Risk management is at the heart of banks’ financial intermediation process and has assumed utmost importance at a time when complexity and volatility in financial markets have become both differentiating factors building competitive advantages and sources of risk entanglement. Basel II and widespread write-downs have highlighted the importance of sufficient capital adequacy and, more importantly, set a framework for improving the overall risk management architecture in banks.
Islamic financial institutions (IFIs) are no exception. Similar to conventional financial institutions, they face many challenges in adequately defining, identifying, measuring, selecting, pricing and mitigating risks across business lines and asset classes. A number of specific financial risks at IFIs deserve closer examination. IFIs also face a series of non-financial risks, including sharia compliance, reputation, perception, and human resource risks, which are outside the scope of the following discussion, but equally important.
Risk entanglement within IFIs’ asset classes
In IFIs’ portfolios, it is often challenging to distinguish between risk categories. It is generally difficult to distinguish between the market and credit risks attached to a financial transaction abiding by the rules of sharia. In a large number of contracts, risk categories of a different nature are entangled. For example, in an ijara (lease) contract, the IFI buys an asset that is subsequently leased or rented to a customer against periodic rental payments. The IFI remains the owner of the leased asset throughout the duration of the lease contract, leaving the bank exposed to the residual value of the asset. The management of leased assets’ residual value is a feature that differs materially from credit risk management and assumes access to reliable market data as to asset-price volatility and behavior across business cycles, all the more so as IFIs tend to run a portfolio of asset inventories. Inventory management is another aspect that separates IFIs, from a risk management perspective, from their conventional peers.
Such constraints attached to the status of IFIs as sellers and buyers of tangible goods also have risk-mitigating benefits. In Islamic finance, any financial transaction should be backed by a tangible, identifiable underlying asset. This is a powerful way for the IFI to secure strong access to collateral. IFIs naturally have a high level of collateralization on their credit portfolios, and thus are in a position to somewhat reduce their exposures at default. This is helpful for sector diversification in credit, and somewhat mitigates IFIs’ concentration risks by name and geography.
IFIs evolving in balance-sheet management
Investment allocation and liquidity management continue to vex IFIs’ balance-sheet managers. The limited scope of eligible asset classes for IFIs increases concentration in investment portfolios, which is mitigated by a lower appetite for speculative transactions. Financial Islam forbids gharar (uncertainty) and maysir (speculation). Therefore, IFIs are naturally crowded out from the high-risk/high-return leveraged and/or structured investment asset classes. As such instruments tend to be based either on riba (interest) or derivatives, their technical eligibility is in most cases difficult to justify. IFIs thus limit the scope of their investment strategies to plain vanilla asset classes such as stocks, sukuk and real estate. A limited range of permissible asset allocations leads to concentration risks in IFIs’ investment portfolios, by asset class, legal sector and also usually by name.
Liquidity management is far from being an easy task for IFIs. There is still a great shortage of liquid instruments. Typically, Islamic banks would place their excess cash reserves into short-term interbank murabahas, at a cost compared to conventional banks. Indeed, short-term murabahas make it necessary for commodity brokers to be involved, triggering higher transactional costs for managing liquidity. IFIs are subject to the constant trade-off between profitability and liquidity in a binary way. IFIs at this stage of the development of the Islamic financial industry barely have an alternative: profitable but highly illiquid asset classes; or highly liquid short-term murabahas with investment-grade banks, but at a cost. In the future, as the industry matures, margins might come under pressure and the trade-off between liquidity and profitability might lead to an increase in IFIs’ risk appetite.
A limited range of possible funding sources leads to concentrated liabilities, imbalanced funding mixes and stretched capital management strategies
IFIs’ wholesale liabilities tend to be concentrated. IFIs are generally well entrenched in retail banking, which gives them access to a large pool of relatively cheap deposits, when these are not in the form of Profit-Sharing Investment Accounts (PSIAs).
Apart from retail accounts, which are in most cases both granular and stable across business cycles, IFIs also resort to wholesale creditors for funding. So far, sukuk have not served as the main term funding source. Instead, IFIs typically fund bank and non-bank customers, who tend to be price sensitive, relatively unstable and concentrated.
IFIs’ funding continuums remain imbalanced. Between deposits in their various forms and Tier 1 capital, IFIs have so far had access to a limited number of alternative funding sources. Only very few subordinated sukuk have been issued so far. Bank securitization, other Tier 2 instruments, Tier 3 short-term debt to cover the regulatory capital charge of market risk, as well as plain vanilla and innovative hybrid capital notes are inexistent in the Islamic financial industry. One of the reasons behind such a vacuum lies in the fact that a number of sharia supervisory boards have been uncomfortable so far with the concept of subordination.
Therefore, IFIs’ capital management strategies tend to be stretched. Allocation of economic capital to business units is barely applied. Capital allocation tends to be inefficient at this stage, although this is not disadvantageous as capitalization ratios are high and capital is not scarce in the geographies where IFIs are most active (typically in the Gulf region).
In the future, lower net returns directed towards more demanding shareholders could put pressure on IFIs’ capital positions. Funding would therefore attract less core equity and more alternative refinancing vehicles such as sukuk (including subordinated, convertible and exchangeable sukuk), hybrid instruments, securitization techniques, and various classes of PSIAs.
How specific should ALM be at IFIs?
Controlling margin rates is at the heart of IFIs’ ALM. Similar to interest-rate risk management at conventional bank, IFIs must manage maturity gaps and asset-liability profit-rate imbalances. However, unlike conventional banks, the charge attached to funding costs is supposed to be a function of asset yields, as per the core principle of profit sharing underlying Islamic banking and finance, which is at the heart of PSIAs.
Should there be no smoothing of returns to PSIA-holders, those IFIs that resort materially to PSIAs for funding would in theory be less profitable than conventional banks when the interest or profit-rate cycle is at its peak, because when conventional banks would face a predetermined cost of funds, IFIs would, on the contrary, be in such a position as to share more returns with the holders of PSIAs.
As well there is the fact that in some cases the opposite scenario would also be true: when the interest — or profit-rate cycle trends down towards its trough — IFIs would buffer the decline by distributing less profit to PSIA-holders, whereas conventional banks would have to absorb the same cost of funds at a time when net asset yields had shrunk, therefore reducing more substantially their margins.
Therefore, “displaced commercial risk” is always at stake, giving birth to various mechanisms of smoothing returns. “Displaced commercial risk” (DCR) is a term reflecting the risk of liquidity suddenly drying up as a consequence of massive withdrawals should the IFI’s assets yield returns for PSIA-holders lower than expected. Managing DCR efficiently, by smoothing returns, is a subtle, dynamic exercise.
Traditionally, there are three lines of defense against DCR. Investment risk reserves (IRRs) and the bank’s mudarib fee tend to absorb expected losses; profit equalization reserves (PERs) are used to cover unexpected losses of manageable magnitude. IRRs come as a deduction from the asset portfolio, in the same way that loan-loss reserves are deducted from conventional banks’ loan books. Reducing mudarib fees to protect returns to PSIA-holders remains a management decision.
In case asset yields deteriorate beyond levels absorbable by IRRs, the IFI’s management team, in line with the board’s formal approval, could reduce management mudarib fees ex post.
Finally, PERs are built based on the excess return to PSIA-holders in periods where assets have performed better than expected, and are subsequently distributed to depositors when the cycle reverses.
Anouar Hassoune is the Vice President – Senior Credit Officer of Moody’s France SAS
