Islamic Finance (The Regulatory Challenge) || Risk Characteristics of Islamic Products: Implications for Risk Measurement and Supervision

CHAPTER 3Risk Characteristics of Islamic Products:Implications for Risk Measurement and

Supervision

Dr. V. Sundararajan∗

1. I N T R O D U C T I O N

T his chapter discusses risk characteristics of various Islamic financeproducts and key issues in the measurement and control of risks

in Islamic financial services institutions. In particular, the chapterhighlights the role of risk sharing in Islamic finance, and the impli-cations of profit-sharing investment accounts (PSIA, or ‘‘investmentaccounts’’) for risk measurement, risk management, capital adequacy,and supervision. Empirical evidence suggests that the sharing of riskswith PSIA is fairly limited in practice, although, in principle, well-designed risk (and return) sharing arrangements with PSIA can serveas a powerful risk mitigant in Islamic finance. Supervisory authoritiescan provide strong incentives for effective and transparent risk shar-ing; and the associated product innovations. The scope of supervisoryintervention and a value-at-risk (VaR) methodology for measuringthese risks are discussed.

A key principle underlying the design of Islamic financial productsand services is the notion that mutual risk sharing (for example,between banks and entrepreneurs, or between banks and depositors)is a viable alternative to interest-based financing, which is prohib-ited in Islamic finance. Islamic financial products and institutions

40

Islamic Finance: The Regulatory ChallengeEdited by Simon Archer and Rifaat Ahmed Abdel Karim

Copyright © 2007 John Wiley & Sons (Asia) Pte. Ltd.

Risk Characteristics of Islamic Products 41

offering Islamic financial services (IIFS) face a unique mix of risksand risk-sharing arrangements that arise from the contractual designof instruments based on Shari’ah principles, and the overall legal,governance, and liquidity infrastructure governing Islamic finance.

Effective risk management, however, requires appropriate riskmeasurement that recognizes the specific mix of risk factors in Islamicfinancial contracts and the extent of risk sharing embedded in thecontracts. The issues of risk measurement and disclosure are centralto adapting the New Basel Capital Accord – International Conver-gence of Capital Measurement and Capital Standards: A RevisedFramework (Basel II) – for both conventional and Islamic banks. Riskmeasurement is also crucial to an effective disclosure regime that canharness market forces to reinforce official supervision.

The purpose of this chapter is to review the risk characteris-tics – defined as the type and mix of risks and the arrangements toshare risks – of Islamic products and the related issues in the mea-surement of risks in IIFS. In particular, the chapter analyzes theimplications of profit-sharing investment accounts for risk measure-ment, risk management, capital adequacy, and supervision. Islamicbanks in most countries offer two types of PSIAs: restricted andunrestricted, normally based on a mudarabah contract. The bank asmudarib is entitled to a pre-specified percentage share of the profitsfrom the investment as a fee for fund management, but does notshare in a loss except by not receiving any fee. There is thus, inprinciple, a considerable degree of risk sharing between the bank andthe investment account holders (IAHs) with respect to the assets inwhich the PSIA are invested.

The restricted investment accounts are a type of collective invest-ment scheme in which the bank as mudarib invests the funds of theIAH according to a restricted mandate that limits the asset alloca-tion to a pre-specified category of assets. The unrestricted investmentaccounts are designed as a Shari’ah-compliant alternative to conven-tional interest-bearing deposit accounts; the IAH funds are invested atthe bank’s unrestricted discretion and are normally commingled forinvestment purposes with other funds such as the bank’s own capitaland current accounts. (The latter are a liability of the bank and donot share in profits.)

Available empirical evidence shows that in practice, because theproduct is intended to provide a Shari’ah-compliant alternative toconventional deposits, there is considerable smoothing of the profitspaid out to unrestricted IAHs, and correspondingly reduced sharing of

42 Islamic Finance: The Regulatory Challenge

risk between the bank and the holders of such investment accounts,with banks in fact bearing the majority of the risk despite widedivergences in risk. The extent of this de facto departure from therisk-sharing principle for unrestricted IAHs (referred to as displacedcommercial risk, or DCR, following AAOIFI, 1999) varies betweencountries; in some countries, banks are expected – though not legallybound1 – to bear virtually all of the asset risk, while in others itis simply a matter of competitive pressure. References to IAHs,investment accounts, or PSIA in the remainder of this chapter shouldbe understood as being to unrestricted IAHs.2

This chapter proposes a specific approach to the issue of DCRby measuring the actual sharing of risks between shareholders andIAHs, based on value-at-risk methodology. The main conclusions ofthe chapter are as follows:

1. Appropriate management of PSIA, with proper measurement,control, and disclosure of the extent of risk sharing with IAHs,can be a powerful risk mitigant in Islamic finance.

2. Supervisory authorities can provide strong incentives foreffective overall risk management, and transparent risk shar-ing with PSIA, by (a) linking the treatment for capital ade-quacy purposes of the share of assets on the bank’s balancesheet that is financed by PSIA to a supervisory review ofbank policies for risk sharing; and (b) mandating the disclo-sure of risks borne by PSIA and of the DCR borne by theshareholders, as part of the requirements for deciding theamount of any capital charge to be applied to this shareof assets – that is, the fraction of the PSIA share of risk-weighted assets that could be excluded from the denominatorof the bank’s capital adequacy ratio (CAR). The evolv-ing standards for capital adequacy, supervisory review, andtransparency and market discipline are consistent with theseproposals.

Several key conclusions and policy messages can be highlighted at theoutset.

• Effective risk management in IIFS (and a risk-focused supervi-sory review process) requires that a high priority be given toproper measurement and disclosure of:


• aggregate banking risks (to reflect the volatility ofmudarabah profits accruing to IAHs)

• specific types of risks (to control effectively the extent ofcredit, market, operational, and liquidity risks)

• facility-specific risks (to properly price individual facilitiesby measuring the full range of risks embedded in eachfacility).

• The unique mix of risks in Islamic finance and the potential roleof IAHs in sharing some of the risks call for a strong emphasison proper risk measurement, and disclosure of both risks andrisk management processes in IIFS.

