Risk Management for Islamic Banks Recent Developments

180 RISK MANAGEMENT IN ISLAMIC BANKING advisory board in their organizational structure. The supervision and control of syari’ah compliance does not only rely within the Islamic bank’s organi- zation structure; the regulator of Islamic banks and other Islamic financial institutions forms a syari’ah board to ensure the implementation of syari’ah principles in an Islamic financial institution. In performing their task, the syari’ah supervisory board can be proactive or responsive. The syari’ah supervisory board should actively supervise, col- lect data, analyze it, and correct any findings on an Islamic bank’s syari’ah noncompliance, ensuring that the operational guidelines and every aspect of the bank’s business operations are still within the corridors of syari’ah. These last aspects cover the review function of the syari’ah supervisory board. The syari’ah supervisory board is responsive as well as actively contributing to the Islamic bank when the bank is about to issue a new product or enter a new line of business and thus requires a new operational guideline. The function of the syari’ah supervisory board can be equated with his- bah, but with a more narrow scope. Since its main function is to supervise, ideally the members of the syari’ah supervisory board are involved in the daily operational activities of the Islamic bank to ensure that any potential lapse of syari’ah principles can be minimized. The transactions done by the Islamic bank are usually customized, thus there are always some variations in the contracts entered by the bank and its clients from the baseline standard set. This is the where the opportunity for transgression of syari’ah principles becomes significant. If the syari’ah supervisory board does not have enough time to intensively monitor and get involved with the bank’s operational activities, then it’s impossible to minimize any potential lapses effectively. Other than that, the intensive involvement of members of the syari’ah supervisory board in the Islamic bank’s operational activities will enable a quick resolution to every syari’ah issue occurring in transactions as well as contracts. Based on the tasks and responsibilities entrusted, there are at least four functions attached to the syari’ah supervisory board. The first is the func- tion to periodically review an Islamic bank’s syari’ah compliance. Second is the risk management control function over syari’ah compliance, performed by identifying, measuring, monitoring, reporting, and controlling syari’ah compliance risk. Third is the syari’ah research function over any findings and reports given by the risk committee. And fourth is the syari’ah com- pliance audit function. The syari’ah supervisory board is only responsible for evaluating and ensuring syari’ah compliance over products and opera- tional guidelines issued by the Islamic bank. They are not responsible for the syari’ah compliance of the bank’s daily business operations. Under this scheme, the audit function over syari’ah compliance is still the authority of the audit committee.

Syari’ah Compliance Risk 181 There are two functions held by two different units. The syari’ah com- pliance review function is done by the syari’ah supervisory board, and the syari’ah compliance audit is done by the audit committee. It is unavoidable that some fields between the two of them intersect. The audit committee and the syari’ah supervisory board both provide independent and objective judg- ment and participate in developing an Islamic bank’s syari’ah compliance. Yet a syari’ah compliance auditor is generally not an employee with a special- ization in syari’ah itself. Because of this, some coordination and cooperation are needed between the auditor and the syari’ah supervisory board. There are several forms of syari’ah supervisory board engagement in syari’ah com- pliance audit, and they usually cover: (1) providing general direction related to audit strategy and planning, (2) providing support to audit process in the field, (3) assisting in the audit report process as well as providing recommen- dation over audit findings, and (4) reviewing audit results and following up on the findings with the management. National Syari’ah Board In several countries, for example Indonesia, the national syari’ah board only issued a very general fatwa product with inadequate technical details and stipulations. Under these conditions, the potential for any deviations from Islamic principles in practice becomes significant. As an example, the national syari’ah board in Indonesia issued a fatwa on the lawfulness of selling gold products. Some Islamic banks in Indonesia responded to the fatwa by creating a “gold orchard” product that combined the elements of a loan and an investment in one product. This gold orchard product became controversial because there were lawsuits from disgruntled customers, not to mention the sizeable market risk exposure it generated for the Islamic bank (due to fluctuations in the price of gold). A general fatwa product has a weakness of having loopholes that can allow deviations from syari’ah principle in practice in the field, especially in a competitive banking sector that is constantly challenged to be innovative and dynamic. Yet a general fatwa also allows an opportunity for the Islamic bank to be more creative in constructing products to offer to the wider public. A detailed fatwa touching the technical aspects will create a constraint on the amount of variation that can possibly be done to the product, thus minimizing potential deviations. The responsibility borne by the syari’ah supervisory board in an Islamic bank also becomes lighter this way, considering that the syari’ah supervisory board would now only need to compare between the current practice in the field with the standard operating procedure published by the national syari’ah board. If the fatwa is general in nature, then the role and responsibility of the syari’ah supervisory

182 RISK MANAGEMENT IN ISLAMIC BANKING board in safeguarding the application of syari’ah principles in the bank must be increased. The syari’ah supervisory board thus becomes the front line in the monitoring and supervision of practices in the field. The Islamic bank’s flexibility in creating banking products must be balanced with the ability of the syari’ah supervisory board to monitor the Islamic bank’s activities and operations. If the syari’ah supervisory board can perform its role well, then the weakness in a fatwa that is too general can be covered. Integrity and Independence of Members of the Syari’ah Supervisor Board Members of the syari’ah supervisory board have a very significant duty and responsibility. It is necessary for a member of syari’ah supervisory board to have a strong understanding of fiqh, Islamic jurisprudence, as well as a strong integrity. A strong understanding of fiqh is necessary to ensure that a member of syari’ah supervisory board can give a fair and knowledgeable decision for every fiqh issue that can reasonably occur in an Islamic bank. Other than that, a strong fiqh understanding is also the greatest weapon of a member of the syari’ah supervisory board in monitoring the Islamic bank’s operational activities. A member of the syari’ah supervisory board should also be of good char- acter: honest, independent, firm, trustworthy, and the like. A fiqh expert of bad character will bring great harm, since he or she is able to manipulate the lawful status of any activity, having enough fiqh knowledge to couch trans- actions that should have been declared unlawful in legal terms that can pass moderate scrutiny. Even if there is scarcely any research to gauge the integrity of members, there have been several interesting findings in the media. The article from BBC News addressed at the beginning of this chapter expresses several findings in the field of some ulama without strong integrity. In that article, an investment banker stated: We create the same type of products that we do for the conventional markets. We then phone up a Sharia[sic] scholar for a Fatwa (seal of approval, confirming the product is Shariah[sic] compliant). If he doesn’t give it to us, we phone up another scholar, offer him a sum of money for his services and ask him for a Fatwa. We do this until we get Sharia[sic] compliance. Then we are free to distribute the product as Islamic. Even if the above article is not a strong enough reason to assume the generality of such behavior, it can serve as a warning of the sort of harm that an unscrupulous member of the syari’ah supervisory board can do. If such

Syari’ah Compliance Risk 183 manipulations are common, then the Islamic banking and financial services industry is the same as the conventional banking industry. Apart from the issue of fiqh comprehension and integrity of members of the syari’ah supervisory board, another factor important for the board is independence in making decisions, both for those that are in the form of fatwa as well as positions and decisions regarding a product, transaction, or procedure in an Islamic bank. The system of syari’ah governance in a country should provide independence to the syari’ah supervisor board to fulfill its role and function. With independence, the syari’ah board is better able to come to the best decisions, unrushed, fair, and unimpeded by any pressure. The pressure in the Islamic banking and finance industry is usually significant, considering how dynamic and sizeable this industry is. To issue a banking product, it is possible for industry actors to exert pressure on the syari’ah board to ensure that the fatwa issued is not the best one with the most reasonable consideration. IDENTIFICATION PROCESS OF SYARI’AH COMPLIANCE RISK According to the IFSB, syari’ah compliance risk is defined as the risk that occurs due to the Islamic bank’s noncompliance with syari’ah provisions and principles as determined by the syari’ah advisory board or similar institutions where the Islamic bank operates. Noncompliance risk occurs when a financial institution fails in implementing syari’ah principles in their operations, either in financing, channeling, or other banking services. Judgment on an Islamic bank’s syari’ah principles compliance covers all the components related to the operational activity of Islamic banking. Because of this, the process of identifying syari’ah compliance risk in an Islamic bank should begin in a comprehensive and thorough manner, from the beginning of the contract process and the discussion of ideas for new products to the details of transaction schemes between the Islamic bank and the debtor, the contract’s period, and the contract’s termination. The process of identifying syari’ah compliance risk in an Islamic bank can thus be done through: 1. Reviewing the appropriateness of the business activities reflected in the contract with the purposes of syari’ah 2. Identifying any transgression of syari’ah principles on the syari’ah bank’s entire business, with regards to the possible presence of elements of usury, gharar, maysir, tadlis, coercion, or the unlawfulness of the contract object 3. Checking that the principles and conditions for completion in every contract made by the Islamic bank are fulfilled.

184 RISK MANAGEMENT IN ISLAMIC BANKING The above three methods are usually done by applying the syari’ah com- pliance audit process to ensure the Islamic bank applies syari’ah principles to its entire operations. Islamic Banking Syari’ah Compliance Audit in AAOIFI AAOIFI defines the syari’ah compliance audit process as an inspection process covering checks on contracts, agreements, policies, products, trans- actions, memorandum, financial statements, internal reports, central bank inspection reports, and other related documents. According to the AAOIFI, the purpose of audit on Islamic financial institutions is to provide opinions that the financial statement presented is in accordance with syari’ah prin- ciples and rules without any material flaws. Next, the coverage of syari’ah compliance audit covers all of the Islamic bank’s business and operational aspects: financial statements, internal control, and syari’ah compliance governance. The last part in itself covers organization structure, employees, process, and information technology systems. Syari’ah Auditing Methods As has been discussed before, the compliance risk of an Islamic banking institution covers at least two fronts: the legal aspect and the syari’ah aspects. To gain a comprehensive result, the syari’ah audit process can be done by combining several approaches: the halal–haram approach, the contract approach, the legal documents approach, the magashid syari’ah approach, and the financial statement approach. In the halal–haram approach, the main discerning purpose is to find out whether any of the Islamic bank’s activity is related to various things that are prohibited in mu’amalah, including prohibited transactions (usury, gharar, maysir, and tadlis) and commodities that are prohibited and unlawful to transact in (intoxicants, pigs, prostitution, and the like). Thus, the main focus of this approach exists in the effort to identify all of those prohibited transactions. The second is the contract approach. The purpose of this approach is to identify the validity of each of the Islamic bank’s financial contracts. As such, the audit process is focused on the efforts to identify the contracts and validity principles and requirements, as in: the presence of sellers and buyers (transaction actors), the price, the contract’s object, the transaction, the ijab-qabul (statements of entering the contract), and other specific details directly related to the type of contract done. From this approach, the validity of every financial contract done by the Islamic bank can be known. The third is the legal approach. This is slightly different from the previous two approaches, in that the main purpose of this approach is to

Syari’ah Compliance Risk 185 ensure that all the rights and responsibilities of the transaction actors are fulfilled according to the agreement written in the contract document. As such, the audit process with the legal approach will try to identify various elements related to the contract, that is: elements of coercion (ikraha), mistake (khata’), inequality in power (ghubn), fraud (taghrir), illegal products, and illegal motive element. Complementing the halal–haram and the contract approach, the mag- ashid syari’ah approach is also done to ensure that all of the Islamic bank’s activities are in line with the purpose of syari’ah’s revelations: the mainte- nance and preservation of religion (din), soul (nafs), descendants and line of descent (nasl), reason (aql), and wealth (mal). The audit process will thus focus on identifying whether any of the Islamic bank’s activities, through transactions and contracts entered, will endanger any of the five elements mentioned. As an example, a usurious transaction is identified as transgress- ing syari’ah compliance, as it is considered to bring harm to wealth. The fourth is the financial statements approach. Financial statements contain information with regard to the financial conditions of a company; included in the financial statements are changes in a firm’s financial posi- tion as well as its performance. As such, the syari’ah audit process with this approach tries to evaluate syari’ah compliance in all the transactions reported in the Islamic bank’s financial statements. Syari’ah Audit Process in Islamic Banking The audit result should be able to provide a representation of an Islamic bank’s syari’ah compliance. Before the audit, the Islamic bank should ensure that the audit’s process and methodology are capable of measuring, evalu- ating and gauging the effectiveness of the Islamic bank’s internal control systems in syari’ah compliance governance. Because of this, good audit plan- ning covers several things: ■ Provide enough understanding about the Islamic bank’s operational activities to ensure that the auditor has enough material to audit in the field and to determine which audit activities are relevant ■ Prepare a comprehensive audit plans and program, that cover the purpose, audit scope, audit assignment, sampling, supervision, and determination of audit time ■ To ensure a good and accurate syari’ah compliance audit, check that the auditor has references from relevant sources—for example, the deci- sions of the syari’ah advisory board, fatwa from the syari’ah advisory board, results from a prior syari’ah compliance audit, and an internal checklist related to syari’ah compliance

