Islamic banking: Meeting the global standard

In Islamic banks, depositors who deposit for sharing profit or loss with banks are known as IAHs (investment account holders). The IAHs typically expect their funds to be managed and invested in such a way that will ensure returns on their funds that are comparable to the returns paid by competitors (Islamic banks and conventional institutions). They also expect the Islamic bank to comply with Shariah rules and principles all along. Consequently, the banking operations of all Islamic banks pose two common risks which are as follows:

1. a) Shariah compliance risk: Shariah compliance risk arises when Islamic banks fail to comply with the Shariah rules and principles determined by the Shariah Board of the banks or relevant body in the jurisdiction in which Islamic banks operate. According to Islamic Financial Services Board (IFSB), Shariah compliance should be given higher priority than anything else since violation of Shariah principles will result in transaction being cancelled or income generated from them shall be considered illegitimate. Beside, this may hamper the reputation of the bank.
2. b) Displaced commercial risk: If Islamic banks fail to perform their fiduciary responsibilities and show poor performance in attaining the objectives of the investors and shareholders, they may start losing their customers which will affect banks' liquidity. This risk mainly arises when an Islamic bank needs to pay its investment account holders (IAHs) a rate of return higher than what would be payable under the "actual" terms of the investment contract in order to induce its IAHs not to withdraw their funds and invest elsewhere.

In order to minimise these risks, many Islamic banks across the globe maintain following two reserves:

1. Profit equalisation reserves (PER): It is an amount set aside from the investment profits before allocation between shareholders and IAH's and the calculation of the bank's share of profits. It is used to reduce the variability of profit payouts on investment deposits to offer returns that are aligned to a market rate of return without the need for the bank to forego any of its shares when return on investment declines.
2. Investment risk reserves (IRR): It is the amount appropriated by the institution offering Islamic financial services out of the income of investment account holders after deducting the share of the bank. It can be used to redistribute income accruing to investment accounts, so as to cushion against future investment losses and maintain payouts.

In Jordan, Malaysia and Qatar, the industry supervisor (the central bank) requires Islamic banks to maintain profit equalisation reserve (PER)) and investment risk reserve (IRR). In Bahrain, the industry supervisor (the central bank) does not impose any such requirement, but Islamic banks in that country use some or all of these techniques.

In Bangladesh, Islamic banks do not maintain such reserves. Therefore, the profits paid to depositors dropped sharply in 2014 for all deposit products except for the Mudarabah Foreign Currency deposits.

There are various risks involved for the banks due to the unique nature of their assets.  Let us consider the case of Murahaba which is the most popular financing mode among Islamic banks.

Under this mode, Islamic banks buy an asset and sell it to its clients by expressing the purchase price and adding some profit to it. The clients may pay the price at a time or according to agreed terms. A Murabaha transaction is completed in various stages and each stage takes time and involves a fresh contractual agreement that increases the risk of disagreements and complications. Further, it is also very important for banks to maintain the sequence of the contract in Murabahah transactions. Inability or failure to conform to the sequences and Shariah requirement will result in transaction to be deemed illegitimate. Other risks that may arise in case of Murabaha are:

- Inability to meet the specified commodity stipulated in the contract and subsequent failure to deliver the specified product agreed in the contract on due date.

- Breach of contract for not meeting commitment to buy the commodity.

Bai-Muajjal also bears the same risk like Murahaba. Hire Purchase under Shirkatul Melk (HPSM) is a Special type of contract consisting of three contracts: Shirkat, Ijarah and sale and completed in three stages: Purchase under joint ownership, hire and sale and/or transfer of ownership to the other partner Hirer. In Hire Purchase under Shirkatul Melk Agreement, the exact ownership of both the Bank and Hirer (Client) must be recognized in order to avoid the risk of any complications and disagreement.

 The share of the purchased asset owned by the Bank is put at the disposal/possession of the Client keeping the ownership with the Bank for a fixed period under a hire agreement in which the amount of rent per unit of time and the benefit for which rent to be paid along with all other agreed clauses are also to be clearly stated.

 Islamic bank may be exposed to legal risk in respect of the enforcement of its contractual right to repossess the asset in case of default or misconduct by the Hirer. This may be the case particularly when the asset is a house or apartment that is the lessee's home, and the lessee enjoys protection as a tenant.

Furthermore, Ijarah (leasing), contract does not provide Islamic banks with the ability to transfer substantial risks and rewards to the lessee as leased assets must be carried on to the balance sheet of banks for the term of the lease. In case of Salam (purchase with deferred delivery) contracts, banks agree to buy the commodity on a future date against current payment and also hold the commodity until it can be converted to cash which exposes banks to both credit and commodity price risks.

It is clearly evident from above that the risk of running Islamic banks is similar to that of conventional banks but includes several additional elements. The unique features of Islamic financial contracts and the nature of business make Islamic banks exposed to some unique risks which are substantially different from conventional ones.

The relative complexity of contracts, the fiduciary obligations, Shariah compliance risk and legal constraints imply that the dimension of risk exposure in Islamic banks is more sophisticated than that of conventional banks.

The regulatory authority should consider all these unique risks in their risk management guidelines and regulations. The absence of clear guidelines, regulations and monitoring to tackle these risks may hinder the usage and applicability of various Islamic contracts which may ultimately affect the industry and its growth.

LIQUIDITY: Effective short-term liquidity management, both liquidity absorption and liquidity injection, pose challenges for Islamic banks in the country. Bangladesh Bank has developed a number of tools to address this issue. It introduced 'Bangladesh Government Islamic Investment Bond' in 2004. In 2012, the BB initiated Islamic Interbank Fund Market (IIFM) in order to facilitate effective short-term liquidity management by Islamic banks.

In 2014,  Bangladesh Bank amended the 'Bangladesh Government Islamic Investment Bond (Islamic Bond) Policy, 2004' with the objective of developing a sound foundation for the Islamic bond market and converting  excess liquidity into investment through Islamic bonds.

According to Bangladesh Bank report (2017), Islamic banks in Bangladesh have been experiencing excess liquidity for a long time as they cannot invest in Government Treasury Bills and Bonds because of the interest-bearing nature of those monetary instruments. For this, the amount of surplus liquidity of most of the Islamic banks is increasing day by day which have been affecting their net profit and increasing the cost of fund.

While above two liquidity instruments are currently available in the country, Islamic financial institutions across the globe have adopted various other tools for effective liquidity management. There is scope for introducing various other Shariah-complaint liquidity instruments for Islamic banks in the country. For example, Commodity Murahaba  and sukuk, two  commonly used liquidity  instruments  by Islamic banks in many countries, can be introduced in the country.

Islamic banks have the potential to contribute to socio-economic development of the country by financing the real economic activities, fostering green banking activities, CSR activities and promoting financial inclusion. However, the exiting supervision and regulatory framework needs to be improved with further legal, accounting, governance, regulatory and supervisory enhancements for Islamic banks to develop its full potential.

The author is working in a private bank in Bangladesh and has a post-graduate degree in Islamic Banking, Finance and Management from United Kingdom.

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