Risk Management for Islamic Banks Recent Developments

332 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING not motivated by higher rates of return or better financial services, but rather by the depositors’ religious commitment and loyalty. Many Islamic depositors chose to place their funds with Islamic banks to avoid the need to engage in usurious transactions with conventional banks (or keep their money under their pillows). For these people, low or even zero returns are deemed acceptable; in fact, they may grow suspicious if the bank offers a high rate of returns that may imply the use of riba, gharar, or maysir elements. However, Islamic banks should not continue to rely solely on incoming funds from this type of depositor; the bank must also make moves to become more competitive amid the financial industry at large. Islamic banks also need to realize that their high growth rates at present owe much to the high monopoly rate among Islamic banks, especially with regard to transparency in price setting and the validity of financial con- tracts. The banks will not be able to maintain this situation indefinitely. As the public grows more educated about various Islamic banking prod- ucts and services, they will also become more capable of judging which banks really work according to syari’ah and which ones merely use it as a smoke screen. Today, banks enjoy high margins (murabahah, istishna’), fees (ijarah), or profit ratios (mudharabah, musyarakah), but eventually their customers will take note of this. By observing data on market price move- ments for a contract object, the customer will be able to measure the actual costs incurred by the bank. The customer would also be able to construct a simple model to predict the future performance of ventures funded by the bank and simultaneously tie this performance to the risks faced by the bank. Through this projection and relationship analysis, the customer would be able to find a stronger position for negotiating margins or profit ratios with the bank. Moreover, the increasing competition in Islamic banking due to the increasing number of banks would strengthen the customers’ bargain- ing position. They would have more alternatives to choose from in finding venues for syari’ah-compatible financial transactions. Neither are Islamic banks the only players that can offer Islamic financial products; many con- ventional banks have begun to offer similar products through their Islamic business units (Islamic windows), branches, or subsidiaries. There are also other financial institutions like Islamic pawnhouses, multifinanciers, leasing companies, and micro-finance (baitul maal wa tamwil) that offer financial products similar to those offered by Islamic banks. Positive Response to Increasing Competition The entrance of many new players into the industry indicates that the Islamic banking industry will continue to grow. Of course this is encourag- ing news, but on the other hand it also implies that the level of competition

Future Agenda 333 in the Islamic banking industry will continue to rise. The question is, will today’s Islamic banks be able to survive and compete in the future? The answer depends heavily on how those Islamic banks respond to current developments. The increasing competition would probably make the mar- ket more efficient and transparent, reduce the costs that customers would have to bear (making prices more competitive), and promote innovation and quality enhancement for the financial products and services offered by banks to the customer base. Compared to Islamic banks, established commercial banks are much better prepared to invade the Islamic banking industry and take over the reins. The conventional banks’ advantage stems from their larger size, greater experience, more extensive marketing net- works, more competent human resources, more stable operational systems and internal controls, and more developed pricing, product engineering, and risk management methods. When they decide to enter the industry and compete with Islamic banks, the Islamic banks’ survival will depend heavily on their ability to increase their efficiency, manage their risks, and improve their performance. One response that should immediately be adopted to answer the tremen- dous growth in the demand for Islamic financial products and services is increasing the size of Islamic banks. Size is a crucial factor in increasing the efficiency and quality of a bank’s performance. Larger banks benefit from economies of scale and lower average costs for the financial products and services they offer. They also tend to get additional incentives in the form of positive credit ratings; the market responds positively to their shareholders’ commitment to the expansion of the banks’ business, the greater availability of financing resources, and the larger banks’ greater potential for asset diver- sification. The reverse applies to small banks, which tend to have a harder time getting access to sources of funding, less room for portfolio diversi- fication, lower efficiency, and fewer opportunities for business expansion due to capital limitations. Increasing a bank’s size does not always have to mean asking the shareholders for capital infusions or initiating a merger or acquisition with another bank. An Islamic bank also has the option of increasing its business capacity and efficiency by forming strategic alliances with other banks. REGULATORY AGENDA IN THE FUTURE Islamic banking is unique to its location and conduct, because it will be based on the local custom; and local custom is affected by the variety of schools (madhhab) in Islamic law. The variety will produce slightly different banking products, even in classifying whether a transaction is prohibited

334 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING or not. A transaction or a product could be considered syari’ah compliant in one country and not in another country. This situation must be resolved immediately, hence the need for global regulators and judicial institutions. Standardization Regulatory and Supervisory Framework The enormous variety of schools (madhhab) in Islamic law is something that regulators must tackle in order to allow the Islamic banking industry to move towards product standardization, the development of varied and com- petitive products, and price transparency among Islamic banks. Supervisors must recognize that any regulatory framework they enact must: (1) acknowl- edge the distinct features of Islamic finance and find appropriate responses rather than merely applying solutions more appropriate to conventional banking, and (2) in the case of dual banking systems, offer the same degree of protection to Islamic banks as they do to other banks. Regulatory and supervisory frameworks must apply clear and consistent principles that can- not be arbitrarily modified by market players, including resource adequacy, good governance, reliable control systems, and transparency. Issues specific to Islamic finance, such as the special position accorded to the syari’ah board, bank customers, the rights of unrestricted mudharabah account holders, and accounting may require specific solutions. The same concern applies to the integration of the Islamic financial system into the framework of domestic fiscal, monetary, and legal framework in the interest of promoting Islamic banking (and finance). Strengthening the Syari’ah Board’s Supervisory Framework To ensure that every Islamic bank operates according to Islamic law, regula- tors have decreed that each bank must set up a syari’ah supervision board. At the moment, syari’ah supervision boards still work in a comfortable position, since they only have to supervise the implementation of classic Islamic finan- cial contracts and have not entered the territory of sophisticated modern financial applications. However, banks will eventually move in that direc- tion, and the supervisory board must be ready to review the innovative products. At the very least, the syari’ah supervision board should explain the syari’ah-based limits and boundaries that must not be crossed in any event, such as riba, gharar, and maysir. The board must not only provide applied examples but also an in-depth understanding of all three concepts. The board itself should always make an effort to increase its competence and knowledge about both Islamic law and modern finance.

