Risk Management for Islamic Banks Recent Developments

78 RISK MANAGEMENT FRAMEWORK IN ISLAMIC BANKING to future revenues (so that it should be deferred), or to present revenues (in which case it should be accrued, including unpaid revenues). BASIC CONTRACTS AND INSTRUMENTS IN THE ISLAMIC BANK The scope of an Islamic bank’s financing activities extends farther than that of a conventional bank’s financing. An Islamic bank can choose among a great variety of contract schemes such as qardhul hasan, trade/commerce (mu’ajjal-murabahah, salam, mu’ajjal-musawamah or bi tsaman ajil), leasing (ijarah), and partnership (mudharabah, musyarakah, musaqat, and muzara’ah). These financing contracts can be divided into two broad categories, namely debt-based contracts and equity-based contracts. The debt-based category includes qardhul hasan, trade with delay/deferment (mu’ajjal-murabahah or musawamah, salam), and leasing (ijarah). These debt-based contracts can be further divided into two categories based on the way the debt is incurred; the first category is pure debt (qardhul hasan) while the other covers debts that arise from li tijari contracts such as trade (mu’ajjal-murabahah, salam, mu’ajjal-musawamah or bi tsaman ajil) and leasing (ijarah). These trading schemes can be divided into four categories according to the timeframe for the delivery of the goods and the payment of the price: cash-and-carry (bay’ an-naqdan), pre-orders (bay’ as-salam or as-salaf), sales on credit/deferred payment (bay’ al-mu’ajjal), and the trading of debts (bay’ ad-dayn bi ad-dayn). In cash and carry (bay’ an-naqdan), the seller hands over the goods and the buyer pays the price in full when the trade contract is made; neither side incurs any future liabilities in the process. Pre-ordering (bay’ as-salam) is a trade where the buyer makes an advance payment while the seller promises to deliver goods of the desired specifications (quantity and quality) at a specified date in the future, such as four months, a year, or two years later. In this way the seller owes the delivery of the goods to the buyer. In contrast, a credit trade (bay’ al-mu’ajjal) happens when the seller hands over the goods when the contract is made, while the buyer promises to pay at a later date (deferred payment), whether in credit or as a lump sum. The buyer thus owes the remaining payment (in full or in part) to the seller. But if both the buyer and the seller delay the delivery of their obligations (both the goods and the payment of the price), the trade is considered to be the trading of debts (bay’ ad-dayn bi ad-dayn). This last form of trade is forbidden in syari’ah since Islam stipulates that only one side (either the buyer or the seller, not both) can incur debt in a trade.

Financial Reporting and Analysis in Islamic Banking 79 Classical fiqh studies usually place the discussion of pre-ordering (salam) in the context of the trade of agricultural commodities (such as dates). However, every kind of trade that involves pre-ordering can be regarded as a salam trade even if the object of the transaction is a nonagricultural commodity such as metals or manufactured goods. The financing contract under the preordering system for manufactured goods generally falls under the istishna’ contract. According to the Hanafi School, istishna’ basically includes two contract agreements, namely trade and ijarah. By drawing analogies and performing ihtihsan, they came to the conclusion that istishna’ involves the procurement of the seller’s services in the form of effort and commitment. This makes istishna’ similar to leasing (ijarah), which opens the door for the deferment of the payment without becoming a trade in debts. The payment for the lease in an ijarah contract can be done at the beginning of the contract, during the lease, or after the end/termination of the lease. This does not make ijarah a subtype of trade, even though both are forms of exchange. The Hanafi School draws a distinction between trade (bay’) and ijarah. Trade is defined as the exchange of an asset for another asset, including money. Ibn Hazm in Al Muhalla (VII/4) stated that trade (bay’) turns the buyer into the new owner of the transaction’s object, while ijarah does not confer ownership upon the lessee. It is forbidden to consume the leased asset in an ijarah in a way that reduces the asset’s measure or utility. In other words, ijarah only trades utilization rights (usufruct) rather than the goods as such. To return to Islamic banks’ financing contracts, the only kind of financ- ing contract that does not allow an Islamic bank to obtain profits is pure lending (qardhul hasan). Administrative costs and any other fees can only be imposed upon the debtor if these fees can be unambiguously demonstrated to serve the debtor’s interest, and the amounts must be based upon the actual costs borne beforehand by the bank. In other words, the fees follow a reim- bursement system rather than an allocation of the bank’s overhead to the debtor, and definitely are not meant to cover the opportunity costs borne by the Islamic bank. This means the Islamic bank should only fund qardh with third-party funds obtained through similar qardh contracts (known as wad- hiah yad dhamanah). Preferably this financing category would be funded from the social funds owned or managed by the Islamic bank such as zakat funds, infaq, and shadaqah, or from segregated qardh fund accounts. The next category of financing contracts is equity financing (syirkah). In this arrangement the Islamic bank makes a capital contribution to the client’s business venture. If the Islamic bank provides 100% of the capital, this syirkah is known as mudharabah. However, if the client also contributes to the capital, the contract becomes a musyarakah. Unlike exchange-based

80 RISK MANAGEMENT FRAMEWORK IN ISLAMIC BANKING (trade and ijarah) contracts, the profit-sharing arrangement in syirkah con- tracts (mudharabah and musyarakah) is very flexible and can compensate for changes in the market. In good market conditions and a growing econ- omy, both the bank and the client would be able to obtain higher returns. Conversely, when the market experiences a recession or even a contraction, the bank would be able to absorb the risk and transfer part of it to the client as partners in the investment. At a glance, this kind of contract presents the bank with excellent profit opportunities coupled to a relatively high level of risk. STRUCTURE OF THE BALANCE SHEET An Islamic bank’s balance sheet should mention the name of the bank and the date of the report’s composition. It should contain at least the following components: assets, liabilities, unrestricted investment account holder funds (and equivalents), and owners’ equity. Assets should not be offset against liabilities unless the bank has specific religious and legal rights to that effect and there is an actual expectation for the offset (e.g., delayed profits in a murabahah can be offset against the murabahah’s financing side). Financial reports should also provide information on the total values of assets, liabili- ties, unrestricted investment accounts (and equivalents), and owners’ equity. Composition of Assets Assets are defined as all measurable items that can be used by the Islamic bank to produce cash flows, income, or other economic benefits in the future, whether by itself or in coordination with other assets, with the requirement that the Islamic bank has obtained all rights to retain, utilize, or sell these items at its discretion as a consequence of prior financial events or transactions. Obviously, both the substance of an asset and the means of its acquisition must be fully compliant with syari’ah. The asset component in an Islamic bank’s balance sheet covers a variety of instruments with various contract types, durations, and risk profiles. Assets include both physical items, such as land, buildings, office equipment, or vehicles, and financial items that involve some form of Islamic financing, whether it be short-term financing (such as murabahah and salam), intermediate-term financing (such as ijarah and istishna’), or long-term financing (such as mudharabah and musyarakah). A detailed account of assets should be provided either in the balance sheet or in the notes to financial reports (as an inseparable appendix to the financial reports). Since assets must be syari’ah compliant (halal) in both their substance and the means of their

Financial Reporting and Analysis in Islamic Banking 81 acquisition, any items that include interest-based receivables cannot be accounted as Islamic bank assets. An asset should be financially measurable (with a reasonable degree of reliability) and should not be tied to any rights or liabilities to another party. Composition of Liabilities Liabilities are defined as all measurable items that indicate the bank’s obli- gation to transfer assets, extend the use of assets, provide services to another party, or lose future cash revenues as a consequence of prior economic events or financial transactions. The liabilities side on an Islamic bank’s balance sheet includes two main categories. The first consists of liability claims backed by assets, such as giro (clearing) accounts, savings accounts, or deposit accounts. In managing these accounts, an Islamic bank can choose between four syari’ah-compliant financial contract models, namely wadiah (safekeeping funds), mudharabah (partnership), wakalah (agency), and qardh (loan). The third covers claims not backed by assets, mostly investment accounts categorized according to their profit and loss–sharing (PLS) schemes and the composition of the owners’ equities. PLS invest- ment accounts in Islamic banks provide an alternative solution to the interest-based third-party financing offered by conventional banks. These PLS investments usually follow the mudharabah or musyarakah contract models and the terms of the investments may be restricted (muqayyadah) or unrestricted (mutlaqah). Although investment accounts in an Islamic bank are treated as liabilities, the obligation to return the value of the principal and the profits (if any) belonging to the investment account holder depends entirely on the actual returns from the investments made with these funds. When the syirkah contract expires, the bank is normally required to return the principal and pay the corresponding share of profits to the investment account holder; but if the capital has been lost to normal business risks and losses, the bank has no obligation to restore the lost portion to the account holder. Composition of Equity Owners’ equity refers to the remaining value of the Islamic bank’s assets at the date of the financial report once subtractions have been made for the bank’s liabilities, unrestricted investment account holders’ funds (and equivalents), and haram (non-syari’ah compliant) revenue that must be seg- regated from the Islamic bank’s assets (if any). The disclosure of the owners’ equity is made in the statement of changes to equity and the statement of retained earnings. Islamic banks need capital reserves to protect depositors

82 RISK MANAGEMENT FRAMEWORK IN ISLAMIC BANKING Composition of Financing Portfolio Composition of Funding’s Sources 1. Qardh contract Treated as form of debt, 1. Current account – wadiah contract allowed to be used and 2. Murabahah contract a. Wadiah yad amanah contract 3. Salam contract without cost of fund Wadiah, not 4. Istishna’ contract (rate of return) 5. Ijarah contract b. wadiah yad dhamanah contractallowed to be 6. Multifinancing contract As a syirkah, applied profit-loss sharing 2. Saving account used by Islamic method a. Wadiah contract bank, and without i) Wadiah yad amanah contract cost of fund ii) Wadiah yad dhamanah contract b. Mudharabah mutlaqah contract 7. Mudharabah contract 3. Deposits account –mudharabah mutlaqah a. Mudharabah mutlaqah contract b. Mudharabah muqayyadah contract a. 1month 8. Musyarakah contract b. 3 months c. 6 months d. 12 months e. >12 months FIGURE 5.1 Composition of Third-Party Funds and Financing Contracts and investors from losses due to imprudent risk management. According to Basel or IFSB rules, a bank should have at least two capital reserve com- ponents: Tier 1 (primary) capital and Tier 2 (secondary) capital. Primary capital includes common stocks and retained earnings, but perpetual pre- ferred stocks cannot be included as an equity component in Islamic banks due to its status as a prohibited ribawi (usurious) instrument in Islamic law. Tier 1 capital should be consistent with the bank’s financial health and should not be limited by restrictions, terms, or covenants. On the other hand, Tier 2 capital items can be expected to expire or end their term at some point, so the bank should prepare some way to replace or redeem them without affecting its capital adequacy. Philosophy of the Balance Sheet The unique characteristics in Islamic banking are reflected in the components of the balance sheet and financial report structure issued by Islamic banks. In creating a balance sheet in Islamic banking, composition of the accounts could be arranged based on liquidity or functionality. These two approaches provide different implications to balance sheet structure, but still accommo- date the matching principle between components in assets and liabilities of Islamic banks. Liquidity Assets and liabilities should be grouped according to their nature and ordered by their relative liquidity. Liquidity can be defined as how eas- ily an asset can be sold (or liquidated) in normal conditions without undue

