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

Introduction to Risks in Financial Institutions Session 1 Introduction to Risks in Financial Institutions

Risks—Basic Concept Risk: “existence of uncertainty about future outcomes” “difference between expected and actual result” Uncertainty classified as general and specific 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: 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

Typical Balance Sheet of FI Liabilities Assets Deposits & Debt Banking Portfolio Equity Trading Portfolio

Nature of Risks Arising in FI 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 Credit 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

Risks faced by FIs (2) Liquidity risk Operational risk Funding liquidity risk Trading liquidity risk Operational risk 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 Savings and investment accounts –mudarabah Demand deposits—qard hasan Asset side 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 PSIA—mudarabah contracts Demand deposits—qard hasan Need to keep risks separate 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 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

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 Standardization of contracts Lack of statutes and enforcement institutions Limitations of using RM instruments Derivatives Liquidity management instruments

Risk Perceptions-Types and Instruments Average Ranking 3.08 Credit Risk (CR) 3.24 Market Risk (MR) 2.8 Sale based Instruments (CR+MR) 3.55 Equity based Instruments (CR+MR)

Withdrawal Risk – Perception of IFIs Average Ranking 3.47 The rate of return on deposits has to be similar to that offered by other banks. A low rate of return on deposits will lead to withdrawal of funds 3.13 Depositors would hold the bank responsible for a lower rate of return on deposits

Risks in Islamic Financial Instruments Session 2 Risks in Islamic Financial Instruments

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: possession time (spot/future) liquidity of asset/wealth (asset/cash).

Risk classification according to wealth type and time period Possession time period Wealth Type Future Current/spot CR No risks (NR) Cash CR/MR MR Asset

Financial Murabahah 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 Conclusion of transaction Transaction period Beginning of transaction IFI receives cash—NR Price due—CR IFI buys good, delivery not ensured—MR Murabahah (non-binding) IFI buys good, delivery ensured –NR Murabahah (binding)

Ijarah and Ijarah wa Iqtina 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 Conclusion of transaction Transaction period Beginning of transaction Asset remains with IFI –MR Rent due—CR IFI buys asset—MR Ijarah Asset transferred—NR Ijarah wa iqtina

Salam 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 Conclusion of transaction Transaction period Beginning of transaction IFI receives good—MR Good due—CR Necessary cash in hand—NR Salam IFI receives good, delivers good—NR Necessary cash in hand, and commits to sell good—NR Parallel Salam

Istisna 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 Conclusion of transaction Transaction period Beginning of transaction IFI delivers asset, receives cash –NR Cost of production—MR Price due—CR IFI commits to manufacture asset. Istisna Seller delivers asset, IFI delivers asset, receives cash –NR Seller delay in delivery/not according to specification—CPR IFI commits to manufacture asset, subcontracts. Parallel Istisna

Mudarabah 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 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 Conclusion of transaction Transaction period Beginning of transaction Principal due: Cash—NR Equity—MR Profit share/return due—CPR IFI invests (buys non-voting shares) Mudarabah IFI invests (buys voting shares) Musharakah Asset/equity transferred—NR Diminishing Musharakah

Risk Matrix of IF Instruments Mushar. Mudar. Istisna Salam Ijarah Murab. Risks X ? Benchmark MR Equity price Asset/Com. Price Currency Settlement CR Counterparty

Mitigating risks—financial murabahah Session 3 Mitigating risks—financial murabahah

Murabahah-basic features Murabahah is a sale contract The seller reveals the actual price of the asset/good being sold and indicates the profit in lump-sum or as a percentage Delivery of the asset/good is spot, payment can be spot or deferred Bai-muajjal is a sale with spot delivery and deferred payment

Murabahah as Financing Mode 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

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)

Points to note The commodity cannot be bought from the client If the bank purchases, the agency contract not needed 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

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

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

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.”

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

Post-Sale Risks Mitigation 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)

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”

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

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"

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

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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