Risk Management in Islamic Banking

IS THERE SUCH A THING AS ISLAMIC RISK MANAGEMENT?

I had this conversation recently until the wee hours of morning, and although I never thought a lot about it, I have come to the conclusion that there cannot be an exact replica of the Risk Management in the conventional sense.

Risk Management is a tool used by all conventional banking institution in the name of good governance, risk mitigation and prudent practice. It looks at financial exposures and its inherent risks to the business, and deeply believe in the risk-rewards pay-off within the generally accepted risk appetite of the organisation. It focuses a lot on control processes, performance monitoring, collateral value, and decision making policies for credit, market and systemic risks.

To a large extend, the risk management framework employed by the conventional banking businesses can be easily adapted by Islamic Banking counterparts. The components are the same, and there is little argument on its applicability under Shariah law. However,  the risk management framework for Islamic Banking institutions must be inherently different as well, or maybe extended to include a bigger scope. It cannot just be seen as a replica of the conventional business; the foundation of Islamic Banking is definitely different.

There are a few divergence in the reason an Islamic Banking institutions should (ideally) follow. This is an on-going argument on the fact while Islamic Banking claims to be a different business model, but it is still engineered by the rules of a conventional organisation. But what are these divergent reasons for setting up an Islamic Banking business?

The lending of money to make money is forbidden.

This may seem like a trivial thing for Islamic Banking as many will say there is no difference between profit and interest. But for us practitioners, there is a big difference in its concept. Because of this difference, the way we think about how a product can be structured is paramount. Underlying contracts, assets, ownerships and roles and responsibilities becomes different from a tranditional / conventional bank (whom are essentially a money lender). To validate a transaction, all tenets and requirements in an Islamic contracts must be met or else it becomes an invalid transaction and any gains from it must be given to charity. Any gains obtained without fulfilling the transactional can be deemed as usury (riba’).

There are specific Shariah requirements that takes Islamic Banking beyond banking.

Some terms are pretty alien to traditional banks, such as commodity purchase, operating lease and rentals, sequencing and ownerships. This is where the divergent begins, because Islamic Banks espouses the concept of “trading” and “entrepreneurship” and “partnership” and “service provider”, away from the “lender-borrower” arrangement. Traditional banks struggle to understand issues of ownership of assets, risk and loss sharing, purchases of commodity and rental of assets. These activities are beyond traditional banking, and may become an operational risk issue if it is not fully embraced.

Islamic Banking should be more closer to a venture-capitalist, crowd-funding model than traditional banking.

The fundamental requirements for earning a profit (and to a bigger extent, how much we can earn from a transaction) is the element of risk sharing, which mean both customer and financier takes some form of the risks of the venture. At the same time, such “risky” venture is mitigated by way of ensuring it is not overstretched i.e. the transactions must be either asset-backed (including the presence of collaterals) or asset-based (evidenced by real trading or assets or commodities) to reflect economic activity.

The amount of risk taken under an Islamic contract can be higher (for contracts such as Mudharabah or Musyaraka financing) but it must be reflective of the economic reality and available assets.

The risk assessment of an Islamic contract must then be enhanced to behave similarly to what a venture capitalist can accept. There will be direct risks on equity, investments and returns. There will be corresponding returns as well. But such concepts will be difficult to digest if the bank is set up based on traditional banking fundamentals, which caters for a totally different profile of stakeholders.

As far as possible, the Shariah committee draws a line for transparency, fairness, and justice.

Islamic Banking should be an extended but integral part of economics. Islamic Banking is supposed to be more than a bank. It shoulders a broader responsibility to the people by looking at needs and providing products that serve a purpose. The idea of responsible financing, transparency and customer service should be the by-word of an Islamic Bank. The payment of Zakat (tithe) on profits which goes back into the community recognises the financial role that it needs to play. Corporate Social Responsibilities also play a role.

