Islamic Banks and Stress Testing

A wake-up call has been raised by the current crisis, mainly in countries offering both conventional and Islamic forms of banking. These countries have had to tackle two issues. They have firstly had to manage the crisis, which has largely affected conventional bank. Secondly, they have attempted to gauge the impact of the crisis on the Islamic sector. This led to a muted response to understanding and tackling the risks faced by Islamic banks during the current crisis, largely attributed to the hazy domain of risk management in Islamic banking.

Although it had appeared that Islamic banks were immune to the crisis, they were also affected by the general downturn and the fall in the value of assets since they operate within the same financial system and are asset-based or -backed, as Islamic loans and investments are required to be. However, due to the prohibition on derivatives, the exposure was restricted and therefore so was the direct impact. What still remains to be seen is whether these institutions will be capable of absorbing stresses and shocks, particularly those that are more specific to the Islamic financial market, in the future.

Stress Testing is Back

Stress testing is not a new concept. It has been on the risk management table for several years. However, it has not been implemented comprehensively, primarily due to prevailing focus on ratios and due to excessive stress on value-at-risk (VaR). Some argue that this point is exemplified by the fact that stress conditions were not robust enough to predict what happened.

The current crisis has brought stress-testing to the top of the agenda – not only for commercial banks, but also for several regulators, specifically in the UK, Europe, Bahrain, Kuwait etc. who are responding to the crisis by introducing better liquidity management regimes and improved stress testing. Several regulators are asking for additional reports based on specified stress tests adding to the compliance requirement for most banks. Stress tests are an excellent tool for understanding the plausible impact of a what-if scenario. However, this requires an in-depth understanding of institutions and the market in which they operate. This understanding, however, remained limited to local markets and own institutions, thus missing the contagion effect and systemic risk dimensions.

The importance of including systemic risk in stress testing is more important than ever before. The life-threatening events are rarely captured by VaR, which is certainly very useful for measuring the impact within the not-so-extreme cases, but not so useful for the tail events. Hence stress tests begin where VaR ends. They are especially useful for extreme cases. Stress tests can range from very simple to highly complex and can be for different time buckets and scenarios.

Figure 1: Value-at-risk

Source: FRSGlobal

According to the Basel consultative paper on stress tests of May 2009, stress tests can be performed on several measures, including:

  • Asset values.
  • Accounting profit and loss.
  • Economic profit and loss.
  • Regulatory capital.
  • Liquidity.
  • Funding gaps.

Stress testing is also usually done on external scenarios such as:

  • Systemic shocks
  • Recession
  • Payment crisis

And on internal scenarios such as:

  • Credit losses.
  • Market losses.
  • Operational losses.

Tests can be purely historical but it has become clear that that the past has not been a good predictor of the future. Sensitivity and scenario analysis should be used in combination, as sensitivity provides a one-factor change possibility whereas scenario analysis is a multi-factor approach.

Islamic Banks – Risk Management Perspective

The debate rages on about whether Islamic banks were less affected during the crisis than conventional banks. One argument is that they were not severely affected, as they had no toxic products on their books and were also protected by asset-based financing. Another viewpoint, however, is they cannot remain wholly unaffected as they operate in the same environment.

It should be noted that the risk structures of Islamic banking products are more complex and integrated compared with conventional bank products. For example:

A simple-looking murãbaha (cost-plus financing) has a complex structure of risks ranging from:

  • Credit risk – chances of default of counterparty.
  • Market risk – because the asset under murãbaha is owned by the bank.
  • Operational risk – because the contract structure is highly complex.

A mushãrakah (partnership) contract carries:

  • Liquidity risk – due to adverse cash flow when loss is shared.
  • Credit risk – when there is a major loss threatening the continuity of the business.
  • Market risk – coming from the last equity payment on liquidation, affecting profit and loss (P&L) and balance sheet.

This is also the case for other products including mudãrabah, istisnã, ijãrah and salam. Complex risk structures call for specific stress tests designed for these products, which appear on most Islamic banks balance sheets.

