Risk Management for Islamic Banks Recent Developments

230 RISK MANAGEMENT IN ISLAMIC BANKING of the PSIA investors, then the bank’s share of profit is also automatically reduced. What needs to be observed is that PER is usually used to cover profit decrease for PSIA, but it can also be used to cover for potential dividend reductions too. Thus PER can also be used to smooth dividend payout to shareholders, if the management wishes. There are intergener- ational issues, where the profit generated by investment at year t can be retained and used to cover for decreased return at year t + 1, while it is entirely probable for the investors in t + 1 to consist of different people from investors in t. In practice, PER and IRR are used to cover exposure from displaced commercial risk. To reduce the occurrence of displaced commercial risk, the bank creates policies called PER and IRR. The purpose of the PER and IRR is to prevent erosion of the Islamic bank’s equity, which can arise due to the Islamic bank’s efforts to continue distributing return to IAH customers at a usual rate, no matter their business condition. This practice is usually done by the Islamic bank when the business conditions are slow, and the return received from channeling their assets is down. PER is reserved from total profit before it is allocated to shareholders, IAH customers, and the bank’s share of syirkah profit. IRR is reserved from the profit allocated to IAH customers (after deducting the bank’s share of syirkah profit). PER’s purpose is, more or less, to reduce volatility of syirkah return for IAH customers, while IRR’s purpose is to cover for potential loss that can occur due to losses suffered by the project financed using the funds of the IAH investors. The use of reserves (PER and IRR) has the same benefit as the use of reserve in conventional banks: to smooth shareholder dividend payments. While reserves in a conventional bank are held and acknowledged by shareholders, PSIA investors have no veto rights on the use of PER and IRR. According to Archer and Abdul-Karim (2006), PER and IRR are usually reinvested by the Islamic bank to generate higher potential return for IAH customers. REGULATIONS ON PROFIT DISTRIBUTION MANAGEMENT AAOIFI recommends disclosure and openness in the calculation of PER and IRR, while IFSB publishes a profit-smoothing practices guide for PSIA accounts. Malaysia is one country that has used these practices firmly and consistently, with PER and IRR acknowledged by the Syari’ah Council of Malaysia’s State Bank (Bank Negara Malaysia, or BNM) to ensure no large disparity exists between the return generated by Islamic banks and conventional banks. In Malaysia, the calculation of PER follows several requirements; for example, the maximum accumulated PER cannot exceed

Investment Risk in Islamic Banking 231 30 percent of shareholder’s capital, the monthly maximum transferred to PER cannot exceed 15 percent of gross profit before profit sharing, and its use is not limited to times when the bank experiences reductions in return. Since 2010, PER is no longer recorded as an expense in the income statement, but in a statement of comprehensive amount (balance sheet) in a special section on depositor’s fund. This is because PER is not a general expense. Other than the responsibility to disclose PER, periodical report should also be provided to the BNM to ensure the regulator can monitor any developments in PER management by the Islamic bank. In Singapore, the Monetary Authority of Singapore (MAS), with its “Guidelines on the Application of Banking Regulations to Islamic Banking,” states that PSIA holders are not depositors, and since PSIA is not a deposit, PSIA account holders are not guaranteed. The bank is allowed to offer invest- ment products, with the PSIA included among them, but is not allowed to present it as a deposit. Even if it is not officially in practice yet, syari’ah banks in Indonesia are requested to calculate capital adequacy in order to cover for exposures to rate-of-return risk and investment risk. The two risks are included in the published Bank Indonesia Regulation (Peraturan Bank Indonesia, or PBI) Number 13/23/PBI/2011, “Application of Risk Manage- ment for the General Syari’ah Bank and the Syari’ah Business Unit.” In Pakistan, the regulations pertaining to equity investment risks, espe- cially those related to syirkah contracts, are issued by the Central Bank of Pakistan (CBP). Trading or liquidity risk is covered in the chapter on market risk, while investment risk is discussed in a different chapter, espe- cially in the context of syirkah-based contracts. The guidelines issued by the CBP affirm that partner quality factor, underlying business activities, and operational issues together affect investment risk. The importance of the entrepreneur figure is a consideration in partner selection, and the Islamic bank should be prepared with an exit strategy that can be used when severe issues occur in the investment. There are no specific explanations on the appli- cation of profit distribution management in Pakistan, but the guidelines sug- gest that the Islamic bank should prepare itself for cases of delayed cashflow and varying issues that can arise in the execution of an exit strategy. Even so, Farook, Hassan, and Clinch (2012) state that Pakistan, along with Indone- sia, Bahrain and Saudi Arabia, are countries with higher profit distribution management than Brunei, Malaysia, and the United Arab Emirates.

11CHAPTER Market Risk in Islamic Banking Market risk is any risk that could incur losses in financial institution due to market price movements, which is commonly caused by changes in the prices of equity instrument and trade activities (price risk), currencies (exchange rate risk), quasi-fixed income securities (rate of return risk), and commodities (price risk). The Islamic Financial Services Board’s (IFSB’s) guiding principles define market risk in financial institution as the risk of losses in on- and off-balance sheet positions arising from adverse price movements in market prices—for example, the fluctuations in values in tradable, marketable, or leasable assets and in the off-balance sheet of individual portfolios. Whatever the asset held, the Islamic bank faces market risk when the asset is held until a point before its maturity instead of at its maturity. To be exposed to this risk, the Islamic bank does not have to be involved in an active transaction. It is possible to be exposed even in a passive position, as in the exchange rate risk when the asset owned is denominated in a foreign currency. Market risk can be divided into systematic market risk and nonsystem- atic market risk. Systematic market risk comes from overall movement of prices and policies in the economy, such as currency and market reference rate, while nonsystematic market risk arises from a situation where the price of a specific asset or instrument changes. Market risk affects both the bank- ing book and the trading book. Exchange rate risk and equity price risk affect both books, while commodity price risk, as it is usually placed in the trading book, affects only the trading book. Various market risks arises from different sources, and logically require different treatments. For example, the rise and fall of the rupiah against foreign currencies, the movement of price of shares and sukuk, commodity prices and the real economic value of the assets of Islamic banks—these are all included in market risk, but the risk drivers come from different sources. Several methods are thus needed to mit- igate various sources of risk. As for the case of interest rate risk, it does not directly affect an Islamic bank’s financial position, but is widely used as a benchmark to determine their return. 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. 232

Market Risk in Islamic Banking 233 URGENCY OF MARKET RISK Nowadays, the prevalence of various market risk exposure is inevitable and almost unavoidable for the bank. The proliferation of the Internet has had a multiplier effect on how people conduct financial transactions, in terms of speed of information flow and transaction volume. This is caused by several trends, such as stronger integration between financial markets among countries (stock market and derivatives markets). It enables information and volatility to spread across national borders. This situation amplified the market risk exposure, since financial institutions are more prone to crisis that is systemic. An evolution in banking activities has shifted banks’ traditional inter- mediation function to proprietary trading and market making activities. The treasury operation has three functions: (1) maintenance of bank’s asset liability management, (2) liquidity mismatch, and (3) arbitrary profit oppor- tunity for asset allocation. These functions are performed repetitively in a short-term period, and are not included in the investment portfolio. In a bank, treasury operation is the birthplace of market risk, as the biggest source of market risk is derived from profit-taking aggressive actions, usually through high-risk short-term transactions such as derivatives and stock mar- ket activities. Failure in allocating the fund to the financing side could expose the bank to price risk in real sector activities. For example, financing in the real estate sector through mortgage financing will expose the bank to greater market risk than financing in more stable sectors such as consumer goods. The increase integration of global markets blurs boundaries between financial products even further, generating both risk and the opportunity to gain profit from it. Islamic banking is considered to bear more risk and be less profitable than conventional banks, which is caused by: (1) the lack of an interbank money market; what little was there still significantly lags behind the interbank money market of the conventional banking industry, (2) inad- equate legal framework, with varying opinions and details of any fatwa on banking products, and (3) the lack of syari’ah-compliant hedging instru- ments and methods. These various inadequacies caused the entire risk man- agement approach in Islamic banking to be focused on disciplined reporting and disclosure to the central bank or other local authority in charge. The Islamic bank is expected to practice banking according to standards set by the AAOIFI and IFSB, and to practice multilevel supervision. In the Islamic bank, sensitivity to market risk is measured by market price volatility, at the level of reference rate, exchange rate, commodity prices, and equity value. In facing market risk due to exchange rate and

234 RISK MANAGEMENT IN ISLAMIC BANKING equity value risk, risk measurement using the same approach can be applied to Islamic banks as well as conventional banks, with some basic differences to be considered. For market risk in particular, interest rate as the driver of market risk exposure that’s most dominant in conventional banks does not affect Islamic banks directly, only through mark-up price and displaced commercial risk. Mark-up price can occur if the fixed payment of a murabahah financing is benchmarked against conventional financing relying on the interest rate. If something occurs (for example, the central bank raises the reference risk-free rate), then the conventional bank is able to adjust the rate they charge on financing, while the Islamic bank cannot do it to an ongoing contract. Displaced commercial risk is the situation in which the interest rate of conventional time deposits rise, causing consumers to move from Islamic banks to conventional banks as they expect a higher return. On the other hand, the Islamic bank is directly affected by commodity price risk. Unlike conventional banks, some of the transactions in an Islamic bank (i.e., salam, istishna’, sukuk, and ijarah) mean that an Islamic bank would own commodities in its inventory. The lack of syari’ah-compliant hedging and structured product implies that the Islamic bank cannot minimize risk except by being an active market maker. Other than that, if there are equity investments in the form of musyarakah and mudharabah transactions, where the underlying asset of the transaction involved is a commodity (for trading), then market risk provision is necessary. But even the available commodity market is not liquid enough. Principle 4.1 of IFSB states that to face market risk, Islamic financial institutions should use adequate market risk management framework (including reporting) on all assets, including assets with near nonexistent markets or those exposed to high price volatility. SCOPE OF MARKET RISK IN ISLAMIC BANKS As seen in Figure 11.1, market risk can be categorized into four risks: (1) rate of return (mark-up) or benchmark rate related to market inflation and inter- est rate; (2) commodity price, (3) foreign exchange rate; and (4) equity price, mainly in regards to the equity financing through the PLS modes. Chapter 10, on investment risk, is dedicated to the last point. Rate-of-Return Risk Rate-of-return risk is the risk occurring when there is a mismatch between the yield actually generated by an asset compared to the expected rates.

Market Risk in Islamic Banking 235 Trading Book Banking Book Nondepository financing: Displaced istishna’, ijarah, salam Commercial Client Risk Commodity PSIA Price Risk Bank Depositor Equity Investment in Rate of Financing: Price Risk capital Return murabahah, IMBT market and sukuk Risk Debtor Bank/Other Commodity Companies Price Risk FIGURE 11.1 Market Risk in Islamic Banking Activities This risk naturally occurs when one of the bank’s investments generates underwhelming returns due to shifts in the market. If the rate-of-return risk happens when the benchmark rate is more profitable, it will lead to displaced commercial risk, which will be discussed in another chapter. There are two primary sources of rate-of-return risk. Banking activ- ity covers transactions between depositors and banks, as in bounded and unbounded profit-sharing investment accounts (PSIAs), as well as banks and debtors, where between the chains of activities, the bank expects margin. The first source is the difference between the source or fund expectation by depositors of PSIA and the realized funding result. This risk is called the rel- ative rate-of-return risk, or is usually known as displaced commercial risk. The second is the difference between the expected result of financing debtors and the realized financing, where the realized financing is affected by market movement, economic conditions, or inflation. In the gap between liabilities and cash-generating assets, the bank is exposed to risks. First, liquidity mismatches risk between the bank’s assets (financing) and its liabilities to depositors, especially when long-term fixed assets (such as a murabahah contract) are funded by short-term and medium-term PSIA liabilities. Second, rate-of-return risk also covers repricing risk, the condition where the maturity between the funds from depositors is dissimilar to that of financing; even if the bank acquires new funding, there is no guarantee that it will receive that funding at the same rate as it did before. Third, rate-of-return risk covers displaced commercial

