Principles and Practices of Islamic Banking

Khalifa M Ali Hassanain

Page 1 of 60
Hassanain, Khalifa M
ISBN 9960-32-304-8
Islamic development Bank, 2016
King Fahd National library cataloging –Publication Data

Copy Rights Notice ©

Islamic research and Training Institute 2016 All rights reserved. All parts of this work are subject to sole
ownership of Islamic research and Training Institute (hereinafter referred to as ‘Copyright Holder’) and
remains exclusive property of the Copyright Holder. No part of this work may be copied, reproduced,
adapted, distributed, modified or used in any other manner or media without prior written authorization
of the Copyright Holder. Any unauthorized use of this work shall amount to copyright infringement and
may give rise to civil and criminal liability. Enquiries and communications concerning authorization of
usage may be made to the following: Islamic Research and Training Institute Member of the Islamic
Development Bank Group P.O.Box 9201 - 21413 Jeddah Kingdom of Saudi Arabia E-Mail:irti@isdb.org
Disclaimer
The content of these course have been developed solely for educational and training purposes. They are
meant to reflect the state of knowledge in the area they cover. The content does reflect the opinion of the
Islamic Development Bank Group (IDBG) nor the Islamic Research and Training Institute (IRTI).
Acknowledgement
This textbook was developed as part of the IRTI e-Learning Program (2010), which was established and
managed by Dr. Ahmed Iskanderani and Dr. Khalifa M. Ali.

Page 2 of 60
Contents
Chapter 1....................................................................................................................................................... 6

Chapter Introduction .................................................................................................................................... 7

Learning Objectives....................................................................................................................................... 8

Islamic Intermediation Contracts.................................................................................................................. 8

Basic Nature of Islamic Financial Intermediation ......................................................................................... 9

Understanding the Balance Sheet of an Islamic Bank ................................................................................ 10

Financing Instruments in Islamic Finance ................................................................................................... 11

Types of Islamic Financial Institutions ........................................................................................................ 14

Chapter Summary .......................................................................................... Error! Bookmark not defined.

Key Terms....................................................................................................... Error! Bookmark not defined.

Chapter 2..................................................................................................................................................... 18

Learning Objectives..................................................................................................................................... 19

Types of Risks for a Bank............................................................................................................................. 19

Basics of Risk Management ........................................................................................................................ 20

Components of the Risk Management Process .......................................................................................... 21

Motivation for a Better Risk Management Process .................................................................................... 23

Modes of Evaluation of a Bank ................................................................................................................... 23

Framework of Appraisal .............................................................................................................................. 25

Analysis of the Overall Banking Sector ....................................................................................................... 26

Financial Analysis of Banks.......................................................................................................................... 27

Framework for Risk Analysis of Banks ........................................................................................................ 29

Page 3 of 60
Principles of an Effective Risk Analysis ....................................................................................................... 30

More Principles of an Effective Risk Analysis.............................................................................................. 31

Analytical Tools ........................................................................................................................................... 32

Chapter Summary .......................................................................................... Error! Bookmark not defined.

Chapter 3..................................................................................................................................................... 38

Chapter Introduction .................................................................................................................................. 39

Learning Objectives..................................................................................................................................... 40

Standards and Types of Policies .................................................................................................................. 40

Policies to Reduce Credit Risk ..................................................................................................................... 41

Credit Risks Specific to Islamic Banks.......................................................................................................... 43

More Credit Risk Specific to Islamic Banks ................................................................................................. 44

Analysis of Credit Risk in Asset Portfolio .................................................................................................... 44

Credit Review of Individual Customers ....................................................................................................... 45

Interbank Deposits ...................................................................................................................................... 45

Off Balance Sheet Items .............................................................................................................................. 46

Chapter Summary .......................................................................................... Error! Bookmark not defined.

Key Terms....................................................................................................... Error! Bookmark not defined.

Answers .......................................................................................................... Error! Bookmark not defined.

Chapter 4..................................................................................................................................................... 49

Learning Objectives..................................................................................................................................... 50

Review of Nonperforming Assets ............................................................................................................... 51

Reasons for an Increase in Nonperforming Assets ..................................................................................... 52

Page 4 of 60
What is Asset Classification?....................................................................................................................... 54

Rules of Asset Classification ........................................................................................................................ 54

Loss Provisioning ......................................................................................................................................... 56

Standards for Level of Provisioning ............................................................................................................ 57

Approaches for Managing Asset Losses ...................................................................................................... 57

Workout Procedures ................................................................................................................................... 58

Chapter Summary .......................................................................................... Error! Bookmark not defined.

Key Terms....................................................................................................... Error! Bookmark not defined.

Page 5 of 60
Chapter 1

Page 6 of 60
Chapter Introduction
Welcome to the chapter, Fundamentals of Islamic Financial Intermediation.

Financial intermediation is critical for efficient financial systems.

Nature of financial intermediation between suppliers and users of funds depends upon:

 How it is done.
 Who does it.

Financial intermediation is unique because it involves:

 Acquisition and processing of financial information.

 Financial claims.
 Financial contracting.

Functions of a financial intermediary:

 Asset transformation
 Conduct of orderly payments
 Brokerage
 Risk transformation

Asset transformation happens when intermediaries:

 Match demand and supply of financial products.

 Transform maturity, scale, location of assets and liabilities of borrowers and lenders.

Payments systems include:

 Electronic fund transfers.

 Settlements.
 Clearing.

The brokerage function includes:

 Bringing together borrowers and lenders.

 Offering collateral.
 Offering financial advice.
 Providing guarantees.
 Providing custodial services.

Page 7 of 60
Risk transformation includes spreading risks between the households that supply the funds
and businesses that use those funds. Intermediation was a familiar function in ancient
Islamic society.

Financiers or Sarrafs acted as intermediaries. Their functions included:

 Mediating between buyers and sellers.

 Operating secure and reliable cross-border payment system.
 Issuing letter of credit.
 Issuing promissory notes.

Sarrafs acted as a co-operative, helping each other out in a liquidity crisis.

Learning Objectives
On completing this chapter, you will be able to:

 Identify the three types of Islamic financial intermediation contracts.

