Chapter 3

Risk Characteristics of Islamic Products: Implications for Risk Measurement and Supervision

Venkataraman Sundararajan

1. INTRODUCTION

This chapter discusses risk characteristics of various Islamic finance products and key issues in the measurement and control of risks in Islamic financial services institutions. In particular, the chapter highlights the role of risk sharing in Islamic finance and the implications of profit-sharing investment accounts (PSIA, or “investment accounts”) for risk measurement, risk management, capital adequacy, and supervision. Empirical evidence suggests that the sharing of risks with PSIA is fairly limited in practice, although, in principle, well-designed risk (and return) sharing arrangements with PSIA can serve as a powerful risk mitigant in Islamic finance. Supervisory authorities can provide strong incentives for effective and transparent risk sharing and for the associated product innovations. The chapter also covers the scope of supervisory intervention and a value-at-risk (VaR) methodology for measuring these risks.

A key principle underlying the design of Islamic financial products and services is the notion that mutual risk sharing (for example, between banks and entrepreneurs, or between banks and depositors) is a viable alternative to interest-based financing, which is prohibited in Islamic finance. Islamic financial products and Islamic banks face a unique mix of risks and risk-sharing arrangements that arise from the contractual design of instruments based on Shari’ah principles and the overall legal, governance, and liquidity infrastructure governing Islamic finance.

Effective risk management, however, requires appropriate risk measurement that recognises the specific mix of risk factors in Islamic financial contracts and the extent of risk sharing embedded in the contracts. The issues of risk measurement and disclosure are central to adapting the New Basel Capital Accord—International Convergence of Capital Measurement and Capital Standards: A Revised Framework (Basel II)—for both conventional and Islamic banks. The same may be said in connection with Basel III: A Global Regulatory Framework for More Resilient Banks and Banking Systems, published in a revised version in June 2011, which places an emphasis on liquidity risk which was absent from Basel II.

Risk measurement is also crucial to an effective disclosure regime that can harness market forces to reinforce official supervision. The purpose of this chapter is to review the risk characteristics—defined as the type and mix of risks and the arrangements to share risks—of Islamic products and the related issues in the measurement of risks in Islamic banks. In particular, the chapter analyses the implications of profit-sharing investment accounts for risk measurement, risk management, capital adequacy, and supervision. Islamic banks in most countries offer two types of PSIA: restricted and unrestricted, normally based on a mudarabah contract. The bank as mudarib is entitled to a prespecified percentage share of the profits from the investment as a fee for fund management, but does not share in a loss except by not receiving any fee. There is thus, in principle, a considerable degree of risk sharing between the bank and the investment account holders (IAHs) with respect to the assets in which the PSIA are invested.

The restricted investment accounts are a type of collective investment scheme in which the bank as mudarib invests the funds of the IAH according to a restricted mandate that limits the asset allocation to a prespecified category of assets. The unrestricted investment accounts are designed as a Shari’ah-compliant alternative to conventional interest-bearing deposit accounts; the IAH funds are invested at the bank’s unrestricted discretion and are normally commingled for investment purposes with other funds, such as the bank’s own capital and current accounts. (Current accounts are a liability of the bank and do not share in profits.)

Available empirical evidence shows that in practice, because the product is intended to provide a Shari’ah-compliant alternative to conventional deposits, there is considerable smoothing of the profits paid out to unrestricted IAHs, and correspondingly reduced sharing of risk between the bank and the holders of such investment accounts, with banks in fact bearing the majority of the risk despite wide divergences in risk. The extent of this de facto departure from the risk-sharing principle for unrestricted IAHs (referred to as displaced commercial risk, or DCR, following AAOIFI 1999) varies between countries; in some countries, banks are expected—though not legally bound1—to bear virtually all of the asset risk, while in others it is simply a matter of competitive pressure. References to IAHs, investment accounts, or PSIA in the remainder of this chapter should be understood as being to unrestricted IAHs.2

This chapter proposes a specific approach to the issue of DCR by measuring the actual sharing of risks between shareholders and IAHs, based on value-at-risk methodology. The two main conclusions of the chapter are as follows:

Several key conclusions and policy messages can be highlighted at the outset.

• Effective risk management in Islamic banks (and a risk-focused supervisory review process) requires that a high priority be given to proper measurement and disclosure of the following three risk types:
  • Aggregate banking risks (to reflect the volatility of mudarabah profits accruing to IAHs).
  • Specific types of risks (to control effectively the extent of credit, market, operational, and liquidity risks).
  • Facility-specific risks (to properly price individual facilities by measuring the full range of risks embedded in each facility).
• The unique mix of risks in Islamic finance and the potential role of IAHs in sharing some of the risks call for a strong emphasis on proper risk measurement, and disclosure of both risks and risk management processes in Islamic banks.
• Ensuring progress in risk measurement, disclosure, and risk management will, however, requires a multi-pronged effort for the following purposes:
  • To strengthen accounting standards and harmonise them with prudential standards.
  • To initiate a systematic data compilation process to enable proper risk measurement, including through developing central credit and equity registries suitable for Islamic finance.
  • To build a robust governance and creditor/investor rights infrastructure that would foster Islamic money and capital markets—based on innovative uses of asset securitisation—as a foundation for effective on-balance sheet risk management, including through transparent apportioning of risks to IAHs.
  • To foster this transformation of investment accounts into an effective component of risk management (in addition to collateral and guarantees) through product innovations supported by proper disclosure and reserving policies that make transparent the extent of risk being borne by the investment accounts, and the risk–return mix being offered.
  • To provide supervisory incentives for effective risk sharing with PSIA, by linking the capital adequacy treatment of PSIA to the extent of actual risks shared with PSIA, and by requiring adequate disclosure of these risks as a basis for “capital relief” (that is, the exclusion of part or all of risk-weighted PSIA-financed assets from the denominator of the CAR).

