Risk Management for Islamic Banks. Imam Wahyudi

Assets in Islamic Finance

      Risk-free assets imply that the asset will still give a positive return to its holder, no matter the business condition that has befallen on the firm that issued it, regardless of whether it has succeeded or failed. Other than that, an asset is said to be risk-free if the return that it generates is constant and invariant through time. This term is better known from the CAPM, where the risk-free asset is associated with the opportunity cost borne by the investor when the investor takes additional risk in a project. The investor requests additional return as a compensation for venturing beyond the status quo in placing his or her funds on financial instruments (assets) with a positive yield, and yet risk-free. Here, it is assumed that (1) money can generate real income from itself; (2) alternative projects always generate positive yield; and (3) there is no risk associated with alternative projects; and these three assumptions are frankly not true. Apart from opportunity cost, the concept of the risk-free asset also represents the decline of purchasing power caused by inflation. When there is a positive inflation, if the nominal amount of money does not increase, then within the year, the real value of the money will decline by the same amount as the inflation rate. This is why when investors decide to invest, there is a potential loss if the yield of the project is smaller that the ongoing rate of inflation.

      There are three possibilities of implementation of the concept of risk-free asset: qardh (loan or debt), debt-based sale contract (salam or mu'ajjal), and partnerships or syirkah (mudharabah, musyarakah). In the first case, the application of the concept of the risk-free asset will cause the payment of debt to be larger than what is received by the borrower. For whatever reasons, whether due to opportunity cost or compensation over the effects of inflation, this nominal addition to the future value is not allowed in Islam, and falls under usury. In the second case, the concept of the risk-free asset is used to determine the size of the margin in a mu'ajjal sale or the discounted price in a salam price, and this is allowed in Islamic finance. In the third case, the application of the concept of risk-free asset is only allowed as a benchmark and cannot be set as a predetermined rate of return. This concept can only be used to simulate the ratio for the preferred rate of return and estimate the yield with that ratio. But, after the ratio is set, the realization of the return will rely on the realization of the profit or loss of the business. Thus, different from the second case, on syirkah, the application of the concept of the risk-free asset is abstract and not real.

Chapter 2

      The Islamic Bank and Risk Management

      The Islamic bank is a financial intermediation institution, bridging a deficit sector in funds with one that experiences a surplus of funds. Conceptually, a bank is a win-win solution not only for the surplus sector and the deficit sector, but also for the bank facilitating the needs of the two. This concept is in line with the concept of transaction within Islam; that all mu'amalah transaction began from the intent of mutual assistance (at-ta'awun), and to spread good deeds among men. The party with the surplus funds benefited from the security provided by the bank (wadhiah-based product) or from the returns of the invested funds (profit-sharing–based product). The party with the fund deficit benefited from the needed financing assistance.

      In Islamic finance, Islamic banks are not only expected to be able to fulfill their function as a financial intermediary optimally, but also to fulfill a wider function. The Islamic bank should be able to mobilize the economy by channeling funds that would otherwise lie idle from the surplus sector to business and economic actors in order to support production, distribution, and consumption functions within the society. With this approach, economic benefit will be experienced by all members of society, not only among the richest layers but also by those in need of working capital; this increases the multiplier effect as the gears of the economy move. The function of ‘adalah (fairness) can only be manifested as closely to the ideal as possible if Islamic banks not only act as a “dumb pipe” that funds enter and exit passively, but also involve themselves actively in real economic activities.

      Other than the economic-profit dimension, Islamic banks should also encourage various business activities and operations toward a social dimension; this is beyond just executing a social responsibility function. An Islamic bank is encouraged to accept and distribute social funds, like zakat, infaq, and alms (shadaqah), to parties who need them. Islamic banks may have ended up only channeling these funds to fund the consumption function of the poor and needy, in which afterward the funds will be depleted there, without the ability to generate a new cash flow for the poor or to increase their income capacity. Even then, that is enough for the bank to be said to have fulfilled its social function.

      Differences between an Islamic Bank and a Conventional Bank

      The concept of Islamic banks exists in the middle of the frenetic pace of conventional banking practice, in which these two business entities have different principles. In fulfilling the intermediation function, conventional banks use as a basis the interest rate, both from the asset side and the liability side. Because syari'ah prohibits the application of interest, various modes of financial transaction not involving interest were developed. This prohibition of interest is comprehensive in nature, covering funding, financing, products, and services. This interest system is replaced with a profit–loss sharing system. This profit-sharing system is applied in investment contracts (i.e., mudharabah and musyarakah).

      On the funding side, conventional banks reward depositors with a certain level of interest, and thus the return of the funds kept is already predetermined at the beginning of the contract. This is different from Islamic banks, which reward depositors based on a ratio (nisbah) predetermined at the beginning of the contract between the bank and depositor. As the return is divided according to the profit received by the bank during the investment period, the precise amount cannot be predicted beforehand. For products of credit or loan, conventional banks use interest-bearing instruments to channel third-party funds. In channeling third-party funds in the form of financing, Islamic banks can use a profit-sharing system, asset leasing, or sale-based contracts. In a profit–loss sharing system, other than sharing profit based on an agreed-upon ratio (nisbah), there is also a sharing of risk. This is different from methods involving the conventional bank, in which the whole loss is borne by the entrepreneur or borrower.

      An Islamic Bank Deals in Real Goods or Services, Not in Money

      According to an Islamic perspective, money functions only as storage of wealth and a medium of exchange, not as a tradeable commodity. Because of this, Islam prohibits the sale of money with money in deferred payment/goods delivery, because this is part of usury. Money cannot be sold for a profit. With the lack of interest over loans, Islam offers a solution in the form of interest-free financial products. The transaction can be in the form of sales, profit sharing, or leasing. In sale contracts, the goods sold are real goods.

      In a profit-sharing contract, the business receiving the financing should also produce real goods and services and have viable future prospects. Even more important is to change the paradigms of the bankers; in conventional banking methods, the bankers only consider how to locate prospective financing payments, finance those proposals, and ensure that the bank's funding channeled by the bank will be returned along with a predetermined rate of return. When a proposal is approved and funded, the bankers are more focused on capital recovery than on ensuring that the debtors' businesses have developed according to their expectations. Why does this happen? Because the success of the debtors will not impact the return that they will receive; the bankers will only receive the return in terms of the interest rate that is predetermined at the beginning of the contract. Because of this, the bankers have no real incentive to help develop the debtors' businesses. The bankers' only concern is in recovering the principal of their loan along with its interest. They only enter into an assistance process and intensive oversight when any of the debtors' businesses experience trouble. Once more, the motivation here isn't to ensure the debtors' businesses overcome their troubles and experience success, but only to ensure the return of the bank's capital and its interest. This way of thinking is one that should be eliminated once a banker has crossed over (hijrah) to the Islamic banking system.

      The same beneficial effect to society should also apply to lease contracts: the object being rented should