market efficiency and systemic stability in global islamic finance: challenges of asymmetric...

Market Efficiency and Systemic Stability in Global Islamic Finance: Challenges of Asymmetric

Information and Instrumental Deficits

Presented at theUniversity of Malaya

Graduate School of Business7 June 2011

Kuala Lumpur

Prof. Dr. Volker Nienhaus

Source: Kross 2009, p. 251.

Structure of Basel II

Risks and Banks

finance for the real economy

productiveresources

• mobilisation• employment• allocation

efficient markets: risk reflected in returns to financier

• credit risk• operational risk• liquidity risk

additional risk dimensions for Islamic banks

banks assume and manage risks

entrepreneurialrisks

• mitigation• dispersion• absorption

conventional risks,Basel II + III

major issuefor IFSB 1

2

risk in thefinancial sector

(price volatility of financial assets)

risks in price bubbles(of real assets)

Credit Risk Related to

Definition: potential that a counterparty fails to meet its obligations in accordance with agreed terms

murabahah accounts receivable

salam counterparty risk (e.g. breach of contract)

istisna’ accounts receivable, counterparty risk

ijarah, sukuk held to maturity lease payments receivable

musharahah, mudarabah equity investment risk (capital impairment)

factors relevant for the assignment of risk weights:• external credit assessment (rating) of debtor, counterparty, obligor, security• credit risk mitigation techniques• type of underlying assets• specific provisions for overdue accounts receivable or lease payments receivableCredit Risk Mitigation (CRM) Techniques:• hamish jiddiyyah (security deposit held as collateral)• ‘urbun (earnest money)• guarantee from third party• pledge of asset as collateral• repossession of leased assetsTypes of collateral for CRM: hamish jiddiyyah, ‘urbun, profit sharing investment accounts, cash on deposit, sukuk (rated/unrated), equities and units in collective investment schemes, third party guarantees (by sovereigns, banks, corporate entities), assets pledged as collateral

Risks in Islamic Instruments (1 of 3)

Market Risk Related to

risk of losses in on- and off-balance sheet positions arising from movements in market prices, i.e. fluctuations in current and future values of tradable, marketable or leaseable assets (including sukūk)

equity position in the trading book, sukuk held for trading

foreign exchange positions (incl. gold, silver)murabahah: commodities and inventory (long positions)[incl. precious metals but excl. gold and silver]ijarah: early termination of lease (by defaulting)salam: commodity price fluctuation

Operational Risk Types of Operational Risk

risk of losses resulting from inadequate or failed internal processes, people and systems or from external events

- general- Shari’ah non-compliance risk (= failure to comply with

the Shari’ah rules and principles ), can lead to non-recognition of income and resultant losses

- legal riskDisplaced Commercial Risk Related to

commercial pressure to increase the return that would otherwise be payable to investment account holders (IAH)

competition among financial institutions (Islamic and conventional): better rates of return could induce heavy withdrawals, therefore PER, IRR and smoothening of returns for IAH at the expense of shareholders


Equity Investment Risk Related to

risk arising from entering into a partnership in which the provider of finance shares in the business risk (capital impairment risk)

- quality and risk profile of partner (mudarib or musharkah partner)

- underlying business activities- ongoing operational matters- legal and regulatory environment

Liquidity Risk Related to

potential loss to IIFS arising from their inability either to meet their obligations or to fund increases in assets as they fall due without incurring unacceptable costs or losses

- withdrawals from current accounts- withdrawals from investment accounts (esp. as

result of poor performance [ rate of return risk, displaced commercial risk], concerns about financial condition of bank, Shari’ah non-compliance [ Shari’ah non-compliance risk]

Fiduciary Risk Related torisk that arises from failure to perform in accordance with explicit and implicit standards applicable to fiduciary responsibilities

- interests of all fund providers, in particular IAH- disclosure and transparency- risks arising in subsidiaries or SPVs

Based on: IFSB-1, para 21, 49, 51, 67-69, 81-85, 123, 131-132, 137; IFSB-2, para 19, 33, 36, 44, 45, 47, 55, 64, 76.


bank and customer:Agreementto Purchase(binding or

non-binding)

bank purchases

goods from supplier

price riskif customercancels AP

(IIFS has to sell in the open market,

pricemay be less than purchase price)

risk mitigation:• purchase on

'sales return' basis

• security deposit from customer

bank takespossession

of goods

risks associated

with goods, liable for defects

risk mitigation:• customer as

agent• minimize holding

period

bank sells and delivers

goods to customer

settlement /default risk:customer is

unable to honour the payments

(loss of receivables)

risk mitigation:• urboun (earnest money),

third party guarantees, pledgeof assets

• penalty, blacklisting

maturity ofcontract

customer settles

full amount

Market risk

Credit risk

Change of Risk Characteristics in Islamic Financial Transactions (1 of 3)

Murabaha for the Purchase Orderer

advancepayment of

price bybank

time of delivery

commodity price risk

(future pricemay be less;

decrease of asset value)

risk mitigation:• parallel salam

risk mitigation:• performance

guarantee

settlement /delivery risk:customer is

unable to deliver as agreed upon (specification,

time, etc.)