• Progress in risk measurement, disclosure, and risk managementwill, however, require a multi-pronged effort:• to strengthen accounting standards and harmonize them

with prudential standards• to initiate a systematic data compilation process to enable

proper risk measurement, including through developing cen-tral credit and equity registries suitable for Islamic finance

• to build a robust governance and creditor/investor rightsinfrastructure that would foster Islamic money and capi-tal markets – based on innovative uses of asset securitiza-tion – as a foundation for effective on-balance sheet riskmanagement, including through transparent apportioningof risks to IAHs

• to foster this transformation of investment accounts intoan effective component of risk management (in addition tocollateral and guarantees) through product innovations sup-ported by proper disclosure and reserving policies that maketransparent the extent of risk being borne by the investmentaccounts, and the risk–return mix being offered

• to provide supervisory incentives for effective risk sharingwith PSIA, by linking the capital adequacy treatment ofPSIA to the extent of actual risks shared with PSIA, andby requiring adequate disclosure of these risks as a basisfor ‘‘capital relief’’ (that is, the exclusion of part or all ofrisk-weighted PSIA-financed assets from the denominator ofthe CAR).

All this will set the stage for the eventual adoption of moreadvanced capital measurement approaches envisaged in Basel II and


their adaptations for Islamic finance as outlined in the relevant IslamicFinancial Services Board (IFSB) standards. The chapter highlightssome of the measurement issues arising from the unique risk char-acteristics of Islamic finance contracts and policy considerations inpromoting effective risk sharing between owners and investmentaccounts holders. A VaR methodology for measuring and monitoringsuch risk sharing is proposed.

2. B A C K G R O U N D

Recent work on risk issues in Islamic finance has stressed that featuresof IIFS, and the intermediation models that they follow, entail spe-cial risks that need to be recognized to help make risk managementin Islamic banking truly effective. Karim (1996) and Hassan (2000)have noted that the traditional approach to capital adequacy andsupervision based on the 1988 Basel Capital Accord – Basel I – didnot adequately capture the varied risks in Islamic finance facilities.In a similar vein, recent studies in the Islamic Development Bankdiscuss the special risks in IIFS (Chapra and Khan, 2000; Khan andAhmed, 2001). These studies survey the risk management practicesof IIFS, and note that Basel II provides scope for proper recognitionof risks in Islamic banking products – through a more risk-sensitivesystem for risk weighting of assets and stronger incentives for effec-tive risk management. These studies also highlight a set of issuesin Islamic jurisprudence (‘‘fiqh’’ issues) that need to be resolved tofacilitate effective supervision and risk management. Implicationsof risk sharing with PSIA for the governance, financial reporting,and capital adequacy of Islamic banks are discussed in Al-Deehani,Karim, and Murinde (1999) and Archer and Karim (2002, 2004).A recent World Bank study (El-Hawary et al., 2004) considered theappropriate balance of prudential supervision and market disciplinein Islamic finance, and the related implications for the organizationof the industry. In parallel, recent studies from the InternationalMonetary Fund focus on the financial stability implications of Islamicbanks (Sundararajan and Errico, 2002; Marston and Sundararajan,2003; Sundararajan, 2004). These studies also stress the importanceof disclosure and market discipline in Islamic finance (see also Archerand Karim, 2005); they also note that in addition to the unique mixof risks, for a range of risks, Islamic banks may be more vulnerablethan their conventional counterparts, owing in part to the inadequate


financial infrastructure for Islamic banks, including missing instru-ments and markets, and a weak insolvency and creditor rights regime,factors that limit effective risk mitigation.

Therefore, systemic stability in financial systems with Islamic banksrequires a multi-pronged strategy to bring about:

• a suitable regulation and disclosure framework for IIFS• a robust financial system infrastructure and adequate macro-

prudential surveillance in order to provide the preconditionsfor effective supervision and risk management

• strengthened internal controls and risk management processeswithin IIFS.

Accordingly, a comprehensive risk-based supervision framework isneeded for IIFS, supported by a clear strategy to build up risk manage-ment processes at the level of the individual institutions, and robustlegal, governance, and market infrastructure at the national andglobal levels. In recognition of this need, the international communityhas established the Islamic Financial Services Board, headquarteredin Kuala Lumpur, Malaysia, to foster good regulatory and supervi-sory practices, help to develop uniform prudential standards, and tosupport good practices in risk management.3

The IFSB has advanced the work on the capital adequacy frame-work and risk management in IIFS, through the issuance of standardson these topics in December 2005 (see IFSB, 2005a, 2005b). Inaddition, work is under way (in various IFSB working groups andtask forces) on corporate governance standards (the subject of anExposure Draft issued in January 2006), on disclosure standards topromote transparency and market discipline, on standards for thesupervisory review process, and on additional guidelines for the pru-dential and legal framework for Islamic banks. Recent discussionscoordinated by the IFSB and the Islamic Development Bank haveagain reinforced the importance of building a robust financial infras-tructure for Islamic finance – which constitutes the precondition – tosupport the sound functioning and effective supervision of Islamicbanks.4

In particular, the effective supervision of Islamic banks requiresthat the three-pillar framework of Basel II and the language ofrisks it introduces be adapted appropriately to their operationalcharacteristics. Key issues in the measurement and monitoring of


specific risks and risk sharing in Islamic finance are first reviewedbefore considering policy implications.

3. T Y P E S O F R I S K S I N I S L A M I C F I N A N C EA N D T H E I R M E A S U R E M E N T

A key feature of IIFS is the potential sharing of risks betweenIAHs who provide funds on a mudarabah basis, and the IIFS whichinvests these funds (often commingled with shareholders’ and otherfunds) in various Islamic finance contracts that include murabahah,salam, mudarabah, musharakah, ijarah, istisna’a, and other Shari’ah-compatible financing arrangements, including sukuk. This sectionreviews the overall risks facing IIFS in light of its financing activitieson the asset side, modalities of sharing these risks with fund providers,and the types of risks embedded in individual Islamic finance contractson the asset side of IIFS.

3.1. Mudarabah RiskThe way risks are shared between IAHs who invest on a mudarabahbasis, and the bank as a mudarib, plays a crucial role in Islamic finance.The share of unrestricted investment accounts in the total depositsof Islamic banks varies considerably, from near zero (holding onlydemand and savings deposits) to over 80% in some banks (Exhibit3.1). The implications of such PSIA for risk measurement, disclosures,and bank governance generally have been the topic of several studies(see Clode, 2002; AAOIFI, 1999; Archer and Karim, 2006). In thissection, we will highlight specific risk measurement issues that need tobe addressed in monitoring the risk–return tradeoff in PSIA. The focusis on the financial risks faced by the unrestricted investment accounts;for restricted investment accounts, the risks for banks and depositorsare those attributable to the specific assets to which the investmentaccount returns are linked, and the risk measurement issues discussedin this chapter can be readily applied to the relevant asset portfolio.Both restricted and unrestricted IAHs also face fiduciary risks – risksof negligence and misconduct – reflected in the quality of internalcontrols, corporate governance, and risk management processes ofthe IIFS acting as mudarib.