All this will set the stage for the eventual adoption of more advanced capital measurement approaches set out in Basel II and Basel III, and their adaptations for Islamic finance as outlined in the relevant Islamic Financial Services Board (IFSB) standards. The chapter highlights some of the measurement issues arising from the unique risk characteristics of Islamic finance contracts and policy considerations in promoting effective risk sharing between owners and investment accounts holders. A VaR methodology for measuring and monitoring such risk sharing is proposed.

2. BACKGROUND

Recent work on risk issues in Islamic finance has stressed that features of Islamic banks, and the intermediation models that they follow, entail special risks that need to be recognised to help make risk management in Islamic banking truly effective. Karim (1996) and Hassan (2000) have noted that the traditional approach to capital adequacy and supervision based on the 1988 Basel Capital Accord—Basel I—did not adequately capture the varied risks in Islamic finance facilities. In a similar vein, recent studies in the Islamic Development Bank discuss the special risks in Islamic banks (Chapra and Khan 2000; Khan and Ahmed 2001). These studies survey the risk management practices of Islamic banks and note that Basel II provides scope for proper recognition of risks in Islamic banking products—through a more risk-sensitive system for risk weighting of assets and stronger incentives for effective risk management. (However, in the light of subsequent events and of Basel III, it should be noted that liquidity risk was not covered in Pillar 1 of Basel II and was not highlighted in Pillar 2). These studies also highlight a set of issues in Islamic jurisprudence (fiqh issues) that need to be resolved to facilitate effective supervision and risk management. Implications of risk sharing with PSIA for the governance, financial reporting, and capital adequacy of Islamic banks are discussed in Al-Deehani, Karim, and Murinde (1999), Archer and Karim (2005, 2006, 2012) and Archer, Karim and Sundararajan (2010). A recent World Bank study (El-Hawary, Grais, and Iqbal 2004) considered the appropriate balance of prudential supervision and market discipline in Islamic finance, and the related implications for the organisation of the industry. In parallel, recent studies from the International Monetary Fund focus on the financial stability implications of Islamic banks (Sundararajan and Errico 2002; Marston and Sundararajan 2003; Sundararajan 2004). These studies also stress the importance of disclosure and market discipline in Islamic finance (see also Archer and Karim 2006); they also note that in addition to the unique mix of risks, for a range of risks, Islamic banks may be more vulnerable than their conventional counterparts, owing in part to the inadequate financial infrastructure for Islamic banks, including missing instruments and markets and a weak insolvency and creditor rights regime, factors that limit effective risk mitigation.

Therefore, systemic stability in financial systems with Islamic banks requires a multi-pronged strategy to bring about:

• A suitable regulation and disclosure framework for Islamic banks.
• A robust financial system infrastructure and adequate macroprudential surveillance to provide the preconditions for effective supervision and risk management.
• Strengthened internal controls and risk management processes within Islamic banks.

Accordingly, a comprehensive risk-based supervision framework is needed for Islamic banks, supported by a clear strategy to build up risk management processes at the level of the individual institutions, and robust legal, governance, and market infrastructure at the national and global levels. In recognition of this need, the international community established in 2002 the Islamic Financial Services Board (IFSB), headquartered in Kuala Lumpur, Malaysia, to foster good regulatory and supervisory practices, to help develop uniform prudential standards, and to support good practices in risk management.3

The IFSB has advanced the work on the capital adequacy framework and risk management in Islamic banks through the issuance of standards on these topics in December 2005 (see IFSB 2005a, 2005b). In addition, it has issued corporate governance standards, disclosure standards to promote transparency and market discipline, and standards for the supervisory review process. Recent discussions coordinated by the IFSB and the Islamic Development Bank have again reinforced the importance of building a robust financial infrastructure for Islamic finance—which constitutes the precondition—to support the sound functioning and effective supervision of Islamic banks.4

In particular, the effective supervision of Islamic banks requires that the three-pillar framework of Basel II and the language of risks it introduces be adapted appropriately to their operational characteristics. Key issues in the measurement and monitoring of specific risks and risk sharing in Islamic finance are first reviewed before considering policy implications.

3. TYPES OF RISKS IN ISLAMIC FINANCE AND THEIR MEASUREMENT

A key feature of Islamic banks is the potential sharing of risks between IAHs who provide funds on a mudarabah basis, and the Islamic banks that invest these funds (often commingled with shareholders’ and other funds) in various Islamic finance contracts that include murabahah, salam, mudarabah, musharakah, ijarah, istisna’a, and other Shari’ah-compatible financing arrangements, including sukuk. This section reviews the overall risks facing Islamic banks in light of their financing activities on the asset side, modalities of sharing these risks with fund providers, and the types of risk embedded in individual Islamic finance contracts on the asset side of Islamic banks.

3.1 Mudarabah Risk

The way risks are shared between IAHs who invest on a mudarabah basis, and the bank as a mudarib, plays a crucial role in Islamic finance. The share of unrestricted investment accounts in the total deposits of Islamic banks varies considerably, from near zero (holding only demand and savings deposits) to over 80 percent in some banks (Exhibit 3.1). The implications of such PSIA for risk measurement, disclosures, and bank governance generally have been the topic of several studies (see Clode 2002; AAOIFI 1999; Archer and Karim 2006). In this section, we will highlight specific risk measurement issues that need to be addressed in monitoring the risk–return tradeoff in PSIA. The focus is on the financial risks faced by the unrestricted investment accounts; for restricted investment accounts, the risks for banks and depositors are those attributable to the specific assets to which the investment account returns are linked, and the risk measurement issues discussed in this chapter can be readily applied to the relevant asset portfolio. Both restricted and unrestricted IAHs also face fiduciary risks—risks of negligence and misconduct—reflected in the quality of internal controls, corporate governance, and risk management processes of the Islamic banks acting as mudarib.