 Describe the basic nature of financial intermediation in Islamic finance.
 Explain the typical components of the balance sheet of an Islamic bank.
 Describe the types of financing instruments used in Islamic finance.
 Describe the types of investing instruments used in Islamic finance.
 Describe the types of Islamic Financial Institutions (IFIs).

Islamic Intermediation Contracts

Page 8 of 60
Sharī‘ah recommends different types of intermediation, covering:

 Asset transformation.
 Payment system.
 Custodial services.
 Risk management.

Three classes of intermediation:

 Partnership of finance and entrepreneurial skills

 Placing funds or assets with a third party as security
 Provision of implicit and explicit guarantees to reduce risk

Basic Nature of Islamic Financial Intermediation

Risk profile of Islamic banks is different from conventional banks.

The nature of risk is determined by the nature of financial intermediation.

Mudarabah is the most common type of intermediation in Islamic finance.

Features of Mudarabah contract:

 Partnership between entrepreneur and owner of capital.

 Condition that profits and losses will be shared.
 Contract used for attracting deposits or for acquiring assets.

Role of the Islamic bank:

 Intermediate between depositors of the bank and the entrepreneurs.

 Closely monitor project performance so that depositors’ interests are protected.

The Mudarabah contract has been covered in detail in the chapter A Blueprint of the
Islamic Financial System-Part 4 of the course Islamic Financial System.

Page 9 of 60
Understanding the Balance Sheet of an Islamic Bank

Balance sheets can be presented in two ways:

 According to Maturity profiles

 According to Functionality

Functionality-based view is more popular.

Maturity-based view is important – it provides information about institutional exposure.

On the Liabilities side, Islamic banks follow the two-window approach:

 One – demand deposits window

 Two – special investment accounts

Depositors choose the window.

Special investment accounts are not a liability in Islamic banks.

Investors are partners.

Investment accounts are liability in conventional banks.

Special or restricted accounts are often shown as off-balance sheet transactions.

A 100 per cent reserve is specified for demand deposits (Amanah) because:

 Deposits must be returned at par value.

 There is no increment in value of the funds.

Special accounts are meant for investment.

Depositors are aware of risk when they invest.

Investors are sources of funds (Rab al-māl).

The bank acts as agent (Mudarib).

Profits from special investment are assets, not liabilities.

Investors share profits and losses.

Page 10 of 60
Restricted profit-and-loss sharing Musharakah accounts are also offered for high net worth
individuals.

Greater choice of instruments is available on the Assets side.

For short-term: trade financing and financial claims from a sales contract
(Mudarabah/salaam)

For medium-term: leasing (Ijarah) and manufacturing contracts (Istisna’a)

For long-term: Musharakah partnerships

Islamic bank can form a syndicate with other institutions to provide medium and long-term
capital. How it works:

 The bank appoints external entrepreneur as agent.

 The bank acts as principal.

Islamic banks also provide:

 Customized services.
 Guarantees.
 Underwriting services.

Financing Instruments in Islamic Finance

Financial instruments are used to:

 Finance trade.

 Sell commodities.

 Sell property.

 Pay rent through Ijarah and Istisna’a contracts.

The product being funded is treated as collateral.

These contracts have been covered in detail in the chapter A Blueprint of the Islamic
Financial System-Part 3 of the course Islamic Financial System.

Murabahah contract is most popular for buying products on credit.

Page 11 of 60
Its features are:

 The financier buys commodity on behalf of entrepreneur.

 Both parties agree on profit margin.

 A margin is added to cost.

 Payment is delayed until product is ready.

 Funds are meant only for original sale, not existing inventory.

 The financier is responsible for the product.

 Under Murabahah, banks function as traders.

Bai’ al-Muajjil is sale with deferred payment. Its features are:

 The buyer pays money in instalments or lump sum.

 The buyer and seller agree on price and terms of payment.

 Deferred payments do not attract a charge.

Bai’al-Salaam is forward sale contract. Its features are:

 Buyer pays for commodity against deferred delivery

 Buyer-seller agree on price, price paid up immediately

 Buyer benefits from advance payment, making it possible to invest it

 Seller protected from price fluctuations

 Similar to forwards contract

Ijarah is a lease contract meaning hire and lease of tangible and intangible assets. Its
features:

 It is a sale of the right to use asset (usufruct).

 It combines funding and collateral.

 It is similar to the conventional lease agreement.

 The leasing agency owns asset for lease period.

Page 12 of 60
  There is no compound interest on delayed payment.

Ijarah is useful for financing manufacturing projects.

Istisna’a contract is specific to manufacturing.

The buyer and seller agree on:

 Price.

 Product specifications.

 Payment schedules and timing.

A product not up to specifications can be rejected by buyer.

Istisna’a is useful in funding manufacturing and infrastructure building projects.

Investing Instruments in Islamic Finance

Investing instruments used for capital investment are of two types:

 Fund management (Mudarabah)

 Equity partnerships (Musharakah)

Mudarabah contract is a partnership. Its features:

 One party provides funds.

 Other party provides business skills.

 Profits are shared in pre-arranged ratio.

 Losses are borne by investor.

 Entrepreneur does not share loss unless proven to be negligent.

 Mudarabah can be used on the Asset and Liability sides.

 They are useful for short, medium or long-term contracts.

Musharakah contract combines partnership (Shirkah) and Mudarabah. Its features are:

Page 13 of 60
  Two parties come together to share capital or labour.

 They share profits and losses.

 They share similar privileges and liabilities.

 Different types of partnerships are prescribed by Sharī‘ah under this contract.

 Each partnership has different authority and obligations for the parties.

 Sharī‘ah recommends the contract where there is no debt security.

Types of Islamic Financial Institutions

Islamic financing is evolving to meet market needs.

Muslim countries such as Iran, Sudan and Pakistan practice Islamic economics.

Growth of Islamic financing is primarily in the private sector.

Six types of Islamic financial institutions operate today.

Islamic financial institutions have been covered in detail in the chapters A Blueprint of the
Islamic Financial System-Part 1 and Islamic Banking System and its Financial
Products of the course Islamic Financial System.