Financial Reporting and Analysis in Islamic Banking 83 delays or difficulties and with reasonably low liquidation costs. Liquid assets are normally defined as assets that will realize their benefit or can be con- verted into cash in less than a year, while fixed assets normally refer to nonfinancial assets such as land, properties, automobiles, and the like. As such, the categorization of assets into liquid and fixed assets is unsuitable for the Islamic banking industry. The classification of assets and liabilities on the balance sheet with regards to the banking activities of an Islamic bank is shown in Figure 5.1 and Table 5.1. Most of the contracts can be placed in more than one category, whether murabahah, salam, qardh, ijarah, or istishna’, but trading-based (murabahah and salam) and qardh should be categorized as the Islamic bank’s liquid assets. If these contracts are placed into intermediate- or long-term asset categories, some of the potential impacts are asset illiquidity, vulnerability to rate-of-return risks in a changing business environment, increased risk of nonperformance, a perception of higher prices, and eventually an active contribution to inflation. Similarly, ijarah and istishna’ should be treated as intermediate-term instruments under the notion that these two contract types are normally applied for the procurement of heavy machinery, property, infrastructure, or other TABLE 5.1 Islamic Bank’s Balance Sheet Based on Liquidity Profile Assets Liabilities Short-term assets (liquid assets) Short-term liabilities Cash and cash equivalents Giro accounts (wadiah, qardh) (including regulator deposits) Savings accounts (wadiah, qardh) Qardhul hasan Short-term trade financing Savings accounts (mudharabah) (murabahah, salam) Short-term investment accounts Medium-term assets (less-liquid (mudharabah, wakalah) assets) Medium-term investment accounts Ijarah financing Istisna’ financing (mudharabah, musyarakah, wakalah) Medium-term investment (mudharabah) Long-term investment accounts (musyarakah) Long-term assets (illiquid assets) Long-term partnership Reserve accounts (musyarakah) Fee-based services (wakalah, Equity capital ju’alah, ijarah, syirkah, etc.) Non-banking assets (land, property)

84 RISK MANAGEMENT FRAMEWORK IN ISLAMIC BANKING high-cost assets. If these contracts are categorized as short-term assets, the financial burden upon the debtors would become quite heavy, while the object of the contract could not be guaranteed to produce revenues for the debtor within such a short timeframe. Meanwhile, if they are categorized as long-term instruments, the fact that they are based on debts (mu’ajjal contracts) means that a longer contract duration increases debtor nonperformance risks and rate-of-return for the bank. Murabahah, salam, ijarah, and istishna’ are basically trade contracts with debt elements, where the price (or margin/rent) cannot be changed once it has been set in the mutual agreement. Functionality As a component of the financial system, Islamic banks play a crucial role in ensuring the efficient allocation of resources within the economic system through a variety of economic activities such as asset trans- formation, payment services, and risk transformation. In performing asset transformation, the bank should try to achieve a balance between demand and supply on financial assets (cash, fund deposits on regulators or other parties, various financing contracts, and fixed assets) and liabilities (giro and savings accounts, investment accounts, reserve accounts, third-party debts, and equity), and also to make adjustment to the contract terms, geographical distribution, and scale of these financial assets and liabilities for the purpose of hedging and portfolio diversification. Compared to financing schemes, accounting payment and administration systems such as checks, letters of credit, safe custody, clearing-settlement, and money transfers partake of the characteristics of brokerage (wakalah bil ujrah) or activities with a net balance between the demand and the supply for nonmaterial assets and liabilities as well as contingencies. An Islamic bank’s financial intermediation function not only involves the establishment of a relationship between parties with a capital surplus and parties with capital needs, but also influences the consumption patterns of households (as the source of capital surplus) and business players (as parties that require capital) by facilitating the sharing of risks between these parties. Apart from the maturity/liquidity-based approach, banks have the option of using the functionality approach (Table 5.2) in composing their financial statements. However, a bank that utilizes the function-based approach must still pay adequate attention to the durations/terms of maturity for their asset and liability components (especially on the balance sheet) so that the bank would be able to properly understand its risk exposure. Syirkah between Liabilities and Equity To satisfy accounting standards, the structure of investment account accom- modates two different types of investment activities. The first is mudharabah mutlaqah or unrestricted investment accounts (and their equivalents).

Financial Reporting and Analysis in Islamic Banking 85 TABLE 5.2 Islamic Bank’s Balance Sheet Based on Functionality Assets Liabilities Cash and cash equivalents (including Current and demand deposits (wadi’ah, regulatory deposits) qardh, mudharabah) Financing assets Investment accounts (mudharabah) Qardhul hasan Trade finance (murabahah, salam) Special investment accounts Ijarah finance (mudharabah, musyarakah, wakalah) Istishna’ finance Reserve accounts Investment assets (mudharabah, musyarakah) Equity capital Fee-based services (wakalah, ju’alah, ijarah, syirkah) Non-banking assets (land, property) The Islamic bank obtains these funds from customers (as investors) or pure investors (apart from equity holders) who allow the bank to invest their funds without any restrictions whatsoever (as long as they comply with syari’ah), including restrictions against the mixing of these investment funds with the bank’s own money. The second type is mudharabah muqayyadah, or restricted investment accounts (and their equivalents). In making use of these funds, the Islamic bank is not allowed to mix them with the bank’s own money without the investors’ express permission. This means the Islamic bank acts only as a manager-cum-agent or a nonparticipating mudharib. An accounting measurement attribute known as the cash-equivalent value allows an Islamic bank to revalue the funds within its management, whether in the capacity of a capital partner (joint investor, sharik) in an unrestricted investment account or a manager (mudharib) in a restricted investment account. One of the core principles of Islamic finance is fair measurement. The application of this principle holds that expectations for the value of the funds in investment accounts would depend on the actual value of the investment if it were to be immediately revalued or sold off to a third party. This attribute means that the expectation value reflects the returns that the investor can expect to receive over the duration of the investment even if the investor would only be able to obtain this actual value when the investment is liquidated. However, if the investment is assessed according to the historic cost concept, it would not be measureable at all before its liquidation. If investment account holders are allowed to add or withdraw invest- ment capital in the middle of the investment’s duration, the Islamic bank

86 RISK MANAGEMENT FRAMEWORK IN ISLAMIC BANKING should take care to maintain the principle of fair measures. The bank should be prepared to recalculate the value of the investment after the new deposit or withdrawal has been made so that there would be a reliable common ref- erence for the gains or losses in the investment. Once the recalculation has been accomplished, the profits or losses from the investment so far would be shared among the existing partners, and then finally the investment would be restarted with the new investors (if any) added to the new syirkah. Therefore, in handling unrestricted investment accounts, the banks should take care to ensure the fair distribution of rights and obligations among both unrestricted investment account holders and the bank’s equity owners. To perform peri- odic assessments on the cash-equivalent value that can be expected to predict the likely amount of returns, the Islamic bank should regularly reevaluate restricted investment and asset reliabilities. At the moment, the AAOIFI accounting standard states that “historical cost shall be the basis used in measuring and recording the assets at the time of acquisition thereof,” but the AAOIFI still allows Islamic banks to perform reassessments/revaluations in order to present additional information that may be useful to investment account holders. Ideal Form of Balance Sheet for Islamic Banks The balance sheet structure, investment patterns, and unique religious features should reflect how much attention the Islamic bank has paid to practical implications in the composition and presentation of its financial reports. Every type of financing contract offered by the Islamic bank requires a unique set of accounting treatments in terms of acknowledgment, measurement, and disclosure. Islamic banks perform anticipative risk mit- igation by synchronizing funding sources with fund utilization. The format of the balance sheet should reflect this by displaying the concept of hedging between assets, liabilities, and equity. Islamic banks must not carelessly use third-party capital or funds in their operational activities. For example, in qardh financing, the bank must not use funds that would be expected to provide positive returns (such as investment accounts), and should instead rely on funding sources with the same zero-return characteristics in the form of third-party funds under qardh (zero-cost of fund) contracts. With regards to capital management, the bank should classify its capi- tal into several categories: capital allocation, capital for infrastructure and marketing, regulatory capital, capital buffer, and capital reserves. An Islamic bank may distribute its capital allocations to various business and banking operations that can be expected to create profits for the bank (Table 5.3). In allocating these funds, the bank should develop strategic and business plans, set reasonable risk and return targets, divide its risk and return tar- gets appropriately throughout its portfolio, and then fit the results with

Financial Reporting and Analysis in Islamic Banking 87 TABLE 5.3 Matching Fund Sources to Fund Usage in Islamic Banks Assets Liabilities Cash Current and demand deposits (cash on hand, cash on branches, placement at (qardh, wadi’ah/safe custody, central bank, etc.) wakalah) Unrestricted investment Inventory (real estate, automobiles, etc.) account Qardhul hasan assets (mudharabah) Financing assets through asset-backed Restricted investment accounts transactions (mudharabah, musyarakah) (murabahah/cost plus margin, ijarah/leasing, Profit equalization reserves istishna’/manufacturing, salam/forward delivery) Shareholders’ equity Investment assets through profit–loss sharing transactions (mudharabah, musyarakah) Fee-based services for trade financing (ijarah, ju’alah, wakalah, etc.) Nonbanking assets (properties, branch offices, etc.) the risk-and-return profiles of the financing proposals being considered for approval. When the bank finances infrastructure and marketing expendi- tures, it may place itself as a mudharib rather than a shahibul maal to guar- antee that it would be able to utilize the funds in an effective and efficient manner; as the funds have been entrusted to the bank’s management, any indiscretions in the usage of these funds would adversely affect not only the fund owner, but also the bank, since neither side would be able to obtain a profit share if there were no profits to begin with. Therefore, the bank should not focus solely upon the productivity and profit when it makes deci- sions about its capital allocations, but also upon the efficiency of financing activities for infrastructure and marketing (nonbanking activities). ANALYSIS OF INCOME STATEMENT Gross gains or losses to the value of assets, liabilities, or both generally reflect the revenues and expenses incurred by an Islamic bank in the course of its business and operational activities, such as justifiable investments (from restricted investment accounts), trade, ijarah (leasing), and various

88 RISK MANAGEMENT FRAMEWORK IN ISLAMIC BANKING other business activities (fee-based financial services). However, these revenues and expenses do not include gross gains or losses in assets and liabilities due to new capital contributions or withdrawals by equity owners or investment account holders, the sale or purchase of assets, or the growth or shrinkage of the amount of deposits in giro and savings accounts. In other words, the calculation of revenues and expenses only involves the Islamic bank’s operational activities and does not include investment and financing activities. Like revenues, expenses should ideally be acknowledged as they are incurred, both when expenses are directly tied to some category of revenue that has already been obtained and when they constitute indirect expenses from a certain financial reporting period covered in the income statement. Before an Islamic bank calculates its net profits or losses, it should allo- cate the proper share of investment profits or losses to restricted investment account holders and their equivalents as the returns from their capital partic- ipation alongside the Islamic bank in the funding of investment transactions within the period covered by the profit-and-loss statement. Net profits or losses reflect the actual results of the Islamic bank’s business-oriented oper- ations as well as all events and conditions that affect the value of the bank’s assets and liabilities during the period covered by the profit-and-loss state- ment. All sorts of justifiable changes to equity are included in this definition except for changes caused by investments by or distributions (of dividends) to equity owners. A proper measurement of the bank’s earnings requires three things. First is an effective management with the capability to fairly allocate revenues and expenses to the bank’s business unit according to the characteristics of every business line, product, market segment, and contract type. Second is an inter- nal price transfer system for the measurement of the individual contributions of each business unit. Third is a reward-and-punishment system that is tied to the financial performance parameters of income productivity, expenditure efficiency, and risk mitigation. The overhead that constitutes a joint cost for several business units should be clearly and fairly allocated to reflect each unit’s actual share in the activity. The proper acknowledgment of assets and liabilities in transfer pricing can motivate business units into a healthy and productive competition in improving the bank’s financial health and pro- mote an honest and responsible attitude both in specific business units and in the bank as a whole. PERSISTENCE ANALYSIS Persistence analysis is an important tool that allows the users of the financial statements to detect whether the presentation of financial statement items

