Risks Underlying Islamic
Modes of Financing
by
Habib Ahmed
Lecture Plan
• Session 1: Introduction to Risks in
Financial Institutions
• Session 2: Risks in Islamic Financial
Instruments
• Session 3: Mitigating risks—financial
murabahah
2
Session 1
Introduction to Risks in
Financial Institutions
3
Risks—Basic Concept
•
Risk:
“existence of uncertainty about future outcomes”
“difference between expected and actual result”
•
Uncertainty classified as general and specific
–
–
4
General: ignorance of any potential outcome
Specific: when objective/subjective probabilities can
be assigned to potential outcomes—this is usually
referred to as risk.
Risks—Basic Concept
•
•
•
Risk—usually measured by the variability or
volatility of outcomes—variance or standard
deviation.
Costs involved with higher volatility—
bankruptcy
Objectives of risk management are:
–
–
–
–
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Reduce volatility
Eliminate costly lower tail outcomes
Maintain a certain risk profile
Value maximization
Classification of Risks
•
Business risks and financial risks
– Business risk relates to uncertainty arising
from the nature of firm’s business
– Financial risks relates to movements in the
financial market
•
Systematic risk and unsystematic risks
– Systematic risk is associated with overall
market
– Unsystematic risk is linked to the specific
asset or firm
6
Typical Balance Sheet of FI
Assets
Liabilities
Banking Portfolio
Deposits & Debt
Trading Portfolio
Equity
7
Nature of Risks Arising in FI
•
•
•
8
Risks related to both assets and liability
side
Risks related to the liability side
Risks on the assets side—banking
portfolio (financial instruments)
Risks faced by FIs (1)
•
Market Risks
–
–
–
–
•
Interest rate/benchmark risk
Equity price risk
Asset/Commodity price risk
Currency risk
Credit Risks
– Loan credit risk
– Trading credit (settlement) risk
– Counterparty risk
9
Risks faced by FIs (2)
•
Liquidity risk
– Funding liquidity risk
– Trading liquidity risk
•
Operational risk
–
–
–
–
10
People risk
Technology risk
Process risk
Legal and regulatory risks
A Typical Islamic Bank (IB)
•
•
Typical IB model—one-tier mudarabah with
multiple investment tools.
Liability side
–
–
•
Asset side
–
–
11
Savings and investment accounts –mudarabah
Demand deposits—qard hasan
Fixed income assets (murabahah, installment sale,
istisna, salam, and ijarah)
Variable income assets (mudarabah and
musharakah)
Unique Risks in IBs (1)
•
Contractual Nature of Deposits
•
•
•
•
Fiduciary risk—PSIA are fiduciary contracts
•
•
Lower rate of return or non-compliance with
Shari’ah can be interpreted as breach of contract –
fiduciary risk
Withdrawal Risk
•
12
PSIA—mudarabah contracts
Demand deposits—qard hasan
Need to keep risks separate
Lower returns may lead to withdrawal of deposits—
to avoid this, returns from shareholders transferred
to depositors—transfer of risks associated with
deposits to equity holders (displaced commercial
risk)
Unique Risks in IBs (2)
•
Using PSIA as capital
– Difference between restricted and
unrestricted PSIA
•
Risks in Islamic financial instruments
– As modes are asset-backed or equity based,
market risks are important along with credit
risks
– Market and credit risks intermingle and
transform from one kind to another at
different stages of transaction
13
Unique Risks in IBs (3)
•
Operational Risks
–
–
–
Person risk—lack of qualified professionals who
understand/manage risks in Islamic banking
Technology risk—computer softwares and IT for IBs
Legal risks
•
•
•
Limitations of using RM instruments
–
–
14
Standardization of contracts
Lack of statutes and enforcement institutions
Derivatives
Liquidity management instruments
Risk Perceptions-Types and
Instruments
Average Ranking
Credit Risk (CR)
3.08
Market Risk (MR)
3.24
Sale based Instruments
(CR+MR)
Equity based Instruments
(CR+MR)
2.8
15
3.55
Withdrawal Risk – Perception of
IFIs
Average
Ranking
The rate of return on deposits has to be
similar to that offered by other banks.
3.47
A low rate of return on deposits will lead to
withdrawal of funds
3.47
Depositors would hold the bank
responsible for a lower rate of return on
deposits
3.13
16
Session 2
Risks in Islamic Financial
Instruments
17
Risks in Islamic financial
instruments
•
To understand the risks in Islamic
financial instruments, we look at:
–
the risks at various stages of the
transaction: beginning, during, and at the
conclusion.
– Classify CR and MR according to:
•
•
18
possession time (spot/future)
liquidity of asset/wealth (asset/cash).
