Risk Management for Islamic Banks Recent Developments

280 RISK MANAGEMENT IN ISLAMIC BANKING First, there are fiqh limitations on securitizing debt-based assets such as murabahah, salam, and istishna’ financing. Islamic syari’ah prohibits the sale of debts (bay’ ad-dayn), thus the Islamic bank cannot obtain liquidity by securitizing its debt-based assets. Secondly, almost all well-developed money market instruments are based on interest (usury), making it difficult for Islamic banks looking for money market instruments to maintain liquidity. Additionally, the Islamic money market is not yet stable enough and has inadequate depth, so the types of instruments available are also still very limited, complicating the Islamic bank’s efforts to gain access to financing from the Islamic money market. Limitations on the availability of syari’ah-compliant instruments, as opposed to the wide range of instru- ments available in the conventional market, and the inadequate depth of the inter-Islamic-bank money market limit the bank’s ability to effectively manage its liquidity position. Other than that, not all various securities in the secondary market can be utilized by the Islamic bank, especially those representing financial claims unconnected to any real assets. Third, several financial instruments used by the bank to channel funds contribute to increasing liquidity risk, like salam, istishna’, and murabahah. These three sale contracts are binding for both parties (seller and buyer); thus, once the contract is agreed upon by both, the bank cannot cancel the sale. The bank is also not allowed to securitize the receivables created from these contracts, much less factor or liquidate financial assets based on murabahah, salam, and istishna’ contracts on the secondary market. Fourth, the composition of third-party funds held by the Islamic bank in several countries is dominated by demand deposits and savings, both of which have the feature of being available to be withdrawn at any time, according to the request of the depositor. This results in the bank having to retain a certain amount of idle cash as buffer, especially if the bank does not have any liq- uid short-term financial instruments of its own. Fifth, the discount window facility provided by the central bank as the lender of the last resort available for conventional banks is unavailable for Islamic banks. This often happens because the discount window often applies discounted debt scheme (implicit interest rate), prohibiting the facility from being used by the Islamic bank. Controlling and Mitigating the Liquidity Risk According to the IFSB (2005), the Islamic bank will need to have an effec- tive liquidity management policy, and one that is appropriate based on the unique characteristics of the business, financial market environment or other sources of liquidity. The bank will need to ensure that: (1) the board of direc- tors are actively involved in constructing an effective liquidity strategy that uses healthy and adequate processes in measuring and monitoring the bank’s

Liquidity Risk in Islamic Banking 281 liquidity, (2) there is an effective liquidity monitoring and reporting system, (3) there is adequate financing capacity covering the shareholders’ ability and interest to provide additional capital when necessary, and (4) there are liquidity crisis management procedures in place, as well as effective access to methods to liquidate fixed assets. IFSB Principles for Liquidity Risk Management Principle 5.1 IIFS shall have in place a liquidity management framework (including reporting) taking into account separately and on an overall basis their liquidity exposures in respect of each category of current accounts and unrestricted investment accounts. Principle 5.2 IIFS shall assume liquidity risk commensurate with their ability to have sufficient recourse to shari’ah-compliant funds to mitigate such risk. Source: Islamic Financial Services Board, Guiding Principles of Risk Manage- ment for Institutions (Other than Insurance Institutions) (IFSB Website, 2005). Based on the two principles provided by the IFSB for liquidity risk man- agement, IFSB requires the board of directors of an Islamic bank to imme- diately construct a comprehensive and effective liquidity risk management framework. This framework must be designed to facilitate identification, measurement, monitoring, and reporting of liquidity risks that can arise from overall exposure or individual exposure categories that are separate from current account and unrestricted investment account. IFSB also encour- ages the Islamic bank to find/construct an appropriate measure of its liquid- ity risk, related to the bank’s ability to gain (or access) funds in order to mitigate it.

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

13CHAPTER Development of the Islamic Financial Market Every financial system usually consists of several subsystems: the bank- ing system, the capital market and the money market—all supported by various rules and regulations as well as infrastructure. The banking system functions as a depository intermediate in the economy, since it is capable of collecting capital from the wider public in the form of deposits. Other than that, the banking system is also responsible for managing a prompt and efficient payment system. The capital market and the money market’s main function are to provide short-term and long-term liquidity to all actors in the economy and manage a transparent, prompt, and efficient transac- tion mechanism for it. These three subsystems perform various functions, such as capital formation; information monitoring, collection, and dissem- ination; and facilitation of risk management. In various current literature, it is stated that the presence of an effective and efficient financial system creates several conditions: (1) an efficient intermediation system that mini- mizes transaction and information costs, (2) a stable and smooth payment system, (3) the formation of adequate liquidity in the system, and (4) good risk management processes. The Islamic financial system has two primary differences from the con- ventional financial system. The first difference is the complete absence of any debt-based instrument in the financial system due to the syari’ah pro- hibition on usury. Without the existence of a fixed return in the form of interest, debt-based instruments cannot exist, and the practice of using lever- age automatically does not apply in the Islamic financial system. The second difference is in the way the Islamic financial system offers the concept of risk sharing through various equity-based investment contracts. All parties involved in the investment contract stands on the same level, and all parties entering it are prepared to accept the risk in accordance to their respective roles. As such, the rate-of-return received by both parties will be appropriate with the level of risk that they are ready to bear. With those two features, the Islamic financial system has significant differences compared to the con- ventional financial system. 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. 285

286 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING The Islamic banking system as the primary supporting pillar of the Islamic financial system does not use the debt contract as the primary contract of its business model. Khan (1986) explains that the Islamic bank is different from the conventional bank because the Islamic bank primarily uses equity-based contracts, while the conventional bank primarily uses debt-based contracts. The savings and deposits products in conventional banks are replaced by investment-based saving and deposit products, akin to any equity instrument. Deposit in an Islamic bank is an equity-based investment contract in which the depositors can be considered to be “shareholders” investing their funds in the Islamic bank. The relationship between the Islamic bank and the depositor is one of partnership, where they share risks and profit. Similar things can be said about the Islamic capital market and money market. The transaction to sell debt (in its various forms) is prohibited by the Islamic syari’ah; because of this, the debt-based instruments proliferating in the conventional capital market are nonexistent in the Islamic capital market. Islamic financial instruments in the Islamic capital market can be grouped into two types: equity-based instruments, such as stock, and securities directly tied to real assets. ISLAMIC CAPITAL MARKET To set up an Islamic capital market, supporting institutions such as the Islamic Financial Services Board (IFSB) and the Accounting and Auditing Organization for Islamic Financial Institution (AAOIFI) are needed. Each country also needs to established its own Syari’ah Advisory Council to set up the syari’ah standard and evaluate market discipline toward that standard. The Islamic capital market includes the Islamic stock market, asset-linked securities, Islamic mutual funds, and the Islamic derivatives market. Any transaction is acceptable, as long as it complies with the conscience of Muslims and the religion of Islam. It needs to be free from prohibited activities such as usury (riba), gambling (maysir) and ambiguity (gharar). Risk emerging from Islamic capital market is no different from the conventional market. However, due to certain qualitative and quantitative parameters in Islamic capital market (for example, the prohibition on short selling in the capital market), it is generally considered stricter and thus more safe than the conventional markets. Instruments in the Islamic Financial Market One of the more famous theories related to the allocation of risk in the capital market is the general equilibrium model expressed by Arrow and

Development of the Islamic Financial Market 287 Debreu in 1972. According to the Arrow-Debreu model, in a perfect market, the market is able to provide various contingent instruments. Various types of capital market instruments will be created to fulfill the needs of market actors to diversify risk. Each market actor can choose which capital mar- ket instrument is needed. If the instrument wanted is not yet available, then accumulated demand will certainly drive its creation in the market. There will always be a party providing various capital market instruments that can fulfill the needs of various investors. The only limit on the market actors in accessing those instruments is their budget constraint; they will be unable to purchase market instruments beyond a certain price. The Arrow-Debreu model has extensive implications in the modern capital market. First, there is no limitation in creating various products or instruments in the capital market. Everyone has the right to create any financial instrument, as long as there is the demand for it. Second, the capital market is considered to be able to fulfill part of its function properly if the market is able to provide vari- ous financial instruments appropriate for the different risk profile of every market actor, thus assisting in spreading risk and approaching perfect diver- sification. Those two implications ensure that the global capital market will be flooded with many highly complex financial instruments. The Arrow-Debreu model is not in full compliance with the principles of Islamic syari’ah. Freeing the market to create all kinds of financial instru- ments results in the creation of many capital market instruments that contain usury, gharar, and maysir (e.g., various debt-based instruments as well as the more exotic derivatives). In the perspective of the syari’ah, the nega- tive effects (mudharat) caused by debt-based instruments and derivatives far outweigh any possible benefit they bring. At the beginning, financial instruments such as derivatives were created to facilitate hedging. In their development, the instruments are often used for speculation—an act clearly prohibited by the Islamic syari’ah. The Islamic capital market offers three product categories: stock market, securitized “asset linked” securities, and derivative products. With the prohibition of interest, all debt-based instru- ments have no place in Islamic capital markets. Because of this, Islamic capital markets offer massive risk-sharing applications through the first two market categories. The Islamic Stock Market The syari’ah prohibition on usury and interest eliminates any possibility of using debt-based instrument in the Islamic capital market. However, this prohibition gives equity-based instruments and transactions in the capital market large room to grow in the Islamic capital market. The Islamic syari’ah does not provide a specific limitation on equity instruments and transactions

288 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING in the capital market. Essentially, the sale of stock from the perspective of the Islamic syari’ah is similar to the act of selling in the standard market for goods and services. All the stipulations of the Islamic syari’ah related to sale in the goods and services market should be applied to stock transactions. As an example, Islamic syari’ah requires any trading between buyer and seller to be free of fraud (tadlis). This implies that the market price formed should be the normal expected price and should reflect the quality of the goods or ser- vices sold. All factors that can unnaturally distort the market price should be minimized or preferably eliminated. Thus in transactions involving stock in the capital market, all factors that are able to skew prices abnormally should be removed from play. In modern capital market, any stock price abnormal- ity is usually due to the presence of various activities that are prohibited by the syari’ah as well as the civic law: monopoly of information contributing to asymmetric information, high transaction cost, insider trading, and manip- ulation of stock price by the efforts of one or several significant players to herd market movements in their favor. From the perspective of risk, several people are of the opinion that the stock market is the most effective means of sharing risk, as stocks represent the contingency residual claim on a company. For public firms whose shares can be held by the public, their stocks represent the proportion of claim over various future pay-off possibilities. The rate of return enjoyable for the shareholder will greatly depend on the return of the future. A capital market that is well managed and regulated is highly efficient, as risk is distributed in accordance with the preferences and attitude of market actors on risk. A risk-averse investor will tend to be risk intolerant and thus prefer a secure capital market instrument, one with low risk and low return. Investors that are risk tolerant and able to accept a higher level of risk for the chance of receiving higher return can take various high-risk instruments. Asset-Linked Securities Market Securitization is a process of “packaging” several underlying assets into a marketable security. As an example, a bank can gain liquid funds by col- lecting several assets from its portfolio (of loans) and then issue a security whose underlying asset is those set of the bank’s loans. Consequently, when the security is issued and bought by the investors, the bank gains liquid funds without having to wait for its debtor to return the loans. Since it is in the form of marketable securities, investors who own it can sell it in the sec- ondary market when they are in need of liquidity. This type of product is often called an asset-backed security. The underlying asset inherent to a secu- rity functions as a collateral, improving the value of asset-backed security compared to other securities.

