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CHAPTER 3 - ISLAMIC FINANCIAL SYSTEM

3.6. THE MAIN RISK FACTORS OF ISLAMIC BANKING

3.6.1. Liquidity Risk

Liquidity can be defined as the ability of a bank to meet the redemption of the deposits and other liabilities and, also to fund the demands in the loan and investment portfolio and it is essential to offset the expected and unexpected balance sheet fluctuations and provide funds for growth (Iqbal and Mirakhour, 2007). As Oldfield and Santamero (1997) explain, unexpected demand of borrowers causes cash or liquid assets inadequacies which effect the bank’s ability to provide funds promptly at a reasonable price.

After 1980’s the Islamic banking has grown rapidly and spread to countries other than Islamic countries. Accordingly, studies show that there is a positive relationship between

34 Ayub, 2012, p. 256

the bank size and liquidity risk and therefore, liquidity risks of Islamic banks have increased with the growth of Islamic banking (Ahmed and Usman, 2011; A. Iqbal, 2012).

For Islamic banks, the liquidity risk arises due to lack of liquidity in the market and lack of access to funding (Z. Iqbal and Mirakhor, 2011). The lack of liquidity in the market can be defined as the insufficient level of liquidity in the market or the loss arising from the inability to convert liquid assets into cash promptly and with reasonable price due to the adversities in the financial markets. Lack of access to funding, on the other hand, is the risk of failing to fulfil obligations at a reasonable cost due to irregularities in cash inflows and outflows.

Although Islamic banks comply with the principles of Shari’ah, they operate within the framework of conventional banking procedures, principles and practices. Accordingly, although the measurement and evaluation of the liquidity risk in both types of banks show some similarities, the instruments used in liquidity management differ significantly between Islamic banking and conventional banking since Islamic banks are operated based on Shari’ah principles. In this context, the main factor that causes liquidity risk in Islamic banking is the interest rate ban on accessing liquidity. Accordingly, the main cause of liquidity risk in Islamic banks are shown as the limited number of liquid Shari’ah compliant instruments. More precisely, while conventional banks use the financial instruments in the money market, inter-bank market, the secondary market or discount windows from central bank for liquidity management; Islamic banks cannot use these instruments since they involve interest (Mohammad, 2013). They meet their liquidity requirements through long-term assets or partnership contracts as Ijarah, Mudarabah and Musharakah. Therefore, there exist limited funding options for Islamic banks to manage liquidity risk. Liquidity risk is related to both sides of the balance sheet of Islamic banks.

The reason for being on the assets side of the balance sheet arises from the banks' inability to return their assets to cash when needed without incurring any loss. On the other hand, it exists in the liabilities side in cases of unexpected withdrawals of deposit. For this reason, asset and liability management is very important in terms of ensuring a sustainable risk management in Islamic banking.

3.6.2. Credit Risk

One of the most crucial risks that banks take due to their banking activities is the credit risk. Credit risk can be defined as the potential loss that arises when a counterparty fails to fulfil its financial obligations according to the agreed-terms. The credit risk in Islamic banking is directly related to the financial products as Murabahah, Ijarah, Salam, Istina, Musharakah and Mudarabah.

As already explained in the Section 3.5.4, Ijarah is a leasing contract where a property is leased to the customer in return for a rental payment for a certain period. Murabahah is a transaction where the trader buys a property to sell it to a buyer by placing a certain profit rate (where Islamic banks are the traders). In the context of Murabahah and Ijarah contracts, there is a risk that the customer might not make his/her payments on time (Akkizidis and Khandelwal, 2008). On the other hand, Salam means the prepaid sale of a well-defined product to be delivered in the future. Therefore, for Islamic banks the credit risk occurs, if the customer does not make the agreed payments, where the seller might not deliver the product on time or at agreed quality as well. In Istina contract, a producer creates a good of property based on a specific standard and price. It is an advance sale of a specific commodity that is not manufactured or constructed yet. Islamic banks are exposed to credit risk through Istisna’ contracts if the buyer is disable to buy the agreed product or if the buyer provides the installed payments after receiving the product.

Mudarabah is a contract of partnership where one party provides capital and the other party provides labor and management. Musharakah is a mutual contract to establish a joint venture. One can see that in Mudarabah and Musharakah contracts, the relationship between the Islamic bank and the counterparts is partnership based. Therefore, credit risk occurs if the financial project does not bear the expected revenue (Akkizidis and Kumar, 2008).

3.6.3. Market risk

As IFSB(2005) explains, market risks can be defined as the losses in on and off balance sheet positions which is caused by the market prices such as fluctuations in values in

tradable, marketable or leasable assets and individual portfolios (Islamic Financial Services Board, 2005, p. 16) . Furthermore, the market is also related to the volatility of the foreign exchange rates.

Islamic banks are exposed to higher market risk than conventional banks due to the asset-backed financial instruments. Additionally, most of the Islamic finance contracts have high market risk. Market risk arising from Islamic finance contracts can be explained with respect to Murabahah, Salam and Ijarah agreements.

The Murabahah is associated with the market risk because of the mark-up rate. In Murabahah, mark-up rate is fixed during the contract but the benchmark rate may vary.

If the prevailing mark-up rate exceeds the rate that is agreed in the contract, then the bank cannot benefit from this price change (van Greuning and Iqbal, 2007). Within the scope of the Salam, the market risk arises due to the price fluctuations in the commodity prices.

In other words, market risk arises due to price differences in the period between the delivery and sale of the goods. If the bank cannot supply the product to be offered for sale, it may have to buy the same product at a higher bit price from the market. In operating Ijārah, the lessor is exposed to market risk in two ways. Firstly, market risk arises due to the residual value of the leased asset at the term of the lease. Secondly, if the tenant terminates the lease earlier than the specified period at the time of the lease, then the lessor is exposed to market risk (IFSB, 2005).

3.6.4. Profit/ Rate of Return Risk

The Islamic banks are exposed to rate of return risk due to the mismatches between the bank assets and balances of the depositors (IFSB, 2005). There is an uncertainty in the asset side of the Islamic banks’ balance sheet in terms of the rate of return since there is no a fixed income from the financings as Mudarabah and Musharakah. This uncertainty causes the investment account holders’ expectations to diverge with respect to the price changes. In other words, if benchmark prices increase, the investment account holders expect higher rate of return. Moreover, if the divergence increases, the rate of return risk also increases.

In Islamic banks, the uncertainty is higher compared to the conventional banks.

Conventional banks operate based on interest, thus, on the asset side of their balance sheet, they have fixed income securities and also the return on deposits are predetermined.

However, in Islamic banks, the investments are based on mark-up and equity implying that there is no fixed rate of return and, since there is no pre-agreed return on deposits where the uncertainty of the rate of return on investments is higher (van Greuning and Iqbal, 2007).