Risks of Islamic Financial Contracts - Assignment Example

Name Institution Module Instructor Date 1. Risks of Islamic financial contracts change at different stages of contracts. Explain and give examples from different Islamic Financial Contracts. A contract is a mutual agreement between an employer and his or her employee. The employer can be an organization, a company, or a group of people. In Islamic countries such as Iran, Saudi Arabia and Afghanistan among others, there are different types of financial contracts such as Murabahah, Mudharabah, Musharakah, Salam, Istisna’a and Ijarah. Several researches show that the risks of Islamic financial contracts change at different stages of contracts. To begin with, in the Murabahah type of financial contract, the risks change depending on the stage of the contract. In this type of contract, the first stage of the contract involves a supplier who sells his or her product at a mark up. The risks found here are very different from the risks found in the other stages or forms of the contract. In the first stage where a supplier sells his or her product at a mark up, the risks experienced are mark-up risks. Mark-up risks are often based on benchmarks from other suppliers but once they are determined, they cannot be changed. Mark-up risks include changes in prices and other costs. The second stage in the murabahah type of contract involves the bank buying a product from a supplier and selling the product to a customer at its cost plus a mark up. The product that the bank buys and sells can be buildings, land, cars, and machinery among others. In this stage, the customer who buys the product from the bank normally pays by installments. The risks found in this stage of the murabahah type of contract include credit risks, liquidity risks and operational risks. Credit risks are experienced when a customer does not keep his or her promise. This might happen when a customer has purchased an asset from the bank but wants the bank to finance the asset. Credit risks can also be experienced when the product to be sold gets damaged before the customer buys the product. Consequently, liquidity risks are experienced when a customer defaults his or her payment or cancels his or her promise. This causes problems or challenges for the bank while selling the product. In addition, operational risks are experienced when the bank that is to sell the asset consumes the asset before selling it to a customer. The third stage in the murabahah type of contract involves buying a commodity or a basket of commodities for example metals which are traded in London Metal Exchange which are held by another bank for a predetermined amount at a predetermined price. The risks in this stage are different from the risks found in the previous stages of the murabahah type of contract. The risks available at this stage are commodity risks which are experienced when banks may have to hold on to a product in case the customer who was to buy the product changes his or her mind. This may expose the bank to problems or challenges of disposing the product. Mudharabah is the other example of financial contracts found in Islamic countries. Just like the former, mudharabah has various stages. The first stage involves a financier providing capital in the contract. The risks involved in this stage include equity investment risk and liquidity risk. To begin with, equity investment risk is experienced when the financier provides a lot of capital for the business but the investment is not making profits. The financier can therefore decide to withdraw from the project. On the other hand, liquidity risks in this stage are experienced when funding of the project or investment comes from the deposits yet the depositors are unable to access the funding before the money matures. The second stage of mudharabah type of contract involves an entrepreneur providing for the entrepreneurship. The risks involved in this stage are operational risks. Operational risks are experienced when the entrepreneur providing for the entrepreneurship faces complexity of contracts and difficulties in implementation. The third stage in this type of contract involves sharing of profits at a predetermined ratio. Just like in the former stages, this stage experiences risks. The risks experienced in the third stage include credit risks and mark-up risks. Credit risks are experienced when the payments of profits are delayed or if the profits are not paid completely. On the other hand, mark-up risks are experienced when there are no profits got from the investment because of fluctuations of the prices of products in the global or domestic market. 