Risk management for Islamic banks : recent developments from Asia and the Middle East

  • Book Title:
 Risk Management For Islamic Banks
  • Book Author:
Muhammad BudiNiken IwaniSurya Putri
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  • Advance Praise
  • Title Page
  • Copyright
  • Dedication
  • Preface
  • Acknowledgments
  • About the Authors
  • List of Acronyms
  • Part One: Introduction
  • Chapter 1: Principles of the Islamic Financial System
  • Islamic Financial Contracts: The li-tabarru’ Contract versus li-tijari Contract
  • Principles of Islamic Finance
  • Interest-Based Return versus Profit–Loss Sharing
  • Chapter 2: The Islamic Bank and Risk Management
  • Differences between an Islamic Bank and a Conventional Bank
  • History of the Islamic Bank
  • Global Islamic Banking Entities
  • Risk as an Integral Part of Islamic Bank
  • Stages in Risk Management
  • Risk and Return Trade-Off
  • Various Approaches on Risk Identification
  • The Importance of Risk Management for an Islamic Bank
  • Part Two: Risk Management Framework in Islamic Banking
  • Chapter 3: History of Risk Management in Islamic Banking
  • Basel I and Its History
  • Basel II and its History
  • Basel III and Its History
  • The AAOIFI and Its Role
  • The IFSB and Its Role
  • Chapter 4: The Risk Management Process in Islamic Banking
  • Risk Management Model in Islamic Banks
  • Risk Identification Process in Islamic Banking
  • Risk Matrix
  • Risk Mitigation Process
  • Risk Review Process
  • Infrastructure and Facilities
  • Calculation of Minimum Capital Requirements
  • Chapter 5: Financial Reporting and Analysis in Islamic Banking
  • The Importance of Financial Statements in Risk Analysis
  • Scope of Financial Statement in Islamic Banks
  • Basic Contracts and Instruments in the Islamic Bank
  • Structure of the Balance Sheet
  • Analysis of Income Statement
  • Persistence Analysis
  • Tools of Financial Statement Analysis
  • Core Business Activity in Islamic Banks
  • Off-Balance Sheet Activity in Islamic Banks
  • Part Three: Risk Management in Islamic Banking
  • Chapter 6: Financing Risk in Islamic Banking
  • Urgency of Financing Risk Management in Islamic Banking
  • Characteristics of Islamic Financing Contracts
  • Financing Risk: Definitions and Its Scope
  • Role of Rahn and Kafalah
  • Defining Determinant Factors of Financing Risk
  • Urgency of the Independent Rating Agency
  • Rating and Financing Risk Provisions
  • Risk-Based Financing Limit
  • Concentration Risk in Financing Portfolio
  • Financing Portfolio Management
  • Measuring Financing Risk in the Islamic Bank
  • Chapter 7: Operational Risk in Islamic Banking
  • Urgency of Risk Awareness
  • Operational Risk Coverage in Islamic Banks
  • Identification of Operational Risk Factors
  • Operational Risk in Islamic Financial Contracts
  • Measurement of Islamic Operational Risk
  • Developing an Operational Risk Management System
  • Chapter 8: Syari’ah Compliance Risk
  • Basic Principles of Islamic Economics and Financial System
  • Syari’ah as Principle and Spirit in Business
  • Various Prohibitions in Mu’amalah
  • Why Should Islamic Banking Comply with Islamic Principles?
  • Integrating Syari’ah Compliance in the Islamic Bank
  • Evolution of Syari’ah Governance in Islamic Financial System
  • Syari’ah Advisory Board and Syari’ah Compliance Audit as a Framework
  • Identification Process of Syari’ah Compliance Risk
  • Risk Management and Mitigation of Syari’ah Compliance Risk
  • Models of Syari’ah Governance in Several Countries
  • Chapter 9: Strategic Risk
  • Definition and Scope of Strategic Risk in Islamic Banking
  • Determinants of Strategic Risk and Its Mitigation
  • Issues Related to Strategic Risk
  • Chapter 10: Investment Risk in Islamic Banking
  • Syirkah as a Distinct Trait of Islamic Banks
  • Basic Concept of Investment Risk
  • Forms of Risk and Their Mitigation
  • Regulations on Profit Distribution Management
  • Chapter 11: Market Risk in Islamic Banking
  • Urgency of Market Risk
  • Scope of Market Risk in Islamic Banks
  • Identification of Market Risk Profile
  • Market Risk Measurement in Islamic Banks
  • Market Risk Mitigations in Islamic Banking
  • Implementation of Market Risk Mitigation
  • Chapter 12: Liquidity Risk in Islamic Banking
  • Urgency of Liquidity Risk
  • Credit Multiplier, Financial Stability and Liquidity Crises
  • Definition and Coverage of Liquidity Risk
  • Islamic Bank’s Assets and Liabilities
  • Liquidity Risk Management in Islamic Banks
  • Part four: Future Prospects and Challenges in Islamic Banking
