, revenue-generating ability and taxing authority (such as for sovereign sukuk). The financing quality of an obligation includes both the obligation’s default probability and anticipated recovery rate. To place financing exposure and financing quality (the obligation’s default probability and anticipated recovery rate) in perspective, every risk comprises two elements that are exposure and uncertainty. For credit risk, financing exposure represents the former, and financing quality represents the later. For financing individuals or small businesses, financing quality is typically assessed through a process of credit scoring. Prior to extending financing, Islamic bank will obtain information about the customer. In the case of an Islamic bank issuing credit cards, this might include the party’s annual income, existing debts, whether they rent or own a home, etc. a standard formula is applied to the information to produce a number, which is called a credit score. Based on the credit score, Islamic bank will decide whether to provide financing or not. Then, when the decision is made to make a financing, the terms of the financing, such as the benchmark rate and the term period, is established based on the risk level.

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Table 6.1 The System of Credit Ratings Employed by Standard & Poor’s. AAA AA A BBB BB B CCC CC C D

Best credit quality – Extremely reliable regarding financial obligations. Very good credit quality – Very reliable. More susceptible to economic conditions – still good credit quality. Lowest rating in investment grade. Caution is necessary – Best sub-investment credit quality. Vulnerable to changes in economic conditions – Currently showing the ability to meet its financial obligations. Currently vulnerable to non-payment – Dependent on favourable economic conditions. Highly vulnerable to a payment default. Close to or already bankrupt, payment on the obligation currently continued. Payment default on some financial obligation has occurred.

Note: This is the system of credit ratings Standard & Poor’s applies to sukuk. Ratings can be modified with + or – signs, so an AA– is a higher rating than an A+ rating. With such modifications, BBB– is the lowest investment grade rating. Source: Standard & Poor’s

Credit risk associated with larger institutional counterparties is more complicated and unique, and it is worth assessing in a more systematic manner. The term ‘financing analysis’ describes any process for assessing the financing quality of counterparty does not only encompass credit scoring but also the processes that entail human judgment. The information about counterparty might include its balance sheet, income statement, recent trend in its industry, the current economic environment etc. The rating process conducted by rating agency concerns about the interest of security holders, other creditors and/or counterparties. The rating process focuses on two main areas: business risk and financial risk. In business risk, rating agency evaluates industry characteristic, company position (e.g., marketing, technology, efficiency) and management. In financial risk, the factors that are evaluated are financial characteristics, financial policy, profitability, capital structure, cash flow protection and financial flexibility. This credit rating helps the investor to get information about the creditworthiness of the customer. Even Islamic bank heavily uses credit scoring to assess the financing quality. The recent trend in financial industry shows that Islamic bank needs to use sophisticated methodology such as credit risk modelling to produce an assessment that is more accurate. Traditionally, once financings have been measured or scored, an Islamic bank could decide to accept or reject the implied credit risk of the transaction. However, with new credit risk modelling (besides pricing and transfer tools) Islamic bank can actively manage their financing portfolios to ensure an efficient risk/reward ratio and sufficient diversification of financings.

Credit Risk 151 Box 6.1 Evolution in Credit Risk Modelling Credit risk modelling has gained great momentum over the last few years, since several portfolio credit risk models were introduced in 1997. These credit risk models have helped make credit value at risk (VAR) a practical measure for bankers and other portfolio managers in their battle to assess likely portfolio credit losses. The models produce a portfolio loss distribution that is similar to that produced by VAR models for market risk. The model is used to establish a VAR number indicating the maximum likely loss in a portfolio over a specified period, to a given confidence level. However, VaR is not recognised by supervisors as a measure of credit risk because data on both defaults and recovery rates are not extensive and credit returns are highly skewed and fat-tailed. The credit risk is more difficult to model than market risk. There is no liquid market in pure credit risk, as opposed to credit-linked instruments that are affected by other variables. Therefore, it is difficult to price credit risk for a specific customer and tenor. The true value of default probabilities cannot be observed in the market directly. They must be inferred using public credit rating or equity price data or determined using a subjective process. This also means that default correlations are difficult to measure, making it hard to determine the true credit risk of a whole portfolio. The existing portfolio models are designed to help overcome these problems for credit portfolios consisting primarily of large publicly rated or quoted corporations, although some can incorporate retail credit transactions too. The four commonly used models are KMV’s Portfolio Manager, JP Morgan’s CreditMetrics, Credit Suisse Financial Products’ CreditRisk+ and McKinsey’s CreditPortfolioView. The models use different methodologies to create a distribution of possible credit portfolio values at some future point in time. The portfolio’s risk is the outcome of each asset’s risk, its weight in the portfolio and the correlation between assets. To calculate the credit risk exposure, default probability and recovery rate must be input into the model. These may be calculated and treated in different ways according to the model used. Choice of model is an important decision for any financial institution actively managing its portfolio credit risk. For example, actuarial models (like CreditRisk+) may be more accurate for small business portfolios or illiquid asset classes. On the other hand, Merton-based models (like CreditMetrics and Portfolio Manager) may be better for publicly traded companies. The credit risk assessment can be done by using so-called ‘tools’. The tools are screening, monitoring and collecting. Screening is a process applied before a financing is made, in which Islamic banks evaluate the customer and assess the

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probability of default. If they think that the customer is a good customer, they will continue with the financing process; otherwise, they will deny the applicant. An example of credit screening is credit scoring models that effectively control adverse selection. Monitoring involves an active process of data collection, analysis, communication with the customer and enforcement of covenants after a financing has been made. This tool is used to respond to moral hazards. Islamic bank relies on monitoring as a tool to keep up with current events of the customer, especially any possible setbacks to the financing’s repayment. Islamic bank can ensure that the proceeds from the financing are used according to the terms of the financing agreement, verify the condition and availability of collateral and evaluate other conditions of the customer. By monitoring effectively, Islamic banks can often identify problem financings in advance and can act promptly to ensure repayment. Islamic banks that are constrained by small-size markets to have little diversification within their financing portfolios, or that feel compelled by competitive factors to accept a large proportion of financing applications (i.e., screen less conservatively), may rely more heavily on monitoring to control their overall level of credit risk. Another important tool to manage credit risk is the collection process, in which Islamic bank attempts to recover part or all of the value from a defaulted financing through collateral, negotiation with the customer and other means. Collecting is an integral part of the financing process, and Islamic bank’s effectiveness in collection can make substantial differences in its net financing loss experience. It is well-known that screening, monitoring and collection of financings are important tools of credit risk management. However, there is an issue of whether these tools of risk management are employed as net substitutes or as net complement. Islamic bank may have a comparative advantage in one process, so that it can control its credit risk by devoting resources primarily to process and economise on the other two. Then, if Islamic bank varies according to their comparative advantages, it is expected that a pattern of financing performance is consistent with net substitutability across the three tools. Conversely, Islamic bank might differ primarily in their overall ability and willingness to control credit risk, so that more conservative Islamic banks might employ all three tools more aggressively than less conservative Islamic banks. If Islamic bank has insufficient screening process, it should experience a higher rate of financing delinquency (non-performing financings) than other Islamic banks. Whether Islamic bank’s delinquent financings subsequently become losses (charge-offs) depends in part on the effectiveness of its monitoring process. After a financing has been charged off, the extent to which the unpaid balance is recovered is a function of the effectiveness of the Islamic bank’s collection process. Thus, for some reason, we can use the ratio of non-performing financings to total financings as an inverse measure of the effectiveness of an Islamic bank’s screening process; the ratio of gross charge-offs to non-performing financings as an inverse measure of the effectiveness of an Islamic bank’s monitoring process; and the ratio of recoveries to total charge-offs as a positive measure of the effectiveness of a bank’s collection process.

Credit Risk 153 Box 6.2 Case Studies Studies done by Sackett and Shaffer (2007) show that across the US banking industry, screening and monitoring behave as net substitutes, but collection is complementary to screening and monitoring. On average, if a bank is more adept at screening, it is less effective at monitoring; if it is less effective at either screening or monitoring, it is also less effective at collection. This pattern suggests that banks tend to specialise in their choice between screening and monitoring, but their ability to recover charged-off financing receivables parallels their effectiveness at prior stages of risk management.

Another important issue is the relationship between probability of default (PD) and recovery rate (RR). If a customer defaults on a financing, an Islamic bank’s recovery may depend on the value of the collateral. The value of collateral depends on the economic condition. Some studies show recovery rate variable as independent of expected or actual default rates. If there is a correlation, this has implication for portfolio credit-risk models and pro-cyclicality effect of the capital requirements proposed by the Basel Committee (Altman et al., 2005). The link between credit risk and Basel III can be discussed in the context of two models – standardised model and advanced internal rating-based model. 6.4.1 Standardised  Model

The standardised model for credit risk follows the same methodology as Basel III. For example, the risk weights for claims on sovereigns and their central banks are shown in Table 6.2. Under the previous system (Basel I and II), all commercial financings are viewed as having the same credit risk (and thus the same risk weight). Table 6.2, the new weights in Basel III, allow for differentiation of credit risk within the classification of Organization for Economic Cooperation and Development (OECD) nations, whereas under Basel I and II, all nations carried preferential risk weights of 0% on their government obligation.

Table 6.2 Total Capital Requirements on Sovereigns Obligations under the Standardised Model of Basel III Credit Assessment

AAA to AA−

A+ to A−

BBB+ to BBB−

BB+ to B−

Below B−

Unrated

Risk Weight

0%

20%

50%

100%

150%

100%

Source: BIS (2006)

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As for standardised risk weighting of claims on Islamic banks and securities, there are two options. Under option 1, all Islamic banks incorporated in a given country are assigned a risk weight that is one category less favourable than the sovereign country’s risk weight (with the exception of sovereigns rated BB+ or below). Thus, the risk ratings for option 1 shown in the heading of Table 6.3 pertain to the sovereign’s risk rating. For example, an Islamic bank that is incorporated in a country with an AAA rating will have a 20% risk weight under option 1, which will result in a 1.6% capital requirement. Option 2 uses the external credit rating of the Islamic bank itself to set the risk weight. Thus, the risk ratings for option 2, shown in the heading of Table 6.3, pertain to the Islamic bank’s credit rating. For example, an Islamic bank with an AAA rating would receive a 20% risk weight (and a 1.6% capital requirement) regardless of the sovereign’s credit rating. The choice of which option should be applied is left to regulators and must be uniformly adopted for all Islamic banks in the country. Table 6.3 (last row) also shows that Basel III reduced the risk weights for all Islamic bank claims with original maturity of three months or less. Table 6.4 produces the risk weights for corporate obligation. Under Basel III, Islamic bank’s corporate financings are classified into each of the five risk groups Table 6.3 Total Capital Requirements on Islamic Bank under the Standardised Model of Basel III Option 1 Credit Assessment of Sovereign

AAA to AA−

A+ to A−

BBB+ to BBB−

BB+ to B−

Below B−

Unrated

Risk Weight under Option 1

20%

50%

100%

100%

150%

100%

Credit Assessment of Sovereign

AAA to AA−

A+ to A−

BBB+ to BBB−

BB+ to B−

Below B−

Unrated

Risk Weight under Option 2 Risk Weight for short-term claims under Option 2

20% 20%

50% 20%

50% 20%

100% 20%

150% 20%

50% 20%

Option 2

Source: BIS (2006)

Table 6.4 Total Capital Requirements on Corporate Obligations under the Standardised Model of Basel III Credit assessment

AAA to AA−

A+ to A−

BBB+ to BB−

Below BB−

Unrated

Risk Weight

20%

50%

100%

150%

100%

Source: BIS (2006)

Credit Risk 155 according to the credit rating assigned to the customer by rating agencies, such as Standard & Poor’s, Moody’s and Fitch. To obtain the minimum capital requirement for credit risk purposes, all financing exposures (each is known as the exposure of default – EAD) in each risk weights bucket are summed up, weighted by the appropriate risk weight from Table 6.4 and then multiplied by the overall total capital requirement of 8%. In addition, the standardised approach takes credit risk mitigation into account by adjusting the transaction’s EAD to reflect collateral, credit derivatives, guarantees and offsetting on-balance-sheet netting. However, any collateral value is reduced by a haircut to adjust for the volatility of the instrument’s market value. Moreover, a floor capital level ensures that the financing quality of the customer will always affect capital requirements. Internal Ratings-Based Models for Credit Risk – Under the Internal RatingsBased (IRB) model, each Islamic bank is required to establish an internal ratings model to classify the credit risk exposure of each activity (e.g., commercial financing, consumer financing) whether on or off the balance sheet. For the foundation IRB approach, the required outputs obtained from the internal ratings model are estimated for one-year Probability of Default (PD) and Exposure at Default (EAD) for each transaction. In addition, independent estimates of both the Loss Given Default (LGD) and Maturity (M) are needed to implement the advanced IRB approach. Islamic bank computes risk weights for each individual exposure (e.g., corporate financing) by incorporating its estimates of PD, EAD, LGD and M obtained from its internal ratings model and its own internal data systems. The model also assumes that the average default correlation among individual customers is between 10% and 20%, with the correlation assumed to be the decreasing function of PD. Given the definition of expected losses, there is only one possible credit event (default) and ignores the possibility of losses resulting from credit-rating downgrades. That is, deterioration in financing quality caused by increases in PD or LGD will cause the value of the financing to be written down – in a mark-to-market sense – even prior to default, thereby resulting in portfolio losses (if the financing’s value is marked to market). Therefore, the credit risk measurement model can be differentiated based on whether the definition of a ‘credit event’ includes only default (the default mode or DM models) or it also includes non-default financing quality deterioration (the mark-to-market or MTM models). The mark-to-market approach considers the impact of credit downgrades and upgrades on market value, whereas the default mode is only concerned about the economic value of an obligation in the event of default. There are five elements to any IRB approach: (1) a classification of the obligation by credit exposure – the internal ratings model; (2) risk components – PD and EAD for the foundation model and PD, EAD, LGD and M for the advanced model; (3) a risk weight function that uses the risk components to calculate the risk weights; (4) a set of minimum requirements of eligibility to apply the IRB approach; and (5) supervisory review of compliance with minimum requirements. The IRB approaches require Islamic bank to segment the portfolio according to their own criteria and then apply a given formula to determine the capital ratio

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for each given segment. Islamic bank that selects the foundation regime would have to provide only one input to the formula that is probability of default (PD) for financings in each segment, whereas Islamic banks that select for the advanced approach also need to provide estimates of loss given default, exposure at default and maturity. Foundation IRB Approach – Islamic banks can use own estimates of probability of default (PD) over a one-year time horizon, as well as each financing’s exposure at default (EAD). The average PD for each internal grade is used to calculate the risk weight for each internal rating. The PD may be based on historical experience or even potentially on a credit-scoring model. The foundation IRB approach sets a benchmark for M, maturity at three years. Moreover, the foundation approach sets assume that loss given default for each unsecured financing is set at LGD = 50% for senior claims and LGD = 75% for subordinated claims on corporate obligations. However, the LGD on secured financings is reduced to 45% if fully secured by physical, non-real estate collateral and 40% if fully secured by receivables. The foundation approach formula for the risk weight (RW) on corporate obligations (financings) is given as:  LGD  RW =  ×BRW  50 

(6.1)

12.5 × LGD

(6.2)

or

whichever is smaller, where the benchmark risk weight (BRW) is calculated for each risk classification using the following formula:  (1− PD) BRW = 976.5× N (1.118×G(PD) +1.288) ×1 + 0.0470×   PD 0.44 

(6.3)

The term N(y) denotes the cumulative distribution function for a standard normal random variable (i.e., the probability that a normal random variable with mean zero and variance less than or equal to y), and the term G(z) denotes the inverse cumulative distribution function for a standard normal random variable (i.e., the value of y such that N(y) = z). The BRW formula is calibrated so that a three-year corporate financing with a PD equal to 0.7% and an LGD equal to 50% will have a capital requirement of 8%, calibrated to an assumed loss coverage target of 99.5% (i.e., losses can exceed the capital allocation and occur only 0.5% of the times, or five years in 1000). 6.4.2 Advanced  Internal  Rating-Based  Model

Islamic banks are also encouraged to move from the foundation approach to the advanced approach. A primary source for this incentive results from the utilisation

Credit Risk 157 of the Islamic bank’s actual LGD experience in place of the fixed assumption of a 40, 45, 50 or 75% LGD. Evidence suggests that historical LGD for Islamic bank financings is significantly lower than 50% and, therefore, the shift to the advanced approach is expected to reduce bank capital requirement by 2 to 3%. However, the permission to use actual LGD follows an additional set of minimum requirements attesting to the efficiency of the Islamic bank’s information systems in maintaining data on LGD. Another adjustment to the foundation approach’s benchmark risk weight (BRW) is by incorporating a maturity adjustment that reflects the transaction’s effective maturity, defined as the greater of either one year or nominal maturity, which is the weighted average life ( = Σi tPt / Σt Pt ), where Pt is the minimum amount of principal contractually payable at time t) for all instruments with a predetermined minimum amortisation schedule. The maturity is capped at seven years to avoid overstating the impact of maturity on credit risk exposure. The advanced IRB approach allows Islamic bank to use its own credit risk mitigation estimates to adjust PD, LGD and EAD for collateral, credit derivatives, guarantees and on-balance sheet netting. The risk weights for the mark-to-market. The advanced IRB approach for corporate obligation is calculated as follows:  LGD  RW =  × BRW ×[1+ b( PD)×(M −3) ]  50 

(6.4)

where b( PD) =

[0.0235× (1− PD)] [ PD

0.44

+ 0.0470×(1− PD)]

(6.5)

and BRW is as stated in the foundation IRB approach. The effect of the [1+b(PD) ×(M−3)] term in equation (6.4) needs to be adjusted with the risk of financings for its maturity. For longer maturity instruments, the maturity adjustments increase for low PD-rated customers (i.e., higher rated customers). The intuition is that maturity matters most for low PD customers since they can move only in one direction (downward), and the longer the maturity of the financing, the more this is likely to occur. For high PD (low-quality) customers who are near default, the maturity adjustment will not matter as much because they are close to default regardless of the length of the maturity of the financing. 6.5

Credit Risk Management

In the credit risk assessment process, especially when assessing the probability of default, Islamic bank uses credit scoring or credit analysis to avoid extending financing to parties that entail excessive credit risk. Hence, credit risk limits are widely used. Islamic bank also can use innovative products and structures that have been developed to manage credit risk. The following are some important examples:

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first, structured finance transactions, such as collateralised mortgage obligations and asset-backed securities. These instruments pool assets and transfer all or part of the credit risk borne by originator to new investors and, in some cases, to one or more guarantors, as well. Through the utilisation of the secondary market, investors can transfer the risk to a different party. Second, exchanges and clearinghouses, in which by introducing a structural hub, these entities minimise the need for every pair of contracting parties to create a separate mechanism for managing their counterparty credit risk exposure. Third, credit derivatives, which can be layered to modify the credit risk profile of an underlying asset. Financial instruments are being designed – some simple and some complex – that create a kind of insurance mechanism for transferring the risk of default and, in some instances of financing migrations. For the first time ever, it is now possible to go short on financing. Furthermore, the credit risk to be bought or sold may be tailored as to the amount, period and type of credit event. Credit derivatives instruments can be used to hedge from the danger of default. The instruments are usually in the form of a credit default swap. It changes the way Islamic banks price, manage, transact, originate, distribute and account for credit risk. These financial contracts allow customers to engage protection against defaults from a third party. The third party receives a periodic fee as compensation for the risk it takes, and in return, it agrees to own the debt should a credit event (‘default’) occur. Finally, Islamic bank can hold capital against outstanding credit exposures. However, under financial distress, Islamic bank deposits are exposed to credit risk if Islamic banks collapse, they are not able to return the investors’ principal or may not continue paying returns. The US government helps protect against default risk by banks through the Federal Deposit Insurance Corporation (FDIC) programme, which insures deposits for up to $100,000 if a bank defaults. In Malaysia, Malaysian Deposit Insurance Corporation (PDIM) insures deposits for up to RM250,000 (deposits in each of Islamic banks) if an Islamic bank defaults. The framework of credit risk management is a comprehensive combination of the role of board of directors and team management, risk identification, risk measurement, risk monitoring and risk controlling, and risk mitigation. 6.5.1 Role   of the  Board   of Directors  and  Senior  Management

Board of director and senior management has responsibility developing proper financing, establishing an appropriate environment for credit risk management and installing proper tools. Islamic bank’s financing culture accumulates from the value, belief and behaviour concerning financing practices. The board of directors and senior management should establish a financing culture that can also manage credit risk. The best practices in developing a strong financing culture can be as follows: (1) management regularly assesses the consistency of the financing practices with the Islamic bank’s risk appetite and financing policy; (2) management places high importance on financing quality, and this should be echoed throughout the organisation; (3) strong

Credit Risk  159 management is at the top of the financing function; (4) management accepts responsibility for financing quality and encourages sound financing practices from credit officers; (5) clear accountability is established for every personnel involved in the management of credit risk; (6) management and officer in the financing process are rewarded for financing vigilance or penalised for financing negligence; (7) clear financing policy is enforced by authority. Establishing an appropriate environment for credit risk management requires the board and senior management to periodically review, approve and assess credit risk strategy and plan. The strategy should reflect Islamic bank’s risk tolerance and the level of profitability targeted at various levels of risk. Moreover, they identify, measure, monitor and control the credit risk. In all areas of Islamic bank’s activities, the board and senior management have an important role in overseeing the financing approval process and credit risk management. Therefore, Islamic banks have the responsibility to develop a credit risk strategy or operational plan as a guideline for financing approval and revise the policy and procedure for different activities. The credit risk strategy and policy should be approved and periodically reviewed by the board of directors. The board must realise that the strategy and policy must cover activities with high credit risk exposure. Senior management is responsible for implementing the credit risk strategy approved by the board of directors and developing the policies and procedures to measure, monitor and control credit risk. These include: (1) setting the policies and limit structures as a credit risk tolerance; (2) providing proper channels of communication; and (3) providing adequate and effective operational procedures, internal controls and systems for identifying, measuring, monitoring and controlling credit risks – all are in place to implement the board-approved financing policies and standards; (4) comprehensive credit-risk reporting; (5) having and effective management information system and allocating sufficient resources to manage daily operations etc. Such procedures and policies should be specified in all activities at both individual financing and portfolio levels. Approval authority and responsibility should be appropriately delegated, and a periodic independent review of the financing approval units should be performed. An appropriate implementation of policies such as financing policy helps the bank to identify, measure, monitor and control credit risk. The management must ensure that Islamic bank complies with the financing policy and procedure so that financings are appropriately distributed in line with the targeted markets and the overall strategy. In this respect, the policy should specify the framework and practical guidelines for financing granting activities, including such issues as targeted markets, portfolio composition, pricing and limit structure. 6.5.2  Risk Identification, Measurements and Monitoring

Effective risk identification starts with individual credit assessment. Islamic bank should rate creditworthiness of each customer regularly. Islamic banks may also apply relative rating; for example, parent company’s rating may help revise its subsidiary’s rating. Rating can be done by type of financings or transactions. In

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some cases, Islamic banks may implement both relative rating and rating by type of financing transaction. Risk rating also is applied to off-balance-sheet transactions. The rating process is conducted regularly so that the changes in financing quality will be acknowledged in time and, thus, helps Islamic bank to revise the strategy as well as monitor non-performing financings. Islamic bank should review and analyse each segment and overall portfolio to ensure regular risk rating. Moreover, the rating and review process should be conducted in accordance with the specified risk factors and financing lines. New products that can incur risk should be given much attention in the new product planning process. In this regard, adequate guidelines and control procedures should be specified before new products and transactions are proposed or introduced. This new product and transaction must have approval from the board of directors or special committee. Risk measurement is a process that incorporates customers’ quantitative factors and other related factors in the form of parameters to reflect the quantity of risk of an individual customer and the overall portfolio. An accurate and reliable system is needed to measure the credit risk of individual customers in accordance with the quality, repayment ability and type of financing or business, both on- and offbalance-sheet financing transactions and treasury transactions. This is to make sure that the level of risk can properly be measured, monitored and controlled. An effective risk measurement requires Islamic bank to: first, formulate a policy and strategy in risk measurement and the impact on Islamic bank consisting methods, credit risk analysis, risk measuring technique and management information system; second, formulate risk measurement process, including the objective of the financing model, elements and techniques used to build the model, and create models that incorporate factors related to the transactions and validation/accuracy test on the models; third, asses the asset quality by Islamic bank by incorporating rating guidelines that reflect customers’ level of risk and financing loss provisioning that can be used in analysis on profitability and comparative analysis; fourth, clear customer segmentation and regular assessment of financing concentration. For example, compare the ratio of financings of a group of large customers to total financings and periodically assess changes in that proportion, as well as closely monitor and supervise the relationship; and fifth, assess the current level of financing loss provisioning against credit risk. Sufficient amount of provisioning can help cushion against the credit risk. This can be done by using appropriate ratios to test whether the level of financing loss provisioning is reasonable. Ratio analysis will reveal the trend of relationship between financing loss provision with various factors such as non-performing assets and normal financings, pass due financings, financing and contingent liabilities, and write-off statistics. Risk monitoring is a process to identify the amount and level of customers’ risk in a continuous and timely manner. Financial institutions should arrange to have monitoring of risk regularly as follows: first, proper financing administration and monitoring – Once, a credit is approved, there must be a credit administration support team to continuously monitor the risk of credits. The process includes

Credit Risk 161 effective credit administration (including monitoring documentation, contractual requirements etc.), accurate and timely input data for management information, adequate procedures to control the ‘back-office’, section-wide controls as well as compliance with policies, and policies and procedures that are in line with standards. In addition, banks should focus on monitoring credit quality and adequacy of provisioning. Effective credit monitoring system includes: (1) periodic assessment of customers’ current financial condition, (2) cash flow analysis and assessment of repayment ability, (3) compliance with the existing covenants, (4) monitoring of use of credit lines as in requested credit plan, (5) adequate collateral coverage relative to customers’ current condition, and (6) and periodic identification and classification of problem credits, as well as provisioning. Second, monitoring the structure and quality of financing – Islamic bank has the responsibility to establish a system to monitor the structure and quality of financing portfolios to monitor concentrations within portfolios, which is a major cause of financing problems. This concentration risk can arise from providing financing and other types of Islamic banks’ transactions that involve counterparties. The financial institution should have proper records of information to check and monitor the concentration of financings. The complexity level of the reporting data depends on the size and types of transactions. If Islamic bank wants to extend financings to each industry or transaction, the management must specify separating criteria that incorporate numerical interrelationship between industries in various forms such as type of financing, underlying contract, industry, geographical area, collateral, maturity and default risk. Using this information, Islamic bank will set the maximum proportion of financings to be used internally as risk limit, which depends on the stability of counterparties’ financial condition. At the same time, Islamic bank can use stress testing to identify potential loss that may incur for each customer and type of financings in the portfolio. Third, financing review system – The complexity and scope of financing review system vary depending on the size of an Islamic bank, types of operations and management practices. Financing review system must be independent of financing units. Among the objectives of financing review system are to ensure accuracy of risk rating system; to promptly and accurately identify problem financing, and hence ensure the implementation of appropriate actions to minimise financing losses; to project trends that affect financing collection ability; and to be a source of information on trends on repayment ability. In addition, it also provides information to the board of directors and senior management for quality assessment of the overall financing portfolio. Moreover, it is important to provide information that can be used in determining the adequacy of financing loss provisioning. Fourth, internal risk ratings –This means the rating of financings by type of risks that determine risk characteristics. It will help Islamic bank in more accurate determination of the overall qualitative characteristics of financing portfolio, concentrations, problem financings and adequacy of financing loss reserves. In an effective and sophisticated risk rating system, Islamic bank can use the rating results to determine capital allocation to absorb risk, risk-based pricing, profitability of various transactions and ongoing monitoring of financing quality.

