Banks and Financial Institutions (IBFIs)
Besides standard risks that Islamic as well as conventional banks face and manage, there are other risks that are specific to Islamic banks. Some of these risks are entirely new (like commercial displacement risk) and others are new yet fall under existing categorization of risk (like credit risk, market risk and interest rate risk etc.). These risks are specific to Islamic banks with respect to the Shari’a compliance requirements. Hence, these could be treated as specific operations risks faced by IBFIs.
Although these risks may prove fatal in some extreme cases, the management of IBFIs and their consultants so far have failed to emphasise sufficiently on their importance.
Islamic banks would be exposed to these specific risks due to a number of reasons, including the issuance of certain Shari’a resolutions by its own Shari’a supervisory committee and/or that of a national Shari’a advisory body (or even an individual Shari’a scholar), issuance of new guidelines by a central bank or another financial regulator, or due to issuance of unfavourable decisions by a court of law. In such a scenario, one must expect an adverse impact on profits and revenues of the concerned Islamic bank.
On the other hand, on a lighter note, an Islamic bank may be exposed to a specific risk due to customer defection or customer dissatisfaction. If such a situation arises then this might result in negative marketing (i.e., word of mouth) and if remained unchecked for a long period then it could lead to a permanent loss in the market share.
We focus on some of the most important risk specific to IBFIs.
FACTOR 1: RISK OF UNDERLYING ASSET
Most of the financing transactions in IBF are based on selling or leasing of an underlying asset. In fact, bearing the risk of ownership of an underlying asset entitles an IBFI to claim revenues generated from the sale of the underlying asset. The specific risk that an IBFI faces is a possible or potential loss of the underlying asset prior to execution of sale/ lease contract. According to Shari’a, an IBFI can claim any amount of profit provided it bears the risk of the underlying asset at the time of selling or leasing the same.
As per Shari’a rulings, Islamic banks cannot sell an asset before getting the risk of the underlying asset transferred to itself. For example, if an Islamic bank buys a car from a dealer and if anything goes wrong with the car prior to executing an auto murabaha contract then Islamic bank has to bear the loss. Similarly, in shares financing (as a substitute to personal financing), Islamic bank is exposed to high degree of price risk in case the customer rejects or defaults in signing the murabaha or musharaka of shares. Such kind of risk could be mitigated through various risk minimisation methods. The most common risk mitigation in this respect is to ensure that the Islamic bank (as seller) executes sale of the underlying asset to the customer (as buyer) in the fastest possible time. Obtaining customer’s acceptance through implied consent would facilitate Islamic bank to transfer such kind of risk at the fastest possible way.
As per Shari’a rulings, deferment of risk transfer for a specific asset is not permissible. For example Islamic bank cannot agree to sell a specific asset today where the risk will be transferred after one month. This could be addressed through timing of risk where execution of the sale of the underlying asset is scheduled only when the seller is willing to part away from the underlying asset.
As per Shari’a rulings, once risk of the underlying asset is transferred to the customer (as buyer) then the Islamic bank (as seller) has no Shari’a right of reselling it to other party or the same buyer at profit. Hence many Islamic bank face losses when murabaha customers delay in settling their payments by few months. Islamic banks do not wish to qualify such delay as events of default but still they suffer losses due to fixing the price of murabaha. This could be mitigated through appropriate pricing of risk whereby the Islamic bank (as seller) has to agree on the best rate of return/yield at the time of transferring the risk to the customer (as buyer).
FACTOR 2: SPECIFIC CREDIT RISK
Credit risk specific to Islamic banks can be defined as the financial loss that an IBFI suffers when a customer defaults. In conventional banking, when a customer is late on payments, the lender benefits in terms of default penalty and the additional interest that the customer has to pay to bring their account in order. In some cases, delay in payment is expected and welcomed, as it brings additional benefits to the lender (as is the case in the credit card business wherein credit card provider actually awaits a transactor to become a revolver). As default penalty is not allowed in IBF, and where it is imposed, the finance provider cannot benefit from it except to the extent of the direct administrative costs associated with it, the credit risk for IBFIs includes additional loss of income due to default.