Maturity ofcontract

capital recovery risk:

(no full recovery,insufficient

guarantees, etc.)

cancellation of delivery,

repayment of salam capital

asset replacement risk for parallel salam:need to purchase

from open market to meet

delivery obligation, maybe

at higher price

commodity price risk

(salam without parallel slam)

delivery not as per agreement or no delivery at all

delivery as per agreement

Market risk

Credit risk


Salam (and Parallel Salam)

ijarahcontract(binding)

settlement risk:no rental

payments when due

Maturity of contract

Market risk

Credit risk

purchaseof assetby bank

agreement to lease

(binding?)

price riskwhen customer opts out before leasing contract

(lease/sell at lower rental/

price)

risk mitigation:• security deposit

benchmark riskfixed rental in

long-term ijarah susceptible to

changes in market conditions

risk mitigation:• renewable short-

term leases with price re-fixing (in consent)

• rentals linked to benchmark

risk mitigation:• urboun (deduct for

damages); also advance rental payment

• repossess the assets

asset returned

to IIFS

IMB: transfer of ownership to lessee

residual value risk

fair value of asset below initially

estimated residual value


Operating Ijarah andIjarah Muntahia Bittamleek

User/source ofinformation

Information Requirements

Identical for Conventio-nal and Islamic banks Additional for Islamic banks

Shareholder Accounting, significant management policies, critical decisions

business activities, details of majorsources of income and investment, Zakat details

Clients/ customers

Credit-worthiness, ratings, financial inform.

entrepreneurship abilities, selected personal information

Financed projects

Feasibility reports before the agreement for financing

During the financing period, regular cash flows, income statements, overall conduct of business . At the time of termination of financing (or partnership) contract, balance sheet, income statements

Central bank Statutory reports Special reports needed for Islamic bankingShari'ah [not applicable to

conventional banks]Project details, client details, business lines details, method of financing, treatment of defaults.

Other banks/ institutions

Industry-supportive information, a few details about line of businesses.

details of ethical and Shariah approved conduct of business.

Based on: Akkizidis & Khandelwal 2008, p. 40.

Information Requirements in Conventional and Islamic Banking

Items of Disclosure CommentsRisk managementframework and practices

Disclosures are presented at a very general level and occasionally mention the existence of specific committees, such as the ALM [Asset-Liability Management] committee.

Classification of facilities by asset quality, and data on non-performing loans

All banks disclose classification of facilities by supervisory categories such as current, sub-standard, etc. Only some banks (30%) disclose non-performing loans. Only one bank mentioned the use of an internal rating system.

Specific provisions Most banks (94%) disclose this as a total. Provisions as a percentage of assets varied from less than 1% to 6%. Only some banks (30%) disclose provisions classified by facilities.

Sectoral distribution of credit and connected exposures

Many banks (66 %) disclose this.

Large exposures Very few banks (6%) disclose this.

Capital adequacy All banks disclose capital asset ratios - ranging from 2.5% to 38.4%, while many (66%) disclose regulatory capital to risk-weighted assets.

Value-at-risk None disclose this; one bank reported using VAR.

Liquidity ratios All banks disclose various liquid asset ratios. Ratio ofliquid assets to short-term liabilities ranged from 13% to 144%.

/ continued

Disclosure Practices of Islamic Banks (1/3)

Items of Disclosure CommentsMaturity gap Many banks (64%) disclose gaps at various maturity buckets.

Deposit composition: Share of investment deposits to total deposits

Generally disclosed, ranging from 0% to 95%, and averaging 80%, with some banks (36%) reporting no investment deposits.

Composition of facilities: Share of equity-type assets to total assets

Generally disclosed. Share of equity varied from less than 1% to about 23%, with a significant year-to-year change in some banks.

Return on assets Generally disclosed; large variation from 0.5% to 4.3%.

Return on equity Generally disclosed; large variation from 0.7% to 58%.

Return on unrestrictedinvestment deposits

All banks disclose this, with returns ranging from 1.45% to 16.35%, depending on country and bank.