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An internal risk rating system usually rates financings by type of risk, which can be in the form of numbers or words such as ‘very good’, ‘good’, ‘fair’, ‘satisfactory’ and ‘poor’. In grading risk, Islamic bank must decide whether to rate the risk by type of customer or counterparty or by type of financings or by type of contracts or both. Internal risk rating is an important tool for monitoring and controlling credit risk. The system should include factors that truly reflect credit risk. These factors can be based on past status and qualitative factors such as industry sector profitability, operation trends and compliance with covenants. Fifth, management of problem financings – Islamic bank may have different methods and organisation for the management of problem financings. Whether the responsibility will be assigned to the financing originating unit or a special unit depends on the size and type of financings. In general, a work-out unit should be independent from the originating unit. Organisation should be in line with each Islamic bank’s needs and necessities. 6.5.3 Risk  Controlling  and  Risk  Mitigation

The objective of credit risk management is to maintain credit risk level of Islamic bank, given various factors and variables. Islamic bank will make sure that credit risk level does not exceed an acceptable level specified by the board and senior management. A controlling process by setting a financing line and other procedures will help ensure that credit risk level does not exceed the acceptable level and help management in monitoring compliance with the financing policy. An appropriate system of financing line setting will ensure that management will be informed when the amount of financings extended exceeds the financing line, while management can monitor and control risk to be at an acceptable level. Thus, Islamic bank must have a proper management information system to alert management’s attention if the risk level approaches the specified ceiling (limit). Limits can be based on the internal risk rating assigned to the customer. In addition to the information on financing lines that exceed the risk ceiling, the report should include the outstanding portfolio in the information system of Islamic bank. In controlling risk, the management should set the target and acceptable risk level. As the senior management specify and communicate the strategic targets and business plan, they must use these targets to determine the acceptable risk level. This can be done by specifying a guideline on diversification of the financing portfolio to prevent financing concentration in certain sectors. The proportion of financings for each acceptable level of credit risk needs to be identified. In the process of setting the risk ceiling, Islamic bank needs to know the information about the causes of increased credit risk level before they can take any actions. They also must have a good management information system. The task of the board and senior management is to periodically assess the adequacy of Islamic bank’s management information system, such as monitoring financing growth, business acquisition and change in the level of risk. For example, the management must review the total financings and contingent liabilities, financings in excess of existing financing limits, details of delinquent and/or non-accrual financing.

Credit Risk 163 Financial control also requires Islamic banks to have a process to analyse customers’ ability to repay, especially for new customers. This can be done by using reliable sources of references and accessing credit bureaus. Islamic banks must carefully analyse each financing proposal. An effective credit assessment must specify the minimum requirement of information for analysis purposes. Information such as the purpose of financing and repayment plan, reputation of customers and customers’ current risk profile may help Islamic banks in assessing the creditworthiness of the customers. Finally, Islamic bank must maintain adequate provisioning for ‘expected loss’ from financing and contingent liabilities. Islamic bank will set and control the limit on expected loss relative to the acceptable returns and the capital maintained against loss from problem financings. Expected loss should incorporate all factors that affect the collectability of financings as on the evaluation date. The criteria to determine an adequate level should include loss statistics, trends of financing loss or existing level of classification. The factors that may cause expected losses to differ from statistical losses also are included. 6.6

Credit Risk: The Challenge for Financial Market

The existence of credit risk brings along few challenges for financial markets. In early age of credit risk, the word customer carries connotations of despair and indignity. However today, people do not see themselves as customer. They think of themselves as people using leverage, a word that with entirely different connotations. In fact, the society itself encourages customers to increase their reliance on Islamic banking institutions. For example, Islamic banks attract buyers with a low profit margin on house financings and provide easy terms to customers who cannot afford it. At the company level, they issue shares so that they can acquire capital by borrowing money from the public. In fact, some of them increase the leverage ratio so as to get a tax shield. Similarly, issuing sukuk is seen as a perfectly respectable strategy for companies lacking access to lower-cost forms of financing. They have lost competitiveness in terms of financial strength. In the case of bankruptcy, it is considered an embarrassment and potentially career-ending disaster. However, bankruptcy is now widely accepted as a reasonable strategic option for customers to obtain financing for growth, to extricate themselves from burdensome contractual obligations or to avoid making payments that they deem inconvenient to suppliers, employees or others. The attitude of borrowing raises the instability of the financial industry. We know that financing facility enables individuals or companies to buy homes, cars, consumer goods, investment goods and services. In turn, it creates employment and increases economic opportunity. However, the substantial amount of unpaid financing causes Islamic banks to incur huge losses in their financing activity. In fact, Islamic banks may no longer have the ability or the capacity to manage credit risk effectively. Events such as sub-prime crisis have demonstrated that the judgement of America’s banks is far from infallible. American banks have made a serious

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mistake in lending. While several factors converged to produce the recent bank crises, an adequate credit policy and/or process was surely one of the most important. There are differences between the economic crisis in Latin America in the early 1980s and in Asia in 1997. In the Latin American case, many of the difficulties experienced by those countries were due to external shocks such as sharp declines in world commodity prices and high interest rates following the restrictive monetary policy pursued by the US to control inflation at home. On the other hand, with Asian economies, the problems were caused by an asset bubble in real estate and on the other by excessive investment in productive capacity and decline in export growth. The above experience suggests that they systematically underpriced credit risk, especially commercial credit risk. The reason for inadequate pricing is varied. Some banks have treated commercial financings as a ‘loss leader’ that induces customers to purchase other, more lucrative products from them. In addition, banks have not had good systems for measuring relationship profitability expressed in terms of return on capital. A final cause may be the lack of adequate default and recovery data regarding their own corporate lending experience. The emergence of new kinds of financial transactions has also created greater awareness of credit risk. Financial derivatives such as interest rates or currency swaps represent the unbundling of market risk and credit risk. Derivative expands the concept of credit risk to include counterparty risk. There is a possibility of default by the counterparty with a substantial aggregate exposure could lead to a chain reaction affecting many other institutions. This financial risk has increased simply because there are derivatives transactions, but derivatives entail additional financial contracting and therefore, additional exposure to be monitored and managed by the contracting parties. The emergence of asset-backed securities, similar to financial derivatives, forces market participants to pay closer attention to credit risk. Securitisation involves systematically grading and segmenting these risks. The typical asset-backed transaction involves many variables and understanding the correlations among them may require a high level of analytic sophistication. As securitisation technology spreads to new jurisdictions and as more institutions begin to invest in residential and commercial mortgage-backed securities and asset-backed securities, financial professionals need to know more about managing correlated credit risk, that is, risk associated with separate assets that show a collective tendency to change in credit quality in the same direction. In addition, more attention should be paid on the issue of screening the creditworthiness of the customer to avoid crisis in the future. 6.7

Measurement of Loss Given Default

Islamic banks largely involve in financing activities. Hence, Islamic banks are exposed to what is known as credit risk. Credit risk may result in collapse if Islamic bank does not have enough capital to absorb the losses. Credit risk is largely influenced by default risk. Default is defined as situations that occur when an obligor fails to meet a financial obligation. Specifically, a default is considered to have

Credit Risk 165 occurred with regard to a particular obligor when one or more of the following events has taken place: (1) it is determined that the obligor is unlikely to pay its obligations (principal or profit margin or fee) in full; (2) a credit loss event associated with any obligation of the obligor, such as charge-off, specific provision or distressed restructuring involving the forgiveness or postponement of principal or profit margin or fee; (3) the obligor is past due more than 90 days on any financing obligation; or (4) the obligor has filed for bankruptcy or similar protection from Islamic bank. The sum of the values of all possible losses time the probability of that loss occurring is known as expected loss. Therefore, three factors are relevant in analysing expected loss (EL): loss given default (LGD), exposure at loss (EAD) as well as probability of default (PD) due to credit risk. Loss given default is usually defined as the ratio of losses to exposure at default. Once the default event has occurred, LGD includes three types of losses: the loss of principal, the carrying costs of non-performing financing and workout expenses. Therefore, according to the measurement of LGD for an instrument,7 it can be divided into three categories: namely, market LGD (observed from market prices of defaulted sukuk or marketable financings soon after the actual default event), workout LGD (the set of estimated cash flow resulting from the workout and/or collections process, properly discounted, and the estimated exposure) and implied market LGD (LGDs derived from risky but not defaulted using theoretical asset pricing model). Market LGD – For financings that are traded in the market, price can be observed directly so long as a trade has occurred. The actual prices are based on par = 100 (‘cents on the dollar’) and can thus be easily translated into a recovery percentage (or LGD as 100% minus the percentage recovery). These prices have some desirable properties since they are observed early and reflect market sentiment at that time. After all, they are the result of a market transaction and hence less subject to debate about proper valuation. These prices reflect the investor’s expected recovery and thus include recoveries on both principal and missed profit margin payments as well as restructuring costs and uncertainty of that restructuring process. Workout LGD – LGD observed over the course of a workout is a bit more complicated than the directly observed market LGD. Attention needs to be paid to the timing of the cash flows from the distressed asset. Measuring this timing will affect downstream estimates of the realised LGD. The cash flows should be discounted, but it is by no means obvious which discount rate to apply. For example, debt restructuring could result in the issuance of risky assets such as equity or warrants, or less risky ones such as notes, sukuk or even cash. In principle, the correct rate would be for an asset of similar risk. Importantly, once the obligor has defaulted, Islamic bank is an investor in a defaulted asset and should value it accordingly, possibly at the Islamic bank’s hurdle rate. Implied Market LGD – An entirely different approach one could take to obtain an estimate of LGD is to look at credit spreads on the (much larger universe of) non-defaulted risky (e.g., corporate) sukuk currently traded. Although these new methods have not yet fully migrated into Islamic bank’s credit risk

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arena, they are used in the trading room for fixed-income products and credit derivatives and as such are often used as a check against more conventional credit rating models. 6.7.1 Loss  Given  Default  under  Basel  III  and  IFSB

LGD and EAD as well as PD are explained as components of risk on the Internal Rating-Based (IRB) Approach of The First Pillar BIS III (2006). However, the Basel Committee gives the permission a choose between the Standard Approach and Internal Rating-Based (with supervisory approval) methodologies for calculating their capital requirement for credit risk (including economic capital). The IRB approach is based on the measurement of unexpected loss (UL) and expected loss (EL). Under IRB approach, Islamic bank must categorise banking-book exposures into broad classes of assets with different underlying risk characteristics, subject to the definitions as follow. The classes of assets are (1) corporate, (2) sovereign, (3) bank, (4) retail and (5) equity. Within the corporate asset class, five sub-classes of specialised financing are separately identified (project finance, object finance, commodities finance, income-producing real estate and high-volatility commercial real estate). Within the retail asset class, three sub-classes are separately identified (exposures secured by residential properties, qualifying revolving retail exposures and all other retail exposures). Within the corporate and retail asset classes, a distinct treatment for purchased receivables may also apply provided certain conditions are met. The definition of the classes of assets is explained in detail in paragraphs 218 until 243 of BIS III (2004). Therefore, the estimation of LGD as well as EAD and PD may differ for each class of asset banking-book exposures. Under the foundation approach, Islamic bank provides their own estimate of PD and rely on supervisory estimates for other risk components (LGD, EAD and M). Under the advanced approach, Islamic bank provides their own estimates of LGD as well as EAD and PD, and their own calculation of Maturity (M). For example, the corporate, sovereign and bank exposure; under the foundation approach, Islamic banks must provide their own estimates of PD associated with each of their customer grades, but they must use supervisory estimates for the other relevant risk components (LGD, EAD and M). For retail exposure, Islamic banks must provide their own estimates of PD, LGD and EAD without distinction between a foundation and advanced approach. For equity exposure, banks can apply a market-based approach and PD/LGD approach, while for eligible purchased receivables, both a foundation and advanced approach are available subject to certain operational requirements being met. Table 6.5 shows the distinction between foundation and advanced approach under IRB. Foundation  Approach. BIS prescribes LGD ratios for certain classes of unsecured and secured exposures. For unsecured exposure (exposure without collateral), LGD depends on: (1) senior claims on corporate, sovereigns and banks that are not secured by recognised collateral attract a 45% LGD; (2) all subordinated claims on corporates, sovereigns and banks attract a 75% LGD.

Credit Risk 167 Table 6.5 Distinction between Foundation and Advanced Approach under IRB Data Input

Foundation IRB

Probability of Default (PD

Supplied by bank-based on own estimates Supervisory values set by Basel

Loss Given Default (LGD) Exposure at Default (EAD) Maturity (M)

Advanced IRB

Supplied by bank-based on own estimates Supplied by bank-based on own estimates Supervisory values set by Basel Supplied by bank-based on own estimates Supervisory value set by Basel Supplied by bank-based or at the discretion of national on own estimates, with supervisors, supplied by bankan allowance to exclude based on own estimates, with some exposures an allowance to exclude some exposure.

Source: Heffernan (2005, p. 197)

The effective loss given default (LGD*) applicable to a collateralised transaction can be expressed as: LGD* = LGD× (E * E )

(6.6)

where LGD is that of the senior unsecured exposure before recognition of collateral (45%); E is the current value of the exposure (i.e., cash lent or securities lent or posted); E* is the exposure value after risk mitigation. However, E* is calculated based on the following formula: E* = max {0, E× (1 + He) − c × (1− Hc − Hfx )}

(6.7)

where E* is the exposure value after risk mitigation, E is current value of the exposure, He = haircut appropriate to the exposure, C is the current value of the collateral received, Hc = haircut appropriate to the collateral, and Hfx is haircut appropriate for currency mismatch between the collateral and exposure. The standard supervisory haircut for currency risk where exposure and collateral are denominated in different currencies is set at an additional 8%. The *He and *Hc are derived from Table 6.6 of standard supervisory haircuts proposed by IFSB. However, under certain special circumstances the supervisors, that is, the local central banks, may choose not to apply the haircuts specified under the comprehensive approach, but instead to apply a zero H. Advanced Approach – Under the Advanced-IRB approach, Islamic bank itself determines the appropriate loss given default to be applied to each exposure, based on robust data and analysis. Thus, Islamic bank using internal loss given default estimates for capital purposes might be able to differentiate LGD values based on

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Table 6.6 Standard Supervisory Haircuts Types of Collateral

Residual Maturity (yrs)

Haircuts Sovereigns

Others

Cash Sukuk Long-term: AAA to AAShort-term: A−1 Sukuk Long-term: A+ to BBB− Short-term: A−2 to A−3 Sukuk Long-term: BB+ to BB− Sukuk (unrated) Equities (listed and included in main index) Equities (listed but not included in main index) Units in Islamic collective investment scheme

All ≤1 >1 to ≤5 >5 ≤1 >1 to ≤5 >5 All

0 0.5 2 4 1 3 6 15

0 1 4 8 2 6 12 25

All All All

25 15 25

25 15 25

All

Physical assets pledged

All

Depending on the underlying assets >=30

Depending on the underlying assets >=30

Source: IFSB (2013)

a wider set of transaction characteristics (e.g., product type, wider range of collateral types) as well as customer characteristics. Islamic bank that wants to use its own estimates of LGD will need to demonstrate to its supervisor that it can meet additional minimum requirements pertinent to the integrity and reliability of these estimates. LGD warrants more attention than what has been given to it in the past decade, where credit risk models often assumed that LGD was time-invariant (constant). According to BIS (2006) institutions implementing Advanced-IRB instead of Foundation-IRB will experience larger decreases in Tier-1 capital, and the internal calculation of LGD is a factor separating the two Methods. Basel Committee noticed that LGD is largely dependent on economic cycles. 6.7.2 Calculation   of Loss  Given  Default

Theoretically, for a given maturity, estimation of expected loss (EL) can be divided into two types: Expected loss as an amount: EL = PD×LGD × EAD

(6.8)

and expected loss as a percentage of exposure at default: EL% = PD × LGD

(6.9)

Credit Risk 169 Equation (6.9) shows that the expected loss upon default is equal to the probability of default (in decimal) times loss given times (decimal). However, this equation considers only one possible financing event default and ignores the possibility of losses resulting from credit rating downgrades. Deterioration in financing quality caused by increases in PD or LGD will cause the value of the financing to be written down (in a mark-to-market sense) even prior to default, thereby resulting in portfolio losses if the financing’s value is marked to market. Thus, credit risk measurement models can be differentiated based on whether the definition of a ‘financing event’ includes only default (the default mode model) or it also includes non-default financing quality deterioration (the mark-to-market models). Under BIS (2006), the calculation of LGD (not the effective LGD) is explained in paragraphs 468 to 473. The explanation in paragraphs 468 to 473 raises the following issues: First, BIS in paragraph 468 notes: A bank must estimate an LGD for each facility (contract) that aims to reflect economic downturn condition where necessary to capture the relevant risks. This LGD cannot be less than the long-run default-weighted average loss rate given default calculated based on the average economic loss of all observed defaults within the data source for that type of facility.8 In addition, a bank must take into account the potential for the LGD of the facility to be higher than the default-weighted average during a period when credit losses are substantially higher than average. . . . The calculation of LGD (or Downturn LGD) poses significant challenges to statisticians and practitioners. Practitioners may have only just started collecting the information necessary for calculating the individual elements that LGD is composed of: EAD, direct and indirect losses, security values and potential, and expected future recoveries. Another challenge, and maybe the most significant, is the fact that the default definitions between Islamic banks vary. Calculation of LGD (average) is often composed of defaults with or without losses. This is often the case when default definitions become more ‘sensitive’ to financing deterioration or ‘early’ signs of defaults. When Islamic banks use different definitions, LGD parameters therefore become non-comparable. The following formula can be used to compare LGD estimates from one-time period (say x) with another time period (say y): LGDy = LGD× × (1−Cure Ratey)/(1−Cure Ratex)

(6.10)

Second, BIS (2006) notes in paragraph 472: Estimates of LGD (for corporate, sovereign, and bank exposure) must be based on a minimum data observation period that should ideally cover at least one complete economic cycle but must in any case be no shorter than a period of seven years for at least one source. If the available observation

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period spans a longer period for any source, and the data are relevant, this longer period must be used. Note in paragraph 473 says: The minimum data observation period for LGD estimates for retail exposures is five years. The less data a bank has the more conservative it must be in its estimation. A bank need not give equal importance to historic data if it can demonstrate to its supervisor that more recent data are a better predictor of loss rates. Both paragraphs imply that Islamic bank must have sufficient data to make estimation on LGD. The longer data Islamic bank has, the better the prediction will be. Third, even though there is guidance noted in paragraph 468 (BIS, 2006), where Islamic banks are required to quantify the LGD parameters consistent with economic downturn conditions, still there is no perfect model that can explain the modelling of such LGD (Kim et al., 2007; Tasche, 2004; Hillebrand, 2006). That means the proposal of the Basel Committee on Banking Supervision (International Convergence of Capital Measurement and Capital Standard: A Revised Framework, 2006) on Paragraph 468 leaves the computation of LGD parameter for capital calculation unspecified. Other researchers, such as Flores et al. (2006), claim: that ‘The reform under Basel III will allow banks to develop their own internal risk estimates of key parameters, including (under that advanced IRB approach) LGD. Under Basel III, PD needs to be modelled at the obligor level, LGD at the facility level’. Therefore, any modelling effort will depend solely on the availability of historical data reflecting the Islamic bank financing experience. 6.7.3 Loss  Given  Default  under  Asymptotic  Single  Factor  Models

In general, for a defaulted financing, loss given default is the proportion of exposure that is lost. This is an economic concept that does not necessarily appear in conventional financial accounting records. Since LGD is a fraction, EL takes values between zero and one. By imposing the expectation operator, equation (6.9) can be rewritten as: E ( L) = E ( D)× E ( LGD) or EL = PD×ELGD

(6.10)

Equation (6.10) states that expected loss on a financing equals its expected default rate (probability of default) times the financing’s expected LGD rate. Notation of LGD implies a random variable that has some distribution, and ELGD is the mean of that random variable moment or population parameter. On the other hand, the concept of economic capital quantifies the risk faced by Islamic bank over a defined period (e.g., one year). Specifically, economic capital acts as a buffer against unexpected loss. In estimating the unexpected loss at each transaction level, all the inputs required to estimate expected loss (in equation 10.6)

Credit Risk 171 are needed plus the inputs of volatility of LGD and PD. Unexpected loss at the aggregate level is estimated by considering the default correlations among obligors and the rating that an Islamic bank wants to achieve. All types of loss, including credit loss, are included in the economic capital concept. For a credit loss, it is familiar to use value at risk or ‘credit VaR’ methodologies for economic capital purposes. Like ‘market VaR’, credit VaR models are used to estimate loss at high percentile of the loss distribution (e.g., 99.9th percentile loss). However, economic capital models for credit loss heavily depend on statistical theory and problem with the availability of data on default rate. In contrast, market VaR depends less on theory, because a lower percentile (perhaps the 99th) is used and because there are more data available to characterise a loss distribution. A loss distribution depends on the so-called ‘risk-factor’. In a market VaR model, the factors are the prices of securities or derivatives that resemble portfolio holdings. In credit VaR model, the risk factors are more abstract. Economy recession and boom will affect the economy as whole. Therefore, it is reasonable to think a single economic factor as driving the volatility of economic activity as well as default rate and LGD rate. For any given Islamic bank, purely random influences can cause its default rate and its LGD rate to deviate from the rates experienced system wide. If the Islamic bank portfolio is well-diversified enough, the deviation is very small. To modelling LGD and default rate, Frye (2004) assumes that both rates are associated to any respond to the ‘systematic’ risk factor. By taking the average within a year, the conditionally expected rate of default and LGD can be derived as function of Z. The functions have a monotonic property. This means both rates have positive relationship with economy condition. For example, worse conditions produce a greater default rate and a greater LGD rate. This relationship is easily explained using mathematical functions. In mathematical function, this imply that we must know the probability distribution of Z. Basically, Z is assumed follow a standard normal distribution. Therefore, one can imagine a random realisation of normal Z, then, Z implies the default rate and the LGD rate as shown in Figure 6.1. However, most common realisations of Z are near zero. It means that conditionally expected default rates near 4% but Figure 6.1 shows that much greater default can occur. Weighting all the conditionally expected default rates by their probabilities, the ‘unconditionally’ expected default rate (PD) equals 5%. In Figure 6.1, both functions are sensitive to Z. When standard normal Z takes its 99.9th percentile value of 3.09,9 it produces the stress default rate of 28% and the stress LGD rate of 75%. It also assumed as Z increases without limit, both default and LGD rates approach 100%. Furthermore, as Z falls without limit, both rates approach zero. The rest of this part (LGD under asymptotic single risk factor) is derived from the extension work of Frye (2004). Frye (2004) examines evidence from Moody’s Default Risk Service. For an instrument that defaults, it provides both the date of the default event and the price of the instrument a few weeks later. The percentile difference between pre- and post-default price measures LGD. The data sample include from 1983 and 2001, and it is separated into good (low default) years and bad (high default) years, so the LGD can be observed when the default rate is high.

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100% 80% Default (Z)

60% LGD (Z)

40% 20% 0%

-2

-1

0

1

2

3

4

5

6

Figure 6.1 LGD and Default as a Function of Risk Factor Z Source: Frye (2004)

The definition of bad year is somewhat arbitrary, in this case any year the default rate is greater than 4%. This study chose 49 ‘debt types’ – for each defaulted financing that shares a key trait; that is, it has experienced at least one default in a good year and at least one default in a bad year. As a result, plot of this average will show that position of a ‘bubble’ reflects the two LGD average. This study also chose to take a direct approach, while other researchers such as Kim et al. (2007) focus on the derivation of these functions and on the complexities of the derivation.10 This direct approach is explained in Figure 6.1 and Figure 6.2. The annual rates that have monotonic function property of random Z allow the functions of Figure 6.1 to be converted to probability distribution using a standard statistical technique (‘change of variable’ technique). Figure 6.2 shows the distribution of annual LGD, with horizontal axis showing values of the random variable (LGD) and the vertical axis showing the relative frequency of the values. It also shows the distribution of LGD by deal and it is different from distribution of annual LGD, but it depends on both the distribution of annual LGD and the default function. To illustrate the model, consider an LGD of 32%. About 11% of years have conditionally expected LGD greater than 32%. However, financing with LGD greater than 32% are much more common because the conditions that produce high annual LGD also produce a great many default financings. In Figure 6.1, LGD equal to 32% implies that Z equals 1.25 and associated default rate equals 10%. This is twice the ‘normal’ rate of default, which is 5% (PD). In Figure 6.2, if the LGD equals to 32%, the distribution of LGD by deal has twice the relative frequency of annual LGD. Reasoning this way up and down the range of LGD leads to the derivation of the full distribution of LGD by deal.

