Asset & Liability Management

Durham Islamic Autmun Summer School,
2011 in Istanbul
Asset & Liability Management :

challenges facing Islamic financial institutions
!
Majdi Chaabouni!
Presented at the

Durham Islamic Finance Autumn School 2011
jointly organised by
Durham Centre for Islamic Economics and Finance and
ISAR-‐Istanbul Foundation for Research and Education
Istanbul Commerce University, Istanbul
19th-‐22nd September 2011
1!
Seminar
« Asset & liability Management in the Islamic Banks»
July 2011
Majdi Chaabouni: Biography and conferences participation 2011 !
2!
Majdi Chaabouni- The Risk Exposure of

Asset & Liability Management in Islamic
Financial Institutions 1
2011 in Istanbul
Objectives of the Seminar

1. Understand what’s Asset & Liability Management?
10 minutes – 5 July 2011
2. Explain the main objectives and the goals to achieve in the ALM
3. Understand how to identify the ALM risk in the conventional and Islamic bank
4. Understand how to measure and manage the ALM risk: conventional bank versus
Islamic banks
10 minutes - 5 July 2011
5. Conclusion on the indicators and measurement techniques to be used by Islamic

banks
3!
Seminar “Asset & Liability Management in islamic banks”, July 2011– Majdi Chaabouni
t
Asset & Liability Management in the conventional bank!
Part 1:
The conventional bank & the techniques for the balance-sheet management
4!

2011 in Istanbul
01 Liquidity risk: let’s suppose a bank has the following structure…
5!
01 Liquidity risk: let’s suppose a bank has the following structure…
Need for
financing
Excess of
liquidity
6!

2011 in Istanbul
01 Liquidity risk: Liquidity GAP as a measure of the risk
Liquidity Gap
For every maturity
GAP (T) = Liability (T) – Asset (T)
- If GAP >0 à more resources than a need for financing

- If GAP <0 à the real concern
7!
01 Interest rate risk: Interest rate GAP as a measure of the risk
Illustrative example to clarify the ideas

- Asset side:
- Loan infine: 2 years maturity; nominal 100 Euro with fixed rate 5%
- Liability side:
- Borrowing over 1 year; nominal 80 Euro for 3%
- Capital 20 Euro
What is the Liquidity Gap?

What is the Interest rate Gap?
8!

2011 in Istanbul
9!
Illustrative example to clarify the ideas

Let’s take the same example BUT with variable rates
- Asset side:
- Loan infine: 2 years maturity; nominal 100 Euro with fixed rate 5% for the first year and
variable for the 2nd year
- Liability side:
- Borrowing over 1 year; nominal 80 Euro for 3%
- Capital 20 Euro
What is the Liquidity Gap?

What is the Interest rate Gap?
10!

2011 in Istanbul
11!
In summary:
Only transactions with fixed interest rate risk are the origin of the risk
We can say that the Interest rate GAOP is equal to:

Difference between transactions with fixed interest rate:
} by maturity
} Asset vs Liability
} Another way to say it as well: Interest rate Gap = Liquidity Gap for fixed rate transactions
à Indeed : Variable rate ⎝ there is no extrac-cost for financing
12!

2011 in Istanbul
01 Let’s take an example to illustrate the ALM (Balance-sheet )

risk… The Gap is the simplest technique to measure the risk
Asset Liability
Cost for establishment 500,000 Capital 10,000,000
Mortgage Loans 10,000,000

(Fixed rate 15 yrs)
Mortgage Loans 5,000,000 Bond issue 5,000,000

(Fixed rate 15 yrs) (Fixed rate 15 yrs)
Mortgage Loans 15,000,000 Loan from FIs 15,000,000

(Fixed rate 15 yrs) (Fixed rate 1 year)
Buildings 500,000

(Fixed rate 7 yrs) (variable rate 7 yers)
13!
01 Let’s take an example to illustrate the ALM (Balance-sheet )

risk… The Gap is the simplest technique to measure the risk
Asset Liability
Cost for establishment

Mortgage 500,000
Loans 10,000,000 Capital 10,000,000
(Fixed rate 15 yrs)
Mortgage Loans 5,000,000 Bond issue 5,000,000

(Fixed rate 15 yrs) (Fixed rate 15 yrs)

(Fixed rate 15 yrs) (Fixed rate 1 year)
Le Profit is volatile…& exposed to interest rate risk!

Buildings 500,000

(Fixed rate 7 yrs) (variable rate 7 yers)
14!

2011 in Istanbul
02 The ALM (balance-sheet) risk

Example of Interest rate risk
Let’s consider the following balance-sheet as of 1st January 2006 :
Asset side :
• Loan to retail customers:
• nominal : 1000
• duration : infine reimbursement with a maturity of 1 year
• rate : MMRate (ex. Libor) + 2 %
Liability side :
• Capital (shareholders fund):
• amount : 200
• Reimbursement : indeterminate by the shareholders
• borrowing from the money market :

• amount : 800
• Reimbursement : infine over 6 months
• rate : MMR + 1%
let’s supose the MMR is 5 %
15!