Islamic banks form largest part of IFIs globally.

They function as commercial banks and investment banks.

Banks in Iran, Sudan and Pakistan have been forced to comply with Sharī‘ah laws.

In the Middle East, Islamic banks are owned by public companies, holding companies or
wealthy individuals.

Two major holding companies include Dar al Māl Islami and Al-Barakah.

Islamic banks fall short of conventional banks in many ways:

Not a single Islamic bank is in the list of world’s top 100 banks.

Over 60 per cent of Islamic banks have assets less than $ 500 million lower than viability
level.

The largest Islamic bank has one per cent of assets of largest conventional bank.

Page 14 of 60
In the 1980s, conventional American and European banks started Sharī‘ah-compliant
services.

They helped Islamic banks invest in commercial activities through traders.

Later, they started offering Sharī‘ah-compliant trading services on their own.

Today, conventional banks offering Islamic window are:

 HSBC Global Finance

 ABN Amro

 American Express Bank

 ANZ Grindlays

 BNP Paribas

 Citicorp Group

 Morgan Stanley

 Union Bank of Switzerland

Islamic investment banks focus on large transactions, investment banking and underwriting.

These are different from commercial Islamic banks that focus on retail and consumer
finance.

Islamic investment banks have been successful in financing infrastructure projects in

Pakistan.

Islamic funds shut down in 1980s and revived again in 1990s.

By 2000, 150 Islamic funds were operating globally.

Of them, 85 were equity funds, offering commodity, leasing and trade related funds.

Equity financing became popular in 1900s, but is risky.

It is subject to strict Sharī‘ah laws and strict appraisal.

Fund managers look for equity in Western markets where Sharī‘ah-compliant companies are
difficult to find.
Page 15 of 60
The Dow Jones Islamic Market (DJIM) tracks 2700 stocks to identify Sharī‘ah-compliant
stocks.

The FTSE too has a mechanism to track Sharī‘ah-compliant companies.

The criteria for choosing stocks to be included in Islamic equity funds are covered in detail
in the chapter Islamic Investment Funds of the course, Islamic Financial System.

Islamic mortgage companies target housing for Muslims in Western countries.

Four models of Islamic mortgage in practice:

 Ijarah or lease

 Equity or diminishing Musharakah where lender and borrower have joint ownership.

 Murabahah, a sales contract with property tax

 The co-operative model where members buy equity or Musharakah shares and help
each other buy property

Prominent US agencies in the mortgage industry now underwrite and securitise Islamic
mortgages.

Growth opportunities for Islamic mortgages exist in Western societies such as the USA.

Takaful is similar to insurance. It means mutual guarantee. Its features are:

 Members share losses by contributing periodic premiums.

 Members share residual profits.

 Members are liable for money distributed if premium collected is insufficient to meet
losses.

 Premium can only be invested in Sharī‘ah-compliant companies.

Takaful companies can maintain reserves by collecting money over and above premium.

Takaful companies have been covered in detail in the chapter The Islamic Takaful
System---Part 1 and The Islamic Takaful System---Part 2 of the course Islamic
Financial System.

A Mudarabah company is similar to a professionally-managed fund. Its features are:

Page 16 of 60
 It is incorporated as separate legal entity.

 The fund management company is responsible for investments.

 It cannot accept deposits and is funded entirely by equity owned by subscribers and
the general investing public.

 Mudarabah investment certificates are given to investing public.

 Profits are distributed among investors, according to their share of equity.

 The fund manager gets an appropriate share of profits.

 It can accept multipurpose or specific purpose funds.

 Every Mudarabah company is a separate entity.

Page 17 of 60
Chapter 2

Page 18 of 60
Welcome to the chapter, `Framework for Risk Analysis in Islamic Banking’.

Risk management affects bank profitability and value.

Risk management includes:

 Identification of banking and financial risks.

 Strategic and capital planning.
 Asset-liability management.

Learning Objectives

On completing this chapter, you will be able to:

 Identify the types of risks to which any bank is exposed.

 Describe the basic aspects of risk management.
 Describe the various components of a formal risk management process.
 Identify the two key motivations for improving a bank’s risk management process.
 Distinguish among four modes of evaluation of a bank’s condition.
 Describe the framework of appraisal of a bank, including Islamic banks.
 Explain the need for and benefits arising from an analysis of the overall banking
sector.
 Describe a framework for financial analysis of banks, including Islamic banks.
 Describe a framework for risk analysis of banks, including Islamic banks.
 Recognise the principles that govern an effective risk analysis.
 Identify the kind of questions that comprise a comprehensive risk analysis.
 Describe five analytical tools for risk analysis of banks.

Types of Risks for a Bank

Risk profile of bank includes:

Page 19 of 60
  Financial risk
 Operational risk
 Business risk
 Events risk

Financial risk is the result of:

 Complexity of money market

 Interdependence of elements of money market

For example: A bank dealing with forex currencies will face currency variations daily and
will also face volatility in liquidity or credit if it carries open positions.

Operational risks can occur due to instability in day-to-day functioning.

Examples:

 Computer glitch
 Non-compliance with procedures
 Mismanagement of funds

Business risks arise due to business uncertainties.

Examples:

 Changes in government rules

 Changes in banking norms
 Changes in payment systems
 Changes in auditing norms

Events risks are due to natural or unforeseen disasters.

These affect profitability and capital adequacy.

Basics of Risk Management

Banks handle each risk using a different process.

Page 20 of 60
The process involves:

 Setting objective targets for risk management.

 Identifying exposures to risk.
 Assessing the possible impact of the risk factors.
 Accounting for unexpected changes.

Steps to be put in place:

 Determining permissible level of risk exposure

 Having strategy to hedge over-exposure
 Defining responsibility for each type of risk
 Evaluating the risk management process

Components of the Risk Management Process

Special risk management strategies are essential for banks.

Banks in developing countries need special strategies because:

 There is instability in the economy.

 Markets are poorly developed.

Key components of risk management include the following

Risk Management Authority

The risk management authority must be at the highest level of the bank.

Authority must be responsible for ensuring implementation of bank policies and asset-
liability committee decisions.