Rela˙ve Frequency

Credit Risk 173

LGD by deal

0%

20%

ELGD = 26%

40%

60%

80%

100%

Stress Annual LGD = 75%

Figure 6.2 Two Distribution of LGD Source: Fyre (2004)

The difference between the two distributions depicted in Figure 6.2 can be elucidated by considering the scenario of an Islamic bank with LGDs resulting from defaulted financings in a ten-year period. This period encompasses nine years of favourable conditions characterised low default rates and low LGD and one year of unfavourable conditions characterised by high default rates and high LGD. The unfavourable year produces more than 10% of the default. It shows that an Islamic bank lives by the distribution of LGD by deal, but it deceases by the distribution of annual LGD. An Islamic bank survives by making profitable financing. The pricing for each financing should include the expected loss (EL), which equals to PD times expected LGD. This expectation uses the distribution of LGD by deal. ELGD is shown in Figure 6.2 at 26%. By contrast, an Islamic bank deceases in an adverse year. In a year when Z is at its 99.9th percentile, loss equals to economic capital, which equals the stress default rate times the stress LGD rate. Stress LGD can be found in Figure 6.1, and it is noted in Figure 6.2. Stress LGD at the 99.9th percentile of annual LGD equals 75%. Fyre (2004) further summarises that if annual LGD depends on Z, this gives rise to a probability distribution of annual LGD. If the default rate depends on Z, this gives rise to a distinct distribution of LGD by deal. These two distributions of LGD warrant some observations: (1) ELGD and stress LGD come from different distributions. ELGD is expected LGD by deal. Stress LGD follows the 99.9th percentile of annual LGD. (2) Of the two distributions, the distribution of annual LGD is intrinsically simpler. Annual LGD depends directly on Z. The distribution of LGD is expected to follow by deal, and therefore ELGD depends on both the distribution of annual LGD and annual default rate function. (3) Expected annual

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LGD is less than ELGD. This is because years with greater LGDs contain more LGDs. (4) the average of annual average LGDs (‘time weighted average’ LGD) tends to understate ELGD. The time-weighted average produces an estimate of expected annual LGD, not of ELGD. In the above example, it produces economic capital for financing. The financing has ELGD = 26% and PD = 5%. These are known as unconditional expectations. Both LGD and the default rate vary by year depending on Z, leading to their conditional expectations. Economic capital is the product of the conditional expectation at the stress level of Z. Therefore, in this case, it equals to 21% = (75%*28%). The same approach can be used to provide economic capital for any other type of financing. For a different type of financing, the functions represented in Figure 6.1 are different, leading to different expectations (e.g., PD and ELGD) and different stress values. A problem of sampling error influences a bank portfolio. Sampling error, if coexisting with the diversity of characteristics of financings in the portfolio, makes the exact distribution like those in Figure 6.2 and is difficult to derive. Alternatively, one can specify default and LGD functions similar to that in Figure 6.1, and then performs a Monte Carlo simulation to find the distribution of loss. Economic capital for a portfolio is found at the desired percentile. Re-estimating the model by adding a single financing would produce the economic capital for that financing. If we generalise for a range of financing, the result can be stated as an economic capital function that depends on the characteristics of financing. The function can be represented as follows: K = f (PD, ELGD, other characteristics)

(6.11)

By assuming the asymptotic single risk factor model, Fyre (2004) found that K = 21% = f (5%, 26%). An economic capital function (capital at the margin) shows the effect on capital if financing of the specified type is added to or removed from the portfolio. It also tells the extra capital required when a deal is added to the portfolio, or the capital released when a deal is removed. Therefore, if an Islamic bank wants to evaluate both effects at once, for example, it contemplates changing the mix of characteristics in its portfolio. The resulting change in capital depends on the sensitivities (elasticity) of the capital function to its inputs. 6.8

Exposure at Default

In general, exposure at default (EAD) is defined as an estimation of the level of risk an Islamic bank faces from a counterparty in the event of, and at the time of, that counterparty’s default. It is a measure of potential exposure (in currency) as calculated by a Basel Credit Risk Model for the period of one year or until maturity, whichever is sooner. The definition is based on Basel Guidelines. EAD for financing commitments measures the amount of the facility that is likely to be drawn if a default occurs. Under Basel III, an Islamic bank needs to provide an estimate of the exposure amount for each transaction, commonly referred to as exposure at default (EAD), in Islamic banks’ internal systems. All these loss estimates should

Credit Risk 175 seek to fully capture the risks of an underlying exposure. For retail Islamic bank exposures, any change of a facility (i.e., extending the life of a mortgage such as reducing monthly payments) is regarded as a default, so long as such re-ageing is undertaken in distressed circumstances to stop a customer from not paying their mortgage at all. EAD, as shown in equation (10.3), is a key element of credit loss calculations. EAD can be defined as a random variable that represents the sum of an Islamic bank’s current exposure to a customer plus the expected value of any additional draw down on existing financing lines up to date of possible default, and most credit models assume EAD as known. In equation (10.3), EAD is treated as a known constant. This equation treats EAD as independent of Islamic bank’s probability of default or independent of all other random variables. Independence assumption is crucial for the appearance of unconditional expectations of EAD as well as LGD. This assumption is crucial to estimate the expected loss in equation (10.3). EAD can also be treated as equal to 1 and equal distributions of the single expected loss. This is a good approximation (theoretically) for large portfolios with exposures of the same magnitude (homogeneous portfolios). If this is not the case, one has to take into account the individual randomness for EADs, also known as idiosyncratic or unsystematic risk that is given in equation (10.3). 6.8.1 Exposure   at Default  under  Basel  III

Calculation of EAD is different under foundation and advanced approach. The foundation approach (Foundation-IRB) calculation of EAD is guided by the regulators. With the advanced approach (Advanced-IRB), Islamic bank has greater flexibility on how they would like to calculate EAD. Measurement of EAD, both through either foundation or advanced approach, has important implications on the determination of capital charge as well as expected loss. Islamic banks cannot create loss estimates without considering the amount by which a specific financing facility is drawn at the point of a projected default. Calculating EAD under Foundation Approach – Under Foundation-IRB, EAD is calculated by considering the underlying asset, forward valuation, facility type and commitment details. This value does not consider the type of guarantees, collateral or security (i.e., ignores Credit Risk Mitigation Techniques except for on-balance sheet netting where the effect of netting is included in Exposure at Default). For onbalance-sheet transactions, EAD is identical to the nominal amount of exposure. The netting of financings and deposits to a corporate counterparty in on-balance sheet is permitted to reduce the estimate of EAD under certain conditions. For offbalance-sheet items, there are two broad types which the IRB approach needs to address: transactions with uncertain future drawdown, such as commitments and revolving financing, and over-the-counter foreign exchange, benchmark rate and equity contracts. Under the foundation approach, EAD is estimated using standard supervisory rules. Calculating EAD under Advanced Approach – Under Advanced-IRB, Islamic bank can determine the appropriate EAD to be applied to each exposure. By

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having robust data and analysis, Islamic bank can validate both internally and with supervisors. An Islamic bank may use internal EAD estimates for capital purposes, and furthermore, EAD values can be differentiated based on a wider set of transaction characteristics (e.g., product type) as well as customer characteristics. These values represent the conservative view because it covers the long-run average. An Islamic bank that wishes to use its own estimates of EAD needs to demonstrate to its supervisor that it can meet additional minimum requirements pertinent to the integrity and reliability of these estimates. All estimates of EAD should be calculated based on the net of any specific provisions that an Islamic bank may have to raise against an exposure. In terms of assigning the estimation of EAD based on the broad EAD classifications, Islamic banks may use either internal or external data sources. Given the perceived current data limitations in respect of EAD (external sources) a minimum data requirement of seven years has been set. 6.8.2 Principles   of Estimation   of Exposure   at Default  (EAD)

There are several principles used to estimate EAD. First, all estimates of EAD should vary with facility type (contractual type) and usage. These estimates must consider the expected growth in a customer’s business, a customer’s access to other sources of funding and protection built into documentation to control drawings if a customer’s creditworthiness deteriorates. The inclusion of usage seems to imply that there needs to be an explicit time between the measurement date and the assumed default date to carry out the EAD calculations. Where usage is a factor in EAD estimates, it is up to Islamic bank to choose what period is most relevant in predicting EAD. Second, it is Islamic bank specific. Probably to an even greater extent than with LGD, EAD is affected by actions taken by individual Islamic banks. Estimates based purely on industry averages, without appropriate adjustments will result in inaccurate outcomes. Third, financing conversion factors (FCF) to be applied to all limits and exposures may result in an exposure if the obligor defaults. Islamic banks using their own estimates of EAD may consider all facility types that may result in an exposure when a customer defaults. These include uncommitted facilities and settlement exposure such as earlier settlement. Fourth, the starting point of the inclusion of a facility is the earliest date at which a customer can make drawing under it. This will be earlier than the completion of security and documentation if Islamic banks allow customers to make drawing before that time. Fifth, EAD on a facility can never be less than current drawings. Current drawings include penalty charge (ta’widh or fee) accrued to date. Sixth, Islamic banks are strongly encouraged to avoid incurring exposures where they have no limits. Although the incurred exposure is done on a voluntary basis, an Islamic bank can estimate an EAD, which may be higher than current drawings. Seventh, if Islamic banks make available multiple facilities, they need to understand how exposures on one may be transferred into exposures in another on which the losses are ultimately incurred. Eighth, it is acceptable to estimate the EAD on contingent exposures

Credit Risk 177 based on the amount expected to be claimed, as opposed to the amount of the potential claim. Finally, Islamic banks producing their own estimates of EAD may demonstrate how EAD varies with the economic cycle and make any adjustments accordingly. 6.8.3 Guidance  on  Calculation   of Exposure   at Default

This section will highlight several variables as guidance in calculating the exposure at default. Accuracy of EAD – Estimation and quantitative validation methodologies of EAD are less well developed than those of PD. Therefore, validation of EAD estimates will need to rely more on the qualitative assessment of the estimation process than quantitative techniques. Compared with LGD, EAD for the defaulted facilities is simpler as they are readily observable. Construction of a data set – Islamic banking institution has a choice to use two methods to construct a data set for EAD estimation, namely, cohort method and fixed-horizon method. Under either method, only information about the defaulted facilities should be used. Data of the facilities that defaulted but subsequently recovered should also be included. Under the cohort method, Islam banks should group defaulted facilities into a discrete calendar period for at least one year according to the date of default. For the defaulted facilities in each calendar period, information about the risk factors of these facilities at the beginning of that calendar period and the outstanding amounts at the date of default (i.e., realised EAD) should be collected. Data of different calendar periods should then be pooled for estimation. For example, if a discrete calendar period starting from 1 January 2016 to 31 December 2016, then information about the risk factors of the facilities on 1 January 2016 (the observation point) should be extracted to construct the data set. In addition, the outstanding amounts of the facilities upon default should be captured. Under fixed-horizon method, Islamic banks should collect information about the risk factors for a fixed interval prior to the date of the default for at least one year and the outstanding amount at the date of default, regardless of the actual calendar date on which the default occurred. For example, if the fixed interval is defined as one year; if a default event occurred on 15 June 2016, then in addition to the outstanding amount upon default, information about risk factors of the defaulted facility one year ago (the observation point is then 15 June 2015) is used. 6.8.4 Estimation   of Exposure   at Default

For on-balance-sheet items, the minimum prerequisite is that the EAD estimate for a facility cannot be less than the current drawn amount. Islamic banks may use the outstanding balance (including accrued but unpaid fees) at the observation points as the EAD estimate. However, application to this method requires the Islamic banks to demonstrate conservatism that the estimated aggregate EAD amount for a facility type is higher than the realised aggregate EAD amount for that facility type.

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For off-balance-sheet items, EAD of foreign exchange, interest rate (conventional bank), equity, credit and commodity-related derivatives will be calculated according to the rules for the calculation of credit equivalent amount, that is, based on the replacement cost plus potential future exposure add-ons across the different product types and maturity bands (see Weighting Framework for Credit Risk under Standard Approach, BIS, 2004). For the estimation of EAD for non-derivative off-balance-sheet items, such as lines of credit, financing commitments, letters of credit and credit guarantees, banks should use one of the following formulas: EAD = current drawn amount + FCF×(current limit − current drawn amount ) (6.12) where FCF is financing conversion factor of the exposure. EAD = UR × current limit

(6.13)

where UR is the utilisation rate of the exposure. FCF represents the future drawdown of available but untapped financing. In the data set, current limit or current drawn amount means the relevant limit and drawn amount respectively at the observation point discussed under the cohort method and fixed-horizon method. FCF and UR then become the subject variable that requires estimation. Under either expression, the estimated EAD amount cannot be less than the current drawn amount. Islamic banks are permitted to take 100% of the current limit as the EAD estimate. If Islamic banks use this method, again, they need to demonstrate conservatism that the estimated aggregate EAD amount for a facility type is higher than the realised EAD amount for that facility type. The estimation of the EAD by Islamic banks needs to take into account the following factors (there are interactions and overlaps among factors of different types): (1) factors affecting the obligor’s demand for funding/facilities; (2) factors affecting the Islamic banks’ willingness to supply funding/facilities; (3) the attitude of third parties (e.g., other banks, money lenders, trade creditors, and owners if the obligor is a company), who can act as alternative sources of funding supply available to the obligor; (4) the nature of the particular facility and the features built on it; and (5) the type of obligor, where the differentiation of obligor types is relevant with regard to varying behaviour in financing line utilisation. For example, for large-scale obligors, lines of financing are often not completely utilised at the time of default. In contrast, retail customers and small-scale enterprises are more likely to overdraw the approved lines of financing. The estimation process of EAD for non-defaulted facilities is similar to that of LGD. First, Islamic bank needs to construct a data set storing information (including the relevant risk factors) of the defaulted facilities. Second, FCF and UR of each of these defaulted facilities are calculated. Third, the relationship between the FCF and UR and the risk factors is established (in the form of, for example, regression model or classification by risk factors). Finally, the EAD for the non-defaulted facilities in the current portfolio is estimated with this relationship.

Credit Risk 179 Islamic banks can use expert judgement to fine-tune the EAD estimates to the extent that the reasons for adjustments have not been considered in the estimation. The process of exercising expert judgement should be transparent, well-documented and closely monitored. For every relevant facility type, Islamic banks should compare the estimated FCF or UR with the long-run defaulted-weighted average FCF or UR to ensure that the former is not lower than the latter. The FCF and UR estimate should reflect the additional drawdowns during periods of high financing losses if they are systematically higher than the default-weighted average. For this purpose, Islamic banks should use averages of FCF or UR observed during periods of high financing losses for that product, or forecasts based on conservative assumptions (e.g., at a higher percentile of the distribution of FCF and UR of similar defaulted facilities in the data set). Islamic banks should notice that EAD may be sensitive to changes in the way that they manage financing. For example, a significant change in FCF or UR may result from a change in policy regarding financing line increases or decreases for segments of retail portfolios. Particularly, Islamic banks should raise EAD estimates if policy changes are likely to significantly increase FCF and UR. However, if the policy changes are likely to lower FCF or UR, Islamic bank is not expected to reduce the EAD estimates until a significant amount of actual experience has been accumulated under the new policy to support the reductions. Then, Islamic bank needs to conduct similar types of analyses and tests for assessing LGD estimates in assessing the accuracy of EAD in terms of UR or FCF. Islamic banks should develop statistical tests (unspecified but accurate) to backtest their internal EAD estimates against the realised EAD of the new facilities, establish internal tolerance limits for the differences between the estimates and the realised EAD, and have a policy that requires remedial actions to be taken when policy tolerance is exceeded. For example, Islamic bank can assume a parametric distribution on the FCF or UR estimates for a certain type of product. Based on this distribution, Islamic banks can establish confidence intervals around the FCF or UR estimate. The tolerance limits and remedial actions then can be constructed on different confidence intervals in which the realised default-weighted average FCF or UR of the new defaulted facilities may fall. Islamic banks should compare their internal estimates with external benchmarks if available. If the external benchmarks are not available, Islamic banks can develop internal benchmarks for this purpose. Islamic banks also need to provide the relevant data for comparison amongst Islamic banks’ internal EAD estimates for similar facilities to identify potential outlying predictions. If an Islamic bank uses 100% UR or FCF for some non-derivative off-balancesheet item and current outstanding balance for the on-balance-sheet items, the Islamic bank may not be able to conduct the same types of analyses and tests for assessing LGD estimates in their assessment of the accuracy of EAD. However, the Islamic bank should demonstrate, no less than once every 12 months, which of these EAD estimates are sufficiently conservative. Here, Islamic banks must compare the estimates aggregate EAD amount for the subject facility with the realised aggregate EAD amount for that facility type. Islamic banks also must

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monitor the safety margin under these approaches, where safety margin can be defined as: Estimated aggregate EAD amount of the subject facility type −1 Realied aggregate EAD amount of the subject facility type

(6.14)

If the estimated aggregate EAD amount is below the realised aggregate EAD amount or the safety margin falls below a predetermined tolerance level, Islamic banks should revise the EAD estimates upwards. In establishing the tolerance level, an Islamic bank should consider historical volatility of the safety margin, size of the portfolio, its risk appetite relating to the product and economic outlook. 6.9

Capital Requirements for Credit Risk

6.9.1 Risk  Weights  for  Assets

Major regulations imposed on Islamic banks were aimed at ensuring that the cash reserves were sufficient to cover any withdrawal that depositors might make and at repaying any funds that Islamic banks had borrowed themselves. In general, depositors are safe if an Islamic bank has sufficient shareholders’ funds. However, if an Islamic bank has a substantial financing portfolio, this may not be the case. The regulator requires that Islamic banks’ ability to provide financing is restricted by the size of their shareholders’ funds. This can minimise the risk if the financing book is large and then minimise the exposure to depositors. In this chapter, we try to elaborate the calculation of capital requirement for credit risk. Under Internal Rating-based approach (IRB), the input such as PD (probability of default), LGD (loss given default), EAD (exposure at default) and correlation/default dependencies are estimated to produce the expected losses as well as the capital adequacy for credit risk.11 Use of the credit risk portfolio model can integrate these variables to produce the outcome. This section provides selected examples in the case of Islamic banking system in Malaysia. The 1988 Basel Capital Accord (Basel I) was designed to develop a single capital requirement for credit risk across the major banking countries of the world. Basel Accord 1988 focuses on the total amount of bank capital needed to reduce the risk of bank insolvency. A major focus of Basel I was to distinguish the credit risk of sovereign, bank and mortgage obligations (accorded the lowest weight) from nonbank private sector or commercial (accorded the highest risk weight). There was little attempt to differentiate the credit risk exposure within the financing classification. All financings required an 8% of total capital requirement (Tier-1 plus Tier-2), regardless of the inherent creditworthiness of the borrower, its external credit rating or the collateral offered. Since the capital requirement was set too low for high-risk financing and too high for low-risk financing, the mispricing of financing risk created an incentive for Islamic bank to shift portfolio towards those financings that were more underpriced from a regulatory perspective. Consequently, it was encouraging a long-term deterioration in the overall financing quality of the

Credit Risk 181 Islamic bank portfolio. The aim of the Basel Capital Accord of 2003 (Basel II) is to correct the mispricing inherent in Basel I and incorporate more risk-sensitive credit exposure measures into bank capital requirement. Under Basel II, each category of asset held was assigned to the risk weight according to the category of customer. As mentioned in Chapter 8, Islamic banks are required to calculate the total risk-weighted assets (or known as risk-weighted amount). It measures the total financing exposure. As shown in Table 6.7 (example of a Malaysian bank), there are five categories of risk weight (0%, 10%, 20%, 50% and 100%). Some assets, such as domestic government asset (Treasury bill), have no capital adequacy requirement because they are deemed to be extremely safe, while claims on banks have a 20% weight, which translates into a capital charge of 1.6% of the value of the claims (8% of 20%). Claims on the non-bank private sector are ranked at 100% and therefore come under the full 8% capital adequacy requirement. Table 6.8 shows an example of capital adequacy requirements applied to an Islamic bank’s assets in Malaysia. As shown in Table 6.7, securities issued by the Federal Government carry 0% weight. Thus, the total RM100 million securities of the Federal Government of Malaysia receive zero capital adequacy requirements. As for the interbank funds, they will carry 20% risk weight. If the amount of interbank funds is RM300 million, the risk asset amount will be RM60 million, and the Islamic bank is required to put aside RM4.8 million capital adequacy requirements

Table 6.7 Example of the Risk Weights Weights

Category of Assets

0%

Assets with zero or low credit risk. For example, cash, claims on or guaranteed by the Federal Government, the Central Bank of Malaysia, and claims collateralised by cash and securities issued by the Federal Government, the Central Bank and OECD central governments. Comprises claims on discount houses, claims on or guaranteed by Cagamas Berhad or collateralised by securities issued by Cagamas Berhad. Discount houses trade predominantly in high-quality liquid assets, while Cagamas Berhad is a highly credible institution established by the Central Bank and the banking industry to create a secondary mortgage market in Malaysia. Comprises claims on or guaranteed by licensed financial institutions in Malaysia, banks incorporated in the OECD, domestic development banks, multilateral development banks, domestic non-central governments and other public-sector entities. Claims on non-OECD banks with a residual maturity of up to one year are also weighted at 20%. Provision of housing finance for residential purposes, secured by first charge, are eligible for the concessionary 50% risk weight in the recognition of the low record of loss. All other assets carry a 100% risk weight. These would include claims on the non-bank private sector, claims on the commercial companies owned by the public sector, and investment in shares (other than those deducted from the capital base) and fixed assets.

10%

20%

50% 100%

Economic Capital and Risk Management

182

Table 6.8 Example of Capital Adequacy Requirements for Bank’s Assets Assets

Amount (RM million)

Risk Weighting (%)

Government Securities 100 0 Interbank financings 300 20 Financings to private 500 100 clients Amount of shareholders’ funds required 504.8

Risk Asset Amount (RM million)

Capital Adequacy Requirement at 8% (RM million)

0 60 500

0 4.8 500

(at 8% from RM60 million). For financing to private clients, it carries 100% weight regardless of its external credit rating. Thus, if the amount of financing to private clients is RM500 million, then, the risk asset amount will be RM500 million. The bank has to put aside RM500 million capital adequacy requirements at 8%. Note that the total risk-weighted assets for N on-balance-sheet items equals N

∑w L

(6.14)

i

i=1

where Li is the principal amount of the ith item and wi is its risk weight. Off-balance-sheet items are expressed as a credit equivalent amount. Loosely speaking, the credit equivalent amount is the financing principal that is considered to have the same credit risk. For non-derivative instruments, the credit equivalent amount is calculated by applying a conversion factor to the principal amount of the instrument. Instruments that are from a credit perspective are considered to be similar to financings, such as bankers’ acceptances have a conversion factor of 100%. Table 6.9 shows the example of capital adequacy requirements applied to an Islamic bank’s off-balance-sheet exposures. Consider that an Islamic bank has a committed facility with a private client where it attracts a 100% capital requirement when drawn, but any undrawn fraction (an off-balance sheet liability) has a 50% conversion factor. If RM300,000 is drawn, leaving RM200,000 undrawn, the amount of capital required (at 8% from risk-weighted assets) would be RM24,000

Table 6.9 Example of Capital Adequacy Requirements for Islamic Bank’s Off-BalanceSheet Exposures Principal amount (RM)

Conversion factor

Risk weighting

Capital Adequacy Requirement at 8% (RM)

300,000 200,000

1.0 0.5

100 100

24,000 8,000

Credit Risk 183 and RM8,000, respectively. Note that the credit equivalent amount for an off-balance-sheet item (not shown in Table 6.9) is multiplied by the risk weight for the counterparty in order to calculate the risk-weighted assets. Putting all this together, the total risk-weighted assets for a bank with N onbalance-sheet items and M off-balance-sheet items is N

M

∑w L +∑w C i i

i=1

∗ j

j

(6.15)

j=1

where Li is the principal of the ith on-balance-sheet item and wi is its risk weight for the counterparty; Cj is the credit equivalent amount for the jth off-balance sheet item and/is the risk weight for the counterparty. From the example, we can see that the bank must maintain a capital adequacy requirement of at least 8% of the riskweighted assets. In summary, risk-weighted assets consist of: (1) classifying assets into five risk categories as shown in Table 6.7; (2) converting the off-balance-sheet commitments and guarantees to their on-balance-sheet ‘credit equivalent’ values and classifying them in the appropriate risk categories; (3) multiplying ringgit values of assets in each category by the appropriate risk weight to convert book values into risk-weighted values; and (4) multiplying risk-weighted assets by minimum capital percentages to determine the adequacy of capital. 6.9.2 Capital  Requirement  for  Credit  Risk  under  Basel  III

The members of the Basel Committee on Banking Supervision in 2010–2011 have agreed to introduce a new regulatory framework on bank capital adequacy, known as Basel III. The Basel III was initially implemented from 2013 until 2015, but the complete migration was completed by 2019. Basel III proposes a three-step approach to measure credit risk. Islamic banks can choose the: (1) Standardised Model, (2) Internal Ratings-Based (IRB) Model Foundation Approach or (3) Internal Ratings-Based (IRB) Advanced Model. The standardised approach is based on external credit ratings assigned by independent ratings agencies (such as Moody’s and Standard & Poor’s). The approaches have been discussed in Chapter 10. The internal ratings approach requires the Islamic bank to formulate and use its own internal credit rating system. The risk weight assigned to each obligation is based on the ratings assignment, so that higher (lower) rated, high (low) credit quality obligations have lower (higher) risk weights and therefore lower (higher) capital requirements. Here, the discussion will be focused on the single factor. IRB model requires Islamic bank to establish an internal rating model to classify the credit risk exposure in on- and off-balance-sheet item. There are two choices of model in Internal Ratings-Based model. First, foundation approach, where the bank estimates probability of default using its internal rating system, but other inputs such as loss given default are obtained from external sources (the regulator). Second, advanced approach, where the banks’ own estimates of input data are used

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exclusively (probability of default, loss given default, maturities). In retail framework, no distinction is made between the two approaches. The IRB model is based on the one-factor Gaussian model of time to default. This approach was developed by Vasicek (2002). In a simple way, this approach can be written as follows. Consider a portfolio of N companies. Define Ti (1 ≤ i ≤ N) as the time when company i defaults. Denote the cumulative probability distribution of Ti by Qi. Define V(T,X) as the default rate that will not be exceeded with probability X, so that we have X% certain that the default rate will not exceed V(T,X).  N −1[Q(T )] + r N −1 ( X )    V (T , X ) = N    1− r 

(6.16)

Consider a large portfolio of N financings. WCDR is defined as the worst-case that default rate during the next year is 99.9% and it would not exceed this level, PD is the probability of default for each financing in one year, EAD is the exposure at default on each financing (in RM), and LGD is the loss given default. This is the proportion of the exposure that is lost in the event of a default. Suppose that the correlation between each pair of obligors is ρ.12 We can rewrite the equation (6.16) as  N −1 (PD) + r N −1 (0.999)    WCDR = N    1− r 

(6.17)

It follows that there is a 99.9% chance that the loss on the portfolio will be less than N times; therefore, it can be represented as: EL= EAD × LGD × WCDR

(6.18)

It can be shown that, as a good approximation, this result can be extended to the case where the financings have different sizes and different default probabilities. In general, for a portfolio of financings, there is a 99.9% chance that the total loss will be less than the sum of EAD × LGD × WCDR for the individual portfolio financings.13 This result is the theoretical underpinning of the IRB approach. Table 6.10 shows that WCDR depends on PD and ρ. If the correlation ρ is zero, WCDR is equal to PD because in that case there is no default correlation and the default rate in all years is the same. As ρ increases, WCDR increases. Example: Suppose for corporate, sovereign and bank exposures, Basel III assumes that the relationship between the correlation parameter ρ and the probability of default can be referred to empirical research done by Lopez (2004). His study is based on the following equation:  1− exp (−52×PD )  1− exp (−50×PD )  ρ = 0.12 + 0.24 1− (6.19) 1− exp (−50) 1− exp (−50)  

Credit Risk 185 Table 6.10 Dependence of WCDR on PD and ρ

ρ = 0.0 ρ = 0.2 ρ  = 0.4 ρ  = 0.6 ρ  = 0.8

PD = 0.1%

PD = 0.5%

PD = 1%

PD = 1.5%

PD = 2.0%

0.1% 2.8% 7.1% 13.5% 23.3%

0.5% 9.1% 21.1% 38.7% 66.3%

1.0% 14.6% 31.6% 54.2% 83.6%

1.5% 18.9% 39.0% 63.8% 90.8%

2.0% 22.6% 44.9% 70.5% 94.4%

Because exp (−50) is a very small number, equation (6.19) can be simplified as: ρ = 0.12(1 + e−50×PD )

(6.20)

Equation (6.20) shows that as PD increases, ρ decreases. This inverse relationship implies that as a customer becomes less creditworthy, its PD increases, and its probability of default becomes more idiosyncratic and less affected by overall market conditions. Combining equation (6.17) with (6.20), we can obtain the relationship between WCDR and PD. As proven in Table 6.11, WCDR is increasing the function of PD. However, it does not increase as fast as it would if ρ are assumed to be independent of PD. The formula for the required capital is given as: EAD × LGD × (WCDR – PD) × MA

(6.21)

The first three terms in equation (6.21) can be understood from the earlier discussion. We use (WCDR – PD) instead of WCDR because we are interested in providing capital for the excess of the 99.9% worst-case loss over the expected loss. The variable MA is the maturity adjustment and is defined as: MA =

1+ (M − 2.5)×b 1−1.5×b

(6.22)

where b = [0.11852–0.05478 × In (PD)]2

(6.23)

Table 6.11 Relationship between WCDR and PD for Corporate, Sovereign and Bank Exposures PD WCDR

0.1 % 3.4 %

0.5 % 9.8 %

1.0 % 14.0 %

1.5 % 14.8 %

2.0 % 19.0 %

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and M is the maturity of the exposure. (Note that when M equals to 1, then MA equals to 1.0 and has no effect.) As mentioned earlier, the risk-weighted assets (RWA) are calculated as 12.5 times the capital required, therefore: RWA = 12.5 × EAD × LGD × (WCDR – PD) × MA

(6.24)

so that the capital is 8% of RWA. Under the foundation IRB approach, Islamic banks supply PD, while LGD, EAD and M are supervisory values set by the Basel Committee. PD is largely determined by an Islamic bank’s own estimate of the creditworthiness of the counterparty. It is subject to a floor of 0.03% for Islamic bank and corporate exposures. The LGD is set at 45% for senior claims and 75% for subordinated claims. When there is eligible collateral, in order to correspond to the comprehensive approach that we described earlier, LGD is reduced by the ratio of the adjusted value of the collateral to the adjusted value of the exposure, and both are calculated using the comprehensive approach. The EAD is calculated in a manner similar to the credit equivalent amount in Basel II and includes the impact of netting. M is set at 2.5 in most circumstances. Under the advanced IRB approach, Islamic banks supply their own estimates of PD, LGD, EAD and M for corporate, sovereign and Islamic bank exposures. The PD can be reduced by credit mitigation such as credit triggers. The two main factors influencing the LGD are the seniority of the financing and the collateral. In calculating EAD, Islamic banks can with regulatory approval use their own estimates of financing conversion factors. The capital given by equation (6.21) is intended to be sufficient to cover unexpected losses over a one-year period that we are 99% sure that the expected loss does not exceed. Losses from the one-year ‘average’ probability of default should be covered by an Islamic bank in a way it prices its products. The WCDR is the probability of default that occurs once every thousand years. The Basel Committee reserves the right to apply a scaling factor (less than or greater than 1.0) to the result of the calculations in equation (6.21) if it finds that the aggregate capital requirements are too high or low. Currently, this factor is estimated at 1.06. Example: Suppose that the assets of an Islamic bank consist of RM100 millions of financings to A-rated corporations. The PD for the corporations is estimated as 0.1% and LGD is 60%. The average maturity is 2.5 years for the corporate financings. This means that b = [0.11852–0.05478 × In (0.001)]2 = 0.247 so that MA =

1 + (2.5 − 2.5)× 0.247 1−1.5× 0.247

= 1.59

From Table 6.11, if PD is 0.1%, then the WCDR is equal to 3.4%. Under the Basel III IRB approach, the risk-weighted assets for corporate financing are: 12.5 × 100 × 0.6 × (0.034 – 0.001) × 1.59 = 39.35 or RM39.3 million.