In its most general form, risk is uncertainty associated with afuture outcome or event. To an IAH in an Islamic bank, the risk isthe expected variance in the measure of profit distributions where


EXHIBIT 3.1 Disclosure practices of Islamic banks

Items of disclosure Comments

Risk managementframework andpractices

Disclosures are presented at a very general level andoccasionally mention the existence of specificcommittees, such as the ALM committee.

Classification offacilities by assetquality, and data onnon-performing loans

All banks disclose classification of facilities by supervisorycategories such as current, sub-standard, etc. Only somebanks (30%) disclose non-performing loans. Only onebank mentioned the use of an internal rating system.

Specific provisions Most banks (94%) disclose this as a total. Provisions as apercentage of assets varied from less than 1% to 6%.Only some banks (30%) disclose provisions classified byfacilities.

Sectoral distribution ofcredit and connectedexposures

Many banks (66%) disclose this.

Large exposures Very few banks (6%) disclose this.

Capital adequacy All banks disclose capital asset ratios – ranging from 2.5%to 38.4%, while many (66%) disclose regulatory capitalto risk-weighted assets.

Value-at-risk None disclose this; one bank reported using VAR.

Liquidity ratios All banks disclose various liquid asset ratios. Ratio ofliquid assets to short-term liabilities ranged from 13% to144%.

Maturity gap Many banks (64%) disclose gaps at various maturitybuckets.

Deposit composition:Share of investmentdeposits to totaldeposits

Generally disclosed, ranging from 0% to 95%, andaveraging 80%, with some banks (36%) reporting noinvestment deposits.

Composition offacilities: Share ofequity-type assets tototal assets

Generally disclosed. Share of equity varied from less than1% to about 23%, with a significant year-to-year changein some banks.

Return on assets Generally disclosed; large variation from 0.5% to 4.3%.

Return on equity Generally disclosed; large variation from 0.7% to 58%.

Return on unrestrictedinvestment deposits

All banks disclose this, with returns ranging from 1.45%to 16.35%, depending on country and bank.

Commodity inventories Only some banks (30%) disclose this.

Return on restrictedinvestment deposits

Very few (only one bank in the sample) disclose this.

Profit equalizationreserves

Some banks (30%) disclose this.

Net open position inforeign exchange

Many banks (66%) disclose this; the ratio as a percentageof capital varied from 0% to 100%.

Foreign currencyliabilities to totalliabilities

Many banks (66%) disclose this; the ratio varied from 0%to 100%.


EXHIBIT 3.1 (continued)

Items of disclosure Comments

Net position in equitiesto capital

Generally disclosed, with the ratio ranging from 0% to4%.

Gross income to assets All banks disclose this; it varies from 1% to 8%.Personnel expenses to

total assetsAll banks disclose this; it varies from 30% to 65%.

Operational expenses tototal assets

All banks disclose this; it varies from less than 1% to 5%.

Source: Based on annual reports of 15 sample banks covering the years 2002 and 2003. Percentages ofsample banks that disclose a particular item are shown in parentheses.

the profit is shared between the IAH and the bank. This variancecould arise from a variety of both systemic and idiosyncratic (that is,bank-specific) factors. Actual risk in the investment account (that is,in the underlying investments) may be dampened in practice by the useof profit equalization reserves (PER), investment risk reserves (IRR),and by variations in the mudarib’s share. The PER is used to reduceor eliminate the variability of profit payouts on investment deposits,to redistribute income over time, and to offer returns (payouts) thatare aligned to market rates of return on conventional deposits orother benchmarks, without the need for the bank to forgo any of itsmudarib share. In addition, banks may use the IRR to redistributeover time the incomes accrued to the investment accounts so as tomaintain a payout when a periodic loss is incurred. Nevertheless, froman investor’s point of view, the true risk of mudarabah investmentin a bank can be measured by a simple profit-at-risk (PaR) measure.For example, the standard deviation of the periodic (for example,monthly or quarterly) profit payout5 as a percentage of assets, σp,provides the basis for the simplest measure of the risks of holdingan investment account after the application of the above methods of‘‘smoothing.’’ In banks that practice such smoothing, this risk willof course be lower than the risk of the underlying assets, measuredbased on the standard deviation of the unsmoothed profits. Oneissue is how important it is for IAHs to be aware of this underlyingrisk.

From a monthly time series of mudarabah profit payouts (as ashare of assets), its variance (and the standard deviation σp) canbe calculated, and, assuming normality, profit-at-risk can be calcu-lated as:

PaR = Zα σp

√T


Where, as explained in Chapter 2:

Zα = the constant that gives the appropriate one-tailedconfidence interval with a probability of 1 − α for thestandard normal distribution (e.g. Z.01 = 2.33 for a 99%confidence interval).

T = the holding period or maturity of the investment accountas a fraction of a month.

Such aggregate PaR for a bank as a whole provides a first-cutestimate of risks attaching to profit payouts in unrestricted mudarabahaccounts. Such risk calculations could also be applied to individualbusiness units within the bank (also for specific portfolios linkedto restricted IAHs). In addition, if specific risk factors that affectthe variation in mudarabah profit payouts can be identified, thismeasure σp can be decomposed further in order to estimate theimpact of individual risk factors, and this would help to refine thePaR calculation. In practice, however, profit equalization reserves andinvestment risk reserves are actively used by IIFS to smooth the returnon investment accounts. As a result, risks in investment accountsare absorbed, in part, by banks themselves, in so far as the PER isstrongly positively correlated with net return on assets (gross returnon assets minus provisions for loan losses) – that is, PER is raised orlowered when the return on assets rises or falls, and hence the profitpayout on the investment accounts is smoothed, and low or zeropayouts are avoided except in the case of a loss when recourse is hadto the IRR. Banks can also adjust their share of profits to maintainadequate returns to shareholders. As noted above, such absorption ofrisks by bank capital is referred to as ‘‘displaced commercial risk.’’The correlation between the movements on the PER and the assetreturn could, therefore, be viewed as an indicator of DCR. Thus, theprecise relationship between the risk to IAHs and the aggregate riskfor the bank as a whole arising from the variability of net returnon assets (gross return net of specific provisions) depends upon thepolicies toward profit equalization reserves, investment risk reserves,and mudarib’s share. These policies determine, in effect, the extentof risk sharing between investment accounts and bank capital. Theserelationships are discussed further in Section 4 of the chapter.

