Risks Underlying Islamic Modes

of Financing (I)

Islamic Development Bank

http://www.isdb.org
 Summary of the Previous Lecture
We studies the following topics in todays lecture;
• Popular Sukuks
• Salam Sukuk
• Istisna Sukuk
• Murabaha Sukuk
• Sukuk Growth
• Controversies in different types of Sukuks
• Differences between Sukuk and Bonds
 Sukuk versus Conventional Bonds
Sukuk Conventional Bonds
1. Income is generated 1. Income is derived from
from assets debt instrument.

2. Return is expected 2. Return is interest and

pre-determined.
3. Negotiability is
restricted to specific 3. Negotiable financial
types of Sukuk paper
 Sukuk versus Conventional Bonds
Sukuk
4. Sukuk issueR is a seller
of assets
5. Sukuk holder is an
owner of assets
6. Seller-Buyer
relationship
7. Business risk-return
relationship
Conventional Bonds
4. Bond issuer is a
borrower
5. Bond holder is a
lender
6. Lender-borrower
relationship
7. Issuer guarantees the
payment of face value
and periodic interest
 Sukuk versus Conventional Bonds
Sukuk Conventional Bonds
8. Major risk lays with 8. Major risk is with issuer
underlying assets – credit risk

9. Return is expected from 9. Interest payment is an

the underlying assets obligation

10. Return of investor’s 10. Issuer is obligated to

capital cannot be return investor’s capital
guaranteed (face value)
 Controversies in Sukuk
Sukuk al Musharakah
some Shariah Boards approved the structure
or allowed their respective institutions to invest in
such business deals, others have
prevented institutions under their respective
supervision to invest in such Sukuk
viewing them Shariah non-compliant.
 Controversies in Sukuk

Sukuk al Musharakah

Disagreement arises on the permissibility for one of

the Musharakah partners to give an undertaking to
purchase the shares or units of the second partner
of the Musharakah, at the maturity of the Sukuk, at
face value and predetermined price.
 Criticism against the Ijarah Sukuk
1. Guarantee in Sukuk issuance:
• A third party who is normally the originator of
the Sukuk provides a guarantee for the
principal capital of the Sukuk.
• The originator benefiting from the Sukuk
proceeds establishes a Special Purpose Vehicle
(SPV) that issues the Sukuk while the
originator stands by to provide a guarantee
against any shortfall.
 Criticism against the Ijarah Sukuk
1. Guarantee in Sukuk issuance:
The first collective resolution issued by the Islamic
Fiqh Academy in its resolution 30(5/4) pertaining to
Ijarah Sukuk:
"There is no Shariah objection to mention in the
prospectus of the issue or in the document of Sukuk
the promise of a third party, who is independent
personally and in term of financial liability from the
two parties to the contract,…………
 Criticism against the Ijarah Sukuk
1. Guarantee in Sukuk issuance:
The AAOIFI Shariah Standards No.17. on Investment
Sukuk states the
following:
"The prospectus must not include any statement to
the effect that the issuer of the certificates accepts
the liability to compensate the owner of the
certificates up to the nominal value of the
certificates in situations other than torts and
negligence nor that he guarantees a fixed
percentage of profit. It is, however, permitted to an
independent third party to provide a guarantee free
of charge…………..
 Criticism against the Ijarah Sukuk
1. Guarantee in Sukuk issuance:

• Whereas guaranteeing of capital is prohibited by all

schools of Islamic law.

• Even if the third party guaranteeing the capital is

government, it shall be declared non-permissible as
the government treasury is the property of the
whole community and should not be exposed to
financial risk of some individuals or entities.
 Criticism against the Ijarah Sukuk
2. The Sale and Lease Back Structure:
• Renting an asset to the party who sold it, has
been questioned by scholars.
3. Pricing of Sukuk
• Muslim economists and Shariah scholars have
not come up with an alternative to the
interest rate as a readily available indicator of
profitability. Hence the use of LIBOR/KIBOR as
a benchmark has become part of the practice
in Islamic financial institutions.
 Criticism against the Ijarah Sukuk
3. Pricing of Sukuk
• However, in practice this return is not at all reflecting the
rental of the underlying asset but the prevalent interest rate.
For example, if there are two real assets which are totally
different from each other, then based on market realities we
expect to have different rental income on them.