  • Chapter 13: Development of the Islamic Financial Market
  • Islamic Capital Market
  • Derivative Islamic Market
  • Regulation and Supervisory in Islamic Financial Market
  • Institutional-Based Development Framework
  • Stability in Islamic Financial System: Lesson from Global Financial Risk
  • Chapter 14: Development of a Pricing Model in Islamic Banking
  • Fundamentals in Islamic Pricing Model
  • Time Value of Money in Pricing Model
  • Current Islamic Pricing Model
  • Urgency of Pricing Mechanism in Islamic Banks
  • Chapter 15: Pathways of Risk Management in Islamic Banks
  • Islamic Banks as Real Implementation of Risk Management
  • Challenges of Islamic Banking in the World
  • Blueprint for Islamic Banking Regulation
  • Prospects and Challenges of Islamic Banking Development
  • Strategic Issues in the Implementation of Islamic Risk Management
  • Chapter 16: Future Agenda
  • Landscape of Integrated Islamic Risk Management
  • Synergy and Integration among Islamic Financial Institutions
  • Competency and Competitiveness of Islamic Banking
  • Regulatory Agenda in the Future
  • Anticipating the Potential Systemic Risks
  • Part Five: Conclusion
  • Chapter 17: Summary and Conclusion
  • Glossary
  • Bibliography
  • Index
  • End User License Agreement
  • List of Illustrations
  • Chapter 2: The Islamic Bank and Risk Management
  • Figure 2.1 The Evolution of Islamic Risk Management
  • Figure 2.2 Top-Down and Bottom-Up Approaches
  • Figure 2.3 Risk Mapping Based on Business Line and Unit Function
  • Chapter 3: History of Risk Management in Islamic Banking
  • Figure 3.1 Basel II Framework
  • Figure 3.2 Milestones of Basel Regulations
  • Chapter 4: The Risk Management Process in Islamic Banking
  • Figure 4.1 Evolution of Risk Management
  • Figure 4.2 Risk Management Framework
  • Figure 4.3 Risk Management Process Flow
  • Figure 4.4 Illustration of Risk Appetite
  • Figure 4.5 Illustration of a Risk Register
  • Figure 4.6 Illustration of a Risk Matrix
  • Figure 4.7 Illustration of a Composite Risk Matrix
  • Chapter 5: Financial Reporting and Analysis in Islamic Banking
  • Figure 5.1 Composition of Third-Party Funds and Financing Contracts
  • Figure 5.2 Strategy for the Development of a Competitive Advantage for an Islamic
  • Bank
  • Chapter 6: Financing Risk in Islamic Banking
  • Figure 6.1 The Business Process of an Islamic Bank’s Financing
  • Figure 6.2 Qardhul Hasan Scheme Illustration
  • Figure 6.3 Illustration of the MPO Contract
  • Figure 6.4 Illustration of the Salam Contract
  • Figure 6.5 An Illustration of the Scheme of an Istishna‘ Contract
  • Figure 6.6 Illustration of the Operating Lease Scheme
  • Figure 6.7 Illustration of an IMBT Contract Scheme
  • Figure 6.8 Risk Contribution and Risk Distribution
  • Figure 6.9 Managing Cycle in a Financing Portfolio
  • Chapter 7: Operational Risk in Islamic Banking
  • Figure 7.1 Identification of Operational Risk
  • Figure 7.2 Coverage of Operational Risk
  • Figure 7.3 Frequency and Severity of Operational Risk
  • Figure 7.4 The Taxonomy of Operational Risk
  • Figure 7.5 Operational Risk Based on the Frequency and Effects of Its Occurrence
  • Figure 7.6 Loss Distribution for AMA According to Basel II
  • Chapter 8: Syari’ah Compliance Risk
  • Figure 8.1 The Evolution of Syari’ah Governance
  • Figure 8.2 Syari’ah Governance Framework for IFI in Malaysia
  • Chapter 9: Strategic Risk
  • Figure 9.1 Taxonomy of Strategic Risk
  • Chapter 10: Investment Risk in Islamic Banking
  • Figure 10.1 An Illustration of a Mudharabah Contract as Financing
  • Chapter 11: Market Risk in Islamic Banking
  • Figure 11.1 Market Risk in Islamic Banking Activities
  • Figure 11.2 Capitalization Required by Basel II and Basel III
  • Figure 11.3 Flow of Market Risk Measurement
  • Figure 11.4 The Loss Distribution and RAROC Calculation
  • Figure 11.5 Business Cycle and Market Risk Exposure
  • Figure 11.6 Market Risk in a Murabahah Scheme
  • Figure 11.7 The Effect of Parallel Contracts in Salam
  • Chapter 12: Liquidity Risk in Islamic Banking
  • Figure 12.1 Liquidity Risk Management Process
  • Chapter 14: Development of a Pricing Model in Islamic Banking
  • Figure 14.1 Pricing Wage in an Islamic Economy
  • Figure 14.2 Determinants of Profit Share in Mudharabah
  • Figure 14.3 Determining Profit Sharing in Musyarakah
  • Chapter 16: Future Agenda
  • Figure 16.1 Synergy between Financial Services Institutions
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Principles of the Islamic Financial System