1. Different risks are bundled in certain Islamic Financial Contracts. Explain and give as many examples as possible. As earlier mentioned, examples of Islamic Financial Contracts include Murabahah, Mudharabah, Salam, Istisna’a and Ijarah (IDB 17). Different risks are bundled in these Islamic financial contracts. To begin with, the Murabahah contract is a trading transaction which takes different forms or stages. The forms include a supplier selling products at a mark-up, a bank buying the product from a supplier and selling it to a customer and finally, buying a commodity which is held by another bank at a predetermined price. There are various risks bundled in the murabahah type of contract. One of the risks includes credit risks. Credit risks are experienced when a customer does not keep the agreed promise or when a customer buys a product and wants the bank to finance it. The other types of risks bundled in the Murabahah type of contract are mark-up risks, liquidity risks, operational risks and commodity risks. Mudharabah is the other type of Islamic financial contract. It involves a financier as provider of capital. It also involves an entrepreneur as provider of entrepreneurship. In mudharabah type of contract, profits are often shared at a predetermined ratio. However, losses are borne completely by financier. Just like the former, mudharabah has different risks bundled in it. Examples of risks bundled in the mudharabah type of contract include equity investment risks, credit risks, operational risks, mark-up risks, and liquidity risks. To begin with, equity investment risks often occur when the project in place or at hand is incurring losses rather than profits. Credit risks occur when profits are incurred in the project but their payment is delayed or not paid at all. Credit risks are found to be usually very high because the project at hand could be long term or because there is no collateral. On the other hand, operational risks in the mudharabah type of contract occur due to complexity of contracts and difficulties in implementation. Mark-up risks are also experienced in this type of contract. They occur because of rise and fall of product prices in the market. Finally, liquidity risks occur but they depend on the size and nature of funding for the project. More often, if funding comes from the investment deposits but the depositors cannot withdraw the money until maturity; therefore, the risk of liquidity risk is often reduced. The other type of Islamic financial contract is the Salam. This type of contract is a forward contract on commodities with immediate payment of the full price. In this type of contract, quality, date and place of delivery must be predetermined and agreed by both parties. The risks bundled in this type of contract include credit risks, liquidity risks, operational risks and commodity price risks. To begin with, credit risks occur when there is late or no delivery due to crop failure or weather risks, and disputes over quality. On the other hand, liquidity risks occur because the Shariah laws that exist in Islamic countries do not allow the sale of products that a person does not possess yet. In addition, after taking possession, the bank may not be allowed to sell the product immediately giving rise to storage and insurance costs. Operational risks in this type of contract occur when the purchaser faces several challenges from the beginning of the contract. The other type of risk that is bundled in this type of contract is the commodity price risk. 2. How does the IFSB recognize the above 2 points in risk weighting the Islamic financial contracts? Give examples. Risk weighting is a method of weighing the importance or significance of a particular risk and assigning the risk to an organization in order to deal with it. The Islamic Financial Services Board (IFSB) recognizes the above points of risks of financial contracts changing at different stages of contracts and different risks being bundled in certain Islamic Financial Contracts. The IFSB deals with these risks by risk weighting the Islamic Financial Contracts. The IFSB recognizes the above points by ensuring or enhancing the use of a capital adequacy framework which would better serve the purpose of article 21 of the Articles Agreement. Article 21 of the Articles of Agreement specifies that “the total amount of equity investments, amounts of loans outstanding and other ordinary operations of the bank shall not, at any time, exceed the total amount of the unimpaired subscribed capital, reserves, deposits, other funds raised and surplus included in ordinary Capital Resources” (IDB 20). If this is done, it will translate into a risk sensitive methodology hence reducing risks bundling in Islamic Financial Contracts. The change of risks from one stage of a contract to another will also be reduced or rather stopped. In addition, the IFSB recognizes the above points by releasing a capital Adequacy Standard for institutions offering only Islamic financial services in 2005 with a view for implementation which would start in 2007. This also helped reduce the bundling of risks in Islamic contracts (IDB 20). 