Commodity inventories Only some banks (30%) disclose this.

Return on restrictedinvestment deposits

Very few (only one bank in the sample) disclose this.

Profit equalizationreserves

Some banks (30%) disclose this.

/ continued


Items of Disclosure CommentsNet open position inforeign exchange

Many banks (66%) disclose this; the ratio as a percentageof capital varied from 0% to 100%.

Foreign currency liabilities to total liabilities

Many banks (66%) disclose this; the ratio varied from 0%to 100%.

Net position in equities to capital

Generally disclosed, with the ratio ranging from 0% to 4%.

Gross income to assets All banks disclose this; it varies from 1% to 8 % .

Personnel expenses to total assets

All banks disclose this; it varies from 30% to 65% .

Operational expenses tototal assets

All banks disclose this; it varies from less than 1% to 5%.

Based on annual reports of 15 sample banks covering the years 2002 and 2003. Percentages of sample banks that disclose a particular item are shown in parentheses.

Source: Sundararajan 2007, pp. 47-48.


Credit Risk

Quali-tative Disclo-sures

1 A description of the IIFS’s credit risk management policies and objectives

2 Risk management structure

3 Disclosure of the names of external credit assessment institutions used for the purpose of assigning risk weights to assets

4 Disclosure of definitions of past due receivables & impaired financial assets, and policies and practices for making loss provisions on financial assets

Quanti-tative Disclo-sures

5 Total gross credit exposures and average gross credit exposures over the period in terms of geographical area, counterparty and industry, and residual contractual maturity for each class of Islamic financing assets, giving the percentages funded by the IIFS’s own capital and current accounts and by PSIA, respectively

6 Total gross credit exposures and average gross credit exposures over the period by rating categories, where applicable

7 Total gross exposure and average gross exposure to equity based financing structures by type of financing contract

8 Amount of past due and impaired financing assets, as well as specific and general loss provisions, classified by counterparty, industry and significant geographic areas, for each class of Islamic financing assets

9 Disclosure of the amount & changes in loss provisions during financial year

10 Disclosure of any penalty imposed on customers for default, and the disposition of any monies received as penalties

Risk Related Disclosures as Recommended by IFSB (1 of 8)

Credit Risk Mitigation


1 Disclosure of use of collateral, and other Shari’ah-compliant risk mitigation techniques together with related policies for assets leased under Ijarah Muntahiyah Bittamlik

2 A description of the main types of collateral and other credit risk mitigants taken by the IIFS, such as Hamish Jiddiyyah, Urbun, PSIA, pledged assets, Sukuk, and guarantees by third parties

3 Disclosure of the policies and processes for valuation of collateral and for ensuring its enforceability, together with related policies and processes for assets leased under Ijarah Muntahiyah Bittamlik. When the assets are not readily convertible into cash by the IIFS, the policies for disposing of the assets, or for using them in the IIFS’s operations, shall be disclosed

4 Where a third party guarantee is taken as a risk mitigant, the risk weight applicable to the guarantor shall be disclosed


5 Disclosure of the total carrying amounts by type of collateral of any assets held as collateral by the IIFS (including any haircuts) and the terms and conditions relating to the pledges

6 Disclosure of the carrying amount of assets owned and leased under Ijarah Muntahiyah Bittamlik


Liquidity Risk


1 A summary of the liquidity risk management framework in addressing risk exposure for each category of funding as well as on an aggregate basis:• current accounts;• unrestricted investment accounts; and• restricted investment accounts

2 General information on policies to address liquidity risk, taking into account the ease of access to Shari’ah- compliant funds and diversity of funding sources


3 Indicators of exposures to liquidity risk such as short-term assets to short-term liabilities, liquid asset ratios or funding volatility

4 Maturity analysis of financing and various categories of funding (current account, unrestricted investment account and restricted investment account) by different maturity buckets


Market Risk


1 Disclosure of appropriate framework for market risk management, including reporting, in respect of all assets held for sale, including those that do not have a ready market and/or are exposed to high price volatility


2 Indicators of exposures to market risk, such as:• breakdown of market RWA by:

i) equity position risk in the trading book and market risk on trading positions in Sukuk;

ii) foreign exchange risk; andiii) commodity risk;

• foreign exchange net open positions to capital;• commodity net open positions to capital; or• equity net open positions to capital

3 Total amounts of assets subject to market risk by type of assets

4 Measures of value-at-risk or other sensitivity analyses for different types of market risk, such as;• foreign exchange risk;• commodity price risk; and• potential losses due to movements in market rate of return,

benchmark rates or equity prices


Operational Risk


1 Policies to incorporate operational risk measures into the management framework – for example, budgeting, target-setting, and performance review and compliance

