Stress Testing for Islamic Bank Capital

Stress Testing for Islamic Bank Capital P

Abdul Ghafar Ismail Professor of Islamic banking and financial economics Lecture delivered at Universiti Kebangsaan Malaysia

Jan-16

1

Introduction Role of capital: ◊ to assess the safety and soundness of a bank ◊ as safety net for a variety of risks ◊ to absorb losses ◊ to provide the basis for maintaining the confidence of the depositors

Jan-16

2

Issues ◊ Jamshaid (2013) used the Balance Sheet (BS) as the basis - BS are exposed to risk but limited to market and credit risk (because this paper was presented in the 9th ICIEF) ◊ But the author incorporates IFSB-13 (build mainly on Basle Committee on Banking Supervision and European Banking Authority ◊ Previous studies focus on the conventional banks, this study focuses on Islamic banks (IBs) ◊ Since, there are many developments such as Basel III (previous studies refer to IFSB-2), and IBs are s.t. new guidelines and new law – need to revisit ◊ Opportunity for us – bottom up approach, a revised model of stress testing

Jan-16

3

Revisit the Stress Testing Matrix ◊ Step 1 - objective(s) of conducting the stress testing ◊ Step 2 - risk factors – identification of risk parameters (e.g. MR, CR, OP, DCR, LR) ◊ Step 3 - Data requirements – if there is no data (incl. no quality data), proxy to be considered ◊ Step 4 - Scenario type and scenario stress ◊ Step 5 - Frequency ◊ Step 6 – Methodology – sensitivity or scenario test analysis, deterministic or stochastic models ◊ Step 7 – Output and remedial actions ◊ Step 8 - Disclosure

Jan-16

4

Specific Issues that Require Stress Testing ◊ Specificities of IF – shariah as basis including certain prohibitions, no re-pricing of sale contracts, asses-backed, shariah compliant, risk transformation (for example asset available for sales) ◊ Balance sheet components – exposed to CR, MR, OR but also shariah non compliance risk, fiduciary risk (IFSB-1), ROR (IFSB-1) and DCR (IFSB-1)

Jan-16

5

Islamic Bank Business Activities

January 16

Page 6

Stylized Balance Sheet of an Islamic Bank

January 16

Stylized balance sheet of Islamic banks Assets Cash and cash equivalents Investment in securities Sales receivables Investment in leased assets Investment in real estates Equity financing Equity investment in capital ventures Investment in subsidiaries

Outcomes

Liabilities Current account Other liabilities Equity of Profit Sharing Investment Accounts (PSIA) Profit sharing investment accounts Profit equalization reserve Investment risk reserve Owners’ Equity

Liabilities Hibah Hibah

Revenue Revenue Revenue Revenue Revenue Revenue Revenue Revenue

Dividend Dividend Dividend Dividend

7

Unique

Risk Profile of Islamic Bank (Step 2) Shariah non-compliance risk

Displaced Commercial risk

Rate of return risk

Equity Investment risk

Islamic bank

Generic

Credit Risk

Strategic

January 16

Operational risk

Market risk

Legal

Fiduciary

Reputation

Liquidity risk

Transparency

Regulatory compliance

8

CAR Formula as Basis of Stress Testing (Step 2)

CAR =

Eligible Capital {Total Risk-weighted Assets (Credit Risk + Market Risk) + Operational Risks

Less (1-α)[Risk-weighted Assets funded by PSIA (Credit Risk + Market Risk)] Less α[Risk-weighted Assets funded by PER and IRR (Credit Risk + Market Risk)]}

Jan-16

9

Think to ponder ◊ Pre-fixed sale price – MP affects the benchmark ◊ ↑CAR, IBs cut the supply of financing

◊ α factor – risk-weighted assets financed by PSIA ◊ Smoothing practices – IBs may consider DCR, PER and IRR ◊ Credit risk should be looked in two perspectives – shariah compliant and NPF ◊ Market risk - investment based on mudharabah/musharakah are prone to market shocks ◊ Liquidity risk - to promote the short-term resiliency of the liquidity risk profile of IBs by ensuring that they have sufficient high quality liquid resources to survive an acute stress scenario lasting for one month; to promote resiliency over longer-term time horizons by creating additional incentives for IBs to fund their activities with more stable sources of funding on an ongoing structural basis ◊ Operational risk – to model the shariah risk Jan-16

10

Sources of Shari’ah Risk (OP) (Step 2) Shari’ah Operational Shari’ah breaches from operational perspective i.e. fraud, wrong sequencing, communicating Shari’ah rulings

Market Conduct Wrong information with regard to Shari’ah requirements.

Operational infrastructure

Legal infrastructure Product structure or clauses in the documentation that are contradicting to the revalent provision of the law. Legal uncertainty for example Wa’ad.

Legal documentation

Inadequacies of support to ensure Shari’ah compliance. i.e. system weaknesses, leveraging structure IT, recovery, outsourcing, credit processing.

Clauses which are contradicting Shari’ah rulings

Differences in Opinion Changes in Shari’ah Rulings Institution is not aware of changes in Shari’ah ruling i.e. national level, institution level.

Fiduciary Function Weaknesses in ensuring Shari’ah compliance investment and mandate.

Opinion on internal Shari’ah Adviser differs from other institutions for example investment in tawarruq based Sukuk.

Data and Methodology (Step 3 and Step 6) ◊ Case study – HSBC Amanah

Jan-16

12

Continued…

Jan-16

13

References ◊ Jamshaid Anwar Chattha (2013) Assessing The Stability And Resilience Of Islamic Banks Through Stress Testing Under Standardized Approach Of The Ifsb Capital Adequacy Framework. Paper presented at the 9th International Conference on Islamic Economics and Finance (ICIEF) to be held on 9-10 Sept, 2013 in Istanbul, Turkey ◊ Abdul Ghafar Ismail and Ahmad Azam Sulaiman (2008) Whether Islamic Banks Chose to Adjust their Assets Due to Capital Adequacy Requirements. Journal of Islamic Economics, Banking and Finance, 4(1): 27-37. http://www.aeaweb.org/econlit/journal_list.php ◊ Abdul Ghafar Ismail and Ahmad Azam Sulaiman .2007. Default and Recovery Rates on Islamic Banks Financing: Implications for the New Capital Adequacy Standard. Review of Islamic Economics, 11:107-122. (http://www.aeaweb.org/econlit/journal_list.php)

Jan-16

14