Asset & Liability Management : challenges facing Islamic financial institutions! Majdi Chaabouni!

Transcription

1 Asset & Liability Management : challenges facing Islamic financial institutions! Majdi Chaabouni! Presented at the Durham Islamic Finance Autumn School 21 jointly organised by Durham Centre for Islamic Economics and Finance and ISAR- Istanbul Foundation for Research and Education Istanbul Commerce University, Istanbul 19 th - 22 nd September 21 1! Seminar «Asset & liability Management in the Islamic Banks» July 21 Majdi Chaabouni: Biography and conferences participation 21! 2! Financial Institutions 1

2 Objectives of the Seminar 1. Understand what s Asset & Liability Management? 10 minutes 5 July Explain the main objectives and the goals to achieve in the ALM 10 minutes 5 July Understand how to identify the ALM risk in the conventional and Islamic bank 10 minutes 5 July Understand how to measure and manage the ALM risk: conventional bank versus Islamic banks 10 minutes - 5 July Conclusion on the indicators and measurement techniques to be used by Islamic banks 10 minutes 5 July 21 Seminar Asset & Liability Management in islamic banks, July 21 Majdi Chaabouni 3! t Asset & Liability Management in the conventional bank! Part 1: The conventional bank & the techniques for the balance-sheet management Seminar Asset & Liability Management in islamic banks, July 21 Majdi Chaabouni 4! Financial Institutions 2

3 Liquidity risk: let s suppose a bank has the following structure 5! Liquidity risk: let s suppose a bank has the following structure Need for financing Excess of liquidity 6! Financial Institutions 3

4 Liquidity risk: Liquidity GAP as a measure of the risk Liquidity Gap For every maturity GAP (T) = Liability (T) Asset (T) - If GAP >0 à more resources than a need for financing - If GAP <0 à the real concern 7! Interest rate risk: Interest rate GAP as a measure of the risk Illustrative example to clarify the ideas - Asset side: - Loan infine: 2 years maturity; nominal 100 Euro with fixed rate 5% - Liability side: - Borrowing over 1 year; nominal 80 Euro for 3% - Capital 20 Euro What is the Liquidity Gap? What is the Interest rate Gap? 8! Financial Institutions 4

5 Interest rate risk: Interest rate GAP as a measure of the risk 9! Interest rate risk: Interest rate GAP as a measure of the risk Illustrative example to clarify the ideas Let s take the same example BUT with variable rates - Asset side: - Loan infine: 2 years maturity; nominal 100 Euro with fixed rate 5% for the first year and variable for the 2 nd year - Liability side: - Borrowing over 1 year; nominal 80 Euro for 3% - Capital 20 Euro What is the Liquidity Gap? What is the Interest rate Gap? 10! Financial Institutions 5

6 Interest rate risk: Interest rate GAP as a measure of the risk 11! In summary: Interest rate risk: Interest rate GAP as a measure of the risk Only transactions with fixed interest rate risk are the origin of the risk We can say that the Interest rate GAOP is equal to: Difference between transactions with fixed interest rate: } by maturity } Asset vs Liability } Another way to say it as well: Interest rate Gap = Liquidity Gap for fixed rate transactions à Indeed : Variable rate there is no extrac-cost for financing 12! Financial Institutions 6

7 Let s take an example to illustrate the ALM (Balance-sheet ) risk The Gap is the simplest technique to measure the risk Asset Liability Cost for establishment 500,000 Capital 10,000,000 Mortgage Loans 10,000,000 (Fixed rate 15 yrs) Mortgage Loans 5,000,000 (Fixed rate 15 yrs) Mortgage Loans 15,000,000 (Fixed rate 15 yrs) Bond issue 5,000,000 (Fixed rate 15 yrs) Loan from FIs 15,000,000 (Fixed rate 1 year) Buildings 500,000 Mortgage Loans 15,000,000 (Fixed rate 7 yrs) Loan from FIs 15,000,000 (variable rate 7 yers) 13! Let s take an example to illustrate the ALM (Balance-sheet ) risk The Gap is the simplest technique to measure the risk Asset Liability Cost Mortgage for establishment Loans 10,000, ,000 (Fixed rate 15 yrs) Capital 10,000,000 Mortgage Loans 5,000,000 (Fixed rate 15 yrs) Bond issue 5,000,000 (Fixed rate 15 yrs) Mortgage Loans 15,000,000 (Fixed rate 15 yrs) Buildings 500,000 Loan from FIs 15,000,000 (Fixed rate 1 year) Le Profit is volatile & exposed to interest rate risk! Mortgage Loans 15,000,000 (Fixed rate 7 yrs) Loan from FIs 15,000,000 (variable rate 7 yers) 14! Financial Institutions 7