Financial Reporting and Analysis in Islamic Banking 89 truly reflects the bank’s performance or is merely based on opportunistic motivations. In income statements that measure profitability and ability to generate cash flows, the bank’s management has the option to present special items separately or in aggregation with other items. Initially, managers use the income statement as a mechanism to help users of financial statements in identifying and understanding the bank’s financial performance by highlight- ing special items in the income statement. On the other hand, opportunistic behavior could lead to ambiguous presentation in the income statement. This behavior normally manifests upon nonrecurring items with different properties from other income components, increasing frequency and mag- nitude, and a heterogeneous profile across several characteristics. Logically, these special items would have less persistence than other income compo- nents (earnings before special items) and even lower compared to footnote items. Opportunistic managers like to engineer performance targets by sep- arating the presentation of special items to produce ambiguities in earning benchmarks. This opportunistic behavior in the treatment of earning bench- marks can give equity owners a biased picture in the evaluation of present earnings. Similarly, the sums paid in the form of profits (for depositors and investment account holders), dividends (investors), and taxes (for regulators or government agencies) may not reflect actual profits if the manager behaves inconsistently in placing the various items that constitute the income state- ment, including by shifting core expenses (such as cost of gold) into special items so that “core” earnings become overstated. TOOLS OF FINANCIAL STATEMENT ANALYSIS Generally, financial analysis seeks to fulfill five aims. The first is to identify the strengths and weaknesses in the bank’s performance (or that of its opera- tional units) and provide information from multiple perspectives in order to develop a detailed picture on the financial performance of the bank or one of its operational units. The second is to develop indicators that can serve as a management tool suitable for the planning, supervision, and evaluation of the bank’s performance. The third is to measure the liquidity, profitabil- ity, efficiency, and credit risks disclosed in the financial statements in order to check the sufficiency of the bank’s capital and liquid funds, the bank’s financial position (or that of its operational units), and the bank’s ability to sustain its operations. The fourth is to review the bank’s ability to repay its obligations through the correlations between assets and liabilities, and also to measure the ability of the bank’s assets to cover liabilities over a given period. The fifth is to provide the bank’s stakeholders (especially depositors, investors, and creditors) with financial information that will reassure them of the bank’s ability to fulfill its economic obligations to them.

90 RISK MANAGEMENT FRAMEWORK IN ISLAMIC BANKING Common-Size Analysis Common-size analysis (also known as vertical analysis) can be performed upon the statement of financial position or the income statement. The common-size analysis for the statement of financial position can generally be done by comparing a number of specific components with the total value of assets—for example, by finding out the proportion of liabilities relative to assets, particular types of financing relative to assets, current account against assets, and the like. On the other hand, a common-size analysis on the income statement is generally performed by comparing one or more components in the report against the total revenue, such as the proportion of net income relative to total revenue, gross income relative to total revenue, and the like. Cross-Sectional Analysis Risk analysis through financial statements is the scrutiny of asset compo- sition across periods, also known as trend analysis, horizontal analysis, or cross-sectional analysis. For example, if the amount of murabahah financ- ing provided by an Islamic bank displays a drastic rise (whether in absolute terms or relative to the total amount of financing) from year t to year t+1, the change would indicate a potential increase in liquidity risks, financing risks, and market risks all at once. Financial Ratio Analysis Ratio analysis is the method most frequently used in analyzing financial reports. It is not only easy and practical to use, but also easy to modify and adjust with required analysis. Thus, the types of ratio used to value one industry and another could be different. However, in general, many types of ratio could be classified into four categories: short-term liquidity ratio, solvency ratio, profitability ratio, and efficiency ratio. Short-Term Liquidity Ratio Liquidity ratios measure a bank’s ability to quickly convert its assets into cash at face value in order to fulfill liabilities that are due for payment in the short term, including cash demands from debtors and depositors; these liquidity risks normally arise from excessive withdrawals on giro and savings accounts. The cash-to-deposit ratio tends to be higher in an Islamic bank, since the bank has to be more conservative in the utilization of available funds while at the same time dealing with far fewer opportunities to use loan financing. The principle of profit-sharing on the liabilities side (third-party funds) makes it difficult for Islamic banks to finance consumptive personal loan proposals and motivates the bank to

Financial Reporting and Analysis in Islamic Banking 91 increase the proportion of direct financing based on profit-sharing schemes, whether mudharabah or musyarakah. Solvency Ratio The solvency ratio represents the bank’s ability to gener- ate future cash flows and to pay off its financial obligations in the long term. Solvency analysis includes capital adequacy analysis. The capital ade- quacy ratio displays the bank’s financial health with regards to its ability to absorb potential losses. At the same time, this ratio puts the focus upon the identification of issues in Islamic banking, as it shows a reverse correla- tion with the Islamic bank’s risk exposure and capital inadequacy issues. The capital-to-asset ratio reflects an Islamic bank’s ability to discharge its obliga- tions in crisis situations. There are a few reasons why the bank should pay close attention to this ratio. First, regulatory authorities require the bank to retain at least a minimum amount of capital. Second, the bank’s capi- tal size has implications upon the bank’s financial health, especially for the mitigation of risks stemming from the bank’s potential inability to fulfill its obligations to its creditors. Third, capital size would affect the rate of returns provided to the Islamic bank’s equity holders. Profitability Ratio Profitability refers to a bank’s ability to consistently produce earnings. The profitability ratio is a measurement that allows the assessment of the management’s efficiency in running its operations and in utilizing the bank’s assets to produce profits, such as margin and rate-of- return analyses on assets, deposits, investments, and equity. Currently, the profitability of an Islamic bank is generally influenced by the dominance of short-term financing (murabahah, ijarah, and istishna’) and the low instance of equity-based financing (mudharabah and musyarakah). There are two major categories of factors that determine the profitability of an Islamic bank. The first category comprises controllable factors related to the bank’s internal condition, which would be reflected in the management of the balance sheet and the income statement. The other category is controllable factors related to the bank’s external condition, such as competition, own- ership structure, concentration, capital scarcity, market share, economic scale, bank size, regulation, and inflation. Efficiency Ratio Efficiency ratio shows an Islamic bank’s effectiveness in using its assets to produce revenue, obtain quality financing, make timely payments to suppliers, perform effective inventory management, and efficiently control operational expenses. The analysis of an Islamic bank’s efficiency must pay attention to the volume of troublesome assets (such as nonperforming financing), compliance costs, and joint costs (if any). The scope of efficiency ratios includes the operational ratio and the deployment

92 RISK MANAGEMENT FRAMEWORK IN ISLAMIC BANKING ratio. The deployment ratio allows investors to evaluate the bank’s ability to make use of its resources. The bank itself may use the cost-to-revenue ratio to evaluate its own efficiency (Table 5.4). Peer Group Analysis Peer means equal; in other words, a peer is an entity among a group of other entities that are similar to it, according to a certain set of criteria. Peer group analysis is useful for monitoring an Islamic bank’s behavior over time and comparing its financial performance with that of several others in its peer group, which consists of banks that are similar to each other in several characteristics such as geographical spread (market of operation), lines of business, size, age, etc. The improvement (or decline) of a bank’s financial performance can be measured by comparing its performance over the years. However, such an analysis is entirely focused upon the condition of a single bank and does not take account the context of other Islamic banks’ performance within the industry. The improvement (or decline) in a bank’s performance does not necessarily proceed from internal factors and the success of the bank’s management; it is perfectly possible that the change happens since market conditions are experiencing a corresponding improve- ment (or decline) and dragging the bank along with them. To see whether the change in the bank’s performance is due to actual changes in internal performance (as opposed to external and relative factors), it is necessary to compare the performances of several banks within the same peer group. If the improvement in the bank’s performance is slower than the improvement of other Islamic banks’ performance within the same peer group, the man- agement would have to immediately perform an internal evaluation and find out why the bank is not growing as fast as its competitors. CORE BUSINESS ACTIVITY IN ISLAMIC BANKS A strategy focused on the core business is useful not only for extricating the bank from sticky situations, but also as a part of the bank’s competitive strat- egy. During and after a crisis period, regulators tend to require banks to per- form corporate restructurization in order to avoid financial problems and the risk of failure. This corporate restructurization normally covers five aspects: improving the bank’s financial structure (quality), eliminating mutual pay- ment guarantees between affiliated parties, focusing upon the core business, increasing transparency, and improving corporate governance. The bank is asked to identify one core business that it would focus upon going forward

TABLE 5.4 Financial Ratios in Islamic Banking Liquidity Ratio Calculation Meaning and Intent Current ratio Cash and accounts with banks Indicates the bank’s ability to fulfill present obligations. A higher / total deposits current ratio indicates that the bank has more liquid assets to repay Current asset ratio its depositors. This ratio also indicates the bank’s excess liquidity. Current assets / total assets Cash and portfolio Indicates the percentage of liquid assets owned by the bank. The higher investment to [Cash and portfolio the current asset ratio, the more liquid the Islamic bank is. deposit ratio investments] / deposits Measures the bank’s ability to fulfill depositors’ withdrawal requests Financing to deposit and gauges the utilization rate of the bank’s deposits. ratio Total financing/ deposits Shows the percentage of deposit funds that have been used for Financing to assets or financing. This ratio measures the bank’s dependence upon disbursed ratio [total financing + advance] / funds. Higher LDR shows that the bank places more trust in its fund disbursements and hints at higher liquidity. deposits Net financing / total assets Measures the relative proportion of total financing to total assets. or Higher NLR means that more funds have been disbursed, that the [financing + advances] / total bank has been more efficient in performing its intermediation function, and that the bank is more illiquid. assets Solvency Ratio Calculation Meaning and Intent Equity multiplier Assets / shareholders’ equity Measures the proportion of bank assets funded from shareholders’ equity. At the same time, this ratio shows how much loan capital the Debt to equity ratio Total debt / shareholders’ Islamic bank has used to fund assets, which is both good (utilizes equity leverage to increase profitability) and bad (increases risk). 93 Measures the bank’s ability to absorb financial problems and shocks. (continued)

94 TABLE 5.4 Financial Ratios in Islamic Banking Solvency Ratio Calculation Meaning and Intent Debt to total assets Total debt / total asset Indicates the bank’s financial power for repaying its obligations to ratio creditors. This ratio measures the percentage of assets funded by loan capital, the bank’s solvency, and the bank’s financial strength Deposit to assets Total deposit / total assets and its ability to provide additional funds for the financing of ratio potentially profitable investments. Capital Adequacy Calculation Since deposits constitute the main source of funding for the bank, this Ratio Equity / liabilities ratio is an indicator of leverage. This ratio is used to review the influence of the bank’s liabilities upon its profitability and how well Equity to liabilities the bank uses these liabilities. ratio Meaning and Intent Equity to assets ratio Total equity / total assets Measures the Islamic bank’s ability to fulfill all of its liabilities. This Financing loss [General provision + specific ratio measures the bank’s capital adequacy, or, in other words, how coverage ratio provision + income in much of the bank’s liabilities can be covered by its equity. The higher suspense] / gross financing the ratio, the more capable the bank is of handling its liabilities. or Indicates the strength of the bank’s capital and shows the bank’s ability [Collective assessment + to absorb losses and overcome risk exposures alongside its stockholders. individual assessment + general provision] / gross This ratio measures an Islamic bank’s ability to absorb the potential financing losses from nonperforming financing contracts. This way, the bank can define its asset (financing) quality and how well it can protect itself against losses due to financing-related issues. A higher value for this ratio implies that the bank is better at handling issues that arise from existing financing contracts. (continued)

