FACULTY OF ECONOMICS AND MUAMALAT

SEMESTER 6 SESSION 2016/2017

RISK MANAGEMENT
MFC 4013

INDIVIDUAL ASSIGNMENT:
CREDIT RISK ISSUE IN PARTNERSHIP CONTRACT THE CASE OF
MUSHARAKAH

LECTURERS NAME:
DR. SAFEZA BINTI MOHD SAPIAN

PREPARED BY:
NAME STUDENT ID TUTORIA
L
1. MUHAMAD AMIRUL HISYAM BIN AZMAN 1142147 TMA4
ABSTRACT

The concept of risk was well known in ancient societies. Even in financial
decisions, people knew very well that lending to someone who is bankrupt
has a high probability of losing the money as compared to a debtor with
good standing. Nevertheless, risk became an important tool of decision-
making when it became possible to measure it and to assign values to
different situations. Islamic banking is interest free banking which makes it
necessary for Islamic banks to take active part in the operations of the
business, i.e. share profits as well as losses. Banks including Islamic banks
prefer to take minimum risk. On the surface, it may seem that Islamic banks
face more risk and hence, will have more volatile or even negative returns on
their assets.

Partnership is considered as the essence of Islamic banking. Therefore,

Islamic banks are supposed to rely on the partnership contracts for
acceptance of deposits and investment of funds. In practice, Islamic banks
adopt partnership contracts for accepting deposits. However, these are
rarely used while investing. All over the world, Islamic banks rely heavily on
non-partnership contracts for investment of funds. The present paper
provides a review credit risk issue in partnership contract the case of
musharakah. This review highlights the features and common issues relating
to credit risk of partnership and the constraints in the application of
partnership contracts in Islamic banks. From this review, concentrations of
research efforts are identified and directions for future research are
proposed.

In this paper I want to explain how do Islamic banks manage credit risk when
reclassifying of a non-performing loan regarding the case of musharakah and
how Islamic banks manage liquidity and the associated risks.
CONTENT OUTLINE

1.0 INTRODUCTION TO RISK MANAGEMENT

2.0 RISK MANAGEMENT IN ISLAMIC PERSPECTIVE

3.0 THE IMPORTANCE OF RISK MANAGEMENTT IN ISLAMIC BANKING AND

FINANCE INDUSTRY

4.0 CREDIT RISK ISSUES IN PARTNERSHIP CONTRACT THE CASE OF

MUSYARAKAH
4.1 DEFINITION OF CREDIT RISK
4.2 TYPES AND ELEMENTS OF CREDIT RISK

5.0 MUSHARAKAH CONTRACTS OF PARTNERSHIP AND FINANCIAL RISKS

5.1 THE FEATURES OF MUSHARAKAH
5.2 ISLAMIC SALES CONTRACTS
5.3 COMMON ISSUES IN FINANCING RELATED TO CREDIT RISK
5.4 SOLUTIONS

6.0 RECOMMENDATION AND THE WAY FORWARD

7.0 CONCLUSION

REFERENCES
1.0 INTRODUCTION OF RISK MANAGEMENT

Uncertainty is inherent in activities involving the future. While risk can be

defined as the existence of uncertainty about the future outcomes, a
distinction can be made between its metaphysical and epistemological
concepts. The metaphysical property of risk is a reality that exists in its own
right in the world and the epistemological concept of risk is a judgement
made by a person or the application of some knowledge to uncertainty
(Althaus 2005: 568-69). Risk and uncertainty are central in economic
analysis. Frank Knight distinguishes between risk and uncertainty. Risk
relates to cases when objective or subjective probabilities can be assigned to
potential outcomes allowing quantification. Uncertainty refers to cases of
complete ignorance of any potential outcome, making quantification and
rational decision-making impossible. The implication is that in the case of
risk, the unknown can potentially be controlled by applying available
knowledge. In uncertainty, the unknown is random and cannot be predicted
or controlled.