In this repect, the Shariah committee plays an important role as gatekeepers to the products and services on offer. Because of the unfamiliar territory of Islamic products, Shariah insists that transparency is critical to avoid uncertainty (gharar), the terms to the products are fair and the banks are ethical in its conduct to ensure justice. Fees and charges must reflect actual costs. Efforts are made to help a customer in distress. And conduct of the bank must comply with the requirements of Shariah.

SO, BASED ON THE ABOVE, WHAT ARE THE  OF RISKS FACED BY ISLAMIC BANKS? 

As a general rule, all risks faced by a conventional Bank must be “transferable” i.e the nature of the financial transaction must, as far as possible, allow for the TRANSFER OF RISKS. Wherever the opportunity arises, the Bank must be able to quickly pass the risk of the asset or valuation to the customer. Such understanding is also apparent in Islamic Banks. Looking at most Islamic Banking contracts, their structure allows for the transfer of risks, which follows the transfers of ownership, responsibilities and obligations from one party to the other. Contracts  such as Murabahah, Musawamah and Qard works by transferring the ownership, responsibilities and obligation from the Bank to the Customer.

Alternatively, mostly exclusive to Islamic Banks, are structures that allows for SHARING OF RISKS. The structure is more “participative” in nature, where there are benchmark by which determines the level of risks a party should have. The regular types of contracts that continues to share risks are Mudarabah, Musyarakah and Ijarah.

COMMON RISKS 

As mentioned before, the risks faced by a conventional bank and Islamic Bank should be very much the same, except for risks arising to the execution of Islamic contracts or pronouncement of the Shariah. While there will be common elements of risks for both types of Banks, the importance of Shariah ruling and decisions result in Islamic Banking becoming so unique. The following are the Risks commonly faced by Islamic Banks:

GENERAL RISKS – Risks existing in both conventional and Islamic banks. 

  • Credit  Risks – Arises due to counterparty risks (possibility of default by the party taking financing) where the counterparty fails to meet its obligations, in terms of payment, uncertainty of industry,  change of direction or diminished collateral value. This lead to settlement risks which means the Asset quality has diminished.
  • Market Risks / Interest Rate Risks – More macro in terms of effect on the risks. It relies on the performance of the market as well as the quality of the financial instruments (price, performance, valuation, demand, yields and inability to reprice. It leads to exposure to interest rate risks, where the risk of the bank increases with movements in the rates.
  • Liquidity Risks – Refers to the risk of inability to return cash to investors or stakeholder in stressed scenarios, resulting in forced borrowings from the market (usually at higher price) coupled with the possibility of not able to dispose assets. This may lead to valuation risks.
  • Operational Risks – Due to inadequate control of internal processes and operational practices, the risks may result in real loss of income and potentially reputation. Human errors may be difficult to unwind especially if there is financial implications. There may also be legal risks as it may be considered a breach in contract by the bank.

ISLAMIC SPECIFIC RISKS – Risks arising from operational and processing function

  • Transactional risks – Especially under Islamic Banking structures, transactions play an important role as part of the Aqad, where required.  For example, the sequencing of a Murabahah transaction. Failure to ensure compliance to the Aqad requirements will lead to potential invalid transaction and loss of income (or flow to charity).
  • Valuation Risks – Due to the nature of some Islamic Banking contracts, especially equity based structures, there will be challenges in valuation of the portfolio.  Reduction in valuation will result in real losses for the investors.
  • Displaced Commercial Risks – Displaced Commercial Risk (DCR) refer to the risk of mismatch between the fixed/contracted obligation to the depositors vs the uncertain returns on the financing (income) which may result in the income is insufficient to meet the obligations to the depositors. For example, the commitment for Islamic Fixed Deposit is 4% (contractual) but the Financing portfolio into which the Fixed Deposits is deployed into only earns 3% (actual returns). Therefore, the 1% shortage is the DCR where the Bank will have to flow 1% of  income from other portfolio to meet the deposit obligation of 4%.

