risk mitigation in islamic banking
TRANSCRIPT
RISK MITIGATION IN ISLAMIC BANKING
By: Camille Paldi
CEO of FAAIF
Introduction
• Interest based financial contracts separate entitlement to return from the responsibility of loss by protecting both the principal amounts of a loan as well as a fixed return on it.
• Hence, these contracts transfer the risks of loans to the borrower while the lender retains the ownership of the funds.
• Islamic finance prohibits the separation of entitlement to return from the responsibility for ownership.
• By doing so risk transferring is discouraged and risk sharing is encouraged.
Credit Risk Mitigation
• Credit risk is the most important risk faced by banks, because default can also trigger liquidity, interest rate, downgrade, and other risks.
• Therefore, the level of a bank’s credit risk adversely affects the quality of its assets in place.
• The process of credit risk mitigation involves estimating and minimizing expected credit losses.
• Calculation of expected credit losses requires the calculation of probability of default, maturity of facility, loss given default, exposure at default, and the sensitivity of the assets value to systematic and non-systematic risks.
Loan Loss Reserves
• Sufficient loan loss reserves offer protection against expected credit losses.
• The Islamic banks are required to maintain the mandatory loan loss reserves subject to the regulatory requirements in different jurisdictions.
• Islamic modes of finance require more rigorous and credible systems for expected loss calculation.
• There is a need for uniform standards for loss recognition across modes of finance, financial institutions, and regulatory jurisdictions.
Collateral
• Collateral is also an important security against credit loss.
• Islamic banks use collateral to secure finance because al-rahn (an asset as a security in a deferred obligation) is allowed in the Shariáh.
• A debt due from a third party, perishable commodities and something, which is not protected by the Islamic law as an asset, such as interest-based financial instruments are not eligible for use as collateral.
• On the other hand, cash, tangible assets, gold, silver, and other precious commodities, share in equities, and debt due from the finance provider to the finance user are assets eligible for collateral.
Legal Risk Mitigation
• The legal systems in the jurisdiction in which Islamic banks operate generally do not support the qualitative aspects of a good collateral as in most cases it is very difficult to obtain control of the asset and convert it into liquidity without a high cost.
• There are no uniform standards to recognize a default event and to litigate disputes.
On Balance Sheet Netting
• On-balance sheet netting implies the matching out of mutual gross financial obligations and the accounting for only the net positions of the mutual obligations.
• Carefully prepared, netting overcomes credit risk exposures between the two parties.
• With the participation of a third party playing as a clearinghouse for the obligations, the arrangement becomes a powerful risk mitigation technique.
• The Islamic banks have so far not designed any such mechanism.
Guarantees
• Guarantees supplement collateral in improving the quality of credit.
• Although some Islamic banks also use commercial guarantees, the general Fiqh understanding goes against their use.
• In accordance with the Fiqh, only a third party can provide guarantees as a benevolent act and on the basis of a service charge for actual expenses.
• Due to this lack of consensus, the tool of guarantee is not effectively used in the Islamic banking industry.
Letter of Guarantee Not Allowed
• A fee can be acceptable only if: • It is deducted from outstanding debt owed by the beneficiary
when Letter of Guarantee is executed; and
• It is used to initiate a legitimate transaction.
MDB-led Syndication
• Participation in multilateral development bank-led syndication provides an automatic guarantee to a participating commercial bank against risk of loss due to the cost differential between borrowing at home and borrowing abroad and enhances credit quality.
• By participating in the MDB-led syndication schemes, the commercial banks can mobilize funds in foreign currency at the cost of mobilizing funds in local currency.
Contractual Risk Mitigation
• Appropriate contracts between counterparties work as risk control techniques.
• Price fluctuations in a salam contract may work as a disincentive for fulfilling contractual obligations.
• The risk can be minimized by a clause in the contract showing an agreement between the two parties that a certain level of price fluctuation will be acceptable, but beyond that point the gaining party shall compensate the party, which is adversely effected by the price movements.
• In Sudan, such a contract clause known as Band-al-Ihsan (beneficence clause) has now become a regular feature of the salam contract.
Istisnaá
• In Istisnaá, contract enforceability becomes a problem particularly with respect to fulfilling the qualitative specifications.
• To overcome counterparty risks, Fiqh scholars have allowed Band al-Jazaa (penalty clause).
• Again in Istisna’a financing, disbursement of funds can be agreed on a staggered basis subject to different phases of construction instead of lumping them towards the beginning of the construction work. This could reduce the banks’ credit exposure considerably by aligning payments with the progress of the work.
Parallel Istisnaá
• In a parallel Istisna’a arrangement, the client commissions the financier to manufacture the specified asset for one price (the purchase price).
• In parallel, the financier then commissions a third party (the contractor) to manufacture the same asset for a lower price (the sale price).
• The difference between the present value of payments under the two contracts is the banks compensation for the finance.
Istisnaá Sukuk
• Project financing can be undertaken through an Istisna’a contract, whereby funds are advanced to pay for the supplies and labor costs by an Islamic bank.
• Once the project is completed, the advances are repaid from the revenue derived from the project. Originally, istisna’a was seen as an appropriate way of financing manufacturing as goods have to be produced and costs incurred before they are sold.
Istisnaá Sukuk
• To introduce bonds based on istisna’a, a parallel istisna’a contract is generally used where by the financier enters a contract with a subcontractor who actually builds the facility being financed.
• To use istisna’a, the public authority or private company commissioning the project provides details of the specifications and timing of the schemes.
• The financier then sets these out in the tender documents.