Islamic finance is an integrated social, economic, and financial system based on a set of principles that brings a positive motive for economic activity, balanced between material and spiritual needs and between personal and societal interest. Among those principles are balance between work and reward, equal treatment of humans, responsibility over self and society, fairness in scale and measurements, the principle of coexistence, prioritization of the interest of other people and society over one’s self-interest, and freedom of conscience.

The initial purpose of the modern financial industry’s intermediation is to assist the economy and from it the distribution of resource within society. But then, this purpose encounters obstacles in the form of “bourgeois appetites,” democratic politeness, and individual work ethic. These three forces cause humans, as economic agents, to never be satisfied with the resources that they already own, and propel the mechanism of financial manipulation to create “high-powered money,” ending in excessive risk-taking behavior.

The combination of these three powers supports the idea of individual freedom and achievement, but abandons the idea of the economic agent’s part in social responsibility. Islam recognizes the three powers as nafs, a catalyst for economic activity and the progress of civilization that can only aid in achieving prosperity when coupled with institutional reform and a mechanism to check the morality of the actions of humans in its execution. Islamic financial institutions arise as entities that are trusted to have a strategic function for institutional reform in the direction of prosperity as well as priority in the real sector, complemented with an ethical oversight mechanism through syari’ah principles that grounds operations and transaction activity.

Islamic Financial Contracts: The li-tabarru’ Contract versus li-tijari Contract

Based on the purpose or reason of a contract’s formation between two people or more, financial contracts can be divided into three. First is the contract for the purpose of generating profit, called li-tijari. Every party in the contract is aware that they or their cosigners enter into the contract for the purpose of acquiring personal gain for themselves through the contract. Usually there is a bargaining and negotiating process, either bilaterally or multilaterally, on the specifications of the contract, such as the terms for price, quality, and quantity of the object; the ratio; the timeframe of settlement; the time of delivery; the time of payment; and the like.

With this awareness, all sides have willingly accepted the risk inherent in the contract and have no regrets if the realization of the contract is different from their expectation. In mu’amalah, there are many examples of this sort of contract, like sale (bay‘), rent or lease (ijarah), partnering in business (syirkah), the cultivation of agriculture (musaqat), and so forth. Islam allows anyone to enter a transaction with the intention of gaining profit as in the various contracts mentioned, as long as the contracts are made properly and are also executed properly.

The profits gained  from these contracts are incomes that are lawful and good, for they are gained by the efforts of one’s own hand.

Second is the contract that is made with the purpose of giving reward, aid, or assistance to other people; this is called the li-tabarru‘ contract. This type of contract is usually entered by those who are in need, have lived through a catastrophe, or are under problems that cause them to need the assistance of others. In this contract, negotiation or bargaining is rarely found except in payment terms and due date, where both are related to the ease preferred by the party in need. Because of this, Islam loathes anyone who exploits the opportunities that arise from other people’s needs for personal gain or profit, material or immaterial, through any assistance rendered.