Development of the Islamic Financial Market 289 The Islamic capital market can provide an alternative instrument to asset-backed securities by creating an instrument called asset-linked securi- ties (or sukuk). Instruments in the form of asset-linked securities have many similarities with asset-backed securities. Asset-linked securities are securities whose underlying assets are assets or syari’ah contracts owned by the issu- ing firm. The issuing form can choose a type of asset that will be financed and then finance it by issuing asset-linked securities based on a particular contract type, such as ijarah, mudharabah, musyarakah, murabahah, and so on. Table 13.1 compares these instruments. All the cash flow provided by asset-linked securities comes completely from the cash flow of the project or asset that is its underlying asset. This is the primary difference between asset-backed securities and asset-linked secu- rities. In asset-backed securities, the securities issued are debt-based, thus the presence of the underlying asset is only to serve as the securities’ collateral. The cash flow of asset-backed securities, their level of risk, and their rate of return do not completely rely on the asset guaranteed. In asset-linked securities, however, the asset that is the underlying asset of the instrument is truly the source of cash flow received by holders of asset-linked securi- ties. The function of the underlying asset is not just as collateral, but also as the determinant of value in asset-linked securities, and whose cash flow will later be distributed to investors. This is because in asset-linked securi- ties, the type of contract used is an equity-investment contract instead of a debt-based contract, which is common in asset-backed securities. Investors purchasing asset-linked securities, then, have a direct relationship with the asset or project that is the security’s underlying asset. Investors have an own- ership stake in proportion to the amount of related asset-linked securities owned. The cash flow generated by the underlying asset then belongs entirely to the investor, according to the ownership proportion of all the investor’s asset-linked securities. The interaction between the issuer and the investor is not merely a debtor-creditor relationship. The relationship between the two of them depends on the type of contract used in the asset-linked securities. If the mudharabah or musyarakah contract is used, then the relationship between the two of them is one of partnership. If the ijarah contract is used, then the relationship between the two parties is that of a lessor and lessee. As an example, a firm interested in financing its investment in long-term fixed assets can issue asset-linked securities with an ijarah contract, where the security is a proof of equity ownership in the fixed asset. In asset-linked securities, the owner of the fixed asset is the investor, and the issuer pays its lease to the investor(s) periodically. At the time of maturity, the issuer can have an unbinding option to repurchase the asset from the investor(s) without a predetermined price already set in the asset-linked

290 TABLE 13.1 Comparison between Stock, Asset-Backed Securities, and Asset-Linked Securities Description Stock Market Security Conventional Asset-Backed Islamic Asset-Linked Security Security (theoretical) Security type Equity based Fixed income (debt based) Hybrid, depending on the contract and underlying assets. Could be quasi- Contractual Equity share, capital ownership Debt-based contract fixed income or risk sharing or both agreement Stockholder has ownership interest in Security holder does not own the assets Diverse, ranging from leases (rental) to Ownership the residual assets but owns a security against the asset equity (risk sharing). Could be Collateral amortizing or rental stream or pass Recourse Business assets (tangible and intangible) Underlying assets through Stockholder has recourse to the residual Security holder does not have recourse Pricing variables Security holder has ownership interest asset in the event of distress to the assets in the event of distress in the underlying assets Linkage with asset value Based on expected yields, growth, Based on expected yields, current Underlying assets current levels of returns, residual interest rates, and other variables Security holder has recourse to the Risk value of issuer’s assets, business influencing the asset owner’s decision- Principal earnings, and expected value of the making to prepay or refinance. underlying assets in the event of asset at maturity Creditworthiness of asset owner or distress protection the guarantor influences prices Based on expected yields, current levels Risk shifting Payoffs may be linked to residual value of returns, market value of of the issuer’s assets No direct link to the market value of underlying assets, and expected value underlying. Indirect variables such as of the underlying asset at maturity Business risk loan-to-value ratio are used as proxy Principal is linked to residual value of In general, final or other payoffs may be Credit risk linked to market value of the issuer’s assets Principal is protected irrespective of the underlying assets Risk sharing value of underlying assets Asset risk, credit risk Risk transfer Principal is linked to market value of underlying assets Risk sharing

Development of the Islamic Financial Market 291 securities contract. All the risk in asset-linked securities is primarily contributed by the underlying asset. As such, it can be said that asset-linked securities are a security representing the contract that took place between the issuer and the investor. Development of Sukuk Market The global Islamic financial industry has expe- rienced rapid growth and development in the last several years. According to data held by the Kuwait Finance House Research (KFHR), at the end of 2013, the total global assets of the Islamic financial industry reached US$1.8 trillion, with a compound annual growth rate (CAGR) from 2009 to 2013 of 17 percent. From that number, the Islamic banking sector provides the largest contribution compared to other Islamic financial institutions or products, in the range of US$1.4 trillion, or 77.77 percent of total global Islamic finance assets. After the Islamic banking industry, the sukuk instru- ment is the second-largest growth contributor of Islamic financial assets, with an outstanding market value of US$270 billion and an average CAGR of 18 percent. What is interesting is that in the sukuk sector, the Asian countries con- tribute the most to the total global sukuk asset value. The high value of outstanding sukuk in the Asian region shows that Asian countries have been aggressively issuing sukuk as an alternative capital market instrument to investors. Among countries in Asia, Malaysia and Bahrain are the coun- tries that issued the most sukuk as to finance various infrastructure projects (KFHR 2013). The popularity of sukuk as an alternative financial instrument in the global capital market gathered momentum during the period after the global financial crisis of 2007–2008. In 2010, the value and number of global sukuk issued experienced a year-over-year growth of 61 percent. With this high level of growth, sukuk was a rising star as liquidity in the conven- tional capital market was experiencing a drastic fall. Other than that, the characteristics of sukuk as asset-linked securities made them suitable as a source of financing for various long-term infrastructure projects, contribut- ing to the demand for sukuk by many investors. It is often the case that investor demand for sukuk far exceeds the number of sukuk issued (Islamic Financial Services Industry [IFSI] Stability Report 2014 published by IFSB). Islamic Mutual Fund For Islamic financial institutions, mutual fund products are products that are designed to target a specific and particular market segment. At the end of 2012 the growth of funds managed by investment managers (assets under management) had a CAGR of 9.4 percent (from the 2008 period). At the end of 2013, even if the global financial market has yet to perfectly recover,

292 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING the Islamic mutual fund is still able to grow at an excellent rate. Among countries with Islamic mutual funds, 41 percent of the AuM Islamic mutual fund is dominated by Saudi Arabia (41 percent), Malaysia (22 percent), and Jersey (10 percent). Of the types of mutual funds available, the stock index mutual fund dominates more than a third of the total global Islamic mutual funds. Money market and fixed income (sukuk) mutual funds are also in high demand by the public (IFSB Stability Report 2014). In developing an Islamic capital market, Islamic mutual fund products can be encouraged to grow at a faster rate. Improvement in financial liter- acy in the emerging markets also contributes to the increasing demand for Islamic mutual fund products. The proportion of the public entering into the “high net worth individual” category is also increasing, and they are usually dissatisfied with the rate of return they can receive from deposit and sav- ing banking products. Investment managers must then be provided with the incentive to increase the quantity and quality of Islamic mutual fund prod- ucts. To ensure transparency, investment managers should provide periodical reports to mutual fund owners related to the historical performance of the Islamic mutual fund managed, the details of the assets included in the Islamic mutual fund portfolio, and the manager’s investment strategy in the market. As such, the public will have perfect information about the Islamic mutual fund products that they own. DERIVATIVE ISLAMIC MARKET Unlike stock and sukuk, derivative instruments are those whose type and value are derived not from an underlying assets or projects, but from other primary financial instruments (e.g., stock and sukuk), hence the name derivative. If stocks and sukuk are proof of claims on the cash flow of the issuing firms, then the derivative instrument is a proof of claim over a financial instrument. In a financial system, there are three main functions of the creation of derivatives. First is risk reduction. The main purpose of creating derivative instruments is to hedge the value of an asset or liability from various risks that can possibly occur in the future. With derivative instruments, a party can transfer the risk it faces to other parties that are more capable of managing and bearing it. Second is price discovery and stabilization. Several marketable derivative instruments, such as futures contracts and options, are expected to improve the flow of information into the capital market; thus the process of price formation for various financial instruments goes well. Third is the completeness of markets. One of the purposes of derivative instruments is to ensure that every party involved in the capital market has an alternative instrument

Development of the Islamic Financial Market 293 that can be used as a vehicle for hedging as well as speculation (to gain profit). With the presence of derivative instruments, a market actor can easily obtain a financial instrument in accordance to his or her preference. Because of this, the variations existing in each type of derivative instruments are numerous. Since one of the functions of derivative instruments is completeness of markets, supporters of the efficient market theory consider the presence of derivative instruments in the capital market as absolutely necessary, and there is no need for them to be stringently and rigidly regulated. With the presence of derivative instruments, the practice of speculation will flourish, encouraging a more dynamic flow of information which in turn will improve the price formation process to become better and faster. In the Islamic financial system, the legality of derivative instruments from the perspective of syari’ah-compliance is still the subject of intense debate. Those opposing the presence of derivative instruments consider that their costs and harm (mudharat) are larger than their benefit (maslahah). Even if at the beginning the purpose of derivative instruments is for hedging, in its development, the instrument is used more often as a vehicle of specu- lation. Another mudharat of derivative instruments is seen in how they were the main contributor to the American subprime mortgage crisis, which then spread to various countries and into a global financial crisis. In addition, from an Islamic syari’ah review, all derivative instruments contain most of the characteristics that are prohibited from a mu’amalah transaction such as usury, gharar, and maysir. Almost all current international fiqh institu- tions still prohibit all the derivative instruments present in the conventional capital market. The parties supporting the idea of “Islamic” derivative instruments are of the opinion that the Islamic financial system requires instruments that can be used to hedge and protect against various the financial risks faced by Islamic financial institutions. They consider the maslahah obtained from the existence of derivative instruments to be substantial, and could even sup- port one of the points of magashid syari’ah (the purpose of syari’ah), which is the protection of wealth. The parties supporting the idea of an Islamic derivative instrument also hold the opinion that various rules of the Islamic syari’ah still enable the creation of an “Islamic version” of derivative instru- ments. As an example, the option contract in conventional capital market can be modified using the bay’i al-‘urbun contract scheme available in the fiqh mu’amalah literature. Based on the above two perspectives on the legality of derivative instru- ments in the Islamic capital market, the opinion prohibiting the use of deriva- tive instruments is stronger than the one in support. From the angle of fiqh mu’amalah, not one of the different contract variations in fiqh is the same as

294 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING the schemes used in the derivative products. It can thus be concluded that the presence of derivative instruments in an Islamic capital market is not pos- sible. Empirical data so far has also proven that the presence of derivative instruments in a capital market contributes to its instability, as in the case of the subprime mortgage crisis in the United States. As was explained at the beginning of this chapter, if the Islamic financial system is applied thor- oughly and ideally, it is able to significantly reduce the level of risk attached to various financial asset transactions significantly. The Islamic financial sys- tem promotes the application and use of risk sharing in the financial market, making risk easier to manage compared to the conventional financial mar- ket. The risk-mitigation process can still take place even without the use of derivative instruments. REGULATION AND SUPERVISORY IN ISLAMIC FINANCIAL MARKET In many countries, the Islamic financial market, especially the Islamic capital market, is not regulated by a single regulator that specializes in the Islamic capital market. Instead, in almost every country where its growth is rapid, the supervision of the Islamic capital market is under a division or depart- ment of the general capital market regulator. As an example, the Indonesian Financial Services Authority (IFSA) has a special department responsible for the regulations necessary to create an efficient Islamic capital market that is syari’ah-compliant and transparent. Other than that, the special depart- ment for Islamic capital market under the IFSA is also supported by National Syari’ah Board of Indonesia’s Council of Ulama, which is responsible for issuing fatwa and judging the syari’ah compliance of Islamic capital mar- ket products. In Malaysia, the Islamic Capital Market Department and the Shariah Advisory Council (SAC) were established in 1996 under the Securi- ties Commission. The presence of SAC directly under the Securities Commis- sion has made the process of issuing capital market regulations faster and more efficient. In the international market, since 2009, the Islamic Financial Service Board (IFSB) has published several special rules related to Islamic financial market instruments such as sukuk and other syari’ah securities. In the IFSB-7 document, several rules related to sukuk, such as capital ade- quacy, collateral, parties involved in a sukuk transaction, and the like, have been described clearly and in detail. Those rules become one of the references that can be used by the regulator in various countries to construct regula- tion framework for Islamic capital markets, and included in the rules is the issue of sukuk.

