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Islamic Financing Management

BWFS 2053

CHAPTER 8

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CHAPTER 8
The Financing Risk
Chapter outline
8.1 Introduction
8.2 Overview the concept of risk from Islamic and
Conventional Perspectives
8.3 Definition and concepts of financing risks
8.4 Types of financing risk
-Credit risk
-Market risk
-Operational risk
-Liquidity risk
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8.1 INTRODUCTION

Dealing with a financing risks is an integral part of


banking business. As financial intermediaries, banks are
pivotal in leveraging out funds from depositors to generate
returns from mobilization of assets to borrowers and
investors.
Financial assets such as loans, overdraft and advances
are form of financing offered by banks to borrowers.
From the time of a loan application to the time of the loan
settlement, the lending bank is prone to various risks.
It is therefore, imperative for banks and related parties to
recognize financing risk and how to manage them.

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Hence, financing risks need a special focus. With
the integration of global financial markets, one
ought to recognize that risk associated with bank
financing originate from two sources. There are
from internal and external factors.
Internal factors are factors associated with the
banks internal factors such as Non-Performing
Loans (NPL), loan concentration, leverage and
others.
External factors are factors outside the control of a
bank such as economic performance Gross
Domestic Product (GDP), money supply and
consumer price index.

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8.2 THE CONCEPT OF RISK FROM ISLAMIC
AND CONVENTIONAL PERSPECTIVES
Definition of risk
In finance and banking, risk is defined as the
likelihood that we would receive return on an
investment that is different then what we had
expected.
The risks associated with Islamic Banking
institutions refer to the probable reductions in their
value due to changes in the business environment.
Risk refers to probable loss of income and asset
value.

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CONCEPT OF RISK FROM CONVENTIONAL
PERSPECTIVES
Conventional risk have the structure and means for
risk management and control that enable them to
choose a suitable level of risk that the owners of
the banks are willing to bear.
Their operations are based on the rule that risk and
time are like goods that are bought and sold. There
are markets where it is possible to trade them
freely.
The main essence about risk is the uncertainties of
an outcome.

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Investors are divided into 3 distinct categories
according to their risk tolerance levels.

Type of
investors

Risk- Risk Risk


Averse Neutral Seekers

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In conventional finance, the fundamental failure of
the moral sphere is a real issue. Consumers were
receiving mortgages they cannot afford, which in
Islam is unethical.
For the sellers of financial products, greed is a
moral issue and is a root cause of the actions
contributing to the financial meltdown.

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CONCEPT OF RISK ISLAMIC FROM PERSPECTIVES

Islamic finance is one of the most rapidly growing


segments of the global financial system importance
of Islamic finance, particularly in developing
economies in the Middle East and South-East Asia,
religious and social complexity has acted against a
fuller understanding by regulators, policymakers,
researchers and risk taking mitigates many
concerns.
Some also view the integration of ethics and values
into finance as a positive development on Shariah-
compliant finance to be more resilient to global
economic

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The term risk in Islam is Gharar (Arabic language).
It is referred to the risk or probability. This term
means risk, hazard and perils.
An Islamic finance term describing a risky or
hazardous sale, where details concerning the sale
item are unknown or uncertain.
Gharar is generally prohibited under Islam, which
explicitly forbids trades that are considered to have
excessive risk due to uncertainty.
There are strict rules in Islamic finance against
transactions that are highly uncertain or may cause
any injustice or deceit against any of the parties.

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All businesses involves some level of risk, therefore
unlike riba, gharar is a relative concept when it
comes to uncertainty, risk and hazard, with a
certain level of uncertainty being tolerated.
However, when it comes to deceit or fraud, gharar
is an absolute concept.
Then, if contains elements of gharar that will cause
the contract to be void.
Islamic finance does focus on demand side issues
as well as the supply side. This can include for
instance, promoting responsibility among
consumers, promoting accountability, providing
guidelines on the take up, use and payment of
debt, and providing warnings to the dangers of
excess.
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8.3 CONCEPT OF FINANCING RISK
Risk are uncertain future events that could
influence the achievement of Banks objectives
including strategic, operational, financial and
compliance objectives.

Uncertain future events could be :


Failure of a borrower to repay a financing.
Fluctuation of foreign exchanges rate.
Fraud, incomplete security documentations.
Non- compliance with shariah law and principles.
Other events that may result in a loss to the bank.