Capital adequacy Total capital / risk weighted Measures an Islamic bank’s compliance with regulatory requirements ratio assets on the minimum capital amounts that must be retained by the bank, calculated as a percentage of the value of risk-weighted assets. This Core capital ratio Core capital / risk-weighted ratio calculates the bank’s capacity for fulfilling liabilities and facing assets various financial risks. The minimum capital reserve is mandated by Leverage ratio regulators to ensure that the Islamic bank would not acquire excess Internal growth rate Tier 1 risk-based capital / leverage that renders it insolvent, to protect depositors, and to average assets promote the stability and efficiency of the Islamic finance system. of capital This ratio also helps to ensure that the bank would not expand its [Previous period net business without adequate capital. income – cash dividend] / previous period total equity Similar to the capital adequacy ratio, but places an emphasis on the adequacy of core capital in bearing all sorts of liabilities and financial risks such as nonperformance risk, market risks, operational risks, and liquidity risks. This ratio represents the bank’s ability to survive losses and tracks the degree of risk incurred by the bank. Measures economic or balance-sheet leverage. Measures the bank’s resilience, capital strength, and ability to escape financial trouble by making use of its operational profits. (continued) 95

96 TABLE 5.4 Financial Ratios in Islamic Banking Profitability Ratios Calculation Meaning and Intent Return on assets Earnings after tax / average Refers to increases or decreases in the quality of an Islamic bank’s assets assets, especially to financing contracts that must bear provisions for nonperformance. This ratio shows the ability of the bank’s Return on deposits Earnings after tax / total management to attract deposits and invest them into profitable Return on equity deposits ventures. The ratio measures the amount of earnings (after tax) the bank can obtain for every unit of capital invested into the bank’s or assets. This ratio can be further divided into two more detailed [net income before tax and ratios: the net profit margin and the risk provision margin. The net profit margin provides a general picture of total profits and zakat] / total assets operational expenses. The risk provision margin measures the Earnings after tax / average Islamic bank’s financing risks and how the bank manages these risks; it is calculated as the percentage of financing loss provisions relative equity to total assets. or [Net income before tax and Measures the rate of returns (through earnings after tax) for every unit of deposited customer funds. This ratio measures the effectiveness of zakat] / total equity the bank’s management in converting deposits into earnings. Measures the percentage of returns obtained by the bank from every unit of equity invested by its investors. This ratio reflects the maximization of shareholder value and the Islamic bank’s risk of bankruptcy. Further elucidation of this ratio would display the bank’s financial performance in a complete and comprehensive manner, covering profitability, investment, equity, and debts as the quantification of risk. ROE before taxes can be used to mitigate the impact of differences in taxation rates between different countries. (continued)

Profit to expense Profit before tax/ operating Measures an Islamic bank’s profits relative to its operational expenses. ratio expense Reflects the bank’s ability to gain profits through its investment Profit to total assets Pretax profit / total assets strategy. Net financing margin Net financing income / average Defined as net financing income (including incomes from trade Gross impaired assets financing, ijarah, istishna’, and investment) divided by the average of financing ratio income-producing assets. An increase in this ratio shows that the Gross impaired assets / gross Islamic bank has been able to optimize its fund disbursements Net special financing through financing and investments to obtain higher margins or commission returns. [Special commission Net impaired income – special Impaired assets are assets whose actual values are lower than their financing ratio commission expense] / total recorded values in the Islamic bank’s balance sheet, especially if these assets assets are not likely to revert to the bank’s possession and thus need to be written down; the value of the impairment would then be Net impaired assets / [gross acknowledged as an expense in the income statement. This ratio also financing – collective reflects the bank’s contribution to financial stability, the assessment – individual sustainability of its intermediary function, and the bank’s own assessment] health. 97 Constitutes the net income obtained by the bank from interest-free activities (such as fees, service charges, and foreign currency transactions) divided by total assets. This ratio reflects the management’s ability at producing revenues out of deposits through interest-free banking activities. Similar to the gross impaired financing ratio but calculated from the value of net impaired financing. (continued)

TABLE 5.4 Financial Ratios in Islamic Banking 98 Efficiency Ratio Calculation Meaning and Intent Income to expense Average income / expense Measures the income produced by the bank from each unit of ratio operational expense. This ratio shows the bank’s productivity in Total operating expense / total generating income. Operating efficiency operating income Measures how efficient the bank is at utilizing its assets, generating Asset utilization ratio Total revenue / total assets income, and minimizing expenses. This ratio display’s the bank’s ability at reducing expenses and increasing productivity. Cost to income ratio Total operating expenses / total operating income Measures the bank’s ability to generate income with the assets in its Other operating possession. A higher value in this ratio indicates a higher income to assets Other operating income / productivity for the bank. ratio average assets Measures how cost-effective and efficient the Islamic bank is. This Operating expense to [markup expense + ratio compares the income obtained with the cost of funds borne by income ratio nonmarkup expense + the bank. noninterest expenses + provision for losses + bad Measures the bank’s ability to generate income outside its core business debts write off] / [markup with the assets in its possession. This ratio shows the bank’s income + nonmarkup innovation, creativity, and flexibility in generating income beyond income + noninterest the original purposes of the bank’s assets. This additional income income] enhances the bank’s profitability and the productivity of its assets and also provides a reserve should the bank’s core business experience a decline in performance. This ratio measures the operational expense needed to generate every unit of income. At the level of individual assets, this ratio compares the asset’s operational costs to the income generated by the asset. This ratio is useful for making comparisons between expenses with similar properties, and also serves as an early warning system. If an asset has a high value for this ratio on any particular operational expense (say, mark-up expenses), there should be some deeper scru- tiny into why this expense is higher than in other similar assets. This ratio generally measures the bank’s operational efficiency; the lower the ratio, the more efficient the bank’s operational activities are. (continued)

Investment to equity Total investment / [total equity Measures how efficient the bank is at utilizing its resources. and deposit ratio + total deposits] Measures the efficiency of the bank’s resource utilization by including a Investment to Total investment / total number of short-term deposits without return expectations. liabilities ratio liabilities Measures the operational expenditure that the Islamic bank has to Operating expenses Total operating expenses / make in order to operate its assets. This ratio is also known as the to total assets ratio total assets management expense ratio. It indicates the bank’s operational efficiency. The bank should focus on minimizing expenses as a way to achieve superior returns in the management of its assets. Asset Management Calculation Meaning and Intent Financing to assets Total financing / total assets Compares the total value of financing with total assets. The higher the ratio NLR, the more funds have been mobilized, the more efficient the bank is at its intermediation function, and the more illiquid the bank Equity to assets ratio Total equity / total assets becomes. Deposit to assets Deposits / total assets Apart from showing the bank’s capital strength, this ratio reflects the ratio use of investors’ capital to fund total assets, the bank’s ability to absorb losses, the bank’s long-term solvency position, and the bank’s Operating income to Total operating income / total capacity to handle its risk exposure. assets ratio assets Since deposits are the principal source of funding for the bank, this ratio is an indicator of leverage. It is used to review the influence of the bank’s liabilities upon its profitability and how well the bank utilizes those liabilities. An efficiency indicator that displays how good the bank is at utilizing its assets to generate earnings. 99

100 RISK MANAGEMENT FRAMEWORK IN ISLAMIC BANKING and close (or divest) the rest of its operations. The application of business strategies in the form of cost leadership or differentiation also calls upon an Islamic bank to focus upon its core business and core competence. A bank that loses focus and offers too much variation in its financial products is essentially putting its own business sustainability in danger. The bank is then automatically pushed aside from the competition within its peer group. In the long term, the bank would have to drastically improve its performance or it would lose and be submerged in the intra-industry competition. This performance improvement generally requires a tighter focus on the bank’s highest priorities (Figure 5.2). The lack of clear priorities for improvement would also render the improvement efforts ineffective. The consistency of core business processes plays an important part in allowing the bank to make quick and appropriate responses to every shift in the market, and Competitive advantage 1. Fitting core competence, key success factors, strengths, weaknesses, and environmental dynamics all together to develop and implement an appropriate strategy 2. Fitting value chains to the activities needed to implement the strategy 3. Achieving a sustainable competitive advantage Cost leadership Differentiation Bank offers the same financial product or Bank offers a unique financial product or service at a lower cost service for a premium price Business strategies Business strategies 1. Efficient production level 1. Superior quality and variety in the financial 2. Economies of scale and scope products and services offered 3. Lower input cost and operating expense 4. Minimize overhead expense 2. Customized, first-rate customer service 5. Minimize research and development (R&D) 3. Strong brand image 4. Massive investment on research and and advertising (marketing) costs 6. Tight cost control system development 5. Focus on creativity and innovation Information prerequisites 1. Understand both the internal and the external business environment (internal and external analysis) 2. Identify banking regulators and supervisors along with their regulatory and supervisory frameworks 3. Recognize all banks and other financial institutions that participate in the financial industry 4. Measure the ease of access to regulatory aid programs, the money market, and other support institutions to the banking industry. FIGURE 5.2 Strategy for the Development of a Competitive Advantage for an Islamic Bank

Financial Reporting and Analysis in Islamic Banking 101 also facilitates the minimization of risks from such processes as employee resistance, operational disturbances, and the like. OFF-BALANCE SHEET ACTIVITY IN ISLAMIC BANKS Prior to the Enron scandal, many enterprises sought to hide the extent of their liabilities (intangible leverage) through off-balance sheet activities. The user should be prepared to check whether liabilities off the balance sheet would have a significant impact upon the evaluation of the bank’s financial performance, the effectiveness of leverage utilization, and the financial risks faced by the bank. The management usually places assets (and liabilities) as on-balance sheet components when the asset is fully owned by the bank (or the bank is at least responsible for it); if the asset (or liability) is uncertain, then it must be predictable, measurable, and material. If these criteria are not met, the bank’s management may treat the asset (or liability) in question as an off-balance sheet item. When the bank offers asset management or brokerage services to a client, the asset (or securities) will refer directly to the client in the trust fund where the bank provides investment management services, depositories, or other financial services. The bank is responsible for carrying out its fiduciary duties and has no claim upon the asset in question. The bank would report this fund management activity as an off-balance sheet item, specifically in the “assets under management” category. For example, financing contracts made by the bank are recorded on the balance sheet. If the financing is securitized and sold as an investment, the securitized financing does not appear on the balance sheet and becomes an off-balance sheet component. A growing issue in Islamic banking is whether accounts under wakalah or restricted mudharabah contracts should be treated as on-balance sheet components (like unrestricted mudharabah) or as off-balance sheet components. On both the domestic and the global stage, today’s banks face leverage limits that can help capture the risks from off-balance sheet items and pre- vent the bank from hiding various obligations and transactions that may put stakeholders at risk. In current banking practice, bank managers often pre- fer off-balance sheet financing to on-balance sheet financing. Most financial statement users are relatively naïve; they like the look of a sophisticated bal- ance sheet even though it may cause them to underestimate the bank’s actual leverage. Off-balance sheet financing allows liabilities to go unreported since no debts or equities have been generated. For example, in an operating lease (ijarah) contract, the lessee may choose to make a down payment up front and then pay periodic rents. The asset remains on the lessor’s balance sheet,