236 RISK MANAGEMENT IN ISLAMIC BANKING risk. Finally, there is benchmark rate risk, which can occur when the rate-of-return for a sukuk is different than the one for the market, especially when there is some uncertainty in the sukuk’s income caused by differences in the yield curve. However, rate-of-return risk also occurs when expected returns are not met due to the market price movement; for example, changes in inflation rate will influence bank profitability, and an increasing interest rate leads to rises in conventional adjustable mortgage rate. These risks include expectations of periodical return, such as mortgage payments using credit murabahah con- tract, leasing using ijarah, as well as a one-time payment such as in salam and istishna’ transactions. Some literature incorporates the results of the periodic payment of financing musyarakah and mudharabah as a source of risk and returns, but others include them in equity risk. An issue with benchmark rate or rate-of-return risk in Islamic banks is that an Islamic financial contract with a fixed income asset can’t be readjusted to follow the market return or the benchmark rate of return. As a result, Islamic financial institutions are unable to avoid the “opportunity momentum” to increase its rate of return. This is considered as an opportunity cost, given other banks are able to reap higher margin or to avoid future opportunity loss. Price (Mark-Up) Risk Price risk is one of the simplest market risks and the most often encoun- tered. If there are any differences between purchase price and selling price, in which the selling price of the risk object is lower than expected, then that is the result of price risk. One of the dominant drivers of price risk is commodity price risk. Commodity price risk is a risk possessed by the bank by having the physical assets (commodities) before they are traded or sold. Commodity price risk can occur in murabahah, salam, istishna’, and ijarah contracts, but commodity price risk should be differentiated from the price risk experienced due to mark-up of murabahah price, because mark-up risk falls under rate-of-return risk, which is benchmark risk. Among the com- modities usually held by Islamic banks are agricultural products, metal, real estate, and factory equipment (for ijarah contracts). The causes of price risk can be categorized as specific factors that can occur due to changes in com- modity and nonfinancial asset price due to an event, and can be caused by changes in price in general, especially when caused by inflation or deflation. Inflation increases default risk, especially in murabahah transactions, and also increases the price of real assets and commodities. Under these condi- tions, an Islamic bank’s income from murabahah will decrease, but income from salam will increase. Any change in market price before and after asset acquisition is part of market risk. For example, a bank purchases agricultural products using a

Market Risk in Islamic Banking 237 salam contract. After the bank receives and owns the commodity, there is a chance that the market price will fall. The bank can mitigate this exposure by finding a buyer for the commodity before it is even delivered and can bind the buyer by selling it at a predetermined price. In an ijarah contract, the equipment rented/leased is exposed to commodity price risk, and the rent/lease that has to be paid per period is exposed to rate-of-return risk. If the ijarah contract lasts for a significant period with a fixed rental rate, then it can be assured that the contract is vulnerable to commodity price risk and rate-of-return risk exposure. Several Islamic banks mitigate the risk from the ijarah contract with an ownership option of the rental object at the end of the leasing period. Of course, the type of risk mitigation strategy used needs to be observed carefully to ensure syari’ah compliance. Another instrument exposed to price risk is sukuk. The essence is the same as mark-up risk in murabahah and commodity price risk. Movement in market price causes the price of sukuk to be different than expected, as it is influenced by the current yield available in the market. In several literatures, the sukuk’s current yield risk is included in the rate-of-return risk, but we consider it to be more appropriate to include this risk in price risk. Exchange Rate Risk The exchange rate risk occurs due to exchange rate fluctuations between the purchase and sale time, or as the results of conducting business, specif- ically due to maintaining assets and liabilities in different currencies. Using murabahah, ijarah, salam, or ishtisna’ contracts denominated in a foreign currency will expose the bank to exchange rate risk. In mudharabah and musyarakah contracts, whenever the core business invests or is indebted in foreign currency, the bank faces exchange rate risk as well. Exchange rate risk only has two results: loss or gain, depending on the direction of changes to the exchange rate, and the bank’s position when it happens. For example, if the bank is in a net long position, then the depreci- ated domestic rate would profit the bank; the opposite is also true. Exchange rate risk can be classified as economic, transaction, and translation risk. Eco- nomic exposure is the risk that occurs from competitive loss due to changes in exchange rate, and this exposure covers both parties with active foreign currency accounts as well as those without one. An example of this is a small Indonesian company producing batik clothes from local raw materi- als, and one without debts denominated in foreign currency. The company can still be exposed to exchange rate risk, because in times when the Indone- sian rupiah strengthens against the U.S. dollar, the clothes would be relatively more expensive to international buyers. Translation exposure occurs in the recording process. If a branch of a bank in a particular country states that it

238 RISK MANAGEMENT IN ISLAMIC BANKING has 8 percent profit per annum, then the real profit must be translated, in the sense that if the currency of the country of the headquarters strengthens by 4 percent compared to the currency where the branch exists, then the actual profit is only 4 percent. Yet the asset value of the branch is unaffected. Transaction risk exposure is caused by any delay in the payment of payables or receivables. The exchange rate of receivables (murabahah install- ment, trade receivables) or over assets held can be depreciated in the future, while future payables (debt, liabilities) can increase. This exposure affects the firm’s entire value and can be fatal to business continuity. Due to this vulnerability, compliance with the central bank’s regulations on this issue is important, and daily risk measurement should be done with care. For example, the bank does not have a net open position for a currency higher than the central bank’s statutory net open position. Due to the lack of a syari’ah-compliant hedging instrument, then the most effective method to protect value is to establish a branch in the country where the target market is. For the Islamic bank, developing an international branch or network is one of the methods that can be utilized to reduce exchange rate risk. Equity Risk This risk happens in contracts with a profit-sharing scheme as well as indi- rect investment in the capital market. In the context of market risk, what is meant by equity risk is the risk faced by the Islamic bank when the income expected from this investment decreases in value, caused by fluctuations in the market as well as the business cycle that can affect asset price movements in the financial market. For example, if the share price of a company that an Islamic bank invested in plummets because business is bad, the Islamic bank experiences a manifested market risk. In more permanent mudharabah and musyarakah investments, the realization of periodic income (profit-sharing) may be affected by market risk, in the form of inflation and exchange rate risk, which in turn will affect the real income received by the bank. In princi- ple, the bank is given the opportunity to exit the contract by selling a part or all of its ownership in a business or company. The price of equity, as a rep- resentation of the bank’s ownership, can be reduced compared to the bank’s initial investment value in the business or company, and the bank thus suffers loss from it. Equity risk can occur without entering into a profit-sharing contract, if the bank took a long position (in a trading book) on equity. In such a position, then, the equity risk faced by the syari’ah bank is the same as the one faced by a conventional bank, even if conventional banks can protect value by hedging with options, forwards, or other similar instruments. It is very important to find out not only how return variability is formed, but also whether the risk that is created is measurable.

Market Risk in Islamic Banking 239 IDENTIFICATION OF MARKET RISK PROFILE Risk and capital are important pillars of the Basel framework. With Basel II, liquidity risk, concentration risk, and fiduciary risk can be measured with pil- lar II, even though for market, credit, and operational risk, Basel II has yet to accurately reflect an Islamic bank’s entire risk profile. The main difficulty for Islamic banks in measuring market risk and credit risk is the lack of adequate data to measure. Even if until Basel III there was no special notice from Basel Committee Banking Supervision (BCBS) for the syari’ah banking industry, the IFSB has formulated rules relevant to Islamic banking. IFSB has cre- ated the liquidity standard, the liquidity coverage ratio, for Islamic financial institutions, based on Basel III. Other than that, IFSB also writes recom- mendation reports for central banks for an institutional approach to risk management, and build the basic principles of stress-testing Islamic banks as well as their regulatory authorities. The weakness in hedging instruments, markets for commodities, and other assets held in inventory, as well as the increasing stringency in requirements from Basel and IFSB, make the Islamic bank demand a better solution to risk management. If the current solution for risk is to reserve capital (the standardized approach), then Basel III will ensure that the world’s banking industry reserves at least 20 percent of its capital. So far, the internal model used placed importance on the sophisti- cation of the measurement, which is not wrong but is not guaranteed to be comprehensive to fully mitigate risk. Banking Book and Trading Book The largest source of market risk in an Islamic bank is price risk, and it can come from fluctuations in commodity price (salam contract), raw materials price (istishna’ contract), price of goods in the market (murabahah and ijarah contract) or stock prices and other lawful investment vehicles. Commodities in a salam contract and raw materials in an istishna’ contract can both be categorized as commodities and thus are considered as the product of the trading book, while stocks and other similar investments (like murabahah and ijarah) are the product of the banking book. The banking book consists of all banking activities, such as transforming third-party funds into financing or loans. Banking book is also an account- ing term that states that the assets in a bank’s balance sheet are held until maturity. The trading book consists of activities related to the buying and selling of commodities, financial assets (securities), and nonfinancial assets. Simply put, the trading book records all financial instruments and commodi- ties for the purposes of transaction, and the banking book records assets and financial instruments that will be held until maturity or for the bank’s own

240 RISK MANAGEMENT IN ISLAMIC BANKING use. If a corporate client of the bank, for example, is about to issue security to finance itself (instead of taking a loan from the bank), then the security is held by the bank in a trading book. The placement of this security in the trading book is usually because the stock of the client is not intended to be held for long periods by the bank, and the security is not the bank’s own asset or debt but is the bank’s responsibility to immediately issue. If in the bank’s endeavors in underwriting it receives commission, then it will be noted in the banking book. Another difference between the banking book and the trading book is that the value of the assets in the trading book is calculated daily and marked to market, while all the assets in the banking book are recorded according to their historical costs. Another difference is that, based on Basel II, the value at risk (VaR) of assets in the trading book is calculated at 99 percent confidence level every 10 days, while the assets in the banking book are calculated at a 99.9 percent confidence level annually. Banks can reduce their reserved capital by moving an asset from the banking book to the trading book. Yet this move is suspected to be one of the causes of the 2008 crisis, leading to credit downgrades, loss of liquidity and increasing credit spread. In 2009, the Basel Committee revised a new Basel rule to prevent or reduce such events from happening. A reserve rule called the incremental risk charge (IRC) is put in place after the revision, where banks are required to calculate 99.9 percent VaR annually for trading book products that are sensitive to credit fluctuations. Market Risk in IFSB, Basel II, and Basel III The effect of Basel III for Islamic banking can be divided into several categories. The first is capitalization; banks are expected to have sizeable equity-based capital as well as additional reserves, as can be seen in Figure 11.2. This is not an issue for the Islamic bank, because it is will always be high in equity, and the same can be said for demands for capital quality, consistency, and transparency. This is because Islamic banks do not have hybrid capital, and thus do not have what is categorized as Tier 3 capital in Basel II. The second is liquidity; there are additional demands in the calculation of a bank’s liquidity, among them the liquidity coverage ratio (LCR) and net stable funding ratio (NSFR). Islamic banks will feel the effects of this requirement due to the limited availability of syari’ah-compliant short-term investment instruments. Basel requires a bank to calculate the capital adequacy ratio (CAR) from the difference between banking book and trading book. This minimum capital requirement is used as the basis of risk management, because capital is still considered to be the most secure model to mitigate risk. The risk measurement begins by identifying the risk drivers, also called risk factors, generated from positions in foreign currency, security, asset, and

Basel II Basel III Core Tier For Loss Common Total Tier 1 1 Capital Absorption Equity Ratio Tier 1 Hybrid Max 50% of and for Additional Total Capital Core Tier Tier 1 Going Tier 1 Ratio 2 Capital Concern Tier 2 Class 1 Max 100% of Innovative Hybrid Tier 1 (Max 15% of Tier) For Loss Tier 2 Tier 2 Absorption Class 2 Innovative Hybrid Tier 3 (Max 15% of Tier) and for Going Concern FIGURE 11.2 Capitalization Required by Basel II and Basel III 241

