FINAL YEAR PROJECT

CREDIT RISK IN ISLAMIC BANKING SYSTEM

AND FINANCE
(INTRODUCTION)

STUDENT NAME
NUR AIN NAZIRAH BINTI MD NOOR
FATIN KHAIRUNNISA BINTI AZHAR






CHAPTER 1: INTRODUCTION

1.1: Introduction

1.2: Background of study
In the past, theoretical studies on Islamic banking have focused on Islamic modes of
financing and their ability to perform financial intermediation for catering to the needs of people
so as to be substitutes for loans while ensuring the compatibility of these modes with laws
regulating banking operations. Banking supervision, however, has not received its due share in
these studies. It is well known that banking supervision is concerned with various aspects of risk
in banking operations. As the bank is a trustee of public funds, it is incumbent upon it to utilize
these funds in ways that protect the rights of the owners of these funds. Therefore, comparative
studies on risk underlying Islamic modes of finance are extremely important. The unique features
of Islamic banks do not insulate them from risk. Instead, the Syariah perspective on the concept
of profit itself stresses that profit is a return to those who are willing to undertake risk..
Credit risk is defined as the possibility that an Islamic bank customer or third-party will
fail to meet obligation in accordance with agreed terms. Credit risk management aims to
maximise banks risk-adjusted rate of returns by maintaining credit risk exposure within
acceptance parameters. Islamic banks need to manage the credit risk inherent in the entire
portfolio as well as the risk in individual credits or transactions. Islamic banks should also
consider the relationships between credit risks and the other risk. The effective management of
credit risks is a critical component of a comprehensive approach to risk management and
essential to the long-term success of any banking organization.
For most Islamic banks, financing are the largest and most obvious source of credit risks;
however, other sources of credit risk exist throughout the activities of a bank, including in the
banking book, the trading book, and both on and off the balance sheet. Islamic bank are
increasingly facing credit risks or third-party risks in various financial instrument including sale
receivables, acceptances, interbank transactions, trade financing, foreign exchange transactions,
financial futures, swaps, sukuk, equities, options, and inthe extension of commitments and
guarantees, and the settlement of transactions.
The term Al-Itiman is correctly used by economists to denote the meaning of the
banking term "credit. In some dictionaries, the following meanings are given under the term
credit: It is the belief held by people that a certain person is wealthy.The author of the dictionary
adds: It is an obligation created by the bank for one who demands from it that he be permitted to
use a particular asset on account of the confidence reposed in him with respect to it.
This exactly is the meaning of itiman. It is incorrect to state that itiman means granting
a loan. Itiman is the confidence reposed by the bank in someone before it is prepared to grant a
loan or provide a guarantee. Accordingly, loan is dependent on this confidence and is a result of
it. Guarantee is part of what is termed credit in banking jargon and is based on the same
confidence. In some banking dictionaries, it has been defined as the ability to raise loans and
purchase goods in return for a promise to pay in the future. There are others who have defined it
as mans confidence in man.
The unique features of Islamic banks do not insulate them from risk. Instead, the Syariah
perspective on the concept of profit itself stresses that profit is a return to those who are
willing to undertake risk. The foundational fiqh axiom of Islamic banking, al-khiraju bi al-daman
and al-ghunmu bi al- ghurm, are risk-based. These two axioms basically mean that the
entitlement to the returns from assets.
Therefore, those who are willing to invest their deposits should be willing to accept
negative outcomes even as they expect positive returns from their investments. Islamic banks
that act as investment intermediaries and commercial banks, deal with risk-taking activities
hence they are also subjected to risks, similar to their conventional counterparts. However, the
types and sources of risks faced by Islamic banks differ from those of conventional institutions
duet to the differences in the philosophy and operating principles that government Islamic
banks.Operating side by side with conventional banks, Islamic banks are not spared but equally
vulnerable to risks. The exception is that the nature of risks facing Islamic banking is unique.
This uniqueness arises from the composition of its assets and liabilities.
.On the asset side, investments, whose funds are Shariah based, can be undertaken in the
form of profit sharing modes of financing (Mudarabah and Musharakah), fixed-income modes of
financing such as Murabahah (cost-plus or mark-up sale), installment sale (medium/long term
murabahah), Istisna /salam (object deferred sale or prepaid sale) and Ijarah (leasing). In contrast,
on the liability side, its deposits can either be kept in the form of current accounts or in
investment accounts. Current account depositors get their deposits on demand whilst investment
depositors in Islamic bank are rewarded with the opportunity to share with the bank the profit
and business risks (or losses) of the investment activity. The different nature of its asset and
liability composition and the profit and loss sharing basis change the nature of risks that Islamic
