Islamic Finance Issues - Coursework Example

Islamic finance RM Question 1. Credit Risk in different financial contracts The different types of credit risk encountered by the Islamic banks and financial institutions are Murabahah and Murabahah for the purchase order, Mudarabah, Ijarah and Muntahia Bittamleek, Salam and parallel Salam, Istisna and parallel Istisna, Musharakah and Diminishing Musharakah and Sukuk that is held as an investment. These types of credit risk mainly arises in relation with the account receivable and counterparty risk in the Istisna contracts, Sukuk held to maturity in the books of the banking, account receivable in case of Murabahah contract and lease payment receivable in case of Ijarah contracts and cap[ital impairment risk in Musharakah or Mudharabah. The unique consideration concerning credit risk in Islamic banking are current account is considered as more stable source of credit financing since it constitutes largest percentages of the finances. The five years maturity period of ijarah Sukuk is considered as the unstable fund since it takes long time for its maturity. Mudarabah, Musharakah, Qard and Ijarah are working together in the Islamic banks. Musharakah cannot perform its function without Mudarabah and it cannot work in the absence of Qard, therefore they are expected to work together. 2. The credit risk mitigation instruments/ techniques that can be applied by an Islamic bank are Oversight by board and management: IIFS is expected to possess a comprehensive risk management process which includes the senior management oversight for controlling the different types of credit risks. Processes: The risk management process is required to be designed in such a way that it can easily monitor and review the credit risk for processing the loan. Strategy: IIFS is required to adopt a strategy for financing its instruments in compliance with shariah where it can recognize the potential credit exposures. Due diligence and internal control: IIFS must monitor and control the exposures to suppliers during the time of delivery between the IIFS and the suppliers. Loans loss reserves: It must make necessary arrangement for monitoring its loan reserves Client maturity: The deposit of the bank is required to be held till the period of maturity. Size: The risk mitigation technique should fulfill the nature size and complexity of the IIFS credit related activities. Contracts: clear and adequate procedures are required to be adopted by the board for governing the laws for contracts associated with financing transactions. Pricing: Appropriate credit strategy including tolerance and pricing for undertaking the various types of credit risks. Guarantee: IIFS should provide enforceable guarantees. Collateral: The board is required to arrange permissible collateral Business line Reports: IIFS shall formulate appropriate methodologies for reporting and measuring the credit risk exposures arising under the Islamic financial institutions. Rating: The risk rating is expected to take into account the pricing decisions. Syndication, Concentration, Monitoring: IIFS is required to concentrate and monitor the relevant categories of risks. 3. Credit risk weighting for the Islamic finance institution can be explained as 400% risk weighted is applied in case of all commercial and private enterprises and 300% of risk weighted funds on Mudarabah basis for withdrawal by the investor during the short notice period. It is useful since it acts as a pledge of assets as collateral, it provides guarantee to the third party and leased assets. Question 2 1. The Rate of Return Risk mainly manages the maturities and re- pricing opportunities of the assets and liabilities of the banks. IIFS are mainly exposed to Rate of Return Risk associated with overall balance sheet exposures. It ensures that it can understand the characteristics of their balance sheet position and different currencies jurisdictions. IIFS adopts balance sheet techniques for minimizing the exposures using the strategy which includes determining the future profit ratio, developing new Shariah instrument, expectation for fulfilling the market condition and issuing securitization. Rate of Return Risk focuses on sensitive gap management for reducing the risk and minimizing the gap between maturities of assets and liabilities. Rate of Risk Management emphasizes on immunization of on balance sheet exposure and hedging the off balance sheet exposures. Zero gaps indicate that the balance sheet is fully immunized. The reprievable features of the balance sheet includes the liabilities such as capital, current accounts etc and not re price able features includes the assets. 2. The nature of PSIA’s as core funds and the nature of receivables as core assets possess serious risk to the Islamic banks since the re price able liabilities dominates the re price able assets and the negative gap also increases and the rate of return risk is also high which creates a huge difference between the maturity of the assets and liabilities. The Rate of Return Risk is considered to be negative when the dollar amount of re-price- able assets is less as compared to the dollar amount of the re price able liabilities. It creates problem of short term maturity. The rating will be lower and the cost of raising its long term funds will be higher. Therefore it is required to borrow for matching with its maturities. Therefore it is required to borrow to meet its short term obligations. 3. The Islamic Profit Rate swap deals with exchanging a stream of fixed profit rate payments for floating profit rate payment or vice versa. It deals with fixed and floating rate portion. Fixed rate portion is a regular commodity for Murabahah transaction. The party is required to pay a fixed rate for selling a commodity known as fixed profit rate on a deferred basis. The installment dates are agreed in advance. The fixed rate payer decides to sell the commodities for cash settlement on a spot basis. Figure 1: Profit rate Swap Question 3 1. Liquidity risk is considered as the potential loss to IIFS arising from the inability to meet the obligations or increase in funding of its assets as they become due without incurring unacceptable losses or costs. The liquidity risk is mainly classified into two types of risks which mainly include the market liquidity risk and the funding liquidity risk. The funding liquidity risk is that risk which the IIFS will not able to meet efficiently both in terms of the expected and unexpected cash flows and collateral needs without affecting the financial and operating needs and conditions. The asset risk is that risk which the IIFS will eliminate the position at the market price because of market disruption and inadequate market depth. 