Over the last decade, Islamic banking has experienced global growth rates of 10-15 percent per annum, and has been moving into an increasing number of conventional financial systems at such a rapid pace that Islamic financial institutions are present today in over 51 countries. Despite this consistent growth, many supervisory authorities and finance practitioners remain unfamiliar with the process by which Islamic banks are introduced into a conventional system. This research attempts to shed some light in this area by describing the differences between Islamic and Conventional Banks on Credit Risk Management.
Topic
"COMPARISN OF ISLAMIC BANKING TECHNIQUES ON CREDIT RISK MANAGEMENT WITH CONVENCTIONAL BANKING"
Research Brief
BANKING
A system of trading in money which involved safeguarding deposits and making funds available for borrowers, banking developed in the middle Ages in response to the growing need for credit in commerce. The lending functions of banks were undertaken in England by money- lenders. Until their expulsion by Edward I in 1291, the most important money-lenders were Jews. They were replaced by Italian merchants who had papal dispensations to lend money at interest. In the 13th century, credit was essential to finance commerce and major projects. The most important was the wool trade but other examples included large buildings such as Edward's castles in north Wales. When Italians had their activities in England curtailed in the early 14th cent., they were replaced by English merchants and goldsmiths, whose rates of interest were sufficiently low to avoid the usury laws.
Monarchs had borrowed from merchants and landowners for centuries. By the late 17th cent., the growth of parliamentary power over government expenditures required more regulation. The Bank of England, Ireland and Scotland, founded in 1694, gave the government and other users of credit access to English funds. Similar developments occurred in Scotland and Ireland. These banks remained without serious competition until the later 18th cent., when expanding commercial activities gave scope to merchants, brewers, and landowners to establish banks based on their own cash reserves. Errors of judgement sometimes occurred and 'runs on the bank' took place when depositors, fearing for the security of their money, demanded its return.
Fluctuations in the value of money because of the return to a gold-based currency after the end of the Napoleonic wars (1815) precipitated a series of crises. To stabilize the currency the government eventually introduced the 1844, which gave the Bank of England the functions of supervising the note issue and of monitoring the activities of the banking system. Regulatory powers were put in place in 1845 to control banking in Scotland and Ireland.
In the 19th cent., overseas trade and the expanding British empire reinforced the place of London as a centre of merchant banking. The skills of these specialist bankers attracted business from foreign firms and governments Seeking loans. These arrangements made possible the rapid development of railways, heavy engineering, mines, and large commercial developments. Many of these merchant banks survive, including Rothschilds, Lazard Brothers, Kleinwort Benson, and Schroders. Internal trade was funded mainly by a larger number of local banks which, after the middle of the 19th cent., became consolidated into a much smaller number of banks. Numbers continued to diminish so that by 1980 banking was dominated by four companies: Barclays, Lloyds, Midland, and National Westminster.
Banking has been characterized, largely because of technological innovation, by an increasingly sophisticated provision of banking services and an expansion of consumer credit. The business of safeguarding and lending money is often arranged through machine-readable cards and continuous access by telephone.
ISLAMIC BANKING
Definition
A banking system that is based on the principles of Islamic law (also known as Sharia, or Shariah) and guided by Islamic economics. Two basic principles behind Islamic banking are the sharing of profit and loss and, significantly, the prohibition of the collection and payment of interest. Collecting interest is not permitted under Islamic law.
Example:
Here's an example of how the Islamic banking system uses methods of profit/loss sharing to facilitate financial transactions: for some types of loans, the borrower only needs to pay back the amount owed to the lender, but the borrower can choose to pay the lender a small amount of money to serve as a gratuity.
Since this system of banking is grounded in Islamic principles, all the undertakings of the banks follow Islamic morals. Therefore, it could be said that financial transactions within Islamic banking are a culturally-distinct form of ethical investing (for example, investments involving alcohol, gambling, pork, etc. are prohibited). The Dubai Islamic Bank has the distinction of being the world's first full-fledged Islamic bank, formed in 1975.
Islamic finance refers to the means by which corporations in the Muslim world, including banks and other lending institutions, raise capital in accordance with Sharia, or Islamic law. It also refers to the types of investments that are permissible under this form of law. A unique form of socially responsible investment, Islam makes no division between the spiritual and the secular, hence its reach into the domain of financial matters. Because this sub-branch of finance is a burgeoning field, in this research, we will offer an overview to serve as the basis of knowledge or for further study.
