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International Journal of Islamic and Middle Eastern Finance and Management Emerald Article: Formulating withdrawal risk and bankruptcy risk in Islamic banking Rifki Ismal Article information: To cite this document: Rifki Ismal, (2012),"Formulating withdrawal risk and bankruptcy risk in Islamic banking", International Journal of Islamic and Middle Eastern Finance and Management, Vol 5 Iss: 1 pp 63-77 Permanent link to this document: http://dxdoiorg/101108/17538391211216848 ownloaded on: 08-04-2012 References: This document contains references to 8 other documents To copy this document: permissions@emeraldinsightcom This document has been downloaded 4 times Access to this document was granted through an Emerald subscription provided by Emerald Author Access For Authors: If you would like to write for this, or any other Emerald publication, then please use our Emerald for Authors service Information about how to choose which publication to write for and submission guidelines are available for all Additional help for authors is available for Emerald subscribers Please visit wwwemeraldinsightcom/authors for more information About Emerald wwwemeraldinsightcom With over forty years' experience, Emerald Group Publishing is a leading independent publisher of global research with impact in business, society, public policy and education In total, Emerald publishes over 275 journals and more than 130 book series, as well as an extensive range of online products and services Emerald is both COUNTER 3 and TRANSFER compliant The organization is a partner of the Committee on Publication Ethics (COPE) and also works with Portico and the LOCKSS initiative for digital archive preservation *Related content and download information correct at time of download

The current issue and full text archive of this journal is available at wwwemeraldinsightcom/1753-8394htm Formulating withdrawal risk and bankruptcy risk in Islamic banking Rifki Ismal Faculty of Economics, University of Indonesia, Jakarta, Indonesia Formulating risk in Islamic banking 63 Abstract Purpose The purpose of this paper is to formulate both withdrawal risk and bankruptcy risk to mitigate the risks and to find the equilibrium area of revenue sharing to depositors Taking the case of the Indonesian Islamic banking industry, this work might benefit the Islamic banks, banking regulators and all stakeholders to manage the risks and maintain the robust development of the industry esign/methodology/approach First, the application of revenue sharing ratio in Islamic banks is studied Withdrawal risk might happen because of the displaced commercial risk and bankruptcy occurs when the banks fail to manage such withdrawal risk Referring to that, by using a mathematical approach, the formulas of withdrawal risk and bankruptcy risk are created with some underlying scenarios Finally, mathematical formula and three dimensions area of the equilibrium revenue sharing ratio are developed Findings The paper generates the financial mathematical formulas to assess the vulnerable and invulnerable conditions of the withdrawal risk and the bankruptcy and solvency conditions of the bankruptcy risk to be used by decision makers to mitigate the risks The ultimate output of the paper is the equilibrium area of the revenue sharing ratio, which locates Islamic banks in a proper condition of no withdrawal risk and bankruptcy risk Originality/value To the best of the author s knowledge, this is the first paper trying to analyze the issues under the Indonesian case Keywords Indonesia, Islam, Banks, Risk analysis, Bankruptcy, Withdrawal risk, Bankruptcy risk, Revenue sharing Paper type Technical paper 1 Background of the Indonesian Islamic banking industry The Indonesian Islamic banking industry grows promisingly after the establishment of the first Islamic bank (Bank Muamalat Indonesia) in 1992 The awareness of people to employ Islamic banks spurred by the government and Indonesian Moslem Scholars Council (MUI) has made the industry meaningful Until January 2010, there are six Islamic commercial banks (BUS) followed by 25 Islamic banking unit/islamic windows (UUS) and 140 Islamic rural banks (BPRS) integrating 1,083 offices around the country (Table I) Moreover, the industry shows a healthy financial intermediary function and prudential banking operations The financing to deposit ratio has been lying on 10676 percent on average from January 2001 to 2010 (while conventional LR is 5845 percent on average in the same period) The non performing financing is between 2 and 4 percent, when conventional one records 5-8 percent Other measures, like total assets, financing and deposits grow annually for more than 50-60 percent on average Lately, the total assets have reached Rp6743 trillion with total financing of Rp4714 trillion, whilst the total deposits are Rp5316 trillion International Journal of Islamic and Middle Eastern Finance and Management Vol 5 No 1, 2012 pp 63-77 q Emerald Group Publishing Limited 1753-8394 OI 101108/17538391211216848

