Qualitative Research in Financial Markets

Emerald Article: Credit risk management: a case differentiating Islamic

and non-Islamic banks in UAE
Omar Masood, Hasan Al Suwaidi, Priya Darshini Pun Thapa

Article information:
To cite this document: Omar Masood, Hasan Al Suwaidi, Priya Darshini Pun Thapa, (2012),"Credit risk management: a case
differentiating Islamic and non-Islamic banks in UAE", Qualitative Research in Financial Markets, Vol. 4 Iss: 2 pp. 197 - 205
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Credit risk management: a case

differentiating Islamic and
non-Islamic banks in UAE
Omar Masood

Credit risk
management

197

London, UK

Hasan Al Suwaidi
Business school, London Metropolitan University, London, UK, and

Priya Darshini Pun Thapa

Department of Business Management, South London College, London, UK
Abstract
Purpose The purpose of this paper is to identify any differences between the Islamic and
non-Islamic banks in the UAE on credit risk management.
Design/methodology/approach The study uses survey based methodology for data collection.
The sample for the study consists of six commercial banks from UAE with three non-Islamic and three
Islamic banks and with 148 credit risk managers as respondents for the survey. The study aims to
investigate factors which distinguish between Islamic and non-Islamic banks in UAE. This is achieved
by fitting a binary logistic regression model.
Findings The study shows that the managers in Islamic banks now do not rely only on personal
experiences and simple credit risk analysis. The Islamic banks appear also to be developing and
practising the newer and robust techniques, in addition to traditional methods, to manage their credit
risk in UAE compared to non-Islamic banks, which indicates a possibility of further improvement in
their credit risk management.
Originality/value The paper uses questionnaire-based methodology, which has not been used
previously in the UAE financial sector, as well as in studies of credit risk management. Therefore, this
research could become the cornerstone of further academic research in other developing countries
using this methodology.
Keywords United Arab Emirates, Islam, Banking industry, Financial services, Credit management,
Credit risk management, Islamic and non-Islamic banks, UAE financial sector,
Logistic regression analysis, Questionnaire method, Banking and finance
Paper type Research paper

1. Introduction
Risk is inherent in all aspects of a commercial operation; however for banks and financial
institutions, credit risk is an essential factor that needs to be managed. Credit risk is the
possibility that a borrower or counter party will fail to meet its obligations in accordance
with agreed terms. Credit risk, therefore, arises from the banks dealings with or lending
to corporate, individuals, and other banks or financial institutions (Gontarek, 1999).
In the past risk has been a minor factor in business management for many years, and
its measurement drew little attention from the academic and the consulting community.
Banks managers relied on personal relations and experience and simple credit analysis
techniques to assess the risk of their clients (Angelopoulos and Mourdoukoutas, 2001).

Qualitative Research in Financial

Markets
Vol. 4 No. 2/3, 2012
pp. 197-205
q Emerald Group Publishing Limited
1755-4179
DOI 10.1108/17554171211252529

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Altman and Saunders (1998) have opined that credit risk measurement has evolved
dramatically over the last 20 years in response to a number of secular forces that have
made its measurement more important than ever before. In response to these forces
academics and practitioners alike have responded by:
.
developing new and more sophisticated credit-scoring/early-warning systems;
.
moved away from only analyzing the credit risk of individual loans and
securities towards developing measures of credit concentration risk (such as the
measurement of portfolio risk of fixed income securities), where the assessment
of credit risk plays a central role;
.
developing new models to price credit risk (such as the risk adjusted return on
capital models (RAROC)); and
.
developing models to measure better the credit risk of off-balance sheet
instruments.
The nature of laws followed by Islamic banks, features of processes followed and the
types of financing opportunities require strong and effective risk analysis and
management. The profit and loss sharing (PLS) nature of Islamic financing is a practical
and justified way of performing financial business yet it introduces several risks to the
shareholder or people who deposit their money since the loss has to be borne by all the
parties. These risks are more meaningful to the bank due to the loss that can be borne by
these investors. This is because of administering the PLS strategy is much more
complex in nature in comparison to the conventional financing. The determination of
PLS includes identifying the ratios amongst economic investments and auditing
standards of financial projects to ensure proper governance standards are in place.
According to Khan and Ahmed (2001) Islamic banking industry possesses some of
those financial management styles followed by Islamic laws which are susceptible to
numerous types of risks. Research shows that success of financial institutions depends
on their strength to stand against external risks and the capacity to survive during
tough economic situations so to be stay profitable for shareholders. Nation trusts on
banks based on their power to survive through such conditions and the level of their
maturity within risk management.
Akkizidis and Khandelwal (2008) also argue the risk management for Islamic
banking institution is set up in the form of cautiously created standards for availability
of funds, by Islamic Financial Services Board (IFSB). IFSB has recognized the
importance of effective risk management. They realized this importance after a very
short period of establishing Islamic banking concept because of the challenges
enforced by international laws and pressures against Shariah.
This paper attempts to identify any differences between the Islamic and non-Islamic
banks in UAE on credit risk management. This paper uses questionnaire-based
methodology which has not been used previously in UAE financial sector as well as in
studies of credit risk management. Therefore, this research could become the
cornerstone of further academic research in other developing countries using this
methodology.
The layout of this paper is as follows. Section 2 consist of literature review. Section 3
discusses the survey methodology and introduces the statistical methodology used and
Section 4 gives the empirical results. Section 5 concludes.