SHARIAH RISKS – Risks arising to non-compliance of Shariah decisions and Shariah instructions.

  • Shariah Compliance Risks – The operation of an Islamic Bank is hugely dependent on the requirements of the Shariah Committee and approvals obtain on the process and procedure. Inability to comply with Shariah requirements puts the operations of the Islamic bank at risk as the department may be regarded as non-Shariah compliant business.
  • Fiduciary / Ownership Risks – Some of the structures under Islamic contract requires the bank to operate outside the scope of a financial intermediary. It requires the bank to hold property or trade commodities or own and lease assets, with various contracts using various roles and responsibilities. The risk of multiple roles and function must be clearly defined and implemented.
  • Regulatory / Reputational Risks – Changes in regulations requires quick adaptation to ensure compliance to regulation and maintaining the banking reputation intact.?

SO HOW DO YOU MANAGE ISLAMIC RISKS AND SHARIAH RISKS

As mentioned, Islamic management of risks should not be any different for the base of conventional bank’s methodology of measuring risks. There must be deep understanding of the products and structure for the bank to be able to assess the risks associated. To manage an Islamic Bank and its risks, the bank must first identify each of the risks and form safeguards to settle the above. Then only an Islamic bank can formulate suitable controls to ensure the Shariah specific processes and Shariah pronouncements are being monitored and implemented with sufficient support (internal or external). Wallahualam.

Types of Murabahah

One of the common questions I get with regards to the Murabahah Standards issued by BNM is on the types of Murabahah covered under the standards. Murabahah is essentially a Sale of goods (cost plus profit) where there is a “deferred” element which validates the profit earned arising from the sale transaction. To understand the difference, it is key to analyse the “deferred” elements, and the risks associated to the deferment.

Essentially, there are two types of deferment in a Murabahah i.e.:

1. Deferment arising from future/deferred settlement of Sale Price – This is the most common form of Murabahah where risks to the Seller is minimised by the almost immediate transfer of ownership of the goods.

Murabahah Deferred Sale

This is generally used for debt creation where the Seller (usually a Bank in the case of financing products) purchase goods into its ownership and quickly Sells the goods to the Buyer (usually customer) where the Sale Price (inclusive of profit) is concluded with the future settlement terms agreed. Once the debt creation is completed, the ownership transfers from the Seller to the Buyer and the Buyer will start to make payments on the agreed Sale Price.

All risks on the goods (valuation, pricing, ownership) are transferred quickly from Seller to Buyer; the Seller only holds the credit risk of the debt i.e. the risk that the Buyer may not able to pay the Sale price at the future date as agreed.

This category of Murabaha is generally classified as a Debt-Based structure where the Bank only holds the Credit Risks (Valuation Risks is held by the Customer).

2. Deferment arising from future delivery of goods sold – This structure is more riskier than the earlier mentioned deferment of Sale Price settlement. Deferment of delivery of goods means the Seller purchases the goods now but do not enter into a Sale transaction with the Buyer until much later.

Murabahah Deferred Delivery

Instead, the Seller holds the ownership of the goods for a period of time and enters into a contract at an agreed future date. The Seller will carry the ownership risks and valuation risks until the goods are sold at the Sale Price (inclusive of profit). Once the Buyer enters the contract, the ownership of goods is transferred on settlement of the Sale Price at spot (either a Murabahah arrangement or Musawamah Simple Sale transaction).

Due to the riskier nature of the above, the Buyer is usually required to undertake to enter into the Sale contract (via Letter of Undertaking in favour of the Seller).  On then the Seller procure the goods from Supplier, creating a legal obligation on the Buyer to complete the sale at the agreed future delivery date, even if the Buyer decides not to complete the Murabahah transaction (default on the arrangement). By this undertaking, the Buyer takes on the pricing risks as at the date of Sale transaction; the price of goods on the open market may be higher or lower than the contracted Sale Price.

