RISK MANAGEMENT FOR ISLAMIC BANK

Week 4: Credit Risk and�Equity Investment Risk in Islamic Bank

From counterparty obligations to business-performance risk

CREDIT�RISK

EQUITY�INVESTMENT

Islamic Banking Risk Management • Week 4

01

Credit Risk

Risk of a counterparty failing to meet obligations according to the structure of the Islamic contract.

CREDIT RISK

Why Credit Risk Matters

4

Key points

• Financing is typically the largest asset of a bank.�• Deteriorating financing quality raises NPF and provisioning.

Continued

• Higher provisions reduce profit and put pressure on capital.�• Credit risk can trigger liquidity, rate of return, DCR and reputational risk.

CREDIT RISK

Conventional vs Islamic Credit Risk

5

Conventional Bank

• Focus: principal and interest repayment�• Often understood as loan default risk

Islamic Bank

• Not always payment default�• May involve payment, delivery, completion, performance or moral hazard�• Risk depends on the underlying akad

CREDIT RISK

What Counts as Credit Risk?

6

Key points

• Default Risk�• Settlement Risk�• Delivery Risk�• Completion Risk

Continued

• Performance Risk�• Counterparty Risk�• Moral Hazard Risk

CREDIT RISK

Credit Risk Changes with the Akad

7

CREDIT RISK

Murabahah & Ijarah

8

Murabahah

• Instalment default�• Late payment�• Declining repayment capacity�• Collateral value decline�• Goods dispute / weak documentation

Ijarah

• Rental payment default�• Asset damage�• Asset unusable�• Maintenance dispute�• Credit + ownership + market risk coexist

CREDIT RISK

Salam & Istisna

9

Salam

• Bank pays now; goods arrive later�• Failure or delay in delivery�• Quality / volume mismatch�• Core issue: Delivery Failure

Istisna

• Project or asset is manufactured / built�• Delay, poor quality, cost overrun�• Project may not be completed�• Core issue: Completion Failure

CREDIT RISK

Mudharabah & Musyarakah

10

Mudharabah

• Bank provides capital; customer manages�• Weak transparency / hidden profit�• Misuse of funds / moral hazard�• No fixed return → harder to measure

Musyarakah / MMQ

• Bank and customer both contribute capital�• Business failure / cash-flow mismatch�• Asset value decline�• Exit may fail�• Equity-like characteristics

CREDIT RISK

Credit Risk Identification

11

Key points

• Identify the counterparty and the akad used.�• Clarify the contractual obligation and when it must be performed.�• Assess customer character, reputation and business experience.

Continued

• Understand business model, profitability and cash-flow stability.�• Review contract structure, rights and obligations.�• Assess collateral value, legality and liquidity.

CREDIT RISK

Credit Risk Assessment — 6C

12

Key points

• Character — willingness to pay�• Capacity — ability to pay�• Capital — financial strength

Continued

• Collateral — security�• Condition — economic environment�• Compliance — Sharīʿah compliance

CREDIT RISK

Portfolio Assessment Matters Too

13

Key points

• Sector concentration�• Geographic concentration�• Business-group concentration

Continued

• Contract concentration�• NPF trend�• A sound assessment looks beyond a single customer to the portfolio as a whole.

CREDIT RISK

Credit Risk Measurement

14

1

PD�Probability of Default

2

LGD�Loss Given Default

3

EAD�Exposure at Default

4

Expected Loss�PD × LGD × EAD

CREDIT RISK

Measurement Must Follow the Contract

15

Key points

• Murabahah & Ijarah: PD-LGD-EAD can be relatively similar to Basel debt-like exposures.�• Salam & Istisna: default also includes delivery and completion failure.

Continued

• Mudharabah & Musyarakah: PD-LGD-EAD alone is insufficient.�• PLS exposures also require business analysis, scenario analysis, stress testing, governance assessment and reporting quality.

CREDIT RISK

Prevention vs Mitigation

16

Prevention

• Prevent risk before it emerges�• KYC and legal verification�• Business & cash-flow review�• Correct akad and financing structure�• Strong documentation and Sharīʿah due diligence

Mitigation

• Reduce loss when risk materialises�• Collateral / Kafalah / Takaful�• Diversification and limits�• Intensive monitoring�• Restructuring and recovery

CREDIT RISK

Credit Risk Monitoring & EWS

17

Key points

• Monitor payment delays, declining turnover and customer behaviour.�• Track collateral values and changes in industry conditions.