102 RISK MANAGEMENT FRAMEWORK IN ISLAMIC BANKING so all responsibilities related to the assets and liabilities involved in the ijarah contract are not recorded in the lessee’s balance sheet. Lessor and lessee alike only have to note down the periodic rent payments as revenues or operational costs on the income statement. Additionally, banks like to use off-balance sheet financing since it has a positive effect on the leverage ratio, earnings manipulation, profitability ratios, and tax effects. Off-balance sheet activities can be used to smooth out financial performance from one account- ing period to the next, “pretty up” risk curves, and present an image of good capital formation structure. Inherent Risks in Off-Balance Sheet Financing The main benefit of off-balance sheet financing is the creation of liquidity without affecting leverage, so the bank’s financial performance on the bal- ance sheet appears to be better. The bank can manipulate the debt-to-equity ratio to appear low. The downside is that the bank usually has to pay more in order to derive these benefits from off-balance sheet financing. Various off-balance sheet activities can increase the earning ratio much more quickly than on-balance sheet activities. Earning ratios generally use asset compo- nents as their denominators. When the earnings from off-balance sheet activ- ities are recorded as income while the assets balance remains unchanged, the earning ratios would be dramatically higher than if the income had been derived from on-balance sheet activities. Similarly, since these activities do not appear on the balance sheet, they would not affect capital-to-asset ratios (except for the risk-based capital ratio) without regard to the vol- ume of the business undertaken by the bank. However, the top management and external regulators should keep a close eye upon the volume and risks of off-balance sheet activities in capital adequacy evaluations. Regulators particularly have to monitor off-balance sheet activities since such activi- ties are important sources of credit risks and market risks with systemic consequences. Transparency and Risk Mitigation As interbank competition continues to intensify, various technological devel- opments, product/marketing innovations, and domestic deregulation mea- sures would cause a change of focus with regards to contingent liabilities. Intense competition tends to diminish the income spread from on-balance sheet activities, which in turns motivates banks to exploit various off-balance sheet activities in the search for more fee-based income. The risk on–risk off characteristics of off-balance sheet activities mean that regulators tend to give close scrutiny to off-balance sheet activities, especially in times of

Financial Reporting and Analysis in Islamic Banking 103 economic uncertainty. With respect to contingent liabilities (off the balance sheet), the bank should perform thorough risk measurement that covers potential exposures, sources of funding, internal control systems (limit poli- cies, approvals, and documentation discipline), and the adequacy of risk management. In measuring the sufficiency of asset–liability management, the Islamic bank must evaluate anticipated outlays from financing commit- ments and lines of financing relative to anticipated sources of funding. The amount of anticipated funds that are not used up by commitments and lines of financing would show the bank’s liquidity position. Cash flow projections can also be useful in obtaining a picture of cash availability and whether financing would be required to fulfill anticipated withdrawals. Controlling Off-Balance Sheet Activities The bank should apply the same evaluation techniques upon off-balance sheet financing items as upon the direct financing portfolio. Any policies on contingent liabilities should be made and approved by the board of directors; these policies include underwriting standards, documentation, file maintenance, collection procedures, review procedures, financing limits, committee/directors’ approval, and periodic reporting to the board of directors. In the specific interest of preventing serious concentration risks, the bank should emphasize overall limitation policies upon contingent liabilities and sublimits upon various off-balance sheet activities; indeed, if possible, the bank should also apply sublimits for every client group, con- tract form, economic sector, or geographic area. The bank should also place off-balance sheet activities as an integrated and inseparable companion to on-balance sheet business endeavors; the risk analysis for off-balance sheet activities should be seen as an integral component of the Islamic bank’s overall risk profile. The bank should pay attention to every single financing agreement between the debtor and the bank (such as direct financing, letter of credit, and financing commitment). The bank should also consider the range of parameters normally used to review direct financing as a good framework for reviewing contingent liabilities (letter of credit and financing commitment); these parameters include financial performance, repayment capability, will to repay, collaterals (rahn), third-party guarantees (kafalah), and future business prospects. The bank must analyze the probability of withdrawal under the terms of the agreement and whether the provisions adequately reflect the risks inherent to off-balance sheet financing activities. The bank should categorize off-balance sheet provisions as “other liabili- ties” since these provisions are not included in the calculation of normal provisions on the balance sheet.

PART Three Risk Management in Islamic Banking Risk Management for Islamic Banks: Recent Developments from Asia and the Middle East. Imam Wahyudi, Fenny Rosmanita, Muhammad Budi Prasetyo, Niken Iwani Surya Putri. © 2015 by John Wiley & Sons Singapore Pte. Ltd. Published 2015 by John Wiley & Sons Singapore Pte. Ltd.

6CHAPTER Financing Risk in Islamic Banking The basic role of Islamic banks is to channel funds from parties with excess funds to those who need them. The Islamic bank collects excess funds from depositors (also called third-party funds) in the form of time deposits and savings with a contract for safekeeping purposes (wadiah yad amanah), agency (wakalah) and debt (wadiah yad dhamanah, qardh) or in the form of time deposits with a syirkah contract (mudharabah mutlaqah) and wakalah. The third-party funds that are collected will be channeled further by the Islamic bank to greater society, in the form of various financing contract. The financing contracts that are commonly used in recent times can be grouped into two types: debt-based contracts and partnership (syirkah)–based con- tracts. There are two types of debt contracts: pure debt (qardhul hasan) and debt that emerges from exchange activities like salam, muajjal (musawamah or murabahah), istishna’, and leasing (ijarah). The syirkah contracts that are generally used are mudharabah, musyarakah, musaqat, mugharasah, and muzara’ah. The final-three syirkah contracts are only used for the agricul- tural and horticultural sector. URGENCY OF FINANCING RISK MANAGEMENT IN ISLAMIC BANKING In the ages past, centuries before that particular conclusion had been reached in banking literature, Islam has defined a very good concept of risk and return. In a hadith, it was mentioned, “al ghunmu bil ghurmi,” which meant that inherent in profit is risk. In the context of finance theory, the fiqih princi- ple of “al ghunmu bil ghurmi” is what is known as risk-return trade-off. This means that the larger the return expected, the larger the risk that must be borne. The other side is also true; the larger the risk borne, then the larger the potential return that should by right be received as compensation for taking that risk. Mispricing can occur when the bank does not use an appropri- ate price differentiation strategy. Good debtors feel that they are charged a “price” that is too high for them, leading them to end their partnership Risk Management for Islamic Banks: Recent Developments from Asia and the Middle East. Imam Wahyudi, Fenny Rosmanita, Muhammad Budi Prasetyo, Niken Iwani Surya Putri. © 2015 by John Wiley & Sons Singapore Pte. Ltd. Published 2015 by John Wiley & Sons Singapore Pte. Ltd. 107

108 RISK MANAGEMENT IN ISLAMIC BANKING with the bank. On the other hand, bad debtors feel that they are given a cheap enough “price,” encouraging them to enter and submit their propos- als. In the long run, bad debtors with high default risk will mostly fill the bank’s portfolio. When the bank applies the appropriate risk-management techniques during the debtor selection and price-setting process, the outcome will be different. With the application of risk management, the Islamic bank will find it easier to recognize risks, taking those risks and transforming them into business opportunities, turning it into the bank’s competitive advantage in competing in the market. CHARACTERISTICS OF ISLAMIC FINANCING CONTRACTS A financing contract must be free from usury, gharar (vagueness, uncertainty, or lack of clarity), maysir (gambling), and tadlis (fraud); these various restric- tions do not suddenly make the Islamic bank incapable of functioning as a financial intermediary. Islam has provided various financial contract options that can be adopted by Islamic banks, such as contracts of exchange (salam, mu’ajjal, musawamah, murabahah), ijarah (including but not restricted to leasing and rent), partially prepaid production contracts (istishna’), equity placement or investment contracts (mudharabah, musyarakah), agency con- tracts (wakalah), or guarantees (kafalah and rahn). Like other financial insti- tutions, the Islamic bank should continuously develop, innovate, and create financial products and services, as well as improve the efficiency of the inter- mediation process. Ideally, the financing portfolio of the Islamic bank is dominated by the syirkah contract according to the profit–loss sharing prin- ciple. With this contract, the bank is able to realize the principles of justice and fairness in the intermediation process, as reflected in the distribution of income and wealth that is fair in scale. The justice principle is reflected when the debtor (entrepreneur) is not punished with the responsibility of paying for the capital with a predetermined rate of return, without consid- ering whether the business run by the debtor has succeeded or failed. This practice is the opposite of the conventional banks. As a result, when the project and business run by the creditor defaulted, the bank, as the inter- mediation institution, would also default. The cascading effects from then on could disturb the entire financial system as a whole. With the profit–loss sharing principle offered by Islam, the bank is more efficient in allocating funds based on the productivity, profitability, and risk of a business, com- pared to just the creditworthiness rating of the business or project owner. Because of that, the Islamic bank not only fulfills the role of intermediary, but also is an active socioeconomic agent for continuous growth. At a practical level, a bank as a business and social entity is inseparable from speculative activity, such as market risk, default risk, operational

Financing Risk in Islamic Banking 109 risk, and liquidity risk; but any contract made by the bank should be free from gross speculation (maysir). Other than gross speculation, the financial contract should also avoid gross uncertainty of contract terms (the subject matter, price and time of delivery) as well as unjust enrichment where the bank profits unjustly over the efforts (suffering) of another party (debtor), like the use of interest on a loan contract (qardh). Among debt-based instruments, the murabahah contract is a usury-free (interest-free) mode of financing popular in Islamic banking. Banks apply profit (mark-up, profit margin) over the acquisition cost of asset to the debtor. The Islamic bank buys and owns the asset needed by the debtor and then resells it to the debtor with a predetermined margin added to the acquisition cost on spot or deferred payment. The bank claims the margin as its profit because the bank bears several asset-ownership risks, like market risk, asset damage or loss risk, and holding cost. Murabahah financing with price margin with the deferred payment method provides an interest-free financing. Once the contract is set, even if the debtor fails on fulfilling one of the installment payments at the agreed upon time, the mark-up cannot be increased due to this delay. The previous mode of financing, that is murabahah, is usually in the form of mu’ajjal with the bank acting as the seller of the asset. The reverse of the mu’ajjal form is salam. In a salam contract, the bank acts as the buyer of the asset sold by the debtor, buying in cash at a discounted price and receiving the asset with agreed-upon specifications at a certain date in the future. The bank can use salam to finance imports, infrastructure projects (istishna’), and commodities (produce as well as nonproduce). Regarding istishna’, the bank can use the mu’ajjal method with the bank in the posi- tion of the seller. With this contract, the bank agrees to construct and sell the fixed asset, property, or infrastructure at current price for the delivery of the asset according to agreed-upon specifications and at a particular date; where the payment terms are flexible according to agreement. Another debt-based financing contract used by the Islamic bank is qardhul hasan. In this con- tract, the bank has no room to gain profit. Thus the qardh contract is usually the one used by the bank to assist others for social reasons, like the poor, or for microfinance. The Islamic bank can also use a leasing (ijarah) con- tract in fulfilling its intermediary function. This contract is a quasi-debt and quasi-fixed-income instrument. The Islamic bank buys or rents a fixed asset from a third party, and then rents it to the debtor; the rent fee charged already covers the rate of return that the bank requires. In Islamic finance, the type of leasing allowed is operating lease. The ownership of the asset is firmly on the bank’s balance sheet, along with all the profit and risk attached to it. The ijarah contract has developed extensively in Islamic banking, including the ijarah mumtahia bi tamlik (IMBT), ijarah wal musyarakah mutanaqishah,

110 RISK MANAGEMENT IN ISLAMIC BANKING ijarah wal iqtina’, and the like. In these various derivatives of the ijarah contract, it is stated that at the end of the lease period, the ownership of the asset is transferred to the debtor. FINANCING RISK: DEFINITIONS AND ITS SCOPE Financing risk is often tied to default risk. Debtors experience this condition when they are unable to fulfill the responsibility of returning the capital the bank has channeled to it. Other than returning capital, this risk also covers the inability of debtors to present the portion of profit that has been agreed upon at the beginning of the contract. In an Islamic bank, the definition over this sort of financing risk (default risk) only covers contracts that are based on debt: qardhul hasan, trade financing (mu’ajjal and salam), istishna’ and ijarah. Debtors choosing these forms of financing for their affairs are required to pay the amount of money that has been promised to the bank according to the time period of the payment. The debtors’ failure to fulfil their responsibilities is considered a condition of default, both in the form of failing to pay the principal repayments of the financing or the proportion of the profit that is the right of the bank (e.g., profit margin, price discount, rent, etc.). Financing risk emerges from a debtor’s failure in fulfilling his or her responsibilities. Because it emerges from the side of the debtors, this risk is also called the counter-party risk. Whatever the term used, in understanding the concept of financing risk in Islamic banks, what is important is to under- stand the business process of every financing contract used by the Islamic bank. By understanding business processes, one is able to define financing risks comprehensively, identify the crucial points where risk occurs in various stages of the business process, and analyze various factors contributing to the manifestation of that risk. With that, the construction of a risk-mitigation system will be better focused, systematic, and holistic. Generally, the busi- ness process involved in the financing channeled by the Islamic bank can be shown by Figure 6.1. Based on Figure 6.1, at least five problems that will be faced by the bank in channeling its funds can be identified in the business. The first is the issue of uncertainty of market conditions that will affect the debtor’s ability to return the capital (risk of ability to pay). The second is the probability of the difference in the selling price of a guarantee or collateral (rahn) at the time the contract is made and at the end of the contract. This leads to the risk of not being able to recover capital in the event of debtor default. The third is the issue of the credibility of the information provided by the debtor (information opacity) at the time of the financing’s proposal. This issue trig- gers the existence of information asymmetry between the bank and debtors.

