Financing Risk in Islamic Banking Risk Management in Islamic Banking Review & Definition Fin a n c in g R is k in Is l a m ic B a n k in g Financing Risk Review & definition ★ Risk that emerges because of the failure of the customer or other parties ★ to fulfill their liabilities to the Islamic bank according to what is already contracted This failure in payment/default can be caused by two things: ○ ○ the inability to pay the unwillingness to pay ○ ○ ○ ○ ○ default risk credit risk rating downgrade risk contract completion risk counterparty risk ★ Also called Prof. Md Mohan Uddin, PhD LinkedIn | Google Scholar | ResearchGate | ORCiD Wahyudi, I., Rosmanita, F., Prasetyo, M. B., & Putri, N. I. (2015). Risk management for Islamic banks: Recent developments from Asia and the Middle East. John Wiley & Sons. Role of Islamic Banking & Financing Risk Fin a n c in g R is k in Is l a m ic B a n k in g Review & definition ★ Islamic banks mobilize fund ○ excess funds from the savers to deficit investors ○ ○ ○ ○ ○ safekeeping agency debt partnership time deposit ★ Various contracts with the savers include Prof. Md Mohan Uddin, PhD LinkedIn | Google Scholar | ResearchGate | ORCiD Wahyudi, I., Rosmanita, F., Prasetyo, M. B., & Putri, N. I. (2015). Risk management for Islamic banks: Recent developments from Asia and the Middle East. John Wiley & Sons. Role of Islamic Banking & Financing Risk Fin a n c in g R is k in Is l a m ic B a n k in g Review & definition ★ Various contracts with the deficit investors include ○ debt-based ○ partnership Prof. Md Mohan Uddin, PhD ■ ■ pure debt exchange activities ■ ■ ■ mudarabah musyarakah other LinkedIn | Google Scholar | ResearchGate | ORCiD Wahyudi, I., Rosmanita, F., Prasetyo, M. B., & Putri, N. I. (2015). Risk management for Islamic banks: Recent developments from Asia and the Middle East. John Wiley & Sons. Sources & Scope Sources of Risk in the Financing Process Fin a n c in g R is k in Is l a m ic B a n k in g Sources & scope ★ Five problems in the business process may lead to financing risk ○ ○ ○ ○ ○ uncertainty of market conditions uncertainty related to the selling price of a guarantee or collateral issue of the credibility of the information provided by the debtor problem of granularity caused by the myriad of debtors financed inability to differentiate between ability and willingness to pay Prof. Md Mohan Uddin, PhD LinkedIn | Google Scholar | ResearchGate | ORCiD Wahyudi, I., Rosmanita, F., Prasetyo, M. B., & Putri, N. I. (2015). Risk management for Islamic banks: Recent developments from Asia and the Middle East. John Wiley & Sons. Fin a n c in g R is k in Is l a m ic B a n k in g Tools of Financing Risk Management Sources & scope ★ ★ ★ ★ ★ Debtor selection Terms setting Collateral Third party guarantee Monitoring Prof. Md Mohan Uddin, PhD LinkedIn | Google Scholar | ResearchGate | ORCiD Wahyudi, I., Rosmanita, F., Prasetyo, M. B., & Putri, N. I. (2015). Risk management for Islamic banks: Recent developments from Asia and the Middle East. John Wiley & Sons. Models for Measuring Financing Risk Fin a n c in g R is k in Is l a m ic B a n k in g Qualitative Models Models for measuring financing risk ★ More useful when public information is not available ★ Information from private sources might be used ○ ○ ○ Credit file/ deposit file Purchase information Credit Information Bureau (CIB) ★ Subjective judgement about the probability of default based on key factors with appropriate weights ○ ○ Prof. Md Mohan Uddin, PhD Borrower specific factors Market/economy specific factors LinkedIn | Google Scholar | ResearchGate | ORCiD Saunders, A., & Cornett, M. (2017). Financial institutions management: A risk management approach (9th ed.). McGraw-Hill Education. Fin a n c in g R is k in Is l a m ic B a n k in g Qualitative Models Models for measuring financing risk ★ Borrower specific factors ○ Reputation ○ Volatility ○ Collateral ○ Leverage Prof. Md Mohan Uddin, PhD ■ ■ ■ ■ LinkedIn | Google Scholar | ResearchGate | ORCiD borrowing -lending history Variability of business situation/earning/cash flow Value and marketability of collateral Existing financial obligations Saunders, A., & Cornett, M. (2017). Financial institutions management: A risk management approach (9th ed.). McGraw-Hill Education. Fin a n c in g R is k in Is l a m ic B a n k in g Qualitative Models Models for measuring financing risk ★ Market/economy specific factors ○ The business cycle ○ The level of interest rates Prof. Md Mohan Uddin, PhD ■ ■ ■ ■ LinkedIn | Google Scholar | ResearchGate | ORCiD