Risk in economics and finance are classified in various ways. One way is to
distinguish between business risk and financial risk. Business risk is due to
the uncertainty arising from the nature of a firms business. It relates to
factors affecting the product market. Financial risk is the uncertainty arising
from possible losses in financial markets due to movements of financial
variables (Jorion and Khoury 1996:2). Risk entails both vulnerability and
opportunities. There are various costs associated with higher risk (volatility)
of cash flows. These include higher expected bankruptcy costs (e.g.,
payments to lawyers, court costs, etc.), higher expected cost to corporate
stakeholders, and higher expected tax payments. Successful firms are not
those the reduce risks but those that take advantage of the opportunities
offered by risk-taking. The objectives of risk management are first and
foremost to reduce the volatility of income, cash flows, a firms market value,
return on equity and cost of borrowing.

From a risk management perspective, risks facing financial institutions can

be classified into three types: risks that can be transferred to others, and
risks that can be managed by the institutions themselves. Financial
intermediaries avoid certain risks by simple business practices and will not
take up activities that impose risks upon them. Risk management and capital
are in some ways substitute for each other in the protection against risks in
financial exposures. When firms lower their risk by efficient risk management
procedures, the requirement for capital is also reduced.

2.0 RISK MANAGEMENT IN ISLAMIC PERSPECTIVE

The broad perspective on risk and its management are embodied in the
overall goals of Islamic law or maqasid al-shariah. Chapra (2008) quotes al-
Ghazali in defining maqasid as promotion of the well-being of the people,
which lies in safeguarding their faith (din), their self (nafs), their intellect
(aql), their prosperity (nasl), and their wealth (mal). The principle of
maqasid would imply taking all the precautions to safeguard present and
future wealth. As risk in economics represents the probable loss of wealth, it
is not desirable in itself from an Islamic perspective. While risks are not
desirable on their own, they must be undertaken to create wealth and value.
From an Islamic perspective, economic activities are not judged by their
inherent risks, but by whether they add value and/or create wealth.

There are many Quranic verses that guide mankind to have risk
management in wealth and financial affairs. Those verses precisely show the
significance of strategic planning to control and mitigate anticipated risks.
The absence of efficient risk management will harm certain parties to the
extent that the risk most likely endangers ones life. It is stated in surah
Yusuf:
 47
48
49

[Joseph] said, You will plant for seven years consecutively; and what you
harvest leave in its spikes, except a little from which you will eat. Then will
come after that seven difficult [years], which will consume what you saved
for them, except a little from which you will store. Then will come after that a
year in which the people will be given rain and in which they will press
[olives and grapes]1 (Quran, 12:47-49).

In the above verses, prophet Yusuf (p.b.u.h.) interpreted the dream of the
king of Egypt that Egyptian would face seven years of drought after seven
years of prosperity. Hence, he advised the king to develop an economic
strategy in order to overcome the upcoming catastrophe. To be precise,
Egyptians had to implement the proposition by actively planting crops during
the first seven years and store much of the proceeds as a preparation to face
seven years of drought, as interpreted by prophet Yusuf. As
recommendations implemented it resulted in the country surviving the seven
years of drought (Ibn Kathir, 1988).

Hassan (2009) identifies three types of risks from the Islamic perspective.
First, is the essential risk that is inherent in all business transactions. This
business risk is necessary and must be undertaken to reap the associated
reward or profit. Two legal maxims associating returns to essential risks from
the basis of Islamic economic transactions. The first maxim states the
detriment is a return for the benefit (al-ghurm bil ghunm) (Majalla Art. 87).
This maxim attaches the entitlement of gain to the responsibility of loss.
This maxim is usually used to propose the preference for profit-and-loss-
1 Surah Yusuf, 12:47-49
sharing (PLS) financing instruments. The second maxim is derived from the
Prophetic saying al-kharaj bil daman stating the benefit of a thing is a
return for the liability for loss from that thing (Majalla Art. 85). The maxim
asserts that the party enjoying the full benefit of an asset or object should
bear the risks of ownership. Note that linking returns to risks of ownership
does not necessarily relate to PLS contracts. The principle points out the risks
related to ownership associated with sale and leasing transactions. For
instance, the implication for a sale-based transaction is that the seller must
bear all the risks associated with the object of the sale, and in a leasing
contract, the lessor should be responsible for the asset leased out.