2. Literature review
Crouhy et al. (2006) singled out that the expert system is the most used traditional
method in assessing credit risk. When commercial banks have a loan application
concerning a particular project, banks might organize a committee composed by experts
to make a decision based on qualitative and quantitative information. This means the
experts expertise and subjective judgement play an important role in the
decision-making process. However, Heffernan (2005), Jesswein (2008) and Strischek
(2009) indicated that the most popular expert system to assess credit risk is the five Cs
system. The experts analyze the five factors and make a decision based on the subjective
balance between the five Cs. The five Cs are character, cash flow, capital, collateral
(or security) and conditions, respectively. Five Cs of credit is one of the most common
expert system to measure risks. They are character, capital, capacity, collateral and
cycle (or economic) condition. New approaches to measure credit risk has been
developed basing on the traditional one, but it is hard to draw a line between these two
since many of the better ideas of traditional models are used in new model (Saunders and
Allen, 2002).
In relation to commercial banks practice of risk management in UAE, Al-Tamimi
(2002) found that the inspection by branch managers and financial statement analysis
are the main methods used in risk identification. The main techniques used in risk
management are benchmarking, credit score, credit worthiness analysis, risk rating
and collateral. The recent study by Al-Tamimi and Al-Mazrooei (2007) was conducted
on banks risk management of UAE national and foreign banks. Their findings reveal
that the three most important types of risks encountered by UAE commercial banks
are foreign exchange risk, followed by credit risk, then operating risk. Not only that,
there is no significant different on risk identification between UAE national and
foreign banks, hence, the UAE banks clearly identified the potential risks relating to
each of their declared aims and objectives. Moreover, risk identification is positively
significant to influence risk management practices.
In the case of Islamic banks, studies made especially on risk identification and risk
mitigation includes the work of Haron and Hin Hock (2007) on market and credit risk,
and Archer and Haron (2007) specifically on operational risk. They explain the inherent
risk, i.e. credit and market risk exposures in Islamic banks. Also, they illustrate the
notion of displaced commercial risk that is important in Islamic banks. They conclude
that certain risks may be considered as being inherent in the operations of both Islamic
and conventional banks. Although the risk exposures of Islamic banks differ and may
be complex than conventional financial institution, the principles of credit and market
risk management are applicable to both. In addition, the IFSBs standards on capital
adequacy and risk management guiding principles mark the first steps in an ongoing
process of developing prudential standards and filling regulatory gaps in the field of
Islamic finance. Apart from those two risks, Archer and Haron (2007) state that Islamic
banks are exposed to a number of operational risks that are different from those face
by conventional banks. They argue that the complexities of a number of their products,
as well as there relative novelty in the contemporary financial services market,
combined with the fiduciary obligations of Islamic bank when it acts as a Mudarib,
imply that for Islamic banks operational risk is very important consideration. Because
of that, the IFSB has taken the position while investment account holders (IAHs) may
be considered in the absence of misconduct and negligence by the Islamic bank to bear