242 RISK MANAGEMENT IN ISLAMIC BANKING inventory held by the Islamic bank. The daily return of the risk factors is then measured. The net position of the portfolio owned is measured, first by clas- sifying every asset based on its maturity (maturity ladder), and is then offset by liabilities in the same maturity class or less before being mapped to the daily return of the risk factor. If there is any open position that can’t be off- set, then it will generate a capital charge. The VaR of each portfolio or asset category is then gained. From these, the capital risk charge is determined, and from the standard model, the amount of capital that will be reserved is set based on the formula used by the regulator. If there are risk basis and forward gap, then additional capital charge will also be added. Last, the market risk-weighted asset (RWA) that is formed will be accompanied in the CAR calculation. Generally, there are several risk measurements that are inadequate in Basel II. In the model-based approach, the measurement used to capitalize exposure in the transaction book uses 10 days’ VaR, calculated at the 99th percentile. The use of 10-day VaR is useful for short-term, internal risk man- agement calculation, but it does not answer an important risk management question. Can the 10-day VaR guarantee the bank has enough capital to sur- vive a high impact, low probability or “tail” event? With only 10-day VaR, the available model is unable to capture exposures to credit risk, liquid- ity risk, and provisions experienced by the bank. While in the standardized model, since it is standardized, its weakness is less sensitivity to risk and inability to capture risk from more complex financial instruments. For that, in 2009, the market risk framework in Basel II was improved on. This revi- sion on Basel II is usually called Basel 2.5. Basel 2.5 covers (1) IRC to accommodate the migration of credit risk and bankruptcy risk, (2) the addition of stressed VaR to existing VaR, (4) treat- ment of securitization exposure between banking book and trading book, and the introduction of the concept of comprehensive risk measure (CRM) for several correlated trading activities, and (4) improvement on the scope of risk factor in the internal model, which is risk that is not included in the VaR, as well as the basis risk and event risk. So far, the basis risk and the event risk haven’t been included in the IRC. Even so, further improvements are still necessary in Basel III. One of the issues is in the design of capital adequacy regulation, as the boundaries between the banking book and the trading book have not been tested for long enough to be able to determine how the market reacts with it. Thus, market risk for both Islamic banks and conventional banks will be treated stringently in Basel III, with special focus on the trading book. Additional charge will increase a bank’s RWA compared to previous years. The occur- rence of a financial crisis also caused the Basel committee to increase the risk component included in the RWA, especially for credit risk and market risk, as seen in Figure 11.3. The additional charge came from asset value

Source of Market Risk + Specific Securities Position: + General Equity, Sukuk Market Foreign Exchange Standardized + Single Currency Market Risk Market Risk Position Approach + Portfolio Capital Capital Asset Held: Requirement Weighted Commodities, (MRCR) Asset = 12.5* Asset Leased, (MRCR) Inventory Maturity + Directional + Ladder/ + Forward Gap Bucket Simplified + Forward Gap FIGURE 11.3 Flow of Market Risk Measurement 243

244 RISK MANAGEMENT IN ISLAMIC BANKING correlation, the inclusion of counterparty credit risk in the trading book, asset value correlation for risk charge, and additional charge on the process of asset securitization. This restriction in Basel III is expected to improve bank discipline in risk management, auditing, and compliance and in man- aging capital. MARKET RISK MEASUREMENT IN ISLAMIC BANKS The greatest challenge for the Islamic bank is, firstly, the lack of models and instruments to manage market risk that are appropriate to its characteristics. The various existing literature tends to only use approaches modified from preexisting models and instruments that are well known by conventional banks. Several efforts to construct hedging instruments that are in accor- dance with syari’ah principles have been done, but have yet to be accepted on a global scale. The second challenge is the lack of a robust syari’ah-compliant market, in the interest of both risk management and profit-making. In Basel III, the calculation of capital reserve is revised and empha- sizes Tier 1, which consists of regular shares and retained earning. Tier 2 in Basel II used to be allowed to be 100 percent of Tier 1 in proportion, but is now limited to 50 percent, while anything categorized as unrealized gain will be monitored. Tier 3 is completely removed. How does this affect the Islamic bank? There will be no direct result from this change, since Islamic banks have never been allowed to enter into usury-based transac- tions. The Islamic bank thus concentrates its capital in Tier 1 (the bank’s own stock), and even if some Tier 2 capital exists, then it cannot exceed 100 percent of Tier 1. This change will only directly influence conventional banks, since they have to adjust capital reserve calculation to only include their own capital (Tier 1). The effects of this adjustment are the change in the Islamic bank’s competitive position compared to the conventional banks before the change occurred. If a bank is considered risky, then its capital reserve will have to be sizeable compared to the risk that it faces. In Islamic banking, the process of calculating CAR is problematic, since several types of products (like a profit-sharing investment account, or PSIA) have yet to be classified properly into either the trading book or the banking book, unlike contracts from the conventional bank. Even if the risk inherent in the PSIA is not held by the bank, but is directly transferred to the account holder, PSIA cannot be included in equity capital. Similar conditions can be said of market risk that came from the trading book (salam and istishna’). One of the methods to mitigate risk from this transaction is by requiring capital charge.

Market Risk in Islamic Banking 245 The effect on overall risk calculation is in the calculation of the CAR, where BCBS and Basel III states that CAR should be more than 8 percent. The IFSB determines CAR as follows: CA = Regulatory Capital Total Risk Weighted Asset (CR + MR + OR) − RWA Funded by Restricted PSIA (CR + MR) − (1 − ������) RWA Funded by unrestricted PSIA (CR + MR) − ������(RWA Funded by PER and IRR of Unrestricted PSIA) × (CR + MR) Information: CR: Credit Risk MR: Market Risk OR: Operational Risk Source: IFSB The influence of including PSIA in the capital adequacy calculation is the reduction in ������ (alpha) of the RWA with unrestricted PSIA as part of the denominator, and adjusted with the RWA that came from PER and IRR from the investment account holder (which will reduce risk for the bank). IFSB allows the central bank or the banking supervisory authority to determine ������, depending on the stability of the banking and financial system of each respective county. From Basel III, we find that there are two ways to mitigate any sort of risk: (1) tightening the capital adequacy of banks, and (2) closely supervising. The tightening means that banks are required to keep a high amount of reserved capital; the higher the bank’s risk exposure, the higher the amount of capital that would have to be reserved. The specter of a future crisis that might begin from systemic risk drives policy makers to increase capital reserve requirement, if necessary up to 25 percent of capital (I Basel III; the total Tier 1 and 2 hasn’t reached the 2-digit percentages). Yet high CAR does not guarantee that the bank will be more stable when faced with risk events. As a consequence of the financial crisis, the Basel Committee determines the increase of RWA, especially the ones from credit risk and market risk. Market risk is one of the key risks that can trigger the manifestation of other risks, like liquidity risk. For example, if there are market price movements that reduce asset values, they will affect the bank’s balance sheet and have the potential to drag the bank into liquidity risk. Unlike conventional banks,

246 RISK MANAGEMENT IN ISLAMIC BANKING where market risk tends to only happen in treasury activities (except in financing denominated in foreign currency), in Islamic banks, almost every financing scheme is exposed to market risk. Market risk can occur due to fluctuations in the prices of commodities and physical assets as a conse- quence of salam, istishna’ and ijarah transactions. But this has not been included in Basel II and III, because no special regulations have been made on behalf of Islamic banks. Market risk originating from salam and istishna’ would be suscepti- ble to market volatility. If overall risk calculation of this market volatility influences the stress-test scenario, then the bank will have to increase its capital adequacy. Similar to the heuristic that what happens at the present will continue to happen in the future, high market volatility is a cause for the Islamic bank to always prepare additional reserve capital. Yet Basel III also ensures that conventional banks will have to increase their RWA, because the trading book of conventional banks contain higher portions of financial instruments such as CDO, Repo (repurchase agreement) derivatives, and the like—instruments that are not held by the Islamic bank. Sources of Market Risk The types of risk present will affect the risk mitigation process. Risk can be divided into two: pure risk and speculative risk. Speculative risk occurs when the results of the bank’s activities can be in the form of profit or loss related to a specific asset of the banks. Pure risk is where the bank has no way of evading it and will always generate a loss. Examples of pure risk are natural disasters, wars, or riots. In market risk, the bank faces risks generated by market dynamics and price fluctuation that cannot be controlled by the bank. This meant that there is a dimension of speculative risk attached to market risk. But when its effects to the bank are considered, the bank can experience loss or gain, depending on the bank’s position at the time of transaction, whether as seller or buyer. Not all price falls in the market are injurious—the bank can even make a profit because it can buy at a low price. From this consideration, market risk is categorized as speculative risk. This is especially true because the bank’s exposure to it depends heavily on the bank’s decision to be involved with business activities containing the determining factors of market risk (e.g., providing financing in a foreign currency, salam financing, etc.). Yet there are also aspects of market risk that are not reliant on business decisions; among these is the risk caused by inflation or exchange rate pressure. Another basic character of speculative risk is the way its probability of occurrence and the magnitude of its effects can be reduced through risk management. So far, measuring the market risk of an instrument is done by

Market Risk in Islamic Banking 247 using the VaR method to find out the largest loss potential possible based on the asset’s profit and loss distribution. This in turn is measured by observ- ing the difference between parameter movements with the position of the bank’s assets that are measured periodically. If the instrument is present in a portfolio, then the effect of that portfolio is to reduce the individual risk of each instrument through offsetting. The bank will categorize each instru- ment with a different maturity class to be offset (those in an open asset position will be offset by liabilities, and vice versa). The price movement of an instrument will be affected by correlation with other similar instru- ments; for example, a bond with a 10-year maturity will certainly correlate in movement with a similar bond that matures in 11 years, though the cor- relation is imperfect. The risk that occurs from imperfect offsetting is called basis risk, and has begun to be accounted for in Basel III. If basis risk is present, then there will be additional capital charge on the bank. Market Key Risk Factors Market movement can generate many kinds of effects depending on the behavior of the asset price related to market price. Apart from that, even when there exists a risk that affects almost all assets (e.g., exchange rate risk), not all assets are affected by the same amount of magnitude or in the same direction, as each asset’s degree of sensitivity is different. Some assets move in the same direction as the market, some others are in the opposite direction, and there are even assets whose movement does not track with the market’s at all and appear to be random compared in how they react to the market’s movements. Of course, the analysis determining the behavior profile of an asset’s price is not based on the movement of the price in the market, but on the asset’s fundamental condition. The Islamic bank’s analy- sis will need to separate and dissect the fundamental components of the asset, before then reviewing their relationship with various market statistics, the economic cycle, the business cycle, and the harvest patterns of the primary commodities that are its raw materials. The analysis that is done does not rely singularly on the movement of economic indicators like inflation, unem- ployment values, reference interest rate, and the like but also on microcondi- tions such as raw material components, balance sheet and income statement structure, production pattern, and so forth, but on different levels—from the individual assets to the portfolio. Simply put, no one can state that there has been market movement in the stock and sukuk market, for example, because there is comovement of market parameters. This is because the parameters of both markets do not move in step, even when the exchange rate weakens, which will weaken the market index and increase inflation. This concept is stated as general

248 RISK MANAGEMENT IN ISLAMIC BANKING versus specific risk, or stated as systematic and unsystematic risk. Though different, the two have the same underlying idea: there exist risks, gener- ated by market parameters affecting price in general, that trigger comove- ment (correlation) in prices. This is because, in principle, each price in this asset group depends on the same group of market parameters, called sys- tematic factors. Price volatility that is not reliant on market parameters is called specific risk, which is easier to isolate and mitigate at any moment in time. Problems in Measuring Market Risk One of the problems faced by Islamic banks in measuring risk is the lack of data available to use as measurement basis; the measurement of credit risk and market risk requires an ample supply of historical data. Illiquid instru- ments also make it difficult for Islamic banks to mitigate risk. An example is the difficulty in performing parallel salam when finding potential buyers is difficult. The third, and the problem that plagues measurement the most, is the issue of using conventional proxy prices. The core of market risk management is that, by measuring volatility and correlation of market prices, it is possible to forecast the direction and magnitude of future price movements and determine their potential impact. What is next is to calculate how the price change affects the bank’s net value position, or how it affects the bank’s business—whether it affects earnings, cash flow, or both. Since 1995, the BCBS has allowed banks to own and use their own risk management models to calculate risk and the reserve capi- tal ratio. So far, there are at least three steps to mitigate market risk. First, analyze the determining factors of market risk and use them as elements to build the market risk calculation model, using the internal model approach (IMA), for example. Second, calculate the rate of return based on market risk profile. Third, determine market risk management policy; an example of this is using parallel contracts (salam or istishna’), limiting positions, and setting reserves for possible losses. To calculate market risk, the easiest way is by using the variance of the market price of the asset. Not all price variance has a negative effect on the bank. With this approach, the bank manager will need to set limits: which variance is beneficial to the bank and which is detrimental? From the result- ing detrimental variance, the bank then sets the limit of acceptable risk (and unacceptable risk). In other words, the purpose of market risk mitigation is to avoid the negative effect of price changes in the market on financial and investment assets as optimally as possible.