Future Agenda 335 Regulators should encourage an immediate improvement in both the numbers and capacity of the ulama sitting on the national syari’ah boards as well as those on the syari’ah supervision board of individual Islamic banks. Every ulama should be equipped not only with knowledge of fiqh mu’amalah but also with a broad understanding of banking and finance. The ulama do not have to be experts in both fields since they’re chiefly responsible for enforcing syari’ah compliance/compatibility, but they need to understand the issues they may encounter when they review the products of innovation in modern finance. On the flip side, regulators should also encourage bankers to acquire knowledge about Islamic law so that the product innovations they propose would not contradict the rules and principles of syari’ah. A work- ing understanding of Islamic laws should motivate the bankers to exercise greater prudence in the operation of Islamic banks and naturally promote the implementation of risk management in Islamic banks’ business activities. ANTICIPATING THE POTENTIAL SYSTEMIC RISKS Neither the Islamic banking industry nor the conventional banking industry is entirely immune from the potential of systemic risks, especially nowadays where product and institution are more interlinked. Previous financial crises have left clues and lesson to be learned in order to keep future systemic risks away from Islamic banking industry—for example, how should the ethical standard in an Islamic bank guide bankers to safer conducts? Interconnection and Cross-Border Products The 2008 U.S. subprime mortgage crisis has led to financial crises in other parts of the world such as Latin America, Europe, and even Asia. The 2008 crisis was exacerbated by the vulnerability of financial systems due to global- ization and increasing integration among financial institutions; this is known as interconnection risk or the “too-connected-to-fail” phenomenon. Addi- tionally, financial bubbles often result from easy credit, excessive credit, speculation, greed, fraud, and corruption. Easy credit and weak supervision result in weak market discipline, which stimulates excessive and unhealthy financing. Interconnection among financial institutions can be direct or indi- rect. Direct interconnection takes place through balance sheet claims such as the relationship between assets (through receivables or payment portfolios) and liabilities. A financial institution such as an Islamic bank may suffer the impact from the default of another financial institution that also happens to be its debtor. Indirect interconnection takes place through investments or the ownership of securities in financial markets (capital market and money market), in which case a bank suffers the impacts of the risk when the issuer of the security fails to perform.

336 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING An understanding of systemic risks is a prerequisite for financial stabil- ity. There are several different definitions for systemic risk. Kaufman (1995) defines systemic risk as the probability of cumulative losses from an event that causes a chain of losses in an institution or market within the financial system, and this systemic risk is seen as a chain reaction triggered by the fail- ure of interconnected “dominoes.” De-Bandt and Hartmann (2000) define systemic risk as the risk that a financial system may suffer a systemic event. According to the Bank for International Settlement or BIS (1994), systemic risk is the risk that one party’s failure in meeting its contract obligations would lead other parties into nonperformance, liquidity problems, or credit issues under a chain reaction that leads to broader financial problems and threatens the market’s stability and self-confidence (European Central Bank 2004). Schwarcz (2008) defined systemic risk as the risk that an economic shock (such as the failure of a financial market or institution) could lead to a chain of failures (through panics or similar causes) in the market at large and cause significant losses to financial institutions, which in turn makes finan- cial market prices very volatile, increases the cost of capital in the market, and reduces the availability of capital in the market. The analysis of systemic risks is often connected to interbank lending relationships through the contagion effect to identify crisis propagation paths and mechanisms between markets and countries. One of the main cri- sis propagation paths is the foreign currency market (as in the 1997–1999 Southeast Asian currency crisis and the 1998 LTCM crisis), interest rates, and conditional volatility in the capital market. The linkage between coun- tries during crisis periods and spillover effects from one country to the next can manifest through trade routes, financial linkages, or interconnection among banks. A systemic failure in the global banking system can happen through the failure of interbank payment systems or the loss of public trust in banks and the consequent global bank run. The failure of interbank payments would mean that creditor banks would be unable to receive or demand payment for the loans they’ve extended, and this would render them insolvent. In turn, bank insolvency and bank runs can exacerbate economic and financial spillovers, such as through the acceleration of an ongoing credit crunch and macroeconomic contraction. The shocks that may lead to systemic risks can be divided into three broad categories: big shocks such as the failure of major banks, spillovers such as the East Asian contagion, and common shocks. Conducting the Islamic Ethical Business One of the aims of Islamic law is to promote universal justice for all humankind, and there is no way to achieve this unless every individual

Future Agenda 337 and institution contributes to it on every aspect of human life—social, economic, and political. Universal justice would be one of the first steps towards both material and spiritual prosperity for the entire human race. For this reason, the financial system should reflect the principle of fair mea- sures in order to build strong and stable foundations. The owners of surplus funds should be willing to share risks instead of leaving entrepreneurs (business managers) to bear any and all losses. Every business and economic actor should implement the concept of “al ghunmu bil ghurmi, al kharaju bidh dhaman” or “no risk, no gain.” Furthermore, the financial system should guarantee the availability of capital in fair amounts and sufficient availability to the poor for the purpose of helping them meet their needs and lifting them above the poverty line. Unlike the conventional financial system and its focus upon the eco- nomic and financial aspects of business activities, the Islamic financial system stresses the moral, ethical, and social dimensions for the sake of justice and equitability in people’s economic lives. Krichene and Mirakhor (2009) defined Islamic finance as the financial activities of an economic system based on social balance. Islamic banks, as commercial institutions, must pay due attention to social and economic justice in their economic activities and financial transactions while keeping these activities sahih (legally valid) and free of interest/usury. Islamic finance recognizes the three forbidden notions of taking no risk, taking excessive risk, and transferring risk (Hassan and Kayed 2009). Taking no risk runs contrary to the principle of “al ghunmu bil ghurmi, al kharaju bidh dhaman.” Any profit that has no correspond- ing risk is regarded as usury. Taking excessive risk can involve the overuse of debts/loans (over-leveraging), chasing profits under financing contracts based on sale-and-purchase arrangements without due regard for financ- ing quality, putting too much trust in complex investment instruments, and excessive speculation that leads to gambling (maysir). Last but not least, transferring risk is considered an unfair and unethical practice since all risks and losses have to be borne by the debtor while the bank (as the creditor) has no responsibilities beyond monitoring the use of the funds. The Islamic financial system seeks to minimize the severity and fre- quency of financial crises through the application of stricter discipline within the system; the inculcation of social and religious ethics that would discourage corruption, greed, and fraud; the tying of credit expansion to the growth of the real economy; the requirement that creditors be willing to share risks and act in a prudent manner; and the use of adequate provision policies. With respect to risk management processes, Islamic finance already has some clear-cut rules. There are at least two levels of screening that must be passed: (1) negative syari’ah screening to rule out transactions that involve usury, injustice, gharar (uncertainty), and maysir (gambling), both

338 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING before the investment is made and during the decision-making process for risk management, and (2) positive syari’ah screening that focuses on whether each transaction would contribute to justice, ethics, and accountability. Determinants of Financial Crises Hassan and Kayed (2009) explained several causes of financial crises. The first cause is the appearance of complex derivative products and excessive leveraging among financial institutions, which resulted in financial difficul- ties and the bankruptcy of those institutions. In the 2008 crisis, the secu- ritization process mixed both good and bad mortgages together into new securities that were then released to the market. Afterwards, these securities were traded in secondary markets. Greed and lack of understanding about the risks contained in these securities encouraged investors to spend cash in order to obtain additional fresh loans and make more money. The derivative model worked reasonably well as long as the debtors kept up their payments, but once payments stopped, the model became stuck in a vicious circle where financial globalization caused the transfer of systemic risk inside and outside the country. The second cause of financial crisis is asset–liability mismatch. The lack of a direct connection between third-party funds and the underlying long-term assets prevents the bank from renewing the short-term debts used to fund long-term investments in the form of mortgage securities in the United States, thus precipitating a bank run. Third is regulatory failure. Inadequate regulation made banks less trans- parent and accountable to their stakeholders. Banks were motivated to seek profits with no regard for adequate liquidity, especially through lax lending (extending more loans to generate fees and commissions) that prioritized loan volume over loan quality. The fourth is the combination of fraud, corruption, and greed. The fifth is contagion, which occurs when the collapse of one bank (whether through lack of liquidity, bad loans, or bank runs) causes dam- age to many other financial institutions and threatens the stability of the entire money market. The sixth is money supply issues, namely the uncontrolled printing of paper money without the backing of a real commodity (such as gold), which leads to inflation. Global Crisis Impacts on Islamic Banking The impacts of the global financial crisis upon the Islamic financial and banking industry can be viewed from two different angles. The first is the