The second risk is the prohibited risk in the form of excessive gharar. Gharar
is usually translated as uncertainty, risk or hazard, but it also implies
ignorance, gambling, cheating and fraud. Generally, gharar relates to
ambiguity and/or ignorance, either regarding the terms of the contract or its
object. Thus, a sale can be void due to gharar: due to risks of existence and
taking, possession of the object of sale on the one hand, and uncertainty
about the quantity, quality, price or time of payment on the other. Ibn
Taymiyyah provides another perspective on forbidden gharar by equating it
to activities leading to evils and unjustified devouring of peoples wealth, as
in the case of gambling. Thus, transactions having gambling-like features are
forbidden due to excessive gharar.

The final form of risk identified by Hassan is the permissible risk that does
not fall in the above two categories. Examples of these risks can be
operational risks, liquidity risks, etc. These risks can either be accepted or
avoided.

Siddiqi discusses the approaches to risk management in financial

intermediation from an Islamic perspective. He identifies two ways of
managing risks in financing: sharing and transferring. While the tendency in
conventional finance is to transfer risks (through debt-based financing), he
asserts that the approach in Islamic finance should be risk-sharing. Thus,
modes such as musharakah and mudarabah reflect the spirit of Islamic
teachings and should be used by Islamic financial institutions (IFIS). He
maintains that selling or buying of risks associated with other peoples
businesses is akin to gambling and is prohibited in Islam.
3.0 THE IMPORTANCE OF RISK MANAGEMENT IN ISLAMIC BANKING AND
FINANCE INDUSTRY

Risk management is widely developed in the conventional financial market

frameworks. However, it is underdeveloped in the Islamic financial markets
due to limited resources, high cost and lack of technological machinations to
assess and monitor risk in time. Islamic banks face crucial challenges in
improving their risk management strategies as they are exposed to various
types of risks. Conventional risk management techniques and tools are
based on interest, gambling and speculation, which are prohibited by
Shariah. Islamic finance is sorely lacking on product breadth, depth and
sophistication. There are still only few risk hedging instruments and
techniques in Islamic finance despite its rapid growth. A number of risk
management techniques are not available due to requirements for Shariah
compliance. In particular, these are credit derivatives, swaps, derivatives for
market risk management and money market instruments (Syed Alwi, 2008).

Hence, the development of prudential regulations and systems related to risk

management, capital adequacy and corporate governance of Islamic banking
is all the more pertinent. Financial engineering is another operational
challenge for Islamic banks, which demands standardization of the process of
introducing new products in the market. An Islamic bank currently has its
own Shariah board examining and evaluating each new product, without
having coordinated efforts with other banks. This process should be
streamlined and standardized to minimize time, effort, cost and confusion.
Cross border comparison of Islamic banking performances is difficult because
the regulatory frameworks of Islamic banking jurisdictions are not
standardized and remain highly divergent, ranging from frameworks that
promote dual banking such as in Malaysia to frameworks that only
recognized Islamic banking system such as in Iran.
In Islamic banking, according to its characteristics, the initial evaluation and
approval process is a critical milestone, because the banks are only willing to
accept moderate risk. In other words, only those can take advantage of the
banking facilities that have the required banking records; those who have
relevant information on the present and future plan. In fact, what we do in
Islamic banking is evaluating the project as well as the person asking for the
loan. Project appraisal is a generic and structured term that refers to the
process of assessing. In short, project appraisal is the effort of calculating a
project's viability.