Authority must have importance internally.

Risk Management Strategy

A well thought-out risk management strategy is necessary.

Page 21 of 60
The strategy should reflect operational requirements and targets.

The traditional approach of using a variety of strategies is not good enough.

Formal Decision Making Process

Set parameters for risk exposure.

Establish decision-making process for managing risk.

Incorporate both into every business process.

Parameters are usually ratios, which indicate acceptable risk levels.

Example: Debt-equity ratio indicates credit risk for depositors.

Risk Analysis

A risk analysis process is necessary to base decision-making on quantitative and qualitative

analysis of risk factors.

It should include a comprehensive risk analysis to study the details of non-obvious risk
factors.

Data Gathering Process

Data is necessary for formulating risk management strategies.

It must:

 Be complete, timely and consistent.

 Cover all business processes and functional units in bank.

Include information about market trends and macro indicators.

Development of Quantitative modelling

A quantitative model is necessary to simulate and analyse risk factors.

Page 22 of 60
The model helps identify impact of changes on bank’s profitability and net worth.

A variety of quantitative techniques are available with financial institutions and software
vendors.

The type of modelling depends on intensity of risk management in bank.

Motivation for a Better Risk Management Process

Basel Capital Accord:

 Internal ratings-based (IRB) approach to measuring capital adequacy

 Banks motivated to use quantitative modeling to identify risk

Will force banks to upgrade risk management strategy

The market moves faster than a bank’s ability to identify risks.

Banks don’t respond to market changes immediately.

Traditionally, banks are only prepared for credit risk.

Today, there is awareness that all types of financial and operational risks must be handled.

Modes of Evaluation of a Bank

Changes in the market economy have changed the way banks work.

Banks must modify and upgrade risk management processes.

External agencies monitor banks, their viability and compliance to regulation. Checks are
typically conducted annually.

Some external agencies are:

 Supervisory bodies

 External auditors

Page 23 of 60
  Third party evaluators

 Central bank evaluators

Supervisory Bodies

Supervisory bodies conduct an evaluation of banks to study:

 Their operations, viability and compliance with regulations.

 Their ability to fulfill obligations to depositors.

 Their activities to ensure they do not jeopardize the banking industry.

External Auditors

External auditors are retained by bank’s board. Their task is to:

 Assess if financial statements are true.

 Examine if banks adhere to Board regulations.

Study management policies to ensure no undue risk.

Third Party Evaluations

Third party evaluators conduct:

 Financial assessments.

 Extended portfolio reviews.

 Limited assurance reviews.

These activities help understand institutional weaknesses of a bank.

Third party analysis is conducted when the bank:

 Wants to participate in international funding.

 Receives a foreign loan.

 Wants to establish correspondence with banks in other countries.

Page 24 of 60
  Accesses foreign markets.

 Wants to attract foreign investment or private investment.

 Is being considered for a rehabilitation programme.

Central Bank Evaluation

The central bank of a country supervises the nation’s banking industry and individual banks.

Its primary responsibility is to plan and implement monetary policy.

Another responsibility is to supervise banks because they influence money supply.

Framework of Appraisal

Appraisal of Islamic banks must consider the unique contractual nature of transactions.

Parameters for appraisal:

• Overall risk profile

• Financial condition

• Viability

• Future prospects

Outcomes of appraisal:

• Institutional weakness – recommendation for corrective action.

• Unviable – recommendation for reform or closure.

• Analysis on whether the bank can be reformed or the bank’s condition threatens the
entire industry

Review conclusions take the form of:

 Letters to shareholders.
Page 25 of 60
  Memorandum of Understanding.

 Institutional programme.

An institutional programme specifies priorities for improvement. The report carries:

 Documents to support claim.

 Information needed for reform and revival.

Reports are useful for authorities planning revival.

Analysis of the Overall Banking Sector

Sectoral analysis of banks important because it:

 Provides understanding of the entire sector.

 Gives an understanding on flow of funds to industry.
 Permits fixing of norms that can help measure deviations.

Analysis of the banking sector helps:

 Understand changes in the industry.

 Evaluate impact on other areas of economy.
 Understand the direction of local and global economies.
 Provide a greater insight into the changes and trends in the industry, that
macroeconomic models cannot capture.

Structured review helps to provide:

 Inputs to monetary policy.

 Details about money supply, credit needs.
 Inputs for monetary policy.

Risk management is a complex subject and needs a holistic perspective.

Page 26 of 60
A bank must have:

 Good management
 Effective strategies
 Supervision
 Sound macroeconomic policies
 Good legal framework
 Solid financial infrastructure
 Safety nets
 Market discipline

To analyse a bank in depth, a banking analyst must have:

 Knowledge of the market in which the bank operates.

 Understanding of the regulatory framework.
 Awareness of the larger economic context of the bank.

Financial Analysis of Banks

Financial analysis:

• Study of bank’s performance

• Comparison of performance over previous years

• Conversion of data into financial metrics for decision making

Aim of financial analysis is to reveal:

• Absolute performance of bank.

• Performance with respect to competition.

• Potential future performance.

• Projected value of the bank and its shares based on future performance.

Page 27 of 60
Financial analysis is based on:

• Financial statements.

• Footnotes.

• Management discussions.

Statements contain data on:

• Bank performance.

• Financial condition.

Statements may not contain:

• Nonfinancial information.

• Future projections.

For comprehensive study, analyst must use:

• Financial statements of bank.

• Industry information.

• Information about economy.

Projections of future performance are useful for:

• Identifying bank’s stock value.

• Conducting credit analysis.

• Evaluating if the bank is capable of financing projects.

• Checking if it is capable of repaying debts with interest.

• Assessing if it is capable of complying with financial regulations.

Sources for these projections are:

Page 28 of 60
• Bank’s projections.

• Bank’s previous financial statements.

• Industry structure and outlook.

• Macroeconomic forecasts.

Problems in financial analyses:

• Off-balance-sheet obligations are listed as liabilities.

• They are accounted for differently in different places.

• These entries also distort ratios and conclusions drawn thereof.

Example: Operating lease is treated as rental contract and not as an asset. The practice
goes against global accounting practices.