Generally, customers of Islamic banks have two kinds of financial obligations: a) debt settlement; and b) periodic purchase or lease.
In debt settlements (for example settling dues of murabaha, istisna’ and salam, etc.), the customer has to settle the outstanding financial obligation irrespective of availability or non-existence of the underlying asset. Hence, if a car sold on a murabaha basis is destroyed, even then the due price has to be paid by the customer. However, on the downside, Islamic bank cannot claim any extra returns over the contracted sale price or the outstanding debt. For example, during financial crises, Islamic banks in Dubai had to stick to the capped profit amount agreed upon at the time of executing murabaha. This incurred heavy losses to a number of Islamic banks that financed properties under construction, which got delayed on delivery. This is a major risk facing IBFIs using murabaha as a dominant tool of financing in their business.
This is one of the reasons that an increasing number of IBFIs have now started preferring other modes of financing, which offer flexibility in the wake of an adverse event. One solution that has been in practice in some countries is the use of periodic purchases and sales contracts. Ijara-based leasing is another risk mitigation tool. In cases of periodic sales and leases, returns for the coming periods can be adjusted to compensate the Islamic bank for loss due to customer’s default or changing financial conditions. For example, in case of ijara, it is possible to increase the rent of the subsequent months, followed by a default on part of a customer. Similarly, in case of a periodic sale contract, the sale price can be increased in subsequent sales if a regular customer happens to default on a particular obligation.
However, it should be noted that there is a possibility of a trade-off between specific credit risks and the specific risks arising from the ownership of the underlying assets. While moving to ijara-based products may help in reducing credit risk, it is expected to increase the risks associated with the underlying assets. Similarly, moving to multiple and periodic sales to mitigate credit risk is also expected to increase likelihood of operational risk (in terms of mistakes, errors and omissions by the bank’s personnel).
Given this trade-off, care must be exercised to decide on the contract choice, and other factors like price volatility, customer’s credit history, and the expertise level of the bank staff must also be taken into account. If, for example, downward price volatility is the dominant factor, then one-off murabaha transaction may be a better choice. If, however, customer’s default is likely (and is still within the acceptable risk threshold), then periodic sales and ijara contracts may be more feasible. If, on the other hand, an IBFI faces excessive incidence of operational risk, simple one-off murabaha transactions may be preferred.
FACTOR 3: RISK OF HUMAN CAPITAL
All banks and financial institutions face people risk, which is categorized under operational risks. In case of IBFIs, this risk has an additional dimension, given the Shari’a compliancy requirements. After all, IBF is driven by Shari’a sensitivity of customers. If IBFI customers perceive employees of such institutions less than committed to IBF, this will adversely affect their patronage and custom.
In recent times, a number of Islamic banks in the Middle East have suffered losses due to irregularities in operations and inadequacy of policies adopted by the top management that was not particularly committed to Islamic banking. Similarly, all the Islamic banks set up in UK had CEOs who came from non-Islamic background. These CEOs were gradually replaced with Muslim CEOs who are seen more favourably by the users of Islamic financial services. A number of Shari’a boards advise their banks to choose pious Muslims to lead their businesses, an advice that has not been taken seriously in many cases though. In South Africa, there has been at least one case where a top manager of Islamic banking operations was found to be involved in activities that were questionable from a regulatory perspective.
Consequently, shareholders of IBFIs in Africa have now adopted a cautious approach in deciding top leadership of such institutions.
In Malaysia, now there is an implicit understanding that the central bank will approve only Malay Muslims to lead Islamic banks and takaful companies as CEOs. This is, however, not so far the case when it comes to appointments in the Islamic capital market wherein Securities Commission Malaysia has yet to adopt such an implicit approach to manage risk of human capital specific to IBFIs.
In the wake of Islamic banking making its route to new markets like East Africa where local expertise in Shari’a structuring, development and audit is highly uncommon, IBFIs are expected to this specific risk, at least at the initial stage of development of IBF therein. This is a real challenge faced by IBFIs in the new jurisdictions where they face acute pressure from their conventional counterparts. Incapable, inadequately qualified or less committed human resources in such instances find it difficult to overcome competition pressure through structuring innovative products and adopting processes
and procedures that favour IBF. Many industry observers believe that credibility of Islamic banks with less committed workforce will adversely impact their Shari’a identity and branding.