• Bids are subsequently invited from contractors who will specify how they intend to sell completed parts of the project over time and the amount of each payment instalment expected.
Istisnaá Sukuk
• These instalments will include an element of profit over the construction costs. As the financier is expecting a stream of payments over a specified period, certificates can be issued based on the income expected.
• It should be noted that as the deferred price certificates represent debt obligations they cannot be traded for cash at below face value in a secondary market.
• They can, however, be used to purchase goods or services whose price is equal to the face value of the certificate.
Istisnaá Sukuk
• The purchase price of the goods may be less than the deferred price as this represents a trading transaction.
• Permission to transfer the debt contract from the financier to a supplier of goods and services must be sought from the original debtor, the public authority, or private company commissioning the project.
Partnership
• Islamic bank may sign a partnership agreement with manufacturer.
• Islamic bank provides funding and collects payment.
• Manufacturer provides expertise and skilled work.
• They share profits.
• All technical risks are now borne by the manufacturer.
Murabahah
• In Murabahah, to overcome the counterparty risks arising from the non-binding nature of the contract, up-front payment of a substantial commitment fee has become a permanent feature of the contract.
• In several contracts, as an incentive for enhancing re-payment, a rebate on the remaining amount of mark-up is given.
• Due to non-presence of a formal litigation system, dispute settlement is a serious risk factor in Islamic banking.
• This is why I propose the Dubai World Islamic Finance Arbitration Centre (DWIFAC) and Jurisprudence Office (DWIFACJO).
Murabahah
• It can be proposed that to avoid the default by the client in taking possession of the ordered goods, the contract shall be binding on the client and not binding on the bank.
• This suggestion assumes that the bank will honor the contract and supply the goods as contractually agreed, even if the contract is not binding on it.
• An alternative proposal could be to establish a Murabahah clearing market (MCM) to settle cases, which may not be cleared due to the non-binding nature of the Murabahah contract.
Murabahah
• Since the murabahah contract is approved with the condition that the bank will take possession of the asset, at least theoretically the bank holds the asset for some time.
• This holding period is almost eliminated by the Islamic banks by appointing the client as an agent for the bank to buy the asset.
• Nevertheless, the reason of approving the contract is the responsibility of the bank for the ownership risk. For this risk, capital needs to be allocated.
Risk Mitigation in Murabahah
• 1. The purchase from the supplier and sale to the buyer may be done at the same time in order to minimize risk of liability for damage to the goods or the goods not matching specifications or meeting delivery dates, etc. (This may be seen as a ‘Murabahah to the purchase-orderer’) (The payment of the marked-up price is usually done at a later date, which in addition to risk, involves the provision of credit).
Risk Mitigation in Murabahah
• Side Note: Scholars accept a transaction in which the aggregate value of the deferred installments equals the spot price (since even if such a transaction is viewed as a combination of a sale of goods with a loan advanced by the seller to the buyer, the loan in this case would be interest-free). (islamicfinance.com)
• 2. The Bank can negotiate with the buyer to waive her rights to any claims against the bank for breach of warranty. (indemnification)
Two Step Murabahah Contract
• In a two-step contract, the Islamic bank can play the role of a guarantor in facilitating funds to the users.
• Since guarantee cannot be provided as a commercial activity, in a two-step contract, it can be provided by the Islamic bank’s participation in the funding process as an actual buyer.
• In the existing Murabahah contracts, the bank makes an up-front payment to the suppliers on behalf of the client.
• In the two-step contract, the bank will have two Murabahah contracts, as a supplier with the client and as a buyer with the actual supplier.
Two-Step Murabahah Contract
• The bank will hence not make an up-front payment to the actual supplier.
• The two-step Murabahah contract will have a number of implications for the banks.
• It can serve as a source of funds. In a longer maturity contract, such funds can be considered as tier-2 capital of the bank, based on the criteria allocated to such capital by the Basel Accord.
• The contracts will enhance the banks’ resources under management. This will have both good and adverse implications. The adverse implications will arise from the increased amount of financial risks.
Two Step Murabahah Contract
• If these risks are managed properly, the contracts can prove to be instrumental in enhancing the net income and hence competitiveness of Islamic banks.
• This will enhance the liquidity position of Islamic banks. Although liquidity is not the immediate problem of Islamic banks, the availability of liquidity always enhances stability.
• It will provide flexibility in liability management by offering different maturity of liabilities. The banks can match the maturity of their liabilities and assets more efficiently.
Two Step Murabahah Contract
• The banks will actually guarantee the re-payment of the funds by the clients. Hence, guarantee is provided in a more acceptable and transparent manner.
• The concept of the two-step contracts is not restricted to Murabahah, it is equally applicable to istisnaá, leasing, and salam.
• Finally, the new contracts would be an addition to the available instruments thus paving the way for developing further instruments.
Hedging Murabahah Price Risk with Salam and Parallel Salam
• Price risk can either be due to transitory changes in prices of specific commodities and non-financial assets or due to a change in the general price level or inflation.
• Inflation poses risk to the real values of debts (receivables), which are generated as a result of Murabahah transactions.
• However, as a result of inflation, it is expected that the prices of the real goods and commodities, which the banks acquire as a result of salam transactions will appreciate.
• This divergent movement of asset values created as a result of Murabahah and Salam has the potential to mitigate the price risks underlying these transactions.
Hedging Murabahah Price Risk with Salam and Parallel Salam
• Although permanent shifts in assets’ prices cannot be hedged against, the composition of receivable assets on the balance sheet can be systematically adjusted in such a way that the adverse impact of inflation is reduced.
