Islamic Banking: How to Manage Risk and Improve Profitability

ISLAMIC BANKING
  • Book Title:
 Islamic Banking How To Manage Risk
  • Book Author:
Amr Mohamed El Tiby Ahmed
  • Total Pages
220
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ISLAMIC BANKING – Book Sample

Contents – ISLAMIC BANKING

  • Introduction to Islamic Banking 3
  • CHAPTER 2
  • History and Development of Islamic Banking 7
  • The Early Days of Islam 7
  • The Modern Islamic Banking System 9
  • Regulatory Agencies for Islamic Financial Services 14
  • The Spread of Islamic Banking 17
  • Summary 23

PART TWO                                                                                             

  • Risk in Islamic Banking 25
  • CHAPTER 3
  • The Nature of Risk in Islamic Banking 27
  • Banking Risk and the Inherent Risk Associated with IIFS 29
  • Summary 43
  • CHAPTER 4
  • The Inherent Risk in Islamic Banking Instruments 47
  • Murabahah 47
  • Salam and Parallel Salam 49
  • Istisna and Parallel Istisna 50
  • Ijarah and Ijarah Muntahia Bittamleek 52
  • Mudarabah 54
  • Musharakah and Diminishing Musharakah 56
  • Summary 57
  • CHAPTER 5
  • Operational Risk in Islamic Banking 59
  • Noncompliance with Shari’ah Rules and Principles 60
  • Fiduciary Risk 61
  • Legal Risk 63
  • Major Concerns with Legal Risk 68
  • Summary 69
  • CHAPTER 6
  • The Islamic Capital Market 71
  • Definition, Role, and Importance 71
  • The Islamic Bond Market (Sukuk) 72
  • Sukuk Structure and Types 73
  • Challenges Facing the Development of the Market 76
  • Summary 78

PART THREE                                                                                          

  • Capital Adequacy 81
  • CHAPTER 7
  • The Importance and Role of Capital-Literature Review 83
  • Definition, Functions, and Importance of Capital 84
  • History of Capital Adequacy Regulations 88
  • The Need for Banking Regulations and Supervision 89
  • Summary 93
  • CHAPTER 8
  • The Regulatory Framework of the Conventional Banking
  • System: Basel I and II 97
  • The Regulatory Bodies 97
  • Basel Capital Accord I: 1988 101
  • Basel Capital Accord II: 2004 105
  • The Revised Framework 107
  • Three Methods for Calculating Operational Risk 113
  • Summary 117
  • CHAPTER 9
  • The Regulatory Framework of Islamic Banks 119
  • Background 119
  • The Capital Adequacy Standard (CAS) 120
  • The Definition and Role of Capital 123
  • Determination of Risk Weights 124
  • Credit Risk 126
  • Minimum Capital Requirements for Islamic Financing Assets 130
  • Recommendations 138

PART FOUR                                                                                           

  • Corporate Governance 141
  • CHAPTER 10
  • The Supervisory Review Process and Issues 143
  • The Supervisory Review Process 143
  • Supervisory Issues of Islamic Banking 146
  • Issues Specific to Islamic Windows 147
  • The Relationship between Banking Supervision and
  • Bank Risk Management 148
  • Summary 149
  • CHAPTER 11
  • Corporate Governance in Islamic Banking 151
  • Definition of Corporate Governance 153
  • Corporate Governance Models 155
  • The OECD Principles 156
  • The Corporate Governance Framework 157
  • Mobilization and Use of Funds 161
  • Issues in Islamic Windows 164
  • Shari’ah Governance System 165
  • Summary 169
  • CHAPTER 12
  • Market Discipline and Transparency in Islamic Banking 171
  • The Disclosure Framework for IIFS 172
  • Market Discipline Issues 176
  • Summary 179
  • CHAPTER 13
  • Challenges Facing Islamic Banking and Recommendations 183
  • Conclusions 184
  • Recommendations 185

Preface

The global economic crisis brought to the fore the inadequacy of conventional banking regulations in general and their capital adequacy in particular in relation to the risks associated with their business; both aspects require serious reconsideration.

Bankers, supervisors, and regulators across the globe are evaluating the causes and subsequences of the global economic crisis and the credit crunch facing banks. A better understanding of the role and importance of a solid regulatory framework and its weaknesses and strengths is crucial to ensure a safe and sound financial system.

Islamic banks were the least affected by the credit crunch due to their asset-based nature of operations. However, they still face many challenges; many bankers as well as regulators are assessing Islamic banks’ robustness. The Islamic financial system, while still in its infancy if compared to the conventional financial system, has proven to have solid foundations. The Banker’s third annual survey in 2009 of the top 500 Islamic financial institutions worldwide shows growth of assets at an extremely healthy rate of

28.6 percent to reach assets of $822 billion in 2009 compared to $639 bil- lion in 2008, whereas in conventional banking the rate of growth of assets of the top 1,000 world banks has declined from 21.6 percent in 2008 to 6.8 percent in 2009 (The Banker 2009).

The book also explores the regulatory framework of the Islamic financial institutions, the regulatory issues and concerns, and the challenges facing the Islamic financial industry. It is important to note here that while much has been achieved in the regulatory framework of Islamic banks, much remains to be done.

The book has four parts: Part One provides an introduction and history of the development of Islamic banks. Part Two reviews the nature of risk in Islamic banks and Islamic financial instruments. It highlights the critical roles of regulation and supervision and sound corporate governance. Part Three considers the regulatory framework for both the Islamic and conventional banks. Part Four discusses corporate governance features specific to Islamic finance. A concluding chapter provides a summary and perspectives.