Recession - luxury or durable goods perform worse Financing to such industry should be limited in a recessionary phase Explore upcoming business cycle of Bangladesh and it’s implication in financing risk management Restrictive monetary policy → higher interest rate ● ● ● → funds are scarce and expensive for banks → debtors take excessive risks → riskier debtors are more in number Saunders, A., & Cornett, M. (2017). Financial institutions management: A risk management approach (9th ed.). McGraw-Hill Education. Fin a n c in g R is k in Is l a m ic B a n k in g Quantitative Models Models for measuring financing risk ★ Credit scoring models ○ ○ Linear probability and logit models* Linear discriminant analysis* ★ Newer models ○ ○ ○ ○ Prof. Md Mohan Uddin, PhD Mortality rate models RAROC models Term structure of credit risk/ reduced-form models Option model/ structural models LinkedIn | Google Scholar | ResearchGate | ORCiD Saunders, A., & Cornett, M. (2017). Financial institutions management: A risk management approach (9th ed.). McGraw-Hill Education. Fin a n c in g R is k in Is l a m ic B a n k in g Quantitative Models - Credit Scoring Models for measuring financing risk ★ Credit scoring are the mathematical models that use observed financing applicant’s characteristics to ○ ○ calculate a score representing the applicant’s probability of default sort borrowers into different default risk classes ★ Benefit: more accuracy Prof. Md Mohan Uddin, PhD LinkedIn | Google Scholar | ResearchGate | ORCiD Saunders, A., & Cornett, M. (2017). Financial institutions management: A risk management approach (9th ed.). McGraw-Hill Education. Fin a n c in g R is k in Is l a m ic B a n k in g Quantitative Models - Credit Scoring Models for measuring financing risk ★ Overall steps ○ identify objective economic and financial characteristics of debtor ○ Assign weights based on the relative degree of importance of these characteristics Collect data related to the identified characteristics Apply statistical techniques ○ ○ Prof. Md Mohan Uddin, PhD ■ ■ LinkedIn | Google Scholar | ResearchGate | ORCiD Consumer financing: income, assets, age, occupation, location, etc. Commercial financing: cash flow, financial ratios, etc. Saunders, A., & Cornett, M. (2017). Financial institutions management: A risk management approach (9th ed.). McGraw-Hill Education. Fin a n c in g R is k in Is l a m ic B a n k in g Quantitative Models - Credit Scoring Models for measuring financing risk ★ Linear Probability Model and Logit Model ○ past data of important j number of important characteristic variables are used as inputs (Xij) for i- number of old customers into a model to explain repayment experience (PDi) ○ divide old loans into two observational groups: ○ linear regression is used to estimate the importance (βj) of the j-th variable: Prof. Md Mohan Uddin, PhD ■ ■ LinkedIn | Google Scholar | ResearchGate | ORCiD those that defaulted (PDi = 1) and those that did not default (PDi = 0) Saunders, A., & Cornett, M. (2017). Financial institutions management: A risk management approach (9th ed.). McGraw-Hill Education. Fin a n c in g R is k in Is l a m ic B a n k in g Quantitative Models - Credit Scoring Models for measuring financing risk ★ Linear Probability Model and Logit Model ○ ○ ○ take these estimated βj-s multiply them by the observed Xij for a prospective borrower derive an expected value of PDi, E(PDi), for the prospective borrower ★ Major weakness: E(PDi) can often lie outside the interval 0 to 1 ★ Logit model overcomes the weakness ○ Prof. Md Mohan Uddin, PhD plug the E(PDi) into the following formula, where e is exponential (equal to 2.718) and F(PDi) is the logistically transformed value of E(PDi): LinkedIn | Google Scholar | ResearchGate | ORCiD Saunders, A., & Cornett, M. (2017). Financial institutions management: A risk management approach (9th ed.). McGraw-Hill Education. Fin a n c in g R is k in Is l a m ic B a n k in g Quantitative Models - Credit Scoring Models for measuring financing risk ★ Linear Probability Model and Logit Model Prof. Md Mohan Uddin, PhD LinkedIn | Google Scholar | ResearchGate | ORCiD Saunders, A., & Cornett, M. (2017). Financial institutions management: A risk management approach (9th ed.). McGraw-Hill Education. Fin a n c in g R is k in Is l a m ic B a n k in g Quantitative Models - Credit Scoring Models for measuring financing risk ★ Linear Probability Model and Logit Model Prof. Md Mohan Uddin, PhD LinkedIn | Google Scholar | ResearchGate | ORCiD Saunders, A., & Cornett, M. (2017). Financial