As of 1st Jan 2006 the balance-sheet has the following shape:
ASSET LIABILITY
Loans 1000 Capital 200
Borrowing from FIs 800
Total ASSETS 1000 Total LIABILITY 1000
In summary :
The Balance-sheet is equilibrated as of today (1st Jan 2006)

The Bank has 200 of capital & 800 of borrowing placed in retail customers
loans (commercial portfolio)
16!

2011 in Istanbul

As of 1st Jan 2006 the balance-sheet has the following shape:
1 Trim. 2 Trim. 3 Trim. 4 Trim. Year N +1
ASSET
- Loans to customers 1000 1000 1000 1000 1000
LIABILITY
- Capital 200 200 200 200 200
- Money Market 800 800 0 0 0
Liquidity Gap
0 0 -800 -800 +200
(stock)
onvention :
Gap (+) : Excess of liquidity
Gap (-) : Need for liquidity
17!
02 ALM risk:
computation of the interest rate margin (IRM)
The interest rate margin is equal to interest received and
interest paid
ASSET
- Loans to customers ¼ x 7% x 1000 17.5 17.5 17.5 -

= 17.5
LIABILITY
0 0 0 0 -
- Capital
¼ x 6% x 800 -12 0 0 -
- Money Market
= -12
Marging before financing

5.5 5.5 17.5 17.5 -
Important :
The margin before financing is giving the wrong picture…we need to
equlibrate the balance-sheet starting from the 3rd trimester
18!

2011 in Istanbul
02 ALM risk:
Let’s suppose interest rate will stay stable over 1 year from now
ASSET

= 17.5
LIABILITY
- Capital 0 0 0 0 -
- Money Market -12 -12 0 0 -
- Refinancing 0 0 - ¼ x 5% x 800 -10
=-10
Margin aafter refinancing
5.5 5.5 7.5 7.5 -
Important :
The computation of the margin after refinancing is giving better picture
19!
02 ALM risk:
Let’s suppose now that MM Rate of ▲ r over 1 year

ASSET

= 17.5
LIABILITY
- Capital 0 0 0 0 -
- Money Market -12 -12 0 0 -
- Refinancing 0 0 - ¼ x (5% + ▲r) x 800 10 -200x ▲r -
=-10 -200x ▲r
Margin after refinancing
5.5 5.5 7.5 -200 x ▲r 7.5 -200 x ▲r -
20!

2011 in Istanbul
02 ALM risk:
there are possbilities for hedging with derivative products
We can eliminate the risk of volatility of the Margin using derivative products
We can eliminate these risks by putting in place :
ð Swap contract with a notional amount of 200

ð Forward Rate agreement (FRA) :
- Nominal 800; maturity 3rd trimester

This FRA will generate unique cash flows on the 3rd trimester :
¼ x 800 x (r – 5.5%)
- Nominal 800; maturity 4th trimester

This FRA will generate unique cash flows on the 3rd trimester
¼ x 800 x (r – 6%)
Let’s suppose that forward rate are equal to 5.5% and 6% respectively for 3rd
trimester and 4th maturity based on the yield curve
21!
t
Asset & Liability Management in the Islamic bank!
Part 2:
The Islamic bank & the techniques to manage the balance-sheet
22!
22

2011 in Istanbul
01 The principle of banking is the intermediation of risks on different

maturities: can we say that Islamic bank is doing the doing the
intermediation of risks as well?
Banking is about intermediation of short-term risks
Linkages with other balance sheets

Linkages with other balance sheets
Depositors
Asset side
risks
BANK CAPITAL
Counter-
Funding
parties
side risks
Contingent claims 23!
01 The balance-sheet ou ALM risks existent even in the islamic bank
1. Depositors: May withdraw;
2. Banks: Tend to accumulate assets to maximize return on

equity;
3. Counter-parties: May default;
4. Regulators: Seek banking soundness;
5. Other companies and households within the interlinked

balance sheets, have contingent claims on each other and
6. Public/tax payers: Faces the cost of deposit protection and

financial crisis.
24!