Islamic banks may have higher operational risk; greater number of contracts,
newer supporting system, evolving skill sets and lack of consistency of best
practice. Islamic banking is perceived to be more exposed to operational
risks associated with the failure of controls, procedures, information
technology systems and analytical models. Operational risk goes beyond the
mathematical models and capital adequacy; a cultural change in the
organization regarding the operational risk is needed in order to develop
sound operational risk management practices (Akkizidis and Kumar, 2008).
The issue of capital framework and liquidity standards is central to adopting
the Basel III2.

The banking institutions are required to raise minimum capital requirements

and hold a capital buffer. However, Islamic banks are exposed to operational
risk arising from compliance to Basel III requirements. Some of the principles
of risk management as proposed in Basel III can be applicable to the Islamic
financial industry with necessary modification and adaptations. Even so,
Basel III could not answer all the risk management issues for Islamic financial
institutions; hence there has been a need for alternative and supportive
standards on risk management. Nevertheless, serious and sustained efforts

2 A comprehensive set of reform measures, developed by the Basel Committee on

Banking Supervision, to strengthen the regulation, supervision and risk of the
banking sector.
are needed to find the applicability which is specific to countries and
markets.
4.0 CREDIT RISK ISSUES IN PARTNERSHIP CONTRACT THE CASE OF
MUSYARAKAH

4.1 DEFINITION OF CREDIT RISK

Credit risk is risk where the counter-party will fail to meet its obligations on
time and in accordance with the agreed terms due to volatility in default
rates and credit qualities. This risk can occur in the banking and trading
books of the bank. In the banking book, loan credit risk arises when the
counter-party fails to meet its loan obligation in a timely manner and fully in
accordance with the agreed terms. This risk is associated with the quality of
assets and the probability of default. Due to this risk, there is uncertainty of
net income and market value of equity arising from non-payment and
delayed payment of principal and interest.

Similarly, trading credit risk arises due to a borrowers inability or

unwillingness to discharge contractual obligations in trading contracts. This
can result in settlement risk where one party to a deal pays money or
delivers assets before receiving its own assets or cash, thereby, exposing it
to potential loss. Settlement risk in financial institutions particularly arises in
foreign-exchange transactions. While a part of the credit risk is diversifiable,
it cannot be eliminated completely.

Credit risk is one of the earliest recognized risks in the financial industry.
During the early eighties, a large part of a banks profit came from lending
businesses; hence. The focus was primarily on credit risk. Credit risk exists
for complete portfolio as well as individual accounts. It is important for banks
to recognized suck risks since a few large counterparty failures can lead to
serious consequences. Credit risk cannot be accurately calculated before the
event since the likelihood of default is highly uncertain and thus is difficult to
predict accurately.
Although there are developments in the calculation of credit risks, the major
difficulty remains with the availability of the data. Several standard measures
have been developed over the years to calculate the credit-worthiness of the
project and the client. Rating agencies have played a significant role in
standardizing the understanding of credit risk, although they have failed to
predict major failures. Rating agencies such as Moodys, Standard & Poors,
Fitch have developed elaborate techniques to rate projects and parties.
Ratings are based on several factors and rating by one or more of these
rating agencies is generally available to large issues or issuers.

Due to the absence of rating facilities for small customers and projects,
banks have their own in-house-developed rating standards, which are used
to rate their customers and projects. Ratings are relative measure of risk and
hence not largely useful for accurately measuring the probability of default.
The first challenge is modelling the probability of default directly with credit
risk models and the second is capturing portfolio effect in credit risk
measurement. In the case of credit risk, controls are required at credit
portfolio levels. The risk categories for credit risk include different levels and
segments of credit such that the maximum total loss in case of credit risks is
limited to the total exposure of the credit volume.

In some cases, credit risk can be related to other risks, such as market risk
and operational risk. In transaction involving cross-border trade, credit risks
cover country risks as well as political risks. Credit risk can also acquire the
dimension of concentration risk when counterparties having similar risk
profiles group together.