Framework for Risk Analysis of Banks

Islamic banks follow different intermediation principles and accounting policies.

Risk analysis is same as for conventional banks.

Traditional analysis is completely ratio-based; studies liquidity, capital adequacy, lending.

Risk analysis is evolving constantly.

It’s necessary for practices and procedures to keep pace with market innovation.

The balance sheet is the key element of financial analysis. .

Risk-based analysis also includes:

• Quality of governance.

• Management policy.

• Internal controls.

This type of analysis views ratios in the light of changes in risk profile.In balance sheet
analysis, a bank must be studied as:

Page 29 of 60
• Individual entity.

• Consolidated enterprise, particularly when subsidiaries operate in multiple locations.

Peer-based risk analysis compares an entity’s practices to peer-group entities and industry
standards.

Change in risk profile of individual institution could be:

• The result of unique circumstances.

• An early indicator of trends.

Principles of an Effective Risk Analysis

Financial analysis involves:

• Interpretation of data.

• Evaluation of performance of bank.

• Forecast of future performance.

• Analysis based on financial statements.

Financial statements prepared using IFRS and GAAP:

• Contain all financial information

• Do not contain non-financial information needed for analysis.

IFRS statements contain information on past performance and asset-liability ratios.

Analyst must use statements along with industry information to make valid investment conclusions.

Analysis may be two kinds:

• Off-site – financial conditions, risk exposure/management

• On-site – quality of governance, quality of infrastructure and ability of management to use

information

Page 30 of 60
More Principles of an Effective Risk Analysis

To make a review effective, analyst must:

 Use knowledge and skill

 Create storyline to data

 Provide a context to the review

Context includes:

 Country

 Sector

 Legal framework

 Accounting and auditing practices

 Corporate governance

 Financial and operational risks

Good storyline includes:

 Data spanning 5-10 years

 Graphs

 Industry trends

 Conclusions

 Recommendations

Purpose

Questions for analyst before review:

 What is the purpose of the analysis?

 What level of detail will be needed?

Page 31 of 60
  What factors or relationships will influence the analysis?

 What are the analytical limitations and will these limitations impair the analysis?

 What data are available?

 How will data be processed?

 What methodologies will be used to interpret the data?

How will conclusions and recommendations be communicated?

Meaning

Questions the analyst must answer during the analysis:

 What happened?

 Why it happened?

 What is the impact of the event or trend?

 How did the management respond?

 What are the recommendations?

 What are the weaknesses and where is the bank vulnerable?

Analytical Tools

Models applicable to Islamic banks:

 Questionnaire

 Excel

These format s help easy analysis.

Questionnaire

Questionnaires:

 Should be answered by management.

 Aim to get responses on management policy, functioning, control processes

Page 32 of 60
The questionnaire should address:

 Institutional development needs.

 Overview of the financial sector and regulation.

 Overview of the bank (history and group and organizational structure).

 Accounting systems, management information and internal controls.

 Information technology.

 Corporate governance, covering key players and accountabilities.

 Financial risk management including asset-liability management, profitability, credit

risk and other major liabilities.

Data Input Tables

Financial analysis requires the use of tables to input data.

 Data is used by analysts for review.

 Data is used to create ratios and graphs.

 Ratios help in risk management.

 Ratios help understand financial condition of bank.

Balance sheets and income statements are anchor schedules that can used together with
other schedules.

Output Summary Report

Reports:

 Summarize analysis, based on questionnaire and financial statements.

 Represent `informed analyses’.

 Provide information about bank’s financial condition and risk management.

Graphs, charts and ratios are financial indicators of bank’s future performance.

Page 33 of 60
Ratios

Ratio = Relationship of one variable with respect to another

Financial ratios express the different kinds of relationships between different variables.

Ratios indicate the following:

 Operational efficiency

 Liquidity

 Profitability

 Debt and leverage

 Solvency

 Earnings, share price and growth

Other ratios required by regulators and supervisory authorities and the market.

Advantage of ratios:

 Help determine creditworthiness of bank

 Help determine financial flexibility

 Help evaluate management

Disadvantage of ratios:

 Can be made to look favourable

Must be verified with deeper review of operations

Graphs and Charts

Graphs provide a wide range of information. They:

• Permit comparison across units/across time.

• Give indication of trends.

Page 34 of 60
• Give management high-level overview of performance.

Graphs show:

• Asset and liability position.

• Income.

• Profitability.

• Capital adequacy.

• Investment portfolios.

• Credit risk exposures.

• Exposure to interest rates.

• Liquidity, market and currency risk.

Graphs are useful for on-site reviews.

They can illustrate details of performance for senior management. Graphs and Charts

Graphs are powerful tools for analysis because they can provide a wide range of
information.

They permit comparison of numbers across units and over time, giving an indication of
trends.

They provide the management with a high-level overview of the bank’s performance.

Graphs can show:

• Asset and liability position

• Income

• Profitability

• Capital adequacy

• Investment portfolios

• Credit risk exposures

Page 35 of 60
• Exposure to interest rates

• Liquidity, market and currency risk

Graphs are useful as a starting point for on-site reviews, where they can be used to
illustrate details of performance to the senior management.

Graphs provide a wide range of information. They:

 Permit comparison across units/across time.

 Give indication of trends.

 Give management high-level overview of performance.

Graphs show:

 Asset and liability position.

 Income.

 Profitability.

 Capital adequacy.

 Investment portfolios.

 Credit risk exposures.

 Exposure to interest rates.

 Liquidity, market and currency risk.

Graphs are useful for on-site reviews.

They can illustrate details of performance for senior management.

Page 36 of 60
Page 37 of 60
Chapter 3

Page 38 of 60
Chapter Introduction

Welcome to the chapter, Credit Risks with Assets and Their Management.

Credit risk is the chance that the debtor or an issuer of a financial instrument will default
on:

• The payment of the principal.

• Any other investment related cash flow mentioned and specified in the credit terms.

Credit risk needs to be effectively managed as it affects the bank’s liquidity.

Problem:

Islamic credit-rating agencies are nonexistent.