EXHIBIT 3.1 Disclosure Practices of Islamic Banks

Based on annual reports of 15 sample Islamic banks covering the years 2002 and 2003. Percentages of sample banks that disclose a particular item are shown in parentheses.

In its most general form, risk is uncertainty associated with a future outcome or event. To an IAH in an Islamic bank, the risk is the expected variance in the measure of profit distributions where the profit is shared between the IAH and the bank. This variance could arise from a variety of both systemic and idiosyncratic (that is, bank-specific) factors. Actual risk in the investment account (that is, in the underlying investments) may be dampened in practice by the use of profit equalisation reserves (PER), investment risk reserves (IRR), and by variations in the mudarib’s share. The PER is used to reduce or eliminate the variability of profit payouts on investment deposits, to redistribute income over time, and to offer returns (payouts) that are aligned to market rates of return on conventional deposits or other benchmarks, without the need for the bank to forgo any of its mudarib share. In addition, banks may use the IRR to redistribute over time the incomes accrued to the investment accounts so as to maintain a payout when a periodic loss is incurred. Nevertheless, from an investor’s point of view, the true risk of mudarabah investment in a bank can be measured by a simple profit-at-risk (PaR) measure. For example, σp, the standard deviation of the periodic (for example, monthly or quarterly) profit payout5 as a percentage of assets, provides the basis for the simplest measure of the risks of holding an investment account after the application of the above methods of “smoothing.” In banks that practice such smoothing, this risk will of course be lower than the risk of the underlying assets, measured based on the standard deviation of the unsmoothed profits. One issue is how important it is for IAHs to be aware of this underlying risk.

From a monthly time series of mudarabah profit payouts (as a share of assets), its variance (and the standard deviation σp) can be calculated, and, assuming normality, profit-at-risk can be calculated as:

Where:

Zα = the constant that gives the appropriate one-tailed confidence interval with a probability of 1 − α for the standard normal distribution (e.g. Z.01 = 2.33 for a 99 percent confidence interval).

T = the holding period or maturity of the investment account as a fraction of a month.

Such aggregate PaR for an Islamic bank as a whole provides a first-cut estimate of risks attaching to profit payouts in unrestricted mudarabah accounts. Such risk calculations could also be applied to individual business units within the bank (also for specific portfolios linked to restricted IAHs). In addition, if specific risk factors that affect the variation in mudarabah profit payouts can be identified, this measure σp can be decomposed further in order to estimate the impact of individual risk factors, and this would help to refine the PaR calculation. In practice, however, profit equalisation reserves and investment risk reserves are actively used by Islamic banks to smooth the return on investment accounts. As a result, risks in investment accounts are absorbed, in part, by banks themselves, in so far as the PER is strongly positively correlated with net return on assets (gross return on assets minus provisions for loan losses)—that is, PER is raised or lowered when the return on assets rises or falls, and hence the profit payout on the investment accounts is smoothed, and low or zero payouts are avoided except in the case of a loss when recourse is made to the IRR. Banks can also adjust their share of profits to maintain adequate returns to shareholders. As noted above, such absorption of risks by bank capital is referred to as “displaced commercial risk.” The correlation between the movements on the PER and the asset return could, therefore, be viewed as an indicator of DCR. Thus, the precise relationship between the risk to IAHs and the aggregate risk for the bank as a whole arising from the variability of net return on assets (gross return net of specific provisions) depends upon the policies toward profit equalisation reserves, investment risk reserves, and mudarib’s share. These policies determine, in effect, the extent of risk sharing between investment accounts and bank capital. These relationships are discussed further in Section 4 of the chapter.

Against this background, the true risks borne by IAHs can be made transparent by disclosing the definition of mudarabah profits, the level and variations in these profits and in profit equalisation reserves, as well as policies toward establishing PER6 that will determine the variance in its movements as well as their correlation with the asset return. At the same time, transparency of internal controls and governance arrangements, including risk management processes, would also be important to provide assurances of integrity of Islamic banks as a mudarib. The measurement of such fiduciary risk could be subsumed under operational risk measurement, as discussed in Section 3.6.7

3.2 Credit Risks in Sales-Based Contracts

Murabahah and other sales-based facilities (istisna’a, salam, and so on) together with lease-based facilities (ijarab) dominate the asset side of Islamic banks, ranging from 80 to 100 percent of total facilities. Equity-type (profit- and loss-sharing musharakah or profit-sharing and loss-bearing mudarabah) facilities still constitute a negligible proportion of assets in most banks. Thus, credit risk in the normal sense—the risk of losses in the event of default of the borrower or in the event of a deterioration of the borrower’s repayment capacity8—is the most common source of risks in an Islamic bank, as in conventional banks.9 The methods of measurement of credit risks in conventional banks apply equally well to Islamic banks, with some allowance required to recognise the specific operational characteristics and risk-sharing conventions of Islamic financial contracts.

Credit risk can be measured based on both the traditional approach that assigns each counterparty into a rating class (each rating corresponding to a probability of default) as well as more advanced credit VaR methods discussed later in the section. The basic measurement principle under both these approaches is to estimate the expected loss on an exposure (or a portfolio of exposures) owing to specified credit events (default, rating downgrade, some non-performance of a specified covenant in the contract, and so on) and also to calibrate unexpected losses (losses that exceed a specified number of standard deviations from the mean) that might occur at some probability level. Expected losses are provisioned and regarded as an expense that is deducted from income, while unexpected losses (up to a tolerance level) are backed up by capital allocation. The risk weights attached to various exposures on the bank’s asset side (in the New Basel Capital Accord, for example) in effect represent the bank’s or supervisor’s judgment on the unexpected losses on the exposures that should be absorbed by capital. The calculation of loss—both expected and unexpected—in an individual loan will require estimates of:

• Probability of default (or probabilities of rating downgrades from one rating class to another).
• Potential credit exposures at default (or at the time of rating transition).
• Loss-given default (or reduction in the value of the asset following a rating transition).