Against this background, the true risks borne by IAHs can bemade transparent by disclosing the definition of mudarabah profits,the level and variations in these profits and in profit equalization


reserves, as well as policies toward establishing PER6 that will deter-mine the variance in its movements as well as their correlationwith the asset return. At the same time, transparency of internalcontrols and governance arrangements, including risk managementprocesses, would also be important to provide assurances of integrityof IIFS as a mudarib. The measurement of such fiduciary risk couldbe subsumed under operational risk measurement, as discussed inSection 3.6 below.7

3.2. Credit Risks in Sales-based Contracts

Murabahah and other sales-based facilities (istisna’a, salam, and soon) together with lease-based facilities (ijarah) dominate the assetside of Islamic banks, ranging from 80% to 100% of total facilities.Equity-type (profit- and loss-sharing musharakah or profit-sharingand loss-bearing mudarabah) facilities still constitute a negligibleproportion of assets in most banks. Thus, credit risk in the normalsense – the risk of losses in the event of default of the borroweror in the event of a deterioration of the borrower’s repaymentcapacity8 – is the most common source of risks in an Islamic bank,as in conventional banks.9 The methods of measurement of creditrisks in conventional banks apply equally well to Islamic banks,with some allowance required to recognize the specific operationalcharacteristics and risk-sharing conventions of Islamic financial con-tracts.

Credit risk can be measured based on both the traditional approachthat assigns each counterparty into a rating class (each rating corre-sponding to a probability of default) as well as more advanced creditVaR methods discussed later in the section. The basic measurementprinciple under both these approaches is to estimate the expectedloss on an exposure (or a portfolio of exposures) owing to specifiedcredit events (default, rating downgrade, some non-performance of aspecified covenant in the contract, and so on) and also to calibrateunexpected losses (losses that exceed a specified number of standarddeviations from the mean) that might occur at some probability level.Expected losses are provisioned and regarded as an expense that isdeducted from income, while unexpected losses (up to a tolerancelevel) are backed up by capital allocation. The risk weights attachedto various exposures on the bank’s asset side (in the New Basel CapitalAccord, for example) in effect represent the bank’s or supervisor’sjudgment on the unexpected losses on the exposures that should


be absorbed by capital. The calculation of loss – both expected andunexpected – in an individual loan will require estimates of:

• probability of default (or probabilities of rating downgradesfrom one rating class to another)

• potential credit exposures at default (or at the time of ratingtransition)

• loss-given default (or reduction in the value of the asset follow-ing a rating transition).

Proper measurement of these three components of credit risk,and calculating unexpected losses, are the fundamental requirementsof the New Basel Capital Accord (Basel II). Measurement of thesecomponents for the case of sales-based contracts – murabahah andsalam – is discussed below.

The default could be defined in the same way as for conventionalbanks, based on the financial condition of the borrower and thenumber of days the contract is overdue.10 Estimation of the probabilityof default is traditionally based on ex-ante assignment of ratings tocounterparty exposures or a portfolio of exposures of a particularvariety (such as all commodity Murabahahs for a class of goods).A modern approach that can be used for larger listed companiesis based on market information on equity prices. Observed marketvalue of a firm’s equity and estimated volatility of equity prices canbe used to estimate the likelihood of default using the option pricingapproach to bankruptcy prediction.11 In practice, various methodscan be combined during the risk management process in order toarrive at a credit rating and the associated probability of defaultbased on historical experience. The estimation of probabilities – orcorrect assignment of ratings – will, however, require historical dataon loan structure and performance, borrower characteristics, andthe broader industry and macroeconomic environment; and thus theratings will change over time as financial conditions and environmentchange.

Losses will clearly depend upon the potential credit exposures at thetime of default (exposure at default, or EAD). In general, exposureat default would be facility-specific, depending upon the extent ofdiscretion that the borrower can exercise in drawing down lines ofcredit, prepaying already drawn accounts, or any specific events thataffect the value of contingent claims (for example, guarantees to thirdparties). In murabahah and salam contracts, EAD in most cases would


simply be the nominal value of the contract. In long-term ijarah andistisna’a contracts, EAD will depend upon projected environmentalfactors that will be facility-specific.

Losses will ultimately depend upon the rate of recovery followingdefault, or, in a mark-to-market model, the reduction in the valueof the loan if ratings change. Loss-given default (LGD – that is, oneminus recovery rate times EAD) is likely to depend upon ease of col-lecting on the collateral, the value of the collateral, the enforceabilityof guarantees, if any, and, most importantly, on the legal environmentthat determines creditors’ rights and the features of insolvency regime.For example, the juristic rules for murabahah imply that ‘‘in case ofinsolvency, [the] creditor should defer collection of the debt until hebecomes solvent.’’12 The precise interpretation of such considerationswould determine the length of time needed to recover overdue debt.In addition, there could be legal risks owing to difficulties in enforcingIslamic finance contracts in certain legal environments.13 Moreover,the inability of Islamic banks to use penalty rates as a deterrent againstlate payments could create both a higher risk of default and longerdelays in repayments.14 Finally, the limitations on eligible collateralunder Islamic finance – or excessive reliance on commodities andcash collateral – may exacerbate credit risks generally, and reduce thepotential recovery value of the loan if commodity collateral provestoo volatile in value. For these reasons, LGD in murabahah facili-ties could be different, probably higher, than in conventional banks,thereby affecting the size of losses and capital at risk.

Given the estimates of probability of default (PD), or probabilitiesof transition from one rating class to another (transition matrix),and the estimated LGD (or change in value of the loan for anygiven transition from one rating class to another), the expected andunexpected losses can be readily computed. For example, in theDefault Model, expected loss (EL) is given by:

EL = PD × LGD × EAD

where LGD is expressed as a proportion of exposure at default.The unexpected loss (UL) can be calculated based on assumptions

on the distribution of default and recoveries. Assuming that LGDis fixed, and that borrowers either default or do not default, thedefault rate is binomially distributed, and the standard deviation ofthe default rate is:

σ = √[PD(1 − PD)]


Therefore, a measure of UL on the loan is:

UL = Zα

√[PD(1 − PD)] × LGD × EAD

Zα above is a multiple (for example, a normal deviate) that lim-its the probability of unexpected losses to a specified level. Thisis the value-at-risk for this credit facility, representing the amountof capital needed to cover the unexpected loss in this exposure.In the case of a mark-to-market model, the calculation of EL andUL takes into account the prospects for both upgrades as wellas downgrades of the loan, and considers the change in valueof the loan for each possible change in the rating of a facilityfrom its current level, and the corresponding probability of ratingtransition.15