• Suppose that an Islamic bank has sold assets worth $100 on Murabahah basis for six months, it can fully hedge against inflation by buying $100 worth on Salam basis. If for example, 10% of the value of the previous assets is wiped out by inflation, its salam-based receivables can become valuable by the same percentage. Moreover, as for as the salam is concerned, it can be fully hedged by the bank by adopting an equivalent parallel salam contract as a supplier.
Parallel Salam
• The financier may at the same time enter into a parallel but separate bai salam with a third party to resell the asset for an increased price (also calculated by reference to a conventional benchmark such as LIBOR) or it may simply sell the asset on delivery.
• Conditions of the Parallel Salam
• There must be two different and independent contracts, these two contracts cannot be tied together, and performance of one should not be contingent on the other.
• Parallel Salam is allowed with the third party only.
Non-Binding Promise
• Hedge Murabahah risks with non-binding promise.
• Non-binding promise = a parallel right to cancel with the merchant.
Sukuk al Murabahah
• Designing a sukuk with capital protection.
• Deferred price = principal plus mark-up.
• Suppose markup = 5.2% for 20 years.
• Principal = 49% of the total price.
• Markup = 51%.
Sukuk al Murabahah
• 51% of the price is debt in-kind.
• Trading debt in-kind for cash is possible if exchanged for cash, but not if originated in exchange for money.
• The Deferred price is therefore liquid enhancing price liquidity.
• The Markup reflects the market returns.
• The real value of the markup is preserved.
• And The Nominal value of capital preserved.
Sukuk al- Murabahah
• If the markup is less than 51%, it is possible to securitize only the tradable portions and speed up payment of the money portion.
• If buyer does not want to pay in-kind: Invite a third party.
Value Based Salam
• Future commodity is determined by value.
• Value = Quantity * Unit Price.
• Value is determined in contract.
• Unit price is known at maturity.
• Quantity becomes known at maturity.
• Quantity then is delivered to the buyer.
Market Return on Value-Based Salam
• Combine traditional and value-based salam.
• Future commodity = value + quantity.
• The Value-based portion protects capital.
• The Quantity portion allows for market return.
Sukuk al Salam
• The salam based contract is usually used for short-term financing of underlying assets, and is based on spot sale (salam) and/or deferred payment sale (bai al muajjal) or deferred delivery sale (bai al salam) where the investor undertakes to deliver a specific asset, which will be sold to the client at an agreed profit margin.
• For example, a special vehicle is set up to buy petroleum on a spot price basis and the purchase price is entirely paid up front from the proceeds of the issue sukuk certificates.
• The SPV will then sell the oil at a later date to the beneficiary of the oil on a certain designated delivery date.
Sukuk al-Salam
• Since salam sukuk results in a purely financial claim that is not linked to the underlying asset, the Shari’ah only allows such securities to be traded at par value.
• This affects its trading in the secondary market and investors are forced to hold this security until maturity.
• This contract resembles the conventional forward contract (which is not permissible in Shari’ah) except that in case of salam contract, payment is made in advance and in the case of the latter payment it is usually settled at the delivery date.
Sukuk al-Salam
• The salam contract was allowed as a special case during the Prophet’s time to avoid farmers and traders being forced to take usurious loans.
• It is considered less onerous than the usurious loan.
Sukuk al-Salam
• The concept of salam refers to a sale whereby the seller undertakes to supply a specific commodity to the buyer at a future date in return for an advanced price, paid in full on the spot.
• Hence, the price is cash, but the supply of the purchased goods is deferred.
Sukuk al-Salam
• Muslim farmers used salam to receive cash advances in order to meet immediate commitments until their crops were grown as they were not able to borrow on the basis of riba.
• The attraction for the buyer of a salam contract is that the advance payment is usually less than the amount that would have to be paid if the buyer deferred his purchase and bought the same commodity spot in one or three months’ time.
Sukuk al-Salam
• Salam represents a type of forward contract, but such a contract is forbidden under Shari’ah law unless there are strict conditions attached that aim at the elimination of uncertainty (gharar).
• Firstly, the initial payment by the buyer must be paid in full, to ensure that there is no uncertainty over outstanding payments.
Sukuk al-Salam
• Secondly, salam can only be used for commodities that are standardized, and where the quality and quantity are measured exactly.
• Originally, such contracts were used for the purchase of grains such as wheat, barley, and rice, but salam contracts could also be used for commodities such as oil, iron, or copper, or indeed even electricity supplies that can be measured in kilowatts.
• Some authors even suggest that they can be used for the purchase of aircraft seats.
Sukuk al-Salam
• How can certificates based on salam contracts be issued? The onus is on the purchaser who can finance advance payments by issuing certificates that are equivalent to the purchase price, which are then sold.
• The buyers of the certificates are entitled to the commodities for which the original purchaser contracted at the end of the one or three months, or whatever period was stipulated in the contract.
• For them the attraction is that they are purchasing the commodities at a discount, the difference between this and the eventual selling price of the commodities representing their return.
Sukuk al-Salam
• There has been some debate amongst Shari’ah scholars about whether it is legitimate to exchange the rights to commodities sold on a salam basis prior to delivery, or, in other words, to trade salam certificates.
• Ibn Taymiyyah ruled that such exchanges are permissible as long as when the certificates were sold to the seller it was not for a price higher than that agreed originally, as this might be seen as exploitation. Sales to third parties could be at any price that such buyers are willing to pay.
• The Maliki School of Islamic jurisprudence stipulated that salam contracts relating to foodstuffs should not be traded, as this could be interpreted as speculating on necessities.