Continued

• Use Days Past Due, internal rating, covenant breach and repeated restructuring as warning signals.�• Monitoring must cover customer, sector, product, akad, portfolio and enterprise levels.

CREDIT RISK

From Deterioration to Loss

18

1

Healthy Customer

2

Warning Signal

3

Special Mention

4

NPF

5

Loss

CREDIT RISK

Reporting, Provisioning & Capital

19

Key points

• Risk reporting supports management, Board, Risk Committee, DPS and regulator decisions.�• Reports cover financing, NPF, provisions, restructuring, recovery, write-off and top obligors.

Continued

• Higher NPF → higher provisions → lower profit → pressure on capital.�• Credit risk affects RWA, capital needs, CAR and capacity for financing growth.

CREDIT RISK

Credit Risk in ERM

20

1

Credit Risk

2

Liquidity Risk

3

Rate of Return Risk

4

DCR

5

Reputational Risk

CREDIT RISK

Credit Risk Appetite & Common Mistakes

21

Key points

• Set NPF targets and concentration limits by sector, akad, group and maturity.�• Do not treat Murabahah as conventional credit.�• Do not rely on collateral while ignoring cash flow, business and character.

Continued

• Do not stop monitoring after disbursement.�• Risk reporting must be a decision tool, not an administrative exercise.

02

From Repayment to Business Performance

Credit Risk asks “Can the counterparty fulfil the obligation?” Equity Investment Risk asks “Will the business perform?”

TRANSITION

Credit Risk vs Equity Investment Risk

23

Credit Risk

• Focus on repayment / contractual performance�• Return relatively more predictable�• Default is the key issue�• Debt-like exposure

Equity Investment Risk

• Focus on business performance�• Return is uncertain�• Profitability and investment value are key�• Equity-like exposure

03

Equity Investment Risk

Risk arising because the bank participates in profit-sharing or partnership financing and becomes exposed to business performance.

EQUITY INVESTMENT RISK

Why Equity Investment Risk Matters

25

Key points

• Islamic banking includes profit sharing, partnership and risk sharing.�• The bank earns profit only when the underlying business generates profit.

Continued

• If the business underperforms or loses money, the bank is directly affected.�• Loss can arise even without a contractual default.

EQUITY INVESTMENT RISK

Core Characteristics

26

Key points

• Profit and Loss Sharing�• No Fixed Repayment�• Business Risk Exposure

Continued

• Agency Problem�• Information Asymmetry�• Difficult Exit

EQUITY INVESTMENT RISK

Akad Exposed to Equity Investment Risk

27

EQUITY INVESTMENT RISK

Why It Is More Complex

28

Key points

• Business risk — sales, cost, competition and economic conditions.�• Agency problem — partner may behave opportunistically.�• Information asymmetry — partner knows more than the bank.

Continued

• Governance weakness — weak reporting and controls.�• Market and liquidity risk — value can fall and exit can be difficult.�• Operational and legal risks can compound the exposure.

EQUITY INVESTMENT RISK

Agency Problem — The Central Challenge

29

Key points

• Underreporting profit: actual profit may be higher than reported.�• Excessive risk taking: partner takes more risk because losses are shared.

Continued

• Misuse of funds: investment is used outside the agreed purpose.�• Weak transparency increases moral hazard and makes monitoring difficult.

EQUITY INVESTMENT RISK

Equity Investment Risk Identification

30

Key points

• Partner: reputation, experience, integrity, track record and management competence.�• Business: model, competitive advantage, profitability and demand stability.�• Industry: growth, cyclicality and market exposure.

Continued

• Governance: organisation, internal control, reporting, audit and segregation of duties.�• Cash flow: sources, receipts, expenditures and volatility.�• Legal structure and contract-specific risks must also be understood.

EQUITY INVESTMENT RISK

Identification by Akad

31

Mudharabah

• Quality of mudharib�• Transparency�• Quality of reports

Musyarakah / MMQ

• Partnership governance�• Control mechanism�• Asset valuation�• Sustainability of rental / cash flow

EQUITY INVESTMENT RISK

Equity Investment Risk Assessment

32

Key points

• Assess probability of loss, profit volatility and business sustainability.�• Evaluate management quality, industry, governance, leverage, market conditions and cash-flow stability.

Continued

• Partner assessment: integrity, capability, experience, reporting quality and commitment.�• High profit is not necessarily attractive when volatility is high, governance is weak or transparency is low.