186 RISK MANAGEMENT IN ISLAMIC BANKING ■ Perform the syari’ah compliance audit and then communicate the findings to the Islamic bank’s syari’ah advisory board and the audit committee ■ Provide recommendations and suggestions for improvement on any find- ings of syari’ah noncompliance Apart from that, the syari’ah compliance audit processes require that at least four instruments be used to identify any discrepancy with syari’ah principles. These are: ■ Accounting instrument The use of accounting instruments such as a balance sheet report, profit–loss statement, and auditing methods helps the auditor in identi- fying the syari’ah noncompliance that may occur in any financial trans- action. According to Lahsasna (2014), a financial transaction can be declared to be free from deviations from syari’ah principles if several conditions are fulfilled: (1) the transaction is legitimate according to the law and legal rulings in place, (2) it has a valid contract and one that is free from usury, gharar, and maysir, (3) the conditions of fairness and transparency are fulfilled between all contract participants (seller and buyer) in terms of object ownership and price, and (4) the balance sheet report presents the bank’s assets and liabilities, and all transactions involving them are clearly classified according to the source of fund and their use. ■ Legal instrument This instrument is useful to test the contract structure and products of the Islamic bank, as well as ensure syari’ah compliance in the clauses of a contract. ■ Fatwa instrument In auditing, understanding the function of fatwa as validation tool over the lawfulness is very important. Fatwa is used to detect devia- tions from a transaction. Auditors use a fatwa to check a transaction documents covering similar topics. ■ Syari’ah compliance review instrument This instrument consists of the syari’ah compliance test used by the syari’ah advisory board on contracts, the contents of a cooperation agreement, banking products, financial statements, and internal state- ments related to the syari’ah compliance issues. Because of this, this instrument can be used by the auditor as an indicator on past issues related to the bank’s deviations on syari’ah compliance. After that, the auditor will evaluate the follow-up action of the review to determine whether the management has improved things or not.

Syari’ah Compliance Risk 187 IFSB also recommends evaluation of the principles and requirements of every contract used in Islamic banking transactions to discover the syari’ah compliance level of every Islamic banking product. RISK MANAGEMENT AND MITIGATION OF SYARI’AH COMPLIANCE RISK Syari’ah compliance risk management is done in two stages, which are: (1) the stage before the business operates and (2) the stage after the business is operating. In the first stage, syari’ah compliance risk management is done to review several new product ideas that will be offered to the wider public. In that phase, the syari’ah advisory board can request all details about the new product’s scheme. If the new product design is considered in accordance with various syari’ah provisions, then the Islamic bank can introduce the new product to the public. In the second stage, syari’ah compliance risk management is accomplished by evaluating every Islamic banking product offered to the public. This is done to ensure that every product and service offered by the Islamic bank is consistent in upholding and practicing syari’ah principles. It may happen that the syari’ah advisory board does not find any transgressions of syari’ah principles on the initial screening, and at the second stage of screening some deviations from syari’ah principles are found in the new product’s implementation process to the wider public. By doing the two stages above, the syari’ah compliance risk manage- ment process is expected to run smoothly, and any tendency to transgress or deviate from syari’ah principles can be minimized. If at the first stage some transgressions on syari’ah principles are found, then the new product’s development must be stopped. If the syari’ah compliance issues are found in stage two, IFSB holds the view that any revenue gained from the transaction cannot be admitted or considered as a loss. The syari’ah advisory board or other related parties could allot sanctions to the Islamic bank for ignoring syari’ah principles in their operational activities. The types of sanction given depend heavily on the regulation in force and the discretion of the authorities responsible for supervising syari’ah compliance. Until now, there have yet to be any clear rules regarding possible mitiga- tion methods to use to minimize potential loss from syari’ah noncompliance risk. One reason for this is the difficulty in measuring and gaining data related to transgressions on syari’ah compliance. In the risk management guide published by the IFSB, the risk of noncompliance does not prompt any need to reserve capital to cover for it. Because the risk of noncompliance is part of an Islamic bank’s operational risk, IFSB only sets the requirements for reserve capital as a whole, around 15 percent of gross revenue.

188 RISK MANAGEMENT IN ISLAMIC BANKING MODELS OF SYARI’AH GOVERNANCE IN SEVERAL COUNTRIES Even though syari’ah governance is important and necessary in an Islamic banking and finance system, its application in practice varies according by country. This section will provide some basic background on syari’ah governance practice in the Islamic banking and finance systems of several countries, such as Malaysia, Pakistan, Indonesia, Kuwait, Bahrain, the United Arab Emirates, and Qatar. Syari’ah Governance in Malaysia Syari’ah governance in Malaysia began with the establishment of Syari’ah Advisory Council (SAC) in Bank Negara Malaysia based on Section 16B of the Central Bank of Malaysia Act 1958. In the Malaysian financial system, SAC plays a large and central role. If any legal problems occur between Islamic financial institutions, SAC can be referred by the local court as one of the legal reference that can be considered in the process of resolving disputes. Bank Negara Malaysia (BNM) as the regulator of the banking and nonbanking financial industry in Malaysia, has also published “Sharia Gov- ernance Framework for Islamic Financial Institutions,” as seen in Figure 8.2, which states (among other things): ■ The syari’ah committee should be present in every financial institution that uses the syari’ah principle, like the Islamic bank, takaful, as well as other Islamic financial institutions. ■ The relationship between the syari’ah committee and the SAC is com- plementary, where the role of the syari’ah committee completes the role as well as the fatwa products of SAC. ■ Members of the BNM are not allowed to be members of the syari’ah committee in any Islamic financial institution in Malaysia (verse 16B (6) from CBA 1958). ■ Every syari’ah advisor is only allowed to become a member of the syari’ah committee of one other Islamic financial institution and is not allowed to double as a syari’ah committee member in any other Islamic financial institution. ■ Every syari’ah committee member must be an individual. Firms or insti- tutions are not allowed to become members of a syari’ah committee in a bank or other Islamic financial institution. ■ Member of the syari’ah committee must have two qualifications, which are the knowledge qualification related to Islamic jurisprudence (Usul al-Fiqh) and the knowledge qualification related to Islamic transaction (Fiqh al-Mu’amalat).

Syari’ah as overarching principle in Islamic finance BOARD RISK BOARD SYARI’AH COMMITTEE BOARD AUDIT MANAGEMENT COMMITTEE Overall oversight on syari’ah governance COMMITTEE structure & syari’ah compliance MANAGEMENT • Ensure executions of business & operations in accordance with syari’ah principles • Provide necessary support to the syari’ah committee Syari’ah Risk Syari’ah Review Syari’ah Research Syari’ah Audit Function Management Control Function Function Provide independent Function Review business operations Conduct in-depth syari’ah assessment & objective on regular basis to ensure research prior to submission to assurance designed to value Identify, measure, monitor, syari’ah compliance the syari’ah committee add & improve IFI compliance report, & control syari’ah non- compliance risk Syari’ah Compliance and Research Functions FIGURE 8.2 Syari’ah Governance Framework for IFI in Malaysia Source: Bank Negara Malaysia, “Sharia Governance Framework” (Bank Negara Malaysia, 2010). 189

190 RISK MANAGEMENT IN ISLAMIC BANKING From the provisions related to syari’ah governance in Malaysia, it can be concluded that independence and focus from members of the syari’ah supervisory board is preserved to ensure the SAC and syari’ah committee can function optimally and as expected. Syari’ah Governance in Pakistan Similar to Malaysia, the syari’ah board in Pakistan is under the central bank, the Pakistan State Bank of Pakistan (SBP). The syari’ah board is the single as well as the highest authority responsible for all the Islamic financial institu- tions in Pakistan. Other than that, the regulation in Pakistan also requires all Islamic financial institutions in Pakistan to have a syari’ah advisor to uphold the syari’ah principles in Islamic financial institutions. Unlike in Malaysia, members of the syari’ah board under the SBP are allowed to become syari’ah advisors in Islamic financial institutions in Pakistan, even if the members are only allowed to become an advisor in exactly one Islamic financial institution. Other than that, the role and function of the syari’ah board and the syari’ah advisor in Pakistan are similar to those in Malaysia, where they have a com- plementary role. All syari’ah foundations or fatwa used by Islamic financial institutions in Pakistan should be referred to the syari’ah board under the SBP. Syari’ah Governance in Kuwait The Central Bank of Kuwait does not have a syari’ah advisory council or syari’ah board like Malaysia or Pakistan. Kuwait prefers to use the self-regulation model for the Islamic financial institutions in Kuwait. In section 10, Chapter 3, Central Bank of Kuwait Law 32/1968 it is stated that all Islamic financial institutions in Kuwait are required to have a syari’ah supervisory board, with several of its members with expertise in fiqh mu’amalah. Every member of an Islamic bank’s syari’ah supervisory board is liable to hold a different perspective from other members regarding an issue that needs to be settled. If the conflict or difference in opinion cannot be immedi- ately settled, then the Board of Directors of the Islamic bank can submit the issue to the fatwa council in the Ministry of Awqaf and Islamic Affairs, even if they’re not required to do so. The fatwa council in the Ministry of Awqaf and Islamic Affairs is the final authority on all fiqh issues in the Islamic financial industry. Even if they are both special institutions functioning as a syari’ah authority, the fatwa council of Kuwait is an institution whose mem- bership is outside the Central Bank of Kuwait. There are also no restrictions on the member of the fatwa council to become member of a syari’ah supervi- sory board. Members of a syari’ah supervisory board are also not prohibited from becoming members of the syari’ah supervisory boards of more than one Islamic financial institution.

Syari’ah Compliance Risk 191 Syari’ah Governance in Indonesia Syari’ah governance in Indonesia has several similarities with the syari’ah governance applied in Kuwait. The Indonesian central bank does not have a special syari’ah board responsible for supervising as well as settling all the syari’ah-related issues in the Islamic banking and finance industry in Indonesia. The industry itself is under the supervision of the IFSA (Indone- sian Financial Services Authority), inside of which several departments exist specifically to handle Islamic financial institutions in Indonesia. But the pres- ence of that special division in IFSA does not completely touch all the syari’ah issues faced in Indonesia. Indonesia differentiates between the banking and finance authority and the syari’ah governance authority. All the rules and regulations related to financial institutions (bank and non-bank) are under the purview of IFSA, while all rules and regulations related to syari’ah issues and problems in the banking and finance industry are under the National Syari’ah Board, a com- ponent of the Indonesian Council of Ulama (NSN-ICU). All Islamic financial products and services created must refer to a fatwa issued by NSN-ICU. In practice, Islamic bank and financial institutions in Indonesia can request that NSN-ICU provide a jurisprudential review of a new product to ensure it is syari’ah compliant. The result of the review will be published in the form of fatwa by the NSN-ICU. Members of NSN-ICU are also allowed to become members of the syari’ah supervisory boards in any Islamic bank or financial institution in Indonesia. It can thus be said that the roles of the NSN-ICU and the syari’ah supervisory board are complementary. NSN-ICU issues various fatwa that are general in character, while the supervisory board supervises their technical implementation in any Islamic bank or financial institution. The legal rules related to Islamic banks or financial institutions in Indonesia require that all their products have a foundation in a fatwa published by the NSN-ICU. According to Law No. 21 Year 2008 about syari’ah banking, every Islamic bank in Indonesia, both for Islamic Banks as well as Syari’ah Business Unit, is required to form a Syari’ah Advisory Board that is tasked in general with advising and suggesting directors, as well as supervising bank- ing activity in order to ensure continual compliance with syari’ah principles. This is what differentiates the organization structure of an Islamic bank from a conventional one. Syari’ah Governance in Bahrain The central bank of Bahrain has a National Syari’ah Board that is responsi- ble for verifying the application of syari’ah principles in the Bahrain central bank. What differentiates it from the practice in other countries is how the National Syari’ah Board is a syari’ah board that serves the central bank in particular, and has no responsibility to supervise the syari’ah compliance

192 RISK MANAGEMENT IN ISLAMIC BANKING in every other Bahraini Islamic bank and related financial institution. The central bank of Bahrain requires all Islamic financial institutions to have a syari’ah supervisory committee and all products issued by an Islamic finan- cial institution in Bahrain to be in line with the accounting, auditing, and governance standards and the syari’ah standards for Islamic financial insti- tutions issued in 2010 by the AAOIFI. Anyone with capability in the field of fiqh mu’amalah is also allowed to become a member of the syari’ah super- visory board in more than one Islamic financial institution in Bahrain. Syari’ah Governance in the United Arab Emirates Syari’ah governance in the United Arab Emirates is marked with the estab- lishment of Higher Syari’ah Authority (HSA), responsible for the supervision of Islamic bank and financial institutions and investments (Art. 5, Federal Law No. 6 of 1985). The institution is also the highest authority on syari’ah issues in Islamic banking and finance in the United Arab Emirates. Apart from that, it is not unlike the arrangement in other countries with a Muslim majority; the Federal Law of the United Arab Emirates requires all Islamic financial institution to form a syari’ah supervisory board. But the Federal Law of the United Arab Emirates does not contain any stipulation in limiting the membership of fiqh experts in more than one syari’ah supervisory board. Syari’ah Governance in Qatar The syari’ah governance system in Qatar is similar to the syari’ah gover- nance system practiced in Kuwait. The central bank of Qatar does not have a special syari’ah advisory council to supervise the application of syari’ah principles in the Islamic banks and financial institutions; because of that, the syari’ah governance system in Qatar is self-regulatory. Even so, Qatar has a Supreme Syari’ah Council, part of the Awqaf Ministry that is respon- sible in handling and settling syari’ah-related issues in the Islamic banking and finance industry in Qatar. The central bank of Qatar also always consults with the Supreme Syari’ah Council in solving syari’ah issues in various cases. The syari’ah governance system in Qatar also does not limit the involvement of fiqh experts in the syari’ah supervisory boards of several Islamic bank and financial institutions in Qatar. From the discussion on the differences in the syari’ah governance practice above, a summary of the differences in their application in several countries can be seen in the following Table 8.1.