Sukuk al-Salam
• Sami Homoud states that it is not permissible to resell the commodity covered by a salam contract before receiving it, but this does not preclude the recipient from reselling the commodity by another contract parallel to the first one.
• The aim of such a parallel or back-to-back salam contract is to ensure that the financier, usually a bank, is not left with a commodity that it has no expertise in trading.
• However, creating salam certificates could also be viewed as a way out of this dilemma for a bank.
Leases
• Commodity price risk arises as a result of ownership of a real commodity or asset.
• Mark-up price risk arises as a result of holding a financial claim, which could be the result of deferred trading.
• Therefore, under leasing, the equipment itself is exposed to commodity price risk and the overdue rentals are exposed to interest-rate risks.
Leases
• Similarly, if the lease contract is a long one and the rental is fixed not floating, the operating lease is exposed to dual edged risks – commodity and mark-up price.
• In order to avoid such risks banks shall prefer leases ending with ownership possibly price fixed in the beginning and rentals periodically re-priced.
• Such a lease would actually be an installment sale contract based on a floating rate mark-up. In this case, the banks can actually minimize their exposure to both the mark-up and commodity price risks.
Leases
• Thus, we can conclude that the Murabahah and Istisnaá transactions are exposed to Murabahah (mark-up Price) or benchmark rate risk and Salam and leases are exposed to both Murabahah price and commodity price risks.
• Due to Salam, and operating leases, commodity price risk exposure of Islamic banks is expected to be higher as compared to their peer group conventional banks.
Sukuk al Ijarah
• Sukuk based on sale and lease back are questionable.
• As an Alternative, it is possible to lease productive assets or equipments for a portion of revenues or diminishing musharakah.
Sukuk al Ijarah
• The sukuk are based on the underlying tangible assets that the SPV has acquired rather than being debt securities, which is the case with the issuance of conventional bonds.
• Instead, the sukuk al-ijarah structure uses the leasing contract as the basis for the returns paid to investors, who are the beneficial owners of the underlying asset and as such benefit from the lease rentals as well as sharing in the risk.
Sukuk al-Ijarah
• The structure commences with a party who is in need of financing, here referred to as the originator.
• The originator will establish an SPV, a separate legal entity with the sole purpose of facilitating this transaction.
• Next, the SPV purchases certain tangible assets from the originator at an agreed pre-determined purchase price, which will be equal to the principal amount of the sukuk.
Sukuk al-Ijarah
• In order to finance the purchase of the assets, the SPV issues sukuk to sukuk holders.
• These sukuk holders are investors looking for Shari’ah compliant securities.
• The SPV uses the sukuk proceeds to pay the originator the purchase price of the tangible assets.
• The SPV will also declare a trust over the tangible assets and hold the assets as a trustee for the sukuk holders, who are the beneficiaries.
Sukuk al-Ijarah
• Next, the originator and the SPV will enter into a lease agreement for a fixed period of time. Under this lease agreement, the SPV (lessor) leases the assets back to the originator (lessee).
• Consequently, the SPV receives periodic rentals from the originator for the use of the underlying tangible assets.
Sukuk al-Ijarah
• The SPV uses these amounts to pay the periodic return to the sukuk holders, since they are entitled to these payments as the beneficial owners of the tangible assets.
• The lease payments from the originator to the SPV and the periodic payments from the SPV to the sukuk holders will continue until maturity date.
Sukuk al-Ijarah
• The SPV uses these amounts to pay the periodic return to the sukuk holders, since they are entitled to these payments as the beneficial owners of the tangible assets.
• The lease payments from the originator to the SPV and the periodic payments from the SPV to the sukuk holders will continue until maturity date.
Sukuk al-Ijarah
• Although in a sukuk al ijarah structure, the sukuk holders must acquire the ownership rights over the tangible assets from a Shari’ah perspective, from a practical perspective, this is often not possible due to legal impediments in most jurisdictions such as the impossibility to register under the sukuk al ijarah structure that the SPV holds the tangible assets in trust for the sukuk holders.
• This means that the legal ownership of the tangible assets will remain with the SPV and the sukuk holders merely acquire the beneficial ownership of the underlying tangible assets.
Sukuk al-Ijarah
• In practice, difficulties arise in meeting the ownership requirements of the sukuk holders. Additional transfer taxes and restrictions on the disposal of governmental assets made it almost impossible for several originators even to transfer the title of the assets to the SPV.
• As a result, in practice the legal ownership of the assets is not even transferred to the SPV.
• The sukuk holders are, consequently, one step further from the underlying tangible assets.
Sukuk al-Ijarah
• The combination of the absence of transfer of legal ownership of the assets from the originator to the SPV with purchase undertakings and other forms of guarantees given by the originator to the SPV and, consequently, the sukuk holders recourse to the originator instead of recourse to the underlying tangible assets represents a move from the asset-backed to asset-based sukuk.
Khiyar al -Shart
• In an Islamic banking contract with a pre-determined price, quantity, and long duration and in which price and object are both postponed, both the two parties are exposed to price risk. The risk is that immediately after the contract of a fixed price and a fixed quantity, the two parties may experience a noticeable change in the market price of the commodity.
• If the market price declines, the buyer will be at a loss by continuing with the contract. If market price rises, the seller will lose by continuing with the contract. Thus, in such contracts of continuous supply-purchase, a khiyar al shart (option of condition) for rescinding the contract will make the contract more just and will reduce the risk for both parties.
