Professional Documents
Culture Documents
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Hassanain, Khalifa M
ISBN 9960-32-304-8
Islamic development Bank, 2016
King Fahd National library cataloging –Publication Data
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Contents
Chapter 1....................................................................................................................................................... 6
Learning Objectives....................................................................................................................................... 8
Chapter 2..................................................................................................................................................... 18
Learning Objectives..................................................................................................................................... 19
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Principles of an Effective Risk Analysis ....................................................................................................... 30
Chapter 3..................................................................................................................................................... 38
Learning Objectives..................................................................................................................................... 40
Chapter 4..................................................................................................................................................... 49
Learning Objectives..................................................................................................................................... 50
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Chapter 1
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Chapter Introduction
Welcome to the chapter, Fundamentals of Islamic Financial Intermediation.
Nature of financial intermediation between suppliers and users of funds depends upon:
How it is done.
Who does it.
Asset transformation
Conduct of orderly payments
Brokerage
Risk transformation
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Risk transformation includes spreading risks between the households that supply the funds
and businesses that use those funds. Intermediation was a familiar function in ancient
Islamic society.
Learning Objectives
On completing this chapter, you will be able to:
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Sharī‘ah recommends different types of intermediation, covering:
Asset transformation.
Payment system.
Custodial services.
Risk management.
The Mudarabah contract has been covered in detail in the chapter A Blueprint of the
Islamic Financial System-Part 4 of the course Islamic Financial System.
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Understanding the Balance Sheet of an Islamic Bank
A 100 per cent reserve is specified for demand deposits (Amanah) because:
For short-term: trade financing and financial claims from a sales contract
(Mudarabah/salaam)
Islamic bank can form a syndicate with other institutions to provide medium and long-term
capital. How it works:
Customized services.
Guarantees.
Underwriting services.
Finance trade.
Sell commodities.
Sell property.
These contracts have been covered in detail in the chapter A Blueprint of the Islamic
Financial System-Part 3 of the course Islamic Financial System.
Funds are meant only for original sale, not existing inventory.
Ijarah is a lease contract meaning hire and lease of tangible and intangible assets. Its
features:
Price.
Product specifications.
Musharakah contract combines partnership (Shirkah) and Mudarabah. Its features are:
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Two parties come together to share capital or labour.
Each partnership has different authority and obligations for the parties.
Muslim countries such as Iran, Sudan and Pakistan practice Islamic economics.
Islamic financial institutions have been covered in detail in the chapters A Blueprint of the
Islamic Financial System-Part 1 and Islamic Banking System and its Financial
Products of the course Islamic Financial System.
Banks in Iran, Sudan and Pakistan have been forced to comply with Sharī‘ah laws.
In the Middle East, Islamic banks are owned by public companies, holding companies or
wealthy individuals.
Two major holding companies include Dar al Māl Islami and Al-Barakah.
Not a single Islamic bank is in the list of world’s top 100 banks.
Over 60 per cent of Islamic banks have assets less than $ 500 million lower than viability
level.
The largest Islamic bank has one per cent of assets of largest conventional bank.
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In the 1980s, conventional American and European banks started Sharī‘ah-compliant
services.
ABN Amro
ANZ Grindlays
BNP Paribas
Citicorp Group
Morgan Stanley
Islamic investment banks focus on large transactions, investment banking and underwriting.
These are different from commercial Islamic banks that focus on retail and consumer
finance.
Of them, 85 were equity funds, offering commodity, leasing and trade related funds.
Fund managers look for equity in Western markets where Sharī‘ah-compliant companies are
difficult to find.
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The Dow Jones Islamic Market (DJIM) tracks 2700 stocks to identify Sharī‘ah-compliant
stocks.
The criteria for choosing stocks to be included in Islamic equity funds are covered in detail
in the chapter Islamic Investment Funds of the course, Islamic Financial System.
Ijarah or lease
Equity or diminishing Musharakah where lender and borrower have joint ownership.
The co-operative model where members buy equity or Musharakah shares and help
each other buy property
Prominent US agencies in the mortgage industry now underwrite and securitise Islamic
mortgages.
Growth opportunities for Islamic mortgages exist in Western societies such as the USA.
Members are liable for money distributed if premium collected is insufficient to meet
losses.
Takaful companies can maintain reserves by collecting money over and above premium.
Takaful companies have been covered in detail in the chapter The Islamic Takaful
System---Part 1 and The Islamic Takaful System---Part 2 of the course Islamic
Financial System.
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It is incorporated as separate legal entity.
It cannot accept deposits and is funded entirely by equity owned by subscribers and
the general investing public.
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Chapter 2
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Welcome to the chapter, `Framework for Risk Analysis in Islamic Banking’.