TABLE 8.1 The Comparison of Syari’ah Governance in Several Countries Country Central Bank Syari’ah Authority Final Authority Restrictions Islamic Financial Institution (IFI) Malaysia Syari’ah Advisory Council Syari’ah Committee Syari’ah Advisory Council Members of SAC cannot serve IFI; one SA can only Pakistan Syari’ah Board Syari’ah Advisor Syari’ah Board serve one IFI in same category Kuwait N/A Syari’ah Supervisory Syari’ah Supervisory Board Members of SB can serve Indonesia N/A Board Dewan Syari’ah Nasional- IFI; one SA can only serve UAE Higher Syari’ah Authority one IFI Bahrain National Syari’ah Board Syari’ah Supervisory MUI No restriction Qatar N/A Board Higher Syari’ah Authority National Syari’ah Board No restriction Syari’ah Supervision Syari’ah Board Authority No restriction Syari’ah Supervisory No restriction Committee No restriction Syari’ah Board 193

9CHAPTER Strategic Risk There is an interesting expression on the importance of strategic risk in business: “Fail to identify the strategic risks and you fail as a business, no matter how well you manage your operational and project risks.” Islamic banks, like all institutions, are constantly faced with competi- tion, from the beginning of their establishment and throughout maturity, as the bank continues to be a going concern. To face this, the bank requires a mature strategy, executed effectively, to survive the competition and even emerge victorious. To survive in a competitive business environment, the bank needs to ensure that its business is optimally healthy and profitable. It is to be expected that any business venture would place profit making as its primary purpose, as long as it does not generate any negative excess to the greater public and the environment in the process. Many historically profitable institutions have had to be closed due to bankruptcy because the management was unable to maintain a workable level of profit for the com- pany. For example, the global crisis of 2008 took Lehman Brothers, a firm that was more than a century old, as its victim; the company went bankrupt due to excessive losses. The lesson to be learned here is that large losses can easily haunt any business institution, no matter the size and age. A firm’s inability to generate profit will lead to its bankruptcy and disappearance from the map. If we observe further, the main cause of bankruptcy in a company begins from mistakes made by the management in business strat- egy, or in business decision-making. One of the causes of Lehman Brothers’ bankruptcy is the mistake of the firm’s leaders in applying the appropriate investment and funding strategy for the firm. Lehman Brothers’ investment strategy was focused on various derivative financial instruments, derived from housing mortgages of various qualities, and at that time many of them were high risk. On the financing side, Lehman was highly leveraged in order to reap high profit for its shareholders. When the property sector in the United States fell apart, Lehman Brothers’ strategic mistake extracted a fatal cost. In this real case, it can be concluded that a firm’s accuracy in choosing and practicing a business strategy directly affects the firm’s survival rate. As a bank that practices syari’ah principles daily in its operational activ- ities, the Islamic bank should strive to survive business competition with 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. 194

Strategic Risk 195 both conventional banks as well as other Islamic banks. The bankruptcy of an Islamic bank will ruin the image of Islam or Islamic syari’ah in the eyes of both the Muslim and non-Muslim communities, similar to the way the image of Islam in the international world has become unsavory due to the prevalence of poverty in most of the countries with a Muslim majority. Because of this, the Islamic bank has a heavier burden than the conventional bank in ensuring the sustainability of the Islamic bank’s business in the long term. In order to survive in the midst of a dynamic and competitive business environment, the Islamic bank should observe two important factors: ideological factors and strategic factors. Ideological factors determine how far the Islamic bank is committed to practicing various syari’ah principles in its operational activities. The farther an Islamic bank strays from Islamic syari’ah, the less any blessing remains in the Islamic bank itself as it approaches near indistinguishability from conventional banks. Strategic factors will determine the Islamic bank’s ability in interacting with their competitor. Both factors must be fulfilled and balanced by the Islamic bank in a holistic way. If the Islamic bank ignores the aspect of accuracy of strategy, then it can be assured that the Islamic bank will not survive long and will be easily defeatable in business competition by conventional banks. The public will be doubtful of any excellence of the Islamic financial system since the failed bank became an example of how an Islamic bank does not manage to survive in competition. If the Islamic bank ignores the ideological aspect, then it may have been able to survive for long periods in a business environment, but it will also have lost any identity and blessing. The public will then doubt the validity and originality of the Islamic syari’ah, since the banking institution claiming to practice Islamic syari’ah is principally the same as conventional banks. DEFINITION AND SCOPE OF STRATEGIC RISK IN ISLAMIC BANKING In IFSB and Basel III, strategic risk is not specifically discussed like other risks. In the explanation of operational risk, the terms strategic risk and reputation risk are mentioned in the definition of operational risk. The IFSB and Basel III state that operational risk does not cover strategic risk and reputation risk, clearly separating operational risk from the two of them. In many literatures, strategic risk is defined as a risk occurring due to inaccuracy in the formulation or execution of a strategic decision, as well as to the failure to anticipate changes in the business environment. Strategic risk usually occurs from some of the following causes: The bank uses a strategy that doesn’t fit well with the bank’s vision and mission; the bank

196 RISK MANAGEMENT IN ISLAMIC BANKING fails to comprehensively analyze the strategic environment; and/or there is a discrepancy in the strategic plans between strategic levels. Other than that, strategic risk can also occur due to a failure to anticipate a changing business environment, covering failure in anticipating changing technology, changing macroeconomic conditions, the dynamics of market competition, and policy changes. In addition to the above factors, strategic risk can also manifest from the behavior of the bank’s various stakeholders, like clients, suppliers, shareholders, and employees, as well as the general public. DETERMINANTS OF STRATEGIC RISK AND ITS MITIGATION From the above discussion, strategic risk can be identified based on the tax- onomy of strategic risk, as shown in Figure 9.1. Changing Business Landscape Strategic risk could rise from a change in the business landscape. Current business characteristics change dynamically, which could bring significant risk if the change is not well anticipated. Two important factors that should be anticipated are entrance of new competitors and the emergence of new substitution products. Entrance of a New Competitor Changes occur in the business landscape due to various reasons, from the entrance of a new player to the development of a new substitute product. In the banking industry, there is an interesting phenomenon in which large banks tend to underestimate the small banks that are new entrants to the industry. The thinking of “too big to fail” is still so strongly held that the smaller bank’s survival chances are underestimated. But of course, would small banks always stay that way? A small German bank by the name of ING DiBa can provide a timely lesson. The bank was established in 1965 and was underestimated by the major banking players in Germany at that time. After four decades, ING DiBa has shown that it is not entirely harmless. The bank worked hard when it was awarded the title of most popular bank in Germany. In 2005, it had more than 5 million clients (around 6 percent of the total German citizens). Many of those clients migrated to them from bigger banks. The larger banks were slow to react, after underestimating small banks. They had to accept the presence of a competitor they couldn’t afford to ignore anymore. Time can make the dif- ference: The small competitor is not always unable to compete with larger rivals, and there is no guarantee that customers will always be loyal to their first choice.

Strategic Risk Change of business Improper strategic Innovation challenges Changes in the Changes in landscape formulation macroenvironment stakeholder behavior Inadequate Entrance of new Strategy is not in research and Changes in the Changes in competitor accordance with a development (R&D) macroeconomic customer behavior The emergence of bank’s vision or Not adaptive indicators Changes in new substitution mission enough to various supplier behavior Changes in the product The strategic technological authority policies Changes in environmental progresses investor behavior analysis done is not Regional comprehensive No improvement in cooperation Changes in business process agreements (AEC, employee behavior enough APEC, AFTA, etc.) A discrepancy exists between the strategic plans of different strategic levels FIGURE 9.1 Taxonomy of Strategic Risk 197

198 RISK MANAGEMENT IN ISLAMIC BANKING The entrance of new players in an industry cannot be separated from the various regulations managing the rules of the industry. The banking industry has a unique side compared to others, especially in light of barriers to entry and exit. Unlike other industries, the banking industry is highly regulated, thus the barriers to entry and exit in the banking industry tend to be larger than other industries. Regulators usually establish various regulations (e.g., minimum capital requirements, percentage of ownership), for business people interested in entering the banking industry, including the Islamic banking industry. As an example, the regulation in Indonesia states that every citizen or legal entity can establish an Islamic bank if able to provide paid-in capital of at least IDR1 trillion, equivalent to USD110 million, and already has the permit to do so from the Financial Services Authority. The size of the paid-in capital becomes the barrier to entry for other parties that may be interested in establishing a new Islamic bank in Indonesia. A similar thing can be said of barriers to exit. In the banking industry, bankruptcy does not automatically mean that the bank can easily exit the industry. This is because the bank’s survival is also in the interest of many people, not just its owners, and thus its failure does not infer that the bank will be closed. Thus the competitive landscape of the banking industry relies heavily on regulatory policies in place. In its relation to the Islamic bank, risks occurring due to the changing business competition landscape are presented in Table 9.1. Emergence of New Substitution Products Substitute products of the Islamic bank may emerge from other financial institutions that operate similarly to a bank. The financial institution might not even be a financial institution like a bank, insurance, financing company, or the like, but it has a business process model that is similar, with some banking operations. This institution is called a shadow bank, and a set of these institutions is often called the shadow banking system. In the modern financial and banking system, there are differences in the business process between financial institutions, and they are managed by regulation. Banks are usually called depository financial institution, which meant that the banks can collect funds from the public in the form of savings and deposits and channel them back to the public in the form of loans or financing. Other financial institutions are called nondepository financial institution, which means that they are not allowed to collect funds from the public in the form of savings and deposits, even if they are allowed to channel funds to the public in the form of financing (the same practice done by a venture capital company, for example). The shadow banking institution above is not part of the non-bank financial institution, but is a separate institution that is not a part of the modern financial and banking

Strategic Risk 199 TABLE 9.1 Risk of Changes in Business Competition and Its Risk Mitigation Methods Determinants of Risk Risk Mitigation Methods The entrance of a new ■ The entrance of a new Islamic bank to the industry Islamic bank into the can be considered as a blessing, as these new banks industry will be able to add depth and variety to the Islamic finance industry. On the perspective of an The emergence of new individual established Islamic bank, however, new substitute products entrants cannot be underestimated. The bank (example: e-banking is a would need to form a special task force to examine substitute of analog all details relevant to the new entrant, and then banking service; Islamic recommend the best step is to face the new credit card can be entrants in healthy competition. considered a substitute for a debit card) ■ New entrants also cannot be automatically considered as rivals. They also represent potential partners, and thus co-opetition, instead of pure competition, is practiced. ■ Whatever new products show up on the market, the Islamic bank should keep its path firmly within compliance of Islamic values. If the new product offered by other new Islamic banks is considered to be in line with the bank’s vision and mission, then it is better for the bank to follow in issuing it. ■ The need to form a communication team able to explain the advantages of the bank’s current products. For example: if the bank does not wish to issue an Islamic credit card because of the controversy, then the bank can explain to the public that a debit card or at least charge card helps financial planning better and fits better with the syari’ah. The bank can also print educational financial planning brochures to explain how a credit card is less straightforward to manage, and so on. ■ Develop a product development division and ensure the staff has up-to-date knowledge with continuous training and information updates about customers’ preferences.