Khiyar al Shart
• If the agreed price is P and the two parties are uncertain about the future market prices, they can mutually determine the upper and lower boundaries for the acceptable movements in market prices.
• Beyond these boundaries they can agree to rescind the contracts.
Hedging Mudharabah and Musharakah Risks
• All instruments must be non-zero sum games.
• Mutual gain is more likely and is the objective of the game.
• Zero-sum outcomes are possible, but less likely and not the objective of the transaction.
Sale of Equity for a Deferred Price
• Sell 95% of equity for a (full) deferred price to a third party (e.g. insurance company).
• Keep 5% for upside return.
• Alternatively, sell equity with the condition to keep a certain share of profits (dividends) for a specified period.
• Benefits: Seller hedges equity risk with upside participation; Buyer provides a guarantee for a share of profits.
Convertible Musharakah
• Company pledges high-quality, low-risk assets to investors (equity owners).
• Investors have the right to substitute their equity for these assets.
• Substitution is on a pre-determined ratio that protects capital value.
• The Result = Hedge equity downside with exposure to upside.
• Can be securitized into sukuk.
• Here the net result is money for asset while in Bai al-Wafa, the result is money for money.
Purchase with Management
• Investor buys a premium real asset for a cash price.
• Investor keeps the right to invest the cash on behalf of the seller for a share of returns.
• Buyer can have the right to convert the asset into the new investment on a pre-determined ratio.
• Can be securitized .
• Buyer protects his investment while Seller provides collateral.
Combining the Two Products
• A company invites a third party (investment bank) who holds high quality real assets.
• Bank sells the asset to investor using “purchase with management” design.
• Investor has the right to convert the asset into a certain share of the project/company.
• Investor has the right to convert HQ asset into equity of the company.
Combining the Two Products
• Banks sells HQ asset to Investor.
• Investor keeps the cash and invests it in the Company.
• If project is successful, Investor converts the asset into equity in the Company.
• If not, investor is hedged and keeps the asset and the Bank loses the asset.
Sale with Management
• Sell a portfolio for a deferred price.
• Keep the right to manage the portfolio for a share of profits.
• Seller: Hedges portfolio risk with upside participation.
• Buyer: Provides a guarantee for a share of profits.
• Liquidity needs to be managed.
Priority of Profits
• To allocate profit claims among partners or shareholders.
• Mitigates risk, but no guarantee.
• Avoids cost of accounting and disclosing sensitive information.
Preferred Shares
• Preferred shares give holders priority in Profits and Capital in case of liquidation.
• Priority in case of liquidation makes it a debt obligation becomes a loan with interest.
• Priority only in profits does not make it a loan with interest – no riba.
• Gharar is minor.
Priority of Losses
• Why must partners share losses based on their capital shares?
• How to allocate losses so that for example the first 10% of loss is absorbed by class B investors?
• Assets must be acquired jointly (50:50).
• Then Class A sells a percentage (10%) of its share to Class B for a deferred price (product # 1).
• Or: Class A buys the portfolio, then sells 50% on cash and 10% on credit.
Sukuk al-Mudarabah
• Sukuk al Mudarabah is structured through the mudarabah contract, with one party looking for Shari’ah compliant financing, the originator.
• The originator will establish the SPV and enter into a mudarabah contract with this SPV.
• Both the originator and the SPV will be partners to the Mudarabah contract. The originator will act as the managing partner, the entrepreneur of the mudarabah venture.
Sukuk al-Mudarabah
• As the mudarib, the managing partner will contribute his labor, skills, and expertise.
• The SPV will act as the silent partner, the rabbul mal of the mudarabah venture.
• As the rabbulmal, the SPV contributes in the form of financial investment.
Sukuk al-Mudarabah
• The SPV will issue sukuk certificates to the sukuk holders.
• The sukuk proceeds will be used to make the financial investment in the mudarabah.
• The SPV will declare a trust over all the units it is holding in the mudarabah in favor of the sukuk holders according to an agreed percentage of the realized revenues.
Sukuk al-Mudarabah
• The participation in the mudarabah will continue until maturity date. At maturity date, the managing partner will buy the units in the mudarabah from the sukuk holders through the SPV.
• The managing partner will pay an amount to the SPV to purchase the units in the mudarabah.
• That amount is used by the SPV to pay the sukuk holders their capital back, so that the sukuk certificates can be redeemed.
Sukuk al-Mudarabah
• This structure is an equity-based sukuk structure where profits and losses are shared between the partners.
• Therefore, the periodic payments to the sukuk holders cannot be fixed returns; neither can their principal amount be guaranteed at maturity.
• However, in practice several instruments were used to fix the periodic returns over the sukuk and to guarantee the principal amount of the sukuk holders.
Sukuk al-Mudarabah
• The periodic returns were often fixed returns; when the actual profits realized were less than the promised returns, the originator provided for funding, while in the case of excess profits any surplus was for the originator as an incentive fee.
• This limited the equity character of these securities, since the losses were borne by the originator and the periodic returns to the sukuk holders were fixed, regardless of the performance of the underlying projects.
Sukuk al-Mudarabah
• At maturity, pursuant to a purchase undertaking, the assets were bought back by the originator for a price equal to the principal amount of the sukuk holders.
• The purchase undertaking guaranteed the principal amount of the sukuk holders, regardless of the possible appreciation or depreciation of the assets.
• These structural features practically turned the equity-based profit-and-loss sharing arrangements into fixed-income instruments.
• This can be considered another deviation from Shari’ah.
Sukuk al-Musharakah
• Musharakah involves establishing a partnership or company to provide financing with the participants sharing in the profits in relationship to the size of their investment share.