Financing Risk in Islamic Banking 111 Contract Contract termination signing date (ending) date Contract (settlement) period Problems that faced by bank: Problems that faced by bank: Problems that faced by bank: 1. Uncertainty of market 1. Uncertainty of market 1. Information opacity conditions conditions 2. Asymmetric information 2. Information opacity 2. Information opacity 3. Asymmetric information 3. Asymmetric information could cause 4. Granularity 5. Ability to pay vs willingness could cause Bank makes mistakes in: to pay from MSME 1. Select the MSME to be client 1. Significant changes in market (adverse selection) currently, controlled price of collateralized asset 2. Determine credit’s limit through: 3. Choose the form of credit’s 2. Uncertainty of MSME’s ability to contract appropriately Manual monitoring system perform and accomplish the credit 4. Determine price/return properly by bank contract 5. Determine the credit’s tenor 6. Determine the adequate of Operational and managerial 3. Uncertainty of guarantor’s ability collateral (assets collateral and implication for bank: to backup the MSME to accomplish guaranty form third party) the debt based contract 7. Assess the market price of assets 1. Monitoring cost is too collateral expensive 4. Bank might obtain profit (return 2. Need adequate human below expectation) finally, could resources in quality and cause quantity 5. Market value of collateral is 3. Time to monitor is too smaller than MSME’s residual Bank faces some risks: long obligations 1. Capital recovery risk occurred 4. Bank’s focus in running when bank miscalculated in business is distracted So, it could be determining the collateral related cause policies and credit’s limit to capacity Finally, could decrease the Bank faces some risks: of MSMEs efficiency of bank’s 1. Capital recovery risk operation 2. Profitability risk 2. Profitability risk occurred when 3. Default risk from MSME bank miscalculated in determining 4. Cut-loss from haircut policy to the price/return minimize loss caused by MSME that experience default 3. Default risk from MSME 5. Risk that bank might be not able to channel fund to MSME in the 4. Uncertainty risk of environment future (reinvestment risk) because dynamics occurred when bank of many MSME defaulted miscalculated in determining the tenor of credit finally, could cause Business sustainability risk of bank FIGURE 6.1 The Business Process of an Islamic Bank’s Financing Source: Wahyudi (2014a, pp. 97) This condition can cause the bank to choose debtors inappropriately (adverse selection) and/or made mistakes in specifying the financing con- tract. These mistakes can take the form of choosing the wrong form of financing, the wrong financing limit, the wrong time limit, wrong profit margin, wrong cost of rent/lease, or wrong discount price, as well as the wrong guarantee or collateral required and wrong value assessment of it. The fourth is the problem of granularity caused by the myriad of debtors financed who yet have small transaction amounts.

112 RISK MANAGEMENT IN ISLAMIC BANKING The fifth is the problem of the bank’s inability to differentiate the causes of different debtors’ default. Default can be caused by problems with the debtor’s ability to pay and/or the lack of goodwill from the debtor to pay (lack of willingness to pay). The second issue occurs from the presence of moral hazard from the debtor, and is usually caused by the problem of infor- mation asymmetry between banks and debtors. Intensive supervision can actually counteract the existence of asymmetric information, but this alter- native is constrained by the lack of competent human resources to do so, and the high cost of doing so prevents the bank from monitoring well. The source of moral hazard could be the basic character of the debtor himself or herself, or it could be caused by external factors, like the bank’s treatment towards other debtors. The bank’s failure in detecting the cause of default from debtors will cause the bank to make mistakes in setting policies of how to finish problematic financing. The moral hazard risk emerging from this collective character is known as systematic risk, or the risk of portfolio concentration. In risk management literature, this is also known as too-many-to-fail or too-big-to-fail. When the financing portfolio owned by the bank consists of many debtors with more or less the same amount of financing, where it is possible for each debtor to communicate with each other and they have a higher degree of cohesivity as a group, then the default of one debtor can trigger the default of other debtors. The consequence is that the bank is forced to restructure debts for many debtors, even if it is costly. If the bank does not restructure its debts, the bank may face an even larger risk of loss—that is, the risk of losing all of the capital invested in the portfolio. This is what is referred to by the term too-many-to-fail. In other hand, the term too-big-to-fail refers to the condi- tion in which the bank concentrates a large proportion of its financing on only several key debtors. If several debtors with the very large proportion of financing default, then the bank is forced to restructure the debt. If not, the bank’s financial stability will be affected. But if the bank restructures the debt of these key debtors, then this will compel all the other debtors with smaller financing value to claim default or payment problems using the bank’s treat- ments of its key debtors as an excuse. The details on the consequences of the concentration of financing portfolio will be discussed later. ROLE OF RAHN AND KAFALAH A group of debt-based contracts has the same characteristic that the nominal set in the contract is the price the binds both parties (banks and debtors) and the remaining amount that has yet to be paid (compared to the listed price) is a debt that will have to be paid by the debtor. After the bank and debtor

Financing Risk in Islamic Banking 113 agree on the price, there are no more additional price increases or changes, even in the event of the debtor being late in payment from the promised period. Any addition of price in any form after the contract is agreed upon (such as an increase in price, late-payment penalty, early-payment penalty, promised gift, etc.) is an unlawful and prohibited form of usury. Various reasons to legalize the addition of the amount of debt owed (like the concepts of discount, indexing, and time value of money) are vehicles for acts of khilah (circumventing the letter of the law) and must be avoided. To avert the creditor from injustice (by not receiving his or her capi- tal back), Islam allows the bank to request collateral (rahn) and third-party guarantee (kafalah) to the debtor (QS Al Baqarah: 282). Collateral (rahn) refers to a real asset pledged as a guarantee of payment by the debtor to the bank, while kafalah refers to the guarantee given by a third party to present the debtor when the promised time of repayment arrives, or the guarantee that the third party will bear the settlement of the debtor’s debt if the debtor defaults, either from the loss of ability to pay or from avoidance or unwilling- ness to pay, both on the total debt or only partially. In this kafalah contract, the guarantor (kaafil) is in the same position as the debtor at the time of settlement; that is, if the debtor defaults, the bank has the right to demand the settlement of the debt to the guarantor. When the debtor defaults and the bank intend to recover its capital as soon as possible, the liquidation of assets pledged as collateral or the execution of kafalah becomes the win-win solution. Even when in Islam it is very much recommended for the bank to provide a grace period and additional time, debt restructuring and partially (if not completely) writing off the debt as charity (shadaqah), the liquidation of pledged collateral is needed so that the bank as the lending party does experience injustice, considering that the capital that is lent to the debtor is actually third-party funds that the bank must take responsibility of and that must be returned to its depositors. Any delay in the repayment of debt by debtors will increase liquidity risk, reduce the bank’s opportunity to create profit, and increase solvability risk, as well as the amount of capital that the bank must reserve against its various risks. Regarding the liquidation of collateral, it is necessary to remember that the ownership right of the collateral asset still belongs to the debtor. This means that ideally, the debtor should be the one to liquidate the asset pledged, the proceeds of which would then be used to fulfil the debtor’s obligations to the bank. In practice, with the permission of the debtor, the bank can assist in selling the pledged asset. When the debtor is unwilling or reluctant to sell the asset pledged as the collateral, then the best party to sell it would be a judge (qadhi), to avoid any conflict of interest. The debtor, of course, prefers to sell the asset at the highest price possible, but that position makes it harder to find buyers at that price. The bank, on

114 RISK MANAGEMENT IN ISLAMIC BANKING the other hand, prefers the asset to be sold as quickly as possible, even if it would mean selling it at a discount, just to recoup some of its capital as soon as possible. The judge in the middle of this issue of a collateral asset is expected to be able to find a middle ground for these two competing interests. After the price of the collateral asset has been agreed upon, the bank only has rights over as much as the value of the remaining debt or obligation of the debtor that has yet to be paid, without any form of additional fine or penalty charged on top of that. The excess value over that amount still belongs to the debtor, and the bank or judge is obligated to turn that over to the debtor. The opposite is also true; if the proceeds from the asset’s sale are not enough to cover the debtor’s remaining debt to the bank, then the difference between them is still considered as the debtor’s debt. Considering the importance of the collateral asset’s function as well as third-party guarantee, the bank needs to design and implement a series of adequate mitigation policies, like determining the types of asset that can be pledged as a collateral, a valuation method for the asset’s expected value, the expected changes over the asset’s price in future periods, an analysis of the availability of a market if the object pledged as a collateral is to be liquidated, and the limit of possible financing given according to the expected value of the asset used as a collateral. Even so, collateral and third-party guarantee should not be used as an excuse to abandon monitoring mechanisms and other financing risk mitiga- tion methods. If the bank adopts the collateral approach as a basis for the acceptance or rejection of financing proposals offered by (potential) debtors and in setting various contract terms (like price or margin or rent/lease or price discount, period/tenor, type of contract, and the financing limit or ceil- ing), then this will translate into making the behavior of the Islamic bank not so different after all from conventional banks. This is then certainly against the principles of Islamic finance, which are the operational foundation of Islamic banks: the principle of universal complementarity, the principle of elimination of usury, and the principle of justice in measurement. DEFINING DETERMINANT FACTORS OF FINANCING RISK In a conventional bank, financing products can only be in form of loans. Thus, factors effecting credit risk are easier to identify. However, in Islamic banks, financing contracts could be in a variety of forms, from social-based contracts (li tabarru’) to commercial-based contracts (li tijari). The variety of contracts could result in different determining factors of financing risk for each contract.