8 The ALM (balance-sheet) risk Example of Interest rate risk Let s consider the following balance-sheet as of 1st January 2006 : Asset side : Loan to retail customers: nominal : 1000 duration : infine reimbursement with a maturity of 1 year rate : MMRate (ex. Libor) + 2 % Liability side : Capital (shareholders fund): amount : 200 Reimbursement : indeterminate by the shareholders borrowing from the money market : amount : 800 Reimbursement : infine over 6 months rate : MMR + 1% let s supose the MMR is 5 % 15! The ALM (balance-sheet) risk Example of Interest rate risk As of 1st Jan 2006 the balance-sheet has the following shape: ASSET LIABILITY Loans 1000 Capital 200 Borrowing from FIs 800 Total ASSETS 1000 Total LIABILITY 1000 In summary : The Balance-sheet is equilibrated as of today (1 st Jan 2006) The Bank has 200 of capital & 800 of borrowing placed in retail customers loans (commercial portfolio) 16! Financial Institutions 8

9 The ALM (balance-sheet) risk Example of Interest rate risk As of 1st Jan 2006 the balance-sheet has the following shape: 1 Trim. 2 Trim. 3 Trim. 4 Trim. Year N +1 ASSET - Loans to customers LIABILITY - Capital - Money Market Liquidity Gap (stock) onvention : Gap (+) : Excess of liquidity Gap (-) : Need for liquidity ! ASSET ALM risk: computation of the interest rate margin (IRM) The interest rate margin is equal to interest received and interest paid 1 Trim. 2 Trim. 3 Trim. 4 Trim. Year N +1 - Loans to customers LIABILITY - Capital - Money Market Marging before financing ¼ x 7% x = ¼ x 6% x = Important : The margin before financing is giving the wrong picture we need to equlibrate the balance-sheet starting from the 3rd trimester 18! Financial Institutions 9

10 ALM risk: computation of the interest rate margin (IRM) Let s suppose interest rate will stay stable over 1 year from now 1 Trim. 2 Trim. 3 Trim. 4 Trim. Year N +1 ASSET - Loans to customers LIABILITY - Capital - Money Market - Refinancing Margin aafter refinancing ¼ x 7% x = ¼ x 5% x = Important : The computation of the margin after refinancing is giving better picture 19! ALM risk: computation of the interest rate margin (IRM) Let s suppose now that MM Rate of r over 1 year 1 Trim. 2 Trim. 3 Trim. 4 Trim. Year N +1 ASSET - Loans to customers LIABILITY - Capital - Money Market - Refinancing Margin after refinancing ¼ x 7% x = ¼ x (5% + r) x x r - = x r x r x r - 20! Financial Institutions 10

11 ALM risk: there are possbilities for hedging with derivative products We can eliminate the risk of volatility of the Margin using derivative products We can eliminate these risks by putting in place : ð Swap contract with a notional amount of 200 ð Forward Rate agreement (FRA) : - Nominal 800; maturity 3rd trimester This FRA will generate unique cash flows on the 3 rd trimester : ¼ x 800 x (r 5.5%) - Nominal 800; maturity 4th trimester This FRA will generate unique cash flows on the 3 rd trimester ¼ x 800 x (r 6%) Let s suppose that forward rate are equal to 5.5% and 6% respectively for 3 rd trimester and 4 th maturity based on the yield curve 21! t Asset & Liability Management in the Islamic bank! Part 2: The Islamic bank & the techniques to manage the balance-sheet Seminar Asset & Liability Management in islamic banks, July 21 Majdi Chaabouni 22! Financial Institutions 11