Risk classification according to
wealth type and time period
Possession time period
Wealth Type
Current/spot
Future
Cash
No risks (NR)
CR
Asset
MR
CR/MR
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Financial Murabahah
•
•
•
•
20
The financial institution buys and then
sells the good to the client at a mark-up
The bank must own and posses the good
The profit rate and other terms should be
clearly specified in the contract
The bank can ask for guarantees or
collateral
Risk Profile of Financial
Murabahah
Beginning of
transaction
Transaction
period
Conclusion of
transaction
Murabahah
(non-binding)
IFI buys good,
delivery not
ensured—MR
Price due—CR
IFI receives
cash—NR
Murabahah
(binding)
IFI buys good,
Price due—CR
delivery ensured
–NR
IFI receives
cash—NR
21
Ijarah and Ijarah wa Iqtina
•
•
•
•
•
•
22
A leasing contract involving sale of usufructs of durable
assets/goods
Ownership of the asset is not transferred to the lessee
The maintenance costs can be paid by the lessee if
included in the contract, but costs of total damage of
asset is borne by owner
A hire-purchase leasing contract—ownership is
transferred to lessee at the end of the contract period
Fiqhi objections—two contracts in one; purchase
contract cannot be binding
Banks give away the asset at nominal value or as a gift
at the end of the lease period
Risk Profile of Ijarah and Ijarah
wa Iqtina
Beginning of
transaction
Ijarah
Transaction
period
IFI buys asset— Rent due—CR
MR
Ijarah wa iqtina IFI buys asset— Rent due—CR
MR
23
Conclusion of
transaction
Asset remains
with IFI –MR
Asset
transferred—NR
Salam
•
•
•
•
•
24
A pre-production sale of goods—selling
goods in advance
Used to finance the agricultural sector
The price has to be fixed and paid when
the contract is concluded
The delivery time should be fixed
Parallel salam
Risk Profile of Salam
Beginning of
transaction
Transaction
period
Conclusion of
transaction
Salam
Necessary cash in Good due—CR
hand—NR
IFI receives
good—MR
Parallel
Salam
Necessary cash in Good due—CR
hand, and
commits to sell
good—NR
IFI receives good,
delivers good—
NR
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Istisna
•
•
•
•
26
A pre-production sale used when an item/asset
needs to be manufactured/constructed
The price of the good/asset should be known
and time of payment (can be negotiated
among the parties)
The seller of the good/asset (bank) can either
manufacture it or sub-contract it—parallel
istisna
The bank, however, liable for the delivery of
good/asset
Risk Profile of Istisna
Beginning of
transaction
Transaction
period
Conclusion of
transaction
Istisna
IFI commits to
manufacture
asset.
Cost of production—
MR
Price due—CR
IFI delivers asset,
receives cash –
NR
Parallel
Istisna
IFI commits to
manufacture
asset,
subcontracts.
Price due—CR
Seller delay in
delivery/not according
to specification—CPR
Seller delivers
asset, IFI delivers
asset, receives
cash –NR
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Mudarabah
•
•
•
•
28
A form of partnership—one party
supplies the capital (rab ul mal) other
manages (mudarib)
Profit shared among parties at an agreed
upon ratio
Financier cannot ask for a guarantee of
capital or return
Mudarabah can be restricted or
unrestricted
Musharakah
•
•
•
29
A partnership contract in which all
partners contribute capital and labor
Like a mudarahah, but all partners
manage the project
Profit shared among partners at an
agreed upon ratio
Risk Profile of Mudarabah and
Musharakah
Beginning of
transaction
Transaction
period
Conclusion of
transaction
Mudarabah
IFI invests (buys Profit
non-voting
share/return
shares)
due—CPR
Principal due:
Cash—NR
Equity—MR
Musharakah
IFI invests (buys Profit
voting shares)
share/return
due—CPR
Principal due:
Cash—NR
Equity—MR
Diminishing
Musharakah
IFI invests (buys Profit
voting shares)
share/return
due—CPR
Asset/equity
transferred—NR
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Risk Matrix of IF Instruments
Risks
MR Benchmark
Murab.
Ijarah
Salam
Istisna
X
?
X
X
MR Equity price
MR Asset/Com.
Price
X
X
X
X
MR Currency
?
?
?
?
CR Settlement
X
X
X
X
X
X
CR Counterparty
31
Mudar.
Mushar.
X
X
?
?