4.2 TYPES AND ELEMENTS OF CREDIT RISK

Credit risk is known as the potential risk attributed to delayed, deferred and
default in payments by counterparties. It covers profit-sharing contracts
(mudarabah and musharakah), receivables and lease (murabahah,
diminishing musharakah and ijarah) and working capital financing (salam,
istisna and mudarabah). The techniques used by Islamic banks to mitigate
risk are similar to conventional banks.

The importance of credit risk management becomes critical in the case of

Islamic financial institutions where lending is replaced with investments and
partnership. The Islamic banks are exposed to the risk of losing entire
invested capital in musharakah, since such capital may not be recovered as
it ranks lower than debt instruments upon liquidation (Akkizidis
andKhandelwal, 2008). A credit risk is the risk of default on a debt that may
arise from a borrower failing to make required payments.

A credit risk can be of the following types which are credit default risk,
concentration risk and country risk. Credit default risk is the risk of loss
arising from a debtor being unlikely to pay its loan obligations in full or the
debtor is more than 90 days past due on any material credit obligation;
default risk may impact all credit-sensitive transactions, including loans,
securities and derivatives.

Next, concentration risk is the risk associated with any single exposure or
group of exposures with the potential to produce large enough losses to
threaten a bank's core operations. It may arise in the form of single name
concentration or industry concentration.

Last but not least, country risk is the risk of loss arising from a sovereign
state freezing foreign currency payments (transfer/conversion risk) or when it
defaults on its obligations (sovereign risk); this type of risk is prominently
associated with the country's macroeconomic performance and its political
stability.3

3 https://en.wikipedia.org/wiki/Credit_risk
5.0 MUSHARAKAH CONTRACTS OF PARTNERSHIP AND FINANCIAL RISKS

5.1 THE FEATURES OF MUSHARAKAH

The prohibition of interest and uncertainty is driving force behind search for
innovative Shariah compliant financial avenues. Here it is only the profit
sharing ratio, not the rate of return itself that is predetermined. Muslim
entrepreneurs must avoid dealing with bank interest as they can still meet
their financing needs without compromising their religious beliefs. They can
enter into partnerships with their fellow Muslim or organizations offering
those Shariah compliant products.

Musharakah is governed by a contract signed by the two parties. The

partnership contract is wide in coverage, accurate and flexible. It extends to
include financing as well as the management of the project. The contract
shows the financial shares and management obligations, distribution of
expected profit or loss and other conditions, which govern the partnership
relations. These conditions include the conduct of the partnership operations
through a joint account opened in the name of the partnership, in which
withdrawals and deposit of sales proceeds are made according to the
contractual plan. Moreover, joint storage of raw materials subject to
partnership is also specified in the contract, and an insurance cost added to
the total cost. In the case of financial loss, the damages incurred shall be
borne by the two parties in the same way, unless it is otherwise proved to be
due to the neglect, abuse or violation of terms agreed upon by the party
undertaking the management and operation of the venture, in which case
such party shall bear the cost of all damages.

The normal principle of musharakah is that every partner has a right to take
part in its management and to work for it. However, the partners may agree
upon a condition that the management shall be carried out by one of them,
and no other partner shall work for the musharakah. But in this case the
sleeping partner shall be entitled to the profit only to the extent of his
investment, and the ratio of profit allocated to him should not exceed the
ratio of his investment, as discussed earlier. However, if all the partners
agree to work for the joint venture, each one of them shall be treated as the
agent of the other in all the matters of the business and any work done by
one of them in the normal course of business shall be deemed to be
authorized by all the partners.