Stress Testing for Islamic Banks

The balance sheet structure of an Islamic bank is different compared with conventional banks and has a different effect on liquidity management. On the asset side of the balance sheet, Islamic banks have cash and reserves, where the reserves are not completely free and require permission from the depositors and the returns on the deposit are not guaranteed. Investment items appearing on the asset side include Shariah-approved securities. On the liabilities side, Islamic banks have different contractual agreements for deposits.

In addition, investment deposits can be particular, with a restriction on investments in a specific portfolio or general, where investments can be in any of the Shariah-approved portfolio, thus needing a separate grouping for further risk analysis. The major source of liquidity is operational financing, which comes largely from murãbaha and mudãrabah contracts. Another notable feature of Islamic banking balance sheets is their heavy reliance on short- to medium-term financing, especially when funded by savings and time deposits. This is gradually changing as longer-term alternatives are evolving.

Stress testing is very common to all types of banks. There are several stress tests that are common to conventional and Islamic banks. Stress on exchange rates, interest rates (although Islamic banks do not operate on interest rates, they are indirectly exposed to them), equity prices, commodity prices and other market variables are regularly needed by both types of banks. Downgrading of counterparty ratings and other similar stresses certainly affect the Islamic banks. However, in addition to these, there are specific stress tests that are unique to Islamic banks.

The maturity mismatch in Islamic banks is far more distributed compared to conventional banks and has been the main source of the liquidity issue. In addition, the distribution of liabilities is skewed more towards short- and medium-term. Assets, on the other hand, are generally for medium- to long-term, mainly due to an apparent shortage of a Shariah-approved mode of lending. The need for specific stress tests arises partially from the typical balance sheet structure.

Moreover, the banking book of Islamic institutions is loaded with commodities owned by the institutions themselves, as a part of various murãbaha, salam, and ijãrah contracts. On the P&L side, most of the contracts where banks participate in the client equity (mushãrakah and mudãrabah) affect the cash flows depending on what is received at the end of the cycle. Thus, there are several stress tests that should be used by Islamic banks specifically.

The unrestricted investment account (URIA) and restricted investment account (RIA) are the two major concentrations. Hence specific stress (say 10%) on URIA and RIA can help the bank understand the impact on liquidity. Liquidity-related stress tests are pertinent because of balance sheet imbalances on the duration of assets and liabilities. The fluctuations linked to the P&L come from:

  • Known cash flows (murãbaha, ijãrah and diminishing mushãrakah).
  • Conditional but predictable cash flows (salam and istisnã receivables).
  • Conditional but unpredictable cash flows (mushãrakah investments).

Hence, all three types of cash-flow based portfolio need to be stressed. The most popular way of managing short-term liquidity in an Islamic institution is by using commodity murãbaha. According to a study, commodity murãbaha is used, on average, in 45% of the cases for short-term liquidity management. Typically, commodity murãbaha has market risk attached to it due to the changes in the price of the underlying commodity. There is little argument that a stress test on a commodity murãbaha is of great importance to Islamic banks.

Prepayments, withdrawals, and rollovers also need to be stressed, as they appear on murãbaha, ijãrah and mudãrabah accounts. Here, defaults are more pertinent in Islamic banking, due to restrictions on recovery mechanisms. Stress on default, either on total or selected portfolios, is regularly needed. The concentrations should be identified and stress tests should be conducted on notably large concentrations. An Islamic bank’s investment book consists of investments in sukuk, which are also prone to market shocks. So stressing sukuk investment is also imperative for Islamic banks.

Summary

There is a growing concern that Islamic banking risk management practices are not keeping pace with the global financial market. The rapid growth of Islamic banking on all fronts calls for proactive responses to risk management issues. The asset-based characteristics of Islamic banks makes the balance sheet heavy and their P&L more prone to fluctuations. Liquidity management, in the absence of a systematic money market, becomes more complex. Thus stress testing, for various time buckets, including some typical time buckets for mushãrakah accounts (based on the kind of project financed) is needed.

In addition to the regular stress tests on various market risk factors like foreign exchange (FX) prices, commodity prices and indices, tests on `business as usual’ and ‘total stress’ scenarios are also required. The typical ‘run on a bank’ scenario should be assessed regularly since there is a herd mentality observed in Islamic investors. Due to market risk being concentrated in a banking book, more stress tests are needed on the balance sheet, covering market risk variables.

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