200 RISK MANAGEMENT IN ISLAMIC BANKING system. This institution usually exists on the micro level, has depositors and debtors that are dominated by members of society with low financial literacy like small farmers, small and medium enterprise (SME) owners, and so forth. Sometimes the shadow banking institution charges a rate that is too high and is beyond the debtor’s ability. The shadow banking institution can be a substitute for the Islamic bank, especially for the segment of society with a low financial literacy. Members of the public with low financial literacy tend to be afraid and reluctant to interact with banking institutions, including Islamic banks. In many devel- oping countries, such as Indonesia, the village populace tend to be reluctant to interact with banks (both for saving as well as borrowing) because they are worried about dealing with a series of procedures that they consider to be troublesome. They prefer to deal with “moneylenders” rather than with an Islamic bank, even if they usually suffer the higher interest rate required by those moneylenders. The percentage of the public with low financial liter- acy is very high, representing a significant market potential to be cultivated by the Islamic bank. Improper Strategy Formulation Incorrect strategy formulation will crucially affect the occurrence of strate- gic risk. At the very least, this can happen if the strategy taken is not in accordance with the bank’s vision and mission, or the strategic environmen- tal analysis done is not comprehensive enough, or if there is a discrepancy between strategic plans of different parts of the bank. The problem of incorrect strategy formulation or execution is the same issue faced by 20 state member banks in the United States, that are faced with large material and nonmaterial losses. As an example, CapitalSouth is a bank in the United States focusing on channeling credit to SMEs. In 2003, CapitalSouth’s management decided to expand their business, channeling credit to the property sector as well. The result? Between 2005 and 2007, the bank’s credit portfolio increased more than two fold, from US$250 million to US$644 million. Unfortunately, this rapid growth was not accompanied by good risk management. The credit channeled to the property sector at that time proved to be of higher risk than it was worth. In the end, CapitalSouth was faced with massive losses. Similar cases happened in several other banks, like Barnes, Marco, and IUBT. When the bank’s management chases after high growth without good risk management, then it is the same as inviting disaster. In its relation to the Islamic bank, risks occurring due to incorrect strategy formulation are presented in Table 9.2.

Strategic Risk 201 TABLE 9.2 Incorrect Strategy Formulation Risk and Its Risk Mitigation Methods Determinants of Risk Risk Mitigation Methods The strategy is not in ■ Periodically monitor the implementation of the accordance with the bank’s bank’s vision and mission to ensure that vision or mission business strategy and achivement are in accordance with the existing vision and mission. The strategic environmental analysis done is not ■ Internalize the values from the bank’s vision as comprehensive enough well as the bank’s mission through various forms of information and communication A discrepancy exists between media, in the forms of various gatherings or the strategic plans of events, posters, videos, etc. different strategic levels ■ Form a special division responsible for formulating the firm’s strategy. This division can work with outside consultants, but should always be the one with the final decision-making authority over the formulated strategy that is chosen. ■ Formulate plans A, B, C, etc., based on an analysis of various scenarios that can emerge in the environment. This will enable the bank to be more flexible in implementing its strategy, as it does not take for granted that everything will run smoothly and prepares for it. ■ Increase coordination and communication between strategic levels to ensure the strategy taken does not generate conflict between one strategic level and the other. ■ Internalize the mutual goals to aim for, for the banks as a whole, in order to avoid an isolated/egocentric approach to goals between strategic levels. Innovation Challenges The rapid change in business environment, especially the changes caused by technological progress, force the bank to adjust to its surroundings quickly. One of the larger changes in the banking industry was the birth of the ATM (automated teller machine). The number of ATMs that a bank has (along with other accessibility factors like bank location and number of branches) is a key factor for consumers in choosing a bank. Not only ATMs but also other innovations are required by the customer nowadays as part of good

202 RISK MANAGEMENT IN ISLAMIC BANKING banking service, including other technological services like non-cash and cash deposits machine (CDM), and e-banking services, which usually cov- ers Internet banking, phone banking, SMS banking, mobile banking, and other services. The innovation can also be done within a bank’s business process. At the time being, the process of applying as a funding or financing client is still done manually. Several banks have started to introduce electronic applica- tion processes, thus saving all clients and potential clients from having to spend a long time in the bank filling the application forms. To become a funding and financing client, they can fill in the required data online before- hand, along with any necessary document copies or scans. After filling the application, they can print out the receipt for the finished form and bring it to the bank to be processed further. With the type of business process that is as advanced as applying online for a visa to various developed countries, the employees’ as well as the clients’ time is more efficiently spent. Without all those innovations, banks will become their own obstacles in serving their customers. More details on risks from innovation challenge are discussed in Table 9.3. TABLE 9.3 Innovation Challenges Risk and Its Risk Mitigation Methods Determinants of Risk Risk Mitigation Methods Inadequate research and ■ Form several divisions about R&D, or development (R&D) as well integrate the function with the product as continuous improvements development division on business processes ■ Subscribe to relevant mass media or Not adaptive enough to available Islamic banking database(s) to various technological ensure the bank constantly receives progresses up-to-date information about the public’s expectations of the bank ■ Hold business competition among employees to improve the bank’s internal R&D capabilities ■ Develop various technological facilities needed, in-house ■ Work with various IT consultants to develop such facility. ■ Cooperate with other banks to jointly manage technological facilities in some areas, thus pushing down costs. For example: Joint ATMs.

Strategic Risk 203 Changes in the Macroenvironment In some countries, Islamic banks developed in a dual banking system, which is influenced by the macroeconomic conditions both directly and indirectly. Thus all changes in the macroeconomy, whether in macroeconomic indica- tors or government and banking authority policies, as well as the beginnings of regional cooperation agreements (ASEAN Economic Community 2015 [AEC], Asia-Pacific Economic Cooperation [APEC], ASEAN Free Trade Area [AFTA], etc.) will also affect the strategies that must be prepared by an Islamic bank. An example of the change in strategy arising from changes in policy can be seen when the government decides to amend the tax laws. This amendment asserts the erasure of double tax over the murabahah transaction. This will more or less increase the ease with which the Islamic bank channels funds in the form of murabahah contracts. This can also attract the interest of new players to enter the Islamic banking industry. Furthermore, strategic changes can also happen from regional coop- eration agreement—an example of this is the AEC. Several foreign banks from the ASEAN region expressed their interest in investing or establishing a bank in the country. This spirit was also present in Islamic banks in the domestic country, as some intended to expand to neighboring countries. Unfortunately, even though market analysis was done to the best extent possible, the result was not as they expected at all. The market the Islamic bank intended to gain, remittance from migrant workers, does not reach the targeted amount. After some investigation, one possibility is actually that the business locations selected were “too strategic” for migrant workers. The bank’s locations in business center areas instead of in the migrant worker districts might have contributed to their reluctance to choose the bank as a transaction location. Changes of Stakeholder Behavior Various changes in the world also influences the behavior of the bank’s various stakeholders, like clients, suppliers, stockholders, and employees. Clients who at the beginning were loyal even when experiencing long service time and brusque treatment no longer regard that as acceptable. Suppliers who previously were able to wait on delayed payments now have their own policies on collecting and prefer to abandon customers who are difficult to work with. Shareholders are the same, requiring rate of returns that are more and more competitive and compatible with their increasing targets. Employees are also more aware that they are the key to a bank’s successes, and expect competitive remuneration and good treatment from their employing bank. If not, the threat of their alternative choice is clear; it is better for them to resign and work for a more “caring” institution.

204 RISK MANAGEMENT IN ISLAMIC BANKING The bank’s management cannot underestimate any part of this possi- ble chain of events. One of the ways to keep up with the changes that are happening is by ensuring that information is always being shared and sent around, symmetrically instead of just top-down. There are many communi- cation methods that can be used nowadays, including ensuring that the firm has a working intranet, electronic forums, e-mail, social network sites, and the like. The better-distributed information is, the better an Islamic bank can prepare for and manage any behavior changes in the bank’s various stakeholders. ISSUES RELATED TO STRATEGIC RISK After understanding the taxonomy of strategic risk, which might happen, some strategic issues in Islamic banks should also be considered. Those issues are related to strategic risk, especially in Islamic banks. Those strategies are unhealthy competition among Islamic banks, synergies between Islamic finan- cial institutions and systemic risk, interconnection between Islamic financial institutions and systemic risk, specialization between Islamic banks, and reputational risk in Islamic banks. Unhealthy Competition among Islamic Banks Competition ensures that different banks will be motivated to provide the best service they can possibly do. If there were only one Islamic bank, one can easily imagine how exclusive the bank would be. It would have no bench- mark for comparison and no competitors. Yet Islam advises us to look up to better peers when we feel proud of ourselves so we are reminded that there is still room for improvement; and to look to those less fortunate than us when we feel down, to remind us to be thankful with what we have and what we’ve achieved, without making us feel self-satisfied about what we’ve reached. Yet even if it carries the name of Islam, in practice the business com- petition in the Islamic banking industry in some countries has begun to demonstrate unhealthy patterns. The share of syari’ah banking out of the total banking market share is still very small relative to the total national banking market, and yet it has already been fought over by many players. The effect is tragic: cannibalism of key employees, prime depositors, and even debtors among Islamic banks has occurred. To minimize this, it is best for the Islamic bank to start considering ways to compete that are healthier and more sophisticated that what is practiced now. Many researches have begun to show that diversification is not a strategy that can be followed too extensively. Focus is then the action recommended by those researches.

Strategic Risk 205 For that, it is time that Islamic banks begin to focus on particular con- tracts or certain industries that it is the best at providing. Focus improves the ease with which the Islamic bank can innovate, either in product inno- vation or research and development, as well as trying to find more efficient ways of achieving the same results as current business processes. Focusing on more specific consumer segments also allows the bank to provide a more excellent service for them, as well as benefiting the wider society. At the same time, the Islamic bank should be sensitive to which industries and fields are facing stiff competition and which ones are relatively sparse in competitors. If this is done, the potential for friction and unhealthy competition can also be avoided. Even if competition still happened, we would return to the initial idea of how it is the natural order of things, and can easily lead to success or failure. In entering competition, it is important to keep in mind a sense of fairness, justice, and strong ethics, rather than elimination at all costs. Competition can be directed into a positive drive to motivate the Islamic bank to aim for continuous improvement of services to its clients, both debtors and depos- itors. This will also challenge the bank’s resource management to be more focused and efficient—to gain the most yields for the least expenditure. Synergies between Islamic Financial Institutions versus Systemic Risk As a financial institution, the Islamic bank is one of the most important parts of the entire Islamic financial system. To build a strong Islamic financial sys- tem, a high degree of synergy between various Islamic financial institutions is necessary, both for Islamic banks and non-bank Islamic financial institu- tions. With this synergy, the system as a whole can become more productive and beneficial, increasing high-quality syari’ah financial services as well as boosting the rate of growth of each category of Islamic financial institutions. The synergy between Islamic financial institutions meant that every Islamic financial institution, both bank and non-bank, performs its respective roles and function to the best extent possible, without cannibalizing customers due to similar, barely differentiated Islamic financial services products. As an example, an Islamic bank has a different function from Islamic insurance, even when both are financial intermediaries. The Islamic bank should focus in its core business process of collecting funds from the public in the form of savings and deposits, which are then channeled out again to the public in the form of financing contracts. Islamic insurance, on the other hand, has a core business of providing risk-sharing services to the public. One of the other forms of synergy between Islamic financial institutions is the development of cooperation between Islamic financial institutions.