institutions management: A risk management approach (9th ed.). McGraw-Hill Education. Fin a n c in g R is k in Is l a m ic B a n k in g Quantitative Models - Credit Scoring Models for measuring financing risk ★ Linear Discriminant Models ○ divide debtors into high or low default risk classes contingent on their observed characteristics (Xj) ○ also, use past data as inputs into a model ○ forecasts whether the debtor falls into the high or low default class ○ E. I. Altman developed the famous discriminant analysis model, Prof. Md Mohan Uddin, PhD ■ ■ ■ LinkedIn | Google Scholar | ResearchGate | ORCiD called Altman Z-score model, for publicly traded manufacturing firms in the United States, where the Z-score is a default indicator, not a direct probability of default measure Saunders, A., & Cornett, M. (2017). Financial institutions management: A risk management approach (9th ed.). McGraw-Hill Education. Fin a n c in g R is k in Is l a m ic B a n k in g Quantitative Models - Credit Scoring Models for measuring financing risk ★ Linear Discriminant Models ○ Altman’s discriminant function (credit-classification model), or Altman Z-score model takes the form: ○ According to Altman’s credit scoring model, any firm with z-score Prof. Md Mohan Uddin, PhD ■ ■ ■ LinkedIn | Google Scholar | ResearchGate | ORCiD less than 1.81 → a high default risk firm between 1.81 and 2.99 → an indeterminant default risk firm greater than 2.99 → a low default risk firm Saunders, A., & Cornett, M. (2017). Financial institutions management: A risk management approach (9th ed.). McGraw-Hill Education. Fin a n c in g R is k in Is l a m ic B a n k in g Quantitative Models - Credit Scoring Models for measuring financing risk ★ Linear Discriminant Models ○ Prof. Md Mohan Uddin, PhD Altman Z-score LinkedIn | Google Scholar | ResearchGate | ORCiD Saunders, A., & Cornett, M. (2017). Financial institutions management: A risk management approach (9th ed.). McGraw-Hill Education. Fin a n c in g R is k in Is l a m ic B a n k in g Quantitative Models - Credit Scoring Models for measuring financing risk ★ Linear Discriminant Models ○ Prof. Md Mohan Uddin, PhD Limitations: ■ discriminate only between two extreme cases of borrower behavior: ■ very sensitive to the weights for the different variables ■ ignore important, hard-to-quantify factors having crucial role in the default or no default decision LinkedIn | Google Scholar | ResearchGate | ORCiD ● no default and default Saunders, A., & Cornett, M. (2017). Financial institutions management: A risk management approach (9th ed.). McGraw-Hill Education. Risk Management of Various Financing Contracts Fin a n c in g R is k in Is l a m ic B a n k in g Murabahah Transactions Risk management of various financing contracts ★ Bank delivers the asset to the client but does not receive payment from the client in time ★ In case of a nonbinding murabahah, where the client has the right to refuse delivery of the product purchased by the bank, the bank is further exposed to price and market risks Prof. Md Mohan Uddin, PhD LinkedIn | Google Scholar | ResearchGate | ORCiD Greuning, H. V., & Iqbal, Z. (2008). Risk analysis for Islamic banks. World Bank Publications. Fin a n c in g R is k in Is l a m ic B a n k in g Bay’ Al-Salaam or Istisnah Contracts Risk management of various financing contracts ★ the bank is exposed to the risk of failure ○ to supply on time, ○ to supply at all, or ○ to supply the quality of goods as contractually specified ★ Such failure could result ○ in a delay or default in payment, or ○ in delivery of the product, and ○ can expose Islamic banks to financial losses of income & capital. Prof. Md Mohan Uddin, PhD LinkedIn | Google Scholar | ResearchGate | ORCiD Greuning, H. V., & Iqbal, Z. (2008). Risk analysis for Islamic banks. World Bank Publications. Fin a n c in g R is k in Is l a m ic B a n k in g Mudarabah investments Risk management of various financing contracts ★ Islamic bank enters into the mudarabah contract as rab al-mal (principal) with an external mudarib (agent) ★ Enhanced credit risk on the amounts advanced to the mudarib ★ Bank may not have appropriate rights to monitor the mudarib or to participate in management of the project ○ makes it difficult to assess and manage credit risk ★ This risk is especially present in markets where information asymmetry is high and transparency by the mudarib is low Prof. Md Mohan Uddin, PhD LinkedIn | Google Scholar | ResearchGate | ORCiD Greuning, H. V., & Iqbal, Z. (2008). Risk analysis for Islamic banks. World Bank Publications.