Proper measurement of these three components of credit risk, and the calculation of unexpected losses, are the fundamental requirements of the Basel Capital Accords (Basel II and III). Measurement of these components for the case of sales-based contracts—murabahah and salam—is discussed next.

The default could be defined in the same way as for conventional banks, based on the financial condition of the borrower and the number of days the contract is overdue.10 Estimation of the probability of default is traditionally based on ex-ante assignment of ratings to counterparty exposures or a portfolio of exposures of a particular variety (such as all commodity murabahah for a class of goods). A modern approach that can be used for larger listed companies is based on market information on equity prices. Observed market value of a firm’s equity and estimated volatility of equity prices can be used to estimate the likelihood of default using the option pricing approach to bankruptcy prediction.11 In practice, various methods can be combined during the risk management process in order to arrive at a credit rating and the associated probability of default based on historical experience. The estimation of probabilities—or correct assignment of ratings—will, however, require historical data on loan structure and performance, borrower characteristics, and the broader industry and macroeconomic environment; and thus the ratings will change over time as financial conditions and environment change.

Losses will clearly depend upon the potential credit exposures at the time of default (exposure at default, or EAD). In general, exposure at default would be facility-specific, depending upon the extent of discretion that the borrower can exercise in drawing down lines of credit, prepaying already drawn accounts, or any specific events that affect the value of contingent claims (for example, guarantees to third parties). In murabahah and salam contracts, EAD in most cases would simply be the nominal value of the contract. In long-term ijarah (leasing) and istisna’a contracts, EAD will depend upon projected environmental factors that will be facility-specific.

Losses will ultimately depend upon the rate of recovery following default, or, in a mark-to-market model, the reduction in the value of the loan if ratings change. Loss-given default (LGD—that is, 1 minus recovery rate times EAD) is likely to depend upon ease of collecting on the collateral, the value of the collateral, the enforceability of guarantees, if any, and, most importantly, on the legal environment that determines creditors’ rights and the features of insolvency regime. For example, the juristic rules for murabahah imply that “in case of insolvency, [the] creditor should defer collection of the debt until he [the debtor] becomes solvent.”12 The precise interpretation of such considerations would determine the length of time needed to recover overdue debt. In addition, there could be legal risks owing to difficulties in enforcing Islamic finance contracts in certain legal environments.13 Moreover, the inability of Islamic banks to use penalty rates as a deterrent against late payments could create both a higher risk of default and longer delays in repayments.14 Finally, the limitations on eligible collateral under Islamic finance—or excessive reliance on commodities and cash collateral—may exacerbate credit risks generally, and reduce the potential recovery value of the loan if commodity collateral proves too volatile in value. For these reasons, LGD in murabahah facilities could be different, probably higher, than in conventional banks, thereby affecting the size of losses and capital at risk.

Given the estimates of probability of default (PD), or probabilities of transition from one rating class to another (transition matrix), and the estimated LGD (or change in value of the loan for any given transition from one rating class to another), the expected and unexpected losses can be readily computed. For example, in the default model, expected loss (EL) is given by:

EL = PD × LGD × EAD

Where:

LGD is expressed as a proportion of exposure at default.

The unexpected loss (UL) can be calculated based on assumptions on the distribution of default and recoveries. Assuming that LGD is fixed, and that borrowers either default or do not default, the default rate is binomially distributed, and the standard deviation of the default rate is:

Therefore, a measure of UL on the loan is:

Zα is a multiple (for example, a normal deviate) that limits the probability of unexpected losses to a specified level. This is the value-at-risk for this credit facility, representing the amount of capital needed to cover the unexpected loss in this exposure. In the case of a mark-to-market model, the calculation of EL and UL takes into account the prospects for both upgrades as well as downgrades of the loan; it considers the change in value of the loan for each possible change in the rating of a facility from its current level, and the corresponding probability of rating transition.15

While similar considerations apply in the case of salam contracts for calculating counterparty credit risk, there is an additional commodity price risk embedded in these contracts that should be added to the credit risk. The commodity price risk will arise even when the counterparty does not default, and when there is default (for example, delivery of a substandard good, delayed delivery of a good, etc.) the commodity price risk—taking into account any offsetting parallel salam positions—could be included as part of the LGD. Thus, potential loss in a salam contract is the sum of the loss due to credit risk and the loss due to commodity price risk, assuming that delivery takes place according to the contract (that is, there is no credit risk loss). In addition, there could be a correlation between these two types of risk (for example, due to common factors such as drought that could affect both commodity price risk and counterparty credit risk), which could be estimated based on historical data but is ignored for the time being for simplicity. In the absence of liquid commodity markets as well as Shari’ah-compatible hedging products to mitigate price risks, commodity price risk can be measured by calculating the value-at-risk of commodity exposures in different maturity buckets using historical data on prices. While commodity exposures can be treated as part of market risk measurement for capital allocation purposes, it is important to compute this market risk separately for each salam contract or for a portfolio of salam contracts and to add it to the credit risk so that the full risk in each contract (or portfolio of contracts) can be properly measured and taken into account in the pricing of the contract (or the facility). Also, the estimated commodity price risk should be monitored regularly, as price volatility could change over time due to shifts in macroeconomic and market-specific conditions.