Preliminary Review Of The Literature
Islamic banking and finance have been formalized gradually since the late 1960s, coincident with and in response to tremendous oil wealth which, fuelled renewed interest in and demand for Sharia-compliant products and practice.
Central to Islamic banking and finance is an understanding of the importance of risk sharing as part of raising capital and the avoidance of riba (usury) and gharar (risk or uncertainty).
Islamic law views lending with interest payments as a relationship that favors the lender, who charges interest at the expense of the borrower. Because Islamic law views money as a measuring tool for value and not an 'asset' in itself, it requires that one should not be able to receive income from money (for example, interest or anything that has the genus of money) alone. Deemed riba (literally an increase or growth), such practice is proscribed under Islamic law (haram, which means prohibited) as it is considered usurious and exploitative. By contrast, Islamic banking exists to further the socio-economic goals of Islam.
Accordingly, Sharia-compliant finance (halal, which means permitted) consists of profit banking in which the financial institution shares in the profit and loss of the enterprise that it underwrites. Of equal importance is the concept of gharar. Defined as risk or uncertainty, in a financial context it refers to the sale of items whose existence is not certain. Examples of gharar would be forms of insurance, such as the purchase of premiums to insure against something that may or may not occur or derivatives used to hedge against possible outcomes.
The equity financing of companies is permissible, as long as those companies are not engaged in restricted types of business - such as the production of alcohol, pornography or weaponry - and only certain financial ratios meet specified guidelines.
BASIC FINANCING ARRANGEMENTS
Below is a brief overview of permissible financing arrangements often encountered in Islamic finance:
Profit-and-loss sharing contracts (mudarabah). The Islamic bank pools investors' money and assumes a share of the profits and losses. This is agreed upon with the depositors. What does the bank invest in? A group of mutual funds screened for Sharia compliance has arisen. The filter parses company balance sheets to determine whether any sources of income to the corporation are prohibited (for example, if the company is holding too much debt) or if the company is engaged in prohibited lines of business. In addition to actively managed mutual funds, passive ones exist as well based on such indexes as the Dow Jones Islamic Market Index and the FTSE Global Islamic Index.
Partnership and joint stock ownership (musharakah). Three such structures are most common:
Declining-Balance Shared Equity: Commonly used to finance a home purchase, the declining balance method calls for the bank and the investor to purchase the home jointly, with the institutional investor gradually transferring its portion of the equity in the home to the individual homeowner, whose payments constitute the homeowner's equity.
Lease-to-Own: This arrangement is similar to the declining balance one described above, except that the financial institution puts up most, if not all, of the money for the house and agrees on arrangements with the homeowner to sell the house to him at the end of a fixed term. A portion of every payment goes toward the lease and the balance toward the purchase price of the home.
Installment (Cost-Plus) Sale (murabaha): This is an action where an intermediary buys the home with free and clear title to it. The intermediary investor then agrees on a sale price with the prospective buyer; this price includes some profit. The purchase may be made outright (lump sum) or through a series of deferred (installment) payments. This credit sale is an acceptable form of finance and is not to be confused with an interest-bearing loan.
Leasing ('ijarah/'ijar): The sale of the right to use an object (usufruct) for a specific time period. One condition is that the lessor must own the leased object for the duration of the lease. A variation on the lease, 'ijarah wa 'iqtina provides for a lease to be written whereby the lessor agrees to sell the leased object at the lease's end at a predetermined residual value. Only the lessor is bound by this promise. The lessee, by contrast, is not obligated to purchasing the item.
Islamic Forwards (salam and 'istisna): These are rare forms of financing, used for certain types of business. These are an exception to gharar. The price for the item is prepaid and the item is delivered at a definite point in the future. Because there is a host of conditions to be met to render such contracts valid, the help of an Islamic legal advisor is usually required.
