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Islamic Risk Management CREDIT RISK


Presented by:

Resul Sapar Mohammed Arshadullah

Presentation Outline

Definition of Credit Type of Credit

6 Cs of Credit

What is Credit Risk?

Credit Risk and Islamic Finance

Impact of Credit Risk


Credit Risk Management Risk Mitigation Measures Credit Risk and Mudaraba & Musharaka Transactions Q&A

Definition of Credit

Credit is the provision of resources by one party to another party where the second party does not reimburse the first party immediately (thereby generating a debt), but instead arranges either to repay or return those resources (or other materials of equal value) at a later date. The resources provided may be financial (e.g. granting a loan), or they may consist of goods or services (e.g. consumer credit)....Wikipedia

Type of Credit

Conventional

Interest based e.g. Housing Loan, Hire Purchase, Bond Non interest based e.g. Venture Capital, Bank Guarantee

Islamic

Debt based

e.g. Murabaha, Salam, Istisna, Ijara, Sukuk

Profit Sharing Based e.g. Mudharaba, Musharaka, Muzaraa, Sukuk

6 Cs of Credit
1.
2. 3. 4. 5.

Assessment Criteria
Capital
Character Capacity Condition Collateral

6.

Common Sense

What is Credit Risk?

Credit risk is simply defined as the potential that a borrower or counterparty will fail to meet its obligation in accordance with agreed terms.*
It is the risk of failure of the counterparty to honor their commitment (moral hazard), and is also referred as default risk.

*Basel Committee of Banking Supervision, Principles for the Management of the Credit Risk, Bank for International settlement, Basel, Switzerland (1999)

Credit Risk in Islamic Finance


Contracts Murabaha Salam Risk Non payment or delayed payment of debt on due date Non delivery or delayed delivery of the subject matter

Parallel Istisna
Ijara

Non delivery or delayed delivery of the subject matter


Non Payment or delayed payment of rental Devaluation of property price

Mudharaba Musharaka

- Mudarib fail to remit profit and capital - Incompetent Mudarib - Incompetent business partner (IFI & Partner) - Failure to inject capital by any of the partners

Impact of Credit Risk


High

non performance contracts(NPL)


of capital to meet contractual obligation by IFI

Erosion Inability Bank

Run

Insolvency

Credit Risk Management


1. Identification of Credit Risk Exposure

Need to understand the relationships between the following:


Counterparties Islamic Financial Contracts Guaranties and Collaterals (to cover potential losses)

Measurement is a complicated process

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Credit Risk Management


2.Credit Risk Assessment models

Qualitative methods Expert systems Quantitative methods:


Based on quantitative statistical models Data used for modeling the credit risks

Data referring to the past and current behavior of the counterparty Data that defines the losses of the associated risks

Hybrid models

Combination of empirical based models and quantitative models

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Credit Risk Management


3.Credit Risk Valuation
Expected & Unexpected losses

Depends on the calculation of Probability of Default - PD (likelihood of counterparty defaulting) Loss Given Default LGD (weighting of loss at default) and Exposure at Default EAD (estimation of institutions exposure in the event of or at the time of default)

Credit VaR based on expected and unexpected losses


Correlation between a portfolios assets are analysed Estimation of Economic Capital to be held as buffer against the Unexpected Credit Losses

Lack of loss data major hindrance for young Islamic Banking industry

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Credit Risk Mitigation Measures


Collateralization Guarantor Insurance Securitization

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Credit Risk and Mudaraba & Musharaka Transactions

Basel Committee on Banking Supervision (BCBS)*


Banks should not hold significant equity positions in companies they finance. Reason : risk a bank takes increases when owner- ship and the provision of debt funding are in the same hands As a result of this belief, banks that hold equity positions in the companies they finance (e.g., as in Mudaraba and Musharaka transactions) are heavily penalized. Issue for Islamic Banks due to Mudaraba and Musharaka transactions due to PLS nature of contracts Banks with transactions with PLS nature have RWA of 400% In Malaysia, this condition modified to RWA of 250% Hence Islamic Banks avoid these transactions due to high capital requirement and capital costs

*Islamic Finance: Risk Management Challenges and the Impact of Basel II - Dr.Natalie Schoon

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Thank you

& Q&A

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