206 RISK MANAGEMENT IN ISLAMIC BANKING In many developing countries, the percentage of the public with access to financial and banking services is very limited. Many factors contributed to that, one of which is an inadequate Islamic financial infrastructure (includ- ing banks) that does not reach the furthest edges of civilization. To provide Islamic banking service even to the remote villages, the Islamic bank needs to prepare various supporting infrastructures, which often have a significant cost. This issue can usually be settled if the Islamic bank has a tight, mutu- ally beneficial cooperation with microlevel Islamic financial institutions like baitul maal wa tamwil (BMT) as well as Islamic cooperatives. One of the biggest issues faced by micro Islamic financial institutions such as BMT is a lack of adequate funding and competent human resources. The Islamic bank is well funded, compared to the BMT, by several orders of magnitude, with human resources that are well trained and a far cry from those of the BMT. Thus, to improve the reach of Islamic financial services to remote villages, the Islamic bank can channel its funds through BMT and then assist the BMT to help it improve the competence of its people. With the cooperation between the two parties, the Islamic banking and financial ser- vices will be more widely available, and growth in Islamic financial services would also accelerate. Specialization between Islamic Banks Compared to conventional banks, Islamic banks have a higher business vari- ation. Though conventional banks have a wide array of products and ser- vices, the essences of those products are few: deposits, loans, and banking services. In an Islamic bank, the schemes of the products and services offered can vary extensively, including not only deposits and loans, but also invest- ments, sales, and the like. Unfortunately, this extensive potential for varia- tion is rather neglected by the Islamic bank itself. The Islamic bank tends to imitate the business process of conventional banks by forcing the characteris- tics of many transaction contracts to imitate a loan contract. As an example, the basic principle of the mudharabah contract is an investment contract, where the fund owner provides 100 percent of the funds an entrepreneur requires to be managed in a business. At the time of maturity, the managed funds are valuated, and if the amount is larger than the initial capital, the excess is divided between the investor and the entrepreneur according to the proportion agreed upon at the beginning. The business process of the mud- harabah contract is not adopted entirely. The type of mudharabah contract used in many Islamic banks is one that has been modified in such a way that it is very similar to a loan. Entrepreneurs that receives financing will have to return the capital in installments and divide their profits periodically; thus the contract loses its mudharabah essence. Among other contracts, a sim- ilar condition occurs in which the real benefit of the various contracts in

Strategic Risk 207 fiqhmu’amalah disappears. In the end, many members of the public consider Islamic banks to be no different from conventional banks. The variety of business models available to the Islamic bank have provided it with a lot of options for determining its own business model. This variety should’ve easily been leveraged into a competitive advantage by the Islamic bank. The source of this variety lies in the range of the types of contracts available; among these are various sale contracts (murabahah, istishna’, salam), investment contracts (mudharabah and musyarakah), rent and lease contracts (ijarah), and social-oriented loan contracts (qard- hulhasan). Every type of contract has a different characteristic. As an example, a sale contract and an investment contract have distinctly different characteristics from each other. In a sale contract, the amount of profit that can be gained is fixed in nature, and often exists in the form of a debt after the contract is entered. A sale contract is thus the one that is most often used by the Islamic bank, since it is not too different from the practices of conventional banks. In an investment contract, there are no guarantees on the size of the profit and there is an equal relationship between the Islamic bank and the debtor (partners). Since the characteristics of those two contracts are very different, the Islamic bank should provide adequate resources (human resources, information systems, procedures, etc.) if it is interested in optimizing the use of those two contracts. The investment contract is one with a far higher rate of risk compared to the sale contract, and so the risk prevention and mitigation process in those two contracts will also be different. If the Islamic bank is interested in using these two different types of contracts in their products, then the Islamic bank should allocate enough resources to manage those two types of contracts optimally. The inability of the Islamic bank to utilize the type of contract that is appropriate according to the particular characteristic of the transaction best served by the contract will erase the differentiation and benefit of those con- tracts in the eyes of the real sector. As an example, an investment contract like mudharabah and musyarakah is often modified too far, until it looks so similar to a loan contract that the contract’s distinction disappears and its actual benefit for the real sector is very low. On the one hand, the Islamic bank is interested in using various contracts in its products, but on the other hand, the bank does not have adequate resources to manage the different requirements of each contract. This is where the potential for an Islamic bank to specialize exists. By focusing on only several types of contracts, the bank has the opportunity to develop those contract types optimally. In conventional banks, there is a very different specialization focus between a commercial bank and an investment bank. The Islamic bank can learn the lessons of those specializations, but with the added ability to more directly benefit the real sector. Commercial Islamic banks can focus on contracts with

208 RISK MANAGEMENT IN ISLAMIC BANKING a lower relative risk like sale contracts (i.e., murabahah) with a short matu- rity. Islamic banks interested in entering the agricultural sector can focus on the salam contract and all its variations in its product. Islamic investment banks can focus on investment contracts (i.e., mudharabah and musyarakah) as the basis of the development of their various products. With those special- izations, the Islamic bank will be more able to find the appropriate funding model to finance its various activities. For example, if the Islamic bank is focused on long-term investment contracts, then the deposit product offered to the public should be products based on investment contracts, alleviat- ing any difficulties that may exist due to any mismatch between assets and liabilities. Similar things can be said of an Islamic bank for which the major- ity of its assets are dominated by murabahah-based products. The Islamic bank can finance it with a deposit based on a loan contract or safekeeping contract, as each of them has a relatively low cost of fund. Reputational Risk for Islamic Banks If the Islamic banks are still unable to face the competition under the good standards set before, then the Islamic bank should be wary of another risk following in the heels of strategic risk: reputation risk. Any damage suffered to the bank’s reputation is an indicator that strategic risk has manifested. Reputation risk has the potential to injure not only the bank experiencing it, but also the banking industry in general. The occurrence of this risk will also increase the risk of fund and capital withdrawals from depositors and investors, as well as exposing the industry to higher liquidity risk. If the Islamic bank is aware that it takes years to build a solid repu- tation and mere minutes to destroy it, then the Islamic bank will certainly be more aware and more concerned about this risk. Business of the free- wheeling capitalist style is certainly not appropriate when applied to Islamic banking industry. It does not adequately show just how different the Islamic bank’s positioning is compared to conventional banks. Because of that, the practice of ta’awun (cooperation) between Islamic banks, the focus in fields that it masters, and the spirit of co-opetition rather than pure competition are concepts that many people have been looking forward to realizing in Islamic banks.

10CHAPTER Investment Risk in Islamic Banking The Islamic Financial Services Board (IFSB) states that equity risk invest- ment has the risk originating in capital participation partnership contracts in business or financing activities, where the bank actively bears a part of the risk. The risk meant here is specific to the mudharabah and musyarakah contract. The profile of this risk covers the management track record and business plan quality, the quality of the human resource involved, and the risk evaluation of the contract. In equity investment risk management, IFSB recommends that the Islamic bank own an escrow account used to retain a part of the profit from the investment period with the purpose of stabiliz- ing the business’s profit in the ongoing accounting period. If the partnership involved in the escrow account varies, then the bank should inform the old partner(s) of any additional new partner(s), along with the updated rights and responsibilities of all partners. Another requirement is that all partners are expected to contribute (in the form of capital), where their part of the profit is proportional to their capital contribution. IFSB also states that the bank would need to create an exit strategy, like investment recovery, repu- diation for nonperforming investment, or an alternative exit strategy, where the entire plan should be approved by the syari’ah plan. SYIRKAH AS A DISTINCT TRAIT OF ISLAMIC BANKS Before discussing equity investment issues in syari’ah banks, we will explain why this risk is a distinct character of Islamic banking. One of the char- acteristics differentiating Islamic banks from conventional banks is in the presence of syirkah-based contracts (mudharabah) as one of the contracts used to collect funds, other than wadi’ah, and the use of mudharabah and musyarakah in financing. As a form of investment and financing, mudharabah and musyarakah contracts have yet to be widely adopted by Islamic banks, especially since their risk-exposures are difficult to measure and there has yet to be adequate supervision over these types of contracts. Syirkah means partnership, or the alliance of two or more parties. If modern forms of partnership like limited liability company and joint 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. 209

210 RISK MANAGEMENT IN ISLAMIC BANKING venture have different characteristics, the varying forms of classic syirkah in Islam also have differing characteristics depending on the capital con- tribution involved. Yet it is difficult for classic forms of partnership to develop, since one of their characteristics is that they are nonbinding, and any partner can exit the alliance at any time of their choosing. Another characteristic of the classic partnership is that it will dissolve if one of the partners dies. This characteristic gives a disadvantage to classical forms of partnerships compared to the modern ones, as the classic partnerships are considered to have more risk and be less stable. Out of all the forms of partnership in syari’ah literature, the form of partnership often used in banking is mudharabah (silent partnership) and musyarakah. Mudharabah is the form of partnership composed of the capital owner (shahibul maal) and the entrepreneur (mudharib), both contributing their time and skills. In a musyarakah contract, all the parties contribute both in the form of capital as well as its management. Unlike an ijarah contract, where someone may be in the position of managing wealth but only with the status of a paid worker (expenses for the firm), the mudharib has the rights to a portion of the business’s profits, including dividends. Mudharib is also different from representatives in an agency (wakalah) contract, where the representative is paid according to the fee in the management contract, and the contract is not tied to the length of the business’s life. In Islamic banking, mudharabah is used both to collect funds, as well as for financing, while musyarakah is more often used in financing. This is because in a musyarakah contract, the bank can control the daily performance of the debtor better. The unique characteristic of this syirkah-based contract contributes to the uniqueness of the Islamic bank’s balance sheet compared to conventional banks. In an Islamic bank, the balance sheet consists of four components: assets, liabilities, temporary syirkah funds, and equity. The account group of temporary syirkah funds collecting sources of funds in the form of syirkah contracts—usually mudharabah and musyarakah—is situated between the account groups of liabilities and equity. Why is this so? This is because funds collected through a syirkah contract do not have to be returned to the investor if the Islamic bank, as the fund manager, experiences business loss that is not caused by its negligence. Thus, the syirkah fund cannot be included among the liabilities. On the other hand, this category also cannot be included in equity, because the investors of a syirkah contract do not gain the right to vote on the direction of the firm the way shareholders can. BASIC CONCEPT OF INVESTMENT RISK In a conventional bank, investment risk is defined as a risk that can result in the failure of an investment, related to reputation risk, market risk, credit

Investment Risk in Islamic Banking 211 risk, and operational risk. The four risks contribute to the failure of an investment, whatever the form—both direct investments and in the stock market. Investment risk is a broad term whose indicator can be seen from the risk exposures other than the four key risks listed: counterparty risk, strate- gic risk, and country risk also plays a role in the failure of an investment. But in contemporary practice, investment risk is often reduced to investment risk in the capital market, thus the list of possible mitigation efforts usually begins with forming a low-risk investment portfolio. An Islamic bank, however, uses a wider investment concept than just investment in the capital market. In an Islamic bank, the investment activity can be investment in the capital market, or investment through syirkah-based contract. This definition of investment is wider in investment banks and venture capitals, but in a commercial bank, the syirkah-based contract is used in the asset and liability side, and direct investment seldom occurs except in the form of financing. Investment risk is a unique risk faced by the Islamic bank and caused by a syirkah-based contract such as mudharabah and musyarakah. Conventional banks will not face this risk because they lack a profit-sharing contract. Because of this, in this section we will dis- cuss the risks concerning syirkah contracts. Even when it intersects with syirkah-based contracts, there must be some differentiation between invest- ment risk in this part and other risks that also occur in syirkah-based con- tracts, discussed elsewhere in this book. If a syirkah-based contract is used in some of the liabilities of the Islamic bank, then the main risk exposure will originate from displaced commercial risk. This is the condition in which the bank experiences loss or loses profit trying to retain their depositor’s funds. This risk is related with the move- ment of the benchmark return/interest rate, which will affect the interest rate of other banks, thus affecting the Islamic bank’s relative competitive position. This terminology is still new in banking risk literature, and is usu- ally only applicable to a country using the dual banking system. This risk is faced by Islamic banks concerned that their depositors will relocate their funds to other banks due to the fluctuations in the profit that they share. This risk occurs, among other reasons, due to changes in the behavior of an Islamic bank’s depositor and changes in the Islamic bank’s expected rate of return. These changes in expectation can be caused by internal factors, like the reduction in an Islamic bank’s asset value, and/or external factors, like the rise in the return offered by other banks. Changes in expected rate of return can trigger the movement of funds into other banks. Moreover, there has been a significant case of displaced commercial risk experienced by the International Islamic Bank for Investment and Devel- opment, an Egyptian bank. From the middle to the end of the 1980s, they gave up 100 percent of their return to their depositors; not a penny of their

212 RISK MANAGEMENT IN ISLAMIC BANKING profit is one they experienced personally. This also meant that no part of the profit was experienced by their shareholders. Even more distinctive, in 1988 the bank distributed profit that was larger than the amount they actually had; they claimed the difference as loss carried forward. Other issues on the fund-collecting side emerged due to the lack of appropriate treatment for syirkah contract on asset, related to the risk, competition with other banks, and syari’ah compliance aspects. If a syirkah-based contract is used on the part of asset, then there will be issues related to the counterparty risk, as experienced by credit in conven- tional banks. If there are any large-scale losses due to the counterparty’s inability to pay the installments, then the counterparty risk will lead to default risk. Other risks involved are market risks related to the influence of market movement on the position of an asset or commodity, where the asset/commodity is the capital off a syirkah-based contract. If on the side of asset and liabilities the Islamic bank uses a syirkah-based contract, then the bank’s business process will be similar to the classic part- nership form, in which each partner will receive profit based on the capital contribution. But what happens in Islamic banks nowadays is far more com- plicated. Islamic banks use investment schemes in fund collection and sale financing (murabahah) that are similar to credit (debt-based) in channeling funds. Thus, income from assets is constant and periodical, while the amount of profit available for depositors is variable. If there is any mismatch of liq- uidity, maturity, or rate between the two sides, then the bank will be exposed to rate-of-return risk. Profit Sharing and Exposure to Investment Risk Equity-based instruments are different from debt based instruments in several aspects: (1) there is incentive for the capital owner to monitor the individual and company, (2) there is risk sharing, and (3) there is no absolute obligation to repay the investor when the firm encounters difficulties, while repayment is unavoidable in debt, and the debtors inability to pay the debt will end in insolvency. The profit-sharing mechanism for common stock and syirkah-based contract relies on the performance of the issuing company (issuer’s return). The firm’s return variability is also a proxy of the firm’s busi- ness risk, and is divided proportionally between the firm and its investors. Because of this, it is important for the investor not only to examine the per- formance of the business, but also to maintain regular supervision over it to avoid loss. In aggregate, control over a business partner can increase market discipline, while market discipline is one of the factors that is weak in a debt-based system. If risk is also represented in return variability, then fluctu- ation in return will be divided proportionally and symmetrically; thus it can