Musharakah is deemed to be terminated in any one of the following events:

Every partner has a right to terminate the musharakah at any time after
giving his partner a notice to this effect, whereby the musharakah will come
to an end. In this case, if the assets of the musharakah are in cash form, all
of them will be distributed pro rata between the partners. But if the assets
are not liquidated, the partners may agree either on the liquidation of the
assets, or on their distribution or partition between the partners as they are.
If there is a dispute between the partners in this matter i.e. one partner
seeks liquidation while the other wants partition or distribution of the non-
liquid assets themselves, the latter shall be preferred, because after the
termination of musharakah, all the assets are in the joint ownership of the
partners, and a co-owner has a right to seek partition or separation, and no
one can compel him on liquidation. However, if the assets are such that they
cannot be separated or partitioned, such as machinery, then they shall be
sold and the sale proceeds shall be distributed. In case of death of any
partner musharakah contract with him stands terminated. If any one of the
partners becomes insane or otherwise becomes incapable of effecting
commercial transactions, the musharakah stands terminated.

5.2 ISLAMIC SALES CONTRACTS

Musharakah can be used to finance different business needs. It can be
adopted to finance running business needs, purchase fixed assets, livestock
faming, agriculture and any other business areas permissible under Islam.
Other examples of musharakah are structuring project financing, syndicated
financing, asset financing, working capital financing, contract financing,
trade financing and structured products based on securitization such as
Sukuk. One of the common musharakah applications in asset financing is
diminishing musharakah 4.

The musharakah contracts may take two forms; permanent musharakah5 and
diminishing musharakah. In the case where the permanent musharakah
contract is applied, the financial institution participates in the equity of the
company that is investing and receives an annual share of the profits and
losses on a pre-rated basis. During the period where the financial institution
will participate in this investment, profit and loss sharing is intended to
continue until the company is dissolve.

Financial institutions provide permanent musharakah contracts for income-

generating projects. As aforementioned, financial institutions provide capital
for a project in exchange for ownership and profit sharing in the proportion
agreed upon between the two partners. Moreover, the financial institution
may leave the responsibility of management to the partner and retain the
right of supervision and follow-ups.

When the financial agrees on diminishing musharakah contracts; its intention

is to stay in the partnership for a limited time. Its share of the equity is
progressively reduced and the partner eventually becomes the full power.
The partner generally buys the shares by payments on an installment basis.
In diminishing musharakah, home or property financing, the customer and
Islamic banking institution jointly acquire and own the property. The Islamic
banking institution then leases its share of property to the customer on the
4 A form of partnership in which one of the partners promises (wad) to buy the
equity share of the other partner gradually until the title of the equity is completely
transferred to him.

5 A form of financing for projects that require long-term equity investment.

basis of ijarah (lease). The customer, as an owner tenant, promises to
acquire periodically the Islamic banking institutions ownership in the
property. The customer pays rental to the Islamic banking institution under
ijarah, which partially contributes towards increasing their share in the
property. In other words, the portion of the payment proceeds or monthly
installments received from the customer shall be used towards the gradual
acquisition of the Islamic banking institutions share in the jointly owned
property. At the end of the ijarah (lease) term and upon payment of all lease
rentals, the customer would have acquired all the financiers shares and the
partnership will come to an end with the customer being the sole owner of
the house.

A musharakah investment occurs when an Islamic banking institution

becomes one of the shareholders in a newly set-up or an existing company.
Under musharakah investment, an Islamic banking institution may enter into
a musharakah agreement to acquire some shares from a separate legal
entity that undertake Shariah-compliant activities. Musharakah investment
may occur in the following circumstances; the Islamic banking institutions
hold equity in another entity for investment purposes; or the Islamic banking
institutions acquire a proportion of shares in another entity as a risk
mitigation to the financing facilities extended to the entity.

5.3 COMMON ISSUES IN FINANCING RELATED TO CREDIT RISK

Islamic banks cannot merely lend money to earn interest as interest is

prohibited in Islam based on Quranic injunctions. Islamic banks are obliged to
take active part in the business and opt for sharing profits as well as losses
since interest based investments and borrowings are not permitted in Islam.
Since, Islamic banks cannot charge a fixed return unrelated with their clients
operations, it may seem that Islamic banks face more risk and hence, will
have more volatile returns on their assets as they have to own the asset
before they sale or lease it to their clients and take on subject matter risk
which conventional banks do not take.