Development of the Islamic Financial Market 295 The products of the Islamic capital market, with some significant differ- ences in form, type, and characteristics compared to products of the conven- tional capital market, should have their own related rules and regulations as well as specialized institutional support if necessary. An example of this is the asset-linked securities (sukuk) in the Islamic capital market. For prod- ucts like sukuk, special rules related to product development and its trading mechanism will need to be created. Even though many parties are of the opinion that sukuk is very similar to bonds, there are fundamental differ- ences between them. A bond in a conventional capital market is a debt-based security, while sukuk in an Islamic capital market is an asset-backed secu- rity. Sukuk is a proof of equity investment in a real asset, while a bond is a proof of a firm/institution’s indebtedness to the bondholder. This differ- ence affects many things, such as the transaction mechanism in the primary market, determining the fair value of the security in the primary as well as the secondary market, and the transaction mechanism in the secondary mar- ket. Apart from that, rules other than those pertaining to the capital market should also be considered in developing an Islamic capital market, such as rules related to taxes. In a sukuk transaction involving real assets (such as sales, rent or lease, and the like), several countries impose double taxation, reducing investor interest in it. INSTITUTIONAL-BASED DEVELOPMENT FRAMEWORK The Islamic financial system cannot function well and to its fullest poten- tial if it only relies on the various stipulations of the Islamic syari’ah. This is not to imply that the Islamic syari’ah is not a perfect system. The Islamic syari’ah as expressed in several of the verses of the Qur’an and shahih hadith is a complete syari’ah, comprehensive, and always providing solutions to the varied issues faced by humanity, including those related to the finan- cial system. Yet in the current modern scientific age, the implementation of the Islamic syari’ah should be done through various components such as theoretical support, institutional support, regulation support, and the like. From the theoretical side, several scientists concerned with the field of Islamic finance have created various theoretical models related to the Islamic banking system, the Islamic capital market, and the Islamic financial sys- tem as a whole. The theoretical model is constructed based on proven and accepted methodological standards in the economic and finance fields, and thus could be accepted scientifically. As an example, articles written by Khan (1986) and Mirakhor (1993) have successfully proven theoretically that the Islamic financial and banking system based on Islamic syari’ah is better and more stable than the conventional financial and banking system. Yet the the- oretical proof has not been fully followed by an empirical one, considering

296 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING that the real implementation of the Islamic financial and banking system concept has yet to be in complete accordance of the model or theoretical concept that has been formulated. One of the reasons is the still-inadequate institutional support for Islamic banking activity and Islamic capital mar- ket. Institutional support is important, because the lack of one will hinder the complete implementation of Islamic financial system, thus obstructing the effort to apply the Islamic syari’ah in the financial system. Mirakhor (2009) stated that the Islamic financial system is not merely an interest-free financial system. More than that, the Islamic financial sys- tem is a complete and comprehensive institutional framework, ensuring that syari’ah stipulations can be applied unobstructed. Without good institu- tional support, Islamic financial institutions (both banks and non-banks) will find it difficult to differentiate themselves from the practices of conventional banks and financial institutions, which will water down their value proposi- tion and the uniqueness of their offering. As an example, in several countries using the dual banking system, several issues often emerged, such as (1) the vehicle for an Islamic bank to channel excess liquidity doesn’t exist, as almost all instruments in the money market are not syari’ah-compliant, (2) the con- cept of universal banking that is supposed to be implemented by the Islamic bank becomes difficult to practice, as the conventional banking system used in the country still adopts the regulation that separates the banks doing com- mercial banking from those doing investment banking, (3) the Islamic bank is still forced to be involved in the deposit insurance scheme that still uses interest and hence contains usury, due to the absence of a deposit insurance created to fulfill the needs of Islamic banks, or the lack of a deposit insurance scheme that is syari’ah-compliant, and (4) the lack of a syari’ah-compliant reference rate, so that the Islamic bank still uses the market interest rate as its reference rate. In the end, these issues will hinder the Islamic financial system’s development and will box it into using a business model that is still too similar to conventional financial systems. As a result, the advantages that have been shown to exist in the system theoretically are difficult to realize empirically. The support of institutional framework is absolutely necessary to create a functional and ideal Islamic financial system that can benefit the economy and public welfare. STABILITY IN ISLAMIC FINANCIAL SYSTEM: LESSON FROM GLOBAL FINANCIAL RISK There were several causes of the rapid onset of the U.S. financial cri- sis of 2008–2009: debt-based instruments were massively and widely

Development of the Islamic Financial Market 297 used, leverage in the financial system increased to extremely large and unsustainable levels, the risk-transfer process occurred without limitations or control through various derivative instruments such as CDs, and there was a high amount of interconnection between financial institutions (both bank and non-bank) due to the securitization process as well as the repeal of the Glass-Steagall Act, which had previously separated the operational scope of commercial banks and investment banks in the United States. Those three factors made the financial system susceptible to shocks in the economy. In the subprime mortgage crisis, decreases in housing value created a shock to the economic and financial system in the United States, and it was a shock that could not be absorbed by the financial system, causing a catastrophic effect. In the case of subprime mortgage, before 1999, the Glass-Steagall Act separating commercial and investment banking activities, was still in place. The separation existed to avoid any moral hazard risk that might be indulged by practitioners in the financial market. Depositor funds were protected, since they could not be used in speculative activities in the financial mar- ket. In 1999, the Act was repealed and the boundary between commercial and investment bank was removed, contributing to the high interconnection between the two. On the business model side, several financial institutions began to evolve drastically with a business model that has not been done before. Where traditional insurance business had previously only covered pure risk that was not speculative in nature, such as death, health, losses, and the like, the industry soon began to cover speculative risk. The pure risks only have two results: no loss or loss. Speculative risks can have three results: profit, no loss, and loss. Speculative risk was attached to various financial instruments in the capital market, the majority of which are in the form of securities. In the subprime mortgage crisis period, several insur- ance companies began to offer various products intended to cover owners of various securities from speculative risk generated by instruments such as CDs. This step increased the interconnection between insurance firms and other financial institutions such as banks, as investment banks are the majority issuers of securities. When investment banks were threatened with default, the threat easily spread to insurance firms. It can be seen that being too-connected-to-fail increases the threat of systemic risk and destabilizes the financial system. What about the Islamic financial system? As has been explained before, the Islamic financial system is an equity-based system, since debt-based instruments do not have room to grow and develop in the Islamic financial system. Various theoretical models of the Islamic financial system have been developed by academics in Islamic finance, who stated that the equity-based

298 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING Islamic financial system was proven to be more stable and flexible in facing various shocks in a financial system. The use of an equity-based system also meant that risk transfer is replaced with risk sharing; so all the risks inherent in a financial system are borne together by the financial subsystems. Thus, if the theoretical model of the Islamic financial insti- tutions can be implemented effectively and efficiently, supported by the appropriate set of institutions and regulations, then the stability of the Islamic financial system would be far better than that of the conventional financial system.

14CHAPTER Development of a Pricing Model in Islamic Banking Pricing for Islamic banking products is often criticized of being indiffer- ent toward conventional interest based pricing. Arguments regarding Islamic ethical standards for pricing formation are faced by the reality of competition within Islamic banking and between Islamic banking and conventional banking. The biggest challenge that should be passed by Islamic banks is to create a pricing model that is interest-free and also able to reflect Islamic finance principles, such as justice and equity in hisbah and risk sharing among economy agents. Islamic banks not only consider a hurdle rate, as minimum required rate of return, but also they have to see the effect of losing a business opportunity from the borrower, which could affect social welfare. FUNDAMENTALS IN ISLAMIC PRICING MODEL Product price formation includes several factors, such as target profit (safety profit), operational costs, risk premium (especially credit risk, market risk and operating risk), and the actual productive capacity of the debtor or busi- ness that is financed. Risk premium is the element where pricing Islamic products is related to risk mitigation process. As with pricing formations in conventional banking, risk premium could be the sole mode for transferring risk from the bank to another party. However, in Islamic banks, this mode is only applied in debt-based financing, not in capital partnerships such as mudharabah and musyarakah. In these two contracts, the bank is obliged to implement a profit–loss sharing principle. Criticism on Interest-Based Pricing Model There are many empirical studies proving that the interest-based monetary system has ambiguous and negative implications for the real sector’s growth, such as Dayal-Gulati and Thimann (1997), Loayza, Schmidt-Hebbel, and Servén (2000), and Agrawal (2001). Conventional economy places interest 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. 299

300 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING as the return given for the sacrifice of delaying consumption. Yet profit from an economic activity should come from the difference between the price of goods purchased and the price at which it is then sold, as a representation of the value added to the goods sold. In this case, it is also still possible for loss to occur. Interest is a return that is promised to be given in the future, regardless of whether the funds have been used in an economic activity or not; this is what is categorized as usury (Chapra 1985). To date, interest still dominates monetary systems, even as various stud- ies show that an interest-based economic system does not imply positive growth for the real economic sector, such as Tobin et al. (1980), Hansen and Singleton (1983), and Mankiw and Weil (1989). On the other hand, the implementation of an interest-based monetary system generates many nega- tive effects. First, it drives the creation of infinite money by promising interest to the depositors (Ayub 2009). This condition is called “inherent instability” and can trigger “maturity mismatch” due to short-term deposits allocated to finance long-term loans (Friedman 1960). Second, the financial system can become inefficient due to the fact that the allocation of production factors is no longer based on the considerations of real risk-return, as it is distorted by the inherent instability factor. Third, the phenomenon of credit rationing and adverse selection occurs (Stiglitz and Weiss 1981). High-risk potential debtors willing to pay a higher interest rate tend to receive credit, com- pared to debtors who carry less risk but are unwilling to pay the higher rate. Asymmetric information and moral hazard occurs here. Because the interest system cannot be used as an effective screening method to select borrowers, the bank is in the situation of the Walras equilibrium. The Walras equilib- rium is a condition where even when there is a balance between interest supply and demand, the bank is still not guaranteed to gain optimum profit from these conditions, and many credit demands can even stay unfulfilled (a deadweight loss) due to mistakes in selecting potential borrowers (Stiglitz and Weiss 1981). Transparency and Fairness in Pricing Model The function of Islamic financial institutions as a system is to assist the process of resource allocation in the economy, to provide financial services to help bridge the capital flow, and to support continuous growth. Islamic financial institutions divide risk and profit between economic actors, between both the parties with surplus funds and those in deficit (Selim 2008). This risk sharing is the manifestation of fairness in economic activity and is implemented, amongst others, in the risk-sharing scheme (Mills and Presley 1999). Every economic agent involved in financial transactions, whether consciously or not, directly or indirectly, should complement each

Development of a Pricing Model in Islamic Banking 301 other’s strength and weaknesses. Thus, all parties, without exception, can access the money in circulation and resources availability. Of course, the multiplier effect generated will move the economy and increase the welfare of society in general, not just individuals. In Islamic finance, price setting is not measured by prevailing general standards (e.g., CAPM, market interest rate) but by comparing the satis- faction function of capital to individual satisfaction function and, at an aggregate level, comparison to the economic surplus of every individual economic agent. There are at least three principles of Islamic finance: the principle of universal complementary, the principle of usury elimination, and the principle of fairness in scales (Selim 2008). The first principle explains that all elements of the society are economic agents (as produc- ers, consumers, government, household, and industry) that complement each other and generate societal welfare. The loss of individual business opportunity represents a societal loss. It also needs to be understood that “marginal rates of substitution” will be different between economic agents. This difference would contribute to the elimination of the “unified interest rate” as a reference for opportunity cost. The distribution of returns should reflect the division of roles played in an investment, and the risk should be allocated and borne between the economic agents involved. This way, each business opportunity will have a unique return characteristic. In the end, this practice will consistently lead in the direction of usury elimination, remov- ing “predetermined fixed interest” from transactions between economic agents. In other words, economic agents will share risk and return based on the investment’s real performance. Not only is usury considered as a form of tyranny and thus prohibited in Islam, eliminating usury is the implemen- tation of the principle of fairness in scales. Every economic agent receives a different return according to the weight of their efforts regarding their role in the investment as well as risks borne. Ethics in Setting the Price The Islamic financial system has a social dimension, one where the economic welfare of its society is its mandate. Islamic financial institutions are expected to be a catalyst for economic growth. In the current economic system, open- ing unlimited access to increase entrepreneurial opportunities as well as job creation is co-opted by economic agents with unlimited desires. Using the interest rate for the purpose of money creation, productivity, and govern- ment control can also lead to excess debt-taking and speculative activities; it incentivizes risk-taking and reduced prudence in transactions. This condi- tion is usually the precursor to financial bubbles and rising systemic financial risk, just as the ones before the 1997–1999 crisis in Southeast Asia, the