2. The systematic preconditions for effective liquidity risk management system are adequate macro prudential surveillance for monitoring the impact of the macro economic shocks on the financial soundness bin order to adjust the financial and macro policies, adequate clearing system, system of business laws which includes capital, public debt, contract, bankruptcy and laws relating to recovery of assets, well functioning of the Islamic money market, availability of monetary policy instruments and availability of Islamic benchmarks for transacting and pricing of financial products, application of internationally recognized auditing and accounting standards for facilitating the reliability, timeliness and accuracy and the availability of the external credit assessment. 3. Basel III is addressing on three pillars of liquidity risk mitigation for funding its liquidity. The main objective of the net stable funding ratio is to eliminate the funding mismatches by setting a minimum acceptable amount of stable funding that is based on the liquidity characteristics of the bank activities and assets. It sets the systematic liquidity benchmarking and maintaining liquidity required for surviving for a period of 30 days. It deals with liquidity coverage ratio which is engaged in reducing the market and the credit risk, lowering the correlation of the risky assets and easing the certainty of valuation. Question 4 1. According to Basel 1, the total capital should contribute to at least 8% of the credit risk of the bank. There are three types of credit risks according to it namely the on balance sheet risk, the risks of derivatives and non trading off balance sheet risk. Basel II on the other hand premises that financial institutions should have the capability to hold capital which would act as the protector against losses that are respective towards risks associated with each type of assets. The internal rating system varies from banks to banks and from the purposes to purposes. It is used for number of purposes used for monitoring and management reporting, loan pricing and profitability analysis and analysis of the adequacy of the capital and the loss of loan reserves, it facilitates in the supervision of the banks and the financial institutions. It enhances the external ratings and supplements the external credit assessments whereas the ratings of CAMELS possess serious managerial and financial deficiencies, therefore it requires close supervision and it adopts unsatisfactory practices and weak performance resulting in failure. The internal ratting system cannot be applied for assessment of individual risks of the banks on the other hand CAMEL can be used for assessing the individual as well as composite risk of the banks (Chorafas, 2004). 2. The advantages of these ratings are it facilitates in adopting corrective actions, it is effective in assessing the financial health and performance of the institutions and it makes the banks aware of the supervisory monitoring and oversights. The limitations or the disadvantages of this ratings are it does not take into consideration ethical and environmental considerations, it does not target the risk management culture, the supervision is very costly beyond the ability of the supervisory authorities and the onsite supervision is costly and beyond the resources available to the supervisory authorities in the developing countries and it is an expost exercise. Question 5 1. The bank might face liquidity risk as a funding source of the asset. The supervisory authorities are required to establish relevant public and official sector bodies for facilitating the issuance of compliant instrument. Sukuk by the government is required to make provision of Shariah compliant deposit insurance. The supervisory authorities together with other relevant bodies or authorities must facilitate the market makers in Shariah compliant instruments or Sukuk in their jurisdictions to develop secondary markets in such markets in order to increase the market liquidity rate. Sukuk possess some right to manage but not control. Sukuk is considered as the most unstable source of fund as it takes longer time to mature and it contributes less .The return is also less as compared to other funds (Goodhart, 2011). 2. The rate of return for Sukuk is calculated. It is observed that it experiences different Rate of Return on Risk. The Islamic development bank, Qatar Sovereign, Dubai Islamic bank and emirates Islamic bank rated Sukuk differently. It contributed differently for different financial institutions and banks and therefore it is rated differently. It causes risk of its maintenance for different financial institutions. On the first case the Islamic Development Bank was rated with AAA with the rate of 2.35% and an asset of $750 for 5 years. On the second case the same bank on the next year rated the same but the rate of return fell to 1.35% with the asset of $800 or 5 years. The Ijarah Sukuk maturity amount was $2 billion with rate of 2.1% in 2018 for Qatar Sovereign and the rate increased to 3.24% on maturity of the same amount in 2023. The Dubai Islamic Bank rated BBB had the rate of 4.75% with Wakala Sukuk while the Emirates Islamic Bank had the rate of 4.64% with the same kind of Sukuk. Question 6 IFSB standards establish benchmark against the international comparators namely the Basel Committee for supervision of the banks and the financial institutions, the International organization of Securities commission and the international Association of insurance Supervisors. The IFSB acts as a platform or base for developing international cooperation on issues relating to resilience and stability in Islamic finance. It takes into consideration the support and assistance of its wide membership to strengthen the cooperation and support of the supervisory agencies. In order to function effectively the bank are required to abide by the standards formulated by Basel as well as IFSB (International Accounting Standards Board. 2007). References Chorafas, D.N. (2004). Economic Capital Allocation. Burlington: Butterworth-Heinemann. Goodhart, C. (2011). The Basel Committee on Banking Supervision. New York: Cambridge University Press. International Accounting Standards Board. (2007). 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