While similar considerations apply in the case of salam contractsfor calculating counterparty credit risk, there is an additional com-modity price risk embedded in these contracts that should be addedto the credit risk. The commodity price risk will arise even when thecounterparty does not default, and when there is default (for example,delivery of a substandard good, delayed delivery of a good, etc.) thecommodity price risk – taking into account any offsetting parallelsalam positions – could be included as part of the LGD. Thus, poten-tial loss in a salam contract is the sum of the loss due to credit riskand the loss due to commodity price risk, assuming that delivery takesplace according to the contract (that is, there is no credit risk loss).In addition, there could be a correlation between these two typesof risks (for example, due to common factors such as drought thatcould affect both commodity price risk and counterparty credit risk),which could be estimated based on historical data but is ignored forthe time being for simplicity. In the absence of liquid commoditymarkets as well as Shari’ah-compatible hedging products to mitigateprice risks, commodity price risk can be measured by calculating thevalue-at-risk of commodity exposures in different maturity bucketsusing historical data on prices. While commodity exposures can betreated as part of market risk measurement for capital allocationpurposes, it is important to compute this market risk separately foreach salam contract or for a portfolio of salam contracts and to addit to the credit risk so that the full risk in each contract (or portfolioof contracts) can be properly measured and taken into account in thepricing of the contract (or the facility). Also, the estimated commod-ity price risk should be monitored regularly, as price volatility could


change over time due to shifts in macroeconomic and market-specificconditions.

Finally, credit risk of a portfolio of exposures and facilities could belower or higher depending upon the extent of diversification or con-centration in specific credit categories. The credit risk measurementcan take into account the benefits of diversification by computingthe joint distribution of default events based on correlations betweendifferent classes and segments of the portfolio – that is, correlationsbetween defaults among counterparties and the joint probability ofdefault of any pair or group of counterparties can be estimated. Thiscan form the basis for valuing the loan portfolio and computing theexpected loss in the loan portfolio as a whole, based on the jointdistribution of components of the portfolio. In some models, defaultrates and transition probabilities can be made a function of macro-economic variables. The probability distribution of gains and lossesof the loan portfolio, or the loan facility, can then be used to computeboth expected and unexpected losses (at a given probability level).In case of loans to a diversified group of individuals and small busi-nesses, with standard instalments and commodity leases, supervisorsand banks might treat the class of loans as a retail exposure witha smaller risk weight (reflecting lower value-at-risk due to diversi-fication effects). At the same time, credit concentrations by sectorsand rating classes should be monitored as alternative indicators ofcredit risk.

3.3. Equity Risks in Mudarabah and Musharakah Facilities

These are equity-type facilities, typically a very small share of totalassets in part reflecting the significant investment risks that theycarry. In a sample of Islamic banks, the share of mudarabah andmusharakah facilities and traded equities varied from 0% to 24%,with a median share of about 3%. The possible unexpected lossesin such equity-type contracts will depend upon the functions ofthe underlying enterprise or venture in which the bank acquires anequity exposure.16 In a venture formed for trading in commoditiesor foreign exchange, the equity position risk arises from the risk ofunderlying transactions by the venture. A measure of the potentialloss in equity exposures in business enterprises that are not traded canbe derived based on the standard recommended in Basel II (paragraph350) and the IFSB Standard for ‘‘equity position risk in the bankingbook.’’17 In addition, a mudarabah facility may need to be assigned


an additional UL due to operational risk factors, with the extentof operational risk adjustment depending on the quality of internalcontrol systems to monitor mudarabah facilities on the asset side.High-quality monitoring would be very important in Islamic banks,since the finance provider cannot interfere in the management of theproject funded on a mudarabah basis. In the case of musharakah, theneed for operational risk adjustment may be less, in so far as the bankexercises some management control. If the bank’s equity interest in acounterparty is based on regular cash flow and not capital gains, andis of a long-term nature linked to customer relationship, a differentsupervisory treatment and a lower LGD could be used. If, however,equity interest is relatively short term, relies on capital gains (forexample, traded equity), a VaR approach, subject to a minimum riskweight of 300%, could be used to measure capital at risk (as proposedin Basel II).

3.4. Market Risks and Rate of Return Risks

The techniques of market risk measurement in the trading books ofIslamic banks should be broadly identical to those in conventionalbanks. The trading book, in Islamic banks, however, is likely to belimited to traded equities, commodities, foreign exchange positions,and, increasingly, various forms of sukuk. A large share of assetsof Islamic banks also consists of cash and other liquid assets, withsuch short-term assets typically exceeding short-term liabilities andamounts that IAHs are entitled to withdraw at short notice by alarge margin, in part reflecting the limited availability of Shari’ah-compatible money market instruments. Against this background,exposure to various forms of market risk can be measured by thetraditional exposure indicators, such as:

• net open position in foreign exchange• net position in traded equities• net position in commodities• rate-of-return gap measures by currency of denomination• various duration measures of assets and liabilities in the trading

book.

Most Islamic banks compute and often disclose liquidity gapmeasures – the gap between assets and liabilities at various matu-rity buckets – and hence the computation of the rate-of-return or


re-pricing gap should be fairly straightforward. More accurate dura-tion gap measures may also be available in some banks. Gap andduration measures, and their availability in banking statistics, are dis-cussed in the Compilation Guide for Financial Soundness Indicators(IMF, 2004). Duration measures are important indicators of finan-cial soundness, but they are not readily available in many bankingsystems. Baldwin (2002) discusses duration measures in the contextof Islamic banking. The impact on earnings of a change in exchangerate, equity price, commodity price, or rates of return can be directlyobtained by multiplying the appropriate gap or other exposure indi-cators by the corresponding price change. Such a simple approachwill not, however, suffice for computing the impact of changes ininterest rates on equity-type exposures of fixed maturity (such asmudarabah and musharakah). The impact of changes in the ratesof return on the expected rate of profits (that is, mudarabah andmusharakah income) would need first to be computed, or equiva-lently the equity exposures should be adjusted by a multiplicativefactor (which a supervisor can specify) before computing gaps in eachmaturity bucket.

Such gap measures may not, however, capture the maximum lossesthat could occur (at some probability level), particularly in Islamicbanks. They do not properly recognize other market-related risksarising from changes in the spread over benchmark rates, or twistsin the yield curve, or shifts in market volatility, which could affectpotential losses. For these reasons, market risk is commonly measuredby various VaR measures. This is particularly important, given thelikely importance of equities and commodities in Islamic bank balancesheets, which have potential to cause large losses. For example, forboth equities and commodities, VaR based on a 99% confidence level(one-sided confidence interval) could be computed. VaR could bebased on quarterly equity returns (mudarabah or musharakah profitrate) net of a risk-free rate,18 or quarterly or monthly changes incommodity prices.