2011 in Istanbul
01
The Islamic Bank : The resources
Identification of resources of funds (1/2)
ISLAMIC BANKS TRADITIONAL BANKS

Tier – 1 Capital (equity) Tier – 1 Capital (equity)
Tier – 2 Capital (?) Tier – 2 Capital (Subordinated
loans)
Current accounts Current accounts
Saving accounts Interest-based Saving accounts
Unrestricted Profit Sharing Time & certificates of deposits

Investment Accounts (PSIAs)
Profit equalization reserves Reserves
(PER)
Investment risk reserve (IRR)
25!
01
The Islamic Bank : The resources
Identification of resources of funds (2/2)
ISLAMIC BANK TRADITIONAL BANK

Current accounts Current accounts
Banks in both cases use shareholders’ equity to protect
these deposits
Profit sharing investment Time deposits, certificates
accounts (PSIA) of deposits, etc – fixed
Shareholders’ equity protects income liabilities
these liabilities only in case of Shareholders’ equity and
fiduciary risks (theory); Profit subordinated loans
Equalization Reserve (PER) & protect these liabilities
Investment Risk Reserve (IRR) against all risks
Cost of funds: Variable Cost of funds: Fixed
26!

2011 in Istanbul
01
The Islamic Bank : The allocation of funds
Identification of the usage of funds/resources
Uses of Funds
ISLAMIC BANKS TRADITIONAL BANKS
Cash & balances with other Cash & balances with other
banks banks
Sales Receivables Loans
(Murabaha, Salam, Istisna’a) Mortgages
Investment securities Financial leases
Musharaka financing Investment in real estate
Mudaraba financing Securities
Investment in real estate
Investment in leased asset
Inventories (including goods
for Murabaha)
27!
01
The Islamic bank :
investment A/Cs…innovation but complexity and very specific
Risks of PSIA financed assets
Risks Risk Mitigation

Displaced commercial Profit equalization
risk (withdrawal risk) reserve (PER) from
shareholders’
contributions
Fiduciary risk Capital (%?)
Commercial loss PSIA-holder,
Investment risk reserve
(IRR) from PSIA-
holders’ contribution
28!

2011 in Istanbul
01
The Islamic bank :
investment A/Cs…innovation but complexity and very specific
Unique systemic risks
• Risk transmission between current accounts

and investment accounts (between Qard and
Qirad)
• Income mixing between Shari’ah compliant
and non-complaint sources
Need for separate capital as

firewall
29!
02
The Islamic Bank : very specific area…specific way to manage the
balance-sheet and the ALM risk
Financial risk factors
• Credit risk
– Default risk
– Down grade risk
– Counter party risk
– Settlement risk
• Market risk
– Price risk
– Rate of return risk (Risque ALM similaire a celui de la banque conventionnelle)
– Exchange rate risk
• Liquidity risk
– Funding liquidity risk
– Asset liquidity risk
– Cash management risk
30!

2011 in Istanbul
02
Business risk factors
• Management Risk
– Planning
– Organization
– Reporting
– Monitoring
• Strategic Risk
– Research and development
– Product design
– Market dynamics
– Economic
– Reputation
31!
02
Operational risk factors
• People risk • External risk

– Relationships – Event
– Ethics – Client
– Processes risk – Security
• Legal risk – Supervisory
– Compliance – Systems
– Control • Equity
• System risk investment
– Hardware risk?
– Software
– Models
– ICT
32!

2011 in Istanbul
02
Islamic modes of finance:

Unique risk factors
• Liquidity originated market risk
• Transformation of credit risk to market risk and
market risk to credit risk at various stages of a
contract
• Bundling of credit risk and market risk
• Market risk arising from owning the underlying non-
financial asset until maturity of a contract or until the
ownership is transferred to customer
• Treatment of default
33!
02
Unique balance sheet features of IBs

from market risk perspective …(1/2)
• In traditional banks, market risk is mostly in the

trading book
• In Islamic banks, market risk is concentrated in the
banking book due to Murabahah, Ijara, Salam,
Musharakah and Mudharabah in the banking book
asset portfolio
• Hence it is unique for Islamic banks that market
risk and credit risk are strongly bundled together
34!

2011 in Istanbul
02
Unique balance sheet features of IBs

from market risk perspective …… (2/2)
These are not re-price-

Liabilities Assets
These are re-price-
Capital 10 Murabahah 70
Istisna 10
PSIAs 50 Ijarah 10
Current 40 Salam 4
accounts Musharakah 3
able
able
Mudharabah 3
Total 100 100
35!
02
Assumption: 1 % increase in
benchmark price
IB 1 IB 2 IB 3
L A L A L A
Re-price-able 10 10 10 4 5 5
Non-re-price- 0 0 0 6 5 5
able
Balance Sheet .10 .10 .10 -.02 0 0
value change
Asset value 0 -.12 ? 0
change ? ?
36!