X
X
Session 3
Mitigating risks—financial
murabahah
32
Murabahah-basic features
1. Murabahah is a sale contract
2. The seller reveals the actual price of the
asset/good being sold and indicates the
profit in lump-sum or as a percentage
3. Delivery of the asset/good is spot,
payment can be spot or deferred
4. Bai-muajjal is a sale with spot delivery
and deferred payment
33
Murabahah as Financing Mode
•
•
34
As financial intermediaries, banks use
murabahah as financing mode (Purchase
order murabahah or financial
murabahah)
Financial murabahah is a combination of
contracts
Financial Murabahah
Financial murabahah has the following
elements:
1. Promise Agreement: The bank and the
client signs and overall agreement of the
promise to buy/sell
2. Agency Agreement: The bank appoints
the client as an agent to purchase the
good/asset
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Financial Murabahah (contd.)
3. Purchase of the Good from the Supplier:
The client buys the good and takes
possession as a agent
4. Offer of Purchase: The client offers to buy
the good from the bank
5. Acceptance of the Offer: The ownership of
the good transferred from the bank to the
client
6. Debt created: Payment due at future
date(s)
36
Points to note
•
The commodity cannot be bought from
the client
If the bank purchases, the agency
contract not needed
•
•
•
37
In such cases, two separate contracts (for
supplier and buyer) and the purchase has to
be before sale
Bills of trade resulting from transaction
can be transferred at face-value only
Risks in Financial Murabahah
•
Pre-Sale Risks
– Loss/damage of the good before delivery
– Refusal of the buyer to take delivery
– Market (price) risk
•
Post Sale Risks
– Latent defects in goods
– Settlement (credit) risk
– Market (benchmark) risk
38
Pre-Sale Risks Mitigation
1. Loss/Damage of good before delivery:
– Before delivery, the good is bank’s
responsibility
•
Risks mitigated by:
– Minimize the period of holding (time
between purchase and sale)
– If time is long—insurance can be bought
39
Pre-Sale Risks Mitigation
2. Refusal of the Buyer to take Delivery: The
bank is left with the good
• Risks minimized by:
– The bank purchases the good with a right to
return it within a specified time
– The bank sells the good and client pays the
difference between cost and sale price
40
Example of Clause in the Agreements
“If, for any reason whatsoever, the agent shall refuse or fail
to take delivery of the Equipment or any part thereof or
shall refuse or fail to conclude the Sale Agreement, the
Bank shall have the right to take delivery, or cause
delivery to be taken, of the Equipment and shall have the
right to sell, or cause the sale of, the Equipment (but
without obligation on its part to do so) in a manner
determined by it at its sole discretion and shall have the
right to take whatever steps it deems necessary to
recover the difference between the price realized upon
sale and the price paid by the Bank plus any other
expenses incurred by it in relation to the Equipment.”
41
Pre-Sale Risks Mitigation
3. Market (price) risk: Risk of changes in
price prior to delivery of good to client
• Risks mitigated by:
– Minimizing the holding time by selling
immediately after buying
42
Post-Sale Risks Mitigation
1. Latent Defects in Goods: It is possible
that the good supplied by the supplier is
defective.
• Risks minimized by transferring the
liability to the vendor/supplier (through
warranty)
43
Example of Clause in the Agreements
“If a latent defect is discovered in the Equipment, the
Vendor undertakes to assign to the Purchaser, the
benefit of any guarantee, condition or warranty relating
to the Equipment which may have been given to the
Vendor by the Supplier and which has been examined
and accepted by the Purchaser and all other warranties
or guarantees as may be implied by law or recognized
by custom in favour of the Vendor. In addition to the
assignment to the Purchaser as herein indicated, the
Vendor shall take such other action as the Purchaser
shall reasonably request to enable the Purchaser to
claim against the Supplier”
44
Post-Sale Risks Mitigation
2. Settlement (credit) Risk: The risk that the
client will not pay his/her dues on time or
default
• Risk minimized by:
– The bank can ask for a guarantee (sign a
guarantee agreement)
– Ask for a security or collateral—can sell the
collateral if debtor defaults
– Impose penalty for delinquency problem
45
Example of Clause in the Agreements
"The client hereby undertakes that if he defaults
in payment of any of his dues under this
agreement, he shall pay to the charitable
account/fund maintained by the bank a sum
calculated on the basis of ---percent per annum
for each day of default unless he establishes
thorough evidence satisfactory to the bank that
his non-payment at the due date was caused
due to poverty or some other factors beyond his
control"
46
Post-Sale Risks Mitigation
3. Market (benchmark rate) risk: The risk
that the returns of the bank will be
affected if the benchmark rate changes
• Risks minimized by:
– The contracts are usually of short-run
duration
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Conclusion
• Risks in Islamic financial instruments are
complex and change and evolve during the
transaction
• It is important to know the underlying features of
the contracts and risks arising in different modes
of financing
• Risk management would require knowledge of
Islamic contracts and also the appropriate skills
to mitigate risks arising in them
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THANK YOU!
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