Investment Risk in Islamic Banking 213 be said that risk sharing is present in this mechanism. The Islamic bank—as the investor—also bears the risk of a loss experienced by the entrepreneur that it financed. Thus if the debtor-entrepreneur experiences business difficulties or even bankruptcy due to factors that cannot be reasonably considered to be within his or her purview and no negligence is involved, then the principal investment channeled by the bank cannot be regained. Islamic banking has long espoused the virtues of its profit–loss sharing mechanism and equity financing as an ideal method to increase market sta- bility, due to risk-sharing increasing the incentive to control asset manage- ment and fund collection, and this profit–loss sharing mechanism is one of the most distinct aspects of the Islamic bank compared to the conventional one. In practice, a syirkah-based contract with a profit–loss sharing mech- anism still faces many obstacles that will result in investment risk. Profit sharing is highly related to investment performance, and thus investment risk in an Islamic bank can be defined as the risk related to syirkah-based investment and equity-based instruments. Investment risk is tightly related to other risks. Investment risk can occur due to operational risk that can occur due to human error, both from vari- ous types of fraud and/or from negligence. For example, due to the lack of information in an Islamic bank’s financing committee, a mistake occurred in debtor selection. A debtor that is untrustworthy or unprofessional may be chosen to receive financing in the form of a mudharabah or musyarakah contract. If these types of debtors are chosen and they are still untrustwor- thy or unprofessional, then there is a possibility that moral hazard can arise from them and/or mismanagement of their business. This will result in the business not performing to its full success potential. Another related risk to this is reputation risk. The constantly decreasing return distribution or even loss will have to be covered by the part of the profit that should have been the right of the bank’s own shareholders, just to prevent this reputation risk from occurring. If the Islamic bank is not transparent enough in present- ing its financial report, this can also reduce the reputation of the Islamic bank as an institution with good corporate governance, not to mention the possibility of the reputation risk suffered by Islamic banks. If the reputa- tion of an Islamic bank is questionable, after a while, this will result in the withdrawal of funds by depositors because they decide to migrate to other Islamic banks. However, it must also be understood that withdrawal risk does not singularly rely on not having enough transparency on the Islamic bank’s part. This risk can also be caused by other reputation risks, such as if there are any inefficiencies in the Islamic bank’s operations, the services offered are not comprehensive enough, there is a lack of IT and e-banking support, there is a lack of syari’ah compliance, and the like. Exposures to these risks will leave the Islamic bank open to liquidity risk.

214 RISK MANAGEMENT IN ISLAMIC BANKING Investment risk in an Islamic bank is ideally borne together between the debtor, bank, and the depositor investing their funds based on the mud- harabah contract, but it is rarely so in practice. Other factors contribute to this deviation, among them: (1) investor and debtor understanding of the investment risks of a syirkah-based contract are still significantly influenced by conventional perspective, requiring the banks to modify syirkah contracts to emulate familiar aspects of conventional products; (2) the issues of moral hazard, adverse selection, principal-agency problem and the high cost of information and control in financing erodes the bank’s incentive to use a syirkah contract; and (3) there are not enough supporting elements (regula- tions, market, instrument) for the development of syirkah-based contract. Investment and financing risk is affected by information. While access to information is not widespread and even, not everyone can gain advantage from it. The opposite is also true: If there were no such thing as information asymmetry, then intermediaries would not be needed in the financial indus- try, and thus would not exist. Of course, information-based decision making has a cost. In order to handle investment risk in syirkah-based contracts, the regulators in both the government and the financial industry have the task of providing information in ways that are more accessible and widespread, making it more publicly available. Information accessibility reduces infor- mation asymmetry, thus reducing the barriers to entry for direct investment through mudharabah and musyarakah as well as increasing the proportion of investment in equity. No matter how ideal the profit-sharing mechanism is, the banking industry is still reluctant to adopt the scheme on a wider scale because in practice the shahibul maal does not have the ability to access most of the information relevant to a business’ performance. Asymmetric information becomes one of the barriers to the development of mudharabah contracts. The mudharib as the entrepreneur can also report a lower profit than is actually gained in order to reduce the amount of profit shared with the investor. This pervasive presence of moral hazard is one of the main issues of syari’ah-based contracts, in which the entrepreneur or other parties involved have the incentive to violate the agreement or act in ways that are detrimen- tal to its interests. As for the issue of moral hazard, it is not unique to the Islamic banking industry, as it also exists between shareholders and man- agers in conventional companies. The presence of syari’ah principles held by the debtor, depositor, and the Islamic bank opens up the possibility of a trust and control mechanism based on Islamic norms, thus reducing monitoring costs, but in societies that have yet to be educated in these principles and do not yet practice them extensively, the creation of contracts with compatible incentives for clients as well as the Islamic bank should be a priority for the parties involved.

Investment Risk in Islamic Banking 215 Rate-of-Return Risk in Syirkah-Based Investments The spirit that is thus far built in the financial industry is the spirit of the zero-sum game, where the profit of the depositor is a loss for the bank, and the bank’s losses are borne by itself, not transferred to its depositors and investors due to risk transfer. The financing client, on the other hand, has it even worse when lending rates rise, while financing clients on the macroeco- nomic level represents the real economy. The philosophical question that can be raised here is: If it is assumed that the spirit built in the financial indus- try is the spirit of the zero-sum game, where it is to be expected that the profit of one party comes at the expense of the other, then what will moti- vate the losing party to continue to play, except desperation? In the reverse case, where there is symmetrical risk and return borne by both parties, then the system is closer to the case of cooperative games, open to win–win solu- tions, providing ample motivation for active participation of all parties as well as increasing the odds of generating return from the cooperation. Which is more efficient under that situation: the spirit of zero-sum games or cooper- ative games? Theoretically, this is one of the benefits of risk-return linearity between the shahibul maal and the mudharib. But the ideal and theoretical benefit of syirkah-based contracts is not necessarily experienced optimally by the Islamic banking industry or the general public. There is still a large gap in the application of syirkah-based contracts from the theory, as Islamic banks are still reluctant to use profit-sharing contracts and dominantly pre- fer the murabahah (mark-up sale) contract, as it provides a fixed margin. Many factors contribute to the inadequate industry participation of syirkah contracts; among these factors are Islamic banking practitioners with a con- ventional banking mindset, and the lack of markets that would enable trust and transparency to be built over the flow of open information. The limited use of profit–loss sharing contracts in Islamic banking is rooted in issues of information asymmetry and potential fiduciary risk stemming from the mudharib’s discretionary power (Kahn 1985; Haque dan Mirakhor 1986; Bashir 1996; Bashir 2001; Al-Jarhi 2004). This issue of information asymmetry increases the cost of information acquisition, caus- ing the contract to be ineffective for the bank due to high screening and mon- itoring costs (Bacha 1997). In these cases, the bank faces difficulties due to its limited information about the actual return of the investment (Williamson 1986). Return in syirkah-based contracts is one of the important issues, as Islamic banking will face various risks stemming from return, like fluctuating return, moral hazard, asymmetric information, principal-agency problem, lemon market in syirkah-based contracts, cash flow sensitivity, and over-investment problems. Debt-based instruments are considered to be superior compared to syirkah-based instruments due to the sense of security generated by

216 RISK MANAGEMENT IN ISLAMIC BANKING the obligation on paying debt (which is the bank’s return) periodically, something absent from syirkah contracts. On the theory side, presenting this disadvantage of return certainty does not disturb the foundations of Islamic finance, as its principle on return is that it cannot be guaranteed and as such should not be guaranteed. Yet in practice, the uncertainty over return and the general perspective on investment risk caused many financial institutions to avoid as well as reduce investment risk in ways that may be efficient for individual institutions, but not efficient on the larger scale of the whole economic system, instead of accepting that risk is a trade-off from return. This issue causes syirkah-based contracts to be underutilized on the bank’s asset side compared to the murabahah contract dominant in commercial banks as a replacement to conventional credit. FORMS OF RISK AND THEIR MITIGATION This section will discuss types of investment risks and the procedures to mitigate them. This mitigation will become easier if there is analysis of the investment contracts. In general, the type of investment risk faced by Islamic bank happens in mudharabah and musyarakah contracts. Investment Risk in Mudharabah There are several distinct characteristics of mudharabah that differentiate it from other syirkah contracts (Khalil, Rickwood and Murinde 2008): idiosyncratic uncertainty (risk), extreme linearity, and discretionary power. For the bank, a profit-sharing contract presents uncertainty in return, where the return is only reliant on future cash flow reported from operating profitability. Profitability is definitely determined only by the entrepreneur’s investment decisions and the management of assets and liability, because in this contract, the bank is a silent partner. The performance of the entrepreneur and how the performance is able to generate profitability are selection issues faced by banks pre-mudharabah contract. While during the contract, in several cases, the bank cannot manage the assets in a mudharabah contract and cannot mortgage the assets either. The second characteristic is the extreme linearity of the return generated by the project, where the rates-of-return for the investor and entrepreneur are directly proportional to the revenue generated by the project. This linear- ity is an efficient method in dividing the risk contained in the contract, yet the proportion of the return to be received by the shahibul maal is highly reliant on the entrepreneur’s skill and trustworthiness. These factors are difficult for the bank to assess without periodical monitoring, and only the

Investment Risk in Islamic Banking 217 agent (entrepreneur) has the knowledge of the actual return distribution of the project. The third characteristic is the entrepreneur’s discretionary power. The agent or entrepreneur has the right to control the project and to make various investment- and cashflow-related decisions. Complete control over assets and the return generated without having to suffer for financial loss places the entrepreneur in a mudharabah contract in a different position from a CEO in a contemporary company, where the CEO can be replaced and questioned by the shareholders using their voting rights. In a financing contract, mudharabah is a partnership contract between the bank as investor/fund owner (shahibul maal) and the debtor as the fund manager/entrepreneur (mudharib). The debtor is responsible for managing the funds entrusted in a syari’ah-compliant business. In this contract and other syirkah-type contracts, the profits are divided based on the agreed- upon proportion (nisbah), and any mistake not ascribable to the manager’s negligence will be divided based on the proportion of capital invested. The agreed-upon profit-sharing ratio should be included in the contract. If at the time of the contract there is no agreed-upon ratio, then the ratio used refers to current commonly used practice. For example, 30 percent or 50 percent or 70 percent of the actual profit received is allocated to the bank, and the 70 percent or 50 percent or 30 percent remaining is for the debtor. If no general practice ratio is acceptable, the mudharabah contract is voided and the debtor has the right to receive wages according to prevailing standards in the market. Moreover, since in a mudharabah contract the entire business’s capital belongs to the bank, any loss occurring would be borne 100 percent by the bank. On the other hand, the debtor bears loss in the form of time, energy, and fruitless enterprise. Fiqh-wise, there are no limitations on the possible number of investor possible in the business. An Islamic bank can enter a syndication with another bank to channel mudharabah-based financing. This also applies in collecting funds invested into a mudharabah contract. There are no limits on the number of investors/depositors the bank can collect funds from in the position of the mudharib, as long as the bank is still able to manage it. In Islam, returning the bank’s principal capital can only be guaranteed if the capital is whole and is not eroded by losses. The debtor is also not obligated to cover genuine operational losses and to return the capital in its entirety, except under two conditions: (1) the debtor is negligent in managing the funds, for which indicators of this must be agreed upon at the beginning of contract, and (2) the debtor violates the mudharabah contract’s agree- ment. Profit-sharing can only be done if the capital is still whole, while the calculation of profit-sharing cannot be based on (1) expected operating profits, (2) principal capital invested in the debtor by the bank, or (3) a fixed