12 Linkages with other balance sheets The principle of banking is the intermediation of risks on different maturities: can we say that Islamic bank is doing the doing the intermediation of risks as well? Funding side risks Banking is about intermediation of short-term risks Depositors Contingent claims BANK CAPITAL Asset side risks Counterparties 23! Linkages with other balance sheets The balance-sheet ou ALM risks existent even in the islamic bank 1. Depositors: May withdraw; 2. Banks: Tend to accumulate assets to maximize return on equity; 3. Counter-parties: May default; 4. Regulators: Seek banking soundness; 5. Other companies and households within the interlinked balance sheets, have contingent claims on each other and 6. Public/tax payers: Faces the cost of deposit protection and financial crisis. 24! Financial Institutions 12

13 The Islamic Bank : The resources Identification of resources of funds (1/2) ISLAMIC BANKS Tier 1 Capital (equity) Tier 2 Capital (?) Current accounts Saving accounts Unrestricted Profit Sharing Investment Accounts (PSIAs) Profit equalization reserves (PER) Investment risk reserve (IRR) TRADITIONAL BANKS Tier 1 Capital (equity) Tier 2 Capital (Subordinated loans) Current accounts Interest-based Saving accounts Time & certificates of deposits Reserves 25! The Islamic Bank : The resources Identification of resources of funds (2/2) ISLAMIC BANK Current accounts TRADITIONAL BANK Current accounts Banks in both cases use shareholders equity to protect these deposits Profit sharing investment accounts (PSIA) Shareholders equity protects these liabilities only in case of fiduciary risks (theory); Profit Equalization Reserve (PER) & Investment Risk Reserve (IRR) Cost of funds: Variable Time deposits, certificates of deposits, etc fixed income liabilities Shareholders equity and subordinated loans protect these liabilities against all risks Cost of funds: Fixed 26! Financial Institutions 13

14 The Islamic Bank : The allocation of funds Identification of the usage of funds/resources Uses of Funds ISLAMIC BANKS Cash & balances with other banks Sales Receivables (Murabaha, Salam, Istisna a) Investment securities Musharaka financing Mudaraba financing Investment in real estate Investment in leased asset Inventories (including goods for Murabaha) TRADITIONAL BANKS Cash & balances with other banks Loans Mortgages Financial leases Investment in real estate Securities 27! The Islamic bank : investment A/Cs innovation but complexity and very specific Risks Displaced commercial risk (withdrawal risk) Risk Mitigation Profit equalization reserve (PER) from shareholders contributions Fiduciary risk Capital (%?) Commercial loss Risks of PSIA financed assets PSIA-holder, Investment risk reserve (IRR) from PSIAholders contribution 28! Financial Institutions 14

15 The Islamic bank : investment A/Cs innovation but complexity and very specific Unique systemic risks Risk transmission between current accounts and investment accounts (between Qard and Qirad) Income mixing between Shari ah compliant and non-complaint sources Need for separate capital as firewall 29! The Islamic Bank : very specific area specific way to manage the balance-sheet and the ALM risk Financial risk factors Credit risk Default risk Down grade risk Counter party risk Settlement risk Market risk Price risk Rate of return risk (Risque ALM similaire a celui de la banque conventionnelle) Exchange rate risk Liquidity risk Funding liquidity risk Asset liquidity risk Cash management risk 30! Financial Institutions 15

16 The Islamic Bank : very specific area specific way to manage the balance-sheet and the ALM risk Business risk factors Management Risk Planning Organization Reporting Monitoring Strategic Risk Research and development Product design Market dynamics Economic Reputation 31! The Islamic Bank : very specific area specific way to manage the balance-sheet and the ALM risk Operational risk factors People risk Relationships Ethics Processes risk Legal risk Compliance Control System risk Hardware Software Models ICT External risk Event Client Security Supervisory Systems Equity investment risk? 32! Financial Institutions 16