Additionally, with the Letter of Undertaking, the risks on the Seller is mitigated, resulting the credit risk of the Buyer to be similar/equivalent to the “debt” structure of Murabahah arising from deferment of Sale Price.

This arrangement is commonly referred to in the market as “Murabahah Purchase Order” or MPO where the Seller will only proceed to purchase goods to hold it for a period of time with the surety of the Letter of Undertaking as a risk mitigant. This category of Murabaha can be classified as either an Equity-Based structure (if the Bank choose to hold the ownership until sale i.e. open to valuation risks without a Letter of Undertaking) or a Debt-Based structure (where the Bank executes the Letter of Undertaking and effectively transferring the valuation risks to the customer).

Both the structures are sufficiently addressed in the Murabahah Standards issued in 2013.

 

Interconditionality in Bai-Inah

One of the most controversial contracts that resides in Malaysia is the Bai Inah contract. For many years, Malaysia have been taking heat on its use from international forums. The major reasons for this critique is that Bai Inah, while having an underlying transaction in its structure, argues critics, smells suspiciously like a loan with interest. There have been many opinions to this, but I must admit that each argument has its own merits and rationale, and it is difficult to draw the line here.

What is Bai Inah?

But before going further, what is Bai Inah? Why is it always under the Islamic finance microscope for scrutiny? Why are feathers always ruffled when discussing Bai Inah?

Bai Inah Malaysia

 Please Click Here

Goods and Services Tax on Islamic Products

Goods Services Tax (GST)  will be one of the hot topics for the years to come in Malaysia, when the GST finally comes into place in 2015 to replace the Services Tax. Many arguments have been made on both side of the political divide but the reality is that GST will be implemented and have a huge impact on how services and goods are being priced.

A quick look at the GST finds that Sharia compliant banking, while having all its contracts requiring underlying transactions, asset ownership and movement of actual goods, the impact that the GST may have on Islamic contract will remain similar to what impacts a conventional banking product. There is not expected to have a “worse-off” effect on Sharia compliant banking.

GST

It is heartening to see that Customs has made an effort to understand the various Islamic banking contracts and how it works, and identify potential transactional points where a GST may be imposed. I find the attached document (GST Industry Guide – Islamic Banking (As at 1 November 2013)) extremely useful summary of the intended GST implementation on Sharia banking contracts.

10 particular contracts have been identified and the GST points are outlined accordingly.

Please Click Here

Pro-Active Compliance of Regulatory Guidelines

There are days I wish I was a multi-millionaire with vast resources, cool regulatory connections, tech-savvy and excellent people motivator. Someone who sees the new regulations for the opportunity it is and the potential in it.

If I was, I’d quit my cosy banking job and set-up my own company that provide services to all Malaysian Banks to support the compliance of the new guidelines. Instead of all the banks scrambling to meet the requirements, they can just outsource all their problems to my set-up to run it. One stop solution to all your headaches.

Perhaps I am writing this out of frustration because I do not have the resources for it. Or perhaps I am writing this for my own interest, hoping someone like Bruce Wayne takes up the challenge and make all our jobs easier. Maybe some of us can get an offer to join this company. That’s wishful thinking I bet.

What would this company / set-up offer to banks? Hmmm where do we start.

Balancing Act

Compliance with the Investment Account Guidelines.

All Banks do not generally set up their operations to work like fund houses where you have fund managers running their investment desks. Neither are there an infrastructure to manage and monitor the fund or portfolio performance, nor having mechanisms to create mark-to-market valuations of the portfolio. Reading the Investment Account guidelines makes one think that the banking model itself has to change to a pure Mudharaba trading house. A dedicated fund house with ready systems supporting the investment requirements and offering their services to Islamic Banks will ease the burden at Banks to develop their own infrastructure.

Tawarruq Guidelines.