Future Agenda 339 immediate impacts upon Islamic banks, and the second is Islamic finance’s potential role in making positive contributions to the global economic sys- tem. According to Khalaf (2009), the direct impacts of the crisis upon Islamic banks have been minimal, as stated by Emmanuel Volland (Standard & Poor’s analyst): “Islamic banks were not caught by toxic assets, as shari’ah law prohibits interest.” Additionally, Islamic banks’ lack of involvement in the exploitation of sophisticated financial instruments made positive contri- butions in reducing the banks’ vulnerability to changes in the federal finan- cial environment. Although Islamic finance did not suffer the full impact of the global credit crisis, Islamic bank still felt the consequences through the fall in the value of financing portfolios in the real estate industry. The volatil- ity of property and real estate prices must be a matter of serious concern to Islamic banks, especially if they still make up a dominant proportion in the bank’s financing portfolio. For example, according to Standard & Poor’s, the Islamic financial sector experienced a sharp drop in the value of sukuks issued in 2009—a drop of $15.5 billion to $47.1 billion in 2007. Although the sukuk market is fundamentally strong and healthy, uncertainty in the global economic market has had a negative impact upon the Islamic financial industry. Islamic banks still need to diversify their sources of finding apart from retail deposits, perform innovation on old products, and develop new products such as Islamic hedging, liquidity instruments, and risk mitigation. In the context of syari’ah finance, aside from stability and supervisory effectiveness, the development of financial services is intimately connected to Islamic economics’ aims in optimizing production processes and resource allocation in the real economic sector, and improving the equitability of the distribution of these resources. The mechanism for the achievement of these aims relies on fundamental norms such as the prohibition on usury (riba), uncertainty (gharar), and gambling (maysir), which should determine the characteristics of the business activities that can be developed by Islamic financial institutions. In this case, the mapping of interconnections between financial institutions would also provide a picture of how well the norms have been implemented on a systemwide basis to complete the partial/ segmented picture available to each individual institution. The development of the Islamic financial service industry provides room and opportunity for the growth of the syari’ah-based economy, but at the same time the variety of Islamic economic services and products (both packages and individual prod- ucts) tends to increase interconnectivity among the players in the Islamic finance industry. So, even though a syari’ah-based economic system is the- oretically more stable than an interest-based system, it still needs to map its interconnections and its potential for systemic risks in order to maintain the consistency between regulation and practice in the Islamic financial industry.

340 FUTURE PROSPECTS AND CHALLENGES IN ISLAMIC BANKING Managing the Systematic Risk The variety of financial institutions (banking and non-banking) can be seen as part of the risk diversification process of the banking system, with conta- gion risk that is first transferred to other market actors and then to investors willing to accept the risk. However, in this risk diversification process, banks still have a role in the “alternative” intermediation process though financial institutions other than banks, and the bank’s leverage and maturity transfor- mation process can be replicated in the alternative process; either way, the risk diversification process through financial institutions other than banks can still result in the same kind of vulnerability in the financial system. Additionally, the intermediation process may result in regulatory arbitrage with the banking industry to circumvent its more rigid prudential standards. This could lead the lowering of the financing preference and underwriting standards that constitute the bank’s primary function, and the consequent increase in the financial system’s vulnerability. To prevent the propagation of the contagion effect in a banking crisis, the government (through the central bank) guarantees deposits up to a maximum level known as the “de- posit insurance.” In normal situations, commercial banks are allowed to utilize the central bank’s short-term liquidity facilities by discounting finan- cial assets at the central bank. Then the central bank can step in and save banks in liquidity trouble (due to bad decision-making, fraud, mismanage- ment, etc.) that are deemed likely to progress into solvency problems. The central bank would bail out these institutions to mitigate the contagion risk that threatens the payment system. The weakness of a system based upon deposit insurance and bail-outs is an increase in moral hazards, since when a major bank or financial institution (including non-banks) is deemed too big to fail, other market actors are encouraged to take excessive risks. Unfor- tunately, the liquidity facilities provided by the central bank as a lender of last resort are unavailable to Islamic banks since these instruments are interest-based. Therefore, regulators should take steps to develop the best possible syari’ah-compatible regulatory and supervisory frameworks for the regulation of interconnected financial institutions and ensure that these insti- tutions remain within prudent regulatory constraints. There are many ways to measure systemic risk in the financial indus- try. The first is to use the interbank transition mechanism strength method under the assumption that the capital market for major banks is efficient. An increase in the risk of systemic failure for banks can be measured through abnormal returns and nonperformance probability with the Merton struc- tural model or the options model. The second approach is to study the distribution of losses in the financial system, such as in the “systemic risk network” model. The third is the graphics and networks method. This last method tries to map the interconnection relationships among institutions

Future Agenda 341 and financial markets into a graphic (or diagram) in the interest of under- standing systemic issues. The graphics theory is an analytic framework for reviewing the characteristics of the financial system after the system has been mapped in a diagram. This approach divides financial institutions into clusters and evaluates how the system changes when one bank (or finan- cial institution) is removed from its cluster along with the impacts of this removal upon interconnection relationships. Many theories have been pro- posed for the topological analysis of payment and settlement systems (size of institutions, number of institutions in the system, connectivity, the number of existing and maximum possible linkages, clustering coefficients, and the probability of two institutions’ closeness to a third institution). The graph- ics theory has also been applied to more complex financial systems such as interbank markets, domestic banking systems, and the global financial system. By using data on- and off- balance sheet, it is empirically possible to build a model of linkages between financial institutions with respect to direct impacts upon the financial institutions’ balance sheets. This method is also relatively easy to use since the data required to construct is comes from publicly available financial statements. If data on the market process of securities is also available, the analysis of interconnections through this graphics theory can be made more complete with a market-based method.

PART Five Conclusion 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.

