Risk Management gif


to the specialised nature of Islamic banking, some of the risk models suggested by Basel II may actually be harmful to Islamic banks by exposing them to risks that conventional banks are not vulnerable to. Dr. John Lee, executive director of KPMG elaborates on this issue thus, “While the risk profiles of Islamic financial institutions on the surface are generally similar to those of conventional financial institutions, Islamic finan- cial institutions face some unique and distinct risks. In particular, the assets and liabilities are unique to IFIs, given their profit and risk shar- ing structures.”


The risks unique to Islamic banking include:


• Displaced commercial risk: This arises when Islamic bank- ing institutions are under pressure to pay a return that exceeds the rate earned on assets financed by their IAHs, when the return on assets is underperforming in compari- son with competitors’ rates. In the event of such a scenario, the institution may waive its rights to the profits or a part thereof in order to retain its fund providers and dissuade them from withdrawing their funds. • Rate of return risk: This is as- sociated with overall balance sheet exposures whereby mis- matches occur between the assets and liabilities of Islamic banking institutions. Revenue and ex- penses are generally accounted for on an accrual basis when deriving the ex- posure and the Islamic banking institu- tions are exposed to the expectation of IAHs when allocating their profits. • Asset price risk: This concerns expo- sures to price volatility of the underly- ing tangible assets inherent in some financing modes, which are in the form of trading and real investments. The risk arises due to Islamic banking insti- tutions carrying out many asset-based transactions in which they take owner- ship of physical assets as co-investors. • Asset transformation risk: This occurs when the risk associated with a financ- ing structure transforms itself during the term of the financing. For instance, in a diminishing musharaka home financing structure, the risk may initially be an asset price risk, given that the Islamic financial institutions are co-owners of the asset. As the home owners build up their equity ownership further, however, through their repayment of the financ- ing, the risk in the financing structure


transforms to more credit risk. • Fiduciary risk: This manifests itself in the event of a breach of the invest- ment contract for management of IAHs’ funds. • Sharia’a- compliance risk: This arises from non-compliance with sharia’a prin- ciple in the conduct of the Islamic bank- ing institution’s business.


Product


Murabaha Salam Istisna


Assets


Asset-backed transactions Murabahah


Istisna


Ijarah Salam


Profit-sharing transactions


Murabahah Musharakah


Fee-based services Ju`uala


Qard Hasan Off Balance Sheet Restricted investment Direct investors Structure


Residential mortgages Specialised lending Specialised lending


Category 1 3 3


Profit and Risk Sharing Structures Liabilities


DEmand deposits Amanah


Investment accounts Mudarabah


Special investment accounts Mudarabah


Musharakah EQUITY


partner and global Islamic finance leader at PriceWaterhouseCoopers (PwC) explains why the balance sheet is so important in Islamic banking’s relationship with Basel II by saying, “Islamic banks have non-financial assets in their balance sheet such as cop- per, cars and houses whereas conventional banks have loans.


So, for capital purposes under Ba- sel II, it is a big problem as conven- tional banks would have some capi- tal set aside for these loans, but for Islamic banks, that capital is very high because Basel II was never designed to cover the non-financial assets. Hence, Islamic banks need more capital.” The Islamic Financial Services Board (IFSB) recognising the need for Islamic banking to adapt Basel II to suit its own needs, has clarified the risks for Islamic banks and their products under Basel II. This has helped identify proper risk mitigation for Islamic banking that agree with the Basel II philosophywithout unnecessarily exposing sharia’a-compliant banks to risk.


One aspect of the approach to Ba- sel II that Islamic banks are yet to find an alternative to is the Internal Ratings-Based Approach. With this approach, conventional banks’ in- ternal risk management systems are deployed in the measurement of credit risk. The IRB approach thus permits banks to alter the risk weight formula for small and me-


The risk management methods proposed for conventional institutions, therefore, should be amended by Islamic banks to en- sure they help rather than hinder them. For instance, due to the idiosyncratic nature of sharia’a-compliant financial instruments, Islamic banks should keep profit and loss sharing accounts off the balance sheet. To do anything else would leave the banks open to exposure to capital adequacy risk. Certain Accounting and Auditing Organisa- tion for Islamic Financial Institutions (AAOIFI) standards allow Islamic banks a way out, by requiring them to keep all deposits on the balance sheet without having to differenti- ate between current accounts and profit & loss sharing accounts.


The International Accounting Standards (IAS) however, does not have any such account- ing procedure to overcome this obstacle. In those countries where compliance with IAS is mandatory, leaving no room for AAOIFI standards, there may be Islamic banks with profit & loss sharing accounts that are off the balance sheet. Mohammad Faiz Azmi,


dium enterprise borrowers. Such an alterna- tive would be particularly useful to Islamic banks, given the comparatively bugger risk exposure of small and medium enterprises. The advanced risk weight formula would al- low for true reflection of risk regarding small and medium enterprise size and yearly sales figures. If Islamic banks could distinguish the risk weight, they would also be able to estimate the true risk in terms of risks as- sociated with Islamic finance instruments. Next time, we will look more specifically at how each Islamic financial instrument re- lates to Basel II.


Islamic finance products and Basel II The Internal Ratings-Based Approach used by conventional banking institutions in re- lation to Basel II would be ideal for Islamic banks, if it could be adapted accordingly. In terms of retail exposures, the IRB approach includes an expanded treatment, with cred- its categorised thus:


• Collateralized by residential mortgages • Qualifying revolving retail exposures • Other retail exposures


2011 February Global Islamic Finance 49


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