Market Risk in Islamic Banking 249 Mark-to-Market or Mark-to-Model Approaches There are two methods used to calculate exposure in market risk man- agement: marking to market and marking to model. The risk exposure is calculated after the daily return of each risk factor and the return of the bank’s assets portfolio have been measured. For example, for stock portfolios, marking to market is done by mapping stock indexes to stock, commodities to stock indexes, commodity volatility, and the commodity’s index (if it exists). Ideally, all assets should be valued by marking them to the market, but there are assets or financial transaction objects that lack an active market, or sometimes even lack a market at all. In the case of the Islamic bank, this applies to specialized contracts like salam, istishna’, murabahah, and ijarah, and the lack of market reference complicates the risk measurement process. Marking to market is the valuation of daily position from a trusted reference: from an index, for example, the closing position of an active market of a particular instrument, or from a trusted broker. If the bank is the market maker, or if the market where the instrument/risk object is in is active (has numerous bid/ask positions), then the data from the market can be the reference input. On the other hand, the transaction is useless as a reference if it is under unusual circumstances, as in forced liquidation by the court or a fire sale or sales under duress. Marking to model is used only if marking to market cannot be done. The mark-to-market approach is the valuation calculated with market price as the input. Extra care needs to be taken in using the marked-to-model method. The management needs to be aware which elements of the trading book are measured with mark-to-model, with a trustworthy market input reference, under accurate assumptions and reviewed by independent exter- nal parties. The model generated should also be independently tested and validated mathematically. The weaknesses of the model should be known, acknowledged, reviewed, and periodically adjusted. It is very important to find out which risk is best measured with a mark-to-model approach and the reason why. Commodity products or instruments with a lengthy maturity, not standardized and unique, can be said to be illiquid. Since a working market is characterized by a two-way market (there are bids and asks), with standardized product characteristics (volume, quality, type), all products or instruments that are illiquid cannot be judged according to efficient market prices; as these market criteria are not always fulfilled by an illiquid market. Under these conditions, the mark-to-model procedure can be used; that is, the valuation using a model to gain the estimated value. Wherever the mark-to-model approach is applied, what has to be ensured is whether the procedure covers various

250 RISK MANAGEMENT IN ISLAMIC BANKING probable scenarios generated by the movement of risk sensitivity. For example, if a bank has a portfolio containing a unique commodity that is not easily priced on the market, then the portfolio should be divided into subportfolios. The various unique commodities should then be separated according to type and maturity. After that, the subportfolios are identified and assessed based on the model (marked to model). The risk officer can apply the reserve model from outstanding transactions on the subportfolio. The reserve can be liquidated again when the transaction has matured or is close to maturity, when the subportfolio can usually be adequately valued using the mark-to-market model. On the other hand, relying too much on the mark-to-market approach can also cause estimation error. An example of this is in times of market stress. This condition can happen when the underlying market is illiquid, the collateral cannot be sold and the client or counterparty is the side that has a tendency to default. When this condition happens, then the market price of the replacement cost of an asset can become very low. The mark-to-market calculation should also consider the conditions that can affect the market’s opinion about an asset, especially in times of market stress. The weakness of using market price data to calculate the effects of risk lies in the unstable tendency of market price. Measurements of volatility and correlation can demonstrate that great changes in market price have occurred frequently within a short time period. Value at Risk (VaR) The calculation of market risk is based on return uncertainty of an asset or portfolio over a predetermined value. To determine the return or profit-and-loss variation of a portfolio; for example, we need to determine the variation of the price movements of the assets in the portfolio, and how the movement affects the price movements of other assets. To calculate market risk, the easiest way is through the variance of the assets’ market price. Not all price variance affects a bank negatively. With this approach, the bank manager will need to set limits, determining which variance is beneficial to the bank and which is detrimental. Among the detrimental variances, the risk limits of what is acceptable and what is not would also need to be set. In other words, the aim of market risk mitigation is to best avoid the negative effects of market price changes on financial and investment assets. In the past, risk was measured through various simpler methods. Among these are sensitivity measures and scenario analysis. These methods provide a general picture of risk, but do not measure the effects of the risk on the portfolio, or the losses suffered. Scenario analysis provides clues as to how

Market Risk in Islamic Banking 251 losses can affect price nonlinearly, but does not touch the loss’s probability of occurrence. The two methods also cannot calculate aggregate risk; for example, if there are investments other than equity, like sukuk, what would happen to the risk measurement? Would it increase, or would they diversify each other? These questions can be answered by VaR, since VaR provides guidelines on risk probability, by calculating any addition or reduction in risk as well as any occurring diversification. VaR is a risk calculation method based on loss distribution. Because losses are value-neutral, this model can be said to be neutral and can be used for all types of risk, including market risk. Even though it was used and developed earlier among conventional banks, this model can also be used by Islamic banks to measure their market risk. It all depends on how we define the loss distribution that is the basis of VaR calculation. To manage market risk, it is necessary to have a tool that can measure (in nominal amounts) the loss potential of dynamic market movement every day, during several periods. The VaR represents this well, as its output is the position of an asset every day. VaR can also be aggregated to represent position per group, per portfolio, and also per time period. Theoretically, risk managers must report the profit-and-loss distribution faced during a particular period. In practice, the distribution meant can be illustrated by one number, the worst-case scenario at a particular confidence level (for example, 99 percent). VaR only calculates the deviation (variance) of the loss distribution. Other than the loss definition, VaR is also neutral towards the number that a deviation limit is set at. In the banking industry, a percentile is used, usually the significance levels of 1 percent, 5 percent, or 10 percent. The smaller the percentile, the further away it is from the distribu- tion’s average (mean), and thus the larger the loss calculated. For stringent or conservative regulators, they tend to use significance level 1 percent instead of 5 percent or 10 percent because the larger the possible loss that is con- sidered, the larger the capital that will need to be reserved. BCBS suggests the holding period of an asset to calculate VaR is 10 transaction days, and that the data that is used is the daily data. Basel also recommends a 99 per- cent confidence level, equivalent to the 1 percent significance level; thus, any loss that exceeds the VaR value is estimated to occur only once every 100 days, or two to three times a year. Of course, VaR is only a tool to measure risk, and relying only on it is not enough. Stress-testing is necessary to com- plement VaR, where stress-testing identifies potential losses under extreme market conditions (represented at high confidence levels). Risk-Adjusted Return on Capital (RAROC) Business, philosophically, is exchanging risk with profit, because every activity should provide return over the risk it generates. Because of this,

252 RISK MANAGEMENT IN ISLAMIC BANKING the pricing of a product does not only compensate expected losses, but also calculations of risk capital; this can easily be seen in financial products as well. Economic capital or risk capital is capital the bank is required to reserve in order to absorb all loss possibility generated by the risks it faces. The risk-adjusted return on capital (RAROC) calculation still requires VaR because with VaR, we can calculate expected losses and the result can become the basis of the reserve calculation projected to face possible future losses. But what should be done in the case of unexpected losses? We need to be able to calculate the economic capital required to bear the risk. This is where RAROC is beneficial. First, it calculates capital allocation to be reserved as a form of risk mitigation. Second, it calculates performance by considering the risk aspect faced; thus, some business activities require a larger amount of capital reserve than other activities. The main purpose of RAROC is to evaluate economic return of business activities and create a benchmark generated from the business activity. Developed by Banker’s Trust, RAROC calculates the trade-off between risk and return of various assets and investment, as can be seen in Figure 11.4. In conventional banks, RAROC is often used as an additional stage or integration of VaR, because the essence of risk capital is to use VaR calculation. RAROC is the return ratio according to the risk faced by economic capital. Economic capital is defined as the amount of capital required to be reserved against the possibility of negative market price events; it is usually calculated by VaR. The loss estimate is calculated as the previous year’s average loss. In practice, the bank has usually calculated this loss as a risk that is tolerated and has been allocated through provision policy. For the worst loss potential, the bank does not reserve capital because it is too expensive for the bank. Loss distribution α = 5% 0μ Capital provision for risk faced The worst loss Investment loss FIGURE 11.4 The Loss Distribution and RAROC Calculation

Market Risk in Islamic Banking 253 RAROC can be used by the Islamic bank to determine the margin wanted for each different financing instrument; it is currently used to help determine the risk capital of syirkah contracts. The risk in every contract or instrument is very different; because of that, the capital allocation that is set aside for every contract is different. The mudharabah scheme is far riskier than murabahah contract, and should naturally be provided a larger reserve capital, and the same can be said about the margin or ratio set by the bank. If the mudharabah and murabahah line both provide profit of US$10 million, then how do we compare performance between the two? This is where RAROC becomes useful, because the performance information of every business activity will be very useful for expansion purposes as well as risk measurement. RAROC measurement falls through these stages: (1) Risk measurement, which requires the measurement of portfolio exposure to volatility and from the correlation of existing risk factors; (2) VaR measurement, translated into economic capital. VaR does not specifically have to be used; other risk metrics can be used, like expected tail loss in extreme quantiles. But for cap- ital reserve purposes, the bank is required to use a risk metric approved by the BCBS and the central bank. For VaR calculation, the confidence level and horizon of the risk factor is needed, as well as (3) a measure of performance, which can be gained from the Risk-adjusted performance model (RAPM), the economic value added (EVA) model, or the shareholder’s value added (SVA) model. This measure of performance is used as economic capital allocation. MARKET RISK MITIGATIONS IN ISLAMIC BANKING In mitigating market risk, Islamic banks could use many methods, such as netting method, provision limit policy, loss limit policy, and asset secutization. Netting Method Unlike conventional banks, which can hedge using interest-based derivative instruments, Islamic banks are expected to be more creative to cover for long positions in foreign currency. An alternative method that can be used is cost-revenue matching. The bank’s treasury division is usually responsible for calculating all of the bank’s long and short positions in foreign currency daily. The bank’s branches entering any foreign exchange transaction does not create an open position by itself, unless it is through the treasury division. The activity of matching revenue and expense so far is meant more to avoid

254 RISK MANAGEMENT IN ISLAMIC BANKING exposure in foreign exchange risk and offset the possibility of increasing liabilities by increasing assets. For example, matching between floating yield and quasi-fixed yield can be done to cover risk exposure. An ijarah portfolio with a floating rate that could be repriced can be used. If the Islamic bank decides to operate at an international level, strategic policies on exchange rate risk should be put in place preventively. For example, in ijarah-based financing scheme, since most of heavy equipment is leased using a foreign currency (usually in U.S. dollars), the Islamic bank encounters difficulty in managing open positions on market risk if only by relying on the financing side (deposits in the form of U.S. dollars) and currency purchases. There are several basic strategies for the Islamic bank to use to overcome this potential exchange rate risk. Among these strategies is to ensure that every cost and income from an investment is denominated in the same currency. If the bank leases heavy equipment using U.S. dollars, then the Islamic bank enters a contract with the debtor to receive the lease also in U.S. dollars. In the case of international mudharabah contracts, if the investment is denominated in a foreign currency, then the profit-sharing received should be denominated in the same currency. It needs to be kept in mind that keeping revenue and cost in the same currency does not mean eliminating exchange rate risk because in syari’ah, the exchange rate used is the spot rate, while any difference in the time revenue and expense that may occur usually still generates different exchange rate positions. For that, the treasury division of a bank should still actively close any open position daily. Provision Limit Policy Another policy that can be used to manage market risk is by limiting the bank’s position in financing transactions, in long and short positions, by considering market risk and the bank’s position in a transaction, like the commitment to sell or buy new securities. The Islamic bank can apply limit policy on a strategic level. For example, Islamic bank A has set a limit on open position in a foreign currency and cannot exceed 5 percent of loss estimate. Because of this, if there are any requests on new transactions that cause the open position in foreign currency to increase, the bank should hold off on the transaction until the bank’s position improves. The trade-off between the exchange rate risk and the loss of business opportunity occurs with limiting position, but this method is relatively safe to use. The Islamic bank is not allowed to enter into new transactions in foreign currency if doing so places its investors and customers in a situation of a higher risk than it is prepared to face.