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credit and market risks of assets in their funds have been invested by the bank, the
latter must be considered as being exposed to the operational risk arising from its
management of those funds. Siddiqui (2008) elaborates that when Islamic financial
institutions provide funds to other entrepreneurs for their ventures through the PLS
methods, the entrepreneurs do not bare any risks of loss. The bank is responsible for
financial analysis and liquidity of venture so to avoid the potential risk of financial
loss. This is in the context of Mudarabah contract. If PLS contract expires then the loss
can be borne by both parties.
The empirical findings by Al-Tamimi and Al-Mazrooei (2007) highlighted that UAE
banks are somewhat efficient in analysing and assessing risk and significant different
between UAE national and foreign banks in the practice of risk analysis and assessment.
Additionally, the findings show that risk analysis and assessment are influencing risk
management practices. In the context of Islamic banking, few conceptual studies
( Jackson-Moore, 2007) discuss the risk measurement aspects particularly on the unique
risk. A comprehensive risk measurement and mitigation methods for various risk
arising from Islamic financing activities and from the nature of PLS in the source of
funds especially IAHs are explained by Sundararajan (2007). He concludes that the
application of modern approaches to risk measurement, particularly for credit and
overall banking risks is important for Islamic banks. He also suggests that the need to
adopt new measurement approaches is particularly critical for Islamic banks because of
the role IAHs play, the unique risks in Islamic finance contracts. However, Ariffin (2005)
indicates that Islamic banks are perceived not to use the latest risk measurement
techniques and Shariah compliant risk mitigation techniques due to different Shariah
interpretation of these techniques. Also, appropriate measurement of credit and equity
risks in various Islamic finance facilities can benefit from systematic data collection
efforts, including by establishing credit and equity registry. Jackson-Moore (2007)
suggests that bank need to start collecting data, and there can be significant advantages
in pooling information and using common definitions, standards, and methodologies for
operational risk which is argued can lead to significant losses in all financial institutions.
Finally, it is found that risk analysis and assessment particularly on measuring risk in
banking institutions is important for risk management practices.
The nature of risks faced by Islamic banks is complex and bit difficult to mitigate as
some risks are eliminative some are transferable and some require
absorption/management. Ahmed and Khan (2007) describe different reasons for that,
first unlike conventional banks, given trading-based and equity financing instruments;
there are significant market risks along with credit risk in Islamic banks. Second, risk
interrelation and change from one kind to another at different stages of a transaction.
Like trade based contracts Murabaha, Salam, Istisna and Ijarah are exposed to both
credit and market risk. For instance, during the transaction tenure in Salam contract
bank is exposed to credit and at the end of the contract the risk transfer into commodity
price risk. Third reason is the rigidities and insufficiency in the Islamic infrastructure,
institutions and instruments, like Shariah prohibit the use of foreign exchange futures to
hedge against foreign exchange risk or in case of liquidity risk management there are no
Shariah compatible short-term securities in most Islamic jurisdictions.
However, Islamic banks and financial institutions around the globe are trying to
find out and improve different tools and techniques to mitigate risks. According to
Ahmed and Khan (2001) there could be two types of techniques of risks identification

