Risk profile of Islamic

banks
Claudio Porzio & M. Grazia Starita
University of Naples “Parthenope”

1
Agenda
 A taxonomy of Islamic contracts
 Islamic bank contracts: their typical risk
profile
 Liabilities
 Assets
 Murabaha
 Salam
 Ijara
 Istisna
 Mudaraba
 Musharaka
 Risk profile of Islamic banks
 Conclusions

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A taxonomy of Islamic
contracts
Liability side: short-term (liquidity management) and long-term
(investment) funding; banking book mobilisation (ijara, especially).
Asset side: contracts with or without Profit and Loss Sharing (P&LS)
P&LS contracts can be subdivided according to the different needs
(financial, insurance and asset management) satisfied.
No P&LS contracts allow short and long term financing.
Asset finance requires the lender to purchase the asset and to sell it on
to the borrower at a higher price with instalment payments.
Partnership finance requires the lender to participate in the equity of
the transaction.
Lease finance involves the lender acquiring the asset, leasing it to the
borrower in exchange for rental payments.

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A taxonomy of Islamic
contracts
Liability side Funding

Liquidity Securitisation
Investment
management

Islamic
Demand funds Sukuk
deposits (mudarab
a)
Outside the
Investment
conventional
accounts
bank’s boundary

4
A taxonomy of Islamic
contracts
Asset side
P&LS contracts

Financial Asset
Insurance management
needs

Musharak Islamic
Takaful fund
a

Partnership
Mudarab finance
a

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A taxonomy of Islamic
contracts
Asset side
No P&LS contracts

Short-term financing Long-term financing

Murabaha Lease Ijara

finance
Asset finance

Asset
Salam Istisna
finance

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A taxonomy of Islamic
contracts
Salam Householders lending
The parallel with “conventional”
Murabaha Mortgage with bank’s ownership
finance (in the first step of contract)

Ijara Renting / Leasing Asset side

Istisna Sale of real estate under contruction
Musharaka Joint venture / investment deposits

Mudaraba Limited partnership / Investment accounts

Liability side
Mudaraba Mutual funds / bank’s performance bonds
Qardh Demand deposits 11(current accounts)
Other
hasan
Takaful Insurance contract 7

Asset Backed Securities

 Islamic bank contracts -
Liabilities
Losses’ + PS
absorption Investment Equity
accounts
(unrestricted
)
- PS Demand
Investment deposits
Having both debt and accounts (non interest
equity features, are (restricted) bearing)
PSIAs to be accounted
for as off-balance- - +
sheet ?
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Islamic bank contracts -
Liabilities
There is a commercial pressures on Islamic banks to offer market-based returns and
repay in full on due date to ensure PSIAs continue to be funded (displaced
commercial risk).
 What is the boundary between shareholders’ claims and investment account
holders’ claims? What happens in a liquidation scenario?
 What relationship between control rights and cash flow rights?

PSIAs holders’ cash Shareholders’ claims

flow rights
 Dividend (after PER’s
 Return in line with depreciation and
market interest rates IRR’s depreciation)
(after PER’s
depreciation against the  Control rights
displaced commercial
9
risk)
 Islamic bank contracts -
Liabilities
 Profit smoothing Profit Equalization Reserve
(PER)
 Unexpected loss against displaced commercial
risk Investment Risk Reserve (IRR)
 Capital adequacy? Is a different approach to its
calculation and accounting standards necessary?
Capital ratio in case of profit
smoothing
eligible capital
capital ratio =
where: total RWA + OR - RWA PSIA r - (1 - α ) RWA PSIA unr - α RWA PERIRRPSIA unr
RWA = Risk Weighted Assets OR = Operational Risk
RWA PSIAr = RWA funded by Restricted PSIAs RWA PSIAunr = RiWA funded by
Unrestricted PSIAs
RWA PERIRRPSIAunr = Risk Weighted Assets funded by Profit Equalisation
Reserve and Investment Risk Reserve of Unrestricted Profit Sharing Investment
Accounts
α = percentage of assets financed with PSIAunr
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Islamic bank contracts -
Murabaha Short-term financing
Murabaha (purchase and resale) involves three parties:
the purchaser/importer, the seller/exporter, the bank. The last
provides finance by purchasing the desired commodity and
reselling it to the purchaser at a prefixed higher price (mark-
up) payable in installments.
The key risk is that the bank must have title to the goods at
some point in the transaction. The main risk drivers are linked
to:
the contract structure: with or without customer’s promise to pay;
with or without customer’s appointment ;
the enforcement of customer’s promise;

The mitigation techniques (collateral or deposit).