Market Risk in Islamic Banking 255 Loss Limit Policy The mudharabah and musyarakah financing scheme can bring the bank into a situation in which the contract ends as a loss. If this happens, the bank will only receive payment in the form of whatever capital remains for the bank. Of course, in this case the portion of the capital that can be retrieved by the bank is valued at less than its initial investment as a consequence of invest- ment loss in the company. It often occurs that the historical and nominal value of an investment (company) is considered to be too low (underval- ued), while the company overall is predicted to generate robust and generous cash flow in the future. This situation occurs in a company experiencing bankruptcy or financial difficulty. This will become a new source of market risk if the bank’s investment becomes a burden on the balance sheet and cannot be liquidated, or its value is very low. Loss limit policy generally emphasizes exit strategies from an investment if the business the bank has invested in begins to show signs of bankruptcy or major losses. In the profit–loss sharing system, loss is naturally borne together by all business partners in a syirkah contract, according to the partners’ respective capital investments. Because of this, the risk mitiga- tion effort applied in this case is normative, considering the best interest of the business’s continued survival, and should be reasonably supported by good analysis of the firm’s future cash flow potential. Several valuation elements of companies that are undervalued due to large losses, as an ini- tial guide before the bank decides to pull out its funds from the business, include: the company’s historical earnings are considered; the technology used is not out-of-date for at least several more years; the company is not involved in a financial scandal; and the company did not experience great losses from the last economic crisis. All of these are expected to be additional guidelines for the bank in considering the business’s survivability with its partners. Securitization How can a structured asset or a financial product be a good mitigation tool while still being syari’ah-compliant? Several financial institutions have begun to securitize assets and loans, both for financing purposes and to reduce the bank’s risk exposure. Securitization is a process that (1) pools assets, (2) packages the assets in the form of securities, and (3) distributes the securi- ties to investors. Securitization can also be defined as the process of issuing certificates of ownership of a pool of investment or business. Sukuk issuance is a form of securitization, where its underlying assets are financial contracts that are in accordance with syari’ah principles.

256 RISK MANAGEMENT IN ISLAMIC BANKING There are several securitization principles in Islamic finance. The first is avoiding usury. The securitization process must be free from usury, both implicit as well as explicit; among its forms is the use of the bay’ al-‘inah contract structure because of its shadow usury (hilatul-riba). The second is that the process must be free from gharar, tadlis, and maysir. The third is that it must always be linked to the real sector. Unlike conventional derivative instruments, the publication of sukuk is always expected to assist in value creation in the greater economy. The fourth is that the use of funds must always be syari’ah-compliant. The fifth is that the underlying assets should be in accordance with syari’ah principles (maal al-mutaqawwam). Usury-based assets cannot be used as the underlying assets for securitization. In Islamic finance, securitization must be related to the real asset that the issued security is based on. For example, the asset funded through murabahah, istishna’, or ijarah can be used as an underlying asset to issue a sukuk related to payoff, cash flow stream, and the risk-return profile related to the asset. In a similar way, mudharabah and musyarakah sukuk must be related to real business activity or the formation of a physical company. To fufil the needs of short-term and medium-term financing, murabahah, ijarah, and istishna’ can be attractive alternatives, especially since the default risk of these three types of sukuk is relatively controlled with the presence of its real asset backing. Apart from that, this financing scheme is a predetermined term of contract, ensuring that the sukuk is a close substitute of fixed-income securities that can be expected by the rational investor. All sukuk can be sold in the primary market, but there are several that cannot be sold in the secondary market. Included in these are sukuk whose underly- ing contract is debt-based, like qardh sukuk, murabahah sukuk, salam sukuk, and istishna’ sukuk. The sixth is that the structure or scheme of financial con- tracts used should be syari’ah-compliant and avoid securitization structures that contain usury, such as pay-through, sale buy-back, sale-lease buy-back, and asset-backed bond. The seventh is that there should be a clear transfer of asset for the investor (ownership conveyance). IMPLEMENTATION OF MARKET RISK MITIGATION In each contract in Islamic banking, there are multiple risks that are different from each other due to market fluctuation, or fluctuation of benchmark rate. In a murabahah, salam, or istishna’ contract, for example, when the rate of return of the contract is not the same as the market reference, then there is a probability of opportunity loss or benefit, and this is called the rate-of-return risk. In the same contract, exposures to other market risks can also happen, that is the direct exchange rate risk, if the object purchased in the murabahah

Market Risk in Islamic Banking 257 contract is an import good. If the object has a market price that fluctuates, even when controlling for rate-of-return risk and foreign exchange risk, then this means the contract is exposed to commodity price risk. In one con- tract, there could be as many as three risk exposures: rate-of-return risk, exchange rate risk and commodity price risk! The same condition also hap- pens in an ijarah contract, where the benchmark of the ijarah’s rate of return is directly related to the actual market price, and then the ijarah contract will be exposed to a rate-of-return risk. If the ijarah object is vulnerable to exchange rate fluctuation, and then the ijarah contract is also exposed to foreign exchange risk, while the mudharabah and musyarakah are vul- nerable to equity and foreign exchange risk. Studies have shown that risk drivers affecting market risk, like interest rate, stock price fluctuation, and the exchange rate itself, correlate and influence each other. If the exchange rate strengthens, then it can be assured that stock prices will fall and real prices of industrial goods will also fall. Islamic financial contracts, on the other hand, usually have a fixed rate. The Islamic bank then faces the risk from the double movement of the market reference rate (interest rate) and the rate of inflation. Equity Price Risk in Syirkah Contracts Market risk in a permanent musyarakah contract occurs when the company experiences such major losses that it can no longer operate normally. When this happens, the market value of the firm will fall compared to its intrinsic value and will create difficulties if the bank is interested in exiting their con- tract or selling the bank’s portion to another party, as seen in Figure 11.5. In a diminishing musyarakah contract, the bank’s equity will be bought back by the firm periodically within a particular time period. The firm’s inability to buy back the equity owned by the bank, other than affecting credit and liquidity risk, also decreases the possible purchase value compared to what the bank has expected to receive. At the end of the diminishing musyarakah scheme, if the total investment in equity is lower than market value, then market risk occurs. A business entity can certainly never free itself from the risk of loss, in the same way that profit may also happen. When equity investment is no longer profitable but is actually the opposite, losing, market risk mitigation can be done by stopping the investment and walking out of the partnership. The bank should have an “exit strategy” in case of severe loss by selling its ownership or by reserving for that loss potential. This happens if the market price is lower than the historical price of the company, caused by business risk as well as by mere rumors over business risk. In a mudharabah transaction, if the bank receives direct exposure from the equity that is the financing object, then the bank is stated to have been

258 RISK MANAGEMENT IN ISLAMIC BANKING Profit sharing Profit sharing Profit / loss Loss sharing Initial investment The worst loss sharing Contract ending Market risk happens if market movements affect profit / loss sharing periodically, selling the investment principal at the end of the contract, or periodically in diminishing musyarakah FIGURE 11.5 Business Cycle and Market Risk Exposure exposed to equity risk with the equity position noted in net asset value on the reporting date. As an example, if a bank owns equity in several stock markets in several countries, then the bank will need to sum up all the equity positions in every country or every market. Categorizing stock based on country or market is done by considering the closeness of the market’s characteristics, but usually the calculation is done on a country-by-country basis. For the state/national market, where the bank holds the entire equity, the market value of all net positions of individual stocks must be calculated to gain the overall gross equity position of the market. Rate-of-Return Risk on Murabahah Murabahah is the favorite financing scheme of Islamic banks. With a murabahah contract, the profit expected by the Islamic bank is the return of the principal and the predetermined margin, where the payment scheme is in installments. In murabahah (binding or unbinding), market risk can occur at two points; when the bank acquires the asset or commodity that becomes the murabahah object, and when the stream of installments paid by the debtor is relatively lower in value than the reference rate of return. Market risk in a murabahah scheme discussed here isn’t the risk that occurs because the banks sets a fixed installment margin, while the reference return rate in the market, like the price of commodities in the futures market, is floating such that the bank experiences a loss relative to the referred return rate (see Figure 11.6). At the beginning of the contract, the bank will purchase the commodity or asset that will be resold to the potential buyer. After the purchase, the

Market Risk in Islamic Banking 259 Market risk in (Total cost + margin) purchasing price > market price Exchange rate risk Bank buy Installment period The end of assets/commodities installment period FIGURE 11.6 Market Risk in a Murabahah Scheme bank is exposed to market risk if the price of purchase is much higher than the reasonable market price due to the bank’s inexperience. In unbinding murabahah, market risk, operational risk, and credit risk can all occur at the time the potential buyer declines the reservation due to the purchase price being higher than market price. At the time of installment payment, the bank can also be exposed to market risk due to changes in the exchange rate or other market indicators like inflation or commodity prices (relative). Market risk mitigation in murabahah transaction can be done by: short- ening the financing period to reduce exposure to fluctuation market condi- tions, setting the rate-of-return desired by the bank by considering various aspects, building good relations with suppliers to gain advantageous prices, and selecting potential debtors carefully. The simplest form of market risk mitigation in murabahah transactions is by setting a mark-up rate (margin). The margin has to cover the possibility of changes in market indicators. But the higher the margin set by the bank to compensate for market risk, the higher the credit and liquidity risk due to payment delays or defaults from the debtor. The higher the margin, the higher the price that must be paid by the debtor and thus the higher the liability value. Commodity Risk on Salam Contract In the Islamic rules on sale, one of the requirements for a valid sale con- tract is ownership over the goods sold, except in the salam and istishna’ contracts. Even though commodity prices, through the salam scheme, are predetermined, market risk can always manifest due to fluctuations of the

260 RISK MANAGEMENT IN ISLAMIC BANKING commodity’s price in the market. In a salam contract, if, after the payment date and the waiting period, at the date of delivery the market price is higher than the predetermined price, then the bank profits. The seller experiences (relative) loss, since there is the opportunity to sell the goods at a higher price in the market. Again, all this hinges on relative profit and loss (oppor- tunity cost). There are no actual losses until the bank realizes the transac- tion. The salam contract provides ease of liquidity for farmers in producing their harvest, even though there are elements of speculation, risk, or uncer- tainty (gharar). Among the forms of commodity price risk mitigation is the use of paral- lel contracts in salam, as seen in Figure 11.7. Commodity farmers avoid the consequences of price fluctuation at the time of harvest by entering a salam contract with a bank. The bank can also remove market risk, liquidity risk and operational risk, by finding a buyer for the commodity after the delivery time. If the bank does not use a parallel salam contract scheme, the effects of price fluctuation (market risk) can occur in two locations; when the product is delivered and the intrinsic value is different from prevailing market price, and when the commodity is sold and the price is different from prevailing market price. This scheme is only valid if the bank receives the commodity from the farmer and then checks/weighs it again before delivering it to the third party. In risk management, there is an assumption that whatever the risk faced, one of the simplest methods to mitigate risk is by reserving capital. For mar- ket risk due to fluctuating price (price risk), the Central Bank of Bahrain issued a regulation stating that the capital charge for market risk was 15 percent of carrying value. For price risk in commodities using salam con- tract, the capital that must be reserved was 15 percent for every net position Seller and Bank Market Risk 1 Market Risk 2 Buyer and Bank Advance Delivery Time of Receipt Payment Delivery Time of Payment Goods Goods FIGURE 11.7 The Effect of Parallel Contracts in Salam

Market Risk in Islamic Banking 261 in each commodity, added by 3 percent of all gross position, to bear the possibility of basis risk and forward gap risk (basis risk is explained in detail in the Basel section). This 3 percent reserve is also used to cover operational risk exposure when the salam seller fails to deliver the commodity and the bank is forced to purchase from the commodity market. The commodities that are usually included in this category are fungible goods, consisting of agricultural commodities, oil and gas, minerals, iron, steel, valuable jew- els, and metals other than gold and silver. Gold and silver are treated as foreign currency. The commodity risk position and capital charges are calculated based on the bank’s overall business; included in these are the banking book and the trading book Not merely salam and istishna’ contracts, but all the bank’s transactions, including mudharabah and musyarakah contracts, as well as murabahah involving the purchase of commodities vulnerable to commodity price fluctuation, will be subject to capital charges. Even though there are differences in the price fluctuation between commodities, a single uniform capital charge for all commodities is considered adequate for the time being for ease of measurement. OVERVIEW OF THE CALCULATION OF NET SALAM /ISTISHNA’ COMMODITY POSITION The bank states its commodity position (salam or parallel. salam) according to a standard measurement (barrel, kilogram, etc.). The net position of the commodity is calculated by including the asset and liability position related to the commodity. In a market with daily transactions, the contract maturing in the next 10 days is prioritized to be offset (to gain a net open position). The bank gains net open position by placing each commodity in a different maturities basket according to each contract’s order of maturity. Objects that are already physically owned by the bank are put on the highest priority. Instruments existing between two different maturity time bands will be placed in the time band closest to maturing. Positions in different commodities cannot offset each other even in the interest of gaining a net open position. Only commodities from the same category, though of different types (as long as they are considered to be close substitutes), is allowed to offset their respective positions. The requirement for this is the existence of correlation of 0.9 or more in their price movements for a minimum of a year and with the acquis- cence of the central bank.