Among the examples are loan or debt (qardh), entrustment (wadhiah), representation (wakalah), borrowing or lending (dayn), transfer of debts between debtors (hawalah), etc. In qaidah fiqhiyah, it is said, “every loan receivable that generates benefit/gain, then it is usury” (Asy-Syairazi, Al-Muhadzdzab: 1/304). Included in this group of contracts is a contract of guarantee over debts or loans, like third-party guarantees (kafalah) and asset-backed guarantees (rahn).

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It is hoped that by knowing the division of financial contracts and by executing them consistently, one can avoid various forms of usurious transaction. For example, when one is interested in helping others who need capital for business, but is still at the same time interested in turning a profit, then the li-tijari contract can be used, like murabahah or ijarah.

In both of these contracts, the capital owner can receive profit in the form of sales margin or rental fee, and the entrepreneur receive working capital in the form of fixed assets without having to expend money at the beginning. Other than that, by understanding the purpose for financial contracts, the parties involved can realize their position within the contract and their rights and responsibilities.

Principles of Islamic Finance

Risk sharing as a principle of justice is embodied in Islamic economy. Every economic agent involved in financial transactions, consciously or unconsciously, directly or indirectly, should complement each other and the system. All parties, without exception, can access money and other resources in the economy.

The result is a “multiplier effect” that appears to drive the economy and improve the welfare of the community, not just the individual. All of these are summarized into three Islamic finance principles: universal complementarity, justice and equity in al-hisba, and abolition of riba.

Universal Complementarity

Both conventional and Islamic financial institutions function with the purpose of creating a system to enhance the efficiency of resource allocation and distribution in society by providing financial services to bridge the gap between the parties with excess funds on hand and those needing funds, thus setting in motion continuous economic growth.

The basic difference between the two is that an Islamic financial institution must be free from all forms of usury, gambling (maysir), uncertain or doubtful elements (gharar), swindling (tadlis), injustice and coercion (ikhraha).

Islamic financial institutions divide risk and profit fairly between different economic actors, both when there is a surplus of funds as well as when there is a deficit of them. This division of risk is a manifestation of the principle of economic fairness and implemented among the participants in the profit–loss sharing scheme.

Every economic agent involved in a financial transaction, aware or not, directly or indirectly, should complement each other’s absence of skill or function. Thus, everyone, without exception, can access the money in circulation and the available resource. Of course the multiplier effect that can be generated will mobilize the economy and improve the society’s prosperity, not just the individual ones. When every element in the society is considered as an economic agent (producers and consumers, government, households, and industry) with complementary functions needed to achieve societal prosperity, the loss of individual business opportunity is a loss to society.

Justice and Equity in Al-Hisba

Among Islamic financial contract schemes, the profit-sharing instrument is considered to be most representative of Islamic finance’s character. This scheme is dependent on the proportion (nisbah) agreed upon, based on the comparison between the opportunity cost of capital and the expectations of profit or loss of business.

 In Islamic finance, pricing is not determined by conventional standards (e.g., the capital asset pricing model [CAPM], market interest rate, etc.), but from the comparison of the function of satisfaction of capital to individual satisfaction and, on an aggregate level, a comparison to the economic surplus of every economic agent.

Abolition of Riba

Other than the two principles, there is at least another that must hold in the implementation of Islamic finance; the principle of removal of usury (riba). It must be understood that the marginal rates of substitution will be different among economic agents.

This difference should be reflected in the lack of a “unified interest rate” as a reference for opportunity cost. In the allocation of return, it should be based on the division of investment roles along with the risk distributed among them. With that, every business opportunity will have a unique rate of return. In the end, this practice will consistently move in the direction of the removal of usury, which is the removal of a predetermined rate of interest between economic agents.

 In other words, economic agents will share risks and returns based on the actual performance of an investment. Aside from the way that usury is a form of injustice and is as such unlawful in Islam, the removal of usury is an implementation of the principle of fairness in measurement or scales.

Every economic agent receives a different return according to their own measure, dependent on the investment role and risk that they’ve taken.

Interest-Based Return versus Profit–Loss Sharing

In Islamic finance, money is only considered as a medium of exchange and does not have intrinsic value on its own; because of that, if the money is idle (left in the bank or lent to other people) and not used in business, then money should not increase. On the other hand, Islamic finance considers that the human endeavor, initiative, innovation, creativity, and risk inherent in productive business are more important than the money used to fund the project itself.