This can be a huge component of businesses in the near future. As BNM place more and more emphasis on the big 3 of Musyaraka, Mudharaba and Murabaha, more and more focus will be placed on building the long term infrastructure to support this. Warehousing infrastructure, including managing physical assets and commodities belonging to the Banks, will support the Murabaha envisioned by BNM. A re-vamp of the credit policies and a different approach to risks assessment will support Musyaraka. Mudharaba will encourage the Bank’s “entrepreneurial appetite”  as Banks take a more hands-on approach to investments. Ensuring a compliant structure and supporting the requirements of Sharia on sequencing, documentation, management of commodities, ownership transfers, usufruct and beneficial ownerships and valuation must be developed for the long run. A company which offers these services, or provides an IT platform for this, are something that can reduce the stress placed on the industry.

Special Purpose Vehicles (SPVs).

There a easy lot of opportunities for SPVs to flourish in the Islamic banking market. To support the ownership issues, an SPV can be a useful conduit for the movement of assets which will then create the underlying transactions. Huge deals are done on SPVs. Complicated structures need them. This is a viable legal solution for across border deals. The only question is; what do we do with the SPVs once the transaction is done? Rent it out to another entity, I presume. Either way, SPVs are created for win-win situations for everybody.

The IFSA 2013 is like a large pool of compliance that needed development. There are many opportunities out there and with the coming of even more complicated regulations, Banks are always finding ways to meet the requirements set in the regulations. Some will be creative solutions, while others will address the fundamental requirements of the transaction. Whatever they may be, it will only provide possibilities where fortune smiles on the brave. Take that chance. Hopefully, you will succeed to make all our lives easier.

Readings : December Papers x 3

Murabaha

And to close off the year, BNM gave us a further 3 reading gifts for us to enjoy our holidays:

  1. Murabahah (2013)
  2. CP Mudarabah (SR,OP, OR)
  3. CP Musharakah (SR,OP,OR)

The Murabahah Standards looks interesting, and so is the Mudarabah Concept Paper. Do have a read and tell us what you think.

Looking forward to the coming holidays.

Back To Wadiah

Investment Account Guidelines

True to form, BNM have called for an urgent discussion with the industry players on the implementation of the IFSA. The message is very simple; industry players are given time to comply to the IFSA i.e. no later than 30 June 2015. During this time, we are asked to either:

  1. Retain Mudharabah and Wakala structures to comply with the Investment Account guidelines; or
  2. Move the Mudharabah and Wakala structures into an alternative structure.

Obviously no one has the answer to both options. Especially for Current Account and Savings Account now offered under Mudharabah. To retain a simple product such as Savings Account under Mudharabah, the Bank needs to comply with tedious risk profiling of customers and numerous disclaimers on investments. Customers will be confused by this arrangement, and we foresee many will stay away. Marketing wise, it is a nightmare. Operationally as well, if we were to comply with the investment disclosures. Gone will be the simple structures that customers are used to.

Bringing the Current Account and Savings Account into Commodity Murabahah structures is the most viable solution in Shariah’s perspective. However, operationally tedious, money required for system development, revised documentation and more importantly, building customer awareness and acceptance will be the main challenges for the industry to move to this alternative.

Committees were promptly set-up to discuss solutions, and as expected, there can be no commercial viability into moving to Commodity Murabahah, at least not in such a short period of time. For Time Deposits it is possible, but how to address the daily deposits and withdrawals of funds in a Current or Savings Account under Commodity Murabahah?

The easy solution; take a step backwards.

Wadiah is suddenly the solution. Most Banks has decided to migrate back into Wadiah structures, even with limited value proposition. Hang on, this is not the solution. Perhaps only workable for a short term stop-gap measure, but definitely not feasible for moving forward, especially when there is a conventional banking alternative.

Wadiah is definitely not the solution for deposit building. But then, what else is there? Until someone comes up with a brilliant solution, we will have to make the best of what Wadiah has to offer.