Credit, operational, market and liquidity risk exposes both permanent and
diminishing musharakah. Permanent musharakah faces operational risk in
determination of profit and loss sharing. Profit is shared related/unrelated to
capital contribution while loss sharing is precisely based on capital
contribution. When business fails to produce income, it bears credit risk. This
might interrupt payment of PLS to depositors and invite liquidity risk.

Finally, if the business cannot be continued, value of final capital faces

market risk. Diminishing musharakah exposes operational risk when
business partner fails to buy share of diminishing capital. Since expected
income cant be fulfilled, credit risk appears.

When it disturbs payment of PLS to depositors, liquidity risk comes into the
bank. At the end of diminishing musharakah, when value of total equity
investment is different with market value, banks bears market risk. To handle
both operational risk and credit risk, bank must take part in companys
management, do monitoring and insure the business.

Islamic banks usually have excess liquidity. General regulations compliance

combined with Shariah compliance result in slight intermediation inefficiency
in Islamic banks. It is partly due to the fact that most of them are new
entrants and are in the process of converting their equity base into
productive revenue generating assets. Furthermore, Islamic banks cannot
invest in highly leverage companies. They normally invest in companies
having a 60:40 capital structure. It makes their equity investments naturally
less risky.

Market risk is the most important risk that the goods will not be sold or sold
at prices which may not cover costs. This risk is merely borne by the seller
when the goods are held for trade. In musharakah, operational risk is not
taken by the bank. Destruction of property is the only risk taken which is
very remote. It is covered through insurance, the cost of which is added in
the in-transfer pricing. If the tenancy and sale contract were not made
dependent, the banks would have taken market risk which the bank avoids
by making both contracts dependent and locking the price at the outset.
Similarly, delivery risk is borne by the exporter as he does not get the
payment until he supplies goods in order.

One of the common risks in each banking system is Credit Risk. In the
recent decade, many tools and methods have been designed to manage this
risk, which one of them is Credit Derivatives. Credit derivatives method is
used by conventional bank in different methods. In the related references for
risk management, credit risk is translated as a risk in which a borrower is not
willing to pay his loan or debt according to the conditions of contract. So,
payments are paid late or not paid at all and this creates problems in
circulation of cash money. In practice, credit risk is measured by calculation
of replacement cost of cash flows in declination of customers.

Because of its broker nature, Islamic banking encounters with credit risk as
like as conventional banking. In fact, credit risk is irrevocable in banking
activities. To demonstrate credit risk in Islamic banking, we study the reasons
of creation of this risk in banking contracts. In other hands since clean
borrowing is not possible in Islamic banking, Islamic financing is asset backed
and adequately collateralized. Furthermore, title of ownership resets with the
bank in Ijara and Murabaha until the actual sale transaction is made.
Therefore, an Islamic bank can foreclose the asset in case of default.

5.4 SOLUTIONS

Islamic banking can either identify different dimensions of credit risk or

manage them by special tools. The most important methods to avoid or
decrease credit risks in Islamic banking are; bond and guarantee, default
penalty, credit scoring, loan loss reserve, credit derivatives, group loan, full
review and analysis of the applicants and full review of the project.

Bond and guarantee means that if in a loan contract or any other debt
contract, there is a condition that the debtor mortgages something or a bail
near the creditor, this condition is not forbidden even if it is expedient for the
creditor. Thus, mortgage and bail are two important tools for management of
credit risk.

Default penalty is another method to decrease their credit risks. However, if

inflation rate of a country is high, this delay has economic benefit for debtor
and default penalty will somewhat lose its effect.

Credit scoring, this method is a preventive action to decrease adverse

selection that is used by international banks and credit institutions. In fact,
some professional institutions proceed for credit scoring regarding to
financial situations and credit records of companies. Granting facilities to
those with higher ranks decreases credit risk significantly.

Loan loss reserves are amounts that banks reserve against their expectable
credit losses. When a customer will not repay his installments, the related
bank has not any problem and removes its problems by referring to that
reserve.