Learning Objectives
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Financial risk
Operational risk
Business risk
Events risk
For example: A bank dealing with forex currencies will face currency variations daily and
will also face volatility in liquidity or credit if it carries open positions.
Examples:
Computer glitch
Non-compliance with procedures
Mismanagement of funds
Examples:
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The process involves:
The risk management authority must be at the highest level of the bank.
Authority must be responsible for ensuring implementation of bank policies and asset-
liability committee decisions.
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The strategy should reflect operational requirements and targets.
Risk Analysis
It should include a comprehensive risk analysis to study the details of non-obvious risk
factors.
It must:
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The model helps identify impact of changes on bank’s profitability and net worth.
A variety of quantitative techniques are available with financial institutions and software
vendors.
Today, there is awareness that all types of financial and operational risks must be handled.
Changes in the market economy have changed the way banks work.
External agencies monitor banks, their viability and compliance to regulation. Checks are
typically conducted annually.
Supervisory bodies
External auditors
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Third party evaluators
Supervisory Bodies
External Auditors
Financial assessments.
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Accesses foreign markets.
The central bank of a country supervises the nation’s banking industry and individual banks.
Framework of Appraisal
Appraisal of Islamic banks must consider the unique contractual nature of transactions.
• Financial condition
• Viability
• Future prospects
Outcomes of appraisal:
• Analysis on whether the bank can be reformed or the bank’s condition threatens the
entire industry
Letters to shareholders.
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Memorandum of Understanding.
Institutional programme.
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A bank must have:
Good management
Effective strategies
Supervision
Sound macroeconomic policies
Good legal framework
Solid financial infrastructure
Safety nets
Market discipline
Financial analysis:
• Projected value of the bank and its shares based on future performance.
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Financial analysis is based on:
• Financial statements.
• Footnotes.
• Management discussions.
• Bank performance.
• Financial condition.
• Nonfinancial information.
• Future projections.
• Industry information.
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• Bank’s projections.
• Macroeconomic forecasts.
Example: Operating lease is treated as rental contract and not as an asset. The practice
goes against global accounting practices.
It’s necessary for practices and procedures to keep pace with market innovation.
• Quality of governance.
• Management policy.
• Internal controls.
This type of analysis views ratios in the light of changes in risk profile.In balance sheet
analysis, a bank must be studied as:
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• Individual entity.
Peer-based risk analysis compares an entity’s practices to peer-group entities and industry
standards.
• Interpretation of data.
Analyst must use statements along with industry information to make valid investment conclusions.
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More Principles of an Effective Risk Analysis
Context includes:
Country
Sector
Legal framework
Corporate governance
Graphs
Industry trends
Conclusions
Recommendations
Purpose
What are the analytical limitations and will these limitations impair the analysis?
Meaning
What happened?
Why it happened?
Analytical Tools
Questionnaire
Excel
Questionnaire
Questionnaires:
Information technology.
Balance sheets and income statements are anchor schedules that can used together with
other schedules.
Reports:
Graphs, charts and ratios are financial indicators of bank’s future performance.
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Ratios
Financial ratios express the different kinds of relationships between different variables.
Operational efficiency
Liquidity
Profitability
Solvency
Other ratios required by regulators and supervisory authorities and the market.
Advantage of ratios:
Disadvantage of ratios:
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• Give management high-level overview of performance.
Graphs show:
• Income.
• Profitability.
• Capital adequacy.
• Investment portfolios.
They can illustrate details of performance for senior management. Graphs and Charts
Graphs are powerful tools for analysis because they can provide a wide range of
information.
They permit comparison of numbers across units and over time, giving an indication of
trends.
They provide the management with a high-level overview of the bank’s performance.
• Income
• Profitability
• Capital adequacy
• Investment portfolios
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• Exposure to interest rates
Graphs are useful as a starting point for on-site reviews, where they can be used to
illustrate details of performance to the senior management.
Graphs show:
Income.
Profitability.
Capital adequacy.
Investment portfolios.
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Chapter 3
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Chapter Introduction
Welcome to the chapter, Credit Risks with Assets and Their Management.
Credit risk is the chance that the debtor or an issuer of a financial instrument will default
on:
• Any other investment related cash flow mentioned and specified in the credit terms.
Problem:
Outcome:
Islamic banks rely solely on the individual’s track record to judge his/her creditworthiness.
The board of directors lay down formal policies for lending which must be followed by the
bank supervisors and other administrative staff.
Yet it should allow flexibility in lending terms to ensure the consideration of deserving
proposals
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Learning Objectives
On completing this chapter, you will be able to:
Distinguish between three types of risk management policies based on their goal.