Outcome:

Islamic banks rely solely on the individual’s track record to judge his/her creditworthiness.

The sources used by them are:

• Local community networks.

• Other informal sources.

The board of directors lay down formal policies for lending which must be followed by the
bank supervisors and other administrative staff.

A lending policy should define:

• Scope and allocation of credit.

• Guidelines for managing credit portfolio.

Yet it should allow flexibility in lending terms to ensure the consideration of deserving
proposals

Page 39 of 60
Learning Objectives
On completing this chapter, you will be able to:

 Distinguish between three types of risk management policies based on their goal.
 Describe measures that aim to reduce credit risk for Islamic banks.
 Describe credit risk issues specific to Islamic banks in the context of Murabahah,
Mudarabah and Bai’ Salaam contracts.
 Describe credit risk issues specific to Islamic banks and measures used to mitigate
them.
 Identify the parameters to be included in a risk analysis of the asset portfolio.
 Identify the parameters and objectives of credit review of individual customers.
 Identify the parameters of review of interbank lending.
 Identify the parameters of review of off-balance-sheet commitments.

Standards and Types of Policies

Principles of Credit Risk of the IFSB

These cover:

 The identification of existing and potential risks.

 The definition of risk management policies.
 The setting of parameters to control risk.

Principle 2.1

IFIs must have in place a strategy for financing,

using the various Sharī‘ah-compliant Islamic instruments whereby they recognise the
potential credit exposures that may arise at different stages of the various financing
agreements.

Principle 2.2

IFIs must conduct a due diligence review of counterparties prior to choosing an appropriate
Islamic financing instrument.

Principle 2.3

IFIs must use appropriate methodologies for measuring and reporting the credit risk
exposures arising under each Islamic financing instrument.

Page 40 of 60
Principle 2.4

IFIs must implement Sharī‘ah-compliant credit risk–mitigating techniques appropriate for

each Islamic financing instrument.

The three types of policies used by Islamic banks aim to:.

 Reduce the credit risk.

 Classify assets.
 Provide for losses.

Policies to Reduce Credit Risk

In order to mitigate and effectively manage the credit risk exposure, the regulators watch
three issues:

1. Single customer exposure

2. Related party financing
3. Overexposure to a geographic area or economic sector

Single Customer Exposure

Banking regulations specify a threshold limit, usually a percentage of bank’s capital and
reserves, for extending credit to a single party.
Most countries limit single customer exposure to 10-25 percent of the bank’s capital. Banks
are required to report exposures to a single customer after a point just below the upper
limit.

Supervisors must monitor all exposures beyond the threshold limit and take the necessary
precautionary measures.

Two Difficulties:

 How to quantify the less direct forms of credit exposure

 How to define the term “single customer”
Credit exposure to a number of related clients may represent a cumulative credit exposure
risk for banks if:

 Financial interdependence exists among clients.

 The source of repayment of debt is the same.

Page 41 of 60
In order to effectively manage large exposures to a single group:

 Banks need to have thorough information about the debtor, including Common or
related ownership.
 Banks should continuously monitor the performance of the group, regardless of payment
status.
 Concerns should be raised and contingency plan formed if there is any doubt about the
ability to repay of the loan.

Related Party Financing

Extending loans to parties that are connected with the bank in some way can increase a
bank’s credit risk exposure.

Connected parties include:

 Bank’s parent organisations

 Major shareholders
 Subsidiaries
 Affiliate companies
 Directors and executive officers
These parties can strongly influence bank’s credit decisions.

 Are these parties offered credit on the same terms as the public?
 In order to manage this exposure, the regulators stipulate that the credit extended to
related parties should not exceed a certain percentage of Tier 1 capital.
Overexposure to Geographic Areas or Economic Sectors

Sometimes a bank can be overexposed to a single sector of the economy or a narrow

geographic region.

This risk is very prevalent for banks in agrarian economies or countries which are single
commodity exporter.

In many cases, banks do not have or cannot generate data pertaining to the magnitude of
exposure banks are exposed to any of the economic sectors.

Page 42 of 60
Banks giving loans to foreign parties have to face two additional types of risks:

• Country (sovereign) specific risk

• Transfer risk

Two ways to mitigate risks in international loans:

• Provide loans based on merits.

• Ascertain total exposure to country and transfer risks and provide special reserves to
manage risk exposure.

Credit Risks Specific to Islamic Banks

There are additional specific risks that are unique to Islamic banking. They arise in the
following type of contracts:

1. Murabahah
2. Bai’ al- Salaam
3. Mudarabah

Murabahah

In Murabahahcontract, the banks are exposed to credit risk when a client refuses to pay
after the bank delivers goods. The risk is increased further in case of non-binding
Murabahah transactions where a client has the right to refuse the goods delivered by the
bank.

The bank is exposed to:

 Credit risk
 Market risk

Bai’ al-Salaam

In this type of contracts, credit risk arises when banks fail to supply the goods either on
time or as per the contract.

Such failure could result in a delay or default in payment, or in delivery of the product, and
can expose Islamic banks to financial losses of income as well as capital.

Page 43 of 60
Mudarabah

In this type of contracts, the bank acts as a principal (Rab al-Māl) with an external agent
(Mudarib). In this case, the bank is vulnerable because:

 There are typical principal-agent problems.

 It has very little or no control over the activities of the Mudarib.
 There is very less information available and the transparency is low.

More Credit Risk Specific to Islamic Banks

Additional credit risk issues specific to Islamic banks:

1. Default by clients taking advantage of bank’s inability to charge extra interest or

penalty for delay

2. Transformation of share capital invested through a Mudarabah or Musharakah

contract to debt due to misconduct or negligence of Mudarib

3. Difficulties arising from use of collateral as a security

Analysis of Credit Risk in Asset Portfolio

A detailed asset analysis should include the following things:

 The products in which the bank has invested

 To whom the banks has lent money
 The duration of the loan

The analysis of the bank’s portfolio should include the following things:

1. Detailed summary of investment and financing assets, number of customers,

customer types, average maturity and average earnings.
2. Detailed description of the portfolio, and classification of portfolio in different ways.
3. List of government guarantees
4. Accounts classified based on their risk profiles
5. Details of non-performing accounts

Page 44 of 60
Credit Review of Individual Customers
While a thorough portfolio analysis is required, sometimes it is not possible to do an
exhaustive study of all the portfolios.