302 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING subprime mortgage crisis of 2008–2009 in the United States, and the current European crisis. The initial purpose of the modern financial industry intermediation is to enable economic progress and better distribution of resources. But this pur- pose is then obstructed by the three powers that are the motor of capitalism: “bourgeois appetites,” democratic courtesy, and individual work ethic (Bell 1987). These three forces causes humans, as economic agents, to never be satisfied with the resources they own, and drive the mechanism of finan- cial engineering to create “high-powered money” that leads to excessive risk-taking behavior (Chapra 1985). The combination of these three powers carries the idea of freedom and individual achievement, but excludes the role of the economic agent in social responsibility. Islam recognizes these three forces as nafs, the catalysts in economy and civilization, which can only be the tools used to obtain prosperity if they are accompanied by institu- tional reformation and the mechanism that can preserve human morality in their execution. The Islamic financial institution emerges as an entity trusted with a strategic function to reform institutions in the direction of prosperity and support for the real sector, as well as a mechanism preserving morality through syari’ah rules forming the foundations of operations and transac- tion activity. TIME VALUE OF MONEY IN PRICING MODEL Khan (1991) states that the prohibition of usury in Islam rejects various admissions on the time value of money, even when in reality rent/lease, wages, deferred (muajjal) and advanced (salam) sale, all covers a fixed and predetermined element of payment as a compensation for time. The differ- ence between current value and future value of a commodity should not be caused by pure time element, but as the result of changes in supply and demand. Khan (1991) further contends that bearing risk is the basis for the admission of earning profit in Islam, and the rate-of-return on deposits of Islamic banks can be used as the rate-of-return for project appraisal required for investment decisions in Islamic economy. Kahf (1994) tries to explain that there are differences between prohibi- tion of interest (usury) and the admission that there are differences in the element of time in real market transactions. First, the time value of money came purely from consumption preference. The process of consumption requires time to enjoy and generate pleasure. On the other hand, the invest- ment process (transforming goods for consumption into those for produc- tion through new, planned, and directed enterprise) requires time, (usually) generates a positive result (more income in the future), and is inseparable

Development of a Pricing Model in Islamic Banking 303 from risk and uncertainty since there are many uncontrollable factors affecting the investment process. Thus, there are at least three points related to time preference: (1) the satisfaction received from consuming a good is identical, whether in the present or future, (2) expected increment is a compensation for the investor to postpone consumption in the present for investment, and (3) the realized outcome of an investment can be different from expected return due to the presence of risk and uncertainty in the investment process. According to Kahf (1994), time preference is an invest- ment phenomenon, a definition wider than basing it as just a consumption phenomenon, and as such the time value of money should actually be related to investment outcome, risk, and uncertainty (its presence is not entirely discounted from Islamic finance). The second difference is related to profit and risk-bearing. According to Kahf (1994), risk bearing is not a production factor since risk does not cre- ate added value. Only those contributing to the production process should retain the right over the output of the production process. Following the logic of production, investment for production is provided by the investor in physical form (goods of production) or in the form of cash that can be used to purchase factors of production. The capital owner then becomes the owner of what the cash is substituted for. As a consequence, profit is earned by virtue of ownership and not of risk bearing, as stated in the fiqh book: “profits earned by ownership and work” (Al-Mughni 5: 114–129). Because of this, in Islamic finance, risk-bearing alone cannot be considered as a rea- son to stake a claim on profit. An example of this is the kafalah (guarantee). Kafalah contains bearing risk by adding personal guarantee to other people’s responsibility without contributing to the production process or by becom- ing the owner of goods of production. In kafalah, investment is separated from risk bearing, and because of this, syari’ah prohibits the kaafil (guaran- tor) to gain any return or profit when providing kafalah, even if the kaafil naturally bears risk. There are several combinations of production factors. In the first, the entrepreneur obtains investment capital with a profit-sharing scheme on the investment result. With this mudharabah model, the investor (capital owner) is actually and legally the owner of the business asset; they gain the dis- tributed profit based on the agreed sharing ratio and bear all losses incurred to the asset. In the second, the combination of production factors is separated into two units and is legally an independent enterprise. The first enterprise has investment funds and decides on entrepreneurial decisions regarding purchases, owns and maintains fixed assets, and sells the usufruct of the fixed assets. The second enterprise leases the fixed assets by purchasing the usufruct of the fixed assets and purchasing man-hours of labor, and

304 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING uses both in its production process. The output of the first enterprise (the usufruct extracted from the fixed asset owned) becomes the input of the second enterprise; the income received by the first enterprise during the lease period is relatively constant, as the natural output (usufruct) can only be measured in the unit of value of asset per unit of time. This does not mean that there is a time value of money in the lease if the lease exceeds the asset’s depreciation. This is because the increment obtained is the profit of the leasing business; the rent charged in leasing, as with price, depends on the same factors that determine various other market prices. The element of time in the leasing business is a natural part of the business process itself. In the third, in the combination of production factors, investors may gain investible funds through interpersonal relationships (as a loan based on personal pledge or supported by collateral) that will need to be repaid later. This loan becomes the entrepreneur’s, who will then transform this capital into fixed asset and/or working capital for production processes and collect all outcomes as profit or bear all the loss that occurs. The lender is the pledge owner, which is an abstract right over the debtor as a form of interpersonal relationship, which naturally does not have an increasing or decreasing mon- etary value. As a consequence, the lender is not the owner of any assets of production, and as such the lender has no right to any portion of output of the debtor’s investment, only what is owed. Time Value of Money in Salam and Mu’ajjal Contracts To apply this logic to bay’ al-mu’ajjal and salam, we do not have to include other factors such as changes in supply and demand. When discussing the time value of money, we have implicitly isolated other factors. The effect of time value of money is reflected in real time in an exchange transaction, and this effect should be ambiguous when including changes to supply and demand. As in the production process, a seller has ownership over the goods to be sold and intends to sell them at a higher price than their purchase cost. In bay al-mu’ajjal and salam, the seller (owner of investible funds) includes the time value of money into the investment process. In bay al-mu’ajjal, the seller begins the investment process by (1) formulating the expected time value of money, (2) transforming the investible fund into goods owned and taking responsibility in ownership, (3) designing a deferred payment sale, and then (4) transforming their expectation into a higher price compared to an on-the-spot sale, even if the realized future value of money is not always the same as that anticipated. This process in principle is the same as setting the agreed sharing ratio in musyarakah and mudharabah, or in set- ting lease/rent (ujrah) in leasing (ijarah). In salam, almost the same process occurs: (1) formulating the time value of money anticipated, (2) designing a

Development of a Pricing Model in Islamic Banking 305 contract of goods purchase with the advance payment at a discounted price, (3) receiving goods in the future that are already agreed upon, owning them, and taking responsibility over the ownership of the goods, and (4) selling the goods and realizing the actual, future, time value of money, which may or may not coincide with the amount that has been anticipated. The above analysis is related to two rules of the syari’ah. In the first, Islam prohibits the sale of goods and services with two different prices (bay’ at-taqshid), either on the spot or deferred. This is because the evaluation of the time value of money is independent of the actual investment process. Second, in the case of salam-contract cancellation, the buyer (provider of funds) can only retrieve his or her funds in the same amount (nominal) that they have paid. This is because the investment process that was planned did not happen, and as such, no actual time value of money contributed by an economic enterprise took place. Explaining the legitimacy of time value of money in bay’ al muajjal and salam, then, only relies on the rationalization of the foundations of ownership and the difference between anticipated and realized time value of money, as in the various contracts of mudharabah, musyarakah, and ijarah (leasing). CURRENT ISLAMIC PRICING MODEL To date, the process of determining the return of a financial product is still dominated by conventional models such as the capital asset pricing model (CAPM) and arbitrage pricing theory (APT), which uses a particular interest rate as reference. The price-setting process in Islamic banking is allegedly not yet independent from market interest rate (Chong and Liu 2009). This can still possibly happen, considering that there has yet to be significant development of an Islamic pricing model. There is a real need for such a model that is able to represent the real general condition of business activity, instead of just the interest rate (El-Gamal 2003). Several academics have risen to the challenge, and some of the models have already been created. Market Interest Rate In various Muslim countries, Islamic banking operates in the same field as conventional banking. The influence of conventional interest rate as a com- parison in Islamic banking is studied by Haron (1996) and by Haron and Ahmad (2000), as well as Hassan and Bashir (2003). Haron (1996) tested the effects of competition and several external factors on the profitability of Islamic banks, with the interest rate as a measure of capital scarcity in an economy. This study shows that the interest rate, which is the discounted

306 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING interest rate of a country, has a positive relationship with the performance of Islamic banking. Even further, Haron and Ahmad (2000) specifically stud- ied how the interest rate can affect savings and deposits, including those that are the products of Islamic banking. Since there is no predetermined rate-of-return in an Islamic banking system, the behavior of the Islamic bank depositor is affected by conventional theory of economic behavior. Using Malaysian data, they show that the behavior of depositors is still mostly driven by profit-seeking behavior, which in turn is mostly driven by the utility maximization theory, even if there is a negative relationship between conven- tional interest rate and non-interest banking facilities. Hassan and Bashir (2003), however, state that for Islamic banking, the interest rate can posi- tively influence the real interest rate if most of the profit of the Islamic bank is from direct investment, ownership, and/or trading activities (murabahah). The real interest rate can have a negative influence on the profitability of Islamic banks if the higher real interest rate decreases demands for loans. Rate on the Islamic Interbank Money Market Ebrahim and Khan (2002) offered a theoretical framework of Islamic financ- ing facility with a discounted index that is free from usurious elements, but did not explain in more detail how this index can be calculated. DiVianna (2010) shows that several models of a Islamic index can be used, such as: (1) Sheikh Taqi Usmani’s approach, in which the index can be created based on the pool of financial instruments invested in asset-based instruments (such as musyarakah, ijarah), and (2) the approach of the Bank Negara Malaysia, using the mudharabah interbank investments (MII). Until now, there has yet to be an index model that can accurately track the real sector’s rate-of-return and is also syari’ah-compliant. A good benchmark should be able to facil- itate decision making both at the macro- and micro level related to cost of capital and opportunity cost of investment for projects that can be compared with risks of a similar level. Until now, Islamic financial institutions refer to interest-based indices such as LIBOR to determine lending decisions. As an example, Saba and Al Sayed (2010) use the spread between conventional interest rate and Islamic profit level as a mechanism to determine the price of Islamic banking products. The benchmark used was the KIBOR (Karachi Interbank Offered Rate). “Replacement Cost” Approach Mirakhor (1996) suggested the concept of Tobin’s Q as a reference in Islamic financial product return determination. The concept of cost of capital as the benchmark for expected economic return, when debt-based instruments are

Development of a Pricing Model in Islamic Banking 307 not available and projects must be financed using equity, is measured through Tobin’s Q, which is: Q ratio = Market value of equity + Book value of liabilities Replacement value of equity Mirakhor (1996) stated that the cost of capital can be calculated with- out referring to the market interest rate by using modified Tobin’s Q. In calculating the cost of capital when debt-based instruments are eliminated, equity financing is the only source of capital. The business plan brought by the entrepreneur provides the market measure for the physical capital val- ued by capital market investors, and interaction between the two occurs in the capital market. This interaction determines the price of capital offered and is realized in the form of ratio, margin, and discounted price. Tobin’s Q measures return based on the ratio of financial valuation to the replacement cost of capital. Yet this model is criticized by Iqbal (2006), and considered to be too reliant on the capital market. The capital market is considered to be too “noisy” in its price formation process. The ratio of Tobin’s Q requires further review considering that most Islamic countries, or coun- tries with a Muslim majority in their populations, have a capital market that has yet to develop well and is not integrated with the international financial market, so the data is affected by the distortion and noise of the capital market. Micro-Banking Approach The micro-banking model introduced by Stiglitz and Greenwald (2003) was developed from commodity market where it is assumed that monetary policy is focused on the role of credit in the financial system. The phe- nomenon of credit rationing and market imperfection should be addressed by the bank through screening, monitoring, and contract compliance. This approach states that financial market equilibrium occurs when credit and financing consider the internal and external factors of the bank, such as cap- ital, operational costs, market competition, and monetary policy. In other words, the price of credit and financing contract cannot be simplified and described with the interest rate as the sole variable, and even then interest rate is considered nonrelevant. The focus of this approach is that depositor and debtor preference is constructed in order to be able to represent the degree of supply and demand in accordance with the satisfaction function of each party from a transaction. Unfortunately, the preference of depositors and debtors as the price (replacement for interest rate) is still difficult to implement, as satisfaction is subjective.