Money is considered capital only if it is invested in business and the investors accept the possibility of loss or failure in business; thus, investment also opens the possibility of growing. If the money is given to a business in the form of a loan, instead of equity, then because it is debt instead of capital, the money has no right to any return generated by the business (like interest). This is because money only has a time value when it is invested as capital, not when it is idling as “potential capital.” Besides, Islam does not consider loan (or debt) as an income-generating transaction.

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Money, Time Value of Money, and the Discounted Model in Islam

Islam forbids the practice of usury in all its forms, such as a discounted debt (borrowing

$1,000 for a period of 3 months, but the money received at the beginning is only $950, and the borrower is required to return exactly $1,000 at the due date), an interest-bearing debt (borrowing $1,000 for three months with an interest rate of 12% per annum, thus accepting

$1,000 in cash at the beginning and being required to return $1,030 at the end of the three month period), or a return for the due date extension (borrowing $1,000 for three months, without interest, and receiving $1,000, but failing to pay at the due date; the lender extends the due date and asks for an additional payment or late payment penalty of 0.01% per day of delay). This prohibition of usury emphasizes that it is not allowed to apply an indexing method or a discounted model in the case of a debt or loan contract.

On a debt-based sales contract, it is allowed in Islamic finance to set a price that is different from the current market price; a mu’ajjal contract uses a price that is higher than the current market rate (at premium), and a salam contract uses a price that is lower than the current market rate (at discount). Indirectly, Islamic finance accepts the possibility of price different between immediate cash payment and those where the delivery of goods and the delivery of the payment do not coincide in timing; this is an example of the existence of time value of money for the deferral of cash acceptance or goods acceptance. When the price is determined at the beginning of the contract, the profit margin can be immediately recognized, and as long as there is no defaulting payment, then that is also the amount of profit that will be realized.

Considering the way price and margin are formed, this mu’ajjal contract is similar with discounted debt. The difference in discounted debt is that in a pure debt (li-tabarru‘ contract), there are no goods or services that needs to be delivered to the borrower (except for money), because according to the syari’ah the lender has no claim over the difference of what is paid and what is accepted without bearing a part of the risk (other than the risk of default). While in a mu’ajjal contract, the seller transfers the goods to the buyer, where previously the seller must hold the goods and thus bear the market and product risks, and for that cause, according to the syari’ah, the seller has the right to claim the difference between the sale price and the cost of goods sold as profit margin.

Risk-Free Assets in Islamic Finance

 Risk-free assets imply that the asset will still give a positive return to its holder, no matter the business condition that has befallen on the firm that issued it, regardless of whether it has succeeded or failed. Other than that, an asset is said to be risk-free if the return that it generates is constant and invariant through time. This term is better known from the CAPM, where the risk-free asset is associated with the opportunity cost borne by the investor when the investor takes additional risk in a project. The investor requests additional return as a compensation for venturing beyond the status quo in placing his or her funds on financial instruments (assets) with a positive yield, and yet risk-free. Here, it is assumed that (1) money can generate real income from itself; (2) alternative projects always generate positive yield; and (3) there is no risk associated with alternative projects; and these three assumptions are frankly not true.

Apart from opportunity cost, the concept of the risk-free asset also represents the decline of purchasing power caused by inflation. When there is a positive inflation, if the nominal amount of money does not increase, then within the year, the real value of the money will decline by the same amount as the inflation rate. This is why when investors decide to invest, there is a potential loss if the yield of the project is smaller that the ongoing rate of inflation.

There are three possibilities of implementation of the concept of risk-free asset: qardh (loan or debt), debt-based sale contract (salam or mu’ajjal), and partnerships or syirkah (mudharabah, musyarakah). In the first case, the application of the concept of the risk-free asset will cause the payment of debt to be larger than what is received by the borrower. For whatever reasons, whether due to opportunity cost or compensation over the effects of inflation, this nominal addition to the future value is not allowed in Islam, and falls under usury.

 In the second case, the concept of the risk-free asset is used to determine the size of the margin in a mu’ajjal sale or the discounted price in a salam price, and this is allowed in Islamic finance. In the third case, the application of the concept of risk-free asset is only allowed as a benchmark and cannot be set as a predetermined rate of return. This concept can only be used to simulate the ratio for the preferred rate of return and estimate the yield with that ratio. But, after the ratio is set, the realization of the return will rely on the realization of the profit or loss of the business. Thus, different from the second case, on syirkah, the application of the concept of the risk-free asset is abstract and not real.

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