Financing Risk in Islamic Banking 115 Islamic bank (1a) Debtor 24/06/2012 (3b) and (3c) 24/06/2012 (1b) (2a) 24/08/2012: debtor repays the debt (2b) Bank liquidates land (3a) with permission from 24/08/2012: debtor defaults debtor, sold at price (3d) Rp125 million FIGURE 6.2 Qardhul Hasan Scheme Illustration Qardhul Hasan There is a difference in meaning between qardh (loan) and dayn (debt). Dayn is more inclusive in meaning than qardh. In a qardh contract, the bor- rower formally binds the contract of the borrowing of an asset (or money) to another party and promises to return the asset at an agreed-upon time. On the other hand, dayn covers all sorts of financial contract and economic events that leave the presence of debt as an obligation to be fulfilled by one party to another without profit on the principal. Included in the category of dayn are qardhul hasan, salam, and mu’ajjal. Qardhul hasan, as seen in Figure 6.2, falls under the category of pure assistance (li-tabarru’) contract. The Islamic bank is not allowed to take any sort of profit in any form and for any reason. In the context of risk management, the best step that can be done by the bank is only to prevent the risk of losing the capital lent. To guarantee the return of capital invested, the Islamic bank can use the facility of using asset collateral or guarantee (rahn), and third-party guarantee (kafalah). To avoid the possibility of moral hazard, the bank should utilize qard- hul hasan as a short-term contract, for example, for one or three months. This period allows the bank to analyze the debtor’s actual capability to pay, whether the payment comes from the debtor’s actual financial capability or is only an attempt to cover old debt with new debt. The bank’s liquidity level is also more secured this way. The bank can receive its capital as soon as possible and will be able to channel it again into a different qardhul hasan contract, or to divert it toward other forms of financing that can provide the bank with a return. The risk of losing contact with the debtor is also minimized during a short period. Table 6.1 identifies various risk factors for

116 RISK MANAGEMENT IN ISLAMIC BANKING TABLE 6.1 Default Risk Factors in Qardhul Hasan and Their Mitigation Methods Risk that emerges Possible risk mitigation tactics that can be done The bank misjudges the ■ Build a special division for information and data debtor’s ability to pay validation The book value of the ■ Standardize the required data/information form that asset collateral is will need to be filled by the debtor different from the actual market price ■ Confirm and validate the data/information given by the debtor The guarantor is unable to pay the debtor’s ■ Request a collateral/guarantee debt ■ Construct and use an rating system integrated with Debtor defaults the selection system and credit terms setting, like the size of credit, time period, settlement scheme, etc. ■ Contract an independent rating agency to periodically rate debtors ■ Periodically check the market price of the collateral assets ■ Periodically assess and revalue collateral assets ■ Construct simulations of average market price changes of collateral assets compared to the debtor’s loan exposure, relating it to haircut policies at the time of maturity ■ The need for synergy between banks and fiduciary services in managing collateral assets ■ Ascertain the guarantor’s credibility at the time of the contract ■ Maintain a good relationship with the guarantor ■ Periodically evaluate the guarantor’s capability to pay ■ The banking industry needs to help found an association of guarantors to improve the ease of supervision/evaluation, maintain good relationships, and improve the collective credibility of guarantors ■ Run simulations of debt restructuring or choose haircut policies ■ Assess the expected value of a collateral asset as well as the return from the guarantor ■ Build a list of failed debtors and their causes for future consideration and policy input

Financing Risk in Islamic Banking 117 TABLE 6.1 (Continued) Risk that emerges Possible risk mitigation tactics that can be done Debtors indulges in ■ This usually happens when the assessed expected moral hazard value of a collateral asset is far smaller than the value reported at the time of contract, and bank fails to validate it; it can also happen if the guarantor of the debtor is nonexistent or of negligible reputation in society. Because of this, collateral asset value and guarantor assessment are needed to ensure discipline ■ The collateral asset policy will need to be adjusted with the debtor’s credibility level ■ The bank needs to know its debtors, as debtors are often missing because the bank does not know or does not maintain good relationships through monitoring mechanisms default in a qardhul hasan contract, and the various risk mitigation alterna- tives that the Islamic can use. Deferred Sale (Bay’ul Mu’ajjal) In a deferred sale (mu’ajjal), the bank as the seller is required to have owned the goods that are the object of the contract at the time of the contract. The debtors as buyers will delay some payments (in installments) or all payments (lump sum) at the agreed-upon price. Once the price is settled in the contract, then the difference between the total price and the amount that is already paid will become the debt that the buyer will have to pay. No addition to the price is allowed after the contract is done and agreed upon. The mu’ajjal contract used by Islamic banks is still dominated by murabahah. When the bank does not have the goods yet, the request of purchase from the debtor to the Islamic bank should be considered as a form of promise (wa’ad) to buy, not as a sale contract itself, which is not allowed for defining price or mar- gin, and there is a khiyar (right to execute or cancel the promise) for both parties. This contract is known as a murabahah purchase order (MPO), as seen in Figure 6.3. In forming an MPO, the independence of the sale con- tracts between the supplier and the bank, and between the bank and the debtor, must be ascertained and enforced. Other than buying directly from a supplier, the banks can also request assistance from a third party to buy goods from it through an agency (wakalah) contract. It is even allowed for the bank to entrust the debtor candidate as the bank’s agent to buy the asset

118 RISK MANAGEMENT IN ISLAMIC BANKING Supplier (2) 24/06/2012 25/12/2014 (1) (3) 26/06/2012 (4) Islamic bank Debtor (8) (5) 24/12/2014 Settlement period: 26/06/2012 to 24/06/2015 (9) (6) Guarantor (kaafil) (7) and/or collateral 24/12/2014: debtor defaults (rahn) (10) FIGURE 6.3 Illustration of the MPO Contract that will be bought by the debtor, with the requirement that the wakalah contract is completed (finished) before the bank and the debtor enter into a sale contract. In a deferred sale contract, the risk faced by the bank is not only the risk of default from the debtor, but also market risk and other risks related to object ownership. The bank should first realize the sale contract with the supplier without any guarantee that the debtor will certainly buy. When the bank experiences adverse selection or buys at the wrong price—that is, the bank buys at a higher price or at the same price as the going market rate—the bank will suffer from a risk of loss if the (potential) debtor fails to buy; at the very least, the bank should bear all the acquisition costs other than the acquisition price. Other than Table 6.1, various unique risks inherent to MPO and how to mitigate them are shown in Table 6.2. Advanced Sale (Bay’as Salam) In salam financing, as seen in Figure 6.4, the bank acts as the buyer, and the debtor as the seller, where the debtor is not required to actually own the farming land before. At the end of the salam contract, the bank will receive the goods from the debtor in the settlement of the contract’s terms. Because the bank is not focused on commodity trading and instead on finan- cial intermediation, the bank will soon need to find a solution in order to convert the goods that it will receive at the end of the salam contract into

TABLE 6.2 Default Risk Factors in MPO and Their Mitigation Methods Emerging risk Risk Mitigation The risk of loss or damage to goods after the bank ■ Check the condition of the goods at the time of the handover purchases them and before they are handed over to the from the supplier and at the time of handover to the debtor debtor, of the goods being not according to the debtor’s specification, or of the supplier breaching its contract ■ Retain procurement agents, who guarantee performance from the suppliers in their personal capacity The risk of price reduction of goods in the market after the bank buys the goods and yet the (potential) debtor ■ Ensure that the debtor will fulfil their promise (wa’ad) by chooses not to buy the goods after all profiling them before hand and gauging their intent from it The risk of experiencing additional costs due to delays of ■ Some experts allow the bank to request some form of security object delivery to the debtor, like inventory costs, deposit at the beginning (hamish jiddiyah), wherein the bank is security costs, etc. allowed to ask to cover the losses incurred by the price difference between the object’s acquisition price and its liquidation value The procurement agent, as the representative of the bank, will buy goods that are not fresh; debtor has ■ Match the delivery dates from supplier to bank with the one actually bought the goods beforehand and merely from the bank to debtor requires funds to pay for them, thus the ‘inah sale prohibited in Islam occurred ■ Impart to the debtor that any costs occurring due to delays in execution time and object delivery will be charged to the debtor ■ Pay directly to the supplier or seller ■ Ask the debtor for purchase invoice or billing receipt. The date should not be earlier than the date of the agency contract (wakalah) and not earlier than the debtor’s promise to buy ■ Ask for all the supporting purchase and delivery documents from the supplier, like barang dari pemasok, seperti = goods from supplier, such as travel receipts, goods register, entry cards, etc. ■ Physically inspect the goods 119 (continued)

120 TABLE 6.2 (Continued) Emerging risk Risk Mitigation The goods have been used by the debtor or the debtor’s ■ Reduce the time interval when the MPO is done periodically, and affiliate before the proposition or acceptance of MPO, perform random physical inspections or the goods are not available when the murabahah is executed, and all this certainly transgresses the ■ Collect information on related parties, possibly from the debtor’s principles of syari’ah financial report or other sources The debtor purchases from or sells to related parties or a ■ Improve the bank’s relationship and communication process subsidiary company with the debtor to detect any issues beforehand and find out the cause of a delay The debtor is late in paying ■ The use of sanctions (as financial penalty), even if used for social activities, must be done by the relevant authorities (judge). As an alternative, the regulator should make rules regarding the size of the penalties and the parties that are entrusted with the responsibility of enforcing them. Even if the bank were given the position, it would only be as a representative of the regulator.

Financing Risk in Islamic Banking 121 Market Market (5c) (5a) – alternative A (3) 24/10/2012 24/10/2012 24/10/2012 (5b) (5d) 24/10/2012 (4) Debtor 26/06/2012 Islamic bank (1) 25/06/2012 (2), (5e), (6b) 24/12/2014 24/10/2012 (6c) (6a) – alternative B Buyer FIGURE 6.4 Illustration of the Salam Contract liquid funds. The first solution is for the bank to ask the debtor to become the agent of the bank in selling the goods; this is of course only done after the debtor has handed over the goods to the bank, even if only for inspection to ensure that the goods met the specifications of the contract. This handover is necessary in order to transfer the responsibility (dhaman) of the goods from the debtor to the bank. Second is for the bank to sell the goods by itself to the market or some other third party. The third is for the bank to tie the potential buyer of the goods that will be delivered to the bank at a certain period with a second salam contract (parallel salam). With a second salam contract, the bank acts as a seller and a third party that is independent from the first debtor acts as the buyer. These two salam contracts must be independent from each other. Third solutions give different risk consequences. In general, the capital received by the debtor from the bank is used to till and cultivate the land, plant the seeds, irrigate, fertilize, care, and harvest. When a failed harvest occurs, the debtor will certainly find a solution to fulfill the salam contract by buying the required commodity on the market; and that is only with the assumption that the debtor still has adequate funds to buy the replacement commodity. If the debtor is unable due to having run out of capital already, then the debtor will certainly default on the contract, unable to deliver any amount of the requested commodity to the bank. To reduce this possibility of default, the bank can request an asset to use as the collateral (rahn) and/or

122 RISK MANAGEMENT IN ISLAMIC BANKING a third party guarantee (kafalah). If the bank requests a return on its capital invested with the debtor, the bank only has the right to the exact amount of money that it has previously given to the debtor. This condition will profit the bank if it turns out that the market price of the commodity has actu- ally decreased from the time the bank enters into a salam contract, but if the price has actually increased since then, the bank incurs an opportunity cost. Another alternative is for the bank to compel the debtor to deliver the commodity specified in the contract, either directly or indirectly, by execut- ing rahn or kafalah. Other than the ones explained in Table 6.1, the details of the financing risk inherent in a salam contract and its risk mitigation is shown in Table 6.3. Istishna’ contract Like salam, istishna’ is a sale transaction that occurs before the object of the transaction is produced or constructed, where the price and the product specification should be agreed upon at the time of the contract; and must not be changed afterwards. In an istishna’ contract, as can be seen in Figure 6.5, there are several points where financing risk occurs to the Islamic bank, such as contractor failure in delivering a house at the agreed time, the failure of the house to fulfill the requested specification, or the debtor’s default during the contract period. Various risks of the istishna’ contract and their risk mitigation methods are shown in Table 6.1 and Table 6.4. Islamic bank 24/06/2015 Debtor (6) (1) 24/06/2012 (4) 14/10/2013 (3) (5) 14/10/2013 24/06/2012 to 24/06/2015 24/06/2012 (2) Contractor FIGURE 6.5 An Illustration of the Scheme of an Istishna’ Contract