3. Summary of the IFSB risk weighting of the different Islamic Financial Contracts. Treasury Assets Risk Weighting Finance Operations Risk Weighting Equity Investments Risk Weighting Cash 0% Sovereigns rated at least AA- 0% Equity placement with banks Sovereigns rated A+ to A- 20% Listed 100% Banks rated AA- or higher 20% BBB+ to BBB- 50% Unlisted 100% Banks rated A+ to A- 50% BB+ to B- 100% Banks rated BBB+ to BBB- 100% Below B- 150% Unrated 100% Private Sector Portfolio At least AA- 20% A- To A+ 50% Unrated 100% Project Finance 100% Off-Balance Exposures Undisbursed commitments 50% Guarantees 100% 4. Key instruments of credit risk mitigation for an Islamic Bank Credit risk is by far the most important risk ISDB is exposed to. The risk arises as a result of different exposures from financed operations, equity investments and treasury exposures. However, credit risks in Islamic Banks can be mitigated. The key instruments of credit risk mitigation include exposure to the public sector. This has made the biggest chunk of ISDB’s portfolio to be of sovereign lending hence making credit risk to be less severe in Islamic Banks. The other key instrument in credit risk mitigation is the creditor status enjoyed by ISDB. This has also made credit risks in Islamic Banks to be less severe. Conservative financial policies adopted by ISDB are also among the key instruments in credit risk mitigation. Adoption of these policies has led to reduction of credit risks in Islamic banks (IDB 18). 5. SWOT of the credit risk weighting approach used by the IFSB. The credit risk weighting approach used by the IFSB has various strengths, weaknesses and faces several threats. To begin with, one of the strengths of the approach is that it allows for a distinction between less risky countries to those that carry a higher risk. The second strength of the approach is that it is followed in the determination of risk weights and capital wages for financed operations to both the public and the private sector portfolios. The approach has weaknesses. One of the weaknesses is that the approach does not distinguish between listed and unlisted equity for capital backing purposes. The other weakness is that the approach is difficult to understand and interpret. A person who is not literate will be unable to interpret the percentages. The approach faces threats in that it is only acceptable in Islamic Banks and not in the other banks in the world. 6. Report on the rating of the IDB by the three different rating Agencies From the document, it was found that rating agencies have developed their own methods for assessing capital adequacy in MDB. According to the document, there are three renowned rating agencies. They are namely S&P, Moody’s and Fitch Ratings. The rating agencies have all come up with different measures that assess the strength of capital base. Focus on available capital, both paid in and callable, as compared to risk assets. Risk assets are defined by the three rating agencies as all outstanding exposures (on and off balance sheet). S&P mostly relies on both Narrow and Broad Risk Bearing Capacity relative to Development Related  Exposure whereas Moody’s uses Risk Assets Coverage Ratio and Fitch Ratings utilizes Usable Capital to Required Capital Ratio (IDB credit rating and capital adequacy doc, pg 14). The rating agencies use risk weighted capital ratios to assess solvency of financial institutions (IDB 20). Standard and Poor’s According to the document, S and P is believed to be in its process of developing a new risk adjusted capital framework characterized by a new measure called Basel II adjusted ratio. This ratio will neutralize differences arising from the application of Basel II during the transition period. This rating agency uses an approach that relies on the risk Bearing Capacity to Development Related Exposure ratio to measure the true risk carried by an MDB. This rating agency is also found to have two measures of risk bearing capacity which are variant. These two measures are found to be the narrow risk bearing capacity and the broad risk bearing capacity. The narrow risk bearing capacity equals to the adjusted shareholder’s equity in addition to the accumulated provision for losses on loans and guarantees. The broad risk bearing capacity is believed to be the first measure plus ‘AAA’ rated callable capital (IDB 14). Moody’s According to the document, this rating agency is found to rely on the Risk Assets Coverage Ratio to assess the risk bearing capacity of an MDB. In addition, there are two variants of this ratio namely Usable Equity as a percentage of Risk Assets and Usable Equity plus a portion of the Callable Capital as a percentage of Risk Assets (IDB 14). Fitch Ratings According to this document, a Fitch rating is found to be similar to the previously mentioned agencies. This rating agency has devised its own capital adequacy ratios. These ratios range from traditional ones like ‐the ratio of equity to assets and the ratio of total  exposure to total capital‐ to more sophisticated risk sensitive ones like the ratio of usable capital to required capital. Fitch attaches more importance to the ratio of usable capital to required capital because it assesses the MDB’s asset quality and shareholders’ support (IDB 15). Work cited IDB. IDB credit rating and capital adequacy. The Islamic development bank group risk management department. 2009. Web. Read More