EQUITY INVESTMENT RISK

Measurement: Different from Credit Risk

33

Key points

• PD-LGD-EAD alone is not sufficient because the focus is business performance.�• Profit Variability Analysis measures volatility of earnings.�• Cash Flow Analysis assesses resilience and liquidity of the business.

Continued

• Net Asset Value Analysis tracks changes in investment value.�• Sensitivity Analysis tests changes in sales, cost and margin.�• Stress Testing applies severe scenarios; concentration measurement assesses portfolio exposure.

EQUITY INVESTMENT RISK

Example — Profit Variability & Sensitivity

34

EQUITY INVESTMENT RISK

Prevention Before Investment

35

Key points

• Conduct due diligence on partner, business, industry, governance and market.�• Assess partner competence, honesty and experience.�• Assess profitability, sustainability, scalability and competitive advantage.

Continued

• Use strong structuring: rights, obligations, nisbah, reporting, governance and exit mechanism.�• Require sound records, internal controls and auditable reports.�• Diversify by sector, partner, region and tenor; design exit strategy from the start.

EQUITY INVESTMENT RISK

Mitigation After Investment

36

Key points

• Ongoing review, report analysis, management discussions and site visits.�• Covenants: monthly reporting, annual audit, transaction restrictions and leverage limits.�• Collateral/security does not eliminate business risk but can reduce negligence, fraud and misuse of funds.

Continued

• Step-in rights allow corrective action or intervention where contractually permitted.�• Portfolio rebalancing can reduce excessive sector exposure.

EQUITY INVESTMENT RISK

What Must Be Monitored?

37

Key points

• Financial performance: revenue, profit, margin, cash flow, leverage and working capital.�• Operational performance and actual existence of assets/business activity.�• Governance: reporting quality, contract compliance, controls, management changes and shareholder conflict.

Continued

• Industry conditions, market development and competition.�• Early warnings: falling sales/profit, late reports, management changes, disputes and negative cash flow.

EQUITY INVESTMENT RISK

Equity Investment Risk Deterioration

38

1

Healthy Business

2

Profit Declines

3

Cash Flow Declines

4

Liquidity Problems

5

Investment Loss

EQUITY INVESTMENT RISK

Reporting & Dashboard

39

Key points

• Reports include investment value, profit sharing, valuation changes, portfolio concentration, monitoring results and governance issues.�• Management focuses on performance, profit trends, key problems and mitigation.

Continued

• Board focuses on material exposure, concentration, strategic and capital implications.�• DPS needs information on contract compliance, use of funds, profit distribution and potential Sharīʿah breaches.

EQUITY INVESTMENT RISK

Equity Investment Risk in ERM

40

1

Equity Investment Risk

2

Profit Declines

3

IAH Return Declines

4

Rate of Return Risk

5

DCR

6

Liquidity Pressure

EQUITY INVESTMENT RISK

Fiduciary, Sharīʿah Governance & Risk Appetite

41

Key points

• Large investment losses can raise IAH questions, fairness concerns and fiduciary risk.�• Ensure halal business/activity, contract-compliant profit sharing and no profit manipulation.

Continued

• Set maximum exposure, sector and partner limits, minimum target return and concentration limits.�• ERM looks at the entire investment portfolio, not only one project.

EQUITY INVESTMENT RISK

Common Mistakes

42

Key points

• Treating Mudharabah like Murabahah.�• Focusing too much on collateral while ignoring business, management and governance.�• Failing to design an exit strategy.

Continued

• Ignoring agency problems.�• Starting monitoring only after problems emerge instead of from day one.

04

Putting Both Risks Together

One framework, two different risk logics: contractual performance and business performance.

SYNTHESIS

Integrated View

44

SYNTHESIS

A Unified Risk Management Cycle

45

1

Identify

2

Assess

3

Measure

4

Prevent

5

Mitigate

6

Monitor

7

Report

8

Integrate into ERM

SYNTHESIS

Week 4 — Key Takeaways

46

Key points

• Credit Risk in Islamic banks is broader than loan default; its form depends on the akad.�• Equity Investment Risk arises because the bank participates in business performance and investment value.�• Debt-like exposures can rely more on repayment metrics; PLS exposures require deeper business and governance analysis.

Continued

• Prevention starts before financing/investment, while monitoring continues throughout the life of the exposure.�• Both risks must be managed at transaction, portfolio and enterprise levels.

Thank You

Ronald Rulindo, PhD

Week 4 • Risk Management for Islamic Bank