218 RISK MANAGEMENT IN ISLAMIC BANKING nominal. For example, a bank channels IDR100 million to the debtor and requests a monthly share of profit of 10 percent of the capital invested, which is IDR10 million. This is prohibited for an Islamic bank, since this is an actual example of nasi’ah usury unlawful and prohibited in Islam. What is lawful is to divide profit according to an agreed-upon ratio (nisbah). The Islamic bank can guarantee the capital returned whole only under condi- tions of debtor negligence, using third-party guarantee (kafalah) as well as collateral (rahn). Mudharabah contracts are used on the asset and financing sides of an Islamic bank’s balance sheet to both collect and channel funds (Table 10.1). On the fund collecting side, mudharabah contract is used in unrestricted profit sharing investment accounts (PSIA), also called mudharabah mut- laqah. The grey highlight shows that PSIA is safeguarded by the profit TABLE 10.1 The Source and Use of Funds in an Islamic Bank and a Conventional Bank Islamic Banks Conventional Banks Sources of Funds (Liabilities) Current Accounts Current Accounts Tier 1: Shareholder’s Equity (Equity) Saving Accounts Interest-Based Saving Accounts Tier 1: Shareholder’s Equity Time and Certificates of Deposits Tier 2: Capital (Subordinated Loans) (Common Equity) Reserves Unrestricted Profit Sharing Placement of Cash and Marketable Investment Accounts (PSIAs) Securities in Other Bank Profit Equalization Reserves (PER) Loans Investment Risk Reserve (IRR) Mortgages Financial Leases Uses of Funds (Assets) Investment in Real Estate Placement of Cash and Marketable Securities Securities in Other Bank Sales Receivables Murabahah, Salam, Istishna’ Investment Securities Musyarakah Financing Mudharabah Financing Investment in Real Estate Investment in Leased Asset Inventories (Including Goods for Murabahah ) Reserves

Investment Risk in Islamic Banking 219 equalization reserve (PER) and the investment risk reserve (IRR) since it is of a higher priority, though shareholder’s equity is higher still than PSIA. Unlike conventional banks whose sources of funds are secured by Tier 1 (shareholder’s equity) and Tier 2 (subordinated loan) capital, PSIA in an Islamic bank theoretically cannot be protected unless there are losses suffered due to bank negligence (fiduciary risk). Thus if the PSIA holders’ return decreases, the bank will use PER and IRR to stabilize return, and the backup from shareholder’s equity can only be used if there is proof of the bank’s negligence in managing funds contributing to losses suffered. The following is the mudharabah investment scheme, as financing and the settlement can be seen in Figure 10.1. Description: (1a) The bank channels Rp100 million as mudharabah capital. The financ- ing will end on December 17, 2012. The agreed-upon profit-sharing ratio between the bank and the client is 40 percent to 60 percent. (1b) The debtor presents a land certificate valued around Rp100 million as collateral to the bank in case of negligence or fraud. The certificate is a collateral, and this is one of the methods of risk mitigation. (2a) The debtor gains operating profit of Rp10 million and gives the bank its share of profit (40 percent × Rp10 million = Rp4 million) along with 17/12/2012: Debtor suffers loss due to force major factors (3b) (3a) Islamic Bank (1a) Debtor 17/08/2012 (3b) and (3c) 24/06/2012 (1b) (2a) 17/12/2012: Debtor makes profit Bank liquidates land (2b) with permission from (4a) debtor, sold at price (4d) Rp125 millions 17/12/2012: Debtor suffers loss due to negligence FIGURE 10.1 An Illustration of a Mudharabah Contract as Financing

220 RISK MANAGEMENT IN ISLAMIC BANKING the principal capital (Rp100 million) → Operational risk is present due to the possibility of fraud as well as mistakes in decisionmaking. (2b) The bank returns the land certificate to the debtor. (3a) The debtor experiences a loss of Rp15 million due to force majeur. Because of this, the bank bears the Rp15 million. → Investment risk occurs. (3b) Bank returns the land certificate to the debtor. (4a) The debtor experiences a loss of Rp80 million due to personal negli- gence; the debtor allows and the bank has the right to liquidate the collateral. → Fiduciary risk occurs. (4b) and (4c) The bank retrieves its principal capital (Rp100 million) from the liquidation proceeds and returns the rest to the debtor. (4d) The debtor receives Rp25 million in excess of collateral liquidation after returning the amount of the bank’s mudharabah principal capital. Even if the syari’ah-compliance of its use is still debated, rahn (collateral) can still be one of the methods used to mitigate investment risk in a mud- harabah contract, and provides the means of recovering the capital of an Islamic bank’s shareholder’s equity. This is only allowed if it can be proven that the loss suffered is due to mudharib negligence. The presence of syirkah-based contracts contributes to the difference between Islamic bank products and those of conventional banks, even if the contract is of the same asset class. In Figure 10.1, it can be seen that all sources of funds in a conventional bank (savings account, time deposit) are fixed rate in nature (including the short-term ones), while the Islamic bank’s source of funds has a floating rate. On the other hand, the use of cash in a conventional bank is almost entirely floating and repriceable while the use of cash in a syari’ah bank is fixed (except for ijarah and syirkah-based invest- ments). This creates a difference in the management of risk in an Islamic bank compared to conventional banks. For example, syari’ah principles pro- hibit a PSIA contract guaranteed by shareholder’s equity, because by prin- ciple, the return of a syirkah-based contract tracks the performance of the enterprise it is invested in, and if any honest operational loss occurred, the mudharib is not responsible in covering it without proof of negligence. In a conventional bank, deposits are safeguarded by shareholder’s equity and by subordinate loan. Investment Risk in a Musyarakah Contract Musyarakah is one of the forms of syirkah-based contracts used for medium and long-term investments. In this contract, both partners invest their cap- ital and also manage the business together, combining capital investment

Investment Risk in Islamic Banking 221 and business management. Musyarakah is a form of partnership where two or more people combine their capital, sharing profit and loss and bearing the same rights and responsibilities over the business or according to their mutual agreement. For example, it may be agreed upon beforehand that a partner recognized to be more talented in starting businesses will con- tribute more effort than others. In Islamic banking, unlike mudharabah, the musyarakah contract is one of cooperation between the bank and the debtor in which each party invests his or her capital in a mutually managed enter- prise. If mudharabah is used in a depository context, musyarakah is only used as the funding source of a real partnership. The profit realized in a musyarakah investment is divided according to the proportion of capital, or at some other previously agreed-upon ratio. A difference in the profit-sharing ratio compared to the invested capital ratio can occur if the partners manage the business in differing degrees of involve- ment and intensity. If a partner decides not to play a significant role in the day-to-day affairs of the business, then the portion of profit allocated to that partner cannot exceed the ratio of the capital actually invested. If any loss occurred, then it is shared according to each investor’s portion of capital contribution. Moreover, the easiest and most common musyarakah capital used is cash, but capital investment in other asset forms is still allowed by the majority of contemporary ulama, as long as it is possible to determine the fair market value. The musyarakah capital contributed by each partner is merged into the business’s capital. The implication of this is that individual ownership will transform into mutual ownership. Thus, any increase over the musyarakah asset will increase the capital of partners according to their agreed-upon ratio. Do issues of asymmetric information in management settled in a musyarakah contract come up, due to the active involvement of both parties in the business? Yes. The issue of moral hazard due to asymmetric information can be overcome, since theoretically the bank is involved in the project’s management. Yet this does not mean that the cost of monitoring and control is then reduced. Musyarakah also faces the same risk as other syirkah-based contracts; it faces investment risk due to the return generated being lower than what was expected. Basel III Recognition of Investment Risk in Syirkah-Based Contracts As a realization of prudential banking, Basel III has discussed in detail the recognition of investment risk, especially through calculation of risk- weighted asset. Moreover, Basel III also provides monitoring instruments and mitigation of investment risk through countercyclical and capital conservation buffers.

222 RISK MANAGEMENT IN ISLAMIC BANKING Calculation of Risk-Weighted Asset In Basel III, the calculation of reserve cap- ital is revised again and returns its emphasis on Tier 1 capital, consisting of ordinary stock and retained earning. Tier 2 capital, which had been allowed to be 100 percent of Tier 1, is now limited to 50 percent of Tier 1, while any- thing categorized as unrealized gain will be monitored. Tier 3 is completely removed. How does this affect Islamic banking? There is no direct influence on Islamic banks, since Islam has never allowed usury-based transactions in the first place. Islamic banks from the beginning have only had Tier 1 capital; even if there is Tier 2 capital, it cannot be more than Tier 1 capital. Indirectly, this change will affect conventional banks that now must adjust the calculation of their capital reserve to only their own capital (Tier 1). The effect of this adjustment is the change in relative competitiveness of Islamic banks to conventional banks, compared to before the change occurred. If a bank is considered to be risky, then its capital reserve must be sizeable to cover for the risks it faced. In Islamic banking, the process of calculating the capital adequacy ratio (CAR) is still problematic, since several types of product (like PSIAs) have yet to be appropriately classified, whether into the bank’s trading book or bank book, as has been stipulated for conventional banks. The mudharabah contract on the bank’s liability side, PSIA, cannot be considered as equity capital. Even though the PSIA’s risk is not borne by the bank but directly held by the account holder, the PSIA cannot be included in equity capital. The effect on the whole risk calculation process is in the calculation of the CAR, where the Basel Committee on Banking Supervision (BCBS) and Basel III state that CAR should exceed 8 percent. IFSB formulates CAR as follows: CAR = Regulatory Capital Total Risk Weighted Asset (CR + MR + OR) − RWA Funded by Restricted PSIA (CR + MR) − (1 − ������) Risk Weighted Asset Funded by unrestricted PSIA × (CR + MR) − ������ (Risk Weighted Asset Funded by PER and IRR of Unrestricted PSIA)(CR + MR) Description: CR: Credit Risk MR: Market Risk OR: Operational Risk Source: IFSB

Investment Risk in Islamic Banking 223 The effect of including PSIA in the capital adequacy calculation is that it reduces the ������ (alpha) of the risk-weighted asset (RWA), with unrestricted PSIA as part of the denominator, and is adjusted with the RWA from PER and IRR from investment account holder (that will reduce the risk for the bank). IFSB allows the central bank or the banking authority in every country to determine ������ depending on the stability of the nation’s banking and finance system. Countercyclical and Capital Conservation Buffers Basel III has two buffers to anticipate the occurrence of systemic risk; neither was part of Basel II. These are the countercyclical buffer and the capital conservation buffer. A buffer (between 0 percent and 2.5 percent) for countercyclical buffer is applied on assets that are loss-absorbing capital (like common equity), depending on a country’s condition. The purpose of this buffer is to safeguard the banking sector from uncontrolled credit growth. The volume of capital conservation buffer is 2.5 percent of RWA. This buffer should consist of Tier 1 assets or common stock, and if it is inadequate, the bank is not allowed to distribute dividends, plan buybacks, or distribute bonuses, until the 7 percent ratio is fulfilled (4.5 percent common equity and 3.5 percent capital conservation buffer). An Islamic bank is not exempt from those two buffers, though the cal- culation method would need to be adjusted for the presence of IRR and PER. IRR and PER are used to safeguard the bank from displaced commer- cial risk in the PSIA contract. In the calculation of RWAs, as in the above formula, the RWA should be deducted for PSIA before then calculating the buffers’ sizes. If the bank’s profits will have to be retained to fulfill the ratio requirement of the two buffers, the profit cannot be allocated to those two buffers before allocating IRR and PER, because the return allocated for PER and IRR does not come from the profit for the bank’s shareholders, but for the PSIA holders. If the bank is incapable in fulfilling the ratio for those two buffers, the bank is recommended to run plans to bind net income to distribute it to shareholders, like restraining dividend distribution and buy- backs, and not to disturb the portion of return allocated for PER and IRR. In the end, the Islamic bank does need to prepare higher capital reserves than a conventional bank. Identifying Investment Risk in a Syirkah Contract Risk exposure in a syirkah contract occurs at each stage of the process. The following are the contract’s stages and the risk potential that can occur in a syirkah contract. First is the precontract stage. At the beginning before the contract, the bank can misjudge the debtor’s ability to manage the business