Therefore, random sampling is useful, provided a statistically significant number of

portfolios are selected

A detailed portfolio review should consider:

 All the customers that have a total exposure of more than five percent of bank’s
capital.
 All exposures to shareholders and connected parties.
 All investments and other financing assets for which the financing schedule have
been changed after such investments were made.
 All investments and financing assets that are declared as substandard, doubtful or
cannot be recovered.

The objectives of a detailed portfolio credit review are following:

 Calculate the probability that a particular loan will be repaid.

 Measure the adequacy of the classification of the loan proposal.
 Judge the quality of collateral held by the bank.
 Assess client’s ability to generate the necessary cash.

Interbank Deposits
Interbank deposits are particularly important where citizens and other economic agents are
allowed to hold foreign exchange deposits.

Two main advantages of having interbank deposits:

1. They facilitate fund transfer and buying and selling securities between banks.
2. They enable banks to take advantage of other banks’ ability to perform certain
services at a lower cost due to their bigger size or strategic geographic location.

A review of interbank deposits should include the following points:

1. The formulation and observation of counterparty credit limits

2. Any interbank loans granted for which a special provision needs to be made
3. The method and accuracy of reconciliation of nostro and vostro accounts
Page 45 of 60
 4. Terms of pricing of any interbank loan granted that is not consistent with the terms
prevalent in the market
5. Detailed listing of banks that contribute toward interbank exposure

Interbank credit increases banks credit exposure. Therefore a bank should review it’s
correspondent bank on the following parameters:

 Correspondent bank’s exposure limit

 Correspondent bank’s ability to provide adequate collateral

Generally banks that are from highly regulated countries are considered to be safe to deal
with.

Off Balance Sheet Items

Any off-balance sheet items that translate into increased credit exposure for the bank need
to be reviewed.

The objective of such review is to make sure that the customer repays the loan on time.

• What to Assess:

• Whether the procedures that analyse the credit risk are sufficient

• Whether there is periodic supervision and administration of off-balance sheet credit

instruments like guarantees

Page 46 of 60
Page 47 of 60
Page 48 of 60
Chapter 4

Page 49 of 60
Welcome to the chapter, Credit Risks with Assets and Their Management.

Credit risk is the chance that the debtor or an issuer of a financial instrument will default
on:

 The payment of the principal.

 Any other investment related cash flow mentioned and specified in the credit terms.

Credit risk needs to be effectively managed as it affects the bank’s liquidity.

Problem:

Islamic credit-rating agencies are nonexistent.

Outcome:

Islamic banks rely solely on the individual’s track record to judge his/her creditworthiness.

The sources used by them are:

• Local community networks.

• Other informal sources.

The board of directors lay down formal policies for lending which must be followed by the
bank supervisors and other administrative staff.

A lending policy should define:

• Scope and allocation of credit.

• Guidelines for managing credit portfolio.

Yet it should allow flexibility in lending terms to ensure the consideration of deserving
proposals

Learning Objectives

Page 50 of 60
On completing this chapter, you will be able to:

• Identify the parameters of review of nonperforming assets.

• Describe the reasons for an increase in nonperforming assets of a bank.

• Explain the concept of asset classification.

• Explain the rules of asset classification.

• Describe the factors that determine adequate level of provisioning for losses.

• Identify the levels of provisioning in different types of economies.

• Describe alternative approaches for managing asset losses.

• Describe parameters to assess workout procedures and typical workout strategies.

Review of Nonperforming Assets

While analysing a nonperforming portfolio, the following factors should be considered:

Page 51 of 60
• Classification of portfolios

• Causes for the deterioration in portfolio quality

• Other nonperforming portfolios

• Provision levels of the bank

• Impact on profit and loss sharing accounts

Reasons for an Increase in Nonperforming Assets

Two common reasons that lead to an increase in nonperforming assets are:

 Mistakes in judgement by the bank.

 Distortion in a bank’s credit culture.

The U.S. Federal Reserve system provides a list of problems that lead to a poor credit
culture. These problems apply to not just any commercial bank but also to any Islamic
financial institution.

Let’s look at each problem in detail.

Self-dealing
Self-dealing is a key problem that affects many banks. Self-dealing happens when banks
compromise on their credit principles and lend too much credit to large shareholders,
directors or their related interests.

Anxiety Over Income

Loans are the primary source through which banks earn their revenue. There are times
when the banks become anxious over their earnings and hope that risks will not materialise
or that loans will be repaid.

Incomplete Credit Information

There are times when loans are granted without proper assessment of the borrower and the
borrower’s ability to repay.
Page 52 of 60
Complacency

Complacency leads to a lot of problems. A complacent bank:

• Does minimal or no supervision of old or familiar borrowers.

• Depends on oral information rather than reliable financial data.

• Ignores any warning signs regarding the borrower, economy, region or industry.

• Ignores known credit weaknesses in a loan because the borrower survived a

distressed situation in the past.

• Does not enforce repayment agreements, including a lack of prompt legal action.

Lack of Effective Supervision

Constant monitoring of the borrower’s affairs during the entire lifetime of the loan is
important. Lack of effective supervision leads to a lack of knowledge about the borrower’s
dealings and subsequently, loans that were once healthy may develop problems and losses.

Technical Incompetence

Loan officers may not be technically sound. They may not possess the ability to evaluate
credentials and assess financial statements.

Poor Selection of Risks

Banks make a poor selection of risks by granting loans:

 To a level beyond the repayment capacity of the borrower.
 That finance a huge portion of a project compared to the equity investment of the
owners.
 Based on the expectation of success in a business transaction, rather than borrower’s
creditworthiness.
 On account of large deposits in a bank, rather than sound net worth of collateral.

 That finance the purchase of speculative securities or goods.

 To companies operating in economically distressed areas.
 That are predicated on collateral of problematic liquidation value.