banks face (Khan and Ahmed, 2001).
Past studies have covered extensively on risk and factors contributing to risks of financial
institutions in the conventional banking system (Khan and Ahmed, 2001; Hassan, 1993,1994;
Berger and DeYoung, 1997; Angbazo et al., 1998;Ahmad, 2003). Despite its importance to
achieving good risk management in Islamic banking, these factors have not been widely
investigated and documented. Previous attempts to study Islamic banking mainly evolve on
conceptual issues underlying interest free system (Hassan and Bashir, 2002). The issue of the
viability of Islamic banks has not received great attention. Hence, given the unique nature of
Islamic banking and the dynamic changes in the global financial markets, which pose numerous
risks to banks, there is a need to identify empirically, key factors influencing risk formation in
Islamic banks an area that has not been widely studied.
Credit risk is one of the main risks that seriously affect banks viability as evident from
the 1997 financial crisis. To this extent, Sarker (1999) found that the amount of bad debt in
Islamic banking is growing. Further, Khan and Ahmed (2001) find that bankers of the view that
there is a lack of understanding of risks involved in Islamic banking. This gap justifies new
efforts to examine as to why Islamic banking experiences increasing bad loans and high credit
risk. This entails an investigation on the factors influencing Islamic banking credit risk. To
ensure that the viability and sustainable growth of Islamic banking is maintained, it is important
that these factors be identified early to ensure necessary precautions and preventions are taken.
In 1984, the Islamic banking was introduced in Malaysia with the establishment of Bank
Islam Malaysia Berhad. The revival of Islam worldwide has paved the way for Islamic banking
growth as more people consciously seek to lead their lives in accordance with the Syariah. In
tandem with the global trend, Islamic banking in Malaysia has achieved a rapid expansionary
performance since its inception in 1984. Its commendable performance and its presence as an
alternative banking with good growth potential have in fact, been the hallmark for Islamic
banking among many Muslim countries.
The sudden impetus to the growth was attributed by the innovative measure taken by
Bank Negara Malaysia to allow conventional banks, finance companies and merchant banks to
offer Islamic banking services or Islamic windows through the creation of Interest-free Banking
Schemes. This scheme introduced in 1993 was later improved to be the present Skim Perbankan
Islam (SPI). As at end 1999, there are 46 SPI windows. The number of banks has increased since
then, with the current policy of permitting foreign banks to offer Islamic banking products and
services. The total deposits and financing of Islamic banking grew from RM2.2 billion and
RM1.1billion in 1993 to RM47.1billion and RM 43.7billion by December 2003. Its market share
(represented by the percentage of loans over the total loans of the banking system) increased
from 0.3% in 1984 to 9.7% in 2003. With a greater number of players and the incorporation of a
second Islamic bank; Bank Muamalat Berhad in 1999, the Islamic banking is poised for further
growth and is competing aggressively with the conventional banking, particularly in extending
financing to customers. These funds are extended to different sectors of the economy.
In the case of Islamic banking, the financing extended to customers is mostly in the form
of credit sale (al-murabahah and ijara wa iqtina) in which an Islamic bank will purchase goods
on a cash basis and sell to customers on credit terms. This financing (known as cost-plus or
mark-up sale) accounts for more than 90 percent of its total assets (Rosly and Abu Bakar, 2003)
in Malaysia. The second largest financing mode is on profit sharing (Mudarabah and
Musharakah). The depositors of an Islamic bank through the profit and loss sharing basis absorb
the credit risk.
The recent development in Islamic banking in Malaysia is the establishment of the
Islamic Financial Services Board (IFSB). IFSB has the important mandate of developing
prudential standards to cater to the unique features of Islamic banking operations. One of the
focus areas in Islamic banking is on instituting robust risk management practices and system.
. Based on a survey of related literature on risk determinants (Ahmad, 2003;Hassan,
1992,1993; Hassan et al.,1994; Shrieves and Dahl,1997;Angbazo et al,1998), several variables
have been identified to form the regression model. NPL to total loans is taken as a proxy for
credit risk (Rose, 1996; Berger and DeYoung, 1997; Corsetti, Persenti and Roubini,1998). The
estimated predictors consist of seven variables: management efficiency (MGT), leverage (LEV),
risky sector loan exposure (RSEC), regulatory capital (REGCAP), loan loss provision (LLP),
funding cost (FCOST), Risk-weighted assets (RWA), natural log of total assets (LNTA) and
proportion of loan to deposit (LD).
Credit risk in the banking system remained stable throughout the quarter amid sustained
debt servicing capacity of borrowers. As at end-June 2013, the ratio of net impaired loans
declined further to 1.3% (1Q 2013: 1.4%), while loans-in-arrears of between one and three
months were lower at 3.1% of total loans (1Q 2013: 3.4%). The credit risk exposures of the
insurance industry, mainly through holdings of private debt securities and reinsurance
placements, remained stable in terms of level and quality, accounting for 3.4% (1Q 2013:3.3%)
of capital base.