224 RISK MANAGEMENT IN ISLAMIC BANKING funded by the bank, due to the issue of asymmetric information leading to adverse selection and the issue of a lemon market. In the precontract stage, good information about potential debtors will be very useful for the bank, but not many banks have complete information on potential debtors, while the expensive cost of information acquisition will burden the bank. The gov- ernment can assist by taking an institutional approach to the data collection process by forming a debtor database and a debtor rating agency. This helps reduce adverse selection from occurring in the screening stage. Second is the contract negotiation stage. The risk potential that can occur in the contract negotiation stage is the moral hazard of the fund man- ager. In a mudharabah contract, the fund manager is the mudharib, with the bank being uninvolved in the business management. In a musyarakah con- tract, the entrepreneur and the bank are both investors in the business. Even so, the potential for abuse of authority and misinformation still exists, with the bank considered as external investor and the entrepreneur the internal investor. Other studies use different terms to specify the difference between the bank and the entrepreneur in the musyarakah scheme. The negotiation stage between the bank and the entrepreneur is related to the profit-sharing proportion, standard operating procedure, and the monitoring of profit dis- tribution and efforts to anticipate fraud. Due to all this, in the negotiation phase, the bank and entrepreneur should design a contract that minimizes all risk without significantly increasing the cost of contract creation. The contract should be thorough and holistic in its consideration of all aspects of business operation, so that no nonharmful act of the entrepreneur will be considered as a breach of contract. The contracts meant here are the main mudharabah contract, as well as any supporting contracts. The supporting contract is the contract used to mitigate risk to help the bank handle invest- ment risk exposure. The last is the contract fulfillment or end stage. The risk that occurs at the end of the contract is market risk, when the asset in the mudharabah financing project must be liquidated. Investment Risk Mitigation Tools in Syirkah Contracts As for the mitigation process for investment risk in shirkah contracts, Islamic banks require many instruments and methods, such as system application of profit to equity issued, providing supporting contracts (rahn, kafalah, tabarru’ fund), post profit sharing audit, incentive compatible contract, using PER and IRR to cover displaced commercial risk, or using systemic and institutional approaches. Profit to Equity Issued Bacha (1997) suggests that profit generated by the business be converted into new equity. In a mudharabah contract, when loss

Investment Risk in Islamic Banking 225 occurs, the bank will bear it, but the entrepreneur reimburses the loss by issuing new equity that will be given to the bank. This can help prevent the entrepreneur from indulging in moral hazard, but it is still reflective and can only be applied in large companies and not small companies, much less MSMEs. Apart from that, there is also the large issue of syari’ah-compliance if the entrepreneur guarantees the bank’s capital. AAOIFI and IFSB state clearly that only a third party has the rights to guarantee capital, not the entrepreneur. Supporting Contracts: Rahn, Kafalah, Tabarru’ Fund A risk mitigation effort that can be done to handle the issue related to potential future moral hazard from the entrepreneur is with collateral (rahn). In Islam, collateral is not a require- ment of a syirkah-based contract, and every loss suffered by the bank due to negligence can be settled by seizing the collateral. Another approach is to use guarantee (kafalah). The entrepreneur is not allowed to become the guaran- tor of the capital in mudharabah, but a third party is allowed to do so. The guarantee can be the mudharabah capital itself, such that in the advent of a proven negligence, the third party can liquidate the capital. But the collateral and guarantee approach is reflective, not preventive. Collateral is certainly a risk-mitigation tool that can be used in a syirkah-based contract, but only in a supporting role. Karim (2000), Khan (2000), and Tegani (2003) state that the entrepreneur can include their capital in the business, not to turn it into the business’s capital, because it would mean changing the contract into musyarakah from mudharabah, but as investment deposit in the form of tabarru’ funds. All these suggested supporting contracts are separate from the mudharabah contract itself. Post Profit Sharing Audit Ahmed (2002) states that to avoid moral hazard, the bank has the right to audit the financial statement and the business pro- cess of the entrepreneur whenever there is a difference between realised and expected profit, since the difference may become the base of profit ratio adjustment in the future. The auditing cost will be borne according to prior agreement, where there will be adjustments or conditional penalties if the entrepreneur is proven honest or dishonest. Incentive-Compatible Contract The design of the mudharabah contract should cover various tools to prevent risk exposure to adverse selection and moral hazard (Table 10.2), with some of the methods already mentioned before. Other than mitigation based on the stages of the contract, investment risk mitigation can also be done by modifying banking products in order to enable the use of syirkah-based contracts in schemes that have managed to reduce moral hazard incentive. One of the cases of the use of incentive

226 RISK MANAGEMENT IN ISLAMIC BANKING TABLE 10.2 Investment Risks and Their Mitigations Risk Factor Risk Mitigation Unobservable Cash Flow 1. Job order short term of mudharabah and musyarakah Uncontrollable Cost Adverse Selection 2. Tabarru’ deposit Moral Hazard (Fiduciary Risk) Post profit sharing audit Expected loss 1. Entrepreneur rating Unexpected Losses from PSIA 2. Guarantor 3. Government’s debtor database Unexpected Losses from Financed Syirkah 1. Revenue sharing 2. Collateral Market Movement 3. Kafalah Unexpected Losses due to 4. Legal action Catastrophic Events Provisions of income 1. PER 2. IRR 1. IRR 2. Capital Diversification of portfolio investment Takaful compatible contract is in Karim (2000) in the case study of an Indonesian bank. In the study, Karim states that incentive compatible contracts can help overcome the issues of unobservable cash flow, adverse selection, and moral hazard. An example of an incentive compatible contract is as follows: entrepreneur X is a supplier of company Z, and requires business capital (to pay for wages, to purchase raw materials) in order to fulfill Z company’s order for a contract period of two years. For this, entrepreneur X contacts Islamic bank A to join in a mudharabah investment scheme. Islamic bank A runs due diligence on entrepreneur X, checking against debtor database and also with company Z, and finds out that entrepreneur X will receive an almost certain income from company Z due to the order it has placed. Infor- mation from company Z also decreases any doubt Islamic bank A has, and hopefully the issue of adverse selection does not occur again in the screening and selection process of a potential mudharabah-financing partner. After the

Investment Risk in Islamic Banking 227 order is delivered by entrepreneur X during several periods, then company Z pays entrepreneur X for the order. Entrepreneur X then pays Islamic bank A from the proceeds. With a clear fund purpose (paying wages, purchasing raw materials), then the issue of unobservable cash flow and uncontrollable cost can be overcome. Investment risk due to profit fluctuation also does not occur, since entrepreneur X works according to a clear job order. Finally, the moral hazard potential in entrepreneur X is substantially reduced with the settlement of unobservable cash flow and uncontrollable cost, and company Z can also guarantee (kaafil) entrepreneur X. Using PER and IRR to Cover Displaced Commercial Risk Customers of Islamic banking can be divided into two types: (1) the type who entrusts their money to be safeguarded, or lent out (qardh); and (2) the type who invests their money in a PSI, who is usually called an investment account holder (IAH). Based on their risk appetite, investors of Islamic banking can also be divided into two types, and these are: (1) retail investors locating a secure place to keep their money or to gain stable return, and (2) corporate investors interested in a more aggressive fund management approach in order to gain a high return on their investment. AAOIFI, in Financial Accounting Standard No. 6, states that PSIA is a category between liability and owner’s equity, because holders of PSIA account are not ordinary investors who will receive fixed income, but it is a profit-sharing scheme. But this does not mean that PSIA account holders are akin to ordinary stockholders, as they do not gain voting rights and managerial rights in the bank’s business processes. This unique category requires a different approach, as not all Islamic banks follow AAOIFI standards either. Some Islamic banks place PSIA as liability in a balance sheet, not unlike ordinary debt. Due to PSIA’s uniqueness, the risk implication it carries is also differ- ent from conventional banks. Since holders of PSIA accounts in theory also bear the risk generated by the bank’s asset return variability, the calculation of capital adequacy as well as its credit risk approach is different. However, Sundararajan (2005) found in practice in a cross-country study that there is a particular profit distribution management done by the Islamic banks for PSIA accounts, in which not all of the investment risk faced by the bank is shared with the PSIA investor. In a profit-sharing scheme, it is the Islamic bank’s responsibility to share profit with the investor, but sometimes profit sharing is done because the Islamic bank chooses to provide a profit distribu- tion that is similar to the interest rate, and so it is more accurate to call this profit competition cost (Sundararajan 2005). Profit sharing should follow real economic return, smoothed out with the presence of profit distribution management. Why is this method of profit distribution practiced, making the Islamic bank bear the burden of providing that profit?

228 RISK MANAGEMENT IN ISLAMIC BANKING Sundararajan (2005) found that profit distribution management used by Islamic banks in Brunei, Malaysia, and the United Arab Emirates shows an average asset spread (an indicator of profit distribution management) that is low, while Islamic banks in Bahrain, Indonesia, Pakistan, and Saudi Arabia show a higher ratio. In addition to Sundararajan, Zuobi and Al-Khazali (2007), Taktak et al. (2010), and Farook, Hassan, and Clinch (2012) state that Islamic banks engage in income-smoothing activities to compete with interest-based deposits. Differences in profit distribution management of each bank are also affected by its base country’s regulatory requirement. The regulators’ interest is to reduce the volatility of the Islamic banks’ earnings to ensure the stability of the banking system. In Jordan, Malaysia, and Qatar, the central bank recommends that Islamic banks “manage” PSIA in order to retain their PSIA investors. Farook, Hassan, and Clinch (2012) study factors contributing to profit distribution management in Islamic banks. They found that the factors contributing to the difference in average profit distribution management are the degree of religiosity, sophistication of financial market, asset bank composition, and the presence of discretionary reserves. The market factors affecting it, on the other hand, are familiarity with Islamic banks, market concentration, degree of depositor dependency, and age of Islamic bank. A group sensitive to market movement, for example the market interest rate, dominates the customers of Islamic banks, especially if the bank oper- ates in a competitive environment either against other Islamic banks and conventional banks. This pressure is not only encountered on the demand side, or pressures from the environment the bank operates in, but also on the supply side, which is the bank’s characteristics and its reaction to exter- nal pressure. This pressure especially applies to competition in the category of fund collection products (interest-bearing deposit). Between the two par- ties of investors in an Islamic bank (the shareholder and the PSIA account holder), the shareholder is the party that will receive his or her profit based on asset return movement. Even if the shareholders and the PSIA holders both dislike variability in cash flow, efforts taken to reduce cashflow volatil- ity will affect shareholders and PSIA holders. Potential shareholders will see a bank with fluctuating earnings as less attractive, or as higher risk than others. The bank’s focus is therefore the tradeoff between the expense of profit distribution management and the cost of losing PSIA investors, which will affect banking profit. There are two investors tightly related with an Islamic bank’s profit distribution management, PSIA account holders and shareholders. If the bank lets PSIA investors receive their profit share with- out profit distribution management, then PSIA investors will bear equity risk coming from the bank’s daily operations. The presence of PSIA investors as a party that can absorb risk could tempt the bank to indulge in risky activities

Investment Risk in Islamic Banking 229 and could therefore increase moral hazard. However, if the bank practices profit distribution management, then the bank covers PSIA investors from all equity risk borne by shareholders, including those stemming from daily operations, while PSIA investors should not be immune from those. Due to these demands, the Islamic bank is not exempt from income smoothing efforts. Recently, profit distribution management has practiced by the bank, especially through loan loss provision. The aforementioned literature like Zuobi and Al-Khazali (2007) and Taktak et al. (2010), stud- ies the behavior in which the loan loss provision is used as a function of the bank’s income before it is reserved for loan loss provision. The result of those studies show a positive relationship between revenue and loan loss provision, where when revenue is high, then loan loss provision is high, and when revenue is low, then loan loss provision is low. In Islamic banks, the use of loan loss provision as an income-smoothing device is not too domi- nant, as the Islamic bank has two other tools in its arsenal: PER and IRR. Zuobi and Al-Khazali (2007), in their studies of Gulf Cooperation Council (GCC) countries, concludes that banks use loan loss provision to manage their profit distribution, while Taktak et al. (2010) state that unlike conven- tional banks that use loan loss provision as an income-smoothing method, Islamic banks use PER and IRR. There are several smoothing techniques explained in the technical guide to smoothing published by the IFSB in 2010, to reduce displaced commercial risk, including: 1. Allowing a part or the mudharib’s entire share of profit to be given to PSIA account holders. With this method, Islamic financial institutions vary the percentage of profit that they receive as the mudharib in order to increase the share allocated to PSIA account holders. The mudharib’s profit stated in the contract is the maximum amount the bank can receive, while the actual amount varies. 2. Partially transferring the shareholder’s retained earnings. With this method, the Islamic bank transfers its profit to PSIA account holders based on a gift contract (hibah). This activity should be done with the discretion of the shareholders; by approving it, the shareholders accept the displaced risk the bank would prefer to avoid and it is borne by the shareholders. 3. Profit equalization reserve (PER). Profit should be set aside in the PER before it is distributed to PSIA account holders and shareholders. This way, the size of the PER will be inversely proportional to the profit received by shareholders and PSIA investors, and since the mudharib’s share of profit is residual from those