NEWHORIZON

NEWHORIZON April to June 2013
ANALYSIS
institutions to safeguard against such
practices.
Prudent Credit Appraisal and
Credit Management Regimes
Credit risk refers to the possibility of
default and delay in the repayment
of debts. This type of risk is faced
by all financial institutions since all
enter into transactions involving
debts. This type of risk can seriously
affect the performance of the
financial institution resulting in high,
non-performing loans, liquidity crises
and other costs. The seriousness
of these issues could have major
consequences for the concerned
financial institutions, e.g. insolvency
and bankruptcy, thereby causing a
blow to the public’s confidence in the
bank. A core factor in the subprime
crisis was that there were almost no
or very little credit risk measurement
and management techniques in
place to manage the credit risk; as
mentioned earlier credit was based
on automated credit approvals and
easy terms like NINA and was given
to individuals with bad or no credit
history.
The mitigation of credit
risk requires prudent credit
management techniques and
appropriate systems to be in place
to measure the risk involved in
various transactions. For Islamic
banks appropriate measures should
also be in place to measure the risk
involved with the various types of
different modes that are employed.
Secondly, proper due diligence
in credit evaluation of the clients
should be done before extending
the facility. This again requires
proper evaluation systems to be in
place, which involves evaluating
past credit history and the ability
to pay the debt on time, which in
turn involves an evaluation of the
client’s income.
For Islamic banks it is also essential
that in the case of profit sharing
modes proper analysis of the
viability of the client’s business or
the project is done. An important
technique to mitigate the credit
risk is to acquire collateral against
the financings. This requires that
a proper valuation of the collateral
is done. Furthermore it is also
The implication is that any player
in the Islamic financial industry,
which acts like a bank, providing
finance and taking deposits
either through a partnership
structure, mudarabah or through
debt financing, which results
in systemic risk, should be
regulated through the same
tight regulatory mechanisms
that apply to normal Islamic
commercial banks.
essential to conduct follow-up
evaluations of the collateral as well
as of the client’s creditworthiness
to ensure that the collateral and
the client’s ability to pay do not
diminish thereby risking default.
For Islamic banks it is also essential
that the collateral is Shari’ah
compliant.
Conventional banks also mitigate
against delays in payment by
charging a heavy penalty in the
form of interest if the repayment
is delayed beyond the due date.
Islamic banks under certain
jurisdictions are not allowed to
make such charges for their own
gain, but they mitigate the risk
by charging a penalty and then
giving the sum away as a charitable
donation.
Another important way of
mitigating credit risk is to diversify
the asset base of the bank and
since the majority of the assets of
banks consist of loans or Shari’ahcompliant
financial transactions it
is important to diversify the credit
base, i.e. credit exposure should
not be excessively biased to one
sector. Similarly exposure should
not be excessively biased to a
small number of clients. This is
mostly taken care of by the sector
limit and per party limit guidelines
issued by the regulatory authority
and linked to the size of the
concerned bank. It is necessary to
follow these guidelines to hedge
against credit risk and improve
the quality of the assets on the
balance sheet. Islamic banks in
this regard must also ensure that
they do not take excessive exposure
on one or two Shari’ah-compliant
modes, but effectively diversify
risk among various modes as far
as the situation permits, since each
mode has its own inherent risks,
which can be mitigated by effective
diversification. It is also necessary
that 10 20% down payments are
made mandatory in mortgage
financings to ensure the inclusion
of customer equity and the
availability of a cushion in the
underlying security in times of
decreasing housing prices.
Regulation of the Non-
Banking Financial Sector and
Systemic Risk
The non-banking financial
sector has grown around the
globe in the past few years.
Major players in this sector are
the investment banks. To date
these institutions have typically
been subject to much lighter
regulations be it related to equity
ratios; leverage restrictions or
per party limits. The crisis has,
however, taught us one important
lesson which can be summed up
in the words of Paul Krugman,
Professor of Economics and
International Affairs at the
Woodrow Wilson School of
Public and International Affairs
at Princeton University. In an
article in the New York Times
in 2010 he said, ‘As the shadow
banking system expanded to rival
or even surpass conventional
banking in importance,
politicians, government officials
and influential figures should
have proclaimed a simple rule:
anything that does what a bank
does, anything that has to be
rescued in crises the way banks
are, should be regulated like a
bank.’
The implication is that any player
in the Islamic financial industry,
which acts like a bank, providing
finance and taking deposits
either through a partnership
structure, mudarabah or through
debt financing, which results
in systemic risk, should be
regulated through the same tight
regulatory mechanisms that apply
to normal Islamic commercial
banks. They should be subject
to same regulatory and reserve
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