TABLE 6.3 Default Risk Factors in Salam Contracts and Their Mitigation Methods Emerging Risk Risk Mitigation Since the price of the commodity in a salam contract is ■ Request a collateral and guarantee from a third party in order given at the beginning, the debtor may choose to default to cover the risk of loss of capital invested at the beginning, right after receiving payment from the bank ■ Liquidate the collateral asset and use it to buy the same commodity in the market; the requirement for this is that the total nominal value should be the same as the amount that the bank has paid to the debtor In the case of multiple commodities and delivery, it opens ■ Explain and specify in the salam contract the quantity, quality, up the possibility of debate regarding the price, quantity, and time of delivery of each commodity in detail to avoid the and quality possibility of multiple interpretation Delivery of goods that are not in accordance with contract ■ Use collateral and third-party guarantee to cover any loss that specifications or ones that are damaged altogether occur Delayed delivery of commodity ■ Improve the bank’s relationship and communication process with the debtor to be able to detect any issues beforehand and 123 find out the cause of a delay ■ The use of sanctions (as financial penalty), even if used for social activities, must be done by the relevant authorities (judge). As an alternative, the regulator should make rules regarding the size of the penalties and the parties that are entrusted with the responsibility of enforcing them. Even if the bank were given the position, it would only be as a representative of the regulator. (continued)

124 TABLE 6.3 (Continued) Emerging Risk Risk Mitigation Commodity price risk. Salam is a sale contract for goods ■ Enter into a parallel salam contract or find a third party that that will be delivered in the future (a forward contract), will promise (wa’ad) to buy the specified commodity where there is the possibility that the commodity’s price will be lower then than the expected price at the time of ■ Only be willing to buy commodities that the bank has the contract. predicted to have the potential to be sold again Marketing risk of failure to sell the commodity. This risk ■ Find a third party that will promise (wa’ad) to buy the occurs with the probability that the bank fails in commodity that the bank will have at the time of delivery marketing the commodity that it receives from the debtor, and this can cause loss/reduction of commodity ■ Turn the seller in the salam contract (the debtor) into its agent and the binding of the bank’s capital in the commodity to sell the goods through an agency (wakalah) contract Asset-bearing risk. The bank will have to keep the ■ Cover the cost through a parallel salam contract, with adequate commodity and thus incurs its inventory cost until the market survey and feasibility study over potential buyers time of delivery. ■ Salam is a contract that binds both parties. The seller (debtor) Possibility of early contract termination. The debtor may is not allowed to break the contract unilaterally, without the return the initial capital given and decline to deliver the consent of the buyer (bank). A penalty from the regulator or commodity/goods. judge can be put into place to prevent this practice In a parallel salam, the actual seller (debtor) may be ■ The bank can buy a commodity with similar specifications in unable to deliver the commodity at the agreed-upon the market and deliver it to the buyer, and then cover the loss, date, while the actual buyer (the third party) in the if any, from the realization of the original salam contract parallel salam contract demands that the bank deliver (debtor – bank) the commodity on time.

Financing Risk in Islamic Banking 125 TABLE 6.4 Default Risk Factors in Istishna’ and Their Mitigation Methods Emerging Risk Risk Mitigation Bank is not the owner of the material used by the ■ Bind the producer or developer (producer or subcontractor) to subcontractor to force it produce the asset in the case of parallel to fulfill the contract istishna’. Thus the bank does not have the right over the asset in the case of default ■ Supervise intensely in order to reduce the risk of Delivery risk occurring because the bank is subcontractor unable to finish the goods according to the underperformance or agreed-upon schedule due to delays in the delivery delays delivery of goods from the subcontractor in the case of parallel istishna’ ■ Require a guarantee over the quality delivered from The bank experiences quality risk with the the subcontractor possibility of delivery of goods of inferior quality by the subcontractor Ijarah Contract Ijarah is a form of exchange where the object is a service. The coverage of this contract is extensive; for example, it includes fiduciary entrustment ser- vices (motorcycle, cars, money, and safety deposit box), fixed asset leasing (houses, automobiles, machines), transportation services (bus, trains, air- planes, and ships), and employing employees in institutions. In fact, when an agency (wakalah) contract is accompanied with a remuneration agree- ment (ujrah), then this wakalah contract is called wakalah bil ujrah and is placed in the category of ijarah. The Islamic bank uses the ijarah con- tract in various forms: financing, fee-based activity and the management of investment funds. Based on the time of delivery, price, and the sale object, ijarah financing done by the bank is usually in the mu’ajjal form, where the bank provides its services or leases its asset beforehand, and then the debtor pays the deferred rent in the future. There are two forms of ijarah contract, namely operating lease and ijarah mumtahiah bi tamlik (IMBT). Operating lease is the original form of ijarah, as seen in Figure 6.6. This contract has several characteristics: (1) the leased object continues to belong to the bank as the lessor; (2) all maintenance and reparation costs are the responsibility of the bank, unless they are negligible compared to the lease; then they may be charged to the debtor as the lessee; (3) the debtor only con- sumes the object’s utility, and does not own the object at all; (4) the debtor is not responsible over the risks related to object damage or loss, unless it is caused by debtor’s own negligence, mismanagement, or intention; and

126 RISK MANAGEMENT IN ISLAMIC BANKING Supplier (2) (1) 24/06/2012 24/06/2012 26/06/2012 26/06/2012 (3) (4) Islamic bank Debtor (5) Contract period: 26/06/2012 to 26/06/2015 (6) FIGURE 6.6 Illustration of the Operating Lease Scheme (5) after the lease contract is over, the object must be returned to the bank as its rightful owner. The lease cost in an ijarah contract can be adjusted periodically based on the agreement between the bank and the debtor. This means that the tenure of the operating lease contract is short term in nature. The risk is that the bank is unable to bind the debtor for a longer time period, especially if there are more competitive leasing rates in the mar- ket. The bank will face the risk of being unable to recoup the capital it had invested in buying the leased object. Yet if the bank binds the debtor with a longer-termed contract, the bank will also face profitability risk when mar- ket conditions worsen and the rate-of-return available in the market for an equivalent transaction has increased. The bank then is unable to adjust the lease rate according to market dynamics. In operating lease, the bank with- olds asset ownership until the time of maturity; this action helps alleviate the risk of default from the debtor (lessee). The bank will share the risk of the leased asset through its responsibility in asset maintenance and insur- ance. The bank as lessor will hold assets with a high marketability to reduce market risk, except in cases of sublease contract, where the bank applies the concept of parallel lease. Since the bank is the asset owner, the bank will bear all the risks related to asset ownership (like depreciation risk, damage risk, and risk of theft) as well as any maintenance or operational costs. IMBT is a development of the operating lease product. IMBT covers: (1) the object ownership transfer-process from the bank to the debtor; (2) lease payables; and (3) the bank’s responsibility over the risk and expenses related with object ownership. At a glance, IMBT seems similar with capital lease in conventional finance. The difference between the two of them is shown in Table 6.5.

Financing Risk in Islamic Banking 127 TABLE 6.5 The Differences between Capital Lease and IMBT Description Conventional Lease IMBT Financing Beginning of leasing Lease begins from the time Lease begins from the period the bank purchases the time the asset is leased asset transferred to the debtor and is ready to In cases where the debtor The debtor is responsible be used becomes the bank’s for any damage over the representative in buying asset The bank, as the the leased asset … principal, is responsible The sale agreement as the for any damage to the Transfer of ownership vehicle for ownership asset transfer is done at the Form of ownership beginning of the The contract to transfer transfer contract the ownership of the leased asset is done Sale after the lease contract is first finished Sale or grant/bequest Supplier (2) (5) 24/06/2012 26/06/2012 Contract period: 26/06/2012 to 26/06/2015 (3) (1) 24/10/2012 Islamic bank Debtor 26/06/2012 (4) (6) 26/06/2015 FIGURE 6.7 Illustration of an IMBT Contract Scheme Compared to an operating lease, in IMBT, as seen in Figure 6.7, there exists a mechanism to transfer the ownership of the leased asset from the bank to the debtor. This transfer of ownership can be done through promise (wa’ad) of the bank to sell or grant the asset leased/rented to the debtor after the term of the operating lease contract is over. Since it is only a promise to sell, the bank is not allowed to state the sale price at the beginning of

128 RISK MANAGEMENT IN ISLAMIC BANKING the term of the operating lease contract. The price will be negotiated after the operating lease contract is finished. Even if it seemed independent, the realization of the promise to sell or grant is only done after the debtor finishes the operating lease contract. In other words, the sale or grant will not be realized if the debtor does not enter into an operating lease contract and finish it. IMBT with the promise to sell is allowed as long as there still exists the right to choose (khiyar) on both parties and there is no set agreement on the sale price before the lease contract is done. Other than the risk of default, as has been shown in Table 6.1, the financ- ing risks occurring in an ijarah contract (operating lease and IMBT) as well as their risk mitigation methods are shown in Table 6.6. URGENCY OF THE INDEPENDENT RATING AGENCY One of the components of a risk measurement system is the debtor rating, or the rating on the financing received by the debtor. Through the rating system, the Islamic bank will be able to translate various financial and nonfinancial conditions faced by the debtor, both internal and external, that will affect the ability and willingness to pay off the debtor into an objective measurement (metric) that is comparable. Various informations can be extracted from the debtor rating. With this rating, the bank can set various policies related to the acceptance or rejection of a financing proposal and how to determine the terms of a financing contract that is about to be granted, like financ- ing limit/ceiling, time period, type of contract, margin (price discount, lease, or rent) collateral, and guarantee requested. In the monitoring process, the bank can use the debtor rating as an indicator of financing risk. The bank can develop the rating system internally. The rating system can also be maintained by an independent rating agency. Consider the cru- cial position of the rating system, the regulator will need to manage which rating agency is given enough trust to publish ratings and have their ratings admitted as valid. When a synergy between Islamic banks and rating agen- cies exists, the bank no longer needs to bear the cost of rating. The cost will be borne by the potential debtor at the time of proposal submission. During the financing contract, the bank can also request that the debtor be period- ically reassessed by the rating agency, keeping the rating information up to date. With this sort of synergistic scheme, the bank will be more focused and efficient in selecting the financing proposal proposed by the debtor and in monitoring the quality of the ongoing financing contracts. The resource owned by the bank that was previously allocated to validate debtor data and information, extracting and transforming it into a measure that would be converted into rating, can be used for other activities of the bank’s business.

Financing Risk in Islamic Banking 129 TABLE 6.6 Default Risk Factors in Ijarah Contracts and Their Mitigation Methods Emerging risks Risk mitigation Bank purchases the asset ■ Take the debtor’s promise (wa’ad) chosen by the debtor, but ■ If the debtor cannot adequately explain the the debtor rejects from choosing the asset as the reasons for the rejection, the bank can sell the leased asset asset in the market and then take some of the security deposit (hamish jiddiyah) previously Debtor defaults before given by the debtor to cover any occurring loss finishing the contract; the bank cannot cover the ■ Utilize collateral and guarantee to reduce the losses from the risk and size of loss that can occur investment, even after recovering the asset ■ Perform a physical check of the asset and adjust the asset’s utility period with the lease rate paid Risk over asset due to major by the debtor damage or maintenance needed ■ Charge a higher lease rate if there is an early contract termination option in the ijarah Early termination of the contract, adjusting the changes to the asset ijarah contract price on the market with the lease rate paid by the debtor Debtor uses the asset carelessly, causing the ■ Ask for the debtor’s commitment to maintain bank to incur sizeable the asset leased maintenance cost ■ Use the model of mutual ownership (syirkah) Rate of return risk due to over the asset leased by the debtor inflation ■ Request a legally binding legal statement that The asset is sold at the end states any loss caused by debtor’s negligence in of the lease contract and maintaining the asset will be borne by the the debtor does not buy it debtor ■ Cover the risk by using floating lease rate approach, evaluation and periodic renewal of lease rate, but still bind the debtor in a long-term lease contract to avoid early termination risk ■ Ensure that the period (tenor) of the contract is adequate to cover all acquisition costs as well as maintenance costs and the profit margin targeted by the bank