In most Islamic banks, the rate-of-return risk in the banking bookis likely to be much more important than market risk in the tradingbook.19 The rate-of-return gap and duration gap applied to thebanking book would provide measures of exposures to changes inbenchmark rates of return, and of the impact of these changes onthe present value of bank earnings. For example, a simple stress testof applying a 1 percentage point increase in rates of return on both


assets and liabilities maturing–or being reprised–at various maturitybuckets would yield a measure of potential loss (or gain) due to auniform shift in term structure of rate of return.20

Another important source of risk is the possible loss due to a changein the margin between domestic rates of return and the benchmarkrates of return (such as LIBOR), which may not be closely linked tothe domestic return. Many Islamic banks use an external benchmarksuch as LIBOR to price the mark-up in murabahah contracts, in partreflecting the lack of a reliable domestic benchmark rate of return.If domestic monetary conditions change, requiring adjustments inreturns on deposits and loans, but the margin between the externalbenchmark and domestic rates of return shifts, there could be animpact on asset returns. This is a form of ‘‘basis risk’’ that shouldbe taken into account in computing the rate-of-return risk in thebanking book (and also market risks). The existence of this basisrisk highlights the importance of developing a domestic rate-of-returnbenchmark so that both deposits and assets can be aligned to similarbenchmarks.

3.5. Liquidity Risk

This risk is interpreted in numerous ways, such as extreme liquidity,availability of liquid assets to meet liabilities, and the ability toraise funds at normal cost. This is a significant risk in Islamic banks,owing to the limited availability of Shari’ah-compatible money marketinstruments and lender of last resort (LOLR) facilities. A standardmeasure of liquidity risk is the liquidity gap for each maturity bucketand in each currency. The share of liquid assets to total assetsor to liquid liabilities is also a commonly used measure. Whilethe availability of core deposits (current accounts and investmentaccounts) which are rolled over, and not volatile, provides a significantcushion for most Islamic banks, the remaining volatile deposits cannotbe readily matched with short-term liquid assets, other than cash andother low-yielding assets.

In addition, specific aspects of Islamic contracts could increasethe potential for liquidity problems in Islamic banks. These factorsinclude: cancellation risks in murabahah, the Shari’ah requirementto sell murabahah contracts only at par, thereby limiting the scopefor secondary markets for sale-based contracts, the illiquidity ofcommodity markets, and prohibition of secondary trading of salamor istisna’a contracts (see Ali, 2004).


3.6. Operational Risk

This is defined as ‘‘the risk of loss resulting from inadequate orfailed internal processes, people and systems or from external events.This includes legal risk, but excludes strategic and reputation risk.’’21

Such risks are likely to be significant in Islamic banks, due to spe-cific contractual features and the general legal environment. Specificaspects that could raise operational risks in Islamic banks includethe following: (1) the cancellation risks in non-binding muraba-hah and istisna’a contracts; (2) problems in internal control systemsto detect and manage potential problems in operational processesand back-office functions; (3) technical risks of various sorts; (4) thepotential difficulties in enforcing Islamic finance contracts in a broaderlegal environment; (5) the risk of non-compliance with Shari’ahrequirements that may impact on permissible income; (6) the riskof ‘‘misconduct and negligence’’ which would result in mudarabah-based PSIA becoming a liability of the Islamic bank, with consequentcapital adequacy and solvency implications; (7) the need to maintainand manage commodity inventories, often in illiquid markets; and(8) the potential costs and risks in monitoring equity-type contractsand the associated legal risks. In addition, the increasing use ofstructured finance transactions – specifically, securitization of assetsoriginated by banks – could expose banks to legal risks.

The principle of setting a capital requirement in the form ofa risk-weighted-asset equivalent for operational risk is subject todiscussion, since operational risks pertain to a bank’s systems andprocedures, not to its assets or balance sheet positions as such. Ithas to be said that the treatment of this risk in relation to capitalrequirements was a new departure in Basel II. The three methodsbased on ‘‘gross income’’ are undoubtedly crude when applied toconventional banks; in the case of Islamic banks, this is true a fortiori.The use of gross income as the basic indicator for operational riskmeasurement could be misleading in Islamic banks, in so far as alarge volume of transactions in commodities and the use of structuredfinance raise operational exposures that will not be captured by grossincome. The standardized approach that allows for different businesslines is better suited, but still requires adaptation to the needs ofIslamic banks. In particular, agency services under mudarabah, theassociated risks due to potential misconduct and negligence, andoperational risks in commodity inventory management, all need to beexplicitly considered for operational risk measurement. For a further


discussion of this issue, see Jackson-Moore (2006), Chapter 11 in thisvolume.

3.7. Mix of Risks by Type of Products

The above review of risk characteristics of Islamic products by typeof risk poses a challenging issue of how to recognize the specificbundling of risks in individual Islamic finance products, and theassociated correlation among risks. Monitoring the mix of risks foreach facility in a centralized and integrated manner is key to pricing therisks. First, all Islamic finance contracts – whether sales-based, leasedasset-based, or equity-based – in light of the associated operations incommodities, and the need to monitor or intervene in governanceand controls of counterparties in equity-based contracts, are exposedto a mixture of credit and operational risks. In addition, murabahahand salam contracts will also face commodity price risk; holdingsof sukuk, for instance, will carry a mixture of credit, market, andoperational risks. Also, the mix of risks will vary according to thestage of contract execution, as recognized in IFSB (2006b).

4. O V E R A L L R I S K O F A N I S L A M I C B A N K A N DA P P R O A C H E S T O R I S K M I T I G A T I O N

Potential losses due to each category of risk could be quantified andaggregated to derive the total impact of the different risks, and toexamine the adequacy of capital to absorb the risks. However, it isunlikely that the unexpected losses will exceed their upper bounds atthe same time for different types of risk, and the arithmetic total ofindividual risks will be an overestimate of the aggregate VaR for thebank as a whole. Such an aggregate VaR is, however, important forinforming unrestricted IAHs of Islamic banks, who are expected toshare in the overall risks. An overall risk measure could be obtainedfrom historical distribution of earnings, and calculating earningsvolatility, as already discussed.