Credit Risk 187 The foundation IRB and advanced IRB approaches are merged, and all Islamic banks using the IRB approach provide their own estimates of PD, EAD and LGD. There is no maturity adjustment. Therefore, the capital requirement is given as: EAD × LGD × (WCDR – PD)

(6.25)

and the risk-weighted assets (RWA) are given as: 12.5 × EAD × LGD × (WCDR – PD)

(6.26)

WCDR can be calculated by equation (6.27) and ρ is equal to 0.15 for residential mortgage. However, ρ is equal to 0.04 for all other retail exposures. Therefore, the relationship between ρ and PD is specified as: ρ = 0.03

1− exp (−35×PD ) 1− exp(−35)

 1− exp (−35×PD )   + 0.16 1− 1− exp (−35)  

(6.27)

Because exp (–35) is a very small number, equation (11.14) can be simplified as: ρ = 0.03 + 0.13e−35×PD

(6.28)

By comparing equations (6.28) and (6.30), the correlations are assumed to be much lower for retail exposures. Table 6.12 shows the relationship between WCDR and PD for retail exposures. Example: Suppose that the assets of an Islamic bank consist of RM50 millions of residential mortgages where the PD is 0.005 and the LGD is 20%. In this case, ρ = 0.15 and WCDR is given as:  N −1 (0.005) + 0.15 N −1 (0.999)   WCDR = N   = 0.067 1 − 0 . 15   The risk-weighted assets are given as: 12.5 × 50 × 0.2 × (0.067–0.005) = 7.8 or RM7.8 million. Similarly, the risk-weighted assets are given as: RWA = K × 12.5 × EAD

(6.29)

Table 6.12 Relationship between WCDR and PD for Retail Exposures PD WCDR

0.1 % 2.1 %

0.5 % 6.3 %

1.0 % 9.1 %

1.5 % 11.0 %

2.0 % 12.3 %

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where K is capital requirement and EAD is Exposure at Default. Unlike in the standardised approach, collateral is not deducted from EAD. The capital requirement (K) consists of three constituents: K = LGD × PD* × f (M,b)

(6.30)

From equation (6.30), LGD has a considerable impact on the capital requirement K, as they are linearly related. Thus, an increase in LGD raises capital requirements by a similar factor irrespective of the initial level of LGD. In IRB foundation approach, LGD levels are predetermined. As we stated before, senior claims on corporate, sovereigns and banks will be assigned a 45% LGD, whereas subordinated claims will be assigned a 75% LGD. In addition, some collateral types, such as financial collateral or commercial and residential real estate, are eligible in order to reduce LGD levels. In the advanced IRB approach, banks will calculate their own internal estimates of LGD. In equation (6.30), PD* corresponds to a function that integrates the effect of correlation. PD* can be seen as probability of default that takes into account the specific correlation factor of the asset class. Unlike LGD, the function mapping the probability of default to the capital requirement is concaved. Consequently, at high levels of PDs (e.g., non-investment grade), the relative impact on capital requirements of an increase in LGD terms is stronger than for PD term. If we use a simple one-factor portfolio model, return on asset A is assumed to be normally distributed [A ~ N (0,1)], and driven by a systematic factor C and an idiosyncratic factor ε, both are also normally distributed. A = RC + 1− R 2 ε

(6.31)

where R is the loading factor. The probability of default corresponds to the probability that the asset return falls below some threshold K: PD = P (A < K)

(6.32)

Under an average scenario (C=0), we can calculate:  K  PD = p ε <  1− R 2

  = N (−DD)  

(6.33)

where DD is the distance to default. We may also consider a stressed scenario corresponding to the worst realisation of the systematic factor at the 99.9% level. Under the standard normal distribution, this scenario corresponds to 3 standard deviations, that is, C = – 3. The stressed probability of default is given as: PD∗ = P(−3R + 1− R 2 ε < K )

(6.34)

Credit Risk 189  K R  PD∗ = P ε < +3  1− R R 1− R 2

  

(6.35)

Using the normal distribution, PD* = N[-DD+3ρ], where N(.) is the cumulative distribution function for a standard normal random variable and r =[R/(1−R2)1/2]. For various asset classes, the systematic factor loading R is adjusted. In the capital requirement equation, f (.) is a function of M, the maturity of the financing, and b is a maturity adjustment factor depending on the probability of default. In the foundation IRB approach, the effective maturity of the facility is assumed to be 2.5 years. In the advanced IRB approach, the capital requirement formula is adjusted for the effective maturity of each instrument, depending on the level of PD. The impact of maturity shows that high-quality (investment-grade) facilities are more penalised by the maturity adjustment than low-quality ones. It implies that some of the relief granted to the best financings are offset by the maturity adjustment. Note that equations (6.24) and (6.26) as well as equation (6.29) are similar to what has been proposed by Basel Committee. For example, the foundation approach formula for risk weight (RW) on corporate obligation is given as:  LGD  ×BRW RW =   50 

(6.36)

12.5 × LGD

(6.37)

or

whichever is smaller, where the benchmark risk weight (BRW) is calculated for each risk classification using the following formula:  (1− PD) BRW = 976.5× N (1.118×G ( PD ) +1.288)×1 + 0.0470×  PD 0.44  

(6.38)

The term N(y) denotes the cumulative distribution function for a standard normal random variable and the term G(z) denotes the inverse cumulative distribution function for a standard normal random variable. Risk-weighted assets RWA are then computed by multiplying the risk weight RW (equations 6.36 or 6.37) times the exposure at default (EAD). Finally, the minimum capital requirement is computed by multiplying the risk-weighted assets RWA times 8%, that is, the minimum capital requirement on the individual financing = RW × EAD × 8%. Under the advanced approach, Islamic banks with sufficiently ‘rich’ data on LGDs are allowed to input their own estimates of LGD along with own estimates of maturity. Under the advanced approach, Islamic banks with sufficiently ‘rich’ data on LGDs are to be allowed to input their own estimates of LGD along with own estimates of maturity.

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6.9.3 Implementing  VaR  Approach

The VaR model seeks to measure the minimum loss (of value) on a given asset or liability over a given time horizon at a given confidence level (e.g., 99%). An example of tradable instrument such as equity will suffice to describe the basic concept of VaR methodology. Consider the market price (P) of equity today is $80, and the estimated daily standard deviation of its value (σ) is $10. The concern of the trader might be, ‘If tomorrow is bad day, what is the size of loss in value, at some confidence level?’Assume that the trader is concerned with the value loss on a ‘bad day’ that occurs, on average, once in 100 days and that daily asset values (return) are normally distributed around the current equity value of $80. In other words, the one bad day has a 1% probability of occurring tomorrow. The area under a normal distribution carries information about probabilities. We know that roughly 68% of return observations must lie between +1 and –1 standard deviation from the mean, and 95% of observations lie between +1.96 and –1.96 standard deviations from the mean, and 98% of observations lie between +2.33 and –2.33 standard deviations from mean. Similarly, in terms of ringgits, there is a 1% chance that the value of the equity will increase to a value of $80 + 2.33σ (or above) tomorrow, and a 1% chance it will fall to a value of $80–2.33σ (or below). Because we assume σ is equal to $10, there is a 1% chance that the value of the equity will fall to $56.70 or below; alternatively, there is a 99% probability that the equity holder will lose less than $80 – $56.70 = $23.30 in value; that is, $23.30 can be viewed as the VaR on the equity at the 99% confidence level. This section is to show how the concept of value at risk can be implemented in measurement of credit risk and calculation of capital requirement for financing in the Islamic banking book as well. Special attention is given to the CreditMetrics model as it provides a useful benchmark for analysing the issue of VaR. 6.9.4 Capital  Requirement  for  Islamic  Bank

The calculation of capital requirement for Islamic bank can be based on the proposal forwarded by Accounting and Auditing Organization for Islamic Financial Institution (AAOFI) and Islamic Financial Services Board (IFSB), which are respectively written in equations (6.39) and (6.40). CAR =

Total Capital RWAK &CA + 50%RWAULA

(6.39)

where RWAK&CA is the average risk-weighted assets financed by Islamic bank’s capital and depositors’ current accounts and RWAUIA is the average risk weighted assets financed by the unrestricted depositors’ investment accounts. The numerator consists of items classified as capital under the Basel III with the exception of instruments included which have debt as well as equity characteristics (will be discussed in Chapter 8).

Credit Risk 191 The second proposal comes from IFSB (Islamic Financial Services Board) Central Bank of Malaysia, where this standard takes into account the specificity of investment account holders who share part of the risk with shareholders as follows: CAR =

Tier 1+Tier 2 RWA(CR+MR+OR) − RWA funded by PSIA(CR+MR)

(6.40)

where RWA(CR+MR+OR) is total risk-weighted asset include assets financed by both restricted and unrestricted Profit-Sharing Investment Accounts (PSIA). Given the formula proposed by IFSB, we can illustrate the calculation of riskweighted asset (RWA) for credit risk in for Islamic bank. Given the RWA for market risk, credit risk and operational risk, we can determine the capital requirement for Islamic bank. As for the credit risk capital requirement calculation, we need to calculate the amount of exposures and determine the risk weights for those exposures in order to calculate the risk-weighted assets for credit risk. Finally, we will multiply this amount with capital requirement at 0.08. IFSB (2005) suggests credit risk measurement is conducted by using Standardised Approach of Basel II, except for certain exposures arising from investments by means of musharakah or mudarabah contracts in assets in the banking book. IFSB (2005) also mentions that the assignment of risk-weights (RW) is mainly based on the credit risk rating of a debtor, counterparty, obligor or a security that receives external credit assessments. Table 6.13 shows risk weight on individual claims Table 6.13 Risk-Weight on Individual Claims Based on External Credit Assessments Rating/Risk Score14

AAA to AA−

A+ to A−

BBB+ to BBB−

BB+ to B−

Below B−

ECA Country Risk Score15 Sovereigns and Central Banks Non-Central Government Public Sector Entities (PSEs) Multilateral Development Banks IIFS, banks and securities firms Option 1* Option 2a** Option 2b**/@ Rating/Risk Score

1 0%

2 20%

3 50%

4 to 6 100%

7 150%

Corporates

Unrated

100%

Subject to supervisory authorities’ discretion to treat as either IIFS, banks, and securities firms (Option 1 or Option 2a) or as sovereigns 20% 50% 50% 100% 150% 50%

20% 50% 100% 100% 20% 50% 50% 100% 20% 20% 20% 50% AAA to A+ to BBB+ to AA− A− BB− 20% 50% 100%

150% 100% 150% 50% 150% 20% Below Unrated BB− 150% 100%

Note: *Credit assessment based on ECAI (External Credit Assessment Institution) of sovereigns. **Credit assessment based on an ECAI of the IIFS, banks and securities firms. @ Applicable for original maturity ≤ 3 months, which is not rolled over. Source: IFSB (2005)

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based on External Credit Assessments as suggested by IFSB. We will compare this IFSB proposal with Bank Negara Malaysia (BNM) proposal. Note that this credit assessment follows the Standardised Approach under Basel II. In the case of Malaysia, BNM specifically states that exposures to the Federal Government of Malaysia and the bank, which are denominated and funded in Ringgit Malaysia (RM), should be accorded a preferential risk weight of 0%. BNM also states that other national supervisor has accorded a preferential risk weight (i.e., 0% or 20%) to exposures to their federal government and central bank that are dominated and funded in their domestic currency. BNM treats exposures to non-federal government public sector entities (PSES) with 20% risk weights if they fulfil several criteria such as the PSE must establish under its own statutory act, and they do not involve in any commercial undertaking. For exposures to Multilateral Development Banks (MDBs), it should be treated similar to exposures to banking institutions. For highly rated MDBs, it will be eligible for a preferential risk weight of 0%. For exposures to banking institutions and corporates including securities firm, risk weights should be accorded based on their external ratings, which can be in the form of either long- or short-term ratings.16 For off-balance sheet items, IFSB (2005) states that under the standardised approach, the items will be converted into credit exposure equivalents through the use of financing conversion factor (FCF). Commitments with an original maturity over one year will receive an FCF of 20% and 50%, respectively. Any commitments that are unconditionally cancellable at any time (by Islamic bank) without prior notice, or that effectively provide for automatic cancellation due to deterioration in a borrower’s creditworthiness, will receive a 0% FCF. An import or export financing which is based on murabahah will receive FCF of 20%. BNM introduced the FCF for off-balance sheet item that can be summarised as in Table 6.14. IFSB (2005) also states that an IIFS might have investment under profit sharing and loss bearing mode (mudarabah) and profit and loss sharing mode (musharakah) for the purpose of earning investment return. The RW for such investment will be calculated using either simple risk-weight method or slotting method. Under simple risk-weight method, a 400% RW is to be applied to all equity exposure in private and commercial enterprise. For fund invested on a mudarabah basis, RW will be 300%. Under slotting method, Islamic bank is required to map its internal risk grades into four supervisory categories for specialised financing and each of these categories will be associated with a specific risk weight. Figures in Table 6.15 illustrate the risk-weighted asset for credit risk in Islamic bank. The amount of cash and balances with Central Banks is about $1,833,992. Since this asset incurs weight 20%, the capital charge will be $366,798. For balances and deposits with banks, the range of credit risk weights is between 20% and 50%. If the amount of asset is $225,759, the amount of equivalent will be $56,171. Given the amount of $7,502,571 for international murabahah, the credit risk weights between 20% and 50% cause the Islamic bank must put aside capital about $2,279,671. The major source of assets in this Islamic bank comes from investing and financing activities. Each of these activities has credit risk weighted

Credit Risk 193 Table 6.14 FCF for the Various Types of Off-Balance Sheet Items Instrument

FCF

Direct credit substitutes, such as general guarantees or indebtedness (including standby letters of credit serving as financial guarantees for financings and securities), acceptances (including endorsements with the character of acceptances) and credit derivatives (if the banking institution is the protection seller) Certain transaction-related contingent items, such as performance bonds, bid bonds, warranties and standby letters of credit related to particular transactions. Short-term self-liquidating trade-related contingencies, such as documentary credits collateralised by the underlying shipments. The credit conversion factor shall be applied to both the issuing and conforming bank Assets sold with recourse, where the credit risk remains with selling institution. Forward asset purchases, and partly paid shares and securities, which represent commitments with certain drawdown Obligations under an ongoing underwriting agreement (including underwriting of shares or securities issue) and revolving underwriting facilities Lending of banks’ securities or the posting of securities as collateral by banks, including instances where these arise out of repo-style transaction (i.e., repurchase/reverse repurchase and securities lending/borrowing transactions

100%

50% 20% 100% 100% 50% 100%

Source: BNM, Prudential Financial Policy Department: Risk-Weighted Capital Adequacy Framework (Basel II – Risk Weighted Assets Computation).

Table 6.15 Example of Calculation of Risk-Weighted Asset for Credit Risk in an Islamic Bank Credit  Risk

Amount ($)

CR Weight

Capital charge

Cash and balances with Central Banks Balances and deposits with banks International Murabahah (Short term) Financing Activities (1) Commodities and Vehicles Murabahah (2) International Murabahah (3) Real Estate Murabahah (4) Istisna’ (5) Ijarah Investing Activities (1) Mudarabah (2) Wakalah (3) Musharakah in buildings Investment in Securities Off-Balance Sheet Items (FCF: 20–50%) Total Credit Weighted Assets

1,833,992 225,759 7,502,571

20% 20–50% 20–50%

366,798 56,171 2,279,671

5,240,865

20–75–100%

3,574,578

2,433,891.92 810,580.06 1,598,078 4,127,958

20–100% 35–100% 100% 35–75–100%

1,385,256 547,142 1,598,078 3,292,155

1,298,388 283,665 1,677,192.56 123,669 2,235,337

135% 100% 35–100% 20–100% 100%

1,752,824 283,665 859,561 83,586.60 892,353 16,971,839

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varying from 20% to 135% depending on the contracts of the products. The total amounts of each activity are $10,397,209 and $12,896,050. As for the investment in securities, it receives 20–100% risk weight. Therefore, a total of $123,669 will have to allocate to capital, which is about $83,586.60. Finally, the amount of offbalance-sheet item, that is, $2,235,337, receive 100% risk weight and the amount of capital needed to cover this exposure will be $892,353. Overall, the total credit risk-weighted assets will be $16,971,839. Notes 1 Credit for short periods can be given against a trade bill, which can be discounted, so that the seller gets cash immediately and passes the credit risk to whoever buys the bill. 2 Sukuk issued by the federal government, for the most part, are immune from default (as it is guaranteed by government) (http://www.investorword.com) 3 For details see www.coolinvesting.com 4 http://en.wikipedia.org 5 http://riskinstitute.ch 6 For details see www.businessdictionary.com 7 See Schuermann (2004). 8 Please refer to paragraph 460, BIS (2004) for definition of economic loss. 9 Refer to Table D.1 Area under the standardised normal distribution (Gujarati, 2003), e.g., 0.4999x2=99.9th 10 Readers who interested to know the mathematical quantification of LGD are advised to refer Kim et al. (2007). 11 The unexpected loss is defined as the standard deviation of portfolio losses: UL = E{[ L − E ( L)]2 } , while the expected loss: EL = EAD × PD × LGD or EL ≡ E(L), where L denotes the random loss on the portfolio. 12 Note that the Basel Committee publication use R instead of ρ to denote the correlation. 13 The WCDR for an individual financing is calculated by substituting the PD and ρ parameter for the financing into equation (11.4). 14 The notations follow the methodology used by Standard & Poor’s and Moody. 15 For the purpose of risk weighting claims on sovereign, supervisors may recognise the country risk scores assigned by Export Credit Agencies (ECAs). 16 For details (including computations credit risk-weighted asset for Islamic contract), please refer the BNM report on Prudential Financial Policy Department: Risk-Weighted Capital Adequacy Framework (Basel II – Risk Weighted Assets Computation).

References Altman, E. I., Brady, B., Resti, A. & Sironi, A. (2005). The link between default and recovery rates: Theory, empirical evidence, and implications. Journal of Business, 78(6), 2203–2227. BIS. (2004). International Convergence of Capital Measurement and Capital Standards A Revised Framework, June. Bank for International Settlements: Basel Committee on Banking Supervision. BIS. (2006). Guidelines on the Implementation, Validation and Assessment of Advanced Measurement (AMA) and Internal Ratings Based (IRB) Approaches, April. Bank for International Settlements: Basel Committee on Banking Supervision.

Credit Risk 195 Flores, F., Bonson-Ponte, E. & Escobar-Rodríguez, T. (2006). Operational risk information system: A challenge for the banking sector. Journal of Financial Regulation and Compliance, 14(4), 383–401. Frye, J. (2004). Recovery Risk and Economic Capital, Economic Capital: A Practitioner Guide, Dev, A. (Ed.). London: Risk Books. Gujarati, D. (2003). Basic Econometrics, 4th Edition. Boston, MA: McGraw-Hill. Heffernan, S. (2005). Modern Banking. Chichester: John Wiley and Sons Ltd. Hillebrand, M. (2006). Modeling and estimating dependent loss given default. Risk, September, 120–125. IFSB. (2005). Guiding Principles on Liquidity Risk Management for Institutions (Other than Insurance Institutions) Offering only Islamic Financial Services. Kuala Lumpur: Islamic Financial Services Board. IFSB. (2013). Revised Capital Adequacy Standard for Institutions Offering Islamic Financial Services Excluding Islamic Insurance (Takaful) Institutions and Islamic Collective Investment Schemes. Kuala Lumpur: Islamic Financial Services Board. Kim, J., Kim, W. & Kim, K. (2007). Loss given default modeling under the asymptotic single risk factor assumption. Asia Pacific Journal of Financial Studies, 36(2), 223–236. Lopez, J. A. (2004). The empirical relationship between average asset correlation, firm probability of default and asset size. Journal of Financial Intermediation, 13(2), 265–283. Sackett, M. M. & Shaffer, S. (2007). Substitutes versus complements among credit risk management tools. Applied Financial Economics, 16(14), 1007–1017. Schuermann, T. (2004). What do we know about loss given default? ch. 9. In Shimko, D. (Ed.) Credit Risk: Models and Management, 2nd Edition. London: Risk Books. Tasche, D. (2004). The single risk factor approach to capital charges in case of correlated loss given default rates. Working Paper, Frankfurt: Deutsche Bundesbank. Vasicek, O. (2002). Loan portfolio value. Risk, December, 160–162.

7

7.1

Operational Risk

Definition and Sources of Operational Risks

Discussion about operational risk is relatively recent in comparison to discussions about credit and market risk. However, in 1999, this omitted discussion on operational risk received more attention in Basel II, where banks were required to assign capital for operational risk. This proposal comes from the fact that during a tenyear period after the introduction of Basel I, more than 100 operational risk losses had occurred, each exceeding $100 million. In fact, Marshall (2001) reports that the aggregate operational losses in financial services industry during the period of 1988–2009 is approximately $200 billion. Even with the operational risk system already in place, Basel II has led banks to significantly increase the resources they devote to measuring and monitoring operational risk. This is due to the fact that bank has more difficulty in quantifying and managing operational risk than credit or market risk. Specifically, Islamic banks make an alert decision to accept a certain amount of credit and market risks, and there are many instruments used to mitigate such risks. By contrast, operational risk is an essential part of doing business. An important aspect of operational risk management is identifying the types of risks that are being taken and which should be assured against such as Shari’ah-compliance risk. There is always a danger that a huge loss will be incurred from taking an operational risk that ex ante was not even recognised as a risk. Operational risk can be defined in several ways. First, operational risk is defined as a residual risk. It is a risk faced by an Islamic bank that is beyond the market (i.e., benchmark rate risk and exchange risk) or credit risk. By looking at the Islamic bank’s financial statements, the remaining income after deducting (1) the impact of financing losses and (2) the profits or losses from market exposure could be considered as operational exposure. The potential for adverse fluctuations in the profit and loss statement or the cash flow is due to effects that are attributable to customers, inadequately defined controls, system or control failures, and unmanageable events. All the factors are related to the business process. Therefore, the business process is created as a result of the entire process from initiation to execution and delivery, comprising the front, middle and back offices.

DOI: 10.4324/9781003437086-11

Operational Risk 197 Second, operational risk can also be defined, as its name implies, as the risk arising from operational failures within the back office or operations area of Islamic banking institutions. Hence, operational risk originates from Islamic banks’ operational activities, while market and credit risks originate from Islamic banks’ transaction activities. This definition includes the risk of mistakes in processing transactions and making payments. This definition does not include major risks such as the ‘rogue trader’ risk.1 The problem with this ‘narrow’ definition of operational risk is it fails to capture so many risks that lie at the interface of operations and other business areas, for example, reputational, legal or facilities risks. Usually, this definition of risk includes both strategic risk and business risk. Strategic and business risks emanate from external sources such as political instability, and changes in government policy. Third, regulator such as the Board of Governors of the Federal Reserve System Trading Activities Manual defines operational and systems risks as ‘the risk of human error or fraud, or that system will fail to adequately record, monitor and account for transactions or positions’. The definition of operational risk proposed by the Basel Committee on Banking Supervision is based on the causes of operational risk. This definition is something challenging to the Basel Committee. This is due to difficulty in defining the boundaries of operational risk and in part to the difficulty in measuring and tracking operational data. This implies that this definition will make Islamic banks difficult to assess the next steps in the risk management process that are risk measurement and the selection of management methods. The difficulty in defining operational risk is due to two causes. First, operational risk is mostly idiosyncratic as opposed to market and credit risk, which have a much larger systematic component. It is difficult to pin down an industry-wide accepted definition. Second, a definition, somehow paradoxically, needs both to be based on and to abstract from the few major incidents that originally initiated the need for capital requirement of operational risk. There are several reasons that have been highlighted claiming the increasing attention focused on operational risk over the past several years emanates from several important developments: (1) globalisation has increased the complexity of financial services, heightening their exposure to operational risk events; (2) consolidation of the financial services industry has created larger, more complex organisations; (3) increasing reliance on computers and electronic communications in transactions and trading functions has led to higher probabilities of systems failure; (4) cross share-holdings and inter-bank funds have increased exposure to potentially contagious operational loss events; and (5) the growth of e-banking and e-commerce exposes institutions to new and unknown risks, as well as increasing their exposure to traditional risks such as fraud. There are at least four sources of operational risk that is internal process, people, system and external events. These sources of risk are summarised in Table 7.1. First, internal process (Panel A) constitutes of two words: ‘internal’ and ‘process’. It can be seen from two sides. Internal risks are related to those over which

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Islamic bank has control such as the employees they hire, the computer system they develop and business strategy (Panel B). Since operational risk covers all internal risks, it includes not only risks arising from operations but also risks arising from inadequate controls such as the ‘rogue trader’ risk and the risks of other categories of employee fraud. On the other hand, process risk arises from breakdowns in established process, failure to follow process or inadequate process mapping with business lines. Specifically, operational risk arising from internal process is the possibility of financial losses related to the inappropriate design of critical process or to inadequate or non-existent policies and procedures, which may result in shortcomings in transactions and services or the suspension of both transactions and services. For those reasons, risks arising from internal risk include risks associated with failings in the model used, errors in transactions, inadequate assessment of contracts or the complexity of products, operations and services, error in accounts information, inadequate remuneration, settlement or payment, insufficient resources for the volume of operations, inadequate documentation of transactions and failure to meet planned deadlines and budgets. Second, people risk (Panel C) refers to the risk of management failure, organisational structure or other human resource failures. Specifically, risk arising from people may be due to the possibility of financial losses associated with negligence, human error, sabotage, fraud, theft, work stoppages, appropriation of sensitive information, money laundering, inappropriate interpersonal relations and an unfavourable working environment, and the lack of clear specifications in the terms of staff contracts. In addition, it includes losses associated with insufficient staffing or staff with inadequate skills and training. Third, system risk (Panel D) covers instances of both disruption and outsourced operations. Specifically, this risk related to the possibility of financial losses arising from the use of inadequate IT systems and related technologies, which may affect the way institution performs its operations and services by undermining the confidentiality, integrity and availability of information. Risks arising from system risk include risks associated with failing in the security and operational continuity of IT systems, errors in the development and implementation of these systems and their compatibility and integration, problem with the quality of information, inadequate investment in technology, and failure to align with business objectives. Other risks include systems disruption or failure, and inadequate disaster recovery and/or business continuity plans. Fourth, external event (Panel E) – risk of direct or indirect loss resulting from inadequate external event is a possibility of losses arising from the occurrence of events outside the Islamic bank’s control that leads to external risk. External risks include the impact of external events, such as natural disasters (e.g., an earthquake or flood that affects the Islamic bank’s operations), political or regulatory risk (e.g., barriers to operate in a foreign country by that country’s government), security breaches and terrorist/criminal attack. In addition, risks involving in lawsuits, failing in public services and failings in critical services provided by third parties may contribute to external event risk.

