RISK MANAGEMENT IN ISLAMIC FINANCIAL INSTITUTIONS

Risk management is at the heart of banks' financial intermediation process, and has assumed utmost importance at a time when complexity and volatility in financial markets have become both differentiating factors building competitive advantages and sources of risk entanglement. Basel II and widespread write-downs have highlighted the importance of sufficient capital adequacy and, more importantly, set a framework for improving the overall risk management architecture in banks.

Compared to conventional financial institutions, Islamic financial institutions face many challenges in adequately defining, identifying, measuring, selecting, pricing and mitigating risks across business lines and asset classes.

Risk issues at Islamic financial institutions include:

a) The range of asset classes found in Islamic banks;
b) The relatively weak position of investment account holders;
c) The importance of the Shariah supervisory board and the bank's ability to provide the board with adequate information as well as abide by its rulings;
d) Rate-of-return risk;
e) New operational risks.

Islamic finance is a growing subset of the global financial system, and is increasingly becoming a mainstream industry. Notwithstanding a series of specific features that somewhat distinguish IFIs from a number of their conventional peers, the building blocks are very similar for every banking institution. If fully adhering to the core principles of financial Islam, Sukuk in particular should really be equity based, as should risk-sharing securities. Indeed, venture capital and equity are the most common, and the most Halal forms of ethical finance, as all parties share risk and reward.

However, for the majority of existing institutional financing, in the form of Sukuk, investors ask for, and indeed receive, debt securities. Equity is expensive, hence the structural engineering of asset-backed, risk-sharing securities. Securitization is the debt structure that best satisfies the underlying profit-sharing principles of Shariah compliant investment.

In a large number of contracts, risk categories of a different nature are entangled. For example, in an Ijarah contract, the IFI buys an asset that is subsequently leased or rented to a customer against periodic rental payments.The management of leased assets' residual value is a feature that differs materially from credit risk management and assumes access to robust and reliable market data as to asset-price volatility and behaviour across economic cycles and business conditions, all the more so as IFIs tend to run a portfolio of asset inventories that they buy and then sell or lease.

Inventory management is another aspect that separates IFIs, from a risk management perspective, from their conventional peers, and similar issues arise when it comes to diminishing Musharaka contracts. Should the customer default, said the report, the IFI's share in the financed asset would be used as collateral, the value of which might be volatile and naturally subject to scrutiny and management independently from the customer's perceived creditworthiness. Diminishing Musharaka contracts are increasingly used as a financing mechanism for Shariah compliant home purchase, particularly in Dubai.

Similarly, in Istisna'a contracts, IFIs are deemed to remain the beneficial owners of financed assets until the borrowing company pays back the final installment under the Istisna'a agreement. In the case where the borrower defaults before the Istisna'a maturity, the IFI is entitled to dispose of the financed assets, which are generally illiquid because they are specific to the nature of the plant, the industry or the enterprise to which the IFI's funds were initially allocated. In the case of default, the IFI, more than any conventional bank, becomes a merchant, behaving in the field of commerce rather than in that of pure financial intermediation.

This puts additional pressure on IFIs to equip themselves with the correct technical and professional expertise for both credit assessment and the management of underlying asset valuation, trading and liquidity, should loan foreclosure and collateral realisation occur.

In short, IFIs naturally have a high level of collateralization on their credit portfolios, and thus are in a position somewhat to reduce their economic, if not regulatory, exposures at default.

Therefore, IFIs should be in a better position to manage their credit portfolios in terms of sector diversification. Sector diversification is all the more important from a capital perspective as Islamic banks usually face concentration risks by name and geography, and are also skewed heavily towards real estate financing and investment, further weighing on the quality of their assets, and thus on their credit ratings.

CONVENTIONAL BANKS VERSUS ISLAMIC BANKS

From a commercial point of view, the effective returns on Islamic accounts, both deposit and financing, need to be of the same scale as the conventional ones. In reality, the disparity in real returns may potentially represent a threat to the Islamic banking industry, at least in the short-term. As base rates in the conventional banking world have begun to approach zero, the interbank rates, although slow to respond, have now also begun to fall. At present, over 75 % of Islamic financial transactions are based on murabaha and ijara, and others may be wakala, salam or istisna, with a maximum of 5 % for PLS-based structures. Although the majority of Islamic banking is conducted through murabaha and ijara, the rates of return on mudarabah and musharakah are not immediately similarly impacted. The real returns on those products are reflected in the profits made by those enterprises that are financed in the Islamic profit-and-loss sharing (PLS) concept.

So, the dilemma Islamic banks that have financed through mudarabah or musharakah may face is that their returns may be significantly above the rates achieved by conventional banking. They may now face the commercial risk of being overwhelmed by an influx of funds for which there is no short-term liquid market; or alternatively, they may face the ethical dilemma of reducing the real return on their PLS investments to bring them in line with the low interest rates of the conventional world. Sukuk issuers, that have benchmarked their returns from ijara or mudarabah investment pools against LIBOR or other interbank investment rates, may have to deal with this problem soon, as their steady investment returns will be much higher than international rate benchmarks.

When the balance sheets of conventional banks have been decimated by derivatives and other questionable trading strategies, could the real, asset-backed investments of PLS be of genuine interest to conventional bankers anxious to gain some sort of return in a world where their interest-rate based investments are almost worthless? Is it conceivable that it is the conventional banks that lead the way into Islamic banking?

Conventional banks’ lending rates will stay positive even if the base rate goes down to zero and the same will apply to Islamic banks; the impact will be felt by depositors (savers), irrespective whether they are banking with Islamic or conventional institutions.