As a general remedy to human resource-related specific risks faced by Islamic bank, HR departments of Islamic banks should make more serious efforts to raise the standards for those who are willing to join Islamic banking through recruitment, localization and continuous learning and development initiatives. In a study on top Islamic banking brands, Meezan Bank’s employees were found to be most loyal to their bank and its brand (see the previous issue of ISFIRE for further details), and there is a need to study Meezan Bank’s approach to human resource development.
FACTOR 4: MARKETING RISK
Specific risk of marketing faced by Islamic banks is related to the possible financial and reputational suffered due to following inappropriate marketing tools in promoting Islamic financial products. This includes usage of conventional terminology in verbal and written communication.
Legal documentation and marketing material with conventional terminology might lead to shaking Shari’a Board’s confidence in the true essence of products offered by Islamic banks. Also, the personnel using conventional terminology will add doubts to the customers’ minds about Shari’a credibility of Islamic banks and the products offered by them.
Similarly using inappropriate means of promoting Islamic financial products (like through music channels or cinema halls) could force Shari’a boards to take severe and unfavourable measures. As a general remedy to risk faced by Islamic banks due to improper marketing efforts, serious thoughts should be given by the marketing departments of Islamic banks to give a positive and vibrant image of the Islamic banks, which can attract a larger market share.
Moreover engaging Islamic banks in sponsoring Islamic conferences and charitable causes have proven to be a positive step to mitigate any risk of negative marketing.
FACTOR 5: STATUTORY AND LEGAL RISK
Specific risk of statutory and legal risk faced by an IFBI is the risk of financial loss due to being subjected to certain regulatory frameworks or unfavourable decision in a court of law.
Except in a few countries (notably Malaysia), the laws of land do not recognize Shari’a principles and rulings as acceptable and applicable governing law for commercial and financial transactions. This means that Islamic financial transactions become subject to conventional in the event of a dispute. This is particularly true when the legal documentation clearly stipulates a conventional law, e.g., the English law, as the governing law of the transaction.
Furthermore, many Islamic financial transactions are governed by complex lengthy documentations, which may in many instances be not understood by judges (who are not well-versed in the Shari’a law) in the conventional courts. It may also be the case that legal documentation may have gaps and important exclusions, especially if they are prepared by law firms not fully exposed to the Shari’a requirements, or the documentations are not properly vetted by qualified Shari’a advisors. If so, it is very likely that the transaction would be deemed null and void from a Shari’a viewpoint, in case of a dispute going into a law of court and the judge requires an independent Shari’a opinion on the transaction. In such a case, the court will have no option but to adjudge the case from a pure conventional viewpoint. IBFIs in this circumstance are likely to incur financial losses.
Specific risk facing an IBFI in the context of regulatory framework may be understood in the context of liquidity management. In many jurisdictions, Islamic banks do not have access to Shari’a-compliant instruments to manage their liquidity requirements. While conventional banks may have access to a variety of instruments like repos and T-bills, IBFIs may have to resort to expensive bespoke arrangements for liquidity management. This is certainly a risk specific to IBFIs.
As a general remedy to the risks faced by Islamic banks due to statutory and legal factors, it should be ensured that documentation by Islamic banks’ legal departments are thorough and lean in order to cover all the Shari’a requirements to avoid being subjected to conventional rulings that are not in line with Shari’a principles. Also, Islamic banks should work more proactively on Shari’a-compliant alternatives to the existing central bank’s conventional products to avoid any financial or liquidity risk.
CONCLUSION
Risk management in IBFIs is a trick area, which is fast evolving with the increase in size and scope of the Islamic financial services industry. So far, however, risk managers and policy and strategy personnel of IBFIs have taken into account only secular views of risks. Consequently, the risk mitigation and management endeavour by IBFIs have resulted in bringing product development in IBF closer to the conventional practices. A proper consideration of risks specific to IBF must result in product development and structuring in favour of genuinely Shari’a-compliant products that fulfil Islamic requirements in letter and spirit.