Finally, credit risk of a portfolio of exposures and facilities could be lower or higher depending upon the extent of diversification or concentration in specific credit categories. The credit risk measurement can take into account the benefits of diversification by computing the joint distribution of default events based on correlations between different classes and segments of the portfolio—that is, correlations between defaults among counterparties and the joint probability of default of any pair or group of counterparties can be estimated. This can form the basis for valuing the loan portfolio and computing the expected loss in the loan portfolio as a whole, based on the joint distribution of components of the portfolio. In some models, default rates and transition probabilities can be made a function of macroeconomic variables. The probability distribution of gains and losses of the loan portfolio, or the loan facility, can then be used to compute both expected and unexpected losses (at a given probability level). In case of loans to a diversified group of individuals and small businesses, with standard instalments and commodity leases, supervisors and banks might treat the class of loans as a retail exposure with a smaller risk weight (reflecting lower value-at-risk due to diversification effects). At the same time, credit concentrations by sectors and rating classes should be monitored as alternative indicators of credit risk.

3.3 Equity Risks in Mudarabah and Musharakah Facilities

These are equity-type facilities, typically a very small share of total assets in part reflecting the significant investment risks that they carry. In a sample of Islamic banks, the share of mudarabah and musharakah facilities (as mentioned earlier, in the latter both partners share in the profit and/or loss of the venture) and traded equities varied from 0 to 24 percent, with a median share of about 3 percent. The possible unexpected losses in such equity-type contracts will depend upon the functions of the underlying enterprise or venture in which the bank acquires an equity exposure.16 In a venture formed for trading in commodities or foreign exchange, the equity position risk arises from the risk of underlying transactions by the venture. A measure of the potential loss in equity exposures in business enterprises that are not traded can be derived based on the standard recommended in Basel II (paragraph 350) and the IFSB Standard for “equity position risk in the banking book.”17 In addition, a mudarabah facility may need to be assigned an additional UL due to operational risk factors, with the extent of operational risk adjustment depending on the quality of internal control systems to monitor mudarabah facilities on the asset side. High-quality monitoring would be very important in Islamic banks, since the finance provider cannot interfere in the management of the project funded on a mudarabah basis. In the case of musharakah, the need for operational risk adjustment may be less, in so far as the bank exercises some management control. If the bank’s equity interest in a counterparty is based on regular cash flow and not capital gains, and is of a long-term nature linked to customer relationship, a different supervisory treatment and a lower LGD could be used. If, however, equity interest is relatively short term, relies on capital gains (for example, traded equity), a VaR approach, subject to a minimum risk weight of 300 percent, could be used to measure capital at risk (as proposed in Basel II).

3.4 Market Risks and Rate of Return Risks

The techniques of market risk measurement in the trading books of Islamic banks should be broadly identical to those in conventional banks. The trading book in Islamic banks, however, is likely to be limited to traded equities, commodities, foreign exchange positions, and, increasingly, various forms of sukuk. A large share of assets of Islamic banks also consists of cash and other liquid assets, with such short-term assets typically exceeding short-term liabilities and amounts that IAHs are entitled to withdraw at short notice by a large margin, in part reflecting the limited availability of Shari’ah-compatible money market instruments. Against this background, exposure to various forms of market risk can be measured by the traditional exposure indicators, such as:

• Net open position in foreign exchange.
• Net position in traded equities.
• Net position in commodities.
• Rate-of-return gap measures by currency of denomination.
• Various duration measures of assets and liabilities in the trading book.

Most Islamic banks compute and often disclose liquidity gap measures—the gap between assets and liabilities at various maturity buckets—and hence the computation of the rate-of-return or repricing gap should be fairly straightforward. More accurate duration gap measures may also be available in some banks. Gap and duration measures, and their availability in banking statistics, are discussed in the Compilation Guide for Financial Soundness Indicators (IMF 2004). Duration measures are important indicators of financial soundness, but they are not readily available in many banking systems. Baldwin (2002) discusses duration measures in the context of Islamic banking. The impact on earnings of a change in exchange rate, equity price, commodity price, or rates of return can be directly obtained by multiplying the appropriate gap or other exposure indicators by the corresponding price change. Such a simple approach will not, however, suffice for computing the impact of changes in interest rates on equity-type exposures of fixed maturity (such as mudarabah and musharakah). The impact of changes in the rates of return on the expected rate of profits (that is, mudarabah and musharakah income) would need first to be computed, or equivalently the equity exposures should be adjusted by a multiplicative factor (which a supervisor can specify) before computing gaps in each maturity bucket.

Such gap measures may not, however, capture the maximum losses that could occur (at some probability level), particularly in Islamic banks. They do not properly recognise other market-related risks arising from changes in the spread over benchmark rates, or twists in the yield curve, or shifts in market volatility, which could affect potential losses. For these reasons, market risk is commonly measured by various VaR measures. This is particularly important, given the likely importance of equities and commodities in Islamic bank balance sheets, which have potential to cause large losses. For example, for both equities and commodities, VaR based on a 99 percent confidence level (one-sided confidence interval) could be computed. VaR could be based on quarterly equity returns (mudarabah or musharakah profit rate) net of a risk-free rate,18 or quarterly or monthly changes in commodity prices.

In most Islamic banks, the rate-of-return risk in the banking book is likely to be much more important than market risk in the trading book.19 The rate-of-return gap and duration gap applied to the banking book would provide measures of exposures to changes in benchmark rates of return, and of the impact of these changes on the present value of bank earnings. For example, a simple stress test of applying a 1-percentage-point increase in rates of return on both assets and liabilities maturing—or being reprised—at various maturity buckets would yield a measure of potential loss (or gain) due to a uniform shift in term structure of rate of return.20

Another important source of risk is the possible loss due to a change in the margin between domestic rates of return and the benchmark rates of return (such as LIBOR), which may not be closely linked to the domestic return. Many Islamic banks use an external benchmark such as LIBOR to price the mark-up in murabahah contracts, in part reflecting the lack of a reliable domestic benchmark rate of return. If domestic monetary conditions change, requiring adjustments in returns on deposits and loans, but the margin between the external benchmark and domestic rates of return shifts, there could be an impact on asset returns. This is a form of “basis risk” that should be taken into account in computing the rate-of-return risk in the banking book (and also market risks). The existence of this basis risk highlights the importance of developing a domestic rate-of-return benchmark so that both deposits and assets can be aligned to similar benchmarks.