1.3: Problem Statement
In the real world, a bank will have to investigate ones credit history in order to decide
whether to lend money to the person or to determine the interest rate they are going to charge. In
addition, different borrowers pay different interest rates, based on their credit histories.
Therefore, it is not surprising that investors have to get enough information in order to decide
whether to purchase specific bonds. Owing to the importance of credit risk analysis, there is a
growing research stream about it.
Accordingly, many different approaches including individual models, such as linear
discriminant analysis (Fisher, 1936), logit analysis (Wiginton, 1980), probit analysis
(Grablowsky and Talley, 1981), linear programming (Glover, 1990), integer programming
(Mangasarian, 1965), k-Nearest Neighbour (k-NN) (Henley and Hand, 1996), classification tree
(Makowski, 1985), Artificial Neural Networks (ANN) (Malhotra and Malhotra, 2003; Smalz and
Conrad, 1994), Genetic Algorithm (GA) (Chen and Huang, 2003; Varetto, 1998) and Support
Vector Machine (SVM) (Van Gestel et al., 2003; Huang et al., 2004), and some hybrid models,
such as neuro-fuzzy system (Piramuthu, 1999; Malhotra and Malhotra, 2002) and fuzzy SVM
(Wang et al., 2005), are widely applied to credit risk analysis tasks. Two recent surveys on credit
scoring and credit modelling are Thomas (2002) and Thomas et al. (2005)
Based on a survey of related literature on risk determinants (Ahmad, 2003;Hassan,
1992,1993; Hassan et al.,1994; Shrieves and Dahl,1997;Angbazo et al,1998), several variables
have been identified to form the regression model. NPL to total loans is taken as a proxy for
credit risk (Rose, 1996; Berger and DeYoung, 1997; Corsetti, Persenti and Roubini,1998). The
estimated predictors consist of seven variables: management efficiency (MGT), leverage (LEV),
risky sector loan exposure (RSEC), regulatory capital (REGCAP), loan loss provision (LLP),
funding cost (FCOST), Risk-weighted assets (RWA), natural log of total assets (LNTA) and
proportion of loan to deposit (LD).
The question is whether credit risk (CR) have a negative relationship with MGT, LNTA
and REGCAP. Lower efficiency in managing earning assts would probably lead to higher credit
risk; size and capital are risk- related as smaller capitalized bank tend to have lower capacity to
absorb losses. On the other hand, what kind of relationship between LLP, FCOST, RSEC, LEV,
RWA and LD to CR. A bigger loan loss provision is required if a bank anticipated its credit risk
to be higher. Costs related to funding the operations such as loan monitoring, rescheduling and
recovery efforts in the event of high problem loans are expected to increase. Similarly, greater
exposure to risky sectors and a larger proportion of risk-weighted assets tend to have higher
probability of credit risk.

