IMEFM 5,1 64 Table I Selected Islamic banking indicators Banking indicators 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 a Islamic banks (unit) 2 2 2 2 3 3 3 3 5 6 6 Islamic banking units (unit) 3 3 6 8 15 19 20 25 27 25 25 Islamic rural banks (unit) 79 81 83 84 88 92 105 114 131 139 140 Total offices (unit) 146 182 229 337 443 550 567 683 951 998 1,083 Total asset (trillion Rp) 179 272 405 786 1533 2088 2672 3653 4955 6609 6743 Total financing (trillion Rp) 127 205 328 553 1149 1523 1953 2794 3819 4688 4714 Total deposit (trillion Rp) 103 181 292 572 1186 1558 2067 2565 3685 5227 5316 Source: a Bank Indonesia, data until January 2010

In general, deposit instruments on the liability side can be grouped into Wadiah demand deposits, Mudarabah saving deposits and Mudarabah time deposits The historical data from ecember 2000 to January 2010 revealed that Mudarabah time deposits dominated 5786 percent of total deposits, followed by Mudarabah saving deposits at 2786 percent and Wadiah demand deposits at 1428 percent Meanwhile, financing instruments on the asset side are composed of Mudarabah and Musharakah (equity financing); Murabahah, Salam and Istishna (trade financing), Ijarah and Qardh hassan (other types of financing) The trade financing dominated 5714 percent of total financing followed by equity financing 3589 percent and the other types of financing for less than 1 percent However, like the other financial institutions, the operations of Islamic banks face some financial risk problems such as credit risk, market risk, liquidity risk, withdrawal risk Amongst all, withdrawal risk and bankruptcy risk are the most important ones in Indonesian case due to some reasons, especially: The Indonesian Islamic banks operate side by side with the conventional ones As a consequence, they have to perform well in order to be attractive to depositors Some of the Islamic banking depositors position the banks indifferently from the conventional ones, namely rational depositors They expect Islamic banks to give competitive return, provide comprehensive banking services and offer various deposit instruments (Mars, 2008) Consequently, there is a potential of displaced commercial risk The conventional banks can offer attractive return from a variety of banking products which sometimes do not link with the real business activities Islamic banks, on the other hand, are obliged by the sharia (Islamic) principles to produce profit from the real and actual business activities and bear the loss as well The last but not the least, when economic or financial crisis occurs, the increasing trend of interest rate brings Islamic banks into a dilemma It is because the rational depositors expect to receive a higher return from Islamic banks If Islamic banks cannot afford such expectation, it may lead to a severe displaced commercial risk or withdrawal risk Formulating risk in Islamic banking 65 isplaced commercial risk is defined as the transfer of the risk associated with deposits to the equity holders (Ahmed, 2003, p 460) or the risk of divergence between asset performance and the expectation for return on liabilities This risk is one of the triggering factors of withdrawal risk where the bank is exposed to the risk of deposit withdrawals from their depositors (El-Hawary et al, 2003, pp 67-8) Once it occurs and cannot be handled properly, Islamic banks may go bankrupt or at least be taken over by government (banking authority) Inspired by Professor Ahmed s (2003), paper this paper attempts to measure and formulate withdrawal risk because of the displaced commercial risk in combination with bankruptcy risk in the case of Indonesian Islamic banking industry It simulates some scenarios of withdrawal risk and bankruptcy risk and later on constructs the revenue sharing equilibrium ratio based on the two risks Although it takes Indonesian as a study case, the simulations and analyses are also applicable to other countries which implement revenue sharing ratio in their Islamic banking industry