2 Policies on processes (a) to help track loss events and potential exposures; (b) to report these losses, indicators and scenarios on a regular basis; (c) to review the reports jointly by risk and line managers; and (d) to ensure Shari’ah compliance

3 Policies on the loss mitigation process via contingency planning, business continuity planning, staff training and enhancement of internal controls, as well as business processes and infrastructures


4 Disclosure of the RWA equivalent for operational risk

5 Indicators of operational risk exposures, such as:• gross income; and• amount of Shari’ah non-compliant income


Rate of Return Risk


1 Discussion of factors affecting rates of return and benchmark rates, and the effects thereof on the pricing of contracts

2 Processes and systems to monitor and measure the factors that give rise to rate of return risk


3 Indicators of exposures to rate of return risk – for example, data on expected payments/receipts on financing and funding and the cost of funding at different maturity buckets according to time of maturity or time of repricing for floating rate assets or funding

4 Sensitivity analysis of IIFS’s profits and the rate of returns to price or profit rate movements in the market


Displaced Commercial RiskQuali-tative Disclo-sures

1 Disclosure of the IIFS’s policy on DCR, including the framework for managing the expectations of its shareholders and unrestricted IAH, the sharing of risks among the various stakeholders, and the range and measures of risks facing unrestricted IAH based on the IIFS’s general business strategies and investment policies


2 Disclosure of historical data over the past five years:• total Mudarabah profits available for sharing between unrestricted IAH and

shareholders (as Mudarib) as a percentage of Mudarabah assets);• Mudarabah profits earned for unrestricted IAH (as a percentage of assets)

before any smoothing;• Mudarabah profits paid out to unrestricted IAH (as a percentage of assets)

after any smoothing;• balances of PER and IRR, and movements on these in determining

unrestricted IAH payout;• variations in Mudarib’s agreed profit-sharing ratio from the contractually

agreed ratio; and• market benchmark rates


Displaced Commercial RiskQuanti-tative Disclo-sures

3 Five-year comparison of historical rate of return of unrestricted IAH in relation to the market benchmark rate.

4 Five-year comparison between the percentage rate of returns to IAH and the percentage returns to shareholders from Mudarabah profits.

5 Amount and percentage of profits appropriated to PER and IRR.

6 Analysis of the difference between aggregate Mudarabah-earned profits and profits distributed (paid out) to IAH as a function of movements in PER, IRR and the Mudarib’s share

7 Analysis of the proportion of the RWA funded by IAH that should be considered in arriving at the total RWA, as approved by the supervisors, together with an explanation of the underlying rationale

Source: IFSB-4, tables 8-15.


Risk Control: pre-emptive, creating disincentives for taking too much risk; regulators should minimize risk of

failure instead of managing failures once they have occurred

Identification

QuantificationMeasurement

MitigationManagement

Provision: rules aiming at limiting risks

• liquidity ratios (e.g. short-term assets > short-term liabilities, minimum ratio of long-term lending to long-term debt) limiting mismatch risk – gradually disappeared

• capital adequacy (capital level in line with risk, capital as buffer for unexpected losses(beyond expected losses as recorded in loan loss provisions)

Risk Insurance: passive ('after the fact')deposit insurance -- moral hazard

risk bearing capital in IF

specific types of risk in IF

specific types of 'deposits in 'IF

Risk Control and Regulation

UPSIA tend to be assimilated to conventional deposit accounts which are “capital guaranteed” and have a contractually determined rate of return. Thus, in practice, IIFS may find themselves virtually obliged to practise the smoothing profit payouts to UIAH.

Stabilising payouts of UPSIA by

Smoothening profits Cushening losses

IRR2

1 formed out of profits before their allocation between shareholders and UIAH, and therefore having two components, one that is part of the shareholders’ funds and another that is attributable to UIAH funds

2 formed by retaining part of the profit attributable to the UIAH

• Reducing Mudarib share of profits on investments financed by UIAH funds

• Donating part of profits on investments financed by shareholders funds

Note: Losses must be borne by the UIAH if IRR

are insufficienttransfer of risk to shareholders, DCR no risk transfer

Commercial Status of UPSIA in Competitive Markets

PER1

UPSIA = Unrestricted Profit Sharing Investment AccountsUIAH = Unrestricted Investment Account HoldersPER = Profit Equalisation ReserveIRR = Investment Risk Reserve

PSIA in Shari'ah perspective: profit-sharing and loss-bearing.