• Notes can be issued on the basis of such financing and both Sudan and Iran have launched such securities.
• In practice, these have been very similar to mudarabah certificates rather than being a distinct asset class.
Bay al-arboon
• Some Islamic funds utilize down- payment with an option to rescind the contract by foregoing the payment as a penalty to minimize portfolio risks in principal protected funds (PPF’s).
Arboon v Financial Option
Arboon• Mixed Game
• The good must be identified.
• Arboon is embedded into the contract.
Financial Options• Zero-sum game.
• No good is necessary.
• Option premium is independent of sale.
Arboon
• If ownership is not transferred: Call option in substance, zero-sum game.
• If ownership is transferred: Embedded put option; non-zero-sum gam.
PPF Arrangement
• 97% of total funds raised are invested in low risk (low return) but liquid murabahah transactions.
• The remaining 3% of the funds are used as a down-payment for arboon to purchase common stock in a future date.
• If the future price of the stock increases as expected by the fund manager, the arboon is utilized by liquidating the murabahah transactions.
PPF Arrangements
• Thus, the principal of the fund is fully protected.
• In this way, arboon is utilized effectively in protecting investors against undesirable down side risks of investing in stocks while at the same time keeping an opportunity for gains from favorable market conditions.
Netting
• On-balance sheet netting is another method used to minimize the exposure of risks to the net amount between the receivables and payables to counterparty.
• Netting is more suitable for payments between two subsidiaries of a company.
• With non-subsidiary counterparties, the currency position of receivables and payables can generally be matched so that the mutual exposures are minimized.
Swap of Liabilities
• Exchange of liabilities can also minimize exposure to foreign exchange risk.
• I.E. a Turkish company needs to import rice from Pakistan, and a Pakistani company needs to import steel from Turkey. The two parties can mutually agree to buy the commodities for each other, bypassing the currency markets.
• If the dollar amount of the two commodities is the same, this arrangement can eliminate transaction risk for both parties.
• If the ratings of the two companies are good in their own home countries as compared to the other country, this swap will also save them some sort of the cost of finance.
Deposit Swap
• In this method, two banks in accordance with their own expected risk exposures agree to maintain mutual deposits of two currencies at an agreed exchange rate for an agreed period of time.
• I.E. a Saudi bank will open a six months account for SR (Saudi Riyals) 50m in a counterpart Bangladeshi Bank.
• The Bangladeshi Bank will open the TK (Taka) amount of the SR deposit in the Saudi bank for the same period.
• The SR/TK exchange rate will be mutually agreed and will be effective for the deposit period.
Deposit Swap
• After the six months, both banks will withdraw their deposits.
• In this way, the risk exposure for the value of the deposits for the currency involved are minimized according to the two banks’ own perceptions.
• However, under Shariáh, the exchange rate cannot be any rate except the spot rate.
• In this case, the rate is fixed for a period during which there could be a number of spot rates not only one.
• The exchange of deposits is also questionable.
Forward Wa’d-I Product
• A forex forward Wa’d-I product is a unilateral contract involving two parties, where the first party promises with the latter party to buy or sell currency for settlement on a forward value date at the rate and amount agreed today.
• The party who makes the promise is obliged to honor the contract; however, the other party is not obliged to do the same.
Forward Wa’d-I Product
• Customer promises on 24 June 2010 to buy USD10 million from an Islamic bank on 24 July 2010 at the exchange rate 3.2700. The customer is bound by the unilateral promise.
• On 24 July 2010, the bank will pay USD10 million and receives MYR 32.7 million from customer.
• The currency exchange is complete and the customer receives USD10 million at the exchange rate 3.27000 regardless of the market rate.
Permissibility of Wa’d
• The use of wa’d instrument (unilateral binding promise) has been approved in the trading of currencies by the OIC Fiqh Academy, the AAOIFI and the Shariáh Advisory Council of Bank Negara Malaysia.
• However, bilateral promises are not allowed.
• What is allowable? A unilateral promise by one party or two independent unilateral promises given by two parties to each other, but dependent on two different conditions.
Islamic Forex Swap
• This structure is a forex swap based on the concept of wa’d.
• This arrangement consists of bay al-sarf at the beginning of the transaction followed by an undertaking (wa’d) by the customer to enter into a currency exchange (bay al-sarf) on a future date at today’s exchange rate.
• On the future date, another bay al-sarf takes place at the rate, which was promised at the earlier date.
Islamic Cross Currency Swap
• The Islamic Cross Currency Swap is a bilateral agreement between two parties to make regular payments to each other at an agreed interval, but in two different currencies.
• It is used as a risk management tool to hedge both the foreign currency rate and the profit-rate risk.
• The bilateral payments can be done in different arrangements: fixed-exchange rate (Fixed) swapped with floating exchange rate (e.g. based on KLIBOR) (floating), floating-floating, fixed-fixed, or floating-fixed.
• A commodity transaction is used at every settlement date.
Example
• A client receives 5% quarterly for five years for its US$10 million investment. In other words, the client receives fixed investment returns in USD; however, it requires MYR to pay for its liabilities. So, the client swaps this with an Islamic bank for Ringgits, based on KLIBOR. The exchange rate is fixed, thus hedging against forex rates.
Islamic Profit Rate Swap
• The Islamic Profit Rate Swap is a bilateral agreement between two parties to make regular payments to each other at agreed intervals.
• These instruments are used to hedge against adverse profit-rate movements, usually by exchanging cash flow from fixed to floating (or vice-versa) within the same currency.