2011 in Istanbul
02
Unique credit risk features of IBs ….(1/2)
• Treatment of default: In Islam, compensation-based

restructuring of credit is the most well known form of
Riba, namely, Riba Al Jahiliyah – this highly
necessitates credit risk management
• Moral issues in loan loss reserves
• Collateral quality (restrictions on use of sovereign
bonds)
• Insurance – clients’ insurance and facilities
insurance
• Diverse modes and bundled risks
37!
02
Unique credit risks of IBs…. (2/2)
• Mudharabah / Musharakah
– Default event undefined
– Collateral not allowed
• Salam / Istisna’
– Counterparty performance risk
– Separation of market risk from default risk difficult
– Catastrophic risk high
• Murabahah
– Baseline default risk, but counterparty risk due to
embedded option (Murabahah, binding non-binding
matter) also exists
• Conglomeration of risks – each mode having various
risks, credit, liquidity, market, reputation,
38!

2011 in Istanbul
02
Islamic banks’ risks: Unique versus shared with traditional banks
100
90
80
70
60
50
unique 40
30
20
shared 10
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39!
The liquidity management: the real challenge…no much alternatives!

!
40!
40

2011 in Istanbul

!
41!
41

!
42!
42

2011 in Istanbul

!
43!
43
The Islamic Bank : Can we apply the same ALM techniques?!

!
ü Difficult to apply the ALM techniques….but it is feasible…

need research and innovations
üCertain banks ovoid ALM risks
ü That’s way certain islamic banks are avoiding certain

activities
üThe banks have very simple balance-sheets…

ü…the islamic banks have a lot of resources not used…waiting
for allocation
44!
44

2011 in Istanbul
Seminar
« Asset & liability Management in the Islamic Banks»
July 2011
contact: for questions
Majdi Chaabouni
majdi.chaabouni@amanah-consulting.com
45!


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Durham Islamic Autmun Summer School,

Asset & Liability Management :

Presented at the

Majdi Chaabouni: Biography and conferences participation 2011 !

Majdi Chaabouni- The Risk Exposure of

Objectives of the Seminar

10 minutes – 5 July 2011

10 minutes – 5 July 2011

10 minutes - 5 July 2011

5. Conclusion on the indicators and measurement techniques to be used by Islamic

10 minutes – 5 July 2011

Majdi Chaabouni- The Risk Exposure of

01 Liquidity risk: let’s suppose a bank has the following structure…

01 Liquidity risk: let’s suppose a bank has the following structure…

Majdi Chaabouni- The Risk Exposure of

01 Liquidity risk: Liquidity GAP as a measure of the risk

GAP (T) = Liability (T) – Asset (T)

- If GAP >0 à more resources than a need for financing

01 Interest rate risk: Interest rate GAP as a measure of the risk

Illustrative example to clarify the ideas

What is the Liquidity Gap?

Majdi Chaabouni- The Risk Exposure of

01 Interest rate risk: Interest rate GAP as a measure of the risk

01 Interest rate risk: Interest rate GAP as a measure of the risk

Illustrative example to clarify the ideas

What is the Liquidity Gap?

Majdi Chaabouni- The Risk Exposure of

01 Interest rate risk: Interest rate GAP as a measure of the risk

01 Interest rate risk: Interest rate GAP as a measure of the risk

We can say that the Interest rate GAOP is equal to:

à Indeed : Variable rate ⎝ there is no extrac-cost for financing

Majdi Chaabouni- The Risk Exposure of

01 Let’s take an example to illustrate the ALM (Balance-sheet )

Cost for establishment 500,000 Capital 10,000,000

Mortgage Loans 10,000,000

Mortgage Loans 5,000,000 Bond issue 5,000,000

Mortgage Loans 15,000,000 Loan from FIs 15,000,000

Mortgage Loans 15,000,000 Loan from FIs 15,000,000

01 Let’s take an example to illustrate the ALM (Balance-sheet )

Cost for establishment

Mortgage Loans 5,000,000 Bond issue 5,000,000

Mortgage Loans 15,000,000 Loan from FIs 15,000,000

Le Profit is volatile…& exposed to interest rate risk!

Mortgage Loans 15,000,000 Loan from FIs 15,000,000

Majdi Chaabouni- The Risk Exposure of

02 The ALM (balance-sheet) risk

Let’s consider the following balance-sheet as of 1st January 2006 :

• borrowing from the money market :

02 The ALM (balance-sheet) risk

As of 1st Jan 2006 the balance-sheet has the following shape:

Loans 1000 Capital 200

Borrowing from FIs 800

Total ASSETS 1000 Total LIABILITY 1000

The Balance-sheet is equilibrated as of today (1st Jan 2006)

Majdi Chaabouni- The Risk Exposure of

02 The ALM (balance-sheet) risk

As of 1st Jan 2006 the balance-sheet has the following shape:

1 Trim. 2 Trim. 3 Trim. 4 Trim. Year N +1

- Loans to customers 1000 1000 1000 1000 1000

- Capital 200 200 200 200 200

- Money Market 800 800 0 0 0

- Loans to customers ¼ x 7% x 1000 17.5 17.5 17.5 -

Marging before financing

Asset & Liability Management

Asset & Liability Management