A key issue for Islamic banks is to manage the risk-sharing prop-erties of investment accounts – both restricted and unrestricted – inorder to mitigate some of the risks to shareholders. Thus, in addi-tion to collateral, guarantees, and other traditional risk mitigants,the management of the risk–return mix, particularly of unrestrictedIAHs, could be used as a key tool of risk management. Appro-priate policies toward profit equalization reserves (and, possibly,


investment risk reserves), coupled with appropriate pricing of invest-ment accounts to match the underlying risks, would improve theextent of overall risk sharing by these accounts. Under currentpractices, reserves are passively adjusted to provide a stable returnto unrestricted IAHs, effectively not allowing any risk mitigationthrough investment account management – that is, management ofthe risks and returns of the underlying assets in order to producethe desired outcomes.22 For example, many banks with sharplydivergent risk profiles and returns on assets seem to be offeringalmost identical returns to unrestricted IAHs, and these are broadlyin line with the general rate of return on deposits in conventionalbanks.

These relationships have been analyzed empirically in Sundararajan(2005). The evidence reveals a significant amount of return smoothing,and a significant absorption of risks by bank capital (and thus,only a limited sharing of risks with IAHs). This finding raises abroader issue of how best to measure empirically the extent ofrisk sharing between unrestricted investment accounts and bankcapital.

A specific framework for such measurement is suggested below.The definition and measurement of mudarabah profits are first dis-cussed; a methodology is then presented for calibrating risk sharingbetween IAHs and bank owners based on a VaR methodology.

4.1. Accounting Definitions

The relationship between mudarabah income and overall return onbank assets can be specified based on available accounting standards.Drawing on this relationship, a methodology to measure the risksfacing IAHs, and the risk sharing between bank owners and IAHs, issuggested.

According to Financial Accounting Standard No. 6 (FAS 6) of theAccounting and Auditing Organization of Islamic Financial Institu-tions (AAOIFI), when a bank commingles its own funds (K = Capital)and current account (CA) funds guaranteed by the bank (so that thesecount as part of the mudarib’s funds for risk-bearing and profit-sharing purposes) with mudarabah funds (DI = unrestricted IAH),profits are first allocated between the mudarib’s funds K + CA andthe funds of investment account holders, DI, and then the share ofIslamic bank as a mudarib for its work is deducted from the share ofprofits of the IAHs.


In addition, FAS 6 states that profits of an investment jointlyfinanced by the Islamic bank and unrestricted IAHs shall be allocatedbetween them according to the contribution of each of the two partiesin the jointly financed investment. Allocation of profit based on per-centages agreed upon by the two parties is also juristically acceptable(according to the principle of musharakah), but the standards call forproportionate contribution.

The minimum standard for calculating the rate of return – specifiedby the Bank Negara Malaysia in the Framework of the Rate ofReturn (2001, and revised 2004) – calls for the sharing of profitsbetween depositors – that is, unrestricted IAHs – and the bank asmudarib to be uniform across banks as specified in the frameworkdocuments, and provides a uniform definition of profit and provisionsto ensure a level playing field. Profit is defined as income frombalance sheet assets plus trading income minus provisions, minusappropriations to (or plus releases from) profit equalization reserves,minus the income attributable to capital, specific investments, anddue from other institutions. This is the mudarabah income (RM)distributable between investment depositors (unrestricted IAHs) andthe bank (as mudarib). Provisions are defined as general provisionsplus specific provisions and income-in-suspense for facilities that arenon-performing. The framework then distributes mudarabah incomebetween the IAHs and the bank as mudarib and then by type andstructure of IAH deposits.23

In addition, both AAOIFI standards and the rate of return frame-work of the Bank Negara Malaysia recognize the profit equalizationreserve and investment risk reserve. PER (or Rp) refers to amountsappropriated out of gross income in order to maintain a certain levelof return for depositors (IAHs); and this is apportioned betweenIAHs and shareholders in the appropriate proportions that apply tothe sharing of profits. IRR are reserves attributable entirely to IAHs,but are maintained specifically to cover losses on investments madewith their funds.24

4.2. Measuring Risks in Investment Accounts and Risk Sharing

Given the framework for the computation of mudarabah profit – tobe apportioned between the mudarib and the unrestricted IAH – andthe policies on PER and IRR, the risk (defined as unexpected losses)of investment deposits can be calculated based on the variance ofthe rate of return for IAHs. Computation of such unexpected losses


under alternative scenarios for income smoothing (that is, alternativepolicies on PER and IRR) can provide the basis for estimating theadjustment factor α, which is subject to supervisory discretion underthe new IFSB capital adequacy formula. This approach is basedon the consideration that effective investment account managementwould help to determine a value for α that is consistent with therisk–return preferences of IAHs and the bank’s response to these. Afurther elaboration of these issues, including precise approaches toestimation of α, is the subject of a separate paper currently underpreparation.

5. S U M M A R Y A N D P O L I C Y C O N C L U S I O N S

The application of modern approaches to risk measurement, particu-larly for credit risk and overall banking risks, is important in Islamicfinance for at least four reasons:

• to properly recognize the unique mix of risks in Islamic financecontracts

• to ensure proper pricing of Islamic finance facilities, includingreturns offered to IAHs

• to manage and control various types of risks• to ensure adequacy of capital and its effective allocation,

according to the risk profile of the IIFS.

The preliminary review of the current state of financial reportingand disclosure among IIFS suggests that systematic future efforts atdata compilation would be needed, particularly to measure credit andequity risks with some degree of accuracy. The situation is similar formany conventional banks, but the need to adopt new measurementapproaches is particularly critical for Islamic banks because of therole IAHs play, the unique mix of risks in Islamic finance contracts,and the need to make more active use of security markets andsecuritization products for risk management. For these reasons, rapidprogress is important in consumer-friendly disclosures to inform IAHsof the risk–return mix they face, and in market-oriented disclosuresto inform markets of capital adequacy, risk exposures, and riskmanagement.

In addition, managing the risk-sharing property of investmentaccounts through proper pricing, reserving, and disclosure policieswould greatly enhance risk management in Islamic finance. This


requires measurement and disclosure of aggregate value at risk ofmudarabah income in the consolidated balance sheet of IIFS, andgreater use of asset securitization in order to offer assets of specificrisk–return characteristics to IAHs. Also, a measure of the extent towhich the risks to shareholders are reduced on account of risk sharingwith IAHs should be the basis of any capital relief or lower riskweights on the assets funded by investment accounts. For example,the proposed capital adequacy standard for Islamic banks (IFSB,2005b) calls for supervisory discretion in determining the share ‘‘α’’of risk-weighted assets funded by PSIA that can be deducted fromthe total risk-weighted assets for the purpose of assessing capitaladequacy. This share, ‘‘α,’’ represents the extent of total risk assumedby the PSIA, with the remainder absorbed by the shareholders onaccount of displaced commercial risk.