Operational Risk 199 Table 7.1 Source of Bank’s Operational Risks Panel A: Process risk Pre-transaction: marketing risks, selling risks, new connection, model risk Transaction: error, fraud, contract risk, product complexity, capacity risk Management information Erroneous disclosure risk Panel B: People Risk Integrity: fraud, collusion, malice, unauthorised use of information, rogue trading Competency Management Key personnel Health and safety Panel C: Business Strategy Risk Change management Project management Strategy Political Panel D: Systems Risk Data corruption Programming errors/fraud Security breach Capacity risks System suitability Compatibility risks System failure Strategic risks (platform/supplier) Panel E: External Environmental risk Outsourcing/external supplier risk Physical security Money laundering Compliance Financial reporting Tax Legal (litigation) Natural disaster, Terrorist threat, Strike risk Source: Allen et al. (2004)

7.2

Categorisation of Operational Risks

From the previous discussion, the operational risk can be simplified into seven categories. These categories are identified as operational risk events (see Figure 7.1). Definitions of each category are provided in Table 7.2.

200

Economic Capital and Risk Management Events Sources

Operational risk

• • • •

Internal processes People Systems External Events

-

Impacts

Internal fraud External fraud Employment practices and workplace safety Client, Product and business practices Damage to physical assets Business disruption and system failures Execution, delivery and process management

• Human asset • Physical asset • Monetary • Intellectual Property assets • Reputation • Business interruption

Figure 7.1 Relation between Sources and Events in Operational Risk

Table 7.2 Categories of Loss Events Event-Type Category

Definition

Categories

Activities Examples

Internal Fraud

Loss due to acts of a type intended to defraud, misappropriate property or circumvent regulations, the law or company policy, excluding diversity/ discrimination events, which involves at least one internal party

Unauthorised Activity

Losses due to acts of a type intended to defraud, misappropriate property or circumvent the law, by a third party

Theft and Fraud

• Transactions not reported (intentional) • Transaction type unauthorised (with monetary loss) • Mismarking of position (intentional) • Fraud/credit fraud/ worthless deposits • Theft/extortion/ embezzlement/robbery Misappropriation of assets • Forgery • Check kiting • Smuggling • Account take-over/ impersonation, etc. • Tax non-compliance/ evasion (wilful) • Bribes/kickbacks • Insider trading (not on firm’s account) • Theft/robbery • Forgery • Check kiting • Hacking damage • Theft of information (with monetary loss)

External Fraud

Theft and Fraud

Systems Security

Operational Risk 201 Table 7.2 (Continued) Event-Type Category

Definition

Categories

Activities Examples

Employment Practices and Workplace Safety

Losses arising from acts inconsistent with employment, health or safety laws or agreements, from payment of personal injury claims, or from diversity/ discrimination events Losses arising from an unintentional or negligent failure to meet a professional obligation to specific clients (including fiduciary and suitability requirements), or from the nature or design of a product

Employee Relations

• Compensation, benefit, termination issues • Organised labour activities • General liability (slips and falls, etc.) • Employee health & safety rules and events • Workers compensation All discrimination types

Clients, Products & Business Practice

Safe Environment

Diversity & Discrimination Suitability, Disclosure & Fiduciary

Improper Business or Market Practices

Product Flaws Selection, Sponsorship & Exposure

Damage to Physical Assets

Losses arising from loss or damage to physical assets from natural disasters or other events

Advisory Activities Disasters & Other Events

• Fiduciary breaches/ guideline violations • Suitability/disclosure issues (KYC, etc.) • Retail consumer disclosure violations • Breach of privacy • Aggressive sales • Account churning • Misuse of confidential information • Lender liability • Antitrust • Improper trade/market practice • Market manipulation • Insider trading (on firm’s account) • Unlicensed activity • Money laundering • Product defects (unauthorised, etc.) • Model errors • Failure to investigate client per guidelines • Exceeding client exposure limits Disputes over performance or advisory activities • Natural disaster losses • Human losses from external sources (terrorism, vandalism)

(Continued)

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Table 7.2 (Continued) Event-Type Category

Definition

Categories

Activities Examples

Business Disruption & Systems Failures

Losses arising from disruption of business or system failures

Systems

• • • •

Execution, Delivery & Process Management

Losses from failed transaction processing or process management, from relations with trade counterparties and vendors

Transaction Capture, Execution & Maintenance

• • • • • • • • •

Monitoring & Reporting

•

Customer Intake & Documentation

•

Customer/Client Account Management

•

• • • •

Source: Basel Committee (February 2003)

Trade Counterparties

•

Vendors & Suppliers

• •

•

Hardware Software Telecommunications Utility outage/ disruptions Miscommunication Data entry, maintenance or loading error Missed deadline or responsibility Model/system misoperation Accounting error/entity attribution error Other task misperformance Delivery failure Collateral management failure Reference data maintenance Failed mandatory reporting obligation Inaccurate external report (loss incurred) Client permissions/ disclaimers missed Legal documents missing/incomplete Unapproved access given to accounts Incorrect client records (loss incurred) Negligent loss or damage of client assets Non-client counterparty misperformance Misc. non-client counterparty disputes Outsourcing Vendor disputes

Operational Risk 203 These operational risk events are: first, internal fraud – acting with the intention to defraud, misappropriate property or circumvent regulations, the law, or company policy (excluding diversity of discrimination events which involve at least one internal party). Second, external fraud – acting by third party, with the intention to defraud, misappropriate property or circumvent the law. Third, employment practices and workplace safety – acting which are inconsistent with employment, health or safety laws or agreements, or which result in payment of personal injury claims, or claims relating to diversity or discrimination issues. Fourth, client, products, and business practices. It is unintentional or negligent failure to meet a professional obligation to specific clients (including fiduciary and suitability requirements), or from the nature or design of a product. Fifth, damage to physical assets. It covers losses or damages to physical assets from natural disasters or other events. Sixth, business disruptions and system failures. Seventh, execution, delivery, and process management. It includes failed transaction processing or process management, and relations with trade counterparties and vendors. The importance of understanding and managing operational risk is heightened by the fact that an operational risk’s impact extends beyond the loss incurred. The impact can be seen in Figure 7.1. For example, such losses may affect the taxpayer if the loss occurs at government-insured Islamic banks. In some cases, customers may be affected if the operational event involves a breach of fiduciary duty. In some other cases, operational event can affect the stability of financial system if the loss occurs at a systematically important Islamic bank. In the worst case, poor governance prevents management from addressing the loss’s underlying causes; further financial and reputational losses can accumulate until they affect the solvency of the Islamic banking institutions. It shows that there is relationship between operational risk, governance and reputational losses. The potential for adverse financial effects is the main reason that the Basel III capital framework incorporated the treatment of operational risk into risk-based capital requirement. The framework calls for Islamic banking institutions to hold capital to absorb possible losses from their exposures to operational risk. However, risks of loss from an Islamic bank’s operation are not as amenable to statistical modelling as are other risks. 7.3

Operational Risk: Islamic Banks’ Perspective

Islamic banks, in addition to being exposed to the above sources of risks, are also exposed to Shari’ah non-compliance risk. Shari’ah non-compliance risk is the risk that arises from Islamic banks’ failure to comply with the Shari’ah rules and principles. Specifically, Shari’ah non-compliance risk arises from: (1) failure of Islamic bank in anticipating, identifying, assessing and managing unique risks arising from implementing Shari’ah approved contract; (2) failure in anticipating, identifying, assessing and managing the impact of Shari’ah non-compliance events which changed the profile of the unique risks; and (3) Shari’ah non-compliance that has direct impact to the earnings (present and future) because of defective contract.

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Economic Capital and Risk Management

7.3.1 Sources   of Shari’ah  Non-compliance  Risk

The sources of risk are normally discussed in terms of deviation from the optimum solution or process, usually described in terms of expected loss. The optimum solution is such a condition of the ‘contract’ where any changes to certain circumstances will cause risk to occur. Theoretically, the relationship between contracts and risks can be seen from different directions: legal risk, contract risk and business risk. Legal risk – if one chooses to approach contracts and the contracting activity of businesses and other organisations from the perspective of legal risks, contracts will most likely be viewed as sources of risks since contracts in such an approach are easily understood as primarily legal instruments. The perception of contracts as sources of risk seems to be more to the analytical perception of liability risk, because the contracts create contractual relationships loaded with rights and liabilities. Look at the following examples. Example 1: Salam Contract – Salam (advance purchase) is a contract in which advance payment is made for goods to be delivered later. This forward contract implies immediate payment where an Islamic bank assumes the role of the forward purchaser of a commodity. As a purchaser of goods, Islamic banks expose themselves to the following operational risk: first, salam contracts are neither exchange traded nor are traded over the counter (OTC). These contracts are written between two contracting parties, and so, all the salam contracts end up in physical deliveries and ownership of commodities. Islamic bank may have to incur additional costs such as storehouse, takaful or even damage due to catastrophic risks (if the goods are perishable in nature) if it cannot sell the goods promptly following delivery. Second, salam is closely related to the agriculture sector, which often struggles to meet the agreed-upon contractual quality standards. The buyer must either reject goods of an inferior quality to that specified in the contract or accept them at the original price. In the latter case, the goods would have to be sold at a discount (unless the customer under a parallel salam agreed to accept the goods at the originally agreed price). Example 2: Istisna’ Contract – Istisna’ is a kind of sale where a commodity is transacted before it comes into existence. It means to ask a manufacturer to manufacture a specific commodity for the purchaser. In this case, the contract is to supply a constructed asset (i.e., building) for a customer. In turn, Islamic bank enters into a parallel istisna’ with a sub-contractor to have the asset constructed. The validity of istisna’ requires that the price is fixed with the consent of the parties and that the necessary specification of the commodity is fully settled between them. Before the sub-contractor starts the work, any one of the parties may cancel the contract after giving a notice to the other. However, after the sub-contractor starts the work, the contract cannot be cancelled unilaterally. On the other side, Islamic bank’s reliance on the parallel istisna’ counterparty (the sub-contractor) exposes it to the following operational risks: (1) Islamic bank may be unable to deliver the asset on time, owing to time overruns by the sub-contractor under the

Operational Risk 205 parallel istisna’ and, thus, may face penalties for late completion; (2) cost overruns under the parallel istisna’ contract may, unless agreed with the customer under the istisna’ contract, have to be absorbed partly or wholly by Islamic bank; (3) the subcontractor may fail to meet quality standards or other specification, as agreed with the customer under istisna’ contract; and (4) if the sub-contractor turns out to be unable to complete the work and rescind from contract (if the contract is considered as optional and not binding as the fulfilment of conditions under certain Fiqh jurisdictions may need), the bank will need to find other sub-contractor. In certain cases, this may be very difficult and costly to the bank. The sub-contractor rescinding from the contract itself can be considered operational risk. Example 3: Musharakah Contract – Musharakah is a relationship between two parties or more, of whom contribute capital to a business, and divide the net profit and loss pro rata. In the case of Islamic bank, the customer will be the managing partner in the venture, but the bank may participate in the management and thus be able to monitor the use of funds closely. Operational risk exists in musharakah investment in the following manner: (1) Islamic bank may not perform adequately due to diligence in appraising the venture to be financed and the soundness and reliability of the customer. Lack of appropriate technical expertise can be a cause of failure in a new business activity; and (2) during the musharakah investment period, Islamic bank may not carry out adequate monitoring of the financial performance of the venture and may fail to receive adequate financial information in order to be able to do so. Consequently, if the customers mismanage the fund, Islamic bank is exposed to operational risk. Example 4: Murabahah Contract – Murabahah (cost-plus financing) is a contract of sale. There are two types of operational risk relating to the structure of a murabahah contract: (1) Murabahah is approved to be an acceptable mode of financing in many regulatory jurisdictions. The different viewpoints of murabahah’s permissibility can be a source of operational risk since it can lead to ineffective litigation. For example, IT systems employed across jurisdictions may have to be designed to meet the requirements of certain jurisdictions; and (2) at the contract signing stage, since the contract requires Islamic bank to purchase the assets first before selling it to the customer, the bank needs to ensure that the legal implications of the contract properly match the commercial intent of the transactions. Example 5: Ijarah and Ijarah Muntahia Bittamleek Contract – Ijarah concept means selling benefit or use or service (i.e., plant, office automation motor vehicle) for a fixed price or wage (for an agreed period) or best known as an operating lease. Ijarah muntahia bittamleek (ijarah-wal-iqtina’) is selling benefit or use or service to the client against an agreed rental together with a unilateral undertaking by Islamic bank or the client that at the end of the lease period, the ownership in the asset would be transferred to the lessee or best-known as lease-to-purchase. Similar to murabahah, the contracting party is exposed to operational risk during the purchase and holding of the assets. In addition, it also exposes to the following operational risk: (1) if Islamic bank fails to ensure that the asset will be used in a Shari’ah-compliant manner, it exposes Islamic bank to non-recognition of the lease

206  Economic Capital and Risk Management income. The impure income is not permissible. There is a need to repossess the asset and find a new lessee; (2) if the lessee damages the assets in its possession, Islamic bank may refuse to accept the assets from the lessee; (3) if the leased asset is severely damaged or destroyed through no fault of the lessee, Islamic bank as lessor is required to provide an alternative asset, failing which the lessee can terminate the lease without paying rentals for the remaining duration of the contract; and (4) Islamic bank may be exposed to legal risk in respect of the enforcement of its contractual right to repossess the asset in case of default or misconduct by the lessee. Contract risk – other than source of risks, if one chooses the contracts from the concept of contract risks, the details of the contract will be the focus in order to deal with the risks that the contracts are embedded with. In Islamic finance, this type of risk is often related to the various financial contracts. The applied principle of Shari’ah has brought one to potentially engage with such contract risk, that is, Shari’ah risk in which if the change of circumstances deviates from the compliance requirement, the risk does exist. Business risk – if one approaches contracts from the perspective of business risks and sees the contracting activity as another branch of the organisation’s activities, contracts are no longer conceptualised merely as sources of risks. However, its concept is also defined as tools for the management of not only contract, liability or legal risks but also business risks. In summary, Islamic bank is not immune to operational risk exposure. This exposure is due to their specific contractual features and the general legal environment. The risk is due to: (1) cancellation risks in the non-binding murabahah and istisna’ contracts; (2) failure of the internal control systems to detect and manage potential problems in the operational processes and back office functions, and technical risks of various sorts; (3) difficulties in enforcing Islamic contracts in a broader legal environment; (4) need to maintain and manage commodity inventories often in illiquid markets; and (5) costs and risks in monitoring equity type contracts and the associated legal risks. 7.3.2  Profile of Operational Risk

The operational risk is crucial in Islamic banks, partly due to profit-loss sharing activities. The use of profit-loss sharing modes of financing exposes Islamic banks to moral hazards and principal-agent problems. In mudarabah contracts, the nature is such that the Islamic banks bear all losses in the event of a negative outcome and, at the same time, cannot oblige users of the funds to take appropriate action to ensure better returns. Furthermore, Islamic banks do not have the right to monitor or participate in project management. This could lead to the mismanagement of funds by users, exposing Islamic banks to the risk of profit-loss sharing defaults. Since Islamic banks are only entitled to receive the principal of the financing from the entrepreneur only if profits have accrued, in the event of losses, Islamic banks would not be able to recover the principal investment and potential profit share.

Operational Risk  207

Rate of return risk

Shari’ah noncompliance risk

Displace commercial risk

Unique

Equity investment risk

Islamic Bank Credit risk Operational risk

Generic Market risk Liquidity risk

Strategic

Legal

Fiduciary

Reputation

Transparency

Regulatory Compliance

Figure 7.2  Unique and Generic Risk Profiles of Islamic Bank Source: Author’s illustration

Mudarabah could also expose Islamic banks to principal-agent problems since Islamic banks have no legal means to control the agent-entrepreneur who manages the project. The agent may decide to expand expenditure on the project and increase the consumption of non-pecuniary benefits at the expense of pecuniary returns since the increased consumption is partly borne by Islamic banks, while the benefits are entirely consumed by the agents. Operational risks due to a lack of trained personnel could be a problem in Islamic banks. Given that Islamic banks are relatively new, there is a shortage of qualified professionals to manage operations. The lack of technology increases operational risks. The risk profile also covers the Shari’ah non-compliance risk. Therefore, as summarised in Figure 7.2, risk profiles in Islamic banks also comprise rate of return risk, displaced commercial risk (Chapter 8) and equity investment risk. 7.3.3  Impact of Shari’ah Non-compliance Risk

A contract becomes valid (sahih) if it fulfils the pillars of the contract and the income generated from the contract is legal (halal). On the other hand, a contract becomes invalid (ghayr sahih), if it violates the pillars and Shari’ah conditions of the contract. It can be further broken down into two categories: (1) void (batil) – defect in fundamental pillars such as selling impure items, that is, pork and wine, and has a sale contract with excessive uncertainty, that is, selling something non-existent and

Economic Capital and Risk Management

Legal Infrastructure

Shari’ah

Both

Legal

Shari’ah noncompliance

Fully

Operaonal Implementaon

Legal risk

Legal documents, Operaon (people, process, system). Technology

208

Paral

• • • •

Unique Risk Credit Market Liquidity Operaonal

• • • •

Transformed Unique Risk Credit Market Liquidity Operaonal

• Shari’ah noncompliance risk • Legal and regulatory noncompliance risk

Commercial Financial Losses

Commercial Financial Losses

Penalty, Purifcaon of Income, Capital

None

Figure 7.3 Impact of Shari’ah Non-Compliance Risk Source: Author’s illustration

something undeliverable (i.e., birds in the sky); (2) and irregular (fasid) – defect in external factors attached to the pillars. Income from a void contract is considered illegal. Among the elements leading to Fasid contracts are insufficient information with respect to the asset, the price and the delivery time, and existent of an invalid condition (e.g., purchase undertaking in a mudarabah product where capital providers are guaranteed of their capital). Income, as shown in Figure 7.3, becomes legal once these intolerable elements are eliminated. Therefore, income that does not comply with Shari’ah-compliance risk should not be recognised. It should be purified by returning it to customer or given to charity and hence it affects the amount of Islamic bank capital. At the same time, the regulator may ask the Islamic bank to pay the penalty for Shari’ah non-compliance. Other than Shari’ah non-compliance risk, Islamic banks also face the risk of ‘misconduct and negligence’, which would result from mudarabah-based profitsharing investment account. If this account is treated as a liability, it would consequently affect the capital adequacy and solvency. As shown in Table 7.1, people risk significantly contributes to operational risk as in conventional banks. This type of risk arises from fraud, collusion, malice or incompetence. For example, an internal control problem cost the Dubai Islamic Bank $50 million in 1998 when a bank official did not conform to the bank’s credit terms. Consequently, this caused the bank to run on its deposits of $138 million, representing about 7% of the bank’s

Operational Risk 209 total deposits in just one day.2 Person risk can easily threaten the banking system’s stability. In this case, operational risks happen as the Islamic banks may not have enough qualified professionals to conduct Islamic financial operations. For example, lack of competency among professionals could affect its performance, as the Islamic bank cannot implement good governance. In general, operational risk can also arise from various kinds of banking activities, which are somewhat similar for all banking intermediaries, either Islamic or conventional bank. However, the asset-based nature of financing products in Islamic banking such as murabahah, salam, istisna’ and ijarah may create another form of operational risk, which is due to contract drafting and execution that are specific to such products. It is important to be noted that Islamic product is more complex than its conventional counterpart, requiring more processing steps and leaving room for error. Islamic banks naturally hold more physical assets on their balance sheets than conventional banks and are exposed to operational risks associated with this requirement. Other operational risks are associated with the Islamic bank’s fiduciary responsibilities as mudarib toward rabb-ul-mal under the mudarabah contract, according to which in case of misconduct or negligence by the mudarib, the funds invested by the rabb-ul-mal become a liability of the mudarib. It relates to fiduciary risk, which arises from an Islamic bank’s potential failure to perform in accordance with explicit or implicit standards applicable to its fiduciary responsibilities, especially in its role as mudarib. As a result of huge losses on investments, an Islamic bank may be exposed to insolvency. Consequently, the Islamic bank will be unable to meet the demands of current account holders for repayment of their funds or to safeguard the interests of its investment account holders. Finally, operational risk may arise from legal risks resulting from: (1) Islamic bank’s operations, which also exist in other financial intermediaries; (2) problems of legal uncertainty in interpreting and enforcing Shari’ah contracts. Regarding point (2), this problem arises if there is no standard form of contracts for various financial instruments. This happens due to different views and understanding of Shari’ah, local laws and their needs and concern. 7.4

Operational Risk Management

Islamic banks may suffer due to huge losses because of operational risk. Such losses can threaten the Islamic banking stability as well as customers’ deposit. These imply that Islamic banks need to manage the operational risk to reduce the frequency and/or severity of events leading towards operational losses. Operational risk management (ORM) is a decision-making tool to systematically help identify operational risks (and benefits, if any) and determine the best courses of action for any given situation. There are four principles of ORM: (1) accept risk when benefits outweigh the cost, (2) accept no unnecessary risk, (3) anticipate and manage risk by planning and (4) make risk decisions at the right level.

210

Economic Capital and Risk Management

Another way to reduce operational risk exposure is applying takaful against this risk because not all risks are controllable. Takaful can mitigate operational risks by reducing the economic impact of operational losses. There are many takaful products that Islamic banks can use to reduce the economic impact of operational risks from standardised, peril-specific takaful products to tailormade coverage. Takaful also covers information systems failures, although the coverage is often limited to specific types of failures. As most losses due to operational risk are bank-specific, and thus, almost uncorrelated across different banks, takaful provides a way of pooling and diversifying those risks across the industry. Some events such as unauthorised trading and computer crime have been included in takaful policy. However, such moral hazard may give rise to high premiums. Hedging is another channel for reducing risk exposures. The existence of an instrument such as financial derivative is crucial for reducing the overall risk exposure through hedging. The occurrence of various natural disasters worldwide, such Cyclone Nargis, Hurricane Harvey and Pakistan Earthquake, prompted the emergence of risk securitisation in the form of exchange-traded and over-the-counter (OTC) financial instruments. Following this development, it has been suggested to create financial instruments to deal with operational risk. However, the success of these instruments can be achieved only if these instruments are designed in a such way as to overcome problems arising from moral hazard events and nontransparent valuation mechanisms. Risk mitigation tools, as shown in Table 7.3, are considered as complementary rather than replacement through internal operational risk control. For example, employing a range of tools can effectively mitigate and absorb the operational risk. While capital can only be used to absorb the operational risk. The tools only provide a mechanism that quickly recognise, and legitimate operational errors can provide early prevention and thus reduce operational risk exposures. Therefore, risk prevention and reduction seem to be most appropriate management device with respect to operational risk. The implementation of this internal management mechanism is powerful mostly during times in which underlying risk patterns have Table 7.3 Approaches and Tools of Risk Management Approaches Tools

Avoid/Eliminate

Set/System Policy Sell Diversify Hedge/Insure Hold Capital

✓ ✓ ✓ ✓

Source: Ahmed (2009)

Transfer

Absorb/Manage ✓

✓ ✓ ✓ ✓

Operational Risk 211 not been fully understood, sound risk model has not been developed and large databases have not been fully developed. In order to manage risk, Islamic bank needs to address two key components of the risk management process. These are strategic risk management, and tactical risk management and control. In simple words, strategic risk management primarily involves with Islamic bank’s risk environment, while tactical risk management and control deals with the operational procedures and the risk management control functions. An effective risk management strategy requires a consistent approach to both these components. A suitable strategic approach or risk environment without the necessary monitoring and control is unlikely to provide effective risk management. In the same way, excessive emphasis on controls is likely to lead to problems being hidden and thus create an even bigger risk management nightmare. 7.4.1 Elements   in Risk  Management

There are three important elements in risk management for any type of risk including operational risk. There are: (1) establishing risk management environment, sound policies and procedures; (2) maintaining an appropriate risk measurement, mitigating and monitoring process; and (3) adequate internal control. Establishing risk management environment, sound policies and procedures involves the objectives and strategies of the Islamic bank towards risk and its management policies. At the top of management, the board of directors is responsible for outlining and developing policies and procedures to achieve the objectives and strategies of operational risk management. Other than approving the policies of the Islamic bank regarding operational risk, the board of directors should ensure that the management takes the necessary actions to identify, measure, monitor and control this risk. In doing so, attention should be given to include people, process and technology risks that can arise in the institution. The Board of directors, as shown in Panel A, Figure 7.4, also is responsible for providing management with clear guidance and direction regarding the principles underlying the framework and approving the corresponding policies developed by senior management. In addition, they also have the responsibility to periodically review the framework to ensure that it meets the standard. A part of the review process is to update the framework to ensure that all material risks identified in its analysis are captured and that it incorporates the industry’s best practices for an identity of its size and operations. Other than this, they must receive reports from all divisions and ensure that the operational risk management programme is subject to an effective and comprehensive review by the internal audit unit. Senior management (Panel B) is responsible for implementing the operational risk management framework approved by the board of directors. To do so, senior management would maintain a risk management review process, adequate systems

.

.

. .

Board must ensure that the business strategy is backed by a solid risk strategy and an effective risk management structure. Board must provide effective oversight of senior management’s actions to ensure consistency with risk strategy and policy approved by the board. Board must ensure that management has adequate resources and qualified personnel with relevant knowledge. Board must approve product policies, including all Shari'ah-compliant products.

Panel B – Senior Management Oversight

. .

Risk Governance

Panel C – Risk Management and Control .

. .

Senior management is in charge of ensuring that the financial institution's day-to-day operations are in accordance with the board-approved risk strategy and risk appetite

Figure 7.4  Shari’ah Risk Governance Source: Author’s illustration

Shari'ah committee should ensure that all activities are in accordance with Shari'ah rules. Shari'ah committees should be backed by effective Shari'ah control functions such as Shari'ah audit and review functions.

.

Risk management framework must enable the identification, measurement and continuous monitoring of all relevant and material risks Risk management must be supported by robust management information systems that facilitate timely and reliable reporting of risks Risk management must be well integrated throughout the organisation

212  Economic Capital and Risk Management

Panel D – Shari’ah Committee Oversight

Panel A – Board Practices

Operational Risk 213 of risk measurement, a comprehensive reporting system and effective internal controls. Procedures must include appropriate approval processes, limits and mechanism designed to ensure that the bank’s risk management objectives are achieved. For example, the management should develop ‘operational risk catalogue’, where business process maps of any activity are outlined. This catalogue can be used to identify and access the operational risk. Senior management must assign authority and responsibility and develop reporting relationships, which would encourage and maintain accountability. Reports from all units should adequately contain both internal and external market data. They also should conduct assessment of the appropriateness of the management oversight process and determine if the necessary resources are available to manage operational risks. In doing so, they must ensure staffs have necessary qualifications, technical capabilities and access to resources. It is also the task of the Board of Directors and senior management to promote risk management culture. The organisation needs to develop a risk management culture where risk management is seen as the responsibility of the staff at all levels of the organisation. This implies that systems and processes are designed with risk management in mind, and staff training and development focuses on effective risk management practices. The financial institution will only be able to manage operational risk effectively if its management and staff want to. No matter how much money is spent on development in operational systems or the implementation of procedure and operational instruction, the effectiveness of these efforts will be limited as long as the staff refuses to change the way they perceive the operational risk. It is the individuals who have to decide whether they are going to manage operational risk. Maintaining an appropriate risk measurement, mitigating and monitoring process implies that banks must have management information systems for measuring, monitoring, controlling and reporting operational risk exposures. The complexity of operational risk causes the Islamic bank to face difficulty in quantifying it. Islamic bank uses simple and experimental techniques to measure operational risk. The continuous monitoring process is to ensure the integrity of the risk management controls and systems. Monitoring and audit (internal and external) play an important role in auditing and testing the risk management process and internal control. Internal control (Panel C) is a mechanism for reducing instances of fraud, misappropriation and errors. Senior managers must clearly define responsibilities between front office and back office. Operations personnel, who have authorisation for conformation and settlement, must maintain a reporting line independent of trading, where the trade execution takes place. In addition to internal control, Islamic banks must have contingency planning to absorb unexpected/uncontrollable event resulting from inadequate internal control. Shari’ah committee oversight (Panel D) is established to ensure that all the activities comply with Shari’ah requirements. This committee should be supported by effective Shari’ah control functions, such as Shari’ah audit and review functions.