Credit derivatives is one of the common tools to manage credit risks by

banks is credit derivatives. These are contracts that their returns depend on
credit values of one or several companies or governments, and they are used
to manage or transfer credit risks.

In group loan, loan is granted to a group of individuals. In this case, since all
members are responsible against the project, they try to find a better project
with more suitable risk. Combination of them equalizes risk and increases
reimbursement potential.
Full review and analysis of the applicants which is prior to appraisal of the
project, it is proposed to evaluate the applicants in regards to his
qualifications such as financial status, knowledge, skills and experience,
managerial capabilities and reputation.

Full review of the project and it is strongly recommended before undertaking

any activity every entrepreneur has to first make a business plan for his
project. This needs to be a detailed analysis. It has to be a very professional
research oriented endeavor. It is suggested that one must take the help of an
expert in this. It is not only our suggestion but it is our recommendation.
Project report must be made with an objective that the appraisal of the
project and its financing becomes easy and smooth. Project appraisal is the
assessment of the project by the concerned bank in terms of its technical,
economic, financial, political, environmental, social and legal viability.
6.0 RECOMMENDATION AND THE WAY FORWARD

In Islamic banking, according to its characteristics, the initial evaluation and

approval process is a critical milestone, because the banks are only willing to
accept moderate risk. In other words, only those can take advantage of the
banking facilities that have the required banking records; those who have
relevant information on the present and future plan. In fact, what we do in
Islamic banking is evaluating the project as well as the person asking for the
loan. Project appraisal is a generic and structured term that refers to the
process of assessing. In short, project appraisal is the effort of calculating a
project's viability.

The Islamic banking institutions must identify and establish the exit
strategies, including the extension and redemptions conditions for
musharakah contracts. The strategies may include the alternative exit
routes and timing of the exits. For example, if the musharakah business
incurs losses but there is an improved business prospects for that particular
exposure8, the Islamic banking institutions may allow an extension period to
the musharakah contracts. In this case, the extension period given must be
based on the plausible ground that there will be a business turnaround,
which could result in the recovering and yielding of profits. Proper
assessments of the financial position of musharakah and mudharabah
partners and the business prospects for a turnaround need to be done to
avoid the ever-greening of financing/investments.

The Islamic banking institutions may employ guarantors to mitigate risk

exposure in musharakah contracts. This may include a third-party guarantor
to secure the return of the contributed capital in musharakah financing in the
event of fraud or negligence on the part of the customer.

The mechanism on exit strategies must be specifically and appropriately

documented in musharakah contracts. In this regard, any dissolution issues
shall be based on the pre-agreed terms and conditions by the contracting
parties upon inception of the musharakah contracts.
7.0 CONCLUSION

To mitigate various risks embedded in musharakah contracts, the Islamic

banking institutions must ensure that their valuation methodologies on profit
calculation and allocation are appropriate, consistent and mutually agreed
upon by both contracting parties at the inception of the contract. The
potential impact of their valuation methods on profit calculations and
allocations must be properly assessed, particularly with regard to the risk of
potential manipulation on the reported earnings results leading to
overstatements or understatements of musharakah earnings.

Islamic banking institutions must have in place a sound impairment

provisioning methodology that is able to detect and provide best estimates
of losses and determine prudent level of provisions for the exposures to
musharakah contracts.

Islamic finance in principle can contribute to economic development through

the same direct and indirect channels. However, because of its design
principles and emphasis on moral behavior it has the potential to avoid the
problems of disconnect between the financial and real economic sectors. A
disconnect which has resulted in financial growth without employment
growth, increased inequalities, excessive indebtedness and instability. Islam
promotes markets that are based on moral principles: seeking mutual gain
and win-win outcomes that make the two parties of trade better off. On the
other hand, Islamic finance principles of profit and loss sharing automatically
adjusts the cost of finance according to the payback capacity of the project.
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