3.5 Liquidity Risk

This risk is interpreted in numerous ways, such as extreme liquidity, availability of liquid assets to meet liabilities, and the ability to raise funds at normal cost. This is a significant risk in Islamic banks, owing to the limited availability of Shari’ah-compatible money market instruments and lender of last resort (LOLR) facilities. A standard measure of liquidity risk is the liquidity gap for each maturity bucket and in each currency. The share of liquid assets to total assets or to liquid liabilities is also a commonly used measure. While the availability of core deposits (current accounts and investment accounts) which are rolled over, and not volatile, provides a significant cushion for most Islamic banks, the remaining volatile deposits cannot be readily matched with short-term liquid assets, other than cash and other low-yielding assets.

In addition, specific aspects of Islamic contracts could increase the potential for liquidity problems in Islamic banks. These factors include: cancellation risks in murabahah, the Shari’ah requirement to sell murabahah contracts only at par, thereby limiting the scope for secondary markets for sale-based contracts, the illiquidity of commodity markets, and prohibition of secondary trading of salam or istisna’a contracts (see Ali 2004).

Management of liquidity risk in Islamic banks is complicated by the dearth of liquid instruments offering Shari’ah-compliant returns (including “high quality liquid assets” as required by Basel III), and of Shari’ah-compliant interbank markets and lender-of-last-resort facilities.

3.6 Operational Risk

Operational risk is defined as “the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This includes legal risk, but excludes strategic and reputation risk.”21 Such risks are likely to be significant in Islamic banks, due to specific contractual features and the general legal environment. Specific aspects that could raise operational risks in Islamic banks include the following: (1) the cancellation risks in nonbinding murabahah and istisna’a contracts; (2) problems in internal control systems to detect and manage potential problems in operational processes and back-office functions; (3) technical risks of various sorts; (4) the potential difficulties in enforcing Islamic finance contracts in a broader legal environment; (5) the risk of non-compliance with Shari’ah requirements that may impact on permissible income; (6) the risk of “misconduct and negligence” which would result in mudarabah-based PSIA becoming a liability of the Islamic bank, with consequent capital adequacy and solvency implications; (7) the need to maintain and manage commodity inventories, often in illiquid markets; and (8) the potential costs and risks in monitoring equity-type contracts and the associated legal risks. In addition, the increasing use of structured finance transactions—specifically, securitisation of assets originated by banks—could expose banks to legal risks.

The principle of setting a capital requirement in the form of a risk-weighted-asset equivalent for operational risk is subject to discussion, since operational risks pertain to a bank’s systems and procedures, not to its assets or balance sheet positions as such. It has to be said that the treatment of this risk in relation to capital requirements was a new departure in Basel II. The three methods based on “gross income” are undoubtedly crude when applied to conventional banks; in the case of Islamic banks, this is true a fortiori. The use of gross income as the basic indicator for operational risk measurement could be misleading in Islamic banks, in so far as a large volume of transactions in commodities and the use of structured finance raise operational exposures that will not be captured by gross income. The standardised approach that allows for different business lines is better suited, but still requires adaptation to the needs of Islamic banks. In particular, agency services under mudarabah, the associated risks due to potential misconduct and negligence, and operational risks in commodity inventory management all need to be explicitly considered for operational risk measurement.

3.7 Mix of Risks by Type of Product

The above review of risk characteristics of Islamic products by type of risk poses a challenging issue of how to recognise the specific bundling of risks in individual Islamic finance products and the associated correlation among risks. Monitoring the mix of risks for each facility in a centralised and integrated manner is key to pricing the risks. First, all Islamic finance contracts—whether sales-based, leased asset-based, or equity-based—in light of the associated operations in commodities, and the need to monitor or intervene in governance and controls of counterparties in equity-based contracts, are exposed to a mixture of credit and operational risks. In addition, murabahah and salam contracts will also face commodity price risk; holdings of sukuk, for instance, will carry a mixture of credit, market, and operational risks. Also, the mix of risks will vary according to the stage of contract execution, as recognised in IFSB (2006).

4. OVERALL RISK OF AN ISLAMIC BANK AND APPROACHES TO RISK MITIGATION

Potential losses due to each category of risk could be quantified and aggregated to derive the total impact of the different risks and to examine the adequacy of capital to absorb the risks. However, it is unlikely that the unexpected losses will exceed their upper bounds at the same time for different types of risk, and the arithmetic total of individual risks will be an overestimate of the aggregate VaR for the bank as a whole. Such an aggregate VaR is, however, important for informing unrestricted IAHs of Islamic banks, who are expected to share in the overall risks. An overall risk measure could be obtained from historical distribution of earnings and calculating earnings volatility, as already discussed.

A key issue for Islamic banks is to manage the risk-sharing properties of investment accounts—both restricted and unrestricted—in order to mitigate some of the risks to shareholders. Thus, in addition to collateral, guarantees, and other traditional risk mitigants, the management of the risk–return mix, particularly of unrestricted IAHs, could be used as a key tool of risk management. Appropriate policies toward profit equalisation reserves (and, possibly, investment risk reserves), coupled with appropriate pricing of investment accounts to match the underlying risks, would improve the extent of overall risk sharing by these accounts. Under current practices, reserves are passively adjusted to provide a stable return to unrestricted IAHs, effectively not allowing any risk mitigation through investment account management—that is, management of the risks and returns of the underlying assets in order to produce the desired outcomes.22 For example, many banks with sharply divergent risk profiles and returns on assets seem to be offering almost identical returns to unrestricted IAHs, and these are broadly in line with the general rate of return on deposits in conventional banks.