IMEFM 5,1 66 2 Characteristics of Islamic banking industry Following the general figures of the Indonesian Islamic banking industry, it also has some unique characteristics that underlie the analyses of the paper Such characteristics are as written below: (1) The sharing of Islamic banking return is done with the revenue sharing concept rather than the profit and loss sharing (PLS) concept (Karim, 2003, pp 115-211) Therefore, depositors are very likely to always receive a positive and regular return (coded as r b ) from their deposits and they are free from an obligation to bear the business losses (2) Technically, the return from operational financing[1] (coded as ) is shared with depositors under an agreed revenue sharing ratio Then, the banks will bear the operational costs (coded as C o ) in its revenue sharing part Besides operational return, the return from non operational financing[2] fully belongs to Islamic banks including the costs incurred on them epositors do not earn any return from this type of financing (3) The Islamic banking depositors consist of two types (Ismal, 2010, pp 3-10) The first type is the religious (non rational) depositors who position Islamic banks differently with conventional ones They are not affected by whatever interest rate being offered in conventional bank deposits The second one is the rational depositors who place Islamic banks indifferently with the conventional one and keep comparing the return sharing on deposits with the interest rate on deposits This type of depositors commonly has double accounts in Islamic bank (coded as ) as well as conventional bank (coded as ni ) (4) Some liquidity is taken from the total deposits for liquidity reserves The liquidity ratio (g c ) is the sum up of: reserves requirement ratio (G i ¼ G/) allocated in the central bank and; cash reserves ratio (C i ¼ C/) allocated in the internal bank to fulfill the daily transaction needs or simply formulated as g c ¼ (C þ G)/ (5) The conventional interest rate benchmark namely Bank Indonesia Certificate (SBI) is a benchmark return for the rational depositors to invest funds in Islamic banks (Ismal, 2009, p 11) Therefore, this paper treats SBI as the depositors expected return rate (coded as r sbi ) against the revenue sharing offered by Islamic banks (6) The role of Islamic money market and sukuk market is very trivial (less than 5 percent) It is because Islamic banks extend most of the funds (even including shareholder capitals) to the real sector through direct financing scheme (Bank Indonesia, 2009, pp 20-30) Thus, these markets are not covered in this research (7) Some external liquid instruments are also available to be used by Islamic banks to manage the unanticipated liquidity withdrawals such as: repurchasing Bank Indonesia Sharia Certificate (SBIS); borrowing funds from the Islamic money market; using the central bank s intra day emergency fund (FLI); and occupying the deposit insurance company (LPS) to guarantee the deposits (Bank Indonesia, 2006, pp 10-30)

Nevertheless, since Islamic banks have performed well and never have the experience of liquidity shortage, such instruments are not taken into account in this paper Based on all characteristics above, it is obvious that revenue sharing is the central point in Islamic banking to manage liquidity It is very important not only to fulfill the expectation of depositors but also to avoid banks from withdrawal risk and bankruptcy risk The proper revenue sharing ratio has to be determined under some liquidity withdrawal scenarios in the quantitative formulas of withdrawal risk and bankruptcy risk as proposed in this paper The next parts in the following will elaborate the revenue sharing ratio (r b ) responding to the invulnerable and vulnerable conditions followed by the solvent and bankrupt conditions Finally, it will construct the area of equilibrium revenue sharing ratio that brings Islamic banks into the comfortable conditions (invulnerable and solvent conditions) by determining revenue sharing ratio within such area Formulating risk in Islamic banking 67 3 Some assumptions and risk formulas In order to emphasize the liquidity withdrawal scenarios, there are some underlying assumptions First, total deposits of Islamic banks are comprised of Wadiah demand deposits (coded as c ) and Mudarabah time deposits (coded as i ) Hence, the ratio of Wadiah demand deposit over total deposits (coded as d) and the ratio of Mudarabah time deposit over total deposits (coded as i) are defined as d ¼ c /( þ E) and i ¼ i /( þ E) with E as total equity E itself has a ratio over total deposits such that e ¼ E/(E þ ) and because there are some liquidity reserves, the financing is defined as F 0 ¼ (1 C G) Second, when Islamic banks offer deposit products to depositors, the revenue sharing rate of Mudarabah time deposit should be attractive enough It is because there is a level of tolerance among depositors to value the return of Islamic deposits (coded as j n ) which is defined as the difference between the depositors expected rate of return of depositing money in conventional deposits (coded as r e ni ) and the Islamic deposit return from Islamic financing (coded as r d ) Normally, depositors expect to earn a higher return from Islamic deposits than from conventional ones Therefore, if jr e ni r d j $ j n, when the total conventional return (r e ni ) is less than Islamic return (r d ), a displaced commercial risk might not occur or j þ n Nonetheless, in the case of jr e ni r d j, j n, when the total conventional return (r e ni ) is higher than Islamic return (r d )orj 2 n, a displaced commercial risk might occur and lead to withdrawal risk (Ahmed, 2003, p 467) In the subsequent exercises, as described previously, r sbi is used as an approximation of r e and r b as an approximation of r d Third, liquidity withdrawals from depositors (W) are caused by two cases: a displaced commercial risk (j 2 n ) and routine liquidity needs (c c ) The former is as explained above whilst the latter subtracts funds from Wadiah demand deposits Thus, liquidity withdrawals from depositors is formulated as W ¼ c c þj 2 n with 0, c, 1 and these withdrawals can be mitigated by reserving some liquidity Lastly, in the normal conditions, the ratio of liquidity withdrawals over total assets (coded as A) is defined as w ¼ W/A and this is fulfilled by liquidity reserves ratio (g c ) Therefore, Islamic banks are in the vulnerable condition if w g c and not vulnerable if w # g c Following withdrawal risk is bankruptcy risk which may happens if total equity is less than total asset losses or e, l and may not happen if e $ l Such asset