17CHAPTER Summary and Conclusion Among the available financial institutions, the bank is the financial institution that is most highly regulated. Regulators issue various regulations and carefully supervise the industry to ensure that micro- and macro-prudential behavior is observed in the financial sector. The Southeast and East Asian financial crisis of 1997–1999 and the United States’ subprime mortgage crisis of 2008, which spread into an economic crisis in Europe) have shown how fragile the banking system is in facing shocks to the financial market. When the bank is not connected to others apart from the debtor, the bank will only face classical risks (default risk, operational risk, and liquidity risk) that come from the movements of market fundamentals or macroeconomic factors. Yet once the bank began to be connected to the financial market, then the bank was exposed to the effects of security price movement in the market. This is what is known as market risk. Even when the bank is not connected to the financial market, if the depositors have a wide access to alternative means of investment, the bank is then also exposed to rate-of-return risk and reinvestment risk, which will expose the bank to displaced commercial risk. As competitors grow in the banking industry, the bank will be exposed to strategic risk and reputation risk. The bank cannot merely use itself as reference for service quality and performance improvement; it will have to benchmark itself against other banks in its peer group. After all, the market will assess in aggregate, thus the performance and quality of individual banks will also be valued relative to other banks. The stringency of regulation and supervision by the regulator also creates another risk for the bank: compliance risk. All banks will face various risks, financial and nonfinancial; the Islamic bank is not exempt from it either, even if theoretically the Islamic bank is relatively immune to debtor default risk, market risk (in the financial and derivative markets), and operational risk related to fraud and moral hazard compared to conventional banks. Yet all of this can only be ensured if the Islamic bank properly applies the principles of Islamic syari’ah in design- ing its financial products. When the bank applies the mudharabah model (profit-loss sharing) or wakalah, then the bank is not exposed to the effects of financial risk due to fluctuations on the asset side (financing portfolio) 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. 345

346 CONCLUSION since all risks will be absorbed by fund owners (investment account holder). Yet when the bank shifts from its main function as fund manager (an agent) or mudharib, where the bank is willing to bear a part of the risk to ensure the rate-of-return received by the depositor is competitive in the market, then the bank bears this risk of loss, and then transfers it to the shareholders (investors). The investment risk and the rate-of-return risk that should have been absorbed by the investment account holder turn out to be absorbed by the bank to be then transferred to its investors. This practice is not a problem-free solution for the bank to maintain its investors and draw new ones; in the long run, it will contribute to the rise of a larger risk, which is the loss of the Islamic bank’s reputation as a bank that consistently applies the profit-sharing principles that are in accordance with Islamic syari’ah. The Islamic bank is more interested in applying a quasi-fixed rate-of-return scheme through a yield stabilization process that is similar to the practices of conventional bank. The case related to displaced commercial risk has happened to the International Islamic Bank for Investment and Development in Egypt. From the mid- to late 1980s, they passed on 100 percent of the profits that they received to their depositors and received nothing from the profit for the institution. In 1988, the bank even distributed a profit-share that was larger than the actual profit that they received. Thus no part of the bank’s profit was actually distributed to the shareholders, but the difference between actual profit and the amount of profit distributed to depositors was recognized as loss carried forward and was charged to shareholders. In mitigating displaced commercial risk, the Islamic bank should not sacrifice its own equity to preserve the rate-of-return that it could provide to depositors. If the bank resorts to such methods, there are new issues that it would face, such as that of information transparency. The Islamic bank then faces obstacles in displaying valid, reliable, and timely information to the bank’s stakeholders about what actually occurred in its business, what losses the bank is facing, and so on. As such, assessments by stakeholders on the bank’s performance, business, risk profile, and risk management practices in the Islamic bank became less accurate. A reduction in the bank’s accountability can cause a reduction in depositor and investor confidence on the information provided by the bank. This is one of the ways that a bank is exposed to the risk of reputation loss in society. To define the appropriate risk-mitigation tool, the Islamic bank should observe several things: the uniqueness of the financial product/services offered, the relation between the complexity of the measuring tools and the readiness of the bank’s human resource and infrastructure, and how the source of the risk relates to the features of the financial product, as well as reviewing the risk documents (risk appetite, risk charter, and

Summary and Conclusion 347 owner’s philosophy towards risk) and the organizational structure used. More importantly, the Islamic bank should be syari’ah-compliant, both in designing the risk management system, the risk measurement tools, and the policies related to risk mitigation, and in integrating risk management into the process of engineering financial products. As an example; hedging products (such as forward, future, swap, option, and other derivative products) that are available to conventional banks as risk mitigation tools cannot be used by the Islamic bank. The Islamic bank is required to distance itself from all forms of usury, gambling (maysir), gharar, and tadlis, both in creating financial products offered to its customers as well as in mitigating the risks that it faces, even if this implies that it will face higher liquidity risk than conventional banks. Under those various Islamic syari’ah restrictions, the Islamic bank cannot access the majority of modern financial market, which offers financial products that are not free from usury, maysir, and gharar to cover for liquidity shortage or to invest in the short-term when the bank experiences liquidity excess. At the same time, the Islamic financial market (money market, interbank money market, capital market, and commodity market) is not fully developed enough, both in terms of its products (the variety and number of products available in the market) and its market institutions. To develop an Islamic financial market, regulators also need to observe the syari’ah-compliance aspect, the interconnection between an Islamic financial product and the real sector, and the fulfillment of market actors’ expectations over the financial products issued. At the level of the global financial system, in order to improve banks’ health as financial intermediaries, the Basel Committee on Banking Supervision (BCBS) continuously developed rules and guiding principles for banks interested in entering cross-country activity beginning in 1988 with the issuance of Basel I. Over time, rapid developments in financial market institutions, product innovations, financial engineering, and quan- titative research led BCBS to issue Basel II to replace Basel I, which is now considered to be outdated. From the perspective of the regulator, Basel II improves the health of the financial industry, as it was able to associate economic capital requirements given by regulators with the bank’s performance measurement, allocation of resources, product creation, and product price-setting. Apart from that, Basel II also allowed banks to create and apply their own internal risk management systems, including risk measurement methods that are often too sophisticated or difficult to be understood even by the regulator. This condition naturally encouraged the product division to engineer financial products through the utilization of rapidly developing derivative products. Unfortunately, the speed of innovation was not balanced with the risk division’s speed in developing adequate risk-measuring tools and risk-mitigation policy. Additionally,

348 CONCLUSION interaction between banks and other financial institutions increased rapidly. The too-connected-to-fail risk as the beginning of the domino effect in a financial institution was increasing. This can be seen in the way the United States’ subprime mortgage crisis in 2008 spread to Europe. Many financial institutions were burdened by debt, both on-balance sheet as well as off-balance sheet, and this resulted in the erosion of bank equity. At the same time, the risk of financial interconnection with systemic effects was not supported with adequate liquidity reserve as buffer. As a result, the banks were unable to absorb the losses occurring due to market shocks and a financial crisis occurred. At the end of 2010, BCBS updated Basel II through the publication of a document titled Basel III: Global Regulatory Framework for More Resilient Banks and Banking System. BCBS published Basel III for at least four reasons: (1) to strengthen capital and liquidity regulation, (2) to improve the ability and resilience of the banking sector by increasing reserve capital to absorb shocks from economic and financial pressures and prevent the spread of a financial crisis to an economic crisis, (3) to improve the quality of risk management, management, transparency, and openness, and (4) to provide the best resolution for the systemic risk of a bank operating transnationally. Basel III encourages regulators to strengthen their micro-prudential side in the effort of improving the health and resilience of individual banks in facing a crisis through a higher quality and level of capital, with the primary focus on shares and the importance of adequate capital reserve that must be owned by individual banks to form a conservation buffer. To improve the macro-prudential oversight, a new indicator capable of monitoring finan- cial system procyclicality has been built. Banks that are facing systemic risk will also prepare additional reserve capital while the economy is in a good condition with the purpose of absorbing losses at the time of crisis; this is called the countercyclical capital buffer. The bank also needs to prepare the capital surcharge for those considered to carry systemic risk. Other than the procyclicality indicator, BCBS developed two standard measures to mea- sure liquidity: liquidity coverage ratio and longer-term structural ratio. As planned, Basel III was implemented in 2013; all banks were required to strengthen capital reserve by increasing their core reserve from 2 percent to 7 percent. In 2015, the bank should allocate for its core capital (Tier 1) a minimum of 4.5 percent from third-party funds, and by 2018, the bank is required to provide conservation capital as minimum reserve capital of 2.5 percent. Thus, the total good-quality capital that should be collected and retained by the bank in 2019 should be 8 percent. The Islamic Financial Services Board (IFSB), the international authority issuing various principles and standards for Islamic financial institutions, almost always followed the development of the Basel rules governing