214

Economic Capital and Risk Management

7.4.2 Multi-Discipline  and  Process   of Operational  Risk  Management

Operational risk management involves several activities such as identifying, measuring, preventing, mitigating, predicting, transferring operational risk as well as changing the form of the risk to another type of risk and dealing with that risk. At the end of the activities, Islamic banks allocate capital to cover operational risks. All these activities are connected to each other and continuously practiced by Islamic banks. Each discipline, co-opting the term risk management, fills it with its unique set of techniques and concepts. However, some things are shared in all approaches. Risk management involves processes such as exposure identification, risk measurement, analysis, control, prevention, reduction and assessment and financing. Given the definition of operational risk, operational risk management also helps to integrate financial and non-financial risks, traditional financial risk management with takaful and legal liability, and the management of one-off loss events with that of continuous systematic risks. Meaning to say, all the disciplines interact and, hence, form the integrated approach. According to Marshall (2001), operational risk management is related to six disciplines: (1) financial risk management, (2) total quality management, (3) takaful, (4) audit and internal control, (5) operations management and reliability engineering, and (6) facilities management and contingency planning. For example, financial risk management implies that financial risk managers must develop well-defined risk processes and organisational structures to measure, analyse and manage financial risks. Many sophisticated approaches have been applied to quantify market and credit risks, and this approach is also applicable to operational risk management. For example, stress testing and value at risk (VaR) have found their application in operational risk management. However, the most important thing is the adoption of an integrated set of risk processes and an organisational structure to handle operational risks. Obstacles such as the lack of reliable data, the uniqueness of exposures and the absence of hedging vehicles make it difficult to transfer financial risk management techniques to the problem of operational risk management. Another example is takaful, which can be used to transfer some operational risk from the insured to the insurer. If an Islamic bank satisfies with certain criteria, the losses from operational risk will be recovered and, thus, can reduce the capital to absorb operational risk. Insurers can reduce their risk by diversification using a pool of non-correlated exposures. However, not all operational risks can be covered by takaful. Even if they could, the insurer has to pay a large premium. For accounting and internal control, accounting control system is designed to ensure that all operations are in accordance with strategy and policies developed by senior management. Audit process is a process that confirms the existence of all assets and liabilities through a series of interviews and checklists. Operational risk management uses similar quantitative techniques but goes beyond them to quantification and ongoing resource allocation based on the resulting estimates of risk.

Operational Risk 215 Facilities management and contingency planning are important because not all operational risks can be removed or recovered. Contingency planning is required especially when Islamic banks face unexpected scenarios that can threaten their fixed assets and ongoing operation. Contingency planning has two elements; those are providing back-up resources (i.e., capital) and applying them quickly to bring business operations back online. As we mentioned before, there are several activities in operational risk management. Figure 7.5 shows the main activities in the operational risk management cycle or process. In the first place, Islamic banks must set risk management objectives and targets by understanding the risk appetite. There are several questions regarding these risk management objectives: (1) what does the task entail, (2) what do we have to do and (3) are there other ways to this? The last two questions imply what institution or organisation is needed to accomplish the tasks and the conditions under which to conduct them. Having defined the risk management objectives, Islamic bank needs to analyse all its processes and workflows. Experience and common sense can help to identify risks. This will help to identify and list the potential hazards and risks and their causes. All processes must be included in this initial review to identify and record the comprehensive list of all risks and their causes. Islamic bank should identify the operational risk inherent in all material products, activities, processes, systems and personnel, for example, the Shari’ah risk, as shown in Figure 7.6. Then, it will be followed by an effective risk identification. It should consider the risk drivers – both internal factors (such as Islamic bank’s structure, the nature of their activities and products, and the quality of human resources, organisational changes and employee turnover) and external factors (such as changes in environment, political and technology) that – could unfavourably affect the achievement of the objective. The first step toward identifying risk events is to list out all the activities that contribute to operational risk. This step includes several levels: (1) lists the main business groups, corporate finance, trading and sales, retail banking commercial banking, payment and settlement, agency services, asset management and retail brokerage; (2) lists out the product teams in these business groups such as transaction banking, trade finance, general banking, cash management and securities market; (3) lists out the product offered in these business groups, for example, import bills, letter of credit, bank guarantee under trade finance. The second step is to record all associated risk events with these products. A risk event is an incident that has caused or has the potential to cause loss either directly or indirectly in conjunction with other incidents. Risk event can be identified through experience, informed judgements, relevant events or even intuition. This process of identification is crucial because this is the first preventive step to operational risk before the product goes to the market. In the next stage, Islamic banks must assess the risks. There are two important things to address here. First, Islamic banks must assess the severity/criticality of the identified risks. We can (if necessary) assign a figure from 1 to 5 to

• Risk management objectives •

Analysis of workflows and processes List risks and causes

Figure 7.5  Operational Risk Management Cycle Source: Hussain (2000)

Assess the risk •

•

Assess risk severity Assess risk probability

Select risk control measures • Identify control choice • Determine priorities • Make control decisions

Monitor and review

Implement risk controls •

• •

Establish authority and responsibility Define structure Define processes and procedures

• • • •

Define monitoring Infrastructure Monitor process Review processes

216  Economic Capital and Risk Management

Identify risks

Operational Risk 217 Shari’ah Ruling

Risk Drivers

Developing New Methodology

Iden˜fca˜on

Assessment, Measurement, Monitoring and Control

Partly Leveraging on CRM Tools

Figure 7.6 Shari’ah Risk Management Process Source: Author’s illustration

capture variation in severity. For example, 1 = None or slight, 2 = Minimal, 3 = Significant, 4 = Major and 5 = Catastrophic. Second, financial institutions must assess the probability or frequency of events occurring. We also can assign (if necessary) a figure from 1 to 5 to capture the probability of the event’s occurrence. For example, 1 = Impossible or remote under any conditions, 2 = Unlikely under normal conditions, 3 = About 50–50, 4 = Greater than 50% and 5 = Very likely to happen. Both severity and probability are critical elements in operational risk measurement. Without both information, Islamic banks may have problems in quantifying the operational risks. As suggested by Basel Committee on Banking Supervision, there are several tools to assess Islamic banks’ operational risk. First, banks can assess operational risk by self-risk assessment. For example, scorecards allow to translate qualitative assessments into quantitative metrics that give a relative ranking of different types of operational risk exposures. Second, Islamic banks can use risk mapping, where various business units, organisational functions or process flows are mapped by risk type. This process will help to find the area of weakness and prioritise subsequent management action. Third, Islamic banks can use key risk indicators that can give true picture of risk position. The financial statistic indicators need to be reviewed on a periodic basis to alert Islamic banks to changes that may be indicative of risk concerns. Finally, Islamic banks can use model and quantification methods to estimate their exposure to operational risk. Operational risk measurement involves measuring the size and scope of the risk exposures.3 In this process, banks must engage in tracking group-wide operational risk data. The measurement method must be accompanied by data availability. The data on an Islamic bank’s historical loss experience could provide useful information for assessing the exposure to operational risk. On the other side, however, there is no established single way to measure operational risk on bank-wide basis. We will discuss this issue (method of measurement) in the next chapter of this book. It is worth highlighting that quantitative analysis must accompany qualitative assessment to produce accurate results of operational risk exposure. For example, Islamic banks can use scenario analysis in addition to basic approach to produce more accurate results.

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Information from risk assessment can be used to select risk control measures. It involves an investigation of specific strategies and tools that reduce, mitigate, transfer, eliminate or avoid the risk. For example, Islamic banks may use takaful or capital provision to control operational risk. Takaful is used to reduce the economic impact of the event (severity) of operational risk. To reduce the probability of event (frequency), banks can use internal controls on operational risk. Islamic banks can also use other approaches such as operational risk limits. For uncontrollable risk, Islamic banks must decide whether to accept (to some acceptable degree or limit) that risk or to reject it. At this stage, Islamic banks should identify control choices available that may have a significant impact on their organisation and staff. By ranking the priority of control measures, Islamic banks will easily make their choice. This will help the management of Islamic banks to decide which risk control is most appropriate for their organisation (including cost-benefit analysis) and define an action plan for all the risks that have been identified. After selecting the risk control, Islamic banks have to implement this risk control, then provide the time, materials and personnel needed to put these measures in place. The implementation should clearly identify where the authority, responsibility and accountability for the control process lie. Islamic banks should define the structure, process and procedures to achieve the effective risk control. Normally, senior management receives regular reports from appropriate areas such as business units, group functions, the operational risk management unit and internal audit. The operational risk reports must contain internal financial, operational, compliance data, as well as external market information about events and conditions that are relevant to decision-making. These reports must fully reflect any identified problem area, so that action can be taken to solve this problem. At the end of this cycle, Islamic banks must ensure that the risk control is accompanied by diligent monitoring and thorough review. There should be an independent monitoring and review of the control structure. The monitoring and review process should periodically reevaluate to ensure their effectiveness in terms of quickly detecting and correcting deficiencies in the policies, processes and procedures for managing operational risk. Islamic banks must have appropriate indicators that provide early warning of an increased risk of future losses. When thresholds are directly linked to these indicators, an effective monitoring process can help identify key material risks in a transparent manner and enable the bank to act upon these risks appropriately. The monitoring process is most effective when the system of internal control is integrated into the bank’s operations and produces regular reports. Later, the results of monitoring activities are included in management and board reports for the review of internal audit. Internal control as an important part of the process must be done properly to avoid operational risk at the end of the cycle.

Operational Risk 219 7.5

Capital Requirements for Operational Risk

7.5.1 New  Standardised  Measurement  Approach

This section discusses the estimation of operational risk economic capital in line with a new consultative paper on a Standardised Measurement Approach (SMA) published by the Basel Committee on Banking Supervision in March 2016. The Basel Committee on Banking Supervision (BCBS) published its second consultation on the capital measurement for operational risk in March 2016.4 SMA combines the use of business indicator (BI), which is a simple financial statement proxy of operational risk exposure, with Islamic bank-specific operational loss data. Under this approach, Islamic banks with more effective risk management and lower operational risk losses might hold a comparatively lower operational risk regulatory capital charge. The key change was the introduction of historical loss experience as a relevant risk indicator for future operational risk loss exposure. Definition and structure of BI were also improved to address the asymmetric impact on different business models. Under the SMA, Islamic banks are divided into five buckets according to the size of their BI: profit, lease, dividend, services, and financial. As shown in Figure 7.7, there are two main components that become the basis in calculating operational risk; they are multiplied by each other to calculate operational risk capital requirements: (1) business indicator component (BIC) and (2) loss multiplier (LM). The calculation logic is shown in Figure 7.7, where the operational risk capital is the multiplicative of business indicator component and loss multiplier. With the new SMA, Islamic banks with more effective risk management and low operational risk losses are required to hold a comparatively lower operational risk capital. This approach combines the BI approach with an Islamic bank’s internal loss data. 7.5.2 Calculation   of Business  Indicator  Component

The business indicator component includes income statement items related to activities producing operational risk that are omitted or netted in the gross income. Business indicator comprises income, lease, and dividend component (ILDC); services component (SC); and financial component (FC). Three components, which are calculated from profit and loss positions as well as balance sheet positions, are added up to the business indicator. Islamic banks may adopt the buckets presented in Table 7.4 to suit countryspecific requirements.5 They can be divided into five buckets according to the size of their BI. For Islamic banks in bucket 1, capital is an increasing linear function of the BI. It does not depend on internal losses. For Islamic banks in buckets 2 through 5, capital is calculated in two steps: (1) calculate a baseline level of capital using the BI component, and (2) the portion of the BI component above the threshold separating buckets 1 and 2 is multiplied up or down by a function that depends

220  Economic Capital and Risk Management Business Indicator

Loss Data

Business Indicator Component (BIC) . ILDC . SC . FC

Loss Multiplier (LM)

Operational Risk Capital Figure 7.7  Logical Flow of New SMA Table 7.4  BI Buckets in the BI Component Bucket

BI Range ($ billion)

BI Component

1 2 3 4 5

0–1 1–3 3–10 10–30 30−+∞

0.11 × BI $110 m + 0.15 (BI − $1 bn) $410 m + 0.19 (BI − $3 bn) $1.64 bn + 0.23 (BI − $10 bn) $6.34 bn + 0.29 (BI − $30 bn)

on Islamic banks’ internal losses, to differentiate between Islamic banks with different risk profiles The following discussion illustrates the spillover logic: the marginal increase of BI component resulting from one unit increase in the BI is 0.11 (or 11%) in bucket 1, 0.15 (or 15%) in bucket 2, 0.19 (or 19%) in bucket 3, 0.23 (or 23%) in bucket 4, and 0.29 (or 29%) in bucket 5. The constants added to the BI component in buckets 2 to 5 are necessary to ensure that the BI component is continuous. They reflect the value of BI component at the top of the range of the bucket directly below. To calculate BI for year t, a bank must determine the three-year average of the BI, as the sum of the three-year average of its components. The formula for BI follows:

Operational Risk 221 BI = ILDCAvg + SCAvg + FCAvg

(7.1)

where (as presented in Tables 7.5–7.7), ILDCAvg = Min[Abs(IncomeAvg – ExpenseAvg); 0.035 × Income Earning AssetsAvg] + Abs(Lease IncomeAvg – Lease ExpenseAvg) + Dividend Income; FCAvg = Abs(Net Profit and Loss in Trading BookAvg + Abs(Net Profit and Loss in Banking BookAvg) SCAvg = Max(Other Operating IncomeAvg; Other Operating ExpensesAvg) + Max[Abs(Fee IncomeAvg− Fee ExpenseAvg); Min[Max((Fee IncomeAvg− Fee ExpenseAvg); 0.5 × unadjusted] + 0.1 × [(Max((Fee IncomeAvg; Fee ExpenseAvg) – 0.5 × Unadjusted BI)] where Unadjusted BI = ILDCAvg + Max(Other Operating IncomeAvg; Other Operating ExpensesAvg) + Max (Fee IncomeAvg; Fee ExpenseAvg) + FCAvg 7.5.3 Calculation   of Loss  Component  and  Capital  Requirement

The loss component reflects the operational loss exposure of an Islamic bank that can be inferred from its internal loss experience. The addition of loss component to BI improves the risk sensitivity of SMA. Internal loss experience is introduced to the SMA through the internal loss multiplier (ILM). The formula of the ILM is represented as follows:  Loss Component  ILM = ln exp(1) −1 +   BI Component 

(7.2)

where in equation (7.2), the ILM is bounded by ln (e (1)−1) ≈ 0.541. The logarithmic function used to calculate the ILM means that it increases at a decreasing rate with the loss component. However, this formula can be adjusted to effectively include the impact of extreme loss events. If the loss component of an Islamic bank equals to the BI component, the Islamic bank is said to have exposure at the average of the industry. Therefore, under the formula, if ILM is equal to 1, then SMA capital corresponds to the BI Component. Islamic banks with loss experience above the industry average will have a loss component above the BI component and their SMA capital will be above the BI component. Similarly, Islamic banks with loss experience below the industry average will have a loss component below the BI component. Their SMA capital will be below the BI component. Equations (7.1) and (7.2) are used to calculate the capital requirement for operational risk. Capital for Islamic banks in bucket 1 corresponds solely to the BI component. For banks in buckets 2 through 5, capital results from multiplying the

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BI component by the ILM. However, for continuity of the capital requirement, as Islamic banks move from bucket 1 to bucket 2, the portion of the BI component relative to the first $1 billion of the BI (i.e., $110 million) is not multiplied by the ILM. Therefore, for Islamic banks in buckets 2–5, the capital requirement can be calculated by the following formula: SMACapital =  BI Component,if Bucket 1       Loss Component   , (7.3) 110 mill + (BI Component −110 mill)×Ln exp(1) −1 + l       BI Component       ket 2 5 if Buck −   SMA calculations can be used at different levels. First, at the consolidated level, SMA calculations use fully consolidated BI figures, which cover all the intragroup income and expenses. Second, at the sub-consolidated level, SMA calculations use BI figures for the Islamic banks consolidated at that sub-level. Third, SMA calculations at the subsidiary level use BI figures from the subsidiary. Similar to the Islamic bank holding companies, when BI figures for sub-consolidated or subsidiary banks reach bucket 2, these Islamic banks use loss experience in SMA calculations. A sub-consolidated Islamic bank or a subsidiary Islamic bank uses only the losses it has incurred in SMA calculations (and does not include losses incurred by other parts of the Islamic bank holding company). If the subsidiary of an Islamic bank belonging to bucket 2 or higher and does not meet the qualitative standards for the use of the loss component, this subsidiary calculates the SMA capital by applying 100% of the BI component. Ideally, Islamic banks should use ten years of good-quality loss data to calculate the averages used in the loss component. In the transition period, Islamic banks that do not have ten years of data can use a minimum of five years of data to calculate the loss component. As Islamic banks accumulate more years of goodquality loss data, the number of years for the averages used in the loss component should increase until it reaches ten years. Islamic banks that do not have five years of good data (or in general fail to meet the qualitative requirements) must calculate the capital requirement based solely on the BI component. However, Islamic banks with heavy losses could seek to arbitrage Pillar 1 capital by choosing not to meet these requirements. To address such issues, supervisors will ensure that such Islamic banks apply a multiplier to the BI component. 7.5.4 Data  Requirements

Islamic banks with a business indicator greater than $1 billion (bucket 2–5) must estimate a loss multiplier. In general, the data cover: (i) document policies, procedures and processes for identification, collection and treatment of internal loss data (ILD);

Operational Risk 223 (ii) an internal loss data policy that establishes criteria for deciding the circumstances, types of data and methodology for grouping data as appropriate for its business, risk management and SMA regulatory capital calculation needs; (iii) should be able to map its historical ILD into the relevant Level 1 supervisory categories and to provide this data to supervisors on request; (iv) should collect loss data information such as gross loss, recoveries, reference dates (date of occurrence, discovery and accounting), drivers and causes of the loss event; (v) operational risk losses related to credit risk that have historically been included in Islamic banks’ credit risk databases; and (vi) group losses due to a common operational risk event or related operational risk events over time and enter them into the SMA loss dataset as a single loss. The three key BI components are the income, lease and dividend component (ILDC); services component (SC); and financial component (FC). The description of each data related to each component is given in Tables 7.5–7.7. Table 7.5 Income, Operating Lease and Dividend Component Profit and Loss or Balance Sheet Items

Description

Income derived from depositors’ funds and shareholders’ funds

• Income from financing, loans and advances • Income from financial assets (such as assets available for sale, assets held to maturity and trading assets • Other dealing income (such as net gain from sale of financial assets held-for-trading and net gain on revaluation of financial assets held-for-trading • Other operating income (such as net gain from sale of financial assets available-for-sale and net gain on redemption of financial assets held-to-maturity) • Income attributable to customers’ deposits • Income attributable to other banks’ and financial institutions’ deposits and placements

Income attributable to depositors and other banks and financial institutions, except for financial and operating lease Income-earning assets Financial and operating lease income Financial and operating lease expenses Dividend income

• Total gross financing, loans and advances, and financial assets (including sukuk) • Income from financial leases • Income from operating leases • Profits from leased assets • Expense from financial leases • Expense from operating leases • Losses from leased assets • Depreciation and impairment of operating leased assets Dividend income from stocks and funds not consolidated in the bank’s financial statements, including dividend income from non-consolidated subsidiaries, associates and joint ventures

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Table 7.6 Service Component Profit and Loss or Balance Sheet Items

Description

Fee and commission income

Fee and commission income from securities (issuance, origination, reception, transmission, execution of orders on behalf of customers), clearing and settlement, asset management, custody, fiduciary transactions, payment services, structured finance, servicing of securitisations, foreign transactions, and guarantees given Fee and commission expenses from servicing of securitisations, clearing and settlement, custody, foreign transactions and guarantees received

Fee and commission expenses, including outsourcing fees paid by Islamic bank for the supply of financial services, but not outsourcing fees paid for nonfinancial services, for example, logistical, IT or human resources Other operating income, excluding income from operating leases Other operating expenses: expenses and losses from ordinary banking operations not included in other BI items but from operational loss events (excluding expenses from operating leases)

Rental income from investment properties and gains from noncurrent assets and disposal groups classified as held for sale not qualifying as discontinued operations (IFRS 5.36) Losses from non-current assets and disposal groups classified as held for sale not qualifying as discontinued operations (IFRS 5.36); losses incurred due to operational loss events (e.g., fines, penalties, settlements, replacement cost of damaged assets), which have not been provisioned/reserved for in previous years; and expenses related to establishing provisions/reserves for operational loss events

Table 7.7 Financial Component Profit and Loss or Balance Sheet Items

Description

Net profit (loss) on the trading book

• Net profit/loss on trading assets and trading liabilities (such as profit rate swap, sukuk, and equity securities) • Net profit/loss from exchange differences

The current calculation for operational risk capital is compared with requirements of the previous methods to identify gaps of the current approach (GAP analysis). The business indicator buckets are derived in a sample calculation. In single cases, only an exemplary calculation will prove whether a bank must calculate the loss multiplier, too (i.e., in case the business indicator of the bank is greater than $1 billion).

Operational Risk 225 Notes 1 A ‘rogue trader’ is an unauthorised employee making unauthorised trades on behalf of their employer. 2 Refer to Warde (2000). 3 In the general (conventional) form of operational risk management, Risk = Severity × Probability × Exposure. Given figure in severity and probability as well as exposure (For example 1 = None or below average, 2 = Average, 3 = Above average and 4 = Great), we can assign value and guidance to determine control risk choice. For example (value) 80–100 need (guidance) to discontinue or stop, 60–79 correct immediately, 40–59 correction required, 20–39 attention needed, 1–19 possibly acceptable. 4 Available at www.bis.org/bcbs/publ/d355.htm for details. 5 This is the bucket as suggested for European banks.

References Ahmed, S. S. (2009). Risk management in Islamic and conventional banks: A differential analysis. Journal of Independent Studies and Research, 7(2), 67–70. Allen, L., Boudoukh, J. & Saunders, A. (2004). Understanding Market, Credit and Operational Risk: The Value at Risk Approach. Oxford: Blackwell Publishing Ltd. Hussain, A. (2000). Managing Operational Risk in Financial Markets. Oxford: Butterworth-Heinemann. Marshall, C. (2001). Measuring and Managing Operational Risk in Financial Institutions. Singapore: John Wiley & Sons. Warde, I. (2000). Islamic Finance in the Global Economy. Edinburgh: Edinburgh University Press.

Part V

Strategic Planning and Economic Capital

8

8.1

Displaced Commercial Risk and α-Factor

Displaced Commercial Risks

The basic strategy of Islamic banking is to mimic the products or services supplied by conventional banks. Such an approach has resulted in the formation of a dual banking system. The exposure of Islamic banks to interest rate risks may differ from that of regular banks in numerous ways. Profit-loss sharing deposit holders may anticipate a greater rate of return if the benchmark interest rate rises. Rate of return risk differs from interest rate risk, in that Islamic banks are concerned with the outcome of their investment activities at the end of the investment holding period. Islamic banking returns are predicated primarily on the fixed rate of murabahah assets, which are later split between Islamic banks and investment account holders (IAH) or given as a gift to depositors. The rate of return for depositors is decided by the profit earned by Islamic banking activities, whereas the majority of financing is based on a fixed rate. To remain competitive, it may affect the degree of sensitivity to changes in conventional interest rates. As a result, Islamic banks may be exposed to the danger of funds being transferred to conventional banks, a risk known as displaced commercial risk. Investors are permitted to invest in conventional banks. Islamic banks must forego a portion of their return in order to offer competitive interest rates to their IAH clients and prevent them from leaving the bank (liquidity risk). As a result, Islamic banks should examine the displaced commercial risk profiles. When compared to competitors’ rates, Islamic banks may face market pressure to give a return that exceeds the rate generated on assets financed by profit-loss sharing investment holders. The choice of Islamic banks to forego their rights to a portion or all of their mudarib share of earnings in favour of profit-loss sharing investment holders is a business decision that must be supported by clear and welldefined policies and procedures approved by the Islamic bank’s board of directors. The exposure of Islamic banks to interest rates may differ in various ways from that of conventional banks. First, Shari’ah-compliant banking provides and employs financial services and products that adhere to Islamic religious practises and laws, which prohibit the payment and receipt of preset or predetermined interest rates. Second, Islamic banks calculate the return on deposits differently. The DOI: 10.4324/9781003437086-13

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rate of return in a traditional bank is contractually set (fixed in advance or related to a reference rate) and does not directly depend on the bank’s lending performance. If the Islamic bank suffers losses as a result of poor investments, investors may lose some or all of their capital. 8.2

α-Factor and Risk

Islamic banks operate in conformity with Shari’ah principles, which prohibit, among other things, the payment and receipt of interest. Islamic banks cannot enter into interest-bearing loan contracts or take interest-bearing deposits, unlike conventional banks. Islamic banks mobilise and utilise cash through Shari’ah-compliant contracts that are not (often) utilised by conventional banks. Islamic banks rely mainly on their shareholders and depositors to manage their capital structure. Within the banking industry, Islamic banks are rather small, because of their shareholder structure being made up of the public.1 However, under the capital adequacy framework of Islamic banks, this capital only comprises a small portion.2 The main components of the capital structure of an Islamic bank are shown in Table 8.1. The important point is to determine the amount of profit-equalisation reserve (PER), profit-sharing investment accounts (PSIA) and investment-risk reserve (IRR) to capture these risks. The basic idea is to activate this mechanism on acceptable Islamic modes, which preclude payment or receipt of interest and conform to the jurist rules of Shari’ah. Liabilities and assets. Among other things, liabilities of an Islamic bank consist of two main categories: (1) interest-free current accounts and saving accounts; and (2) investment accounts based on the profit-and-loss sharing principle (PLS) between the bank and depositors. The latter is the Islamic alternative of term deposits in conventional banks where the principles of mudarabah and murabahah are used instead of the interest rate. Assets include, among other things, a broad range of financings.

Table 8.1 Capital Structure of an Islamic Bank Assets

Liabilities

Cash & cash equivalents Sales receivables Investment in securities Investment in leased assets Investment in real estate Equity investment in joint ventures Equity investment in capital ventures Inventories Other assets Fixed assets

Current Accounts (CA) Equity of Profit-Sharing Investment Accounts (PSIA) Profit-Sharing Investment Accounts (PSIA) Profit-Equalisation Reserve (PER) Investment Risk Reserve (IRR) Shareholders’ Equity (SE) Total capital = CA + PSIA + SE

Displaced Commercial Risk and α-Factor 231 Investment structure: Two main categories of investment activities are defined (for the purpose of accounting standards): (1) unrestricted investment accounts and their equivalents: these are funds received by the Islamic bank from investors whereby the Islamic bank is free to invest those funds without prior restrictions, including the mixing of these funds with the bank’s own investment; (2) restricted investments and their equivalents: the Islamic bank acts only as manager, agent or non-participating entrepreneur. It is not authorised to mix his own funds with those of investors without prior permission of the investors. Fiduciary service for funds devoted to social purposes: The financial statements of Islamic bank must also reflect its functions as possible agent of zakah payment or manager of waqf properties,3 manager of charitable funds, fund services and qard fund.4 The aforementioned financing, investment and unique Shari’ah aspects have shown to have far-reaching effects not only on the preparation and presentation of Islamic banks’ financial statements but also on the accounting treatment of various Islamic modes of financing, such as issues of recognition, measurement and disclosure. Depending on the type of investment, similar concerns exist when investors can subscribe or withdraw all or part of their assets during the investment period. These operations necessitate the capital adequacy standard (CAS) in order to quantify risk, which is alpha (α). Nonetheless, CAS measurement raises a number of difficulties. Alpha (α) represents the proportion of losses from credit and market risk exposures borne by the Islamic bank, as a result of displaced commercial risk arising from income smoothing practices for profit-sharing investment accounts (PSIA) holders. Table 8.2 defines the Islamic Financial Services Board (IFSB) standard for CAS in two forms: standard and discretionary. In the standard formula, capital is divided by risk-weighted assets excluding the assets financed by investment account holders. The size of the risk-weighted assets is determined for the credit risk and then adjusted to accommodate the market and operational risks. The regulatory capital in the numerator shall be calculated over the total risk-weighted assets as the denominator. It also covers the on- and off-balance items. PSIA balance includes profit equivalent reserve and investment risk reserve or equivalent reserve. The total of risk-weighted assets is determined by multiplying the capital requirements Table 8.2 IFSB Standard Formula for CAS Eligible Capital Total Risk weighted Assets (Credit + Market Risk)

+

Operational Risks

−

Risk weighted Assets funded by PSIA* (Credit + Market Risks)

Source: IFSB *Where the funds are commingled, the RW funded by PSIA are calculated based on their pro-rata share of the relevant assets. PSIA balances include profit-equalisation reserve (PER) and investment risk reserve (IRR) or equivalent reserves.