If Islamic banks use equity-based structures, like mudarabah and musharakah, on asset and liability sides ‘in substance’, their operations will be riskier. While this may provide some comfort in the present economic scenario, in the long term the real rate of return to depositors at Islamic banks will be low, due to compliance with regulatory and taxation rules. Capital adequacy requirements for equity-based products are higher than debt-based ones. Also, taxation treatment of debt makes it more attractive than equity.

In a nutshell, due to the above-mentioned issues, Islamic banking products are not very different from conventional ones. Is it not time to re-think and change the strategy for moving to equity-based structures at least in the markets that are more supportive of Islamic finance, such as Malaysia and Bahrain? Surely, once there is a success story in one market, it will become easier to emulate it in other places.

DANGER : A NEW FINANCIAL THREAT IS LOOMING

Extracted from StarBiz 16 July 2009

A new financial crisis will develop from a failure to effectively regulate derivatives and the extra global liquidity from stimulus spending, says Mark Mobius of Templeton Asset Management Ltd.

"Political pressure from investment banks and all the people who make money in derivatives" would prevent adequate regulation, said Mobius, who oversees US$25biI as executive chairman of Templeton in Singapore. "Definitely we're going to have another crisis coming down, " he said in a phone interview from Istanbul on Monday.

The Bank for International Settlements estimates that outstanding derivatives total US$592 trillion, about 10 times the global gross domestic product. Opaque financial products contributed to almost US$1.5 trillion in write downs and losses at the world's biggest banks, brokers and insurers since the start of 2007, according to Bloomberg data

The US Justice Department is investigating the market for credit default swaps, Markit Group Ltd, the data provider majority-owned by Wall Street's largest banks, said on Monday.

Mobius didn't explain what he thought was needed for effective regulation of derivatives, which are contracts used to hedge against changes in stocks, bonds, currencies, commodities, interest rates and weather. "Banks make so much money with these things that they don't want transparency because the spreads are so generous when there's no transparency, " he said.

A "very bad" crisis may emerge within five to seven years as stimulus money added to financial volatility, Mobius said. Governments have pledged about US$2 trillion in stimulus spending.

Treasury Secretary Timothy Geithner last week urged Congress to rein in the derivatives market with new US laws that are "difficult to evade". He said strong capital requirements were the key. Geithner repeated President Barack Obama's call to force "standardised" as contracts onto exchanges or regulated trading platforms, and regulate all dealers.

In the Senate, Agriculture Committee chairman Tom Harkin, an Iowa Democrat, is pushing for legislation that would require all over-the-counter derivatives trades be traded on regulated exchanges, not just standardised ones as the Obama administration is seeking.

Mobius also predicted a number of short, "dramatic" corrections in stock markets in the short term, saying "a 15% to 20% correction is nothing when people are nervous. "Emerging-market stocks "aren't expensive" and would continue to climb, he said.

Mobius said he favoured commodities and companies such as London based Anglo American Plc, which has interests in platinum, gold, diamonds, coal and base metals. In China and India, Mobius sees value in consumer-oriented stocks and banks.

PROFIT EQUALIZATION RESERVE (PER)

Yesterday, I was having an “exchange-of-ideas” session with a few colleagues and the issue of PER became an interesting topic of discussion. Since not many of us knows what PER means, I have extracted a few pertinent point from various sources on the subject :

PER is a mechanism act to mitigate the fluctuation of Rates of Return arising from the flux of income, provisioning and total deposits.

The creation of PER is to ensure that Islamic Banking Institutions (IBIs) Rates of Return remained competitive and stable. During times of low returns to depositors and investors, IBIs can choose to utilize the PER to improve and stabilize the Rate of Return to its depositors and investors. The main purpose is to protect depositors and investors interest as far as possible.

Currently, PER can be allocated up to a maximum 15% of the total gross income every month. The formula for how much PER can be allocated is as follows:

PER (maximum monthly provision) = (15% x gross income) + net trading income + other income + irregular income such as recovery of non-performing financing (NPF) and write back of provisions.

In Malaysia, as per BNM Guidelines, IBIs are only allowed to maintain a maximum accumulated PER of 30% of Islamic Banking Shareholders’ Fund.

The IBIs may write back the PER into the total gross income, at their discretion, in the event that the prevailing rates have become less competitive. PER is recognized as a liability in the Balance Sheet and as an expense in the Income Statement.

Misconception by IBIs on PER

Although IBIs are given the right to allocate some of its income into PER, it is not right for IBIs to treat PER as another source of income as most bankers assume. PER is a way on how an IBI can manage or control its Rates of Returns. By right, any income generated from the utilization of funds i.e. depositors funds, must be returned back in full to customers accordingly.

WHO ARE THE "REAL" BENEFICIARIES OF THE DUAL BANKING SYSTEM IN MALAYSIA ?

The dual-banking system in Malaysia is expected to put Islamic banks at a disadvantage due to the latter's over-dependency on fixed rate asset financing such as al-bay' bithaman ajil and murabahah. When interest rates are rising, rational product choice among non-Muslim customers (NMC) is expected to produce a shifting effect that may frustrate deposit mobilization and at the same time able deplete an Islamic bank's earnings. The shifting effect occurs when NMC either transfer deposits from Islamic banks to conventional banks, or, in a period of declining interest rates, opt for loans rather than for deferred sale financing. These shifts occur solely due to pecuniary incentives sought by NMC as the suppliers of deposits or demanders of funds. During an economic slowdown normally accompanied by falling interest rates, the shifting effect is expected to increase idle balances as the demand for fixed rate asset financing declines. Thus, in the choice of banking products, it is argued that NMCs will be the main beneficiaries of the dual-banking system since they are open to more options than the Muslim customers (MC).