Summary and Conclusion 349 global financial industry. In December 2013, for example, IFSB issued the IFSB-15 standard, titled Revised Capital Adequacy Standard for Institutions offering Islamic Financial Services [Excluding Islamic Insurance (Taka¯ ful) Institutions and Islamic Collective Investment Schemes], to replace the IFSB-2 standards. IFSB-15 adopted Basel III (issued in 2010) related to the capital component required and the macro-prudential-oriented policies for Islamic banks, such as reserve capital, leverage ratios, and methods of calculating systematic risk that significantly affects domestic banks. These measures include the revision and consolidation of guidelines for the treatment of funding contracts based on profit–loss sharing (mudharabah or musyarakah), guidelines for credit risk mitigation techniques, and the ratification of various models for the calculation of capital charges on mar- ket and operational risks. All of this is important for the regulator to protect the banking industry and the economic system from system-wide shocks. The IFSB hopes that these standards will help Islamic banks increase their loss absorption capacities and develop more comprehensive risk-weighting frameworks for the underlying risk exposures. To allow sufficient prepara- tion for the implementation of IFSB-15, supervisory authorities in the IFSB member countries began its implementation in January 2015.

Glossary ‘Adalah Fairness or justice Adverse selection The increasing risk of making the wrong choice due to inadequate information and ineffectiveness of the selection process Al ghunmu bil ghurmi Every profit has risk attached to it Al-kharaju bidh-dhamani Revenue is gained by bearing a responsibility Al-hisba Reward, calculation Al-‘urf Habits (tradition) that developed and apply in general in a society Altman Z-score A scoring method in credit risk measurement created by Edward Alt- man in 1968 Amanah Trustworthy Arbitration A strategy of gaining profit by utilizing a commodity’s price difference in different location Asymmetric information A condition of inequality in information between parties that are about to or have already entered a contract At-ta’awun Mutual assistance Ba’i al-‘urbun Deferred sale contract with down payment (‘urbun) Balance scorecard A method of performance measurement by using financial and non- financial indicators, covering the short-term and long-term and involving internal as well as external aspects that can be used to judge current conditions as well as future planning Bancassurance A banking service providing an insurance product to provide coverage and an investment product to fulfill the client’s long-term financial needs Bay’ Sale or trading Bay’ ad-dayn bi ad-dayn Sale of a debt for a debt Bay’al wafa A sale in which one party sells a particular good by being indebted to the buyer, with the agreement that after the seller fulfills the debt, the object sold is returned to the seller again Bay’al amanah A sale in which the seller informs the buyer of the purchase price of the object sold Bay’al ‘Inah A sale in which the seller immediately purchases the goods he or she had just sold at a higher price and paid in installments; this is done to circumvent the syariah prohibition over usury Bay’ al-‘Inah A sale where the owner of the goods sells those goods in cash to the buyer, and then the buyer sells the goods to the previous owner by credit at a higher price than the cash price (this sale is a dishonest sale—this is same with before, please use the before) Bay’ al mu’ajjal Jual beli dengan pembayaran tangguh (Sale with deferred payment) Bay’an naqdan A sale in which the seller and the buyer both hands over goods and payment for goods at the time of the sale contract 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. 351

352 GLOSSARY Bay’as salam or as-salaf A sale in which the price is paid full at time of contract and delivery of commodities is done at an agreed time in the future and with the specifi- cations of commodities as agreed in the contract. Bay’s ash-sharf Exchange of currencies Bay’ul muqayadah A barter sale Bay’ul mutlaqah A usual sale Bay’ bi tsaman ‘ajil A sale in which the payment is deferred Capital surcharge Additional capital over capital already present; it can be permanent or temporary Catastrophic A risk with a very high possible loss value; usually very rare Channeling A method in a linkage program in which the bank’s partner (the smaller financial institution) acts as the bank’s agent and does not have the right to make financing decisions without the bank’s permission (Capital) conservation buffer Buffer capital used to guarantee the sustainability of a bank’s operations to prevent bankruptcy when the bank experiences losses Corporate governance Corporate governance which regulates the relationship between a firm’s stakeholders Countercyclical capital buffer Buffer capital to protect the banking sector when the development of the credit market is imbalanced by requiring banks to gradually increase capital when credit growth is high, increasing the bank’s ability to absorb losses CreditRisk+ model A model developed by Credit Suisse First Boston in 1997 using an actuarial approach; in this model, risk is measured based on the probability distri- bution of the frequency of occurrence and the severity of the loss Credit scoring Assessment given by the bank to its client for financing requested based on a scoring system Cut loss (policy) A form of policy to cover a position, both manual and automatic, to limit losses to preserve equity from erosion; this policy is usually applied in market risk management Dayn Debt Dhaman Responsibility Diminishing musyarakah A decreasing musyarakah, a partnership between several par- ties where the ownership of a party slowly decreases as time passes due to partial transfer of ownership from one party to another through sale of ownership Din Religion Displaced commercial risk A risk in which the bank is “forced” to distribute a profit share to its depositors at a “competitive” rate that is larger than the rate-of-return based on previously agreed-upon ratio ERM (enterprise risk management) An approach that integrates a group of risk mea- sures and harmonizes various policies, methodologies, systems, and bank infras- tructures, such as governance system, capital management, and risk management activities Escrow account An account opened to accommodate a special fund; withdrawal can only be done by fulfilling certain requirements in accordance with the instructions or contracts between the depositor of that account and another party with involved with it Executing program A method in linkage program where the bank’s partner (the smaller financial institution) is given the right to make decisions on channeling financing to its clients