308 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING Real-Sector Return Approach In an economic system without interest rate, profit expectation can be taken from the average return on investment in accordance to the perfor- mance of the real sector. This profitability proxy is accurately represented by the profitability of real sector on the industry level, or even on the sub-subindustry level if the data allows. Until now, there has yet to be an index model that is truly able to measure the return of the real sector in a syari’ah-compliant manner, without elements of interest (usury), gharar, and gambling (maysir). But several early efforts are worthy of turning into benchmarks for further studies. Among the real sector return approaches developed is the structure-conduct-performance model relating market structure, market behavior, and market performance (Shepherd 1972; Semos and Sergaki 2005). Hermanto et al. (2012) tried to construct a model through the cash recovery rate (CRR). The basic concept of return measurement is related to the basic principle of finance measuring return as the ratio of cash inflow and cash outflow in every business in an industry (or subindustry). CRR can be used to measure the real performance of the debtor in returning investment capital. CRR can even generate a measure of actual internal return. In financial literature, the return of a project is usually measured using the formula for internal rate of return, based on financial accounting infor- mation. The internal rate of return is found by calculating the discount rate that will enable the present value of all cash flows from the investment’s var- ious period of existence equal with its initial investment. The internal rate of return is a practical method to determine the return of an investment and is considered as the economic return of an investment. Stark (1989) pro- vides three different definitions in interpreting internal rate of return as a measure of a firm’s economic performance. By using financial accounting data, the internal rate of return cannot be observed as it relies on the pre- diction of cash inflow and outflow, both implicitly and explicitly. Salamon (1982) defines CRR as the ratio of cash recovery from an investment done in a period, during one period; he also shows that there is a relationship between internal rate of return and CRR when the firm does not reinvest all its cash flow. A financial report presented based on cash flow data in order to provide consistent information with capital budgeting decisions is not too affected by the accounting method chosen by the firm. This type of report also emphasizes the calculation of cash recovery. If certain conditions are fulfilled, then the internal rate of return estimate can be obtained in the information on cash recovery. The CRR in a general form, as formulated, can be used to measure a firm’s economic performance, and its application can be used to develop public policy and industrial organization.

Development of a Pricing Model in Islamic Banking 309 Stark (1993) stated that there were two important conditions that could make empirical CRR an inadequate measure of actual CRR. The first condition is called as the capitalization/expense case, which is that when advertisement and research expenditure occur, they have to be treated as a joint investment, but stated as expense in accounting book keeping. The second is called as the pension case, which occurs when the empirical CRR cannot measure actual CRR because the joint investment consists of various projects with different investment maturity. If the relations to these two cases can be identified, then the effects of mismeasurement can be reduced. Productivity-Based Pricing Model Pricing of financial products is more common nowadays, especially in financial industry. But there is also pricing for other real activities, such as in leasing (ijarah) for labor service and physical assets, profit sharing, and equity-based partnership (mudharabah and musyarakah). It is important to determine the standard for pricing these models as risk is inherently related in pricing process. Pricing on Ijarah for Labor In the marginal theory of productivity frame- work, one can develop pricing on ijarah for labor service, ijarah for physi- cal assets, and mudharabah and musyarakah (capital and entrepreneurship) that is in accordance with principles of Islamic finance. Related to the size of ujrah (fee, payment) the employer would need to pay to the employee, three things would need to be considered. These are: (1) a kinship between employer and employee should base all the interactions between them, not a relationship between person-and-material, (2) the workload and working conditions should be humane, and (3) the employer should guarantee the basic needs (food, clothing, health, etc.) of the employee with the consider- ations of kinship among members of humanity. These three conditions are used to ensure that the real wage paid is reasonably fair and able to fulfill their basic needs; this means that Islam requires that the wages paid must fulfill all the basic needs of the employee’s family, even if the cost has the potential to at times exceed the employee’s contribution to the production process. Since wages depend on subjective factors (humanity) and objective (contribution and market force), it is important to define beforehand the range of wages that is possible rather than paying out a fixed level of wages. For example, the upper limit of the wage should be the same as the value of average product of labour (VAPL), and the wage rate cannot be higher than VAPL or the firm will experience a loss. The lower bound will be determined by market forces. If the supply and demand curves ensure a reasonable and humane wage, then the two principles can be waived in determining the

W, VMP, VAP310 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING wage and the desired wage will only be determined by the market force as in classical economics. As seen in Figure 14.1, this will cause the demand curve (value of marginal product, VMPL) and the supply curve to intersect at W = VMPL. Thus, wages cannot decrease below VMPL; when the employ- ment level is at the lower bound of the possible wage interval, the range of wages becomes VMPL ≤ W ≤ VAPL, and the exact wage will be within that interval, depending on the application of principles of humanity and the rate-of-return expected by the entrepreneur. The application of the humanity principle depends on the altruistic behavior of the employer, his role as determined by the regulator, or both. If the role of the humanity principle is significant in determining the wage and/or the employer expects a decent average rate of return, then the employer will tend to pay wages that are higher than VMPL at every employment level. DE is an effective labor demand curve existing between VMPL and VAPL, and the intersection of DE and the labor supply curve (SL) will provide a wage rate that is considered consistent with Islamic economic principles. As has been discussed before, the minimum wage will become W1 = VMPL as the intersection between VMPL and SL, and the maximum wage is W2 = VAPL as the intersection between VAPL and SL. Thus the relevant range of SL is MH, indicating the minimum wage at M SL W4 W3 W2 H Wm T DEL We W1 M VAPL DE VMPL Employment FIGURE 14.1 Pricing Wage in an Islamic Economy Source: A. H. M. Sadeq, “Factor Pricing and Income Distribution from an Islamic Perspective,” Journal of Islamic Economics 2, no.1 (1989): 55.

Development of a Pricing Model in Islamic Banking 311 and the maximum wage at H. The employer will not pay a wage higher than OW2 or lower than OW1; in other words, the wage range is W1W2. Figure 14.1 shows that the condition VMPL ≤ W ≤ VAPL is fulfilled in this wage range. If the wage, W, is fixed at the extreme end of OW1 or OW2, then W1 = VMPL or W2 = VAPL is obtained, and both are still within the range of VMPL ≤ W ≤ VAPL. Pricing on Ijarah for Asset Leasing The absence of the humanity principle in determining the rent/lease of physical assets means that the pricing mecha- nism can be fully submitted to market forces through two types of pricing: the price of the fixed asset itself and the price of the service the physical asset can provide. Based on the principles of Islamic syari’ah, a fixed price for the services of a fixed asset is allowed, and this is called a rent/lease (ujrah). Fixed return is allowed even if losses are incurred in the production activ- ity. The entrepreneur receives a contracted service that causes depreciation to the asset, and as such the price (rent) should be paid, without consider- ing the business outcome. Yet the analogy cannot be extended to financial assets, since money is not depreciated in use; new money and old money do not differ as long as they’re both of the same nominal amount. Due to the absence of the humanity principle, the rent rate of a physical asset will depend on market force and the desired rate of return of the asset owner and entrepreneur. Pricing on Mudharabah In a conventional economy, the price of capital is the interest, and the entire profit is owned by the entrepreneur. In the Islamic economy, these two factors share in the profit; this is defined as revenue deducted by all costs and payments to all factors other than entrepreneurship and capital. The Islamic syari’ah rejects interest as the price of capital due to its outsized tyranny, which is: (1) it is an injustice for capital to only receive the benefit and not to share in the loss, (2) it is the primary source of the gross inequalities of income, (3) interest limits investment, and (4) when interest is considered as production cost, the price of the product paid by the customer will be more expensive, as it will be adjusted up with interest cost. In the Islamic economy, the price of capital and entrepreneurship are simultaneously determined. The actual value of the price is known ex post facto, but the ratio is predetermined. The principle of profit or loss sharing depends on business form: mudharabah and musyarakah. In mudharabah, entrepreneurship runs the business with the capital collected from others, while all partners invest in some portion of capital in musyarakah. In the mudharabah case, the share of profit is determined by the interaction of productivity-adjusted demand for capital (DK) and scarcity-adjusted supply of capital (SK) in Figure 14.2. OK and OE are the beginning positions

312 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING OE 100% Capital’s share of profitDK SK Entrepreneur’s share of profit 40% 60% D OK Quantity of K 100% FIGURE 14.2 Determinants of Profit Share in Mudharabah Source: A. H. M. Sadeq, “Factor Pricing and Income Distribution from an Islamic Perspective,” Journal of Islamic Economics 2, no.1 (1989): 61. of capital and entrepreneurship. The price (profit share) of capital and entrepreneurship (in percentage) is measured along the right and left vertical axis, and the amount of capital along the horizontal axis. The upward sloping supply of capital (SK) implies that the quantity of capital offered increases when the profit share of capital increases, and the opposite is also true; the downward sloping demand curve for capital (DK) shows that the quantity of capital requested increases when the profit share of capital decreases. The point of intersection between DK and SK simultaneously determines the profit share for capital and entrepreneurship. If no profit is gained or loss occurs, the risk of zero profit or loss is borne by capital, and the service provided by the entrepreneur stays unpaid. Thus, there are no issues on the distribution of loss in the case of mudharabah, even if it is not illustrated in Figure 14.2. Pricing on Musyarakah In the musyarakah case, there is more than one party contributing capital. As in mudharabah, pricing in musyarakah is based on profit sharing, even if there are different opinions on the basis used for profit sharing. One opinion states that the share of profit is best based on the partners’ contribution in capital, since it can be clearly measured, and thus

Development of a Pricing Model in Islamic Banking 313 each partner receives a part of their profit as much as they’ve contributed in capital. Other opinion states that it is fairer if the profit shared is based on partner contribution over organizational and entrepreneurial services rendered. Using the second opinion, partners can negotiate and determine profit sharing without considering the portions of their capital. Suppose that there are two partners in a business: A and B. In Figure 14.3, OA and OB are the beginning positions of A and B. The lower and upper horizontal axes show the amount of capital contributions of A and B. The left and right vertical axes show the profit share of A and B. Based on the first opinion, the distribution line (OAROB) shows equality in profit and capital percentage. For example, if A contributes 25 percent of capital (along A’s capital axis), then this corresponds to R on the distribution line which implies a profit share of 25 percent for A, and it is simultaneously known that the profit share of B is 75 percent. The distribution line may be different when the second opinion is used. The form of the line will vary from the straight line akin to OAROB to a curved form above or below the straight line. If the profit-share of A is larger, then the distribution curve would be above OAROB, and the opposite is also 100% 75% B’s capital OB 50%A’s share of profitN 50% B’s share of profit 25% R 75% M OA 25% A’s capital 100% FIGURE 14.3 Determining Profit Sharing in Musyarakah Source: A. H. M. Sadeq, “Factor Pricing and Income Distribution from an Islamic Perspective,” Journal of Islamic Economics 2, no.1 (1989): 62.

