Islamic Banking & Finance Page 18-10-2019

Financial Risks in Islamic Banking Business

In practice, Islamic financial institutions follow fiqh al-muʻamalāt (Islamic commercial jurisprudence) which, among other things, incorporates a number of commercial contracts which provide methods of financing that avoid interest, but most of which do not share risk except in the limited sense of being asset-based. These are the so-called exchange-based contracts, which involve the sale (e.g. murābahah) or leasing (ijārah) of the asset by the financier to the customer, as well as working capital financing by means of advance purchasing or progress payments (salam and istiṣnāʻ).  Risk-sharing or equity-based contracts are forms of partnership, either mushārakah (similar to a conventional partnership) or muḍārabah (a “partnership between work and capital”, where the capital provider is a sleeping partner while the managing partner provides the work in practice.

On the liability side of an Islamic bank’s balance sheet, risk- and reward-sharing contracts usually exist in the form of “profit-sharing investment accounts” (PSIA). They are typically used to mobilize funds. Most jurisdictions show an increasing trend in the use of such accounts. In a muḍārabah contract for profit-sharing investment accounts (PSIAs), the bank as muḍārib shares the profits with the profit-sharing investment account holders (PSIAH) as rabb al-māl, while in the absence of misconduct and negligence on the part of the bank, losses on the investment have to be borne by the latter alone.

Profit-sharing investment accounts can be either restricted or unrestricted. The restricted profit-sharing investment account (RPSIA) imposes a number of restrictions on both the investor and the Islamic bank. For instance, while an investor is restricted from withdrawing funds invested prior to the maturity period whereas an Islamic bank has to manage the investment based on a specific investment mandate given by an investor.

RPSIA funds are typically not commingled with either the shareholders’ funds or any other funds mobilized by an Islamic bank and, as such they are treated as an off-balance sheet item but with disclosure in the notes to the financial statements.

On the other hand, where the contract allows an Islamic bank as muḍārib to manage the funds at its own discretion, this type of investment account is generally referred to as an unrestricted profit-sharing investment account (UPSIA). Unlike the RPSIA, it vests in the Islamic bank an unqualified mandate to invest the funds in Sharīʿah-compliant assets. If the funds mobilized via the UPSIA are commingled with other funds on the Islamic bank’s balance sheet, they are treated as on-balance sheet items for financial reporting purposes. This is the treatment set out in the standards of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI), the internationally recognized standard setter for Islamic financial institutions.

However, cross-country analysis reveals existence of issues in the risk-sharing practices in the Islamic banking industry worldwide.

One main issue relates to exploring the practices of the Islamic banks in mobilizing funds using unrestricted profit-sharing investment account UPSIAs. Cognizance is given to the various governance issues raised by the status of UPSIA holders as a type of equity investor, sharing profits and being exposed to the risk of losses.

Primary data elicited from both the RSAs (Regulatory and Supervisory Authorities) and the Islamic banks in the various IFSB jurisdictions reveal that the capital treatment of the UPSIA varies across different jurisdictions and Islamic banking type. In most of the jurisdictions, UPSIAs are considered to be “investments” exposed to losses, rather than “deposits” with capital certainty.

The key distinctions among three different capital treatments are: (1) UPSIAs as “pure investments” with no profit “smoothing” and no capital certainty (2) UPSIAs with varying degrees of profit “smoothing” (whether called “investments” or “deposits”) but no capital certainty; and (3) UPSIAs with “smoothing” and capital certainty. The second category is the most prevalent. It has been noted that Islamic banking windows and Islamic banks in jurisdictions with a small presence of Islamic banking, have yet to adopt various IFSB standards and they most likely consider UPSIAs to be “deposits” rather than “investments”.

The capital treatment of UPSIAs also varies across jurisdictions. In most cases, they are treated as investments with no capital certainty but with the provision that returns and losses may be “smoothed” via PER (Profit Equalization Reserve to accommodate the pool’s abnormal yield fluctuations) and IRR (Investment Risk Reserve (IRR) to accommodate the credit and market risk of financing and investments such as unusually large write offs and/or significant losses on sale of the pool’s investments or as per the Bank’s policy / State Bank of Pakistan’s directives) from time to time.

Some other varying practices across various jurisdictions that exist are: – For instance, while a jurisdiction has a “non-profit-sharing investment account” (NPSIA) whereas some others indicate they have a cap on the amount of “capital considered certain”. Some jurisdictions do not allow any form of smoothing whatsoever, and requires UPSIA holders as rabb al-māl to absorb all losses on assets financed by their funds, in the absence of misconduct and/or negligence on the part of the Islamic bank as muḍārib.

A few jurisdictions also indicate that they have an Islamic deposit guarantee scheme and that the coverage extends to the UPSIA. In most jurisdictions, the UPSIA holders’ lack of governance rights is well-noted by both the RSAs and the Islamic banks. The commingling of the UPSIA funds with the shareholders’ funds exposes both to similar investment risks, and this might be considered to create an incentive for the latter to act in the interests of the former. However, the respondents do not consider such “vicarious monitoring” sufficient to mitigate the lack of governance rights that the UPSIA holders face. The key issue here is the difference in risk appetite between UPSIA holders who are typically risk-averse and seek modest but safe returns, and shareholders who are prepared to face risk in seeking higher returns.

Another issue relates to disclosure, transparency and monitoring. The findings reveal that Islamic banks comply mostly with the disclosure requirements relating to the utilization of PER and/or IRR during the period. Also, Islamic banks consider the basis of allocation of profits between the Islamic banks’ shareholders and UPSIA holders, including the maximum muḍārib percentage share and the average over the past five years, as they state that they invariably have disclosed all these. However, the extent of compliance with the disclosure of the Sharīʿah compliance of the investments into which UPSIA funds are placed is generally weak relative to other disclosure requirements. As stated earlier, this could be due to the fact that there is a requirement in various jurisdictions that financial reports contain a Sharīʿah board’s attestation as to whether the Islamic banking operations are Sharīʿah-compliant in their entirety.

Both the PER and IRR are often used as smoothing techniques in most of the jurisdictions. A number of likely reasons extracted from the literature reveal that account for the limited usage of the risk-sharing modes of financing are grouped into six dimensions for ease of analysis.

The first dimension is on regulatory challenges. In this respect, the findings show that the high regulatory risk weights required on muḍārabah and mushārakah assets (excluding diminishing mushārakah for home purchase finance) discourage Islamic banks from placing funds in such assets.

The rate-of-return risk, liquidity risk management practices and operating structure of an Islamic bank in which it functions as an intermediary also inhibit the use of such assets by Islamic banks. Other reasons include the agency and transactions costs attaching to such assets. Specifically in this regard, the operational risks reflected in the lack of human resources with the requisite knowledge and understandings of the specificities of risk-sharing contracts have been noted.

The Islamic banks also believe that their aversion to incurring the costs of monitoring such assets is also shared by potential customers who are averse to the accounting and related requirements involved. However desirable it may be for Islamic banks to offer risk-sharing financing to their customers. Their doing so would be fruitless if potentially qualified customers do not seek such financing.

A follow-up research on a cross-country basis has been planned by the IFSB to complement and offer richer insights into all the issues arising from these exploratory studies, taking cognizance of jurisdictional peculiarities. It is suggested that this planned studies scope should cover the views of both the RPSIA and UPSIA holders, so as to have a balanced perspective on pertinent matters. Specifically, the proposed studies should look into best practices from various jurisdictions on matters relating to the capital treatment, smoothing practices, transparency and disclosure relating to PSIAs.

In addition, focus should be on best practices relating to granting and preserving of governance rights of both the RPSIA and UPSIA holders, as well as risk management practices peculiar to the structure of the risk-sharing contracts that underlie the investment accounts.

There are also practices in various jurisdictions that require further elucidation. For example, existing practices like running mushārakah and the proposed risk-sharing financial intermediation model.

Further, due consideration should be given to the internal policies and practices relating to the prospects and challenges of risk-sharing contracts on both sides of the balance sheet of an Islamic bank. In this regard, it is suggested that the theorized link between strengthening capital regulation as per Basel III should be made (Basel III is a set of international banking regulations developed by the Bank for International Settlements to promote stability in the international financial system. The Basel III regulations are designed to reduce damage to the economy by banks that take on excess risk. As of 2019, under Basel III, a bank’s tier 1 and tier 2 capital must be at least 8% of its risk-weighted assets. The minimum capital adequacy ratio (including the capital conservation buffer) is 10.5%).

Further incentives should be provided to Islamic banks that are operating risk-sharing accounts on the liability side to obtain benefits like higher losses absorption capacity with lower capital requirements. Specifically, there should be investigation into likely operational incentives that can promote the use of risk-sharing contracts in Islamic banking especially for financing purposes.

From a regulatory point of view, in addition to reviewing the implications of high risk weights for the limited use of risk-sharing contracts for financing purposes should delve further to elicit responses on actual risk weights used for Governance rights of the Restricted Profit-Sharing Investment Account Holders (RPSIAH).

In various jurisdictions, the extent of implementation of the IFSB recommendations and practices regarding supervisory slotting are weak. In addition they should also provide a detailed account of the legal impediments to implement risk-sharing regimes for Islamic banking, which often hinder treating PSIAs as true risk-sharing products in some secular regimes. Specifically, due consideration should be given to the sufficiency of the laws adopted by different jurisdictions to cater for the nature of PSIAs, particularly under the Sharīʿah.

An investigation is also suggested that how various jurisdictions are addressing the issue of lack of human resources with the specific risk-management skills. Further it also needed to address the various peculiar risks involved in financing based on risk-sharing modes. In this regard, the possibility of deploying technology via regulatory sandboxes for instance can be further explored for its usage.