262 RISK MANAGEMENT IN ISLAMIC BANKING The number of the asset and liability positions that match will be multiplied with the spot price of the commodities, plus a spread of 1.5 percent for capital charge. Any unmatched positions in the closest time interval are offset with the opposite position (if it is an asset, then it is offset with liabilities, and vice versa) at the next closest position. An addition of 0.6 percent of net position charged by risk management due to obtaining net positions with different time bands is inaccurate. After a net position is obtained (both in asset as well as liability), a 15 percent capital charge is also subjected over the entire commodity risk. Price Risk on Istishna’ Contracts Basically, istishna’ is similar to salam. The treatment of an istishna’ contract is not much different from that of the salam contract, which is 15 percent of the carrying value on a net long or short position added with 3 percent of reserve to face basis risk (Central Bank of Bahrain 2012). Exchange Rate Risk The exchange rate risk can be categorized into three types of exposure. The first, economics exposure, is the condition in which the operating costs of a bank or firm increase due to changes in exchange rate, causing the goods or services generated by the firm to seem less competitive compared to other products of a similar type. There are not many methods available to reduce the exposure to exchange rate risk in this category. The second is translation exposure, which is the effect of foreign exchange risk that will affect the firm’s income and weaken the balance sheet. To reduce the effects of translation risk, conventional banks will usually use an exchange rate–hedging technique. The third is transaction exposure, which is the activity where unfavorable movement between two currencies occurred throughout the contract period until its end, or during the time of loan given until loan maturity. Transaction exposure can be lessened through factoring (the transfer of receivables to a third party). In the hadith narrated by Muslim (no. 1584 and 1587), the six com- modities (gold, silver, wheat, barley, dates, and salt) mentioned in these hadith are included in the category of usurious goods, and thus are allowed to be bought or sold only when certain requirements are met, that is, the transaction is paid in cash (goods are exchanged on the spot) and for equiv- alent objects—the goods exchanged are of the same measurement (Fatwa

Market Risk in Islamic Banking 263 Al Lajnah Ad Da’imah, 13/442, no. 3291). This means that gold could also be exchanged for silver, as long as the transaction is completed on the spot. Paper currency is included in the same category as gold and silver, which is as a money commodity. This means that rupiah cannot be exchanged with dollars unless in cash (on the spot) and of equivalent amount (equal values). If any of these requirements are broken, the transaction is categorized as usurious. For example, it is completely prohibited to exchange the rupiah with U.S. dollar under conditions of credit. As a consequence, several conventional practices in exchange rate hedging are not applicable in handling risk in an Islamic bank—for example, forward and future transactions. Other than usury, the presence of gharar factors also cause conventional hedging transactions to be inadmissible in Islam; an example of this is selling an object that the seller has yet to own, and included in this is agreeing to sell something in the future without determining the date of the transaction or the price.

12CHAPTER Liquidity Risk in Islamic Banking Liquidity is required by the bank to accommodate every fluctuation of its balance sheet, both expected as well as unexpected, and provide adequate funds for the bank to grow. Covered in this definition is the availability of funds when depositors withdraw their funds, when paying maturing liabil- ities, when fulfilling debtors’ financing demands, and when rebalancing the investment portfolio. However, when the bank is in dire need of liquid funds and yet cannot receive those funds except with difficulty and at an unreason- able price, then the bank can be said to experience liquidity risk. Since the price (or cost) of liquidity is a function of supply and demand in the market, affected by market conditions as well as the perceptions of market actors, then the inherent risk faced by the bank is more complex. URGENCY OF LIQUIDITY RISK Liquidity risk is the specter that haunts the banking industry. Not a single bank is able to escape from liquidity risk. The relationship between banks and liquidity risk is as close as that between a human being and his or her shadow. Wherever and whenever the bank stands, liquidity risk will follow the bank’s operational activities. History has shown that liquidity risk is one of the major causes of bank bankruptcy. The bankruptcy of Long Term Capital Management in America in 1997, the Indonesian banking crisis of 1997, the bankruptcy of Northern Rock bank in the United Kingdom in 2007 and the case of Century Bank in Indonesia in 2008 were all triggered by liquidity risk. Why are banks always haunted by liquidity risk? Is there no way to elim- inate liquidity risk from banking activity? Banks are intermediation institu- tions, bridging the gap between parties with surplus funds and parties with deficit funds. The bank offers depository services to members of the society with excess funds, while allowing them to withdraw their funds any time they need. Even if there is a time limitation, it is usually less than a year. The bank’s offer becomes attractive, with its promise of providing return to mem- bers of the public who depositing their funds with the bank. This way, the bank is able to collect funds from a large number of individuals, increasing 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. 264

Liquidity Risk in Islamic Banking 265 the size of the deposits collected. This pooled investment fund is channeled to entrepreneurs who require financing for various business activities. Depos- itors do not need to worry over the security of their funds due to possible moral hazard on the part of the entrepreneur. It is the banks who will be responsible for monitoring the process of the entrepreneur’s business activi- ties. Banking activities improve access to their funds for the depositors, and the issues of asymmetric information and moral hazard can be minimized as the bank develops specialized expertise in it, as well as in the economies of scale in monitoring debtors’ businesses. These activities greatly improve the efficiency of the economy’s capital allocation processes. Yet the bank’s operating principles, as explained above, create a major consequence that the bank will have to personally bear. The bank will always experience liquidity mismatch due to the profile of deposits being predomi- nantly short term while the bank’s financing portfolio is predominantly long term. Problems arise if, at a particular time, most of the depositors withdraw their funds from the bank while the bank is unable to immediately liquidate the funds they’ve invested in their debtors. Under those conditions, the bank experiences liquidity problems. Seen in this light, it is clear that liquidity problems will always be attached to banking activities, and there is no way to erase the issue completely. The issue of agency problem is also present in bank lending. A bank is a highly leveraged institution borrowing short-term funds (deposits) and lending for long-term periods, and it will be exposed to asset–liability mismatch, creating the potential for liquidity shock and finan- cial instability on a larger scale. To reduce the effects of this liquidity risk, Stiglitz (1989) suggested that the bank reduce their risk-taking activities in channeling funds. But this does not mean that the bank should be resistant in channeling funds; banks do not have to get caught up in the problems of information due to their behavior toward risks—which is called credit rationing. This form of market failure refers to the negative incentives that have an impact on the selection of the inherent risk of hazard moral in the bank’s lending strategy (Askari et al. 2010). CREDIT MULTIPLIER, FINANCIAL STABILITY AND LIQUIDITY CRISES A bank is said to be stable when the maturity of its assets and liabilities match; asset value is preserved, and the financial assets issued are fully backed by gold or a collection of deposits. Excess issuance of gold-based certificates or deposits, bank notes, or fiat money drives instability in the financial system, and the peak of this happens when there is large-scale withdrawal by depositors due to the fall of the money’s value. Under these

266 RISK MANAGEMENT IN ISLAMIC BANKING conditions, the value of the claim exceeds the value of the gold reserve or collateral asset; when liquidity is required, asset conversion is difficult and expensive, thus bank bankruptcy can plausibly happen, or at least the value of the security issued by the bank will be devaluated. In a fiat money system, the central bank can act as the lender of the last resort, preserving stability by printing new money; in turn, this solution will actually lead to a depreciation of monetary value. The bank can issue money in the form of credit; this enables the amount of credit channeled to exceed the deposit received. When the bank experiences liquidity shortage, the bank borrows from another bank issuing debt-based securities or borrows from the central bank. The continuously looping money-creation process by the depository bank and excess credit channeling creates the “credit multiplier effect.” In a conventional bank, the credit multiplier effect depends on the bank’s supply function to lend and the debtor’s demand function to borrow. If the bank competes to provide loans, interest rate will decrease, increasing incentive to lend credit to subprime borrowers; borrowers will find it more acceptable to pile on debt, and credit growth increases. However, if the bank is aware of the direction of this loop and increases the interest rate, or if borrowers face recession and a fall in business profit, then the creation of money may be limited. Under conditions of prudence, the bank stockpiles excess reserve and only provides credit to its main clients. Then, the source of financial instability comes from two things. First, the creation of money in the depository bank drives the unbacked expansion of credit, exceeding the amount of deposits that have been absorbed from the public. Second, asset values depreciate; when facing liquidity shortage, the bank is often forced to liquidate assets at discounted prices and will need to borrow additional funds or ask investors to inject new capital to fulfill their liquidity needs or liability maturity. When the banks are too tightly connected through interbank loans, more complex conditions will arise. An individual bank’s default due to credit freeze trap and sudden loss of liquidity can drag the banking industry into a financial crisis through a contagion scheme and domino effect. Islamic finance is positioned as a more stable alternative compared to the conventional finance system due to three factors. The first factor is the avoid- ance of leverage and debt refinancing through the prohibition on usury. In Islam, people are allowed to borrow only if two conditions are fulfilled: there is an urgent necessity (hajjah) to borrow, and the borrower has the capability to return the loan. On the other hand, the party that lends their money can- not exploit debt to gain profit, as that would fall under the prohibited usury. Thus, even if the absence of usury is able to drastically increase the demand for debt, this increase has no response in supply, since there is no incentive for the lender to lend capital. The second factor is the inherent matching of

Liquidity Risk in Islamic Banking 267 asset and debt. A mismatch between the two of them will create liquidity problems, where the bank has several settlement options: borrowing liquid- ity to other banks, increasing deposits, or minimizing debt monetization. The third factor is the elimination of the credit multiplier effect. When the Islamic bank is in the form of an investment bank, no money creation through the channeling of credit occurs, and all investment is fully supported by savings or deposits. Savings-to-income ratio, the cash inflow into the bank to its wealth-creating activity, is based on real savings and not on credit multipli- ers, as usually occurs in conventional banks. The growth of financing activity is then stable and is determined by the real growth of the economy, and not due to unstable speculative financial factors, the credit multiplier effect, and the money creation effect by financial institutions. The profit distributed to depositors is real profit from the economic sector, not a predetermined return unrelated to the risk profile and return of the business financed. DEFINITION AND COVERAGE OF LIQUIDITY RISK The Islamic Financial Services Board (IFSB) defined liquidity risk as the potential loss that can be experienced by an Islamic bank due to its inabil- ity to promptly meet its matured liabilities, or the Islamic bank’s inability to fund its asset increase at an acceptable cost without suffering significant losses. Bank Indonesia defined liquidity risk as risk that occurs due to the bank’s inability to meet its matured liabilities from its cash flow and/or other high-quality liquid assets that can be easily collateralized without disturbing the bank’s activity and finance. From the two definitions, it is clear that liquidity in banking institutions is more complex than in other financial institutions. Liquidity for a bank covers two aspects: the Islamic bank’s ability to promptly meet its matured liabilities and the Islamic bank’s ability to obtain new funds at low cost. A bank’s maturing liabilities are the sum of the deposits (current deposits, savings, and time deposits) that are about to be withdrawn by the deposi- tors. The new funds mentioned are any type of access or source of financing the Islamic bank can easily utilize when it requires funds promptly, both to finance asset or to fulfill its maturing short-term liabilities. Liquidity risk can even be defined as the risk occurring from excess liquidity or liquidity short- age due to difficulties in transacting an asset, difficulties in securing financing at a reasonable cost, and the lack of liquid assets to fulfill liabilities. Liquidity is needed by the bank to compensate for fluctuations in the balance sheet, both expected as well as unexpected, and to provide enough funds for the bank to grow. The bank is said to have adequate liquidity when the bank can immediately secure the funds it needs (through increas- ing liabilities or equity, securitization, or selling assets) at a reasonable cost.