314 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING true. For example, if the distribution curve is OANOB, then A receives 50 percent of profit by only contributing 25 percent of capital. In case of a loss, the distribution of loss incurred is based on the proportion of capital contribution, because the share of entrepreneurship is not paid. Thus the straight line of OAROB will be used for loss distribution. URGENCY OF PRICING MECHANISM IN ISLAMIC BANKS By considering the basic principles of Islamic finance, the fair rate-of-return reference used in the Islamic system is one from the real sector. Based on several studies, Islamic banking has been criticized due to its reliance on con- ventional benchmark price (e.g., LIBOR, overnight rate and market interest rate) both directly and indirectly in determining the price of its financial products (Chong and Liu 2009). The price in an Islamic financial product, especially for a bank, covers: the offered profit-share ratio for mudharabah/ musyarakah, the margin in murabahah, price discount in salam, as well as the rent/lease and fee (ujrah) in ijarah. Many factors actually affect the product price formation process in Islamic banking, among them the tar- get profit (safety profit), operational costs, risk premium (especially credit risk, market risk, and operating risk), and the actual productive capacity of the debtor or business that is financed. Contemporary scholars and Islamic economy activists state the need for a benchmark price for Islamic bank- ing products that is independent from interest rate and is syari’ah-compliant (Fiqh Academy on OIC 1993; AAOIFI 2004). To preserve the integrity of Islamic principles, it is necessary to have a reference rate-of-return that reflects the activities of the real sector as the operating foundation of Islamic banks, especially as a pricing reference. Set- ting the interest as the cost of fund emerges due to the “stigma” of obligation to provide a return to the customer. Yet based on Islamic finance princi- ples, setting the price of financial products must be independent of interest and must only rely on the real rate-of-return (productivity) of the business financed. This is what the people working on alternative pricing around the world wanted to fix; there needs to be an alternative instrument that can improve the efficiency of the financial sector and optimize the role of the financial industry in supporting the real sector. Even Schumpeter (2002) stated clearly that conventional economy does not have to rely on the interest system if there are better models to determine price.

15CHAPTER Pathways of Risk Management in Islamic Banks The recent global economic crisis has raised awareness of the issues surrounding the global economic system’s stability and harmonization. A number of causes have been identified for the crisis, such as innovations in financial products and the use of increasingly sophisticated financial product engineering techniques. These products were developed to gain short-term profits and market share, ignoring their tendency for excessive leverage and unhealthy risk-taking practices. Financial product engineering was based upon speculation, excessive risk-taking, and a tendency to gamble on future market price movements of the underlying assets. At the same time, the market prices of these assets did not reflect the actual productivity of the economy and was the result of information distortion through rumors, the subjective perception of market actors, and misleading signals about the state of the real economy. In the end, financial market capitalization grew to several times the value of the real economy and created a market bubble. The same problem manifested itself in the banking world as the money creation process and excessive credit creation under the so-called “credit multiplier effect.” These practices thrived in an environment of incomplete information, bolstered by moral hazard and bankers’ excessive risk-taking behavior without the counterbalancing influence of sound risk management practices, diversification strategies, and risk-hedging activities. ISLAMIC BANKS AS REAL IMPLEMENTATION OF RISK MANAGEMENT Islamic banks offer a different approach that repudiates interest, speculative activities and excessive risk-taking (gharar), gambling (maysir), and various other practices that expose the market and market actors to unwarranted risk. The persistence in preserving these unique features contributes towards Islamic banks’ resilience in the face of the global economic crisis, and helps to improve the stability of both domestic and global economic systems. Islamic banks also promote contract models that involve the sharing 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. 315

316 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING of investment profits and losses, which further improves their stability. Investment depositors are treated as investors (quasi-equity holders) who share both profits and risks with the bank. Indeed, in an unrestricted mudharabah, the bank only shares profits, while any losses would be absorbed by the investment account holder. These features protect Islamic banks against market shocks that can erode their capital (as in the case of conventional banks), but they also demand that the bank exercise greater discipline, honesty, and integrity in the management of its investment funds. If the bank turns negligent for any reason whatsoever, it stands to suffer from a whole variety of risks such as reinvestment risk, rate of return risk, displaced commercial risk, reputation risk, and fiduciary risk. Islamic banks are also forbidden from engaging in interest-based finance and the trading of debts in the secondary market, while their financing activities are limited to contracts that can be directly tied to real assets. These unique features limit the Islamic bank’s capacity to finance the real economy but they prevent the Islamic bank from feeding into bubbles caused by the multiplication of credits in conventional banks. The conventional finance industry sees the Islamic financial industry (and its Islamic banking powerhouses) as being rather inflexible and even unproductive. It is not unusual to see statements that the Islamic economic doctrine is too simplistic, incoherent, and irrelevant to today’s economic challenges. The execution of financial activities without interest, the require- ment for financial transactions to be linked to real assets or investments, the need for sellers to physically acquire assets before selling them, and the prohibition upon the trading of debts are all seen as impediments to spec- ulation that force the parties in any given transaction to bear the risks that arise from their activities. It is feared that the lack of speculation will reduce the volume of large-scale transactions and slow down the pace of economic activity. However, these four features should not really have an adverse effect upon economic activities, since the speculative transactions they prevent are zero-sum affairs that do not make any real contributions to the economy. By removing the elements of speculation and uncertainty from finan- cial transactions, Islamic banking offers an alternative to the risk manage- ment practices found in conventional banking. Conventional banks’ use of derivative instruments is considered gharar and thus impermissible in Islamic banking. The shifting of risk to a third party is conventionally seen as a way to secure the bank’s position, but has tremendous follow-on consequences upon the stability of the financial market. In reality, a bank cannot ignore the impact of its policies upon the society as one of its stakeholders. The implementation of risk management in Islamic banks focuses on syari’ah compliance in financial contracts and the prudent utilization of resources in order to provide benefits (maslahah) and prevent waste or loss.

Pathways of Risk Management in Islamic Banks 317 The use of syari’ah compliance as a litmus test for all financial transac- tions undertaken by the bank is implemented at every stage of risk manage- ment. In the identification stage, this filter has a twofold effect: it prevents the ingress of prohibited elements (interest and uncertainty) while providing a weighted evaluation for each activity proposal according to the potential maslahah (benefits), ethics, and transparency. The use of this filter is intended to promote a cautious attitude towards the profit motive and provide a basis for the implementation of risk management with a speculation filter. CHALLENGES OF ISLAMIC BANKING IN THE WORLD Islamic banks’ adherence to the principles of justice and greatest benefit to the society at large should provide added value to the financial industry as a whole. The commitment to this principle should be proven with the development of suitable visions, missions, and strategic goals for Islamic banks and implemented through the prudent and fair execution of financial activities. But in practice, the nascent Islamic banking industry has not yet succeeded in eliminating the influence of the conventional financial industry upon its internal performance, especially with regards to market risks and interest-based monetary policies. Islamic banking also has a number of internal issues that require a coordinated solution. For instance, financing transactions in Islamic banking are always based upon real assets or investments (asset/project-backed financing), while every loan must be intended for the acquisition/production of assets (no clean borrowing) or the execution of productive activities. Cooperative ventures under profit-sharing arrangements should become the powerhouse of the economy under Islamic banking. Unfortunately, this principle still leaves a number of unresolved issues that must be tackled by the Islamic banking industry, such as moral hazards. Islam holds that any lateness in the repayment of a debt or the shar- ing of profits should not be liable to a fine or penalty. This means that a venture partner who has taken mudharabah or musyarakah financing or the debtor in a murabahah loan cannot be forced to pay fines or penalties or be incarcerated if they fail to abide by the payment agreements, unless it can be proven in court that they have acted with malicious intent. Additionally, banking fines and penalties cannot be accounted as sources of income for the bank. There is also considerable difficulty in distinguishing between debtors in genuine trouble (those who deserve a debt restructurization or some extra time for the repayment of their debts) and those acting with malicious intent. If no solution can be found for these issues, Islamic banks are likely to suffer from the proliferation of dishonest clients who would take advantage of the moral hazard that arises from information asymmetry.

318 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING Within certain religious and cultural contexts, social sanctions can be an acceptable solution for making sure that every entrepreneur really works hard on his or her business and that every debtor does his or her best to repay the loan. Similarly, microfinancing allows the use of community collaterals as a system for mitigating the impacts of moral hazards. The loan is given out collectively, and any nonperforming debtor would be bailed out by the other members of the microfinancing group, with the informal consequence that the group will no longer trust the nonperforming individual in the future. Spiritual sanctions in the afterlife can also become a motivation for business actors; for example, a debtor who borrows money for a religious pilgrimage to Mecca would be worried about the validity of the spiritual merit gained through the pilgrimage if he or she does not genuinely intend to repay the loan in full and in time. However, there is currently no way to adapt these social and spiritual sanctions into a formal, rational, and systematic imple- mentation regime in business affairs. There must be a thorough overhaul of the system in order to prevent moral hazards with the use of rational and measurable indicators. It is possible to adopt some of the measures commonly used by the con- ventional banking industry to mitigate moral hazards, such as collaterals, third-party guarantors and periodic audits. However, these mitigation mea- sures can only be applied upon loan transactions such as murabahah, salam, ijarah, istishna’, and qardhul hasan. Capital participation schemes, such as mudharabah and musyarakah, do not allow the bank to demand guaranteed returns. Moreover, loan collaterals or guarantees can only be called when the mudharib can be proven to have committed a breach of contract. Other pos- sible mitigation measures against moral hazards include periodic audits and definite law enforcement measures against fraudulent activities. In any case, the cost paid by the bank for preventive acts such as periodic audits must be regarded as an inseparable part of the implementation of risk management in Islamic banking. Absence of Judicial and Super-Regulatory Institutes The banking business is built upon trust. Islamic banks in particular are sad- dled with a mission to promote social justice. An Islamic bank is required to practice ethical banking and provide an alternative that differs from con- ventional banks in terms of the moral values it espouses. The Islamic bank’s failure to maintain its reputation in the sound management of customers’ funds, especially in an industry prone to be affected by rumors, may put the bank in a more vulnerable position in facing the systemic risks that stem from distrust due to the unethical behavior of a few bad apples. A num- ber of cases have invited controversy throughout the global Islamic banking

Pathways of Risk Management in Islamic Banks 319 industry, such as the use of bay’ al-’inah and tawwaruq. Some countries, such as Indonesia, do not permit the utilization of these two contract forms in Islamic banking, while other countries, such as Malaysia, permit one or both. The development of clear regulations at the national, local, and international levels (such as the Islamic Financial Services Board [IFSB] and the Account- ing and Auditing Organization for Islamic Financial Institutions [AAOIFI]) is already a good start. But the establishment of a stable and harmonious Islamic financial system at the global level still requires the presence of an international dispute resolution mechanism, an international syari’ah court, and a global regulatory authority. BLUEPRINT FOR ISLAMIC BANKING REGULATION The bank’s capital adequacy and reserve funds are also expected to increase the bank’s capacity to attract deposit demands. Depositors would feel safer and more comfortable about placing their money with the bank, since the bank would have enough funds to return their deposits even when it is suf- fering operational losses. Under a strict performance oversight regime, the central bank would be able to provide solutions for improving the bank’s performance or saving the bank from a financial crisis. The bank can quickly avoid the continuous erosion of investment deposits when the debtor’s busi- ness suffers losses, which would drive a flight to quality (and liquidity) while dragging the Islamic bank into a liquidity crisis. The application of the cap- ital adequacy ratio (CAR) and loss-offsetting reserves should be integrated into a risk management system such as enterprise risk management (ERM), designed in a risk management model such as risk-adjusted return on capital (RAROC) or value at risk (VaR), or built into a system like capital adequacy, asset quality, management quality, earnings, liquidity, sensitivity to market risk (CAMEL) (or character, capacity, capital, collateral, conditions [5C]) that measures the health of the bank or the client. The bank should define information disclosure requirements that can accommodate the characteris- tics of Islamic finance and fulfill shareholder expectations. These disclosure standards would not only help the bank maintain a good relationship with its shareholders and build its reputation, but also provide internal benefits in the form of data inputs for the measurement of risk with the development of a database and information technology system. Such an information system would allow the bank to integrate accounting measurement and reporting standards into the risk management system, which in turn would increase the bank’s transparency with regard to the various accounting information that the public would need to evaluate the bank’s health, such as the status of supplies, collaterals, and loss reserves.

320 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING Toward the Optimization Role of the Financial Services Authority Another issue that remains to be addressed by Islamic banking regulators is the development of an Islamic financial environment. The effectiveness of regulatory and supervisory frameworks, along with the satisfactory implementation of risk management by Islamic banks, depends heavily upon how well the Islamic financial environment has been established. Reg- ulators should work to develop Islamic financial markets and instruments as well as the necessary market infrastructure. It has been explained before that the increasing complexity of the risks faced by Islamic banks owes much to the underdeveloped state of Islamic interbank and money markets, limited access to syari’ah-compatible liquidity instruments issued by central banks, legal uncertainties surrounding the Islamic money market, and the limited infrastructure of the Islamic financial market (especially in terms of risk-hedging instruments). Therefore, regulators should take swift and urgent action to develop systemic liquidity arrangements and the infrastruc- ture of the Islamic money market, especially syari’ah-compatible liquidity and risk hedging/mitigation instruments. There have been some attempts to answer this need, such as the International Islamic Financial Market (IIFM) and the Liquidity Management Center (LMC) in Bahrain and the Islamic Interbank Money Market (IIMM) in Malaysia and Indonesia. To return to supervisory frameworks, regulators must develop high- quality accounting standards that would be internationally acceptable to Islamic banks in the interest of promoting disclosure discipline in Islamic banking. Good market discipline and transparency require that the disclosure of financial information by Islamic banks be consistent, reliable, accurate, and comparable across time periods and with other banks within the same peer group. Regulators should enact mandatory external audits for Islamic banks, not only over financial information disclosures but also over the compliance of this information with the principles of syari’ah. With regards to accounting standards, the AAOIFI has developed a series of financial information disclosure standards for the financial reports of Islamic banks, and a significant number of external audit institutions have built upon these standards for the purpose of evaluating the quality of Islamic banks’ financial reports. However, despite the availability of the AAOIFI syari’ah standards, no country has gone so far as to delegate syari’ah-auditing responsibilities to external private parties, except in a few cases of delegation to national syari’ah boards. Anticipation of Systemic Risk through Basel III In some countries, the Islamic banking industry had not had the chance to apply Basel II when Basel III was issued. At the end of 2010, the Basel

Pathways of Risk Management in Islamic Banks 321 Committee on Banking Supervision (BCBS) devised a global financial reform package meant to (1) improve the banking sector’s ability to absorb the impact of economic and financial crises, (2) improve management and governance practices and enhance transparency and disclosures in the banking sector, and (3) strengthen resolutions for banks with systemic and/or multinational operations. This global financial reform package is popularly known as Basel III. Compared to Basel II, Basel III expanded its scope to include the reinforcement of bank resilience at the macroeconomic level, along with the formal accommodation of the systemic risk issue. The anticipation of systemic risks is performed through a reform of macro-prudential arrangements, such as through the implementation of the leverage ratio. This leverage ratio would help mitigate risks that may endanger the economic and financial system, reduce procyclicality, and apply countercyclical capital buffers that must be built up during good economic times so that they can be used to counter the potential risks that may arise during crises. The implementation of the Basel III framework began in January 2013 and is scheduled to continue until January 2019. At the global level, the Islamic banking industry (under IFSB encourage- ment) responds to the accommodation of systemic risks within Basel III by changing the capital adequacy standard for Islamic banks. The revision to the IFSB’s Capital Adequacy Standard (2013) is a response to the potential systemic risk that surfaced in the global crisis of 2008–2009. This set of revisions functions as a comprehensive guideline for regulators with regard to CARs for Islamic banks. The revision also seeks to address a number of weaknesses in previous standards, such as in terms of capital components, credit risk mitigation techniques, the treatment of profit-sharing investment accounts, and alternative syari’ah-based hedging instruments. Like Basel III, the current IFSB focuses on the macroeconomic and micro-prudential treatment of potential systemic risks. Issues Related to Future Regulations One proposal intended to reinforce and stabilize the banking industry against market shocks is the establishment of a multilicense system for banks. Some of the policies included in this multilicense regime are the restructurization of bank capital, the regulation of governance through lim- its on ownership shares, and better approval processes for banking products and activities. The multilicense system will group banks into categories, each of which will work under a specific set of regulations. Every bank will have to adjust the scope of its products and activities to suit the category it has been assigned to. If a bank wishes to obtain the license to undertake activities in a higher-risk category, the bank must upgrade its license by fulfilling a number

322 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING of requirements such as better debt-to-equity ratios and CARs. The bank must also obtain licenses for additional products and investments, such as in the case of a commercial bank that wishes to expand into investment banking or open a new branch office. If the bank would like to maintain its present range of products and activities but lacks an adequate capital structure for it, the bank must make up the shortage in capitalization within a reasonable timeframe or face the prospect of having its license downgraded or revoked. Pathway to Islamic Banking Regulation and Its Improvement In Islamic banking, there are several important points of policy that deserve particular attention. The first is the reinforcement of Islamic banks’ interme- diation function for the real and productive economic sector. Islamic banks should enhance their financing capabilities for the real and productive eco- nomic sector. Considering the great diversity in the economy’s character and profile, Islamic banks should be able to explore the poorly covered domes- tic market by offering Islamic financial services. For this reason, Islamic banks must be capable of serving the market demand of micro, small, and medium-sized enterprises as well as larger corporations. To achieve this, Islamic banks need to focus on the development and enrichment of Islamic banking products in a more coherent manner. This requires facilitation from regulators in the form of product reviews as well as improvements in product regulation and licensing processes. Second, Islamic banks working under a “co-opetition” strategy must contribute towards the development of an institutional infrastructure for Islamic businesses. There must be a cooperative framework that allows synergy without violating syari’ah principles. It must be remembered that Islamic and conventional businesses are built on very different assumptions. Regulators must be capable of laying sound boundaries for cooperative ven- tures between Islamic and conventional entities. Ideally, cooperation with conventional institutions should be able to enhance the potentials, capaci- ties, and competitive position of an Islamic bank, but such cooperation is also prone to various kinds of hilah and syari’ah violations. Thirdly, Islamic banks should continue to improve their governance and risk management systems. Even though the world is still reeling under a global economic crisis that grew out of the U.S. subprime mortgage crisis, the impact upon the Islamic banking industry has not been very significant. Apart from the fact that the Islamic banking sector’s activities are much more closely connected to those of the real economic sector, Islamic banks also lack a strong interdependence with conventional banks. In other words, the Islamic banking industry is naturally isolated from the vagaries of conven- tional banking, and this is exactly as things should be. In some countries, like Indonesia, the growth of the Islamic banking industry tends to show a slow

Pathways of Risk Management in Islamic Banks 323 but steady trend. Today is the ideal period for Islamic banks to strengthen their governance and risk management practices. Periods such as these, when the economic conditions support the growth of banks and the banking indus- try, provide banks with the perfect opportunity to improve their resilience against future risks such as the continuation of the global crisis. Fourth, regulators should reinforce their monitoring and oversight sys- tems. This facilitates the improvement of governance and risk management practices in the Islamic banking industry. The effectiveness of banking over- sight must be improved through such measures as the refinement of oversight and monitoring infrastructures. In the future, regulators should integrate the Islamic banking oversight information system into a single platform in order to facilitate access and increase the quality of the information that forms the basis for regulatory authorities’ analysis. This integration must include applications for the evaluation of the health of the Islamic banking system as well as stress testing applications. Regulators should also evaluate the early detection systems utilized by Islamic banks and improve the guidelines for Islamic banks’ monthly reporting practices. PROSPECTS AND CHALLENGES OF ISLAMIC BANKING DEVELOPMENT The rapid growth of Islamic banking also brings an increasing scope and variety of risks for Islamic banks to cope with. Each bank not only has to face its own idiosyncratic risks but also is exposed to systemic risks due to the increase in interbank and international interactions and activities. Systemic risks manifest themselves through the domino effect and the too- connected-to-fail phenomenon. An Islamic bank has an unlimited range of options in dealing with this risk through funding operations and fund utilizations under the combination of several syari’ah-compatible financing models. These underlying conditions mean that issues in risk management have grown in complexity, including risk measurement, income acknowledg- ment, profit/loss distribution, collaterals, third-party guarantees, and risk disclosure and reporting standards. Therefore, Islamic banks must continue to develop innovative solutions and appropriate adaptations to existing risk management frameworks (or the ones mandated by authorities), especially for systems that suit the unique character of their Islamic financial products and services. For example, the development of new products in the form of bancas- surance is intended to achieve the goal of financial inclusion. This product shifts the bank’s activities into takaful territory, even though technically bancassurance products are still provided by takaful firms and the bank is only involved with their distribution. The logical conclusion of this trend leads to the possibility that the foreseeable future will see the lifting of

324 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING boundaries on banking products, as seen before in venture capital products. Conversely, other financial institutions such as insurance firms, pawn shops, investment companies, and the like will be able to offer financing products normally associated with banks. This situation will lead to more complex competition not only among banks but also with non-bank financial institutions. Non-banking financial products open the door for the bank to produce further benefits such as by providing added value to its cus- tomers, obtaining income from ujrah contracts, enhancing customer loyalty, centralizing financial services, and attracting new customers. A system of cooperation between banks and insurance firms (through joint distribution, strategic alliances, joint ventures, and the grouping of financial services) opens the door for greater information sharing between the two types of financial institutions, especially in the case of customer information. How- ever, this can also puts banks at risk, since banks have hitherto worked under the principle that they will safeguard their customers’ confidentiality. Banks also stand the risk of falling into the territory of ethically dubious products, especially since insurance practice is riddled with maysir and gharar. The potential for the securitization of financing assets in Islamic bank- ing is inherent in such products as real estate sukuk (istishna’), salam sukuk in the agricultural sector, and the like. Liquidity risk is one of the classic risks that always haunt Islamic banks. The minimization of this risk can be performed through the restructurization of funding and financing activities in order to establish a scheduling pattern and other characteristics that would be consistent with profit sharing. For example, when the bank intends to finance an oil palm plantation venture under the “plasma core” model, it can create a super-micro sukuk product to fund the venture, especially since the plantation will not begin financially relevant production for a few years. Similar arrangements can be made for the financing of plantations for other agricultural commodities, such as sugar cane, bananas, and the like (e.g., rice, maize, or vegetables), all of which exhibit a certain lag time between the initial investment and the harvest/productive period. Syari’ah-based deposit products are currently available only under simple mudharabah contracts, but in reality they can be combined with additional features to create super retail sukuk. Such innovations require a high degree of creativity among the product management personnel in the Islamic banking industry. STRATEGIC ISSUES IN THE IMPLEMENTATION OF ISLAMIC RISK MANAGEMENT The extent of strategic issues in banking industry could be described by the idea to abolish fractional reserve banking in conventional banking; it will need a lot of resources and costs for adjustment. In Islamic banking, the

Pathways of Risk Management in Islamic Banks 325 strategic issues involved syari’ah-based versus syari’ah-compliant products, how risk is handled in a profit-sharing scheme, and whether it is possible to change the deposit holder’s perception of him- or herself as an investor. Syari’ah -Based versus Syari’ah -Compliant Products Syari’ah-based products in Islamic finance and banking refer to contracts whose structures and processes have remained essentially the same (accord- ing to Islamic literature) from the era of the Prophet Muhammad to the present day. Contract schemes that fall under this category are salam, mud- harabah, musyarakah, and ijarah. These schemes have been applied verbatim in today’s banking environment. On the other hand, syari’ah-compliant products are banking or financial product and schemes that did not exist in the Prophet Muhammad’s days, but are permitted for use since the majority of contemporary ulama (religious scholars) agree that such products do not violate the fundamental concepts and principles of Islamic law. The majority of Islamic banking products at the moment fall into the syari’ah-compliant category. These products usually result from the modification of conven- tional finance products to suit the principles of Islamic law. One of the most popular examples is the murabahah bil wakalah scheme, which closely resembles personal credit schemes from conventional banks. Islamic banks must be capable of facing the challenges in the industry, especially the demand for liquidity instruments, hedging, risk management, and asset securitization through financial engineering. Syari’ah-based products will not suffice to cope with all of these challenges, so banks must exercise their creativity in devising new low-risk syari’ah-compliant products. Risks behind Profit-Sharing Schemes Ideally, Islamic banks should be able to devise their own products without slavishly copying the portfolios of conventional banks, relying instead upon the Qur’an and the hadith to find ways to answer market demands without resorting to interest-based schemes. As such, Islamic banks’ portfolios should be dominated by profit-sharing products that provide equity financing as opposed to loan/credit financing products, as well as investors who have the vision to facilitate economic development, are capable of choosing projects with good growth potentials, are willing to closely monitor their investments, and favor the channeling of risks toward assets rather than liabilities in the interest of optimizing the bank’s stability. If an Islamic bank decides to shift its activities in favor of profit sharing, the decision will naturally have major implications upon the bank’s risk management practices. Profit-sharing schemes for funding and