• However, it is observed that same rate of return, as reflecting

the prevailing interest rate, is paid on them if they are used as
underlying assets for two different Sukuk issues
 Learning Outcomes
After this lecture you will be able to understand
• The basic concept of risk and its classification into
different types.
• Risks faced by the financial institutions.
• Uniqueness of risk in Islamic banks.
• Risks in Islamic Financial instruments.
• How to mitigate in Islamic financial instruments.
 Risk
• Existence of uncertainty about future outcomes
• Difference between expected and actual result

Uncertainty can be classified as general and specific

• General: ignorance of any potential outcome, e.g.
after the investment in stocks of a company, the
company goes default.
• Specific: when probabilities can be assigned to
potential outcomes—this is usually referred to as
risk, e.g. depending upon the financial conditions of
the company what are chances of default.
 Risks
• Risk is measured by the variability or volatility of
outcomes using statistical tools like variance or
standard deviation.

• Costs involved with higher volatility can lead to

bankruptcy
 Risk

Objectives of risk management

• To reduce volatility in the probable outcomes.

• To eliminate costly lower tail outcomes

• To maintain a certain risk profile

• The value maximization

 Risk
Classification of Risks
• Business risks and financial risks
– Business risk relates to uncertainty arising from
the nature of firm’s business, e.g. decreased
revenues, higher costs, high turnover, etc.
– Financial risks relates to movements in the
financial market (Interest rates, economic
conditions, etc.)
• Systematic risk and unsystematic risks
– Systematic risk is associated with overall market
– Unsystematic risk is linked to the specific asset
or firm
Total Risk = Systematic Risk + Unsystematic Risk
Systematic Risk
Factors such as changes in nation’s economy, tax reform by the
government, or a change in the world economic situation or the
exchange rate movements.
STD DEV OF PORTFOLIO RETURN

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

Total Risk = Systematic Risk + Unsystematic Risk
Unsystematic Risk
Factors unique to a particular company or industry. For
example, the death of a key executive or strike by the
employees of the company.
STD DEV OF PORTFOLIO RETURN

Unsystematic risk
Total
Risk
Systematic risk

NUMBER OF SECURITIES IN THE PORTFOLIO

 Risks faced by Financial Institutions
1. Market Risks
• Interest rate/benchmark risk
• Equity price risk
• Asset/Commodity price risk
• Currency risk (Foreign exchange rates)

2. Credit Risks
• Trade credit (settlement) risk
• Counter party risk
 Risks faced by Financial Institutions

3. Liquidity risk
• Funding liquidity risk (risk to meet liabilities)
• Trading liquidity risk

Funding liquidity – Risk that liabilities:

• Cannot be met when they fall due
• Can only be met at an uneconomic price
• Can be name-specific or systemic
 Risks faced by Financial Institutions

4. Operational risk
• People risk (employees turnover)

• Technology risk (rapidly changing cost efficient

technologies)

• Process risk (Obsolete process)

• Legal and regulatory risks

 Typical Balance Sheet of FI

Assets Liabilities

Banking Portfolio Deposits & Debt

Trading Portfolio Equity

28
 A Typical Islamic Bank Model
• Typical IB model—one-tier Mudarabah with
multiple investment tools.
• Liability side
– Savings and investment accounts –Mudarabah
– Demand deposits—Qard e Hasana
• Asset side
– Fixed income assets (Murabaha, installment
sale, Istisna, salam, and Ijarah)
– Variable income assets (Mudarabah and
Musharakah)
 Unique Risks in Islamic Banks
1. Contractual Nature of Deposits
• PSIA — Mudarabah contracts
• Demand deposits— Qard-e-Hasana

2. Fiduciary (trust) risk—PSIA are fiduciary contracts

• Lower rate of return than conventional banks or non-
compliance with Sharia can be interpreted as breach
of contract – fiduciary risk

3. Withdrawal Risk
• Lower returns may lead to withdrawal of deposits. To
avoid such situations returns (dividends) from
shareholders are transferred to depositors-transfer of
risks associated with deposits to equity holders.
 Unique Risks in Islamic Banks
4. Using PSIA as capital
• Difference between restricted and unrestricted PSIA
5. 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 Islamic Banks

6. Operational Risks
• Person risk—lack of qualified human resource
who understand/manage risks in Islamic banking
• Technology risk - computer software's and IT for
IBs
• Legal risks
 Standardization of contracts
 Lack of legislative act and enforcement
institutions
 Summary of the Lecture
In this lecture we covered the following topics;
• The concept of risk.
• Objectives of risk management
• Classification of risk
• Risks faced by financial institutions
• Islamic bank model
• Unique risk in Islamic Banks