Glossary 353 Fat-tail loss distribution A loss distribution that allows for the occurrence of a loss value that is far larger than usual, generally used for catastrophic risks Financial inclusion A process to ensure that access to financial products and services is available to low-income groups at a fair and acceptable price, and managed trans- parently by relevant institutions Financing The process of channeling third-party funds held by the Islamic bank to the public (debtor) Fiqh A field in Islamic syari’ah that discusses Islamic law, covering various aspects of the life of men and women in their relationship with their Lord as well as with fellow created creatures Fiduciary risk A risk that emerges when the bank fails in taking responsibility over the trust given by the depositor to manage their funds, such as failure to return their funds or to safeguard depositor interest Fraud A transgression against the law that is done on purpose Gharar Naturally occurring uncertainty that can cause a person to be in danger due to imperfect information, without any element of intent from the parties transacting Ghubn Inequality Granularity A portfolio consisting of many financing yet with very small individual value Hadith The collected sayings, actions, provisions and agreement of Rasulullah shalal- lahu ‘alaihi wassalam that is used as stipulation or law Haircut (policy/strategy) A form of strategy (policy) to limit losses experienced using a certain percentage to reduce the market (fair) value of financing that corresponds to its risk; this policy is usually applied in credit risk management Hajjah Need or necessity Halal In keeping with the Syari’ah; divinely permitted Hamish jiddiyah Security deposit Haram Divinely prohibited Hawalah Transfer of debts between debtors Hijrah Crossed over from conventional to Islamic banking Hilah A trick used in a transaction to avoid something prohibited Hilatul-riba Shadow usury Idiosyncratic risk A unique and very specific risk that occurs due to factors only present in certain individuals or institutions, and nowhere else (also called unique risk) Ihtihsan Juristic preference to consider something good Ijarah A form of exchange where the object is service; the scope of this contract is very broad and includes custody services, rental services, transportation services, and the service of an employee working for a company Ijab-qabul Statements of entering the contract Ikhtiar Work, effort Ikhraha Coercion IMBT Ijarah mumtahia bi tamlik, a rental/leasing contract that allows for the transfer of ownership of the rented/leased object from the asset owner to the renter/lessee; this contract is done by renting/leasing the asset for an agreed period, and then followed with a sale or a grant contract of the asset after Information opacity Information limitation that caused something to be less trustworthy Insider trading The sale of securities involving someone with access to internal infor- mation related to the company issuing the security

354 GLOSSARY Iqaalah Cancelation of sales contract IRB Internal ratings-based—a risk measurement method that allows the bank to cal- culate its own risk; only banks that fulfil certain criteria are allowed to use this method Istishna’ A form of order to produce an object that has yet to be available at the time the contract is entered. Payment for this contract can be done in cash or credit. ‘Iwad The basic condition that can determine whether a sale is a lawful sale or not Joint financing Joint financing to a micro, small- or medium enterprise (MSME) done by the bank together with its partner in its linkage program, where the bank usually bears the majority of the financing capital. Joint venture Penggabungan beberapa badan usaha untuk mendirikan satu ben- tuk usaha bersama dengan kontribusi modal secara bersama-sama (A business established by several parties through joint capital investment) Ju’alah Contest Kaafil Guarantor Kafalah Guarantee Kaffah Holistic Kauniyah Evidence in the universe; Qur’an verses Khata’ Mistake Khiyar The right to choose to continue or discontinue a contract La darara wa la dirara Tidak boleh membahayakan dan tidak boleh dibahayakan (Must not be harmful and should not be jeopardized) Leasing Refers to operating lease Li-tabarru’ contract A contract that is purely intended to bring one closer to Allah Ta’ala, such as shadaqah (mutual assistance), zakat (alms, charity) kafalah, and wad- hiah (safe keeping) Li-tijari contract A group of commercial business contracts Linkage program A financing program yang bersifat kemitraan yang biasanya dilakukan oleh bank bekerjasama dengan institusi keuangan yang lebih mikro untuk selanjutnya disalurkan ke sektor riil (A financing program that is a partnership that is usually done by the bank in collaboration with the micro finance institutions to further channeled to the real sector) Liquidity buffer Liquid asset reserve that the bank must own to maintain its liquidity level; the limit on this reserve will be heavily reliant on the condition and character- istic of each bank Liquidity coverage ratio The ratio used to see whether a bank’s assets can cover its short-term liquidity needs Longer-term structural ratio Rasio yang digunakan untuk menganalisis risiko, dihitung dengan cara membagi utang jangka panjang dengan penjumlahan seluruh pembi- ayaan jangka panjang. Makin tinggi rasio ini, makin berisiko institusi tersebut. (The ratio used to analyze the risk, is calculated by dividing long-term debt by the sum of long-term financing. The higher this ratio, the more risky the institution.) Lump sum Pembayaran secara sekaligus (tidak dengan cicilan) (Lump sum payment, not by installments) Maal al-mutaqawwam Assets owned legally, comply with syari’ah, and can be traded at a price Maqashid syari’ah The purpose of syari’ah revelation Maslahah Benefits

Glossary 355 Maysir Gambling Mazhab Literally meant a path or way of passage; terminologically, it meant following an opinion whose truth is trustworthy Mitigation A series of efforts to minimise risk potential and the impact of risk occur- rence Moral hazard A situation where a party in a transaction commits an act based on bad intentions that can potentially cause losses to other parties Mortgage-backed securities Securities that represent claims to the cash flows obtainable from mortgage loans through a securitization process Mu’awadhah Exchange Mudharabah A partnership in which one partner contributes capital while another part- ner contributes expertise, labor, or efforts to manage the capital, with the stipulation that any profit is divided based on prior agreement, while any loss is divided based on the proportion of capital contribution (which means it is completely held by the capital owner) Mudharabah muqayyadah A partnership where the capital owner places certain limita- tions on the fund manager (mudharib); this limitation can be in the form of maturity, business location, business field, management policies, and so forth, but even so, the capital owner should ensure the limitations given do not obstruct the business run by the fund manager (mudharib) Mudharabah mutlaqah A partnership where the capital owner provides complete free- dom to the fund manager (mudharib) to use the funds entrusted for any business field that the fund manager (mudharib) considers as worthy to work in Mudharib Debtor/businessperson/entrepreneur managing the mudharabah funds Mugharasah A partnership contract for planting trees Mukharabah A partnership between a landowner and cultivator to work on a land together where the capital to cultivate it comes the cultivator (similar to musyarakah, as all the parties in the contract contribute capital) Murabahah A sale where the seller informs the buyer of the cost of goods sold and then negotiates a sale margin with the buyer; this type of sale is often called the cost plus margin sale Murabahah li al-amir bi al-syira’ Murabahah with order Musaqat A partnership between a landowner and cultivator in which the division of the gains between them is based on the agreement at the beginning of contract Musawamah A sale with price haggling Musyarakah A partnership between two or more parties where each partner involved contributes capital with the stipulation that profit is divided according to prior agree- ment, while loss is divided based on capital contribution Musyarakah mutanaqishah A musyarakah contract where the portion of ownership of one party is gradually relinquished to another party through sale of ownership Muzara’ah A partnership between the landowner and cultivator to utilize a plot of land, in which the capital to cultivate the land comes from the landowner (similar to mudharabah, as the land and additional capital comes from one party) Nasi’ah usury A usury that occurs due to delays in debt payment with surplus, or the delivery of usurious commodities in the exchange of the same type or commodity group; in modern finance, bank interest falls under this category Nisbah The profit-sharing ratio that has been agreed by the parties entering a partner- ship contract (syirkah)

356 GLOSSARY Off-balance sheet When an asset or liability is not recorded in the balance sheet of an institution In an Islamic bank, the mudharabah muqayyadah transaction can be categorized as an off-balance sheet component On-balance sheet The record of an asset or liability in the balance sheet of an institution Opportunity cost The cost of opportunity lost due to not choosing the investment/ choice Procyclicality A strong interaction within the financial sector and between the financial sector and the real sector that can obstruct economic growth when the economy is in a prime condition, or cause a troubling recession when the economy is weak Profitability risk The risk that the targeted profitability level is not achieved Qabdhu Handover of a transaction object Qadhi Judge Qardh Debt, loan Qurudh usury A usury that occurs in the event of debts and loans Rahn Lien, pledge, collateral RAROC (risk-adjusted return on capital) A method to measure the rate of return on capital after calculating the contribution of the element of risk Rebalancing The process of returning a portfolio into its initial composition Reinvestment risk A risk in which, due to the number of defaulted debtors, the bank cannot channel funds to the public to gain the same profitability level as it did before Re-takaful Reinsurance Riba Usury, an excess or increase in loan or debt transaction Riba buyu’ Type of usury caused by sale of usorious commodities, which is gold, silver, dates, wheat, sya’ir (like wheat) and salt. Risk An uncertainty that can generate loss Risk-adjusted performance Performance evaluation based on the risk calculation related to the performance achievement Risk appetite The expected degree of risk acceptance by the stakeholders in a company Risk-based pricing A price-setting method based on the risk level and profile faced Risk limit The allowed limit of risk tolerance Risk matrix A table used in risk analysis in which the rows in the table show the type of risk, while the columns show the risk probability as well as the effects RiskMetricTM model A model developed by J.P. Morgan in 1997 using a transition matrix basis and correlation between assets in calculating a portfolio’s expected loss Risk profile A complete portrait of risks at a particular time period, consisting of risk description, risk-causing factors, risk probability, risk effects, and the strategy in fac- ing risk, as well as the person in charge of controlling the risk Risk register A document constructed to register the risk profile of an institution; it usually consists of risk description, risk-causing factors, risk probability, risk effects, and the strategy in facing risk, as well as the person in charge of controlling the risk Risk-return trade-off The higher the return expected, the higher the risk that must be borne; the opposite is also true: the lower an object’s risk, the lower the return Risk tolerance The level of risk that can be taken with regard to the level of capital reserve that is quantitatively prepared to anticipate the effects of risk Salam A form of sale where the buyer pays the entire price upfront for the delivery of the goods by the seller at some future period. In a salam contract, the seller and the

Glossary 357 buyer will have to agree on the price, quantity, quality, and the time of delivery to avoid uncertainty. Scenario analysis A process of estimating the conditions that can occur in the future and its effects through several constructed assumptions Severity Loss value Shahibul maal Capital owner, investor in a mudharabah contract Stakeholder A group of people and/or institutions with particular interests in a firm Standardized measurement method A risk measurement method (market) that is stan- dardized or set by regulation both in risk scope, asset classification, weight, and the amount of capital charged Stress testing A simulation used to measure the maximum limits of an institution’s capa- bility in absorbing the worst effects of risk, can be done through scenario analysis. Subprime mortgage Housing credit usually provided to borrowers with low credit rat- ings and high risk; to compensate for the higher risk borne, the bank usually charges a higher price (interest) to these debtors Sukuk Plural of sakk, which means certificates; are syari’ah-compliant financial instru- ment representing ownership over an underlying asset, project or future cash flow Sunna Traditional/social custom and legal practice Sunatullah Allah Ta’ala’s provisions applicable to His creatures Swap A transaction exchanging currencies or interest rate of a security with another currency or the interest rate of another security through cash purchase and credit resale or cash sale and credit repurchase, to avoid losses due to exchange rate or interest rate movement by locking the exchange/interest rate at a fixed rate during the contract Syaikh Religious scholars Syarah Explanation Syari’ah-compliant product A product that was created after the era of Rasulullah sha- lallahu ‘alaihi wasallam and has fulfilled syari’ah rules and principles Syari’ah-based product A product already in existence since the era of Rasulullah sha- lallahu ‘alaihi wasallam and lawful in Islam Syirkah A partnership contract between two people or more with various agreements constructed that bind all partners involved Systematic risk A risk that spreads in a system systematically Systemic risk A risk whose effect touches all the elements in a system Ta’awun Mutual assistance Tadlis Penipuan yang disebabkan oleh kesengajaan dari salah satu pihak yang berkontrak untuk memanipulasi atau meyembunyikan informasi (Deception caused by deliberate action of one of the contracting parties to manipulate or conceal information) Taghrir Fraud Takaful Insurance Tauliyah A sale contract where the seller discloses the cost of goods sold to then request the buyer to purchase at that price; the seller does not expect any profit, merely a return of capital invested Tawarruq A financial contract where the buyer buys an easily sellable asset at higher price, with deferred payment, to raise cash for the buyer. Tenor The term of a contract/financing Treasury Fund management

358 GLOSSARY ‘Ujrah Reward, commission, or salary charged for services/work provided by one party to another. ‘Ulama An individual in the Muslim community with a deep knowledge of the Islamic syari’ah Ummah People, society Undiversified risk A risk that cannot be diversified away Unique risk See idiosyncratic risk Unsystematic risk A risk that only occurs at a particular individual or institution and does not spread systematically to the system as a whole Unsystemic risk A risk that only occurs at a particular individual or institution and cannot spread to the entire system Usufruct The utility of an asset Usury Excess return on the principal of a loan without compensation (‘iwad) Value at Risk A statistic-based approach (standard deviation), of a bank’s loss distri- bution over a particular risk. This approach can be used to calculate the maximum loss of a bank at a particular level of significance, such as 1 percent, 5 percent, or 10 percent. Wa’ad Promise Wad’iyah A sale contract where the seller is willing to sell the product at a Discounted price below purchase price. This is due to various reasons, such as the seller encoun- tering liquidity issues, the product has not been selling well in the market, the product will spoil if not sold soon, etc. The seller discloses the purchase price in order to increase buyer confidence. Wadhiah yad amanah A pure safekeeping contract where the party entrusted with the deposited object is not allowed to utilize the entrusted object, does not charge safe- keeping costs, and is not responsible for any losses/damage incurred by the entrusted object (unless due to negligence or deliberate bad faith). In this contract, the entrusted object remains the property of its original owner and can be retrieved from safekeep- ing by said owner at any time. Wadhiah yad dhamanah The safekeeping is a form of debt, because the party entrusted with the deposited object is allowed to use the object and enjoy the benefits of such an action. The consequence of this is, the party entrusted with the object must return it in its initial condition, both in terms of quantity as well as quality, without any required additions Wakalah Agency, representative Wakalah bil ujrah An agency with remuneration involved, included as a part of ijarah Zero-sum game A situation where one party experiences a win and another suffers losses; the total profit gained by one party is the same with the loss suffered by the other because the property/wealth/object competed for is only transferred from one party to another

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Index Accounting Amanah, 350 acknowledgement/measurement Amar ma’ruf nahi munkar criteria, 77–78 instrument, 186 (establishment), 177 periodicity, 75 Ambiguity (Gharar), 286 reliance, 75–76 Analysis criteria, development, 52 standards, global harmonization, 74 Aqidah (faith/belief), 176, 177 Arbitrage pricing theory (APT), 305 Accounting and Auditing Organization Arbitration, 350 for Islamic Financial Institutions Arrow-Debreu model, 286–287 (AAOIFI), 13 ASEAN Economic Community (AEC), founding, 74 203 Islamic banking Syari’ah compliance ASEAN Free Trade Area (AFTA), 203 Asia-Pacific Economic Cooperation audit, 184 prudential regulations, technical (APEC), 203 Asset-backed securities, 290t, 295 guidelines, 73 Asset-liability management, 103, reporting standards, development, 44 role, 43–44 275 – 276 Acquisition price, 118 Asset-liability mismatch risk reduction, Adab (manners), 176 ’Adalah, 9, 350 275 – 276 Additional Capital Tier 1 (ACT-1), 67–68 Asset-linked securities, 286, 287 Advanced measurement approach (AMA), cash flow, source, 289 165–166, 166f comparison, 290t Advanced sale (Bay’as Salam), 118–122 issuance, Ijarah contract (usage), Adverse selection, 350 Agency mechanisms, implementation, 289 – 290 Asset-linked securities market, 288–291 72 – 73 Assets Akhlak (character), 176 Al ghunmu bil ghurmi, 337, 350 allocation, profit opportunity, 233 bank classification, 130 concept, 133–134 bank seller, role, 109 profit/risk combination, 27, 107 classification, collectability quality Al-hisba, 5–6, 350 Al-kharaju bidh-dhamani, 337, 350 (basis), 131t Allah Ta’ala, 17, 170–171 composition, 80–81 injustice, 175 goods, delivery, 172 Alpha, reduction, 245 high-cost assets, 83 Alternative standardized approach (ASA), leasing, Ijarah pricing, 311 liability management, maintenance, 233 161, 164–165 liquidity, consideration, 268 Altman Z-score, 66, 350 maintenance, failure, 159 Al-’urf, 350 management, 99t, 101 packaging, 288–289 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. 383

384 INDEX Assets (Continued) knowledge, 147 recording, 239–240 liquidity risk, 270 risk, 328 systems, contrast, 15–16 short-term assets, 84 Bank liquidity spread, 228 creation, function (relationship), 269 utilization ratio, 98t level, reliance, 271 value at risk (VaR), 240 risk, sources, 270 value, devaluation, 154–155 Bank Negara Malaysia (BNM), 306 basis, 188, 230–231 Asymmetric information, 221, 350 Bank of Credit and Commerce At-ta’awun, 9, 350 Auditing Organization for Islamic International, failure, 37 Bank risks, 246–247 Financial Institutions (AAOIFI), 319 Audit planning, coverage, 185–186 exposure, control, 46 Automated teller machine (ATM), mitigation, 61 tolerance, 57 impact, 201–202 Bankruptcy, 18, 33 Awqaf (ministry), 190, 192 Banks Az-ziyadatu, 172 asset liability management, Bahrain Islamic Bank, 12, 278 maintenance, 233 Bahrain, Syari’ah governance, 191–192 bankruptcy, liquidity risk (impact), Ba’i al-’urbun, 350 Baitul maal wa tamwil (BMT), 206 264 – 265 Balance scorecard, 350 business decisions, 29 Balance sheet, 35 business process, innovation, 202 cash flow, standard deviation, 16 financing contracts, recordation, 101 earnings, measurement, 88 functionality, 84 financing portfolio, long-term liquidity, 82–84 philosophy, 82–84 process, 265 structure, 80–87, 271 heterogeneous profile, 89 weight/proportion, 271–272 margins/fees, 332 Bancassurance, 350 money, issuance, 266 products, 323–324 operational activities, 194–195 Bank capital performance, improvements, 331–332 adequacy, 245 profit ratios, 332 guarantee, 217–218 rating system, 128 investment, 69 reaction/adaptation, ability/speed, 135 Bankers size, increase, 333 acceptance, 138 social entity, role, 108–109 risk-taking behavior, 315 survival, 198 Banker’s Trust, 252 Basel Committee on Banking Supervision Bank for International Settlement (BIS), (BCBS), 36, 38, 239 336 Basel II revisions, 67 Bank Indonesia Regulation, risks, 231 cash inflow/outflow definitions, 279 Banking global financial reform package, activities, evolution, 233 320 – 321 book, 239–240 publication, 40 industry, regulations (issues), 321–322 rules/principles, 347–348 institutions, liquidity (complexity), 267 Basel I evolution, 36

Index 385 history, 34–36 Bounded profit sharing investment regulation framework, 35 account, 235 Basel II basis, 166f Bourgeois appetites, 302 BCBS revisions, 67 Brokerage, bank service, 101 BCBS update, 348 Business capitalization, requirement, 241f framework, 38–39, 39f changes, occurrence, 196 history, 36–40 cycle, 247, 258f market risk, 240–244 disruptions, 165 pillar I (minimum capital adequacy), 38 entity, loss risk, 257 pillar II (supervision/internal control), innovation challenges, 201–202 institution, risk management 38 – 39 pillar III (market discipline), 39 (implementation), 48 significance, 40 landscape, change, 196–200 Tier 3 capital, 240 lines, 163t, 165 Basel III risks, 46, 212–213 capitalization, requirement, 241f Business competition, 199t history, 40–42 Buyu’ (occurrence), 173 impact, 320–321 implementation, 41 Capacity-building capital, facilitation, 14 market risk, 240–244 Capital monitoring instruments, 221 raison d’être, 40–41 bank classification, 86–87 resolution framework, 41 charges, 162, 163, 261 scope, 40–41 conservation buffer, 69–70, 223, 351 Basel regulations, milestones, 42f conservation ratio, 70t Basic indicator approach (BIA), 161–163 contribution, 209 Bay’ (sale), 4, 350 flow, 300–301 Bay’ ad-dayn bi ad-dayn, 350 funds, sufficiency, 89 Bay’al amanah, 350 guarantee, 217–218 Bay’al ’Inah, 350 inadequacy issues, 91 Bay’ al-’Inah, 256, 350 internal growth rate, 95t Bay’ al mu’ajjal, 304, 350 investment, 69, 255 Bay’al wafa, 350 lease Bay’an naqdan, 351 Bay’as salam (as-salaf), 118–122, 351 IMBT, differences, 127t Bay’ bi tsaman ’ajil, 351 transactions, 159 Bay’ul Mu’ajjal (deferred sale), 117–118 lending, incentive (absence), Bay’ul muqayadah, 351 Bay’ul mutlaqah, 351 266 – 267 Benchmark price, 314 level, requirement (restoration), 39 Benchmark rate risk, occurrence, loss-absorbing capital, 223 market, 285 235 – 236 partnership, 299 Bid/ask positions, presence, 249 profit share, increase, 312 Black-Scholes option-pricing formula, 48 requirement, management, 278 Bottom-up banking approaches, reserve requirement, 244, 245 retrieval, 255 22, 23f surcharge, 351 Capital adequacy, 319 assessment process, 38–39 calculations, 326