326 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING financing contracts such as mudharabah or musyarakah would directly expose the bank to rate-of-return risks and equity risks. The bank also stands to face the impacts of business risks from financing contracts and displaced commercial risks from funding contracts. Unfortunately, Islamic banking regulators throughout the world have not yet figured these two risk categories into capital adequacy calculations. Theoretically, assets and financing contracts funded with shirkah (profit- sharing) funds do not have to be treated as assets that count for capital adequacy since the owner of the shirkah funds (shaibihul/rabbul maal) is willing to bear the losses incurred from shirkah financing contracts such as mudharabah. Some industry practitioners have suggested that Islamic banks should establish a PER (profit equalization reserve) and IRR (investment risk reserve) for shirkah account holders. This notion holds that an Islamic bank should be willing to forego a portion of its profit share as the mud- harib or of banking profits for unrestricted mudharabah account holders so as to maintain the level of profit payments they stand to get. This policy can be used to neutralize the cyclical impacts of the returns obtained from debtors’ payments in poor economic conditions. However, the use of this policy would lead to a system dangerously similar to the interest rate in conventional banks, where the bank pays a fixed and guaranteed level of returns (in the form of interest). Moreover, the PER and IRR would prevent the immobilization of a portion of the bank’s capital, even though these reserves are not recorded in the bank’s contracts. Mudharabah Mutlaqah vesus Mudharabah Muqayyadah In facing systemic risks, the IFSB allows Islamic banks to treat restricted mudharabah account holders as investors and unrestricted mudharabah account holders as ordinary depositors. Unfortunately, this distinction can result in ambiguity over the treatment of depositors when the bank suffers losses. On one hand, unrestricted mudharabah account holders are treated as depositors, so their returns are stabilized with the aid of the PER and the IRR. On the other hand, in case of bankruptcy, the unrestricted mudharabah account holder does not have the conventional depositor’s right to reclaim the full value of the invested funds; instead, they can only claim a share in the ownership of assets or ventures funded by their account. If the bank suffers losses, there are no clear rules for establishing the priority of ownership claims by shareholders and mudharabah investors upon assets and ventures financed by their funds. At present, depositors in Islamic banks (under wadiah, qardh, or mudharabah) usually have a claim upon their savings funds but not upon the bank’s profits. This inconsistent treatment of depositors in an Islamic bank is deemed unavoidable since the public’s

Pathways of Risk Management in Islamic Banks 327 attitude has not shifted from a savings-minded to a more investment-minded position. Even though various studies on Islamic economics assume that the rational behavior of individuals’ microeconomic behavior is focused upon rational risk-taking through investment ventures, the reality is that the public still prefers the idea of saving their money without the risk of suffering losses, and this can be regarded as hoarding behavior to some extent. A consistent treatment of mudharabah account holders, whether as investors or as depositors in conventional banking terms, would have wide-ranging consequences upon risk management in Islamic banking, from the mitigation of business risks to the treatment of assets and liabilities. The treatment of mudharabah account holders will affect how much capital will have to be held in reserve. Arguably, this difficulty stems from the fact that regulators (IFSB in this case) have not yet implemented the same standards across the board for all Islamic banks. Answering the Challenges of Syari’ah -Compliant Products Islamic banking practitioners today tend to take a pragmatic attitude, since they have grown comfortable with the present condition. They see no problem with the predominance of syari’ah-compliant products as long as those products have passed the halal screening enacted by national Syari’ah Advisory Council. The lack of syari’ah-based liquidity instruments and hedging/mitigation instruments is tackled by merely copying and adopting existing instruments in conventional banking. This attitude is inappropriate since these two instrument types make up the principal issues with syari’ah-compliant products. For instance, there is the implementation of murabahah commodity products in the inter-Islamic bank money market. This instrument has been suggested as a possible alternative for short-term liquidity instruments by obtaining income from the sale and purchase of such commodities as precious metals. However, this product has attracted vehement criticism from the ulama since the product is not linked to real physical assets. If the future development of Islamic banking continues to slavishly follow market demands for syari’ah-compliant products rather than trying to shape the market with syari’ah-based products, risk management practices in Islamic banking are not likely to see significant structural changes or innovations. The regulatory treatment and supporting structures (such as rating, recording, and legal systems) will not differ appreciably from those of conventional banking, so the risk measurement tools and methods as well as risk mitigation policies will merely copy the corresponding developments in conventional banking.

16CHAPTER Future Agenda Risks will always be present as long as a bank runs its business. This fact calls for the continuous development of a risk management system. Updates to the system, analyses, and evaluations must be made on a regu- lar and periodic basis to ensure that the system will be able to adapt to the times and to current environmental dynamics without veering away from the bank’s stated visions and missions. There are a number of requirements for this sustained development, namely the commitment of equity owners, a consistent focus in the bank’s management practices, and the development of a management performance measurement model that not only assesses the achievement of goals but also their contributions to risk management. Islamic banking operations involve the transformation of credit risks into market risks, investment risks, displaced commercial risks, and the like. The packaging of risk also differs between the bank and the debtor. A financ- ing portfolio dominated by trade and commodity financing, leasing, and istishna’ means that the level of collaterals in Islamic banks is generally higher than that in commercial banks. Many of the products behind trade and commodity financing have higher asset risks and operational risks. On the other hand, the bank must make sure that a significant pro- portion of the collateral assets can be converted into real assets within the contract’s duration. The conversion of goods bought for trade finance into bank assets may increase the risk of moral hazard in the form of debtor nonperformance. Therefore, the bank needs to develop legal certainty and regulatory support that would allow it to efficiently recover its loans. Sim- ilarly, in mudharabah and musyarakah contracts, the bank stands to face a higher level of asset (portfolio) risks, which may potentially limit the bank’s ability to seize collaterals and recover bad debts. Both of these contract schemes require the bank to share risks with the debtor and absorb losses according to the proportion of capital it has invested in the venture. The execution of collaterals is unavailable to the bank as long as the losses that cause the bank to receive no profit share (or even fail to break even) are not caused by the debtor’s negligence or willful malice. In this way, the bank has to bear a great deal of risk, and the acknowledgment of reductions in actual contract value can only be made at the end of the contract period. As such, 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. 328

Future Agenda 329 the complex variety of contracts available for use and the features of each individual contract model together make it hard for Islamic banks to justify the risk portfolios they have to face over their assets. LANDSCAPE OF INTEGRATED ISLAMIC RISK MANAGEMENT Ideally, the management of collaterals (rahn) and guarantees (kafalah) should be performed by an independent institution. Pawnshops are perhaps the most appropriate institutions available for this kind of collaborative and synergistic effort with Islamic bank financing systems, as seen in Figure 16.1. When collaterals and guarantees (especially their appraisal and maintenance) are properly managed, banks will find their burdens lightened since they will be able to obtain information on the market value or price of collateral goods more quickly, while pawnshops will have an easier time ensuring the sustainability of their businesses. The sharper focus on the collateral business will allow the pawnshops to specialize better and devote more time to the quality and efficiency of their work. They will also be able to devise a variety of ijarah- and wakalah-based products for collaterals. Finally, customers will gain a sense of greater security and fairness since collaterals would be put in the hands of an independent third party not related to the bank that provides financing services. The auction mechanism in case of liquidation would be faster and better structured, and the price Debtor submits a financing proposal with attaching rating certificate Bank asks debtor to provide collateral (rahn) and guaranty (kafalah) Debtor Islamic bank Debtors Rating Running business custody of request to collateral and price appraisal be assessed their rating Pawnshop Rating agency Updating information and rating specific debtor Settlement of disputes Arbitrage or Settlement of disputes law court FIGURE 16.1 Synergy between Financial Services Institutions

330 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING obtained will be more competitive since the process will be in the hands of skilled auctioneers. There should also be an independent body that assesses and rates the risk profiles of bank customers, whether individual customers, small busi- nesses, or major corporations. Apart from the banks’ internal rating systems, the regulator’s credit information bureau has been performing its assigned function as a databank for banking customers involved in credit and financ- ing schemes. However, these entities do not yet have a transparent periodic ranking system that can map customer risk profiles. Such rankings would be very useful as a reference in evaluating prospects for financing and financing restructurization, and they can be an indirect indicator for national business and risk ratings. Indeed, the rating system can provide a reference point for the calculation of country risks with the use of macroeconomic indicators based on the performance of the real sector. There should also be an effective communication system among Islamic banks. At a minimum, this system will allow Islamic banks to help each other in mutually minimizing their liquidity risks. Effective communication would also help minimize unnecessary frictions such as price wars, product plagiarism, and sabotage efforts against other banks’ suppliers, principal debtors, or key employees. It may even open the possibility of jointly work- ing the market. In this way, synergies will be built not only within an Islamic bank’s internal environment but also among different Islamic financial insti- tutions for the achievement of greater benefit for all. SYNERGY AND INTEGRATION AMONG ISLAMIC FINANCIAL INSTITUTIONS Islamic banks stand to face a myriad of challenges in the future. To make a long story short, no single bank can have all the resources needed to fulfill the institutional requirements to provide various ways and means of fulfilling the public’s demand for venture capital, consumer financing, and investment financing, whether for the short or the long term. Islamic banks require mutually beneficial synergy and cooperation with other financial institutions in order to run the various functions they wish to perform. As investment banks, Islamic banks must interact with the Islamic financial market, the real products market, Islamic mutual funds, pawnbrokers, and the like. Even when the Islamic bank handles only commercial banking functions, it still requires a considerable degree of institutional support and regulation from regulatory authorities, such as lenders of the last resort, Islamic insurance and reinsurance facilities, and Islamic interbank and money markets. This pressing need for interinstitutional synergy has created the

Future Agenda 331 need to put all financial institutions under the aegis of a single common regulatory authority. The globalization of the financial industry has resulted in increased com- petition in Islamic banking and the broadening of the range of financial services that can be offered. National financial markets are converging into a single global market, and this has resulted in the liberalization of the foreign currency market, the integration of multiple financial institutions in a sin- gle product service, the rapid dissemination of information, and an increase in systemic risks due to the interconnection of financial institutions across national borders. Similarly, investors have gained better access to the mar- ket and to both domestic and global financial institutions. Funds circulate very quickly in the scramble to find more attractive investment choices. In this situation, an Islamic bank has to compete not only against other Islamic banks in the same Islamic banking industry but also against other Islamic financial institutions in the broader Islamic financial industry and against international actors in the global Islamic finance industry. If the Islamic bank responds to these developments from a self-centered perspective, it will have to face all the challenges alone while fending off everybody else as rivals and competitors. However, the result will be very different if the Islamic bank follows the different paradigm of working for the greater maslahah for society. COMPETENCY AND COMPETITIVENESS OF ISLAMIC BANKING Islamic banking does not have to look elsewhere to market its product. The 2.5 billion Muslims worldwide are the sought-after market. But the sheer number does not guarantee any profit or loyal customers if Islamic banking falls behind conventional banking in delivering the best services. Many Mus- lims understand the concept of riba, but they are using conventional banking anyway due to its excellent service. Competition among Islamic banking is needed to ensure efficiency in terms of service improvement. Awareness for Constant Development Facts on the ground show that Islamic banks have largely succeeded in amassing large amounts of funds within a relatively short timeframe. This success must be maintained through a number of fundamental improve- ments to the banks’ performance. Otherwise, Islamic banks may find it difficult to sustain a reasonable level of growth in the future. Islamic banks should wake up to the fact that most of the deposits they’ve acquired were