IMEFM 5,1 68 losses are defined as the ratio between total part of Islamic banks revenue sharing coming from the return of operational financing or ( (1 r b )) minus the cost of operational financing (Co) over the total operational financing return ( ) or: l ¼ ð1 2 r b Þ 2 C o : Islamic bank faces financing losses if ( (1 r b ) Co), 0 and vice versa 4 Withdrawal risk scenarios Invulnerable condition The vulnerability of Islamic banking is determined by the availability of liquidity reserves to match the demand for liquidity This section assesses the revenue sharing ratio that prevents Islamic banks from the vulnerable condition Recalling the prior invulnerable formula of w # g c and as knowing that w ¼ W/A where W ¼ c c þj þ n in which jr sbi ni r b F 0 j $ j n and g c ¼ C i þ G i, the initial formula above is now becoming: c c þ r sbi ni 2 r b A # C þ G With some mathematical transformation proven in Appendix 1, the revenue sharing ratio (r b ) that brings Islamic banks into the invulnerable condition is derived as: ð1þ r b l ðc c þ r sbi ni Þ 2 Ag c ð2þ It means that when the revenue sharing ratio is higher than SBI rate and the routine demand for liquidity can still be covered by liquidity reserves, Islamic banks are in the invulnerable condition As such, how much liquidity reserves that should be prepared by Islamic banks in this condition is formulated as (see Appendix 1 for the derivation): g c l ðc c þ r sbi ni Þ 2 r b ð3þ A Formula (3) suggests that liquidity reserves should be higher than the total potential of liquidity withdrawals or (c c þ r sbi ni ) less total revenue sharing paid to depositors over the whole banking assets In this case, since the revenue sharing ratio is in higher position than SBI rate, Islamic banks get three advantages: (1) total revenue sharing paid to depositors (or r b F 0 ) is potentially higher than the return from SBI or (r sbi ni ); (2) the less probability of depositors withdrawals (r sbi ni ); and (3) the less liquidity reserves provided as these are actually non profitable funds from the banking business point of view Therefore, maintaining a good banking performance and offering higher revenue sharing ratio than SBI rate are two keys for Islamic banks to get into the invulnerable condition

Vulnerable condition Following the invulnerability condition, with the same computation method, below is the vulnerable condition of Islamic banks if they cannot afford the demand for liquidity from depositors From the vulnerable formula of w g c and knowing that w ¼ W/A where W ¼ c c þj 2 n in which jr sbi ni r b F 0 j, j n and g c ¼ C i þ G i, the vulnerable formula is formulated as (see Appendix 1 for the derivation): r b k ðc c þ r sbi ni Þ 2 Ag c ð4þ If revenue sharing ratio is less than SBI rate (as a benchmark rate) and if liquidity reserves are not enough to cover liquidity withdrawals (Ag c ), Islamic banks are in the vulnerable condition Particularly, when liquidity reserves are low enough to match the demand for liquidity as formulated below, vulnerability occurs (see Appendix 1 for the derivation): Formulating risk in Islamic banking 69 g c k ðc c þ r sbi ni Þ 2 r b ð5þ A Hence, it is imperative to note that when revenue sharing is paid lower than the conventional return, both routine liquidity needs (c c ) and displaced commercial risk (j þ n ) comes together to demand for liquidity Once liquidity reserves are not big enough, Islamic banks face liquidity distress unless employing the other sources of liquidity such as reselling Bank Indonesia Sharia Certificate (SBIS), borrowing from Islamic money market, or asking for Central Bank s intra day emergency fund (FLI) 5 Bankruptcy scenarios Solvency condition The solvency of the bank depends on the availability of bