risk management in islamic finance

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Hosted by CFA Institute www.cfainstitute.org Managing Risk through Shari’a Compliant Solutions: Part I 24 July 2009 Presented by CFA Institute www.cfainstitute.org Rodney Wilson Professor Durham University Contents Managing credit risk Late settlement of obligations due to genuine financial difficulties Repayments risks and unscrupulous defaulters Payments safeguards with collateral Case study examples Liquidity risk 2 Reducing asset and liability mismatch Controlling operational risk Adequacy of reporting systems Foreign exchange risks Permissible hedging instruments Elimination of rate of return risk Implications of prohibition of riba Late Settlement of Obligations Due to Genuine Financial Difficulties Koranic teaching “If the debtor is in difficulty, grant him time till it is easy for him to repay. If ye remit by way of charity, that is best for you if ye only knew” Sura 2:280 3 Sura 2:280 Practical measures Rescheduling but keeping same financing method and terms with no penalty to borrower Swap existing obligations for a qard hasan loan without interest Remission which may bring goodwill from other clients Repayments Risks Moral hazard problems High degree of trust in Islamic finance, but this can be abused • Peer pressure can make borrowers 4 acknowledge their responsibilities Asymmetric information May make concealment of financial position easy Deterrent to mudaraba and musharaka financing Unscrupulous Defaulters “Cannot pay” compared with “will not pay” If no penalty for deliberate late payments then danger that Islamic finance abused Possible non-financial penalties Blacklisting of defaulter 5 Blacklisting of defaulter Seeking redress through the courts involving imprisonment or confiscation of passport Financial penalty Fine for late payments Proceeds given to charity, as no gain permissible for financier Payments Safeguards Sequestration of assets Murabahah and ijara involve financing real assets Can be seized if default, but asset may not be worth much to financier, as resale value limited P l fi i 6 Personal financing Car and home purchase finance based on salary being directly paid into the bank making the advance Bank can impose limits on personal access to salary until bank claims met

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Page 1: Risk Management in Islamic Finance

Hosted by CFA Institutewww.cfainstitute.org

Managing Risk through Shari’a Compliant Solutions: Part I

24 July 2009Presented by CFA Institute

www.cfainstitute.org

Rodney WilsonProfessor

Durham University

Contents• Managing credit risk

• Late settlement of obligations due to genuine financial difficulties

• Repayments risks and unscrupulous defaulters• Payments safeguards with collateral• Case study examples

• Liquidity risk

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• Reducing asset and liability mismatch• Controlling operational risk

• Adequacy of reporting systems• Foreign exchange risks

• Permissible hedging instruments• Elimination of rate of return risk

• Implications of prohibition of riba

Late Settlement of Obligations Due to Genuine Financial Difficulties

• Koranic teaching• “If the debtor is in difficulty, grant him time till it is easy for

him to repay. If ye remit by way of charity, that is best for you if ye only knew”

• Sura 2:280

3

• Sura 2:280• Practical measures

• Rescheduling but keeping same financing method and terms with no penalty to borrower

• Swap existing obligations for a qard hasan loan without interest

• Remission which may bring goodwill from other clients

Repayments Risks

• Moral hazard problems• High degree of trust in Islamic finance, but

this can be abused• Peer pressure can make borrowers

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packnowledge their responsibilities

• Asymmetric information• May make concealment of financial

position easy• Deterrent to mudaraba and musharaka

financing

Unscrupulous Defaulters

• “Cannot pay” compared with “will not pay”• If no penalty for deliberate late payments then danger

that Islamic finance abused• Possible non-financial penalties

• Blacklisting of defaulter

5

Blacklisting of defaulter• Seeking redress through the courts involving

imprisonment or confiscation of passport• Financial penalty

• Fine for late payments • Proceeds given to charity, as no gain permissible for

financier

Payments Safeguards

• Sequestration of assets• Murabahah and ijara involve financing real assets• Can be seized if default, but asset may not be

worth much to financier, as resale value limitedP l fi i

6

• Personal financing• Car and home purchase finance based on salary

being directly paid into the bank making the advance

• Bank can impose limits on personal access to salary until bank claims met

Page 2: Risk Management in Islamic Finance

Hosted by CFA Institutewww.cfainstitute.org

Collateral

• Qualifying assets• Real goods and commodities• Suited for murabaha and ijara financing

• Not permissible• Accounts receivable

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• Financial assets such as bonds or other securities

• Hierarchy of capital suppliers• Unsecured debt junior to secured debt• Notion of hierarchy of entitlement in event of default

repugnant to most shariah scholars• Investment partners all share losses as in mudaraba

and musharaka

Case Study Examples

• Al Rajhi Bank• Vehicle finance• Real estate finance

National Commercial Bank

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• National Commercial Bank• Murabaha Al-Ahli Islamic personal

finance• Tayseer Al-Ahli cash finance

Al Rajhi Bank• Vehicle finance

• Net monthly income more than SR 3,000• Employee for 2 years with approved employer• Letter from employer required• Aged over 20• Salary paid directly into bank

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• Salary paid directly into bank• Housing finance

• As above plus details of property• Property on plot of at least 250 square meters• Building should be completed with guaranteed 20 year

life• Property within development belt limits

National Commercial Bank• Murabaha Al-Ahli Islamic personal finance

• SR 20,000 to SR 1,500,000• Repayments up to 7 years• Suitable for cars, electrical goods, building materials and

furniture• Bank makes all payments and client repays bank

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• Bank makes all payments, and client repays bank

• Tayseer Al-Ahli cash finance• Bank buys commodities and sells them to client for a markup

under tawarruq principle• Client sells commodity back to bank for cash payment• Client repays this plus the markup over 2-4 years on a

monthly basis