and management available to Islamic banks. First, standard techniques such as risk
reporting, internal and external audit, GAP analysis, RAROC, internal rating and so
on, on the other hand there are techniques and tool which need to be developed
according to Shariah compliance. Ahmed and Khan (2001) assert that from many
Shariah scholars point of view sale of debt or derivative and forward foreign exchange
contracts are generally not permitted in Islamic banking since they include an element
of uncertainty and are priced by reflecting an interest differential.
However, from some researchers point of view there should be distinction between
secured and unsecured debt. Like Chapra and Khan (2000) argue that external credit
assessment makes the quality of debt transparent, credit valuation techniques have
improved drastically furthermore, all Islamic debt financing is asset based and secured.
In view of these developments, restrictions on sale of debt may be reconsidered.
According to Ahmed and Khan (2007) some scholars suggest that, although sale of debt
is not possible as such, the owner of a debt can appoint a debt collector under agency
contract (Wakalah) or service contract ( jualah). Collateral is also one of the most
important securities against credit loss. Islamic banks use collateral to secure finance,
because al-rahn (an asset as a security in a deferred obligation) is allowed in the Shariah.
3. Research methodology
The study uses questionnaire method for data collection. The sample for the study
consists of six commercial banks from UAE with three non-Islamic and three Islamic
banks. A total of 148 credit managers were the respondents for the study from National
Bank of Abu Dhabi (23), Abu Dhabi Commercial Bank (27), Emirates Bank
International (24), Emirates Islamic banks (22), Mashreq Islamic Bank (25) and
Abu Dhabi Islamic Bank (27).
The questionnaire consists of demographic questions, i.e. the respondents were
asked questions in relation to their education, years of experience, service, trainings,
credit limit that they could authorize and credit risk management issues. These
included questions regarding attitude towards the importance of various factors
affecting lending decisions, lending policy, the relative importance of different aspects
considered for evaluating bank-wise exposures, credit ratings, factors considered when
lending to corporate borrowers, importance given to company factors while making
lending decisions and expert system.
In order to perform the data analysis, the responses to the questionnaire have been
coded. There are broadly three types of questions and associated relative frequency
distributions. The first type is where the respondent answers Yes or No to a direct question
giving a variable with two categories and has been coded as Yes 1 and No 0.
The second is where the respondent gives four or five ranked responses, e.g. frequency
(once a week, once a month, once every six months and once every year), percentage
(less than 5, 5-10, 10-15 per cent, etc.). The third type of question from the survey is where
respondents give answers that indicate their strength to which some factor is viewed as
important/unimportant or the strength of agreement/disagreement with a statement.
The study aims to investigate factors which distinguish between Islamic and
non-Islamic banks in UAE. In statistical terminology, the factors which increase the
probability of classifying a randomly chosen bank as Islamic should be investigated.
This is achieved by fitting a binary logistic regression model (McCullagh and Nelder,
1989, Chapter 13; Bingham and Fry, 2010, Chapter 8).

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The logistic regression predicts the log odds of an event. The event is a particular
value of y, the dependent variable, where y takes the value if the event occurs and is
zero otherwise. The natural log of the odds of an event is equal to the natural log of the
probability of the event occurring divided by the probability of the event not occurring:


probevent
lnoddsevent ln
probnonevent
The logistic regression equation itself is:
z b0 b1 X1 b2 X2 bk Xk
where:
z is the log odds of the dependent variable ln(odds(event)).
b0 is the constant and where there are k independent (X) variables.
The b terms are the logistic regression coefficients, also called parameter estimates.
Exp(b) the odds ratio for an independent variable the natural log base e raised
to the power of b.
The odds ratio is the factor by which the independent increases or (if negative)
decreases the log odds of the dependent.
Binary (or binomial) logistic regression is a form of regression which is used when
the dependent is a dichotomy and the independents are of any type. In the binary
logistic regression, Islamic bank has been coded as 1 and non-Islamic banks as 0.
4. Results of binary logistic regression
First, the variable Bank is regressed individually on each variable individually to
identify which factors are statistically significant. The results reflects that the variables
penalizing credit officers for issuing default loans, development of risk adjusted return
on capital frame-work, development of frame-work to study inter-bank exposure, use of
derivatives for credit risk management, years of service within the organization,
importance of character, rate of return on lending, frequency of credit risk assessment,
percentage of credit ceiling allocated to different industries by banks and importance
of property deposit were found to be significant since the p-value of the Wald statistics
is less than 0.05. The variable bank is then regressed with each explanatory variables
found significant and the output is shown in the column Model 1 of Table I.
Sequentially, insignificant variables (from that reported in the column Model 1 of
Table I) were deleted from Model 1 based on Wald statistics until only significant
variables remain in the regression. And the model with only significant variables is
presented in the column Model 2 of Table I. Then again the regression was run that
add one of the variables excluded from the Model 2 in turn. That is, for each variable
excluded from the Model 2 just that one variable has been added to the model and
checked if it was significant. Since none of them were significant the final model is
Model 2. The model tests Hosmer Lemeshow Test and Omnibus test of coefficients
have been presented in Table I. A finding of non-significance in the result of
Hosmer and Lemeshow Test corresponds to the researcher concluding the model
adequately fits the data. A finding of significance in Omnibus test of coefficients
corresponds to a research conclusion that there is adequate fit of the data to the model.