Describe measures that aim to reduce credit risk for Islamic banks.
Describe credit risk issues specific to Islamic banks in the context of Murabahah,
Mudarabah and Bai’ Salaam contracts.
Describe credit risk issues specific to Islamic banks and measures used to mitigate
them.
Identify the parameters to be included in a risk analysis of the asset portfolio.
Identify the parameters and objectives of credit review of individual customers.
Identify the parameters of review of interbank lending.
Identify the parameters of review of off-balance-sheet commitments.
These cover:
Principle 2.1
using the various Sharī‘ah-compliant Islamic instruments whereby they recognise the
potential credit exposures that may arise at different stages of the various financing
agreements.
Principle 2.2
IFIs must conduct a due diligence review of counterparties prior to choosing an appropriate
Islamic financing instrument.
Principle 2.3
IFIs must use appropriate methodologies for measuring and reporting the credit risk
exposures arising under each Islamic financing instrument.
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Principle 2.4
Banking regulations specify a threshold limit, usually a percentage of bank’s capital and
reserves, for extending credit to a single party.
Most countries limit single customer exposure to 10-25 percent of the bank’s capital. Banks
are required to report exposures to a single customer after a point just below the upper
limit.
Supervisors must monitor all exposures beyond the threshold limit and take the necessary
precautionary measures.
Two Difficulties:
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In order to effectively manage large exposures to a single group:
Banks need to have thorough information about the debtor, including Common or
related ownership.
Banks should continuously monitor the performance of the group, regardless of payment
status.
Concerns should be raised and contingency plan formed if there is any doubt about the
ability to repay of the loan.
Are these parties offered credit on the same terms as the public?
In order to manage this exposure, the regulators stipulate that the credit extended to
related parties should not exceed a certain percentage of Tier 1 capital.
Overexposure to Geographic Areas or Economic Sectors
This risk is very prevalent for banks in agrarian economies or countries which are single
commodity exporter.
In many cases, banks do not have or cannot generate data pertaining to the magnitude of
exposure banks are exposed to any of the economic sectors.
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Banks giving loans to foreign parties have to face two additional types of risks:
• Transfer risk
• Ascertain total exposure to country and transfer risks and provide special reserves to
manage risk exposure.
1. Murabahah
2. Bai’ al- Salaam
3. Mudarabah
Murabahah
In Murabahahcontract, the banks are exposed to credit risk when a client refuses to pay
after the bank delivers goods. The risk is increased further in case of non-binding
Murabahah transactions where a client has the right to refuse the goods delivered by the
bank.
Credit risk
Market risk
Bai’ al-Salaam
In this type of contracts, credit risk arises when banks fail to supply the goods either on
time or as per the contract.
Such failure could result in a delay or default in payment, or in delivery of the product, and
can expose Islamic banks to financial losses of income as well as capital.
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Mudarabah
In this type of contracts, the bank acts as a principal (Rab al-Māl) with an external agent
(Mudarib). In this case, the bank is vulnerable because:
The analysis of the bank’s portfolio should include the following things:
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Credit Review of Individual Customers
While a thorough portfolio analysis is required, sometimes it is not possible to do an
exhaustive study of all the portfolios.
All the customers that have a total exposure of more than five percent of bank’s
capital.
All exposures to shareholders and connected parties.
All investments and other financing assets for which the financing schedule have
been changed after such investments were made.
All investments and financing assets that are declared as substandard, doubtful or
cannot be recovered.
Interbank Deposits
Interbank deposits are particularly important where citizens and other economic agents are
allowed to hold foreign exchange deposits.
1. They facilitate fund transfer and buying and selling securities between banks.
2. They enable banks to take advantage of other banks’ ability to perform certain
services at a lower cost due to their bigger size or strategic geographic location.
Interbank credit increases banks credit exposure. Therefore a bank should review it’s
correspondent bank on the following parameters:
Generally banks that are from highly regulated countries are considered to be safe to deal
with.
The objective of such review is to make sure that the customer repays the loan on time.
• What to Assess:
• Whether the procedures that analyse the credit risk are sufficient
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Chapter 4
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Welcome to the chapter, Credit Risks with Assets and Their Management.
Credit risk is the chance that the debtor or an issuer of a financial instrument will default
on:
Problem:
Outcome:
Islamic banks rely solely on the individual’s track record to judge his/her creditworthiness.
The board of directors lay down formal policies for lending which must be followed by the
bank supervisors and other administrative staff.
Yet it should allow flexibility in lending terms to ensure the consideration of deserving
proposals
Learning Objectives
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On completing this chapter, you will be able to:
• Describe the factors that determine adequate level of provisioning for losses.
