1. Risks Underlying Islamic Modes of Financingby
Habib Ahmed

2. Lecture Plan
Session 1: Introduction to Risks in Financial Institutions
Session 2: Risks in Islamic Financial Instruments
Session 3: Mitigating risks—financial murabahah

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

4. 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.

5. 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

6. 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

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

8. 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)

9. 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

10. 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

11. 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)

12. 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)

13. 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

14. 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

15. 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)

16. 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

17. Risks in Islamic Financial Instruments
Session 2
Risks in Islamic Financial Instruments

18. 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).

19. 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

20. 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

21. 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)

22. 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

23. 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

24. 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

25. 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

26. 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

27. 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

28. 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

29. 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

30. 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

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

32. Mitigating risks—financial murabahah
Session 3
Mitigating risks—financial murabahah

33. 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

34. 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

35. 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

36. 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)

37. 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

38. 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

39. 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

40. 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

41. 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.”

42. 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

43. 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)

44. 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”

45. 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

46. 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"

47. 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

48. 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

49. THANK YOU!