Compare with the IFSB’s requirement 11

Islamic bank contracts -
Murabaha
Counterparty + with customer’s without
monitoring appointment customer’s
and instalment promise
payment
(“revolving”
murabaha)

- with customer’s with

appointment customer’s
Credit promise
risk
risk due to
the - +
existing
implicit Marketof the underlying market
Knowledge
option to risk
buy
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Islamic bank contracts -
Salam
Short-term financing

Salam (purchase and resale) involves two parties: the

bank as purchaser and his borrower as seller. It is an
agreement to purchase, at a prefixed price, a specific
kind of commodity not available with the seller. The
commodity will be delivered on a specified future date.
The risk profile of Salam depends on:

performance
counterpart
bank’s role;

risk
the presence of parallel contract (parallel salam);

the standardization of the underlying asset.

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Islamic bank contracts - Jiara
Long-term financing
Ijara (leasing): due to the asset-backed nature of the operation,
the bank retains ownership of the asset until maturity, helping to
reduce the credit risk of the counterparty. The bank shares in the risk
through its responsibility for maintenance and insurance.
The main risk drivers are:
the customer’s appointment,
the sale of underlying asset at the end of the contract (the
customer’s promise to buy the underlying asset);
the mitigation instruments (collateral or takaful contract).

Compare with the IFSB’s requirement 14

Islamic bank contracts - Jiara

Counterparty+ with without

monitoring customer’s customer’s
appointment promise to buy
and promise the underlying
to buy the asset
underlying asset

Credit
risk - with without
The full customer’s customer’s
collateral can appointment appointment
mislead in
creditworthin - +
ess Market
assessment Knowledge
risk of the underlying asset
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Islamic bank contracts -
Istisna
Long-term financing

Istisna: the bank finances work in progress or

construction of a building or an installation and then
sells it to the customer; it is payable in instalments.
The main risk drivers are linked to:
the type of contract: customer’s (full

version)/underlying asset’s cash flows (limited

performance
counterpart
version);

risk
the presence of parallel contract (parallel istisna):

the underlying business risk.

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Islamic bank contracts -
Mudaraba
Partnership financing

Mudaraba (PL&LS agreement): a contract

between a bank (acting as a silent partner) and one
or more entrepreneurs (the bank and the depositor
in case of PSAs): The bank provides the
entrepreneur with the funding for a specific
commercial activity. The entrepreneur does not
contribute any funding himself, but contributes
management expertise. The entrepreneur earns an
agreed portion of the profits (‘management fee’).
The profit balance is payable to the bank.
The default event is indefinite and collaterals (or
guarantees) are not allowed
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Islamic bank contracts -
Mudaraba
Bank pay off in tipycal mudaraba

Firm’s cash flow

Bank’s pay-off

In the example, if the firm’s cash flow is positive the bank’s

participation is 50%
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Islamic bank contracts -
Mudaraba
Bank pay off in mudaraba with
maximum profit

Prefixed
level

Strike Firm’s cash

flow

Bank’s pay-off
According to several Islamic schools it is possible to
determine a prefixed level of bank’s partecipation on
firm’s cash flow against the moral hazard of the
counterpart.
It’s similar to pay-off’s put option (short position) 19
Islamic bank contracts -
Musharaka Partnership financing
Musharaka: partnership between a bank and an
entrepreneur: both contributing capital to a project and
sharing in its risks and its rewards. A formal contract is
normally in place, outlining the obligations and rights of
both parties: profits can be allocated in any pre-agreed
ratio, and losses are borne in proportion to the capital of
each partner.
The risk profile of musharaka depends on: It is the
the underlying asset;
purest
the goal of contract such as the link with
Islamic
other contracts (diminishing musharaka
for householders, for example).
contract
thanks to the
sharing of 20
Islamic bank contracts – Risk
unbundling
Contract / Risk Credit Market Liquidity Operation
al
Salam
Murabaha
Ijara
Istisna
Musharaka
Mudaraba
hign Market and credit risks are more ntensely
interdependent and connected
mediu
m Relevant market risks are strictly
low connected to liquidity risks

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Islamic bank contracts - Asset
and Typical
liability
Islamic bank’s balance-sheet
Murabaha Demand deposits
Salam (qardh hasan)
Ijara Investment accounts
Istisna (mudaraba)
Mudaraba Islamic funds
Musharaka (mudaraba)

 No P&LS contracts with high

operational risk
 P&LS contracts inside the
 Losses’ absorption
commercial bank’s boundary of investment
deposits
 Mudaraba on both asset and liability sides

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Risk profile of Islamic banks
Even though Islamic scholars consider mudaraba and musharaka as
preferable Sharia-compliant financing vehicles, Islamic banks
concentrate on selling the lucrative murabaha markup financing.
The most common activities (trade and commodity finance, leasing,
fund/asset management, etc) of dedicated Islamic banks are essentially
no different to similar activities practised by many conventional banks.
However
Certain risks are of greater significance compared to

conventional banks.
Creditworthiness, solvency and profitability are influenced by

their unique characteristics.