These observations suggest several policy and operational consid-erations and proposals:

• Appropriate measurement of credit and equity risks in vari-ous Islamic finance facilities can benefit from systematic datacollection efforts, including by establishing credit (and equity)registries.

• IIFS would require both centralized and integrated risk manage-ment that helps to control different types of risks while allowingdisaggregated risk measurements designed to price specific con-tracts and facilities, including the risk–return mix offered toIAHs. This integrated approach to risks would need to be sup-ported by appropriate regulatory coordination and cooperationamong banking, securities, and insurance supervisors.

• The disclosure regime for IIFS needs to become more com-prehensive and transparent, with a focus on disclosures of riskprofile, risk–return mix, and internal governance. This requirescoordination of supervisory disclosure rules and account-ing standards, and proper differentiation between consumer-friendly disclosures to assist investment account holders, andmarket-oriented disclosures to inform markets.

• The supervisory review process should monitor and recog-nize the actual extent of risk sharing by IAHs in assessingcapital adequacy, and thereby encourage more effective andtransparent risk sharing with IAHs. Adequate disclosure by anIIFS of the credit and market risks borne by PSIA and share-holders, respectively, should be a supervisory requirement for


giving a low value to the α parameter in the capital adequacyformula to be applied to that IIFS. Thus, inadequate disclo-sure would result in a high value being set for this parameter(equivalent to granting little or no ‘‘capital relief’’ in respectof the share of these risks that might otherwise be consideredto be borne by PSIA). The measurement of these risks, andestimation of appropriate capital relief, can be based on VaRmethodology as suggested in Section 4.

ENDNOTES∗ Director, Centennial Group Holdings, 2600 Virginia Avenue, NW, Suite 201,

Washington, D.C. 20037; email: [email protected] Clearly there is no juristic obligation under the Shari’ah for the bank to absorb

risk for the benefit of IAHs; in fact, the reverse is true. But in some jurisdictions thecentral bank takes the view that, as unrestricted PSIA are marketed as a substitutefor conventional deposits, the bank has a constructive obligation to maintain itscapital intact and to pay a competitive return.

2 Since the restricted investment accounts are not generally considered as a substitutefor conventional deposits, this issue does not normally arise for them, although asa matter of commercial policy a bank in a particular year may decide to waivepart of its mudarib share from such accounts in order to offer a better returnto the IAH.

3 See ‘‘IMF facilitates establishment of IFSB,’’ IMF news brief no. 02/41, May 2002;www.imf.org/external/mp/sec/nb/2002/nb241.htm.

4 See papers presented at the seminar on The Ten-year Master Plan for the IslamicFinancial Services Industry, held in Putrajaya, Malaysia, May 2005.

5 The amount need not be physically paid out, but may be credited to the IAHaccount, from where it can be either withdrawn or left as an addition to thebalance invested.

6 The movements on IRR are also relevant, but are not explicitly included in thisanalysis for the sake of simplicity.

7 For a discussion of appropriate practices in defining mudarabah profits, seeAAOIFI, Financial Accounting Standard No. 6, and the Framework of the Rateof Return (October 2001, and revised 2004) issued by the Bank Negara Malaysia.For examples of estimation of such earnings and PaR measures for Islamic banks,see Hakim (2003) and Hassan (2003).

8 In the case of an ijarah-based facility, the risk is that of default by the lessee – thatis, failure to keep up lease payments. However, in an ijarah, the bank as lessorretains ownership of the leased asset and can normally repossess it in the event ofdefault by the lessee.

9 Musharakah- and mudarabah-based facilities give rise to risks of non-performancethat are analogous to credit risk but are typically higher, as the customer has nolegal obligation to repay capital or pay a return unless a profit is earned on theunderlying investment. See Section 3.3 below.

10 Basel II definition (paragraph 452).


11 For a survey of new approaches to credit risk measurement and an overview oftraditional methods, see Saunders and Allen (2002).

12 AAOIFI (2001), Financial Accounting Standard No. 2, Appendix B.13 Djojosugito (2003).14 Chapra and Khan (2000).15 See Wilson (1998) and Caouette et al. (1999) for detailed illustration.16 IFSB (2006b).17 Basel II also proposes another method whereby the loss can be estimated by using

the PD corresponding to a debt exposure to the counterparties whose equity isbeing held, and applying a fairly high loss-given default such as 90% to reflectthe equity risks. A measure of both expected and unexpected loss could then becomputed from these parameters. However, the notion of ‘‘debt exposure’’ as suchis problematic in Islamic finance, and this method is not proposed in the IFSB Stan-dard, which suggests that the method proposed in Basel II based on ‘‘supervisoryslotting criteria’’ for specialized lending may be adapted for such risks.

18 The concept of a risk-free rate is problematic in Islamic finance, since a risk-freereturn is not Shari’ah-compliant. However, the suggestion here is to use such arate merely as a component in a calculation, not in an actual transaction.

19 In principle, in the presence of profit-sharing and loss-bearing investment accountholders, the changes in asset returns due to changes in the benchmark market rateof return would be offset by corresponding shifts in the returns payable to IAHs.In practice, as a result of return smoothing, the risk of losses due to changes inmarket rates of return would remain significant.

20 Alternatively, the impact on the present value of earnings of shifts in the rateof return can be calculated directly from duration measures as follows: impactof change in rate of return = (DA − DL)�ir, where: DA = duration of assets;DL = duration of funding; and �ir = change in rate of return.

21 Basel II, paragraph 644.22 In at least some cases this may, however, be a way of managing the different

risk appetites of shareholders and investment account holders. The bank adoptsa more aggressive investment strategy than would be appropriate for IAHs, andthen uses ‘‘smoothing’’ methods to produce the outcomes for IAHs of a moredefensive strategy. The investment accounts are thus used as a form of leverage.See Al-Deehani et al. (1999) and Archer and Karim (2005).

23 Thus, the income to the bank has two components: the return on bank capital usedin calculating the mudarabah profits (this is the return to the bank’s contributionas a co-investor) plus the mudarib share of the mudarabah’s profits. (This is thefee for its asset management services.)

24 It would not be Shari’ah-compliant for the PER to be used for this, as this wouldamount to the mudarib absorbing part of the loss.

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Documents

Islamic Finance (The Regulatory Challenge) || Risk Characteristics of Islamic Products: Implications for Risk Measurement and Supervision