These relationships have been analyzed empirically in Sundararajan (2005). The evidence reveals a significant amount of return smoothing and a significant absorption of risks by bank capital (and thus, only a limited sharing of risks with IAHs). This finding raises a broader issue of how best to measure empirically the extent of risk sharing between unrestricted investment accounts and bank capital.

A specific framework for such measurement is suggested further on. The definition and measurement of mudarabah profits are first discussed; a methodology is then presented for calibrating risk sharing between IAHs and bank owners based on a VaR methodology.

4.1 Accounting Definitions

The relationship between mudarabah income and overall return on bank assets can be specified based on available accounting standards. Drawing on this relationship, a methodology to measure the risks facing IAHs, and the risk sharing between bank owners and IAHs, is suggested.

According to Financial Accounting Standard No. 6 (FAS 6) of the Accounting and Auditing Organization of Islamic Financial Institutions (AAOIFI), when a bank commingles its own funds (K = Capital) and current account (CA) funds guaranteed by the bank (so that these count as part of the mudarib’s funds for risk-bearing and profit-sharing purposes) with mudarabah funds (DI = unrestricted IAH), profits are first allocated between the mudarib’s funds K + CA and the funds of investment account holders, DI, and then the share of Islamic bank as a mudarib for its work is deducted from the share of profits of the IAHs.

In addition, FAS 6 states that profits of an investment jointly financed by the Islamic bank and unrestricted IAHs shall be allocated between them according to the contribution of each of the two parties in the jointly financed investment. Allocation of profit based on percentages agreed upon by the two parties is also juristically acceptable (according to the principle of musharakah), but the standards call for proportionate contribution.

The minimum standard for calculating the rate of return—specified by the Bank Negara Malaysia in the Framework of the Rate of Return (2001, and revised 2004)—calls for the sharing of profits between depositors (i.e., unrestricted IAHs) and the bank as mudarib to be uniform across banks as specified in the framework documents, and provides a uniform definition of profit and provisions to ensure a level playing field. Profit is defined as income from balance sheet assets plus trading income minus provisions, minus appropriations to (or plus releases from) profit equalisation reserves, minus the income attributable to capital, specific investments, and due from other institutions. This is the mudarabah income (RM) distributable between investment depositors (unrestricted IAHs) and the bank (as mudarib). Provisions are defined as general provisions plus specific provisions and income-in-suspense for facilities that are non-performing. The framework then distributes mudarabah income between the IAHs and the bank as mudarib and then by type and structure of IAH deposits.23

In addition, both AAOIFI standards and the rate of return framework of the Bank Negara Malaysia recognise the profit equalisation reserve and investment risk reserve (IRR). PER (or Rp) refers to amounts appropriated out of gross income in order to maintain a certain level of return for depositors (IAHs); and this is apportioned between IAHs and shareholders in the appropriate proportions that apply to the sharing of profits. IRR are reserves attributable entirely to IAHs, but are maintained specifically to cover losses on investments made with their funds.24

4.2 Measuring Risks in Investment Accounts and Risk Sharing

Given the framework for the computation of mudarabah profit—to be apportioned between the mudarib and the unrestricted IAH—and the policies on PER and IRR, the risk (defined as unexpected losses) of investment deposits can be calculated based on the variance of the rate of return for IAHs. Computation of such unexpected losses under alternative scenarios for income smoothing (that is, alternative policies on PER and IRR) can provide the basis for estimating the adjustment factor α, which is subject to supervisory discretion under the IFSB capital adequacy formula. This approach is based on the consideration that effective investment account management would help to determine a value for α that is consistent with the risk–return preferences of IAHs and the bank’s response to these. A further elaboration of these issues, including precise approaches to estimation of α, is the subject of a separate paper (Archer, Karim, and Sundararajan 2010) and a Guidance Note issued by the IFSB (IFSB 2011).

5. SUMMARY AND POLICY CONCLUSIONS

The application of modern approaches to risk measurement, particularly for credit risk and overall banking risks, is important in Islamic finance for at least four reasons:

• To properly recognise the unique mix of risks in Islamic finance contracts.
• To ensure proper pricing of Islamic finance facilities, including returns offered to IAHs.
• To manage and control various types of risks, including operational and liquidity risks as well as credit and market risks.
• To ensure adequacy of capital and its effective allocation, according to the risk profile of the Islamic bank.

The preliminary review of the current state of financial reporting and disclosure among Islamic banks suggests that systematic future efforts at data compilation would be needed, particularly to measure credit and equity risks with some degree of accuracy. The situation is similar for many conventional banks, but the need to adopt new measurement approaches is particularly critical for Islamic banks because of the role IAHs play, the unique mix of risks in Islamic finance contracts, and the need to make more active use of security markets and securitisation products for risk management. For these reasons, rapid progress is important in consumer-friendly disclosures to inform IAHs of the risk–return mix they face, and in market-oriented disclosures to inform markets of capital adequacy, risk exposures, and risk management.

In addition, managing the risk-sharing property of investment accounts through proper pricing, reserving, and disclosure policies would greatly enhance risk management in Islamic finance. This requires measurement and disclosure of aggregate value at risk of mudarabah income in the consolidated balance sheet of Islamic banks, and greater use of asset securitisation in order to offer assets of specific risk–return characteristics to IAHs. Also, a measure of the extent to which the risks to shareholders are reduced on account of risk sharing with IAHs should be the basis of any capital relief or lower risk weights on the assets funded by investment accounts. For example, the proposed capital adequacy standard for Islamic banks (IFSB 2005b) calls for supervisory discretion in determining the share, “α,” of risk-weighted assets funded by PSIA that can be deducted from the total risk-weighted assets for the purpose of assessing capital adequacy. This share α represents the extent of total risk assumed by the PSIA, with the remainder absorbed by the shareholders on account of displaced commercial risk.