Model fit tests

Hosmer and Lemeshow test: x 2
Omnibus test of model coefficients: x 2
Parameters
Development of risk adjusted return on
capital for risk pricing (Wald)
Development of framework to study interbank exposures (Wald)
Use of derivatives to manage credit risk
(Wald)
Importance of cash flow in lending decision
(Wald)
Importance of property deposits when
lending to coporate borrowers (Wald)
Character of borrower (Wald)
Credit assessment review (Wald)
Rate of return on lending (Wald)
Penalizing credit officers for issuing default
loans (Wald)
Year of service (Wald)
Importance of non-financial data (Wald)
Percentage of credit ceiling allocated to
different industries by the bank (Wald)
Constant (Wald)

Model 1
8.916 *
115.53 *

Model 2
18.818
108.21 *
Odds ratio

2 2.190 (3.609)

(23.58) *(18.936)

0.028

5.36 *(12.517)

4.69 *(15.305)

109.579

6.78 *(16.599)

4.80 *(13.704)

122.045

(2 3.58) *(10.109) (24.00) * (13.462)

2.43 *(4.228)
1.4 *(6.348)
0.31 *(9.847)
0.840 (2.949)

3.0 * (7.845)
1.15 *(5.09)
0.20 * (5.329)

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0.018
20.163
3.183
1.225

2 0.520 (0.318)
2 0.660 (2.934)
1.13 (1.178)
0.310 (0.23)
(2 13.52) * (4.992)

25.100(2.01)

Note: Significant at: *0.05 level

The variables development of risk adjusted return on capital framework for risk
pricing, development of framework to study inter-bank exposure, use of derivatives for
credit risk management, importance of cash flow of company in lending decisions,
importance of character in lending decisions, frequency of credit risk assessment, and
importance of property deposit provided by company in lending decisions are
significant since the p-value of their Wald statistics is less than 0.05.
The variables development of risk adjusted return on capital framework for risk
pricing and importance of cash flow are negatively associated with the dependent variable
bank. It implies that with the increase in the variables development of Risk adjusted return
on capital for risk pricing and importance of cash flow there is lesser chance of a randomly
chosen bank to be an Islamic bank. On the other hand, the variables development of
framework to study inter-bank exposures, use of derivatives for credit risk management,
importance of character in lending decision, frequency of credit risk assessment and
importance of property deposits are positively associated with the dependent variable
bank as they have positive coefficients. It implies that with the increase in the variable
development of framework to study inter-bank exposure, use of derivatives, importance
given to character, frequency of credit risk assessment and importance of property
deposits there is higher chance of a randomly chosen bank to be an Islamic bank.
5. Conclusion
The results reflect that the variables development of risk adjusted return of capital for
risk pricing, development of framework for studying inter-bank exposure,
use of derivative for credit risk management, importance of cash flow and character,

Table I.
Logistic regression
analysis results

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frequency of credit risk assessment and importance of property deposits are significant
which differentiates the credit risk management between Islamic and non-Islamic banks
in UAE. The non-Islamic banks compared to Islamic banks are more likely to have
developed Risk adjusted return on capital for risk pricing and give importance to cash
flow. And the Islamic banks are more likely to practice the credit risk management
techniques like development of framework to study inter-bank exposure and use
derivatives for credit risk management. The Islamic banks appeared to be giving more
importance to the character in lending decisions. Due to the complex nature of financing,
the Islamic banks were found to have more frequent credit risk assessment and give
more importance to the property deposits than the non-Islamic banks in UAE.
The study shows that the managers in Islamic banks now do not rely only on
personal experiences and simple credit risk analysis. In context with UAE, the Islamic
banks are more likely to use newer, sophisticated and robust credit risk management
techniques in addition to the traditional methods of credit risk management than the
non-Islamic banks. The Islamic banks appear to be internalising latest techniques to
manage their credit risk in UAE which indicates a possibility of further improvement
in their credit risk management.
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Altman, E. (2002), Bankruptcy Credit Risk and High Yield Junk Bonds, Blackwell, Oxford.
Corresponding author
Priya Darshini Pun Thapa can be contacted at: pdpthapa@gmail.com

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