1.4: Objective
1.5: Research Question
1.6: Scope Of Study
1.7: Significant Of Study
Those who deal with Islamic banks observe that the cost of financing on average is greater than
the cost of financing by conventional banks. For example, compare the cases of two persons.
One borrows on interest from a conventional bank a sum of 100,000 riyals for a period of three
years with which he buys a car costing 100,000 riyals. The other buys the car himself on the
basis of murabahah with installments running over a period of three years. The second person
will most likely, bear greater costs than the former.11 This means that the excess amount
charged due to delayed payment in murabahah is more than the interest on loan. Islamic banks
do not deny this, but they respond by saying that their operations carry higher credit risks. When
the relationship between the return and the credit risk is directly proportional, it is natural that the
cost of Islamic financing be higher for bearing such risk. This is an issue that needs examination
and consideration because it gives rise to direct effects on the ability of the banks to remain
competitive and the effects on the policies of central banks in supervising and directing Islamic
banks.




1.8: Organization Of Study


























Research aims and Objectives
To evaluate the credit risk in the Islamic banking system in order to highlight the issue of
Islamic banking.
To consider the relationship between credit risks and other risks.
To analyze those factors that give rise to the credit risk in Islamic banking and finance.
To improve risk management in Islamic banking and finance.

Significance of Study
Those who deal with Islamic banks observe that the cost of financing on average is
greater than the cost of financing by conventional banks. The excess amount on the basis of
murabahah in Islamic banking charged due to delayed payment in murabahah is more than
interest on loan in conventional banking. This happens because operations in Islamic banking
carry higher credit risk rather than conventional banking.
When the relationship between the return and the credit risk is directly proportional, it is
natural that the cost of Islamic financing be higher for bearing such risk. This is an issue that
need to consider because it gives rise to direct effects on the ability of the banks to remain
competitive and the effects on the policies of central banks in supervising and directing Islamic
banks.

Rational of Study
Banks and financial institutions are contributing in the economic development through
different segments in the form of investment and landing. Bank of our country play roles from
conventional and Islamic perspective.
Islamic Banks are operating based on Islamic shariah and principles that does not support
with higher interest whereas conventional banks are in favor of interest and conventional rules
and regulation.
.


Research Question
How Islamic banks are also exposed to credit risk due to a default by a counter-party .
What is the relationship between credit risk and other risk.
What factor that contributed to credit risk in Islamic banking system.
What are the similarities and differences between credit risk predictors of Islamic
banking and conventional.
Why are the modes of Islamic banking and finance that is considered to be much riskier
than the conventional.
How to improve risk management in Islamic banking.
How to minimize credit risk in Islamic Banking.







Credit default risk - The risk of loss arising from a debtor being unlikely to pay its loan
obligations in full or the debtor is more than 90 days past due on any material credit obligation;
default risk may impact all credit-sensitive transactions, including loans, securities and
derivatives.
Concentration risk - The risk associated with any single exposure or group of exposures with the
potential to produce large enough losses to threaten a bank's core operations. It may arise in the
form of single name concentration or industry concentration.
Country risk - The risk of loss arising from a sovereign state freezing foreign currency payments
(transfer/conversion risk) or when it defaults on its obligations (sovereign risk); this type of risk
is prominently associated with the country's macroeconomic performance and its political
stability.