Higher profitability, cheaper and more stable deposits, and higher

customer loyalty than for conventional peers tend to be offset by

weaker liquidity; greater concentration; and more heterogeneous and
less rigorous regulatory, accounting and disclosure frameworks.

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Risk profile of Islamic banks
Credit risk peculiarities
 Transformation of credit in risk into market risk and viceversa
 A different bundling of credit and market risks between the bank and
its financed customer.
 As collateral levels are typically higher than in conventional banks, a
significant part of assets must be converted to real assets over a
certain period of time.
 The legal environment is crucial for allowing an efficient loan recovery.
 Many products tend to carry higher asset and operational risk.
 Musharaka and mudaraba expose to heightened asset risk and
potentially limits the bank’s ability to foreclose on loans and recover
bad debts. They carry a fair amount of potential risks, as recognition
of impaired transactions can be assessed only at the end of a
contract.
 Overall, may be difficult to judge an Islamic bank's asset portfolio risk.

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Risk profile of Islamic banks
Credit risk management
 The credit risk management functioning of an Islamic bank is
essentially no different from that of a conventional bank even
if some aspects are key: loan sanctioning process, loan book
concentrations, loan impairment, collateral valuations and risk
appetite.
 A higher transparency and a clear distinction between the risk

management and the Shari’ah board are required. This board

provides guidance and supervision in the development of
Shari’ah-compliant products to ensure that they meet the
requirements of Islamic law. A Shari’ah board should not
involve itself with the actual granting of credit, as it is doubtful
whether scholars are sufficiently skilled in credit analysis.

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Risk profile of Islamic banks
Performance risk
Returns achieved in Islamic banking seem to be high and have
attracted the attention of conventional banks. This is due to:
 the benign operating environment that Islamic banks, mainly those based in
oil-producing countries, have benefited from;
 the asset quality remained healthy;

 the margins on some products tend to be high partly reflecting the lack of

pricing transparency but also limited competition (at least until now);
 as much of an Islamic bank’s funding comes from interest-free customer

deposits, its cost of funding is typically lower than that of a commercial bank.
This, in turn, boosts its ‘net profit’ margin and ‘net profit from financing
activities’ line although it leaves income vulnerable to falling asset yields.

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Risk profile of Islamic banks
Governance and compliance
 Governance structures are quite peculiar because the
institution must obey a different set of rules - those of the
Holy Qur'an - and meet the expectations of Muslim
community by providing Islamically-acceptable financing
modes.
 Many different interpretations of Sharia law can exist at
bank and country level. Although this has hampered
product standardisation, the resulting lack of product
comparability and pricing transparency has helped to
benefit margins. smoother throughout the cycle, as IFIs
do not pay fixed interest on debt and because they
engage in profit-and-loss

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Conclusions - The concerns for
supervisors
Market risk: the specific dynamics of
underlying market of asset-based
contracts (no P&LS contracts) can create
several concerns to the banks in case of
unexpected price shocks or liquidity crisis
Credit risk: the moral value of
borrower’s promise and the
enforcement’s mechanisms of this
promise imply different standards of
credit screening and monitoring
Operational risk: the endogenous
factors of operative risk are under control
thanks to the Sharia “deterrent”
Conclusions - The concerns for
supervisors
 The regulation of Islamic banks in Europe
implies several issues (as above
mentioned) but what is the degree of
growth in Europe?
 What is the real concern of European

supervisors? Is the framework of the

existing regulation, adequate for Islamic
Islamic banks operating in Europe (Islamic Bank of
banks?
Britain, for example) have a simple business,
mainly retail. In particular, on the asset side they
don’t use the P&LS contracts while on the liability
side the degree of freedom in managing PSIAs is
limited.
Conclusions - The concerns for
supervisors
Any regulatory framework has to:
 recognise the special features of Islamic finance and, in case, find
appropriate responses to them rather than simply applying solutions
already devised for traditional banks
 offer those who use Islamic finance the same degree of protection
offered to those who use non Islamic finance.

Principles applied (adequate resources, corporate governance, reliable

control systems, transparency) are general and cannot be modified.
Specific issues relating to Islamic finance (the special position of the
Sharia Board, bank’s and customers’ rights under a contract of
mudaraba), accounting, …) may require specific solutions. In this case, it
is necessary to adjust the domestic fiscal and legal framework to render
it friendlier to the development of Islamic banking (and finance).
Conclusions - The concerns for
Italy
Are there specific problems of compatibility with the existing Italian
regulation?
In addition to products offered, typical risks, investors and depositors protection,
the assessment of corporate governance is crucial.
In fact, in any case:
the authorities cannot give any guarantee as to the Sharia compliance of products
offered;
the role and responsibilities of the Sharia Board vis a vis top management and
shareholders are completely delegated to the bank and its management.
However, some reflections are necessary about the composition of the Board
and its relationships with other stakeholders bank. Although formally
independent and separate, the effective influence on management depends on
the nature of their relationship with the bank which may take different forms.9