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Financing Risk

Financing risk is associated with bank giving financing to


their customers
Financing risk occurs when financial institutions take a large
number of bad loans
Risk may occur when substantial portions of such a loan
portfolio decline in value in the market, which could
subsequently lead to losses, deposit withdrawals by
depositors and ultimately, the closure of the institutions by
regulators

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Financing risk cannot be eliminated because they
are inherent in the banking business.
There are two components of risks

Risk

Non-
Systematic
systematic
risk
risk

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Systematic risk
- Known as market risk.
- Cannot be diversified or mitigated

Non-systematic risk
- Referred to as firm-specific risk.
- Can be diversified or reduced

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8.4 TYPES OF FINANCING RISK

Types of
Financing
Risk

Market Liquidity Operational


Credit risk
Risk Risk Risk

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CREDIT RISK
Credit risk is defined as the probability of the borrower
unable or default to make payment on his loan.
So it leads to a loss for the creditor and, therefore,
becomes a risk for the bank.
The loss may be complete or can arise in a number of
circumstances :
- Consumer fail to make payment due on a
mortgage loan, credit card, personal loan.
- A business or government bond issuer does not
make a payment on a coupon or principal
payment when due.
- An insolvent bank wont return funds to a
depositor
- A government grants bankruptcy protection to an
insolvent consumer or business
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Solution to Reduce Credit Risk

Bankers are aware that not all loans will be paid on


time, so they already set provision for loan loss.
If the losses in interest income are greater than
Loan Loss Provision, the excess amount of the
losses is deducted from the banks reserves.
Should the reserves be inadequate to cover the
losses, the bank might face bankruptcy unless
there is a fresh injection of capital.
Besides, the lender may perform a credit check on
the prospective borrower, may require the borrower
to take out appropriate insurance such as mortgage
insurance or seek security or guarantees of third
parties.
.
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CREDIT RISK FROM ISLAMIC PERSPECTIVES

Islamic banks also face this form of risk in most of


the modes of financing that they use such as
Murabahah, Istisna and installment sale are sales
with delayed payment thus generating debts in the
accounts of the banks.
Salam gives rise to a commodity debt rather than a
cash debt, but it also involves credit risk.

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Mudarabah and Musyarakah, these two also bear a
credit risk in two ways.
1. In the case of tort or negligence, the entrepreneur
is liable to guarantee the capital which means a
debt liability.
2. When the capital of Mudarabah or Musyarakah are
employed in a deferred sale, which is what takes
place in most Mudarabah, the owner of capital
(Rabb al-mal), the bank in this case, bears an
indirect credit risk.
This risk pertains to the ability of the counter parties
to repay.

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MARKET RISK
Market risk is the risk of losses in positions arising
from movements in market prices.
Also referred to as systematic risk.
Market risk is the fluctuation of returns caused by
the macroeconomic factors that affect all risky
assets.

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It also can be thought of as the opportunity cost of
putting money at risk.
Some market risks include the potential impact of
adverse price movements such as:
- Benchmark rates
- Foreign exchange rates
- Equity prices on the economic value of an
asset
- Commodity prices example crude oil, copper

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MARKET RISK FROM ISLAMIC PERSPECTIVES
But even generic risks (including market risk) are not
that straightforward in Islamic banking
For financing that involves financing assets e.g.
Murabahah, Salam, Istisna and Ijarah, the risks of
financing may transform from credit to market and vice
versa at different stages of the contract
Many Islamic Bank use external benchmarks such as
the LIBOR to price markup in Murabahah contract, in
part reflecting the lack of reliable domestic benchmark
rate of return.
If domestic monetary conditions change, requiring
adjustment in the returns on deposits and loans, but the
margin between external benchmark and domestic rate
of return shifts, there could be impact on assets return.
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LIQUIDITY RISK
In finance, liquidity risk is the risk that given security or
asset cannot be traded quickly enough in the market to
prevent a loss (or make the required profit).
Liquidity risk is the current and prospective risk to
earnings or capital arising from a banks inability to meet
its obligations or to fund increases in assets when they
come due without incurring unacceptable costs or
losses.
Liquidity risk includes the inability to manage unplanned
decreases or changes in funding sources.
It is also arises from the failure to recognize or address
changes in market conditions that affect the ability to
liquidate assets quickly and with minimal loss in value.

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LIQUIDITY RISK FROM ISLAMIC PERSPECTIVES

Sources of liquidity risk


Islamic banks cannot borrow funds from the
conventional money market to meet liquidity
requirements.
Malaysias Experience :
a) Establishment of an Islamic money market
helps to cater for Islamic Bank liquidity needs.
b) An Islamic bank can apply for Mudharabah
inter- bank investments either for an overnight
investment one-day or 3 month or other time
periods not greater than 12 month.
c) The returns on investment are shared between
the Islamic bank and the fund provider in a
profit and loss sharing basis. 25
OPERATIONAL RISK
The potential loss resulting from inadequate or
failed internal processes, people and system or
external events.
Operational risk are the possible negative
outcomes due to the bank inefficiency in controlling
their direct cost and staff processing errors.
Bank have to face the possibility that operating
expenses might vary significantly from the
budgeted amount causing a decrease in net
income and firm value.

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Operational risk also arise due to failure in
governance, business strategies and processes.

Other than, the negative from publicity about the


Islamic banks business practices, particularly
relating to Shariah non compliance in their products
and services, could have an impact upon their
market position, profitability and liquidity.

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OPERATIONAL RISK FROM ISLAMIC
PERSPECTIVES
Sources of operational risk
Lack of experienced staff conversant in both the
Shariah and banking operation.

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