• The commodity transaction is used at each settlement date.
• The amount and the period of time between the regular payments are customizable, according to the client’s and bank’s needs.
Islamic Profit Rate Swap
• The fixed rate is determined at the start of the contract and remains the same until the end of the tenure and agreed reset date.
• The floating rate is referenced to an index and is determined at every settlement date.
• The notional amount is usually not exchanged: only the net-off amount (difference) is exchanged at each settlement date.
Example
• A client has a RM 2 million rental obligation with a two-year remaining tenure. The client is paying a floating rental by paying a KLIBOR flat every quarter and wishes to pay an equivalent or fixed rental.
• The Islamic bank agrees to swap the floating rental payments with a fixed rate for the next two years at 3.5% p.a. In other words, the client will give the Islamic bank the rental based on KLIBOR, and the Islamic bank will swap this with the client at a fixed rate of 3.5%.
Forex Wa’d
• The forex wa’d is a structure similar to a conventional option.
• It uses the wa’d promise, which is binding on one party.
• On the start date of the transaction, the bank will undertake to the customer to exchange Currency 1 against Currency 2 at a pre-agreed rate on a future date.
• On the same date, the bank will receive a fee from the customer for its undertaking.
Forex Wa’d
• On the future date, the customer might ask the bank to fulfil its promise or might release the bank from its undertaking.
• If the customer wants to execute the wa’d upon the maturity date, the bank and the customer will exchange the currencies.
• The customer will want to execute the wa’d if the currency rate is favorable to him.
• The upside of the contract is that the customer can wait and see whether the wa’d is more favorable or less favorable then the prevailing market rate. However, the customer is required to pay a fee for the wa’d.
Synthetic Forward
• The purpose of the synthetic forward is to design a currency forward without using the currency forward contract.
• The synthetic forward can be designed given a number of conditions.
• These conditions are the need for hedging against foreign exchange risk, the existence of an equal tenure local murabahah investment, and foreign murabahah investment.
• The existence of a known rate of return on the Murabahah-based investments is another condition.
Synthetic Forward
• Finally, the foreign bank, which invests in dollar-based murabahah, is willing to collaborate with the local bank, which invests in the local currency-based murabahah.
• The dollar amount of the two investments must be the same.
Currency Forward or Future v Islamic Hedge
Conventional Currency Risk• Use Currency Forwards of
Futures.
• Buy future for Euros for Future Dollars at $1.45 per 1 Euro from an investment bank.
• At maturity, importer delivers $1.45 and receives 1 Euro.
• Euro is then delivered to exporter.
Islamic Hedge• Bank buys from exporter in
Euros and sells to importer in dollars.
• Replaces Currency Forwards.
• Integrates risk transfer with value-creation.
• Prevents speculation.
Immunization
• Once the net exposure is minimized, the possibility exists that the exposure can be hedged.
• Suppose an Islamic bank has to pay in three months time $1 million for a contract, which it has signed when the exchange rate is Rs. 60/$.
• The risk is that after three months, the dollar will appreciate as compared to the initial exchange rate.
• The bank can protect against this risk, by raising three months PLS deposit in Rupees for the dollar value of 1m and buying with this amount $1m at the spot rate.
Immunization
• These dollars can then be kept in a dollar account for three months.
• After the three months and at the time of making the payment, the PLS deposit will mature and the bank can share the earning on the dollar deposit with the rupee deposit holders.
• Thus, the dollar exchange rate risk for three months period is fully hedged by the banks.
Islamic Structured Products
• Islamic-structured products are investment products and not risk-management tools. It is firstly an investment product and secondly, it derives its value from an underlying asset, like a derivative.
• Structured products are investment instruments specially created to meet specific needs that cannot be met from the standardized financial instruments available in the markets.
• Structured products can be used as an alternative to a direct investment, as part of the asset allocation process to reduce risk exposure of a portfolio, or to utilize the current market trend.
• I.E. Wa’d Based – Deutsche Bank and Commodity Murabahah – based Structured Product – Calyon Bank.
Istijrar Contract
• Introduced in Pakistan, it has embedded options that can be triggered if the underlying asset’s price exceeds certain bounds. The contract constitutes a combination of options, average prices, and murabahah or cost-plus financing.
• The istijrar involves two parties, a buyer, which could be a company seeking financing to purchase the underlying asset and a financial institution.
Istijrar Contract
• What the istijrar contract attempts to do is to allow for the impact of price changes, but to cap the benefits that accrue as a result.
• Since price changes are allowed only within a band, the advantage to one party and the disadvantage to the other is capped.
• The maximum potential gain or loss is limited.
• Such a contract fulfills the need to avoid a fixed return on a riskless asset, which would be considered riba and also avoids gharar in that both parties know upfront, price and the range of other possible prices (by definition between the upper and lower bounds).
Internal Ratings
• An internal rating system can be described to be a risk-based inventory of the individual assets of a bank.
• To conduct internal ratings, one should collect information regarding the credit quality of the client and maturity of the facility.
• All banks conduct internal ratings of their assets and clients to maintain the regulatory loan loss provisions.
RAROC
• RAROC is used for allocating capital among different classes of assets and across business units by examining their associated risk-return factors.
• An application of RAROC in Islamic finance would be to assign capital for the various modes of financing.
• Using historical data on different modes of financing for investments, one can estimate the expected loss and maximum loss at a certain level of confidence for a given period for different financial instruments.
RAROC
• Then this information can be used to assign risk capital for different modes of financing by Islamic financial institutions.
• The concept of RAROC can also be used to determine the rate of return or profit rate on different instruments ex-ante.