The U.S. Federal Reserve system provides a list of problems that lead to a poor credit
culture. These problems apply to not just any commercial bank but also to any Islamic
financial institution.
Self-dealing
Self-dealing is a key problem that affects many banks. Self-dealing happens when banks
compromise on their credit principles and lend too much credit to large shareholders,
directors or their related interests.
Loans are the primary source through which banks earn their revenue. There are times
when the banks become anxious over their earnings and hope that risks will not materialise
or that loans will be repaid.
There are times when loans are granted without proper assessment of the borrower and the
borrower’s ability to repay.
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Complacency
• Ignores any warning signs regarding the borrower, economy, region or industry.
• Does not enforce repayment agreements, including a lack of prompt legal action.
Constant monitoring of the borrower’s affairs during the entire lifetime of the loan is
important. Lack of effective supervision leads to a lack of knowledge about the borrower’s
dealings and subsequently, loans that were once healthy may develop problems and losses.
Technical Incompetence
Loan officers may not be technically sound. They may not possess the ability to evaluate
credentials and assess financial statements.
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Compromise of Credit Principles
When banks sanction loans that have undue risks or loans that are extended under
unsatisfactory terms, then the banks are said to compromise their credit principles.
Self-dealing
Anxiety over income
Competitive pressures in the bank’s key markets
Personal conflicts of interest.
Asset classification is a process whereby an asset is assigned a grade for credit risk.
The grade is determined by the probability that obligations will be serviced and liquidated
according to the terms of the contract.
Assets are classified at the time of origination of the loan. Then, in a year, assets are
reviewed and reclassified periodically, for example, twice a year or every quarter, depending
on class.
Approaches to Classification
There have been different approaches to asset classification. Some of the approaches are
listed below:
All credits extended to an individual client must be assigned the same risk
classification.
Alternatively, risk in each asset is assessed on its own merits.
When assets are classified objectively or subjectively, the more stringent
classification applies.
If supervisory authorities or external auditors assign more stringent classification,
the bank should modify its classification.
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Standard or Pass
An asset is classified as standard (pass) when the capacity of the borrower to service the
debt is beyond any doubt. For example, assets that are fully secured by cash or cash
substitutes are classified as standard regardless of arrears or other adverse credit factors.
Credit provided to borrowers working under economic or market conditions that may
negatively affect them in the future.
Credit provided to borrowers who notice an adverse trend in their balance sheet, but have
not reached a point where repayment is jeopardised.
Substandard
An asset is classified as a substandard asset only if the primary sources of repayment are
insufficient. and the bank must look to secondary sources, such as collateral, the sale of a
fixed asset, refinancing, or fresh capital
Doubtful
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The collection of the credit in full is doubtful on the basis of existing facts. Although
there is possibility of a loss, this asset can still not be classified as a loss as there
may be certain factors that may strengthen the asset performance.
The asset is at least 180 days past due, unless it is sufficiently secured.
Loss
The credit is uncollectible or not warranted, but partial recovery may be possible in
the future.
The nonperforming asset is at least one year past due unless very well secured
Loss Provisioning
Asset classification is a key tool to:
Manage risks.
Determine adequate level of provisions for possible losses.
To determine an adequate level of reserve, the following factors need to be
considered:
Quality of credit policies and procedures
Prior loss experiences
Quality of management
Collection and recovery practices
Changes in national and local economic and business conditions
General economic trends
Periodically.
Systematically
Objectively.
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Standards for Level of Provisioning
The best method to determine an adequate level of reserve is to estimate each asset on a
case-by-case basis. However this is not a practical solution. Hence, it is recommended that
each classification category is assigned a level of required provisions.
Let’s now look at the provision levels in developed countries and developing countries.
In highly developed countries, the legal framework for debt recovery is highly developed.
Therefore, in the US for example, the loss percentage is as follows:
Substandard 10
Doubtful 50
Loss 100
In developing countries, the legal framework and tradition of collection is less effective.
Hence, substandard assets face a loss in the range of 10 to 30 percent. See the graph for
more information.
These estimates of loss provisions are subjective. However, it is best to exercise
management discretion in accordance with established policies and procedures of the bank.
Click the Resources button at the top of the screen to view the Islamic Financial Services
Board (IFSB) standard on risk management.
Aspect of Overall Loss Allowance
The following aspects of the overall allowance for losses should be considered:
The approaches for dealing with loss assets can be outlined as follows:
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British:
Reserve is large.
Assets are retained on the books until all remedies for collection have been
exhausted.
American:
Reserve is smaller.
Approach is more conservative.
Assets are written off promptly against the reserve.
Workout Procedures
While determining the best workout procedures for an asset, consider the following factors:
Workout Strategies
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1.
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