BASIC INVESTMENT VEHICLES
Here are some permissible types of investment for Islamic investing:
Equities. Sharia law allows investment in company shares (common stock) as long as those companies do not engage in lending, gambling or the production of alcohol, tobacco, weaponry or pornography. Investment in companies may be in shares or by direct investment (private equity). Islamic scholars have made some concessions on permissible companies, as most use debt either to address liquidity shortages (they borrow) or to invest excess cash (interest-bearing instruments). One set of filters excludes companies that hold interest-bearing debt, receive interest or other impure income or trade debts for more than their face values. A further distillation of the aforementioned screens would exclude companies whose debt/total asset ratio equals or exceeds 33%; companies with "impure plus non-operating interest income" revenue equal to or greater than 5% or companies whose accounts receivable/total assets equal or exceed 45% or more.
Fixed-Income Funds.
Retirement Investments. Retirees who want their investments to comply with the tenets of Islam face a dilemma in that fixed-income investments includeriba, which is forbidden. Therefore, specific types of investment in real estate, either directly or in securitized fashion (a diversified real estate fund), could provide steady retirement income while not running afoul of Sharia law.
Sukuk, In a typical ijara sukuk (leasing bond-equivalent), the issuer will sell the financial certificate to an investor group, who will own them before renting them back to the issuer in exchange for a predetermined rental return. Like the interest rate on a conventional bond, the rental return may be a fixed or floating rate pegged to a benchmark, such as LIBOR. The issuer makes a binding promise to buy back the bonds at a future date at par value. Special purpose vehicles (SPV) are often set up to act as intermediaries in the transaction. A sukuk may be a new borrowing, or it may be the Sharia-compliant replacement of a conventional bond issue. The issue may even enjoy liquidity through listing on local, regional or global exchanges according to an article in CFA Magazine titled "Islamic Finance: How New Practitioners of Islamic Finance are Mixing Theology and Modern Investment Theory" (2005).
Basic Insurance Vehicles
Traditional insurance is not permitted as a means of risk management in Islamic law. This is because it constitutes the purchase of something with an uncertain outcome (form of ghirar), and because insurers use fixed income - a form of riba - as part of their portfolio management process to satisfy liabilities.
A possible Sharia-compliant alternative is cooperative (mutual) insurance. Subscribers contribute to a pool of funds, which are invested in a Sharia-compliant manner. Funds are withdrawn from the pool to satisfy claims, and unclaimed profits are distributed among policy holders. Such a structure exists infrequently, so Muslims may avail themselves of existing insurance vehicles if needed or required.
Conclusion
Islamic finance is a centuries-old practice that is gaining recognition throughout the world and whose ethical nature is even drawing the interest of non-Muslims. Given the increased wealth in Muslim nations, expect this field to undergo an even more rapid evolution as it continues to address the challenges of reconciling the disparate worlds of theology and modern portfolio theory.
WHAT IS CREDIT RISK MANAGEMENT
Introduction
1. While financial institutions have faced difficulties over the years for a multitude of reasons, the major cause of serious banking problems continues to be directly related to lax credit standards for borrowers and counterparties, poor portfolio risk management, or a lack of attention to changes in economic or other circumstances that can lead to a deterioration in the credit standing of a bank's counterparties. This experience is common in both G-10 and non-G-10 countries.
2. Credit risk is most simply defined as the potential that a bank borrower or counterparty will fail to meet its obligations in accordance with agreed terms. The goal of credit risk management is to maximize a bank's risk-adjusted rate of return by maintaining credit risk exposure within acceptable parameters. Banks need to manage the credit risk inherent in the entire portfolio as well as the risk in individual credits or transactions. Banks should also consider the relationships between credit risk and other risks. The effective management of credit risk is a critical component of a comprehensive approach to risk management and essential to the long-term success of any banking organization.
3. For most banks, loans are the largest and most obvious source of credit risk; however, other sources of credit risk exist throughout the activities of a bank, including in the banking book and in the trading book, and both on and off the balance sheet. Banks are increasingly facing credit risk (or counterparty risk) in various financial instruments other than loans, including acceptances, interbank transactions, trade financing, foreign exchange transactions, financial futures, swaps, bonds, equities, options, and in the extension of commitments and guarantees, and the settlement of transactions.
4. Since exposure to credit risk continues to be the leading source of problems in banks world-wide, banks and their supervisors should be able to draw useful lessons from past experiences. Banks should now have a keen awareness of the need to identify, measure, monitor and control credit risk as well as to determine that they hold adequate capital against these risks and that they are adequately compensated for risks incurred. The Basel Committee is issuing this document in order to encourage banking supervisors globally to promote sound practices for managing credit risk. Although the principles contained in this paper are most clearly applicable to the business of lending, they should be applied to all activities where credit risk is present.