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for market risk and operational risk by 12.5 (which is the reciprocal of the minimum CAS of 8%) to convert into risk-weighted equivalent assets and adding that resulting figures to the sum of RW computed for credit risk. The second formula – the supervisory discretion formula, as shown in Table 8.3 – accommodates the existence of reserves maintained by Islamic banks to minimise displaced commercial, withdrawal and systemic risks. In markets where Islamic banks maintain profit-equalisation reserve and investment-risk reserve, the supervisory authorities are given the discretion to adjust the denominator of the CAS formula. Supervisors may adjust the formula according to their judgements of the systemic risk and prevalent practices. In the discretionary formula, the supervisory authority has the discretion to include a specified percentage (represented by α in the formula) of assets financed by investment account holders in the denominator of the CAS. The percentage set by the supervisory authority is applied to assets financed by holders of both unrestricted and restricted investment accounts. In order to account for the profitequalisation reserve and investment-risk reserve, a fraction of the risk-weighted assets financed by the reserves is subtracted from the denominator. The justification for this modification is that these reserves mitigate the displaced commercial risk. α refers to the proportion of assets funded by unrestricted PSIA, which is to be determined by the supervisory authorities (Panel C). The value of α would vary based on supervisory authorities’ discretion on a case-by-case basis. The relevant proportion of risk-weighted assets funded by the PSIA’s share of profit-equalisation reserve and by investment-risk reserve (Panel D) is deducted from the denominator. The Islamic bank is required to standardise its conduct with regard to these reserves, and the rights of investment account holders to these reserves must be explained to depositors in a transparent manner. In implementing this capital adequacy standard, a matrix format is provided such that the minimum capital adequacy requirements for both credit risk and market risk exposures stemming from a particular type of financial instrument are addressed under the heading of these instruments. Thus, the objectives of this standard are: (1) to address the distinctive structure of Shari’ah-compliant products and services supplied by Islamic banks that are not specifically addressed by current or prospective capital adequacy rules

Table 8.3 IFSB Supervisory Discretion Formula for CAS Eligible Capital Total Risk weighted Assets (Credit + Market Risk) + Operational Risks

Source: IFSB

−

Risk weighted − (1−α) * Risk − α * Risk weighted Assets funded by weighted Assets Assets funded by Restricted PSIA funded by PER and IRR of (Credit + Market Unrestricted PSIA Unrestricted PSIA Risks) (Credit + Market (Credit + Market Risks) Risks)

Displaced Commercial Risk and α-Factor  233 for Shari’ah-compliant mitigation; and (2) to standardise the technique in identifying and quantifying risks in Shari’ah-compliant products and services, thereby creating a fair playing field for Islamic banks that fulfil the initial requirements. 8.3  Mitigation of Displaced Commercial Risk Islamic banks often engage in this self-imposed practice. The knowledge acquired by attempting to manage misplaced risk has resulted in the development of two industry standard practises. First, Islamic banks are required to keep a profit-­equalisation reserve (PER) and an investment risk reserve (IRR). Profit-equalisation reserve is funded by setting aside a portion of the Islamic bank’s gross income before deducting its own share (as agent). The reserve offers a buffer to ensure future returns are consistent and to strengthen the owners’ equity’s capacity to withstand future shocks. Similarly, an investment-risk reserve is preserved from the revenue of investors-depositors, after allocating the Islamic bank’s share, in order to limit the risk of future investment losses. 8.3.1  Profit-Equalisation Reserve

According to a legal document of mudarabah contract, depositors do not expect the Islamic banks to repay the full principal and profit upon maturity date. When the depositors receive the principal below nominal value or receive less return compared to conventional banks, Islamic banks may make use of the profit-­equalisation reserve. The accounting procedure treats this provision as an allocation from profit and loss account (Table 8.4). While there is no universal definition of this provision, Table 8.4  Hypothetical Income Statement of Conventional Bank vis-à-vis Islamic Bank Conventional Bank

Islamic Bank

Interest income

Income derived from investment of depositors’ funds & others • Loans • Financing income & hibah • Securities • Other dealing income • Deposit with other banks & FIs • Other operating income • Fee & commission (–) Interest expense • Other income • Deposits • Debentures (–) Allowance for losses on financing • Other liabilities (–) Provision for commitments & contingencies (–) Impairment loss from dealing & investment securities (–) Transfer to/(from) profit-equalisation Net interest income reserve (–) Other expenses directly attributable to the investment of the depositors and shareholders’ funds (Continued)

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Table 8.4 (Continued) Conventional Bank (+) Non-interest income • Services • Off-balance sheet activities • Fee • Trading

Net income (–) Non-interest expense • Wages • Premises (rents etc.) • Other expenses Operating profit (–) Allowance for losses on loans, advances & financing

Profit before taxation (–) Taxation Profit after taxation (–) Extraordinary item Profit after the extraordinary item (–) Minority interest Net profit for the financial year Source: Bank Negara Malaysia

Islamic Bank Total distributable income (–) Income attributable to the depositors • Deposits from customers – Mudarabah Fund – Non-mudarabah Fund • Deposits & placements of banks & other financial institutions – Mudarabah Fund – Non-mudarabah Fund • Others Income attributable to the shareholders (+) Income derived from the investment of shareholders’/Islamic Banking funds • Financing income & hibah • Other dealing income • Other operating income • Fee & commission • Other income Total net income (–) Personnel expenses (–) Other overheads & expenditures (–) Amortisation of intangible assets (–) Impairment loss from property, plant & equipment and other assets (–) Finance cost Profit before zakah & taxation (–) Zakah (–) Taxation Profit after zakah & taxation (–) Extraordinary item Profit after the extraordinary item (–) Minority interest Net profit for the financial year

Displaced Commercial Risk and α-Factor 235 the guidelines (framework) stated that provisions are determined on the basis of: (1) a certain percentage of the total gross income (including the gross income, net trading income, other income and irregular income) and (2) maintaining a maximum accumulated profit-equalisation reserve up to 30% of shareholder funds. Islamic banks account for profit-equalisation reserves and the risk of having to allocate them by debiting a profit and loss account called profit-equalisation reserve and crediting a contra-liability account also named profit-equalisation reserve. When it is obvious that Islamic banks have already achieved the maximum amount, the provision is written back through a charge to the profit-equalisation reserve on the balance sheet and a reduction in the outstanding amount of the profit-equalisation reserve. Consequently, total distributable income, that is, income attributable to depositors, and total net income will increase. As shown in Figure 8.1, there are two distinct techniques to accounting for financing loss: discretionary and non-discretionary. Instead of allowing reserves to reflect the anticipated effects of future events, which may take some time to manifest, the rate of return framework requires banks to reflect the effects of current events on total gross income in the current fiscal year. In contrast to this viewpoint, Malaysian banks’ regulators regard profit-equalisation reserves as a reserve built up in good times to meet a need in difficult times. Furthermore, bank regulators have stated that banks must be permitted to have ‘prudent’ reserves adequate to counterbalance a fall in total gross income. While accountants and regulators argue the merits of various standards, each bank’s management determines the actual estimates of profit-equalisation reserves. Bank executives must demonstrate to their accountants and regulators that their estimations are within permitted limits. Due to the lack of definitive standards, bank managers have some leeway over an item that can have a significant impact on a bank’s reported net income and equity capital. In practise, the profit-equalisation reserve is determined using a backward technique in which reserves can only be established after the gross income is disclosed. Profit-equalisation reserve reflects actual losses, the disclosure of which may take some time. Therefore, choices about profit-equalisation reserves should be forward-looking and based on the complete future profile of predicted losses on financings and investments. If an Islamic bank uses methods such as profit-equalisation reserve to increase the predictability of their returns, then the bank’s returns will be more stable. Understanding the determinants of profitequalisation reserve is crucial for assessing financial stability and the confidence of depositors. 8.3.2 Investment  Risk  Reserve

The investment-risk reserve is a reserve appropriated from investment profits attributed to unrestricted IAH, that is, after profits are shared between the bank as mudarib (and so, in effect, the shareholders) and the unrestricted IAH. The investment-risk reserve is intended to cover, in whole or in part, potential asset losses.

236

Earnings from other assets and reserve

Proft from commingled funds

Unsmoothing of Income

Financing Loan Provision (FLP)

Other expenses directly to investors

Profts assigned to shareholders

Returns to shareholder include share 1-˝

Proft Equaliza°on Reserve (PER)

Mudarib’s share, 1-˝ of Mudarabah

Investment Risk Reserve (IRR)

Depositors return to IAH funds

Figure 8.1 Theoretical Framework for Earnings Management in IBIs with Income Smoothing Source: Authors’ own illustration

Proft a˛er subtrac°ng PER&IRR (Mudarabah income)

Smoothing of Income

Strategic Planning and Economic Capital

Earnings

Displaced Commercial Risk and α-Factor 237 Islamic banks actively employ these reserves to moderate the real rate of return given out on investment accounts over time. The practise of generating reserves must include an examination of IAH’s risk profile. Islamic banks must manage IAH liquidity risk in accordance with IFSB No. 12 – ‘Guiding Principles on Liquidity Risk Management for Institutions Offering Islamic Financial Services Excluding Islamic Insurance and Islamic Collective Schemes’. Management should be aware of its potential to share profits with investors by properly maintaining the investment-risk reserve. 8.4

Measuring α-Factor – An Example

The empirical analysis is used to observe whether managers use their discretion to influence reported net income and equity. This task would be simplified if Islamic banks disclose what is the value of their profit-equalisation reserve would be in the absence of the use of managerial discretion or the non-discretionary value of profit-equalisation reserve. However, given that the non-discretionary value of the profit-equalisation reserve is not disclosed, it must also be estimated. The non-discretionary component of profit-equalisation reserve may be proxies by variables reflecting the level of losses in the debt-financing and investment portfolios. Substituting from the previous author, in case of return on assets (ROA), the use of the standard measure of assets would yield a statistical relationship between profit-equalisation reserves. Hence, the basic estimation equation can be represented as: PERit = γ 0 + γ1 NPFI it +λ 2TFIit + γ 3 NCOit + γ 4 NIBPit +

(8.1)

λ 5 EQit−1 + γ 6 ROAitt +εit where NPFIit is the ratio of non-performing financing and impairment loss from investment securities to total assets at time t; TFIit is the ratio of total financing and investment to total assets at time t; NCOit = the ratio of net charge-offs over year t to total assets at time t; NIBPit is the ratio of net gross income before provisions to total assets for bank i in period t; EQit – 1 is the ratio of equity to total assets for Islamic bank i at the end of the prior year; ROAit is the ratio of return on assets for bank i at time t; and εit is error term. The panel least squares result for OLS and Fixed-Effect models in addition to generalised least squares (GLS) for random effects model are presented in Table 8.5. These estimation methods are robust coefficient covariances (heteroscedasticity-robust standard errors) for models estimated by standard OLS.5 The purpose of the estimation is to determine the factors that contributed to the profit-equalisation reserve. The results reported in Table 8.5 are used to lysis with the ratio of profit-equalisation reserve to total assets (PER) as the dependent variable and ratio of the return on assets (ROAit) as one of the independent variables. Models A, B and C correspond to OLS, Fixed-effects and Random-effects

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Table 8.5 Panel Regression Results Explanatory Variables

C NPL it TFIit NCOit NIBPit EQit−1 ROAit N R2 R2̃  (adjusted  R2) F-Statistik Durbin  Watson

Model A

Model B

Model C

OLS-Cross Sec.

Fixed-Effect

Random-Effect

−0.0002 (0.1503) −0.0290 (2.6715)** 0.0017 (0.9590) −0.4491 (2.6918)** 0.0052 (0.2459) −0.0095 (1.2053) 0.0073 (0.5328) 44 0.2947 0.1803 2.5763** 2.0221

0.0046 (1.5046) −0.0344 (1.5625) −0.0022 (0.7548) −0.6852 (2.3055)** −0.0417 (1.3966) −0.0139 (1.1138) 0.0019 (0.1102) 44 0.4496 0.1234 1.3782 2.7632

0.0000 (0.0028) −0.0184 (1.0378) 0.0004 (0.1136) −0.4176 (1.4588) 0.0143 (0.3240) −0.0074 (0.7114) −0.0076 (0.2450) 44 0.3061 0.1225 1.6667 2.5491

Note: Regressions are based on White cross-section standard errors and covariance. Value in parentheses are the standard errors. The Durbin Watson statistics for Model A and C lies between the lower and upper limit (or in the indecisive zone), and there is inconclusive evidence regarding the presence or absence of positive first-order serial correlation. The Durbin Watson statistics for Model B indicates evidence of positive but also nearest negative first-order serial correlation. ** denote significant level at 5% respectively.

respectively (Table 8.6). Both statistic values and the associated p-values reject the null that the effects are redundant. A central assumption in random effects estimation is the assumption that the random effects are uncorrelated with the explanatory variables. One common method for testing this assumption is to employ a Hausman test to compare the fixed and random effects estimates of coefficients. The result of Hausman test based on Chisquare statistic as reported in Table 8.7 suggests that the corresponding effects are statistically insignificant and hence fail to reject H0. The conclusion of the test is that random effects model is appropriate.

Table 8.6 Redundant Fixed Effects Test – Likelihood Ratio Effects Test

Statistic

d.f.

Prob.

Cross-section F

1.499699

(10,27)

0.1934

Displaced Commercial Risk and α-Factor 239 Table 8.7 Correlated Random Effects – Hausman Test Test Summary

Statistic

Cross-section Chi-Square 2.386140

d.f.

Prob.

6

0.8810

In any given year, a higher net income tends to increase profit-equalisation reserve. It implies that Islamic banks follow the pro-cyclicality in managing profit-equalisation reserve. The capital risk proxy by ratio return on assets has a positive and significant relationship with the dependent variable thus supporting the argument that well-capitalised Islamic banks are willing to have lower earnings due to higher profit-equalisation reserve. Since α represents the proportion of commercial risk borne by Islamic banks following the application of displaced commercial risk, the residual value of (1−α) represents the proportion of the commercial risks required to be absorbed by the IAH. The absorption can be managed through the creation of profit-equalisation reserve. As reported in Table 8.5, ROA gives an idea as to how efficient management is at using its assets to generate earnings. Profit-equalisation reserve can also be used as a mechanism to mitigate the fluctuation of ROA arising from the flux in income, provisioning, assets and total deposits. This would ensure that the ROA remained competitive and stable. The profit-equalisation reserve is appropriated out of the total gross income and is shared by both the depositors and the bank. Notes 1 The policy might be introduced by not allowing individuals to acquire more than a certain limit of share in Islamic banks. This allows the institutional investors to inject more capital. 2 This framework specifies the risk measurement methodologies for calculating a minimum capital requirement to be held by Islamic banks against credit risk, market risk and operational risk; for details, refer to Shahimi et al. (2006) and Pratomo and Ismail (2007). 3 Zakah is a fixed obligation calculated by reference to net assets that have appreciated or have the capacity to appreciate over a specific period except for assets acquired for consumption or used in production. 4 Qard is a non-interest-bearing loan, allowing borrower to use the loaned funds for a specific period such that the same amount of loan should be returned to lender at the end of the period – a means of achieving social objectives. 5 OLS estimates are consistent in the presence of heteroscedasticity. Hence, we choose the robust standard errors of White cross section to correct the standard errors. The White cross section method is derived by treating the panel regression as a multivariate regression and computing White-type robust standard errors for the system of equations.

References Pratomo, W. A. & Ismail, A. G. (2007). Islamic bank performance and capital structure. The Global Journal of Finance and Economics, 4(2), 139–145. Shahimi, S., Ismail, A. G. & Ahmed, S. (2006). A panel data analysis of fee income activities in Islamic banks. Journal of King Abdulaziz University: Islamic Economics, 19(2), 23–35.

9

9.1

Stress Testing in the Presence of Shari’ah Non-compliance Risks

Shari’ah Non-compliance Risks

The stress testing came up after the financial crisis in 2008. It started in 2009, when the United States’ bank regulatory agencies came up with a proposal known as the Supervisory Capital Assessment Program, or SCAP.1 The programme is later called the bank stress tests. The largest banking firm became the testing ground for this test.2 What are the impacts of this report?3 First, it provides investors with something they need: credible information about prospective losses at banks. Second, it restores confidence in the banking system and enables its successful recapitalisation. Third, it improves the resilience of the banking system. Since then, many developments and evolutions have taken place in stress testing. New developments have emerged, which are due to many factors, such as the greater sophistication of supervisory stress testing, and the supervisor’s increased emphasis on the effectiveness of banks’ own capital planning process. For sure, many things have been learnt about stress testing since the SCAP – to highlight the increasingly important role of the supervisor in supervising banks in many jurisdictions, and to evaluate the aggregate capital position of the largest banking firms as well as their individual capital levels. In Islamic banking institutions, the presence of Shari’ah non-compliance risks has been identified by many scholars. They, among others Abdullah et al. (2011), Ahmed and Khan (2007), Akkizidis and Khandelwal (2008), Al-Saati (2002), Elgari (2003), Sundararajan (2007) and Noor et al. (2018), have identified the sources and origin of risks, and the issues arise. Despite their usefulness relatively little guidance is given on how to select and use risk indicators in relation to SNC risks. Moreover, it is an area that has proven to be particularly challenging for many supervisors in addressing SNC risk in stress testing programme. There is a need for further guidance in this area. With the establishment of Islamic banking institutions, the supervisor (except in Malaysia) does not consider the Shari’ah non-compliance (SNC) risks that can be considered as part of the stress testing programme.4 Furthermore, the scenario analysis should also incorporate the operational and SNC risks that may occur and translate such risks into loss estimates. Therefore, material risks that are related to both risks need to be identified and key risk indicators for SNC need to be selected. DOI: 10.4324/9781003437086-14

Stress Testing in the Presence of Shari’ah Non-compliance Risks 241 The chapter provides a consensus on how many characteristics must be present in order to mitigate SNC risk and how to identify the key operating indicators of SNC risk. Specifically, SNC is crucial in constructing the operational and SNC loss events model. The benefits are to ensure that the scenario analysis used for operational and SNC risk assessment captures material risks that could occur and translates such risks into loss estimates. Therefore, it provides an additional input to individual Islamic banks to model both risks and translate them into the scenario analysis. 9.2

Material Risks: Operational and Shari’ah-Compliance

An Islamic bank is influenced by the developments of the external environment in which it is called to operate, as well as by its internal procedures and processes. Both the internal and external events may potentially affect the loss of income and asset value. Both events may create operational and Shari’ah risks. Operational risk – External events can have a major impact on an Islamic bank. Therefore, Islamic bank should be aware that both expected and unexpected changes to its operations can be major sources of operational risk. Islamic bank should have in place appropriate arrangements. The internal events may arise due to the failures or inadequacies in any of the Islamic bank’s people, processes and systems or those of its outsourced service providers. The internal events also include legal risks such as exposure to fines and penalties. Shari’ah non-compliance risks are due to internal events. Shari’ah non-compliance (SNC) risk – as a publicly licensed institution, operating as a business entity – Islamic bank and its directors, management and staff must operate in compliance with Shari’ah, laws, rules, regulations and industry standards. SNC risk is the risk to earnings or capital that results from violations or non-conformance with the Shari’ah rules and principles, regulations, or prescribed practices, industry practices or ethical standards determined by the Shari’ah supervisory council (IFSB, 2005). Section 28(3) of the Act sets out clearly the obligations and responsibilities of a financial institution in the case of Shari’ah non-compliance, and the subsequent reporting and disclosure process. Compliance violations expose the Islamic bank to regulatory sanctions, fines and civil money penalties. For example, in Malaysia, under section 245 of the Act, the Central Bank can impose a penalty on Islamic bank for failing to comply with: any provision of the Act, regulations made under the Act, any order made, or any direction issued under the Act by the Central Bank or any standards, condition, restriction, specification, requirement under the Act. Directors and officers may also be personally liable for compliance failures. Compliance violations may result in the loss of an Islamic bank’s ‘rating’, causing damaging consequences, such as the loss of its full-pledged Islamic banking status. Since Islamic banking institutions deal with the contractual features of a product or services, the valid (sahih) contract arises if the pillars and conditions of the contract (1) are fulfilled and (2) establish the legal implications (e.g., the transfer

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of ownership) that Shari’ah has assigned. The contract becomes invalid (ghayr sahih) if both could not be fulfilled upon the execution. The invalid contract can be divided into irregular (fasid) or void (batil). There are several elements that lead to a fasid contract: insufficient information with respect to the subject matter (asset), the price and the delivery time and the existence of an invalid condition – for example, purchase undertaking in a mudarabah contract and capital providers are guaranteed of their capital. There are several ways in which a contract becomes batil: selling impure items such as pork and wine and a sale contract with excessive uncertainty – that is, selling something non-existent and something undeliverable (i.e., birds in the sky). The following treatment could be done on respective categories of invalid contracts. Neither contracting party can recognise the income realised from the invalid contract. Income must be purified. First, if the contract fails to satisfy one or more pillars of contracts, the income should be returned to its owner. Second, if the underlying asset employed in the contract is an item prohibited by Shari’ah such as wine, pork and interest, the income should be channelled to public benefit. It shows that failure to comply with Shari’ah principles would affect the income, resulting in its returned to either the owner or to charitable organisations. The risks associated with SNCs are regarded to be a component of operational risks that impact the capital requirement. The treatment of this risk with regards to capital requirements is a novel departure from the approach introduced in Basel II. The standardised approach, which allows many business lines, is more appropriate, however it still necessitates adaptation to align with the requirements of Islamic financial institutions. All potential risks associated with the features of the contract in SNC must be thoroughly evaluated for precise risk assessment. The indicators regarding SNC risks, however, are currently absent. Risk mapping is the basis of operational risk as, unlike market and credit risks, it is not product specific. The market risk of a derivative contract depends strictly on the contract’s features and on the relevant market risk factors. Once the deal is concluded, the underlying process, by and large, does not matter to the related market risk exposure. It is impossible, on the other hand, to analyse the operational risk in the trading activities of a bank without a thorough understanding of the whole trading process from initial negotiation to final accounting 9.3

Criteria of Good Key Risk Indicators

Several works such as Hoffman (2002), Davis and Haubenstock (2002), Finlay (2004) and Scandizzo (2005) have revealed that there is no consensus about which and how many criteria must be present to select the key risk indicators (KRIs). They believe that the ideal features of KRIs are that they are effective in tracking the risk, they are comparable within and outside Islamic bank, and they are practical and easy to use. Table 9.1 provides some criteria for assessing indicators against these three objectives. Each criterion has its own shortcoming. First, the relevance of an indicator is that relevance can change over time and can also change as new exposures emerge and existing exposures are either mitigated or are no longer of consequence. One

Stress Testing in the Presence of Shari’ah Non-compliance Risks 243 technique that can be used to check and maintain the relevance of selected indicators is to link updates to the indicator programme with the completion of risk and control self-assessments, drawing on the experience, knowledge and understanding that Islamic bank’s business entities/areas (such as business units and functions, Shari’ah control function, management, Shari’ah committee, board and other parties) have of their SNC risk exposures and associated indicators. In this manner, it may be useful to think of potential indicators from the following perspectives: Does it help identify existing risks? Does it help quantify or measure the risk? Does it help monitor the exposure? Does it help manage the exposure and its consequences? The roles of different Islamic bank’s business entities/areas or individuals within the Islamic bank should also be taken into consideration when determining relevance. In many cases, the business entity/area which possesses and can provide data for some specific indicator may have a different perspective on associated SNC risk exposures to those business entities which use the data for exposure monitoring purposes. That is, the relevance of the indicator and its data over time should focus on the following errors or factors: (1) Operational error – This refers to an operational error in the offering of a Shari’ah-compliant product that invalidates the Shari’ah contract being used for the product. Among the potential causes of operational error could be lack of Shari’ah understanding, lack of Shari’ah-related operational guidelines, system issues/errors and human error. (2) Documentation error – This refers to an error in the documentation of a Shari’ah-compliant product that invalidates the Shari’ah contract being used for the product. Among the potential causes of documentation error are: failure to comply with the specific Shari’ah pre-requisites for a valid contract or transaction and the existence of non-Shari’ah compliant term(s) in the relevant documents that may invalidate the transaction. (3) External factor – This refers to an external factor, for example, on impure income for Securities and Fund Services (SFS)’s institutional clients. It happens where certain securities belong to the clients which, initially Shari’ah-compliant, have been re-classified as Shari’ah non-compliant. As a result, the income from those securities is considered impure income and will be channelled to charity. When implementing a new indicator, the measurement technique should be agreed among the stakeholders to ensure that everyone agrees on what the value represents, how it is calculated, what is included or excluded and how variances in the values will be handled. Indictors can provide a leading, lagging or current perspective of an Islamic bank’s SNC risk exposures. The indicator data collection process itself almost invariably implies a historical perspective – by the time the data is collected, quality assured and distributed, time has elapsed and hence the data is ‘lagging’. Many indicators are both lagging and current. For example, the number of unresolved customer complaints – such complaints related to issues that have already occurred (the lagging aspect), but which still need to be addressed (the current aspect). Lagging and current indicators can also have a leading element to them that may need to be considered. In the case of unresolved customer complaints, an Islamic bank’s failure to address these could give rise to a costly lawsuit at some point in the future and or bad publicity, leading to reduced sales.

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Table 9.1 Criteria for Good KRIs Relevance

Comparable

Predictable

Easy to Monitor

Auditable

Indicators should: • relevance to what is being monitored (risk exposure, control effectiveness indicators and measure performance) • be linked to an Islamic bank’s SNC risk • be able to provide management with both a quantum as to current levels of exposure and the degree to which such exposures are changing over time

Indicators should: Indicators Indicators should: Indicators should: • reflect two should: • be numbers • be easy to characteristics • be able to or counts understand – (i) data used provide a (number of days, and use for the indicator leading, employees etc.), should be simple lagging monetary values, and relatively or current percentages, cost effective perspective ratios, time to collect and of an duration or a quantify; (ii) Islamic value from some assure and bank’s pre-defined distribute – SNC risk rating set (such data should be exposures as that used by relatively easy a credit rating to interpret, agency) monitor understand and risk monitor • be comparable over time • be reported with primary values • be meaningful without interpretation to some more subjective measure

Truly leading indicators are rare and are usually related to causal drivers within the business environment within which the Islamic bank operates – they tend to be measures of the state of people, process, technology and the market that affects the level of risk in an Islamic bank. A leading or preventative indicator can be something as simple as the number of limit breaches on market or risk exposures, or cash movements, or the average length of delays in executing activities. In themselves, such occurrences may not be loss events, but if their value starts to increase, this may point to the potential for a higher frequency or severity of operational loss events. In the case of fully predictive indicators, which predict what is going to happen, rather than simply infer that something is changing, single indicators by themselves are of little use, as they need context to become predictive. A crucial aspect relating to the data collection process is quality assurance. The collection cycle needs to incorporate specific deadlines for submission and should be auditable in terms of data sources and collection channels. There should also be an independent quality control process to ensure that erroneous or misleading data is not sent to management.