268 RISK MANAGEMENT IN ISLAMIC BANKING The liquidity cost that must be paid by the bank is a function of the bank’s internal conditions, market conditions, and the market perception over the inherent risk owned by the bank. The availability of liquidity supplier and liquid financial instruments in the financial markets affects market depth and is one of the prerequisites of the financial industry’s stability and continu- ous growth; included within it is the bank. At the same time, the amount of liquid or easily sellable assets that the bank should hold is highly dependent on the stability of the liability structure and the expansion speed of the asset portfolio. The bank will only need to hold a lower liquidity level when it has a wide deposit base with low concentration, with an asset portfolio that con- tains many short-term assets. On the other hand, the bank will need to hold a higher liquidity level if the bank’s deposit base is highly concentrated and its asset portfolio is dominated by medium-term and long-term assets. The bank should prepare higher liquidity if the withdrawal potential from large corporations or small depositors is large and if, on the other side, debtors use a large amount of the bank’s funds. Liquidity Dimension An asset can be considered liquid if the asset can be converted quickly into cash, it has low conversion cost, it can be converted in high num- bers/volumes, and its value after the conversion is not significantly changed. Quick conversion time, low cost, high value, and preserved value after conversion are the four dimensions of liquidity. The absence of even one dimension will reduce an asset’s degree of liquidity. It is possible that an asset is less liquid because it can be converted into cash at low cost and at high volume, but its values will decrease significantly. Even then, an asset is considered less liquid if it can be converted to cash at high volumes and with preserved value but requires a significant time to convert it and the cost of the conversion is not low (e.g., factories, buildings). Another liquidity-related definition is a business’s ability to settle all of its short-term liabilities, defined as all liabilities maturing in a year or less. In settling various short-term liabilities (e.g., supplier payables, wages and salaries payable, and taxes payable), businesses usually use liquid assets. A bank is then said to be liquid if the current assets that it owns are larger than its current liabilities. Under these conditions a bank is said to be liquid enough. From the above definitions, it can be assured that a bank’s asset portfo- lio, including an Islamic bank’s, is predominantly illiquid assets. The primary composition of banking assets consists of all financing channeled to debtors, the majority of which is longer than a year. Other than that, an outstanding financing portfolio is an asset that is difficult to transfer or sell to another party (nonmarketable); even if it is possible to do so, its value would’ve been

Liquidity Risk in Islamic Banking 269 greatly decreased. Judged on the four dimensions of liquidity, the major- ity of a bank’s assets consist of financing that is very illiquid. However, the majority of a bank’s liability portfolio comes from deposits collected by the bank from the wider public (third-party funds) with a maturity that is gen- erally less than a year. A bank that performs its function well will certainly have a low liquidity ratio, with its current liabilities larger than its current assets. Because of this, any bank will experience liquidity problems due to the majority of its assets being illiquid while the majority of its liabilities are less than a year. Banks and the Liquidity Creation Function The bank’s existence is necessary, as it fulfills two important roles in the econ- omy: creating liquidity and transforming risk. The bank can create liquidity both on and off the balance sheet. In the on-balance sheet, the bank creates liquidity by financing less liquid assets with relatively liquid debt. The same can be said in the off-balance sheet; the bank can commit financing and claim over liquid funds. Even more, the presence of the bank’s financing commit- ment can provide a mechanism to share risk optimally, to reduce financing rationalization, and to reduce the effects of information friction between the debtor and the bank. The second function, which is transforming risk, is done by the bank in line with performing its liquidity creation function. Among the methods used by the bank to do this are issuing low-risk deposit and savings products to finance higher-risk projects and businesses. Even if not highly related, the size of the liquidity successfully created will be pos- itively correlated with the degree of risk transformed. Because of this, the regulator will always give serious attention in constructing safe regulations, supervision, and market discipline to control risk-taking behavior done by the bank to create liquidity. The bank’s capital will absorb risk and expand the bank’s risk-bearing capacity. Thus, the higher the capital ratio, the more liquidity the bank would be able to create. There are at least three reasons why the “risk absorption hypothesis” tends to occur in large banks rather than small banks. First, large banks are usually monitored more closely by regulators, where increase in the bank’s capital is also a part of risk management tools. Second, large banks are also the main subject of market discipline and provider of uninsured financing, thus capital has a larger effect on financing and the availability of uninsured financing. Third, several large banks may see a new opportunity to offer commitment to large financing or equity investment in other off-balance sheet activities. Since these various activities involve risk, the banks are requested to increase their equity to anticipate their entrance to these new activities.

270 RISK MANAGEMENT IN ISLAMIC BANKING Determinants of Liquidity Risk Liquidity risk in banking is the result of interaction between the assets and liabilities owned by the Islamic bank. Liquidity issue in an Islamic bank can thus manifest when one or more of these events occur: ■ When many deposits are withdrawn and the Islamic bank does not have adequate funds and immediate source of financing that can be utilized to cover the liquidity demands of its depositors. ■ When the Islamic bank has a sizeable, unrealized financing commitment with a debtor, and at the time of the realization, the Islamic bank has inadequate funds. ■ When a sizeable amount of deposit or deposits is withdrawn and the Islamic bank does not have adequate funds and immediate source of financing that can be utilized to cover the liquidity demands of its depositors. ■ When there is a significant decrease in the bank’s asset value, deposi- tor confidence in the bank decreases, prompting depositors to withdraw their deposits from the bank. The sources of liquidity risk from a bank can be classified into two: direct and indirect. Direct sources emerge from various distortions in cash flow caused by market risk, operational risk, or business risk; and generate liquidity issues, both those causing liquidity deficit as well as liquidity surplus. An indirect source of liquidity risk can occur due to delays in payment or debtor default, massive deposit withdrawals, low ability to collect funds to refinance assets or fulfill liabilities, and asset–liability mismatch. The Islamic bank needs the financial market to manage its liquidity, as well as to adjust its balance sheet and financial positions. The short-term cash positions, both deficit and surplus, occur as the results of imperfect synchronization in the payment period become an important impetus for the existence of the money market. The money market, under these conditions, becomes a source of temporary financing and a place to temporarily park excess liquidity for the banks through portfolio adjustment transaction, utilization of idle funds before being absorbed by the financing portfolio, or temporary placement of acquired depositors’ funds. Even the presence of wide, deep, and resilient money market where assets and liabilities can be traded can reduce income elasticity of demand for cash and financial investment projects. Banks can feel safe in holding illiquid assets as long as the instrument that they own fulfills the requirements of being transacted in the money market.

Liquidity Risk in Islamic Banking 271 ISLAMIC BANK’S ASSETS AND LIABILITIES Since a bank’s liquidity is the result of the interaction between a bank’s asset and liabilities, then a bank’s liquidity level is very reliant on its asset and liability portfolios. The bank’s liquidity condition can be reviewed based on the composition of assets, liabilities, and equity in the bank’s balance sheet. Compared to a conventional bank, an Islamic bank’s balance sheet has sev- eral differences, both on its assets side as well as liabilities. In an Islamic bank, the asset portfolio is much more varied, from sale contracts with many similarities to debt to investment contracts based on profit sharing. On the liability side, Islamic bank is dominated by entrusted funds (wadiah) and investment funds (mudharabah or musyarakah). The composition of an Islamic bank’s balance sheet is shown in Table 12.1. Liquidity Management in an Islamic Bank’s Balance Sheet Balance sheet structure is very important in the risk management process. In-depth and comprehensive analysis over balance sheet components helps the bank to determine the risk levels it faces, such as liquidity risk, market risk, operational risk, and credit risk. Changes in balance sheet structure indicate changes in its underlying risk. Because of this, risk management procedure and policies should be defined and executed after first analyzing the balance sheet. Even though the balance sheet components of all Islamic banks are “almost the same,” the weight/proportion of the balance sheet TABLE 12.1 An Islamic Bank’s Theoretical Balance Sheet Assets Liabilities and Capital Cash and cash equivalent Demand deposits (wadiah) Saving deposits and unrestricted Trade and commodity financing assets (murabahah, salam, ijarah, investment accounts (mudharabah istishna’) mutlaqah) Restricted investment accounts Investment assets (mudharabah, (mudharabah muqayyadah, musyarakah) musyarakah) Reserves Fee-based services (ju’alah, kafalah, Equity capital etc.) Non-bank assets (property and other fixed assets)

272 RISK MANAGEMENT IN ISLAMIC BANKING components varies wildly between different banks all around the world, and this shows that the risk profile of each bank is different. With the form and composition of the balance sheet as shown in Table 12.1, an Islamic bank should find it easier to manage its assets and liabilities reducing the issue of a mismatch between assets and liabilities. Savings and mudharabah deposits can be used to finance debt-based financing assets (murabahah, salaam, istishna’, and ijarah) while investment based on equity-investment contracts (mudharabah or musyarakah) is financed with bounded investment accounts that also use mudharabah or musyarakah contracts. To anticipate withdrawals from depositors with checking accounts, the Islamic bank can use cash and cash equivalents as well as shorter-termed financing. If the mechanism is used, then the Islamic bank is not only able to minimize the mismatch between assets and liabilities, but also maximize the risk-return profile of each of its products. Asset portfolio is not overly focused on debt-based financing, but is well-proportioned to equity investment–based investments, optimizing the bank’s possible return. On the other hand, the equity investment–based risk can also be minimized, as it is financed by bounded investment accounts that are also equity investment based and are bound by commitment to not withdraw their funds before maturity. LIQUIDITY RISK MANAGEMENT IN ISLAMIC BANKS Liquidity is an important thing for an Islamic bank to manage. Liquidity management in Islamic banks is only a little more complicated than the man- agement of other risks. This is because liquidity has two contrasting sides. On one hand, high liquidity secures and stabilizes a bank’s position, but on the other hand, if liquidity becomes too high, a bank’s profitability suf- fers because liquid assets don’t usually provide a high rate of return. This is where the risk-return tradeoff applies. Good liquidity risk management should begin with the process of measuring liquidity in Islamic banks and end with various risk mitigation strategies that can be enacted by the Islamic banks to face liquidity risk. Generally, the detailed stages of liquidity risk management can be seen in Figure 12.1. Measuring Liquidity Risk Liquidity risk can be measured using a standard method: a liquidity gap for every maturity bucket, or the ratio of liquid assets to total assets (or liquid liabilities). This liquidity ratio means that the higher the ratio, the better the bank’s liquidity position. It needs to be remembered that higher ratios are

Liquidity Risk in Islamic Banking 273 Policies related Allocation of Liquidity risk report liquidity risk excess liquidity Funding excess liquidity Liquidity buffer Liquidity risk Liquidity risk management measurement Net funding Back testing requirements Data collection FIGURE 12.1 Liquidity Risk Management Process associated with lower profitability for the bank. This is because the higher the liquid assets held by the bank, the higher the bank’s idle funds, and the smaller the portion of funds that can be invested in productive assets. There are several variations of liquidity measurement available to super- vise a bank’s liquidity conditions. Among these is liquidity ratio calculated by weighting liquid assets available in 30 days to cover the weighted liabili- ties of that period. Several banks also use the available net liquidity measure, calculated as the amount of legal and economic cash flow, both for balance sheet items as well as off-balance sheet items, covering expectations of con- sumer behavior in placing and withdrawing funds to and from the bank. The bank should calculate and evaluate these two measures everyday and set a safe liquidity limit for both. The bank will need to manage liquidity by managing daily and interday liquidity needs; preserving an adequate combi- nation of funding sources; preserving a broad portfolio consisting of highly marketable securities; monitoring international and domestic money market conditions; measuring cash inflow and outflow for one day, one week, and one month ahead; developing a stress scenario model; and constructing con- tingency funding plans updated with current conditions. Other than these two measures, the bank can monitor liquidity with three other measures:

274 RISK MANAGEMENT IN ISLAMIC BANKING the short-term position (calculated as the bank’s ability to pay for all bonds maturing less than a year under conditions of distress), surplus cash capital (measuring the bank’s ability to fund assets under fully collateralized condi- tions, assuming that access to unsecured funding is closed), and basic surplus (measuring the bank’s ability to survive 90-day stress, with the assumption that no funding can be obtained during that period). The bank can also use the cash capital model in evaluating balance sheet liquidity and in deter- mining the appropriate source of short-term funding. Liquidity needs can be managed through liability diversification and investor relationship and through the application of good contingency planning. The second approach is to calculate the maturity gap that provides an indicator over liquidity risk. In calculating maturity gap, the Islamic bank can identify various different scenarios and utilize them to find optimum liquidity positions under various projection assumptions through sensitivity analysis, scenarios, and simulation. The liquidity risk management process begins with the identification of various components of assets and liabili- ties closely related to liquidity in an Islamic bank; assets held generate cash inflow, while liabilities held generate cash outflow. The process of liquidity risk management therefore begins in data collection, covering the process of identifying the various sources of cash inflow (assets) and cash outflow (liabilities) that have been grouped according to their maturity periods. Liquidity measurement is determined by the construction of the matu- rity ladder based on the determination of the appropriate time band. The bank can calculate the net fund requirement, which is the excess or shortage of liquidity at every time period, as the difference between the expectation of cash inflow and cash outflow. If cash inflow is larger than cash outflow, then the Islamic bank experiences excess liquidity, and if the opposite is true, then the Islamic bank experiences liquidity shortage. This information is use- ful for the Islamic bank to determine when to finance liquidity shortage in order to avoid liquidity problems. From this, the bank can construct a series of policies to cover the gap that emerges through asset management, lia- bility management, or a combination of both. With a complete database, the Islamic bank can project cash inflow and outflow periodically per time period (i.e., monthly, quarterly, or annually) in the future. As such, anticipa- tory actions to avoid liquidity problems can take place. To ensure that the projected cash flow model is sufficiently accurate, back testing along with a series of statistical procedures need to be done to minimize any errors in projection. Strategies in Liquidity Risk Mitigation Bank could utilize several methods to mitigate liquidity risk: asset–liability management, treasury activity in the financial market, and maintenance