17 The Islamic Bank : very specific area specific way to manage the balance-sheet and the ALM risk Islamic modes of finance: Unique risk factors Liquidity originated market risk Transformation of credit risk to market risk and market risk to credit risk at various stages of a contract Bundling of credit risk and market risk Market risk arising from owning the underlying nonfinancial asset until maturity of a contract or until the ownership is transferred to customer Treatment of default 33! The Islamic Bank : very specific area specific way to manage the balance-sheet and the ALM risk Unique balance sheet features of IBs from market risk perspective (1/2) In traditional banks, market risk is mostly in the trading book In Islamic banks, market risk is concentrated in the banking book due to Murabahah, Ijara, Salam, Musharakah and Mudharabah in the banking book asset portfolio Hence it is unique for Islamic banks that market risk and credit risk are strongly bundled together 34! Financial Institutions 17

18 The Islamic Bank : very specific area specific way to manage the balance-sheet and the ALM risk Unique balance sheet features of IBs from market risk perspective (2/2) Liabilities Capital PSIAs Current accounts Assets Murabahah Istisna Ijarah Salam Musharakah Mudharabah Total These are not re-priceable 35! The Islamic Bank : very specific area specific way to manage the balance-sheet and the ALM risk Assumption: 1 % increase in benchmark price IB 1 IB 2 IB 3 L A L A L A Re-price-able These are re-priceable Non-re-priceable Balance Sheet value change Asset value change ? -.12? 0? 36! Financial Institutions 18

19 The Islamic Bank : very specific area specific way to manage the balance-sheet and the ALM risk Unique credit risk features of IBs.(1/2) Treatment of default: In Islam, compensation-based restructuring of credit is the most well known form of Riba, namely, Riba Al Jahiliyah this highly necessitates credit risk management Moral issues in loan loss reserves Collateral quality (restrictions on use of sovereign bonds) Insurance clients insurance and facilities insurance Diverse modes and bundled risks 37! The Islamic Bank : very specific area specific way to manage the balance-sheet and the ALM risk Unique credit risks of IBs. (2/2) Mudharabah / Musharakah Default event undefined Collateral not allowed Salam / Istisna Counterparty performance risk Separation of market risk from default risk difficult Catastrophic risk high Murabahah Baseline default risk, but counterparty risk due to embedded option (Murabahah, binding non-binding matter) also exists Conglomeration of risks each mode having various risks, credit, liquidity, market, reputation, 38! Financial Institutions 19

20 The Islamic Bank : very specific area specific way to manage the balance-sheet and the ALM risk Islamic banks risks: Unique versus shared with traditional banks unique shared credit risks market risks liquidity risks business risks operational risks bundled risks infrastructures 39! The liquidity management: the real challenge no much alternatives!! Seminar Asset & Liability Management in islamic banks, July 21 Majdi Chaabouni 40! Financial Institutions 20

21 The liquidity management: the real challenge no much alternatives!! Seminar Asset & Liability Management in islamic banks, July 21 Majdi Chaabouni 41! The liquidity management: the real challenge no much alternatives!! Seminar Asset & Liability Management in islamic banks, July 21 Majdi Chaabouni 42! Financial Institutions 21

22 The liquidity management: the real challenge no much alternatives!! Seminar Asset & Liability Management in islamic banks, July 21 Majdi Chaabouni 43! The Islamic Bank : Can we apply the same ALM techniques?!! ü Difficult to apply the ALM techniques.but it is feasible need research and innovations ü Certain banks ovoid ALM risks ü That s way certain islamic banks are avoiding certain activities ü The banks have very simple balance-sheets ü the islamic banks have a lot of resources not used waiting for allocation Seminar Asset & Liability Management in islamic banks, July 21 Majdi Chaabouni 44! Financial Institutions 22

23 Seminar «Asset & liability Management in the Islamic Banks» July 21 contact: for questions Majdi Chaabouni 45! Financial Institutions 23