Stress Testing in the Presence of Shari’ah Non-compliance Risks 245 9.4

Selecting the Key Risk Indicators for SNC Risks

Having a good understanding of the desirable characteristics of a KRI, we now come to the stage where they must be selected and bundled into a programme for a business area or unit or the organisation overall. Accordingly, the construction of a KRI programme ideally starts with an individual business unit. The selection of the KRIs should become the agenda of: (1) Business Unit, that is, a segment of the organisational structure of an Islamic bank. A Business Unit may also be referred to as a department, division or a functional area (such as treasury, compliance and internal audit) within an Islamic bank or of any other Islamic banks’ entity which are working along with them. (2) Shari’ah Control Officer (SCO), that is, employee of an Islamic bank. SCO tries to ensure that the Shari’ah principles, rules, standards and regulations as provided by the Shari’ah Committee and Shari’ah Advisory Council (SAC) at the Central Bank or other regulatory bodies resolutions are observed by Islamic bank while offering Islamic finance products and services. (3) Management, that is, the management of an Islamic bank who is responsible for managing the business on a daily basis and implementing the guidelines/views of the Shari’ah Committee and the Central Bank. (4) Shari’ah Committee, that is, means the Shari’ah Committee (SC) consisting of minimum five learned and qualified Shari’ah scholars appointed as the SC members of an Islamic bank by the Board and approved by the regulator. (5) Board, that is, a body of elected or appointed members who jointly oversee the activities of an Islamic bank. KRIs are supposed to track key SNC risks; the first step in KRI selection is to identify areas of highest SNC risk for the business unit in question. It is important to have a consistent and comprehensive approach to this analysis. It can be done by risk mapping or profiling each business unit or leveraging risk-and-control self-assessment (RCSA) or profiling contractual assessment programmes that are already in place. The analysis should focus on component processes or business functions within each business, considering how they work and where a material loss has been or could be experienced. Once high-risk areas are identified, the business needs to consider what existing indicators or metrics could be leveraged or new ones created to help anticipate a loss, monitor an exposure, measure the SNC risk, manage the exposure or loss, or report on the SNC risk and its implications. An inventory of existing KRIs as suggested in column 2, Table 9.2, as well as the identification of the high SNC risks for which there are not currently KRIs in place, is often a good first step in this process. Then, a gap analysis is done. Having identified the gaps, it is important to consider a variety of KRIs against each source of SNC risks. Each source of SNC risks is reported in column 1, Table 9.2. Each KRI reflects the specific causal element, which may come into play if a loss occurs. Ultimately, however, to keep the number of KRIs being monitored to a manageable number, it will be necessary to select the few that best reflect the business unit’s collective understanding of the key causes of each potential problem. This selection should also be guided by consideration of the quality of the potential

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indicators against the effectiveness, comparability and ease-of-use criteria discussed above, as well as their contribution to the goal of obtaining a reasonable mix of leading, current and lagging indicators. This is an art rather than a science. However, in the hands of experienced practitioners in the business, it should represent a reasonable start. Once selected, each indicator needs to be defined and specified as reported in column 3, Table 9.2, to ensure clarity of interpretation and implementation. For Table 9.2 Key Risk Indicators for SNC Key Risk Indicators (KRIs)

Description

Internal Research/ ORMS

Number of new Shari’ah-related complaints

x x x

Legal cases

Legal cases/dispute filed in in court and arbitration on the basis of Shari’ah matters (in number) Shari’ah approval not on unanimous basis (Number of instances) Percentage of cases where proposal for product/ documentation/ material were rejected by internal Shari’ah Committee and regulators

Complaints lodged by customers on potential non-compliance with Shari’ah requirements in product implementation, legal documentation, product brochures, transparency etc. Leading indicators to uncover emerging Shari’ah issues and potential impact to the institution and industry Potential Shari’ah issues that may pose Shari’ah risk to Islamic bank and industry Leading indicators in determining inadequacies in processes in Shari’ah support and research

x x

x

x

x

Shari’ah Supervisory Council (SSC) SSC

KRI Programme Other parties Board Shari’ah Committee Management Shari’ah Control Officer Business Units & Functions

Sources

x x

Stress Testing in the Presence of Shari’ah Non-compliance Risks 247 Table 9.2 (Continued) Key Risk Indicators (KRIs)

Description

Internal Research/ ORMS

Number of resignation/ termination/ transferred of Shari’ah qualified (Shari’ah degree) personnel to perform Shari’ah function (research and review) Number of new appointments of Shari’ah qualified personnel

Leading indicators to prompt that there is inadequate qualified Shari’ah background personnel to handle crucial aspect of Shari’ah research and review

x

x

Leading indicators to prompt that there is inadequate qualified Shari’ah background personnel to handle crucial aspects of Shari’ah research and review Leading indicators to prompt that there is inadequate Shari’ah trained personnel to handle crucial Shari’ah support functions, i.e., Shari’ah risk and audit

x

x

x

x

Leading indicators to prompt that there is inadequate Shari’ah trained personnel to handle crucial Shari’ah support functions, i.e., Shari’ah risk and audit

x

x

Internal Research/ ORMS

Internal Research/ ORMS

Internal Research/ ORMS

Number of resignation/ termination/ transferred of Shari’ah trained (training in fiqh muamalat) personnel to perform Shari’ah support function (audit and risk) Number of new appointments of Shari’ah trained personnel

KRI Programme Other parties Board Shari’ah Committee Management Shari’ah Control Officer Business Units & Functions

Sources

(Continued)

248

Strategic Planning and Economic Capital

Table 9.2 (Continued) Key Risk Indicators (KRIs)

Description

Internal Research/ ORMS

Percentage of number of incidences that papers or proposal submitted to Shari’ah committee not in accordance to stipulated submission time frame as specified in internal charter (i.e., new product proposal −2 weeks, product legal documentation – 3 weeks, brochure – 5 days) Number of instances of Shari’ah approval being done via circulation to committee members An amount of impure income as a percentage of total income

Leading indicators as a triggering mechanism that the proposal or paper submitted to Shari’ah Committee expose to higher risk of human error.

Internal Research/ ORMS

External research/ news

KRI Programme Other parties Board Shari’ah Committee Management Shari’ah Control Officer Business Units & Functions

Sources

To monitor the trend as approval done outside the meeting may pose risk of error or non-holistic Shari’ah decision To measure the income realised from the invalid contract

Note: Operational Risk Management System such as Operational Risk Integrated Online Network (ORION), which was introduced by Bank Negara Malaysia on 3 May 2017. There are two requirements on monthly reporting required by BNM to be reported via ORION, that is, on (1) litigation and (2) complaints.

Stress Testing in the Presence of Shari’ah Non-compliance Risks 249 example, a complaint that has been lodged by customers pertaining to SNC aspects of Islamic contracts including transparency and proper implementation of Islamic contracts by Islamic banks (such as legal documents were not properly signed). The next step is to establish bands of acceptance that essentially codify SNC risk appetite, and triggers for escalation and/or some other form of action. For example, on a monthly basis, SNC matters should be escalated to Shari’ah Control Officer and Shari’ah Committee Meeting for further clarity or guidance. Then, indicators are assessed on an ongoing basis against this framework of reference. Thresholds can be set to define each range and trigger each kind of response. After a threshold is breached, actions taken by managers to accept or mitigate the risk should be recorded. Thresholds and escalation triggers are an important risk management tool. KRI thresholds will vary from Islamic bank to Islamic bank, depending on management’s risk appetite, as well as strategy and ability. For SNC risks the thresholds may be quite high, and for others, lower. They can also change over time, if there is a strategic decision to manage risk down (or sometimes up). Managers will become more experienced at setting the appropriate level of threshold over time. This is where art meets science, as there can be no one-size-fits-all approach or algorithm for thresholds. It is subjective and based upon the managers’ risk appetite and experience and that of their peers within the firm. What is a reasonable number of KRIs? Many financial institutions have a very large number. This may be justified by the heterogeneity of operational risks and complexity of financial services and products. We believe that a large diverse institution would reasonably use between several hundred and a few thousand indicators in middle management. Of course, these cannot all be reported to senior levels of management. Accordingly, it is very important to have an appropriate strategy for reporting and aggregating KRIs to senior management and the board. 9.5

Stress Testing – An Example

Stress testing is performed by reflecting the incremental price risk that would impact the profit margin gaps because of shocks to benchmark rate levels. The stress test scenarios are designed by risk economists with input from risk management team. The scenarios are reviewed at least annually. It can be designed along four developed stress scenarios, of which two of those reflect historical extreme scenarios, and the others are of hypothetical in nature. The four developed scenarios are named as Stress Scenario 1 (S1), Stress Scenario 2 (S2), Stress Scenario 3 (S3) and Stress Scenario 4 (S4). The detailed definition and description of each scenario are explained as follows: • Stress Scenario 1 (S1) Assumptions for key risk factor are: (i) Rates/returns move up across the contracts (ii) Foreign currency (FCY) depreciates against the local currency (LCY) (iii) Forex volumes, profit margin volumes, credit spreads go up while equities index gains

250

Strategic Planning and Economic Capital

• Stress Scenario 2 (S2) Assumptions for key risk factor are: (i) Rates/returns move down across the instruments (ii) Foreign currency (FCY) appreciates against the local currency (LCY) (iii) Forex volumes, profit margin volumes, credit spreads go up while equities index declines • Stress Scenario 3 (S3) Assumptions for key risk factor are: (i) Slope impact of the curve is assessed – shorter instruments move up and longer instruments rates move down. (ii) Foreign currency (FCY) depreciates against the local currency (LCY) (iii) Forex volumes, profit margin volumes, credit spreads go up while equities index gains • Stress Scenario 4 (S4) Assumptions for key risk factor are: (i) Slope impact of the curve is assessed – shorter instruments move down, and longer instruments rates move up (ii) Foreign currency (FCY) appreciates against the local currency (LCY) (iii) Forex volumes, profit margin volumes, credit spreads go up, while equities index declines The final stress test result to be applied will be assessed among the scenarios based on the macroeconomic indicators (such as foreign exchange, growth rate and budget deficit) applied. For consistency in the approach, the same selected scenario will be applied to generate the stress loss for SNC as the final applicable result of the stress test. Notes 1 See Bernanke (2009). 2 For more information about the SCAP exercise, see the Board’s website at www.federalreserve.gov/bankinforeg/scap.htm 3 See www.federalreserve.gov/newsevents/press/bcreg/20120313a.htm. The report on this stress test was only released on 13 March 2012. 4 Please refer to Bank Negara Malaysia’s Stress Testing Policy Document, which was issued on 15 June 2017.

References Abdullah, M., Shahimi, S. & Ismail, A. G. (2011). Operational risk in Islamic banks: Examination of issues. Qualitative Research in Financial Markets, 3(2), 131–151.

Stress Testing in the Presence of Shari’ah Non-compliance Risks 251 Ahmed, H. & Khan, T. (2007). Risk management in Islamic banking. In Hassan, M. K. & Lewis, M. K. (Eds.) Handbook of Islamic Banking. Cheltenham, UK: Edward Elgar Publishing Ltd. Akkizidis, I. & Khandelwal, S. K. (2008). Financial Risk Management for Islamic Banking and Finance. New York: Palgrave Macmillan. Al-Saati, A.-R. (2002). Sharia compatible futures. Journal of King Abdulaziz: Islamic Economics, 15(1), 3–25. Bernanke, B. S. (2009). Supervisory Capital Assessment Program. Speech delivered at Financial Innovation and Crises, a Financial Markets Conference Sponsored by the Federal Reserve Bank of Atlanta, held in Jekyll Island, Ga., May 11–13. Davis, J. & Haubenstock, M. (2002). Building effective indicators to monitor operational risk. The RMA Journal, May, 40–43. Elgari, M. A. (2003). Credit risk in Islamic banking and finance. Islamic Economic Studies, 10(2), 1–25. Finlay, M. (2004). KRIs: An industry framework. Operational Risk, July. Hoffman, D. (2002). Managing Operational Risk. New York: J. Wiley & Sons. IFSB. (2005). Guiding Principles on Liquidity Risk Management for Institutions (Other than Insurance Institutions) Offering only Islamic Financial Services. Kuala Lumpur: Islamic Financial Services Board. Scandizzo, S. (2005). Risk mapping and key risk indicators in operational risk management. Economic Notes, 34(2), 231–256. Sundararajan, V. (2007). Risk characteristics of Islamic products: Implications for risk measurement and supervision. In Ahmed, R. & Karim, A. (Eds.) Islamic Finance: The Regulatory Challenge (pp. 40–68). Singapore: John Wiley & Sons (Asia) Pte. Ltd.

Glossary of Arabic Terms

Transliterated from Original Arabic Word

English Meanings

‘adl ‘āmil (‘ummāl) ‘aqār (‘aqārāt) ‘aqd (‘uqūd) ‘arbun/‘urbūn ‘īnah ‘iwaḍ ‘urf al-ghunm bi alghurm

Justice, equity, fairness Worker(s), manager(s), entrepreneur(s) Immovable property(ies), building(s) Contract(s), agreement(s), bond(s) Downpayment Debt buying and selling Compensation Custom usage, common practice Earning profit is legitimised by risk-taking. Earning is subject to taking risk Revenue is subject to liability Speculation Trust, honesty, trustworthiness Mark-up sale Sale(s) Sale with downpayment Sale of debt Sale in which both the delivery of the object of sale and the payment of its price are delayed. It is similar to a modern forward sale contract Sale in which payment is made in advance by the buyer and the delivery of goods is deferred by the seller. Buy-back sale, sale and repurchase Sale at instalments Credit sale or sale at deferred payment Credit sale or sale at deferred payment Buying an object for cash then selling it to the same party for a higher price whose payment is deferred so that the purchase and sale of the object serves as a ruse for lending on interest. Treasury Proof, evidence, reason Guarantee Harm Necessity Basic needs Debt(s)

al-kharāj bi aldamān al-mujāzafah amānah bay‘ al-murābaḥah bay‘ (buyūʿ) bay‘ al-‘urbūn bay‘ al-dayn bay‘ al-kālī’ bi-alkālī’ bay‘ al-salam bay‘ al-wafa’ bay‘ bi al-taqsīt bay‘ bi al-thaman al-ājil bay‘ mu’ajjal bay‘-al-‘inah bayt al-māl dalīl ḍamān ḍarar ḍarūrah ḍarūrīyāt dayn (duyūn)

Glossary of Arabic Terms Transliterated from Original Arabic Word

English Meanings

dhimmah (dhimam) dīnār dirham fā’id (fawa’id) fadl faqīh (fuqaha’) faqir (fuqara’) fatwa (fatāwá)

Liability(ies), responsibility(ies) Dinar (currency) Dirham (currency) Surplus(ses), excess(es) Excess, additional, surplus Jurist(s) Poor person (s) Religious verdict (s) made by a faqih competent Shari’ah scholar Islamic jurisprudence Jurisprudence of transactions Juristic Misappropriation or defrauding others in respect of specifications of the goods and their prices. Spoils of war, booty(ies) Excessive risk and uncertainty, ambiguity Excessive risk Minor risk Indebted, bankrupt Sayings of the Prophet Mohammed. plural of Hadith Gift(s), donation(s) Permissible, lawful, allowed Not permissible, unlawful, not allowed Bill of exchange, promissory note, cheque, draft Donation(s), gift(s) Trick (s), ploy (s), ruse (s) Ombudsman, regulation Ruling, decision Benevolence, compassion, kindness Offer (in contract) Leasing, rent Hire purchase

fiqh fiqh al-mu‘āmalāt fiqhī ghabn/ghubn ghanīmah (ghana’im) gharar gharar fāḥish gharar yasīr ghārim (ghārimīn) ḥādīth (aḥādīth) hadiyyah (hadāya) ḥalāl ḥarām ḥawālah hibah (hibat) ḥīlah (ḥiyal) ḥisbah ḥukm (aḥkām) iḥsān ijāb ijārah ijārah muntahia-bitamlīk ijārah wa-iqtina’ islām istiṣnā‘ istithmār ju‘ālah kafālah kafīl khamr (khumur) kharāj khayr khiyār khiyār al-shart khiyār al-wasf khusrān

253

Hire purchase Submission, peace Manufacturing contract whereby a manufacturer agrees to produce (build) and deliver a well-described good (or premise) at a given price on a given date in the future Investment Commission, fee, wage Guarantee Guarantor Intoxicant(s) A levy on land use, revenue Good, beneficial Choice, option Optional condition Optional specifications Loss, failure (Continued)

254

Glossary of Arabic Terms

Transliterated from Original Arabic Word

English Meanings

madhhab (madhāhib) mafsadah (mafāsid) māl (amwāl) manfa‘ah (manāfi‘) maqsad (maqāṣid al-sharī‘ah) maṣlaḥah (maṣāliḥ) mursalah mawqūf maysir mithlī mu‘āmalah (mu‘āmalāt) mubāḥ muḍārabah

School(s) of Islamic jurisprudence, regime(s), system(s)

muḍārib mufti mughārassah

mujtahid muqāraḍah muqāyadah murābaḥah musāqāh musāwamah mushārakah

mushārakah mutanāqiṣah mushtarik mustahab mutawallī muzāra‘ah qāḍi

Spoiler(s) Capital, money, property, wealth Benefit(s), utility(ies), usufruct(s) Objectives of Islamic law General benefits, public interest(s) Suspended Gambling Similar Transactions Permissible A partnership whereby one party the capital owner provides capital to an entrepreneur to undertake a business activity. Profits are shared between them as agreed but any financial loss is borne only by the capital owner as his loss is his unrewarded efforts put into the business activity The partner in mudarabah contract providing work, entrepreneurship and management Jurist who provides legal Shari’ah opinions Share-cropping between two parties whereby one provides land, equipment and shoots of trees and the other agrees to plant the trees and take care of them in return for a share in the harvest or the profit Legal expert or a jurist who exerts great effort in deriving a legal opinion Same meaning like mudarabah Barter Mark-up sale, sale at a margin A sharecropping contract whereby the owner of a garden/ orchard shares the produce with a worker in return for his services in irrigating the garden/orchard Bargaining on price, haggling Partnership whereby all the partners contribute capital for a business venture. The partners share profits on a pre-agreed ratio while losses are shared according to each partner’s capital contribution Diminishing partnership Participant Meritorious Manager, director A sharecropping contract whereby one party agrees to provide land, seeds and equipment and the other do the work needed in return for a part of the produce of the land Judge

Glossary of Arabic Terms Transliterated from Original Arabic Word

English Meanings

qarḍ (qurūḍ) qarḍ ḥasan qīmah (qiyam) qimār Qur’ān qurūḍ ra’s al-māl ru’ūs al-amwāl rabb al-māl arbāb al-māl rahn ribā ribā al-buyū‘ ribā al-duyūn ribā al-faḍl ribā al-nasī’ah/alnasa’ ribā al-qurūḍ ribḥ (arbāḥ) ṣadaqah jāriyah ṣadaqāt sadd al-dharī‘ah

Loan(s) Interest-free loan Value(s) Gambling The sacred book of Islam. Loans Capital(s)

ṣakk (ṣukūk) salaf salam ṣarf sharākah shari‘ah sharikah (sharikāt) sharikat ‘uqūd sharikat abdān sharikat amwāl sharikat ʿinān sharikat milk sharikat mufawadah sharikat sanāi‘ sharikat wujūh sukūk ta‘āwun tabarru‘ (tabarru‘āt) tadāwul taḥawwuṭ takāful

255

Capital owner(s) Collateral, pledge, guarantee Usury, interest Usury of trade. another name for Riba al-fadl Interest/usury of debt. another name for Riba al-nasi’ah Difference in exchanging two similar commodities Interest-based lending for the delay in repayment Interest on loans Profit(s) Perpetual charity Charity(ies) Prohibition of a deed which, if permitted, may lead to another prohibited deed Asset-based or asset-backed financial certificate(s) Loan. another name for salam Forward sale whereby the price of a specific good is paid in advance for its delivery at a specified time in the future. Currency exchange Partnership Islamic law Company(ies), enterprise(s), partnership(s) Contractual partnership A partnership company based on the skills of professionals working together and sharing the proceeds Financial partnership Limited liability partnership Joint property partnership Unlimited liability partnership A partnership company based on the skills of professionals working together and sharing the proceed. Same as sharikat abdān A partnership company based on the credibility and creditworthiness of the partners Equity-based certificates of investment Cooperation Donation(s), gift(s), charity(ies) Circulation, dealing Hedging Solidarity, mutual support (Continued)

256

Glossary of Arabic Terms

Transliterated from Original Arabic Word

English Meanings

takaful ta‘awuni tawakkul tawarruq

Cooperative risk-sharing and mutual insurance Trust in God The process of buying a commodity at a deferred price, in order to sell it in cash at a lower price. Usually, the sale is to a third party, with the aim of obtaining cash. This is the classical form of Tawarruq, which is permissible. Organised Tawarruq where the bank plays both the roles of seller and buyer is not permissible according to the majority of contemporary fuqaha’ (jurists, scholars) Business, commerce, trade Allowance, commission, fee, salary, wage Islamic legal bases Promise(s), undertaking(s) Deposit(s) Agency is a contract whereby one party appoints another party to perform a certain task on its behalf, usually for payment of a fee or a commission Representative(s), agent(s) Endowment(s), foundation(s), trust(s) Obligatory contribution or poor due payable by all Muslims having wealth above nisab (threshold or exemption limit) An annual levy on the wealth of a Muslim (above a certain level). The rate paid differs according to the type of property owned Levy on treasure trove Levy on business

tijārah ujrah uṣūl al-fiqh wa‘d (wu‘ūd) wadī‘ah (wadā’i‘) Wakālah (wakālat) wakil (wukalā’) waqf (awqāf) zakāh, zakāt zakāt al-māl zakāt al-rikāz zakāt al-tijārah Source: IRTI

Index

AAOFI 6, 190 accountants 13, 235 accounting 6, 13, 17, 19, 24, 25, 34, 96, 170, 190, 214, 223, 231, 233, 235, 242 agency cost 35 agent-principal 67, 71 aqd 62, 74, 75, 83 asset-backed 3, 148, 164 asset classes 23, 48, 127, 151, 166, 189 asymmetric information 15, 42 back-testing 129, 130 Basel III 15–17, 23, 29, 32, 44, 51, 149–157, 166–168, 170, 174–176, 183–190, 203 capital adequacy 6, 7, 15–17, 23, 30, 35, 51, 108, 128, 138, 180–183, 208, 230–232 capital allocations 17, 30, 36 capital ratios 6, 14, 15, 29, 32 cash flows 30, 36, 42, 93–97, 99, 107, 126, 145, 165 cash settlement 92 coefficient 114, 125, 237, 238 collateral pledge 92 commodity 43, 44, 48, 49, 53, 80, 85, 90, 92, 94, 95, 101, 105–108, 110, 112, 118, 128, 131, 136–139, 148, 164, 178, 204, 206 confidence interval 20, 41, 48, 50, 179 contra-liability 235 co-ownership 66, 74, 75, 79, 80, 82–84 corporation 5, 73, 80, 101, 151, 158, 186 cost of capital 15, 19, 21, 35–42, 123, 130 covariance 38–41, 112–118, 120, 122, 237 credit cards 149 credit purchases 69, 80, 81

credit rating 23, 27, 30, 43, 51, 145, 150, 151, 154, 155, 166, 169, 180, 182, 183 credit score 149 crude oil 102, 105 cyclical 102, 148 daily earnings at risk 115, 116 deferred payment 46, 49, 92, 104 derivative 90, 93, 97–103, 105, 106, 108, 110, 112, 118, 121, 122, 132, 136, 137, 146, 155, 157, 158, 164, 166, 171, 178, 210, 242 dhaman 9, 10 directional price risk 137 discretionary 62, 97, 231, 232, 235 displaced commercial risk 207, 229–239 disruptive 109 dual banking 229 early warning 218 economic capital 14–30, 32–57, 140–141, 166, 170, 171, 173, 174, 219 economic profit 22, 36, 41, 42 economic value 41, 94–97, 155 endowment 64 exchange rate risk 89, 136 expected loss 19, 20, 22–24, 48, 50, 113, 155, 163, 165, 166, 168–170, 173, 175, 180, 185, 186, 204 exposure at default 24, 26, 43, 50, 155, 156, 165, 168, 174–180, 184, 188, 189 financial crisis 15, 37, 125, 240 financial intermediation 46 financial stability 13, 235 financing conversion factors 176, 186 Fiqh 46, 72, 205 fixed capital 14

258

Index

fixed income 16, 33, 92, 134, 140 floating rate profit 92 forecasts 29, 99, 105, 122–124, 130, 179 futures contracts 106

mufawadah 75–85 mukhatarah 10 multiplicative 27, 28, 129–131, 139, 219 mutually 47

GARCH 122–125 gharar 3, 10, 49, 82, 83, 101, 104 ghurm 9 gross margin 21

non-discretionary 235, 237 non-performing financings 98, 147, 152, 160 non-tradable portfolio 39

haircuts 54, 167 Hanafis 9, 10, 69–71, 73, 76, 77, 79, 80, 82, 84 Hanbalis 69, 71, 83–85

operational income 22 optimal 15, 35–37, 42, 140 option prices 23 over-the-counter 102, 106, 136, 175, 210

ijab 62 ‘inan 75–85 information system 46, 147, 157, 159, 160, 162, 210, 213 innovation 7, 146 Internal Model 52, 53, 98, 111, 112, 128–131 Internal Rating-Based 15, 153, 156, 157, 166, 180 investment-risk reserve 230, 232, 233, 235–237 Islamic economy 5, 104 Islamic windows 17 istidanah 70, 78, 80, 81, 84, 85

penalty 95, 130, 176, 208, 241 political risk 100 portfolio management 24 precious metals 53 predicted loss 21, 23, 44, 235 predictive 130, 244 price volatility 44, 102, 104–106, 108, 113–115, 132 private equity 104 private property 61 Probability of Default 17, 20, 23, 36, 41, 43, 44, 50, 152, 153, 155–157, 165, 169, 170, 175, 180, 183–186, 188, 189 production 4, 14, 46, 47, 105–107 profit-sharing 4, 44–45, 51, 55–57, 90, 91, 191, 230, 231 proprietary 30 prudential 111

kafalah 54, 76–82, 84, 85 key risk indicators 217, 240, 242–249 leased asset 108, 206 LIBOR 16, 49, 104, 107 Loss Given Default 17, 24, 26, 145, 155, 156, 164–174, 180, 183, 184 Malikis 9, 69, 71, 73, 75, 79–82, 84 maqasid al-Shari’ah 61 market risk 17, 23, 25–28, 40, 44, 48, 50–57, 89–141, 145, 146, 151, 164, 191, 196, 231, 232, 242 mark-to-market 13, 118, 121, 126, 145, 155, 157, 169 mark-up 49, 92, 98, 104, 107, 108 Monte-Carlo 121–122, 141 moral hazard 4, 15, 47, 144, 152, 206, 210 mortgages 69, 146, 187 mu’amalat 13, 61 mudarib 10, 47, 57, 62, 63, 66–73, 75, 104, 209, 229, 235

qard hassan 4 Quran 7, 61 rahn 54 RAPM 17, 19, 35, 36, 42 rate of profit 7–10 recovery rate 43, 50, 149, 151, 153 re-pricing 93, 96, 97, 131 reputational losses 203 reserve funds 20 return on assets 17, 237, 239 riba 3, 4, 7, 10, 98, 100, 101, 103, 104 saving 94, 230 scorecards 26, 217 Shafi’es 9, 69, 71 sighah 62–65, 78, 82 solvency 5, 20, 33, 203, 208

Index speculative 3, 13, 99, 102, 104 spread 4, 14, 36, 50, 92–94, 128, 137, 164, 165, 249, 250 statutory capital 15–17 swaps 92, 93, 97, 101, 102, 106, 107, 126, 136, 146, 164 symmetrical 38 systematic risk 89, 102, 103, 135, 136, 214 tangible asset 49 thresholds 218, 249 time-dependent 122, 123 time lag 100 transfer pricing 19, 97

259

transparency 6, 34, 104, 249 treasury 45, 93–95, 97, 134, 160, 181, 245 trust 4, 13, 61, 62, 73, 77 underwriting 9, 147, 148 Value at Risk 25, 43, 113, 115, 116, 118, 120–122, 126, 128–130, 140, 151, 171, 190, 214 venture capitalists 30, 47 yield curves 93 zero-coupon 132, 133, 138