Liquidity Risk in Islamic Banking 275 of internal and external sources of funds. Conventional banks mainly use the treasury activity, given the abundant resources of short-term financial securities in the market. There are still very limited Islamic marketable securities and Islamic financial markets, therefore Islamic banks usually opt for asset–liability management as well as maintaining internal and external sources of fund. Asset–Liability Management The purpose of asset–liability management is to reach an optimum combination and level of asset, debt, and risk-return profile attached to asset and debt owned by the bank. To achieve this purpose, the bank needs strategic planning, implementation, and control of the process of raising and using funds affecting the volume, composition, maturity, rate-of-return, financial risk, profit-and-risk sensitivity, quality, and liquidity, both on the level of individual assets/liabilities as well as on the portfolio level. When the Islamic bank consistently applies the profit-loss sharing concept, where the bank will transfer all profit and loss that it experiences to the investor-depositor, then the bank will tend to be less exposed to the effects of asset–liability mismatch and equity duration risk compared to conventional banks. Various negative shocks over the rate of return of assets owned by the bank will be directly absorbed by the shareholder and investor-depositor as investment account holders. In practice, the risk-sharing practice is only imperfectly followed by the Islamic bank. Rather than rigidly sharing profit and loss with depositors, the bank prefers to choose to distribute profit to them, even when in reality there is no profit to be had or the actual profit is much lower. This will cer- tainly create distortion and financially burden the shareholders as the bank’s provider of capital. This mismatch is worsened by overreliance on short-term trade financing and the scarce usage of long-term syirkah contracts. This causes the bank’s asset composition to be dominated by short-term assets, low profit (margin, ujrah, price spread), financial claim backed by asset and predetermined rate of return. At the same time, there are only limited funds available to be channeled to more profitable and yet more risky long-term projects (through syirkah contracts). To reduce asset–liability mismatch risk, the bank will need to have enough liquid assets to protect the bank from this risk. Among the causes as to why the bank is reluctant to channel its funds to profit-sharing-based projects is the high level of risk involved, the bank and its depositors’ low acceptance of risk, the lack of availability of competent human resources to manage higher-risk projects, low transparency in the market where the bank operates, and the presence of additional monitoring costs. The bank and the depositor tend to be risk-averse, and thus reluctant to actually enter a profit-sharing scheme. When there are no clear differ- ences between investor-depositors and shareholders, both in terms of policy

276 RISK MANAGEMENT IN ISLAMIC BANKING as well as the calculation and division of profit, then the profit distributed to investment account holders, even when losses to assets are suffered, would consist of profit that should be paid to equity holders. This condition is what is known as displaced commercial risk. Treasury Activity in the Financial Market Generally, liquidity risk manage- ment is not too different from other risks, but especially for liquidity risk, risk management practices must be done to ensure that the Islamic bank is at an optimal liquidity level, where both excess as well as shortage of liquidity are avoided. Because of this, through the treasury department, Islamic bank activity in managing liquidity is more dynamic than other risk management activity. This is because liquidity problems can occur any time. Liquidity risk policy in an Islamic bank usually consists of four things. These are: investment policy on allocating excess liquidity, financing policy to cover liquidity shortage, policy on liquidity buffer, and risk mitigation strategies that can be done by the Islamic bank to avoid losses due to liquid- ity problems. If excess liquidity occurs, which is the condition where cash inflow is larger than cash outflow due to the abundance of third-party funds flowing in, the Islamic bank should locate various short-term investment instruments that can be used to place those funds. Since they are tempo- rary in nature, the investment instruments chosen should be marketable securities, to ensure that the Islamic bank is able to easily liquidate the invest- ment should the funds be needed at any time. The banking industry’s excess liquidity is usually placed in money market instruments, the Islamic inter- bank money market (KL-LIBOR), short-term sukuk, the stock market, and the like. A bank’s activity in the stock market can reduce idiosyncratic liquidity risk of the individual stocks owned as well as manage the liquidity risk of the asset portfolio owned. With active transactions in the stock market, the bank can reduce liquidity risk and rate-of-return risk in its operational activities (such as productivity risk) by holding a well-diversified stock portfolio. The bank can also mitigate premature and unnecessary asset liquidation risk due to liquidity and productivity shocks. This is relevant because naturally, any asset financed by the bank through the issuance of deposit contracts will gen- erate solvency and liquidity risks. Asset and financing portfolio held by the bank contains payoff with risk and liquidation costs if it is liquidated earlier than maturity, while deposits can be liquidated anytime and are often liqui- dated at par value (wadiah and qardh), except in the cases of syirkah-based investment accounts (mudharabah and musyarakah). In the cases of liquidity shortage, which is the condition where the bank’s cash inflow is less than cash outflow due to an increase in third-party funds withdrawal, the Islamic bank will have to locate a source of funds that

Liquidity Risk in Islamic Banking 277 are relatively affordable to finance the liquidity shortage. Since liquidity shortages are usually temporary, the source of funds sought by the Islamic bank is usually short-term as well. Several sources of short-term financing can usually be obtained from various investment instruments in the money market as well as the interbank money market. Another method that is often used to obtain liquidity is through the securitization of several of the assets owned by the bank, where the bank issues marketable securities using several assets, such as fixed asset, equity in syirkah, and the like, as the underlying asset. By doing this, even though the bank’s assets are longer-termed and are difficult to liquidate in the short term, the bank can secure liquid funds by selling those securities. Access to Sources of Funds: Internal versus External The bank faces liquidity issues when expected and unexpected losses in the bank’s operational activ- ities occur or when there is a financial crisis occurring in the market. This liquidity problem could worsen and affect the banking sector as a whole, leading to the occurrence of systemic risk. Usually, the bank is requested by the supervisory authority to simulate and analyze its internal financing ability in facing a liquidity crisis and to develop emergency plans for liquid- ity risks (BCBS 2006). When internal funding is unavailable, the bank can access the financial market to obtain the funds it needs. Yet the main chal- lenge faced by the bank is when obtaining funds (liquidity) from the financial market also becomes difficult during the crisis period. Generally, the bank will hedge its risks when liquid markets are available, and the bank will man- age risks internally and hold liquid assets to prepare for the risk of difficulties in transacting. The regulators in various countries have responded to the limitations faced by the Islamic bank in managing its assets and liabilities. First, the development of sukuk or syari’ah-compatible securities, as by the Central Bank of Sudan, will improve coverage and depth of Islamic financial market is encouraged. Second, establishing several syari’ah-based financial institu- tions, such as International Islamic Financial Market (IIFM) and Liquidity Management Center (LMC) will provide liquidity and at the same time man- age excess liquidity more effectively. IIFM, established in Bahrain in 2002, is a trade association established to encourage the development of financial markets. Among the main purposes of IIFM are (1) to promote cooper- ation among Islamic bank regulators, (2) to overcome liquidity issues by developing the maturity structure of financial instruments, and (3) to review the possibility of sovereign asset-backed securities. To develop sukuk mar- kets, both primary and secondary, IIFM collaborates with the International Capital Market Association (ICMA), and there are two programs currently in development: a repurchase (repo) agreement to assist central banks in

278 RISK MANAGEMENT IN ISLAMIC BANKING managing market liquidity in the sukuk market and a master agreement for commodity murabahah contracts used in Islamic banks’ interbank transac- tions. LMC is an institution established to facilitate investment from banks and Islamic financial institutions with surplus funds through good quality short-term and medium-term financial instruments that are also syari’ah-compliant. Among the shareholders of LMC are the Islamic Development Bank, the Dubai Islamic Bank, the Bahrain Islamic Bank, and the Kuwait Finance House. In providing liquidity enhancement for Islamic financial systems, LMC manages short-term liquidity and is actively involved in supporting the interbank market of Islamic banks. LMC also securitizes assets through various product innovations, turning them into conveniently trade-able instruments (such as sukuk) as well as providing advisory service in the issuance of sukuk and stocks for project and business financing. Several central banks have even signed an agreement on October 2010 to build liquidity facility for Islamic financial institutions by providing liquidity-enhancing products and liquidity through short-term financial instruments transaction. Utilization of the RAROC Model As has been discussed previously, a certain level of the bank’s capital needs to be set aside to preserve stability in the financial market. Banks with an asset portfolio of higher risk will have to maintain a higher level of capital reserve than banks with a less risky asset portfolio. Yet high levels of capital negatively affect a bank’s profitability, as they reduce the proportion of the bank’s deposits used productively and limit the bank’s ability to provide funds to finance productive assets. The bank’s capital should therefore be kept at levels that will ensure the level of profitability that is expected, as well as the bank’s financial stability. The Islamic bank should manage its capital requirement and manage it efficiently. Bank should strengthen risk management practices to find adequate defini- tions of their capital needs. The better the risk management used, the better the bank’s ability to calibrate their capital needs. The Islamic bank can use RAROC to allocate capital to finance different financing models based on their respective risk profiles. Predictable losses and maximum losses vary from one financing model to another, where it can also be estimated through historical data accumulation. Apart from that, RAROC can also be used to determine the rate of return of different financial instruments (Ahmed and Khan 2007). Maintaining the Liquidity Standard Iqbal and Mirakhor (2011) said that the recent financial crisis is closely entwined with liquidity issues, and as such is said to have generated “perfect liquidity surprise.” To prevent a recurrence

Liquidity Risk in Islamic Banking 279 of the crisis—or to reduce its effects at the very least—Basel III introduced the minimum measure of liquidity and monitors the liquidity coverage ratio (LCR) of financial institutions. LCR is designed to guarantee that the bank has enough liquid assets to overcome a short-term liquidity crisis based on a cluster of cash inflow and outflow defined by the Basel Committee on Bank- ing Supervision (BCBS). LCR was planned to be implemented on January 1, 2015, with the minimum set at 60 percent; it will rise in stages until it reaches 100 percent on January 1, 2019 (BCBS 2013). LCR is calculated as coverage ratio, a traditional liquidity methodology used by the bank to measure expo- sure to contingency liquidity events, where the total cash outflow calculated is the scenario for the next 30 days. The bank is expected to maintain LCR at 100 percent or more, even under conditions of financial stress. If necessary, the bank can use high-quality liquid assets to maintain LCR at 100 percent. LCR has two components: a reserve value of high-quality liquid asset and the total net cash outflow. According to BCBS (2013), high-quality liquid assets has these fundamental characteristics: low risk, ease and certainty of valua- tion, low correlation with risky assets, listed on a developed and recognized exchange, active and sizable market, low volatility, and flight to quality. Stock of high quality liquid asset ≥ 100% Total net cash outflows over the next 30 calendar days Liquidity problems have a serious implication for banks, especially Islamic banks, for three reasons. First, Islamic banks do not have access to short-term liquidity instruments in the market due to prohibitions on usury and selling debt. Second, the assets of an Islamic bank are relatively concentrated in trade or commodity finance like salam, murabahah, and istishna’ assets, where all these assets are illiquid and cannot be easily traded in the secondary market. Third, the Islamic bank cannot access the liquidity loan facility from the central bank as the lender of the last resort, the way conventional banks can. This is because generally, this facility is interest-based, and the Islamic bank is prohibited from being involved with it. This meant that even though the Islamic bank is financially healthy, they still have the possibility of future demand of capital due to low access to liquidity. This can prohibit their growth and efficiency. Hurdles for the Islamic Bank in Managing Liquidity Risk Liquidity risk in an Islamic bank is worsened by two conditions: the lack of liquidity in the Islamic financial market and the bank’s inadequate access to sources of financing. There are still several hurdles to an Islamic bank’s investment as well as financing activity in preserving its liquidity levels.