Page 53 of 60
Compromise of Credit Principles

When banks sanction loans that have undue risks or loans that are extended under
unsatisfactory terms, then the banks are said to compromise their credit principles.

Bank compromise typically due to reasons such as:

 Self-dealing
 Anxiety over income
 Competitive pressures in the bank’s key markets
 Personal conflicts of interest.

What is Asset Classification?

It is important that a bank classifies all assets for which it is taking a risk.

Asset classification is a process whereby an asset is assigned a grade for credit risk.
The grade is determined by the probability that obligations will be serviced and liquidated
according to the terms of the contract.
Assets are classified at the time of origination of the loan. Then, in a year, assets are
reviewed and reclassified periodically, for example, twice a year or every quarter, depending
on class.

The review of an asset considers:

 Service performance to the loan.
 The client’s financial condition.
 Economic trends and changes in the market for the price of goods.

Approaches to Classification
There have been different approaches to asset classification. Some of the approaches are
listed below:

 All credits extended to an individual client must be assigned the same risk
classification.
 Alternatively, risk in each asset is assessed on its own merits.
 When assets are classified objectively or subjectively, the more stringent
classification applies.
 If supervisory authorities or external auditors assign more stringent classification,
the bank should modify its classification.

Rules of Asset Classification

International standards recommend assets to be classified in the following categories.

Page 54 of 60
Standard or Pass

An asset is classified as standard (pass) when the capacity of the borrower to service the
debt is beyond any doubt. For example, assets that are fully secured by cash or cash
substitutes are classified as standard regardless of arrears or other adverse credit factors.

Specially Mentioned or Watched

An asset is classified as specially mentioned or watched if the asset has potential

weaknesses that may weaken the asset as a whole or put at risk the borrower’s capacity to
service the debt in the future. These assets should be watched and corrected.

Examples of these include:

 Credit given through:

o An inadequate loan agreement.

o A lack of control over collateral.
o A lack of proper documentation.

 Credit provided to borrowers working under economic or market conditions that may
negatively affect them in the future.
 Credit provided to borrowers who notice an adverse trend in their balance sheet, but have
not reached a point where repayment is jeopardised.

Substandard

An asset is classified as a substandard asset only if the primary sources of repayment are
insufficient. and the bank must look to secondary sources, such as collateral, the sale of a
fixed asset, refinancing, or fresh capital

Examples of substandard assets include:

 Assets whose cash flow may not be sufficient to meet current cash flow
requirements.
 Short-term assets to borrowers whose inventory-to-cash cycle is insufficient to repay
the debt at maturity.
 Nonperforming assets that are at least 90 days overdue.
 Renegotiated loans for which the borrower has paid delinquent interest from his own
funds prior to renegotiations and until sustained performance of the asset.

Doubtful

An asset is classified as doubtful if:

Page 55 of 60
  The collection of the credit in full is doubtful on the basis of existing facts. Although
there is possibility of a loss, this asset can still not be classified as a loss as there
may be certain factors that may strengthen the asset performance.
 The asset is at least 180 days past due, unless it is sufficiently secured.

Loss

An asset is classified as a loss if:

 The credit is uncollectible or not warranted, but partial recovery may be possible in
the future.
 The nonperforming asset is at least one year past due unless very well secured

Loss Provisioning
Asset classification is a key tool to:
 Manage risks.
 Determine adequate level of provisions for possible losses.
 To determine an adequate level of reserve, the following factors need to be
considered:
 Quality of credit policies and procedures
 Prior loss experiences
 Quality of management
 Collection and recovery practices
 Changes in national and local economic and business conditions
 General economic trends

After determining an adequate level of reserve, evaluate the asset value:

 Periodically.
 Systematically
 Objectively.

Support the evaluation by adequate documentation.

Note that loss provisioning:

 Is not mandatory in all banking systems.

 Is taxed differently in various countries.

Page 56 of 60
Standards for Level of Provisioning
The best method to determine an adequate level of reserve is to estimate each asset on a
case-by-case basis. However this is not a practical solution. Hence, it is recommended that
each classification category is assigned a level of required provisions.

Let’s now look at the provision levels in developed countries and developing countries.

In highly developed countries, the legal framework for debt recovery is highly developed.
Therefore, in the US for example, the loss percentage is as follows:

Classification Loss percent

Substandard 10

Doubtful 50

Loss 100

In developing countries, the legal framework and tradition of collection is less effective.
Hence, substandard assets face a loss in the range of 10 to 30 percent. See the graph for
more information.
These estimates of loss provisions are subjective. However, it is best to exercise
management discretion in accordance with established policies and procedures of the bank.

Click the Resources button at the top of the screen to view the Islamic Financial Services
Board (IFSB) standard on risk management.
Aspect of Overall Loss Allowance

The following aspects of the overall allowance for losses should be considered:

 The bank’s provisioning policy and its implementation process

 The asset classification procedures and the review process
 Any loss causing factors associated with a bank’s portfolio
 A trend analysis over a longer period of time
 An evaluation of the current policy’s adequacy on the basis of the loans reviewed

Approaches for Managing Asset Losses

The approaches for dealing with loss assets can be outlined as follows:

Page 57 of 60
British:

 Reserve is large.
 Assets are retained on the books until all remedies for collection have been
exhausted.

American:

 Reserve is smaller.
 Approach is more conservative.
 Assets are written off promptly against the reserve.

Workout Procedures

Workout procedures help in credit risk management. They:

 Help banks take timely action against problem accounts.

 Ensure that these problem accounts are either strengthened or collected.
 Prevent the accumulation of losses to an extent that it can threaten a bank’s
solvency.

While determining the best workout procedures for an asset, consider the following factors:

 The organization, including departments and responsible staff

 The performance of the workout units in terms of the number and volume of
attempted and successful recoveries
 The average time for recovery
 The workout methods already used
 The involvement of senior management

Workout Strategies

The typical workout strategies include:

 Reducing the credit risk exposure of a bank

 Working with the client to assess problems and find solutions
 Arranging for a client to be bought by a more creditworthy party
 Taking legal action, calling on guarantees, foreclosing or liquidating collateral

Page 58 of 60
1.

Page 59 of 60
Page 60 of 60