These observations suggest several policy and operational considerations and proposals:

• Appropriate measurement of credit and equity risks in various Islamic finance facilities can benefit from systematic data collection efforts, including by establishing credit (and equity) registries.
• Islamic banks would require both centralised and integrated risk management that helps to control different types of risks while allowing disaggregated risk measurements designed to price specific contracts and facilities, including the risk–return mix offered to IAHs. This integrated approach to risks would need to be supported by appropriate regulatory coordination and cooperation among banking, securities, and insurance supervisors.
• The disclosure regime for Islamic banks needs to become more comprehensive and transparent, with a focus on disclosures of risk profile, risk–return mix, and internal governance. This requires coordination of supervisory disclosure rules and accounting standards, and proper differentiation between consumer-friendly disclosures to assist investment account holders, and market-oriented disclosures to inform markets.25
• The supervisory review process should monitor and recognise the actual extent of risk sharing by IAHs in assessing capital adequacy, thereby encouraging more effective and transparent risk sharing with IAHs. Adequate disclosure by an Islamic bank of the credit and market risks borne by PSIA and shareholders, respectively, should be a supervisory requirement for giving a low value to the “α” parameter in the capital adequacy formula to be applied to that Islamic bank. Thus, inadequate disclosure would result in a high value being set for this parameter (equivalent to granting little or no “capital relief” in respect of the share of these risks that might otherwise be considered to be borne by PSIA). The measurement of these risks, and estimation of appropriate capital relief, can be based on VaR methodology as suggested in Section 4.

NOTES

1. Clearly there is no juristic obligation under the Shari’ah for the bank to absorb risk for the benefit of IAHs; in fact, the reverse is true. But in some jurisdictions the central bank takes the view that, as unrestricted PSIA are marketed as a substitute for conventional deposits, the bank has a constructive obligation to maintain its capital intact and to pay a competitive return.

2. Since the restricted investment accounts are not generally considered as a substitute for conventional deposits, this issue does not normally arise for them, although as a matter of commercial policy a bank in a particular year may decide to waive part of its mudarib share from such accounts in order to offer a better return to the IAH.

3. See “IMF Facilitates Establishment of IFSB,” IMF news brief no. 02/41, May 2002; http://www.imf.org/external/np/sec/nb/2002/nb0241.htm.

4. See papers presented at the seminar on The Ten-year Master Plan for the Islamic Financial Services Industry, held in Putrajaya, Malaysia, May 2005.

5. The amount need not be physically paid out, but may be credited to the IAH account, from where it can be either withdrawn or left as an addition to the balance invested.

6. The movements on IRR are also relevant, but are not explicitly included in this analysis for the sake of simplicity.

7. For a discussion of appropriate practices in defining mudarabah profits, see AAOIFI, Financial Accounting Standard No. 6, and the Framework of the Rate of Return (October 2001, and revised 2004) issued by the Bank Negara Malaysia. For examples of estimation of such earnings and PaR measures for Islamic banks, see Hakim (2003) and Hassan (2003).

8. In the case of an ijarah-based facility, the risk is that of default by the lessee—that is, failure to keep up lease payments. However, in an ijarah, the bank as lessor retains ownership of the leased asset and can normally repossess it in the event of default by the lessee.

9. Musharakah- and mudarabah-based facilities give rise to risks of nonperformance that are analogous to credit risk but are typically higher, as the customer has no legal obligation to repay capital or pay a return unless a profit is earned on the underlying investment. See Section 3.3.

10. Basel II definition (paragraph 452).

11. For a survey of new approaches to credit risk measurement and an overview of traditional methods, see Saunders and Allen (2002).

12. AAOIFI (2001), Financial Accounting Standard No. 2, Appendix B.

13. Djojosugito (2003).

14. Chapra and Khan (2000).

15. See Wilson (1998) and Caouette et al. (1999) for detailed illustration.

16. IFSB (2006).

17. Basel II also proposes another method whereby the loss can be estimated by using the PD corresponding to a debt exposure to the counterparties whose equity is being held, and applying a fairly high loss-given default such as 90 percent to reflect the equity risks. A measure of both expected and unexpected loss could then be computed from these parameters. However, the notion of “debt exposure” as such is problematic in Islamic finance, and this method is not proposed in the IFSB Standard, which suggests that the method proposed in Basel II based on “supervisory slotting criteria” for specialised lending may be adapted for such risks.

18. The concept of a risk-free rate is problematic in Islamic finance, since a risk-free return is not Shari’ah-compliant. However, the suggestion here is to use such a rate merely as a component in a calculation, not in an actual transaction.

19. In principle, in the presence of profit-sharing and loss-bearing investment account holders, the changes in asset returns due to changes in the benchmark market rate of return would be offset by corresponding shifts in the returns payable to IAHs. In practice, as a result of return smoothing, the risk of losses due to changes in market rates of return would remain significant.

20. Alternatively, the impact on the present value of earnings of shifts in the rate of return can be calculated directly from duration measures as follows: impact of change in rate of return = (DA − DL)Δir, where: DA = duration of assets; DL = duration of funding; and Δir = change in rate of return.

21. Basel II, paragraph 644.

22. In at least some cases this may, however, be a way of managing the different risk appetites of shareholders and investment account holders. The bank adopts a more aggressive investment strategy than would be appropriate for IAHs, and then uses “smoothing” methods to produce the outcomes for IAHs of a more defensive strategy. The investment accounts are thus used as a form of leverage. See Al-Deehani et al. (1999) and Archer and Karim (2005).

23. Thus, the income to the bank has two components: the return on bank capital used in calculating the mudarabah profits (this is the return to the bank’s contribution as a co-investor) plus the mudarib share of the mudarabah’s profits. (This is the fee for its asset management services.)

24. It would not be Shari’ah-compliant for the PER to be used for this, as this would amount to the mudarib absorbing part of the loss.

25. The IFSB has issued a standard on Disclosures to Promote Transparency and Market Discipline (IFSB 2007).

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