Two-Step Contracts and GAP Analysis
• GAP Analysis is used to manage interest rate risk.
• The GAP analysis is used to measure the net income and its sensitivity with respect to a benchmark.
• Risk management tools then target at ideally making the net income immune to any changes in the benchmark rate, i.e. a target net income is achieved whatever the market benchmark may be.
• If such an objective is achieved, an increase in the benchmark will not pose any risks to the targeted net income.
• The cash flows of the bank remain stable at a planned level ensuring stability of net income.
Liquidity Risk
• Liquidity risk is the variation in a bank’s net income due to the bank’s inability to raise capital at a reasonable cost either by selling its assets in place (asset liquidity problem) or by borrowing through issuing new financial instruments (funding liquidity problem).
• All other risks of a bank culminate into liquidity crunch before bringing a problem bank down.
• Operationally, a bank fails when its cash inflows from repayment of credits sale of assets in place and mobilization of additional funds fall short of its mandatory cash outflows, deposit withdrawals, operating expenses, and meeting its debt obligations.
Liquidity Risk
• On average, conventional banks maintain the bare minimum liquidity, which can satisfy regulatory requirements.
• The liquidity position of Islamic banks is much in excess of the regulatory requirements.
• This means that these liquid funds are either not earning any return at all or earning a return much lesser than the market rates.
• Thus, the excess liquidity position of the Islamic banks generates for these banks a serious business risk as it adversely affects the rates of returns offered by them as compared to their conventional competitors.
Liquidity Risk
• Furthermore, in most cases these banks largely rely on current accounts, which is a more stable source of free liquidity.
Islamic Banks are Prone to Face Serious Liquidity Risk
• There is a Fiqh restriction on the securitization of the existing assets of Islamic banks, which are predominantly debt in nature.
• Thus, the assets of Islamic banks are not liquid as compared to the assets of conventional banks.
• Due to slow development of financial instruments, Islamic banks are also not able to raise funds quickly from the markets. This problem becomes more serious due to the fact that there is no inter-Islamic banks money market.
Lender of Last Resort
• The specific objective of Lender of Last Resort (LLR) facilities is to provide emergency liquidity facility to banks whenever needed.
• The existing LLR facilities are based on interest, therefore, Islamic banks cannot benefit from these facilities.
Conclusion
• While Islamic banks have established a relatively good risk management environment, the measuring, mitigating, and monitoring processes, and internal controls needs to be further upgraded.
• Problems include lack of instruments (like short-term financial assets and derivatives) and money markets.
Unique Systemic Risk
• The nature of the Islamic banks’ current and investment accounts creates a unique systemic risk, namely, the transmission of risks of one account to the other.
• In the Islamic banking windows of traditional banks, this systemic risk could be in the form of risk transmission between permissible and impermissible sources of income.
• These two systemic risks can be prevented by requiring separate capital for the current and investment accounts of an Islamic bank as well as for Islamic windows in conventional banks.
Shariáh Compliant Risk Mitigation
• The growth of the Islamic financial industry is dependent on the development of an effective and Shariáh complaint risk mitigation system.
• This calls for more research to develop risk management instruments and procedures that are compatible with the Shariáh.
Management Responsibility
• The Board of Directors can create the risk management environment by clearly identifying the risk objectives and strategies.
• The management can implement these policies by efficiently establishing systems that can identify, measure, monitor, and manage various risk exposures.
• To ensure the effectiveness of the risk management process, Islamic banks also need to establish a proficient internal control system.
Risk Reports
• Risk reporting is extremely important for the development of an efficient risk management system. Islamic banks can improve their system by producing the following periodic risk reports:
• Capital at Risk Report: Credit Risk Report; Aggregate Market Risk Report ; Interest Rate Risk Report; Liquidity Risk Report ; Foreign Exchange Risk Report; Commodities and Equities Position Risk Report; Operational Risk Report.
Country Risk Report
Internal Ratings
• Initially, an internal rating system may be seen as a risk-based inventory of individual assets of a bank.
• Such systems proved highly effective in filling the gaps in risk management systems, hence enhancing the external rating of the concerned institutions.
• This contributes to cutting the cost of funds.
• Internal Ratings systems need to be strengthened in all Islamic banks.
Risk Disclosures
• Disclosures about risk management systems are extremely important for strengthening the systems.
• Introducing a number of risk-based systems can enhance risk disclosures.
Risk – Based Management Information System
Risk – Based Internal Audit Systems
Risk- Based Accounting System
Risk- Based Asset Inventory System
Supporting Institutions and Facilities
• Risk can be reduced by establishing the following institutions:
Lender of Last Resort Facility; Deposit Protection System; Liquidity Management System; Legal Reforms to Facilitate Islamic Finance Dispute Settlement; Dubai World Islamic Finance Arbitration Center (DWIFAC) and Jurisprudence Office (DWIFACJO); Islamic Finance Bankruptcy Court (IFBC) Standardized Contracts; Central Industry Regulator; Uniform Shariáh Standards; Adoption of AAOIFI Standards; Establishing a Supervisory Board for Industry and Centralized Shariáh Board.
International and Industry Standards
• Islamic banks should participate in the follow up process with international standard setters and respond to consultative documents on a regular basis.
• The Islamic Banking Industry should have its own official standard setter and harmonize the use of standards across the industry.
Research and Training
• Risk Management needs to be assigned as a priority area of research and training programs.
• It is imperative to develop Shariáh compatible risk management techniques and organize training programs to disseminate these among the Islamic banks.
THE END