Islamic banking is not unaware about those risks which are faced by conventional banks. All bankers know too well that "Risk has no religion!" Almost all risks common to conventional banks are also faced by Islamic banks...plus more. This article analyses the additional risks Islamic banks are exposed to, by virtue of dealing with Sharia-compliant modes of financing.
Risk is seen as the probable loss of income and the value of assets. Only unexpected losses are included, and expected losses are not included, in the definition of risk. Banking is about the intermediation of short-term risks, which come in different forms and directions.
The "Depositors" may withdraw their funds; the "Banks" tend to leverage with debt and accumulate assets to maximise return on equity; the "Counter-parties" may default on their obligations; the "Regulators" seek banking system soundness and market equilibrium; other "Parties" within the interlinked balance sheets may have contingent claims on each other and, if the matters get worse, the "Public/tax payers" face the cost of deposit protection and financial crisis.
Sources of funds for both conventional and Islamic Banks are quite similar, with some exceptions.
Tier 1 Capital is made up of Equity Capital for both; Tier 2 Capital for conventional banks may be in the form of subordinated loans or preference shares, whereas for Islamic Banks, Sukuk may qualify; Current and Savings Accounts are common to both; Time and Certificates of Deposit in conventional banks are replaced by Unrestricted Profit Sharing Investment Accounts (PSIAs) in Islamic Banks. Further, there are special Reserve requirements for Islamic Banks, in the form of Profit Equalisation Reserve (PER) and Investment Risk Reserve (IRR), to mitigate the Displaced Commercial Risk and Rate of Return risk. Conventional banks generally make provisions for specific bad debts to comply with regulatory requirements.
Risk Management for Sources of Funds, therefore, is different for some, but common for others. Current and Savings Accounts, Time and Certificates of Deposits and other fixed income liabilities in conventional banks are protected by Shareholders' Equity, Preference Share Capital and Subordinated loans.
In Islamic banks, Current Accounts are protected by Shareholders' Equity, whereas PSIAs are protected by Profit Equalisation Reserves (PER) and Investment Risk Reserves (IRR). Shareholders' Equity protects PSIAs only for fiduciary risks where the loss in value results from a bank's own negligence, errors or fraud.
Generally speaking, the Cost of Funding for conventional banks tends to be fixed whereas, theoretically, for Islamic Banks it tends to be variable. However, in practice, even Islamic Banks attempt to keep their Cost of Funding fixed for better management of their Sources of Funds.
Uses of Funds for both conventional and Islamic banks are similar, except that Loans & Advances in conventional banks are replaced by Murabaha, Musharaka, Istisna'a, Salam or Ijara Receivables, which are the Sharia-compliant modes of financing practiced by Islamic Banks. As a result, some related assets and inventories may also appear on their balance sheet to account for assets-in-transition, pending either the completion of a transaction or other reasons. Sustaining losses resulting from reduction in the value of assets follow similar patterns in both conventional and Islamic Banks.
Expected Losses are handled out of the "Income" by both conventional and Islamic Banks. Unexpected Losses from Credit, Market and Operational Risks are generally covered by Shareholders' Equity, Preference Shares, Subordinated Debt and other Reserves by conventional banks. Contingent losses are protected through Insurance coverage.
In order to ensure the stability of an Islamic bank, they tend to cover their Expected Losses from "Income", while Unexpected Losses from PSIA-financed assets are protected by PSIAs (equity in nature), Profit Equalisation Reserve and Shareholders' Capital, whereas assets financed by Current Accounts and Shareholders' Equity are protected by Shareholders' Equity and Investment Risk Reserves. Like conventional banks, Contingent losses are protected through Sharia-compliant Takaful (Insurance).
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