PART ONE: UNDERSTANDING THE ORIGINS             

Part One consists of two chapters:

Chapter 1 gives an introduction and a brief overview of the book’s contents.

Chapter 2, History and Development of Islamic Banking, offers a re- view of the historical background of Islamic banking, starting from the early days of Islam until now. The development of the modern Islamic banks is divided into four periods, beginning in the late nineteenth and early twen- tieth centuries. Each of the four periods is associated with a specific set of social and economic conditions and factors, which contributed collectively to the reviving and development of the Islamic financial system. This chapter will also show the development of the Islamic regulatory bodies and the supervisory agencies that support the Islamic financial system, as well as the development of Islamic banks in five countries: Egypt, Iran, Pakistan, Sudan, and Malaysia.

PART TWO: RISK IN ISLAMIC BANKING                 

Banks, conventional as well as Islamic, are subject to a wide range of risks in the course of their operations. In general, banking risk falls into four categories: financial, operational, business, and event risk. Islamic financial institutions face a unique mix of risks and risk-sharing arrangements result- ing from the contractual design of the financing instruments, which is based on the principles of shari’ah; the nature of the liability base and the unique relationship between the bank and the Investment Account Holders (IAH); the liquidity infrastructure and constraints; and the overall legal framework and environment. Institutions offering Islamic financial services (IIFS) are set on different foundations from the conventional financial institutions. The first priority of IIFS is to adhere to shari’ah rules and principles, which take priority over profit.

IIFS are required to abide by the following ideals: (1) promotion of fairness in transactions and the prevention of an exploitative relationship,

(2) sharing of risks and rewards between principals in all financial/ commercial transactions, (3) the need for transactions to include elements of materiality leading to a tangible economic purpose, (4) the prohibition of interest, and (5) the prohibition of financing activities that are haram (forbidden, meaning anything that is against shari’ah), as all transactions must be legitimate and comply with the shari’ah rules and principles. There- fore, Islamic modes of finance, such as murabaha and profit and loss sharing (mudarabah/musharakah), display unique risk characteristics that must be accounted for in the calculation of capital adequacy requirements and in the development of the risk-management framework.

Part Two consists of four chapters:

In Chapter 3, The Nature of Risk in Islamic Banking, we explore the different types of risk that face banks, and the unique risks associated with Islamic banks in particular.

Chapter 4, The Inherent Risk in Islamic Banking Instruments, reviews and explains the basis and unique characteristics of the finance instruments used by Islamic banks, as well as compares and contrasts them with those used by conventional banks.

The chapter reviews the risks associated with the financial instruments used in Islamic banks and how such instruments operate. In addition, it will show the underlying fundamental differences in financial instruments between Islamic and conventional banks.

Chapter 5, Operational Risk in Islamic banking, discusses one of the most important risks that Islamic banks face. It explores and explains why Is- lamic banks have higher operational risk exposure than conventional banks. The chapter discusses three types of operational risk: (1) shari’ah noncom- pliance risk, (2) fiduciary risk, and (3) legal risk.

Chapter 6 is dedicated to the Islamic capital market. In it, we discuss the importance and role of capital market. We also delve into the Islamic bond market, referred to as sukuk. The chapter concludes with a look at the challenges and obstacles facing the development of the Islamic capital market.

PART THREE: CAPITAL ADEQUACY                         

The capital adequacy standard (CAS) is based on the principle that the level of a bank’s capital should be related to and consistent with the bank’s specific risk profile. The determination of the capital adequacy requirement (CAR) is based on the components of risk, namely credit, market, and operational risk. The Islamic banks’ characteristic of mobilizing funds in the form of risk-sharing investment accounts, together with the materiality of financing transactions, impacts the overall risk of the balance sheet, and subsequently, the assessment of the capital adequacy requirements.

The nature of risk in Islamic banks differs from conventional banks because of the differences in the nature of assets between the two. Whereas the assets in conventional banks are based on debts, the assets in Islamic banks range from trade finance to equity partnership. Therefore, some of the Islamic banks’ instruments carry additional risks that are not applicable to conventional banks. Subsequently, the calculation of risk weights for Islamic banks is different than it is for conventional banks.

Part Three has three chapters:

Chapter 7, The Importance and Role of Capital, sheds some light on and reviews the notion of capital. In this review, we follow two approaches:

  • the importance and role of capital in banking, and in Islamic banking in particular; and (2) historical reviews of the capital adequacy regulations and an examination of the different views regarding the necessity of banking regulations.

Chapter 8 pertains to The Regulatory Framework of the Conventional Banking System: Basel I and II. The regulatory framework of Islamic bank- ing and the work of the Islamic Financial Services Board (IFSB) and the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) are mainly drawn upon the work and regulatory framework of The Basel Capital Adequacy Accord I and II, which were issued by the Basel Committee on Banking Supervision (BCBS).

 Therefore, I found it necessary, in order to better understand the Islamic regulatory framework, to dedicate this chapter to these two accords. The discussion in this chapter focuses on the historical background of Basel I and II, and provides an overview of the framework and regulatory bodies involved, namely, The Bank for International Settlement and the Basel Committee on Banking Supervision. Chapter 9 looks at the regulatory framework for Islamic financial institutions, which includes the three pillars: (1) minimum capital requirements,

  • supervisory review process, and (3) market discipline. This chapter is dedicated to the first pillar of the capital adequacy framework for Islamic financial institutions, which is the minimum capital requirements. We ex- amine the background and development of such regulations and the salient differences between Islamic and conventional banks, as well as how Islamic banks function within the conventional regulatory environment. This chapter also offers a recommendation to adjust the capital adequacy formula to account for the risk associated with the assets funded by IAH funds.

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