UPSIA not treated as liabilities of the IIFS (although reported on the liability side of balance sheet)

in the case of liquidation of the bank: no claims of UPSIA as creditors over the assets of the IIFS (as do conventional depositors)., but

claim to the assets financed by UPSIA (plus share of undistributed profits minus any losses), including

share of assets financed by commingled funds (claims of USIA pari passu with shareholders [after taking account of the fact that the latter are liable for amounts deposited by current account holders and other creditors]).

Legal Status of UPSIA in Case of Bank Default

α [Risk-weighted Assets funded by PER and IRR of Unrestricted PSIA5 (Credit2 + Market2 Risks)]

(1 – α) 4 [Risk-weighted Assets funded by Unrestricted PSIA3 (Credit2 + Market2 Risks)]

EC : { ´ -Total Risk-weighted Assets1 (Credit2 + Market2 Risks)

Operational Risks

Risk-weighted Assets funded by Restricted PSIA3 (Credit2 + Market2 Risks)

+

-

}

1 Total RWA include those financed by both restricted and unrestricted Profit Sharing Investment Accounts (PSIA). 2 Credit and market risks for on- and off-balance sheet exposures. 3 Where the funds are commingled, the RWA funded by PSIA are calculated based on their pro-rata share of the relevant assets. PSIA balances include PER and Investment risk reserve (IRR) or equivalent reserves. 4 α refers to the proportion assets funded by unrestricted PSIA which is to be determined by the supervisory authorities. The value of α would therefore vary based on supervisory authorities’ discretion on a case-by-case basis. 5 The relevant proportion of risk-weighted assets funded by the PSIA’s share of PER and by IRR is deducted from the denominator. The PER has the effect of reducing the displaced commercial risk and the IRR has the effect of reducing any future losses on the investment financed by the PSIA.

-

-

Supervisory Discretion Formula for the Calculation of CAR

Risk bearingProfit smoothening

Loss cushening

DCR

α

FullNoNo

No

0

Investmentproduct

MinimizedYesYes

Maximum

~1

deposit

Commercial Character of Unrestricted Investment Accounts

low profits moderate losses heavy lossesconsiderable losses

deposit insuranceto protect the principal

[in case of a bank default]

losses must be passed on to IAHs

rumours that

bail-out byrecapitalization?(not to be taken for granted + Shari‘ah concerns)

establishment of a Shari‘ah compliant lender of last resort(next step after IILM)

systemic riskactually underrated

and not well reflectedin IFSB standards

consideration in capital adequacy requirements;mitigation of displaced commercial risk (DCR)

• investment risk reserve• profit equalisation

reserve• adjusting mudarib

share of profit• transfers from

shareholders‘ funds

avoidance of withdrawalsthat may cause systemic risk

return on investment of IAHs funds (commingled with sharholders‘ funds)

smoothing techniquesto protect expected returns

too large for smoothing,too small for bank default

can cause a bank run

massive withdrawals

customers considerinvestment accounts

to be risk-free [savings/term]

deposits

Underestimated Systemic Risk Potentials

Market Inefficiencies: Risk-Ignorant Returns

higher risk = higher return?

shareholders' return (profit)

comparison conventional/Islamic:only for standalone Islamic banks because Islamic windows without separate shareholders' equity

returns on investment accounts

conceptually exposed to higher risks than conventional deposits

observation: returns on IAH are not systematically higher than interest on conventional accounts(decisive empirical test still lacking)[also for Islamic windows]

possible explanations:

higher specific risks may beoffset by - disproportionately large

share of current accounts- less than risk-equivalent

returns for IAH

focus primarily on IAH returns

v

Risk Ignorance and Deposit Illusion?

inadequate valuation of (additional) riskno awareness of (additional) risk

• lack of awarenessin principle?

• lack of relevant information (e.g. on smoothening, levelof reserves, risk profile ofassets)

implications for• prudential regulation• effectiveness of market discipline (pillar 3 of Basel II)• capital adequacy requirements (IFSB alpha)• incentives for risk taking / risk appetite (esp. in 'dual banks')• allocation of real and financial risks through the banking system

issues for discussion and further analysis:

deposit illusion risk ignorance?

• practice of Islamic banks: announcement of expected returns, ex post = ex ante [smoothening techniques], no allocation of losses

• deposit guarantee schemes • (explicit/implicit) bail-out guarantees

Contact Details

Prof. Dr. Volker NienhausDachsfeld 38a45357 Essen – Germany

Tel.: +49 (0) 201 8695750Fax: +49 (0) 201 8695752Mobile: +49 (0) 176 63755466Mobile: +60 (0) 19 3040970 (Malaysia)[email protected]

mailto:[email protected]

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