5. The sound practices set out in this document specifically address the following areas: (i) establishing an appropriate credit risk environment; (ii) operating under a sound credit-granting process; (iii) maintaining an appropriate credit administration, measurement and monitoring process; and (iv) ensuring adequate controls over credit risk. Although specific credit risk management practices may differ among banks depending upon the nature and complexity of their credit activities, a comprehensive credit risk management program will address these four areas. These practices should also be applied in conjunction with sound practices related to the assessment of asset quality, the adequacy of provisions and reserves, and the disclosure of credit risk, all of which have been addressed in other recent Basel Committee documents.
6. While the exact approach chosen by individual supervisors will depend on a host of factors, including their on-site and off-site supervisory techniques and the degree to which external auditors are also used in the supervisory function, all members of the Basel Committee agree that the principles set out in this paper should be used in evaluating a bank's credit risk management system. Supervisory expectations for the credit risk management approach used by individual banks should be commensurate with the scope and sophistication of the bank's activities. For smaller or less sophisticated banks, supervisors need to determine that the credit risk management approach used is sufficient for their activities and that they have instilled sufficient risk-return discipline in their credit risk management processes.
7. The Committee stipulates, principles for banking supervisory authorities to apply in assessing bank's credit risk management systems. In addition, the appendix provides an overview of credit problems commonly seen by supervisors.
8. A further particular instance of credit risk relates to the process of settling financial transactions. If one side of a transaction is settled but the other fails, a loss may be incurred that is equal to the principal amount of the transaction. Even if one party is simply late in settling, then the other party may incur a loss relating to missed investment opportunities. Settlement risk (i.e. the risk that the completion or settlement of a financial transaction will fail to take place as expected) thus includes elements of liquidity, market, operational and reputational risk as well as credit risk. The level of risk is determined by the particular arrangements for settlement. Factors in such arrangements that have a bearing on credit risk include: the timing of the exchange of value; payment/settlement finality; and the role of intermediaries and clearing houses.
Aims And Objectives
The objective of this dissertation is to address some of these questions. Specifically the paper aims at the following:
Presenting an overview of the concepts of risks and risk management techniques and standards as these exist in the financial industry.
Discussing the unique risks of the Islamic financial services industry and the perceptions of Islamic banks about these risks.
Reviewing the main regulatory concerns with respect to risks and their treatment with a view to draw some lessons for Islamic banks.
Discussing and analyzing the Sharī'ah related challenges concerning risk management in the Islamic financial services industry. And
Presenting policy implications for developing a risk management culture in Islamic banks.
Research Plan
Time Scale
Time
Activity
Dec 12 - Dec 23
Submission of Proposal
Jan 15 - Jan 28
Carry out secondary literature review
Jan 28 - Feb 14
Preparation for qualitative research (interview guide and acquiring respondents).
Feb 14 - Feb 28
Test and conduct qualitative results as well as collating and structuring.
Mar 01 - Mar 20
Analyse results and write-up of dissertation
Mar 20 - Mar 30
Final revision of dissertation
March31
Submit Dissertation
Research Design
There are so many methods of collecting data but I will use the following ways to collect data. Which are; Case study Base, Primary Data through Observation, Primary Data using semi-structured in depth and group interviews, Primary Data using Questionnaires, Secondary Data, Articles, Internet, Books, Newspapers and Voice and Video records.
To turn the research questions in to research project research design is used. There are three layers of research design research strategies, research choices and time horizons. Research design also gives researcher a plan of how he will go about to answering the research questions. In order to understand the aim, objective and questions of the research, case study approach will be used. Main reasons for selecting the case studies are that one can analyze their situation easily. It also helps to test all the theoretical concepts and implement them. It also helps us to have a deep study of the innovation involved in the field of management. What procedures those companies have followed and what were the outcomes of those innovations. It also helps to answer the entire question 'why' 'what' and 'how'. Case study strategy is best to used in explanatory and exploratory research.
Resources For Data Collection
I will be using Emerald, Business Source Primer, Google Scholars and online library (Wales&LCB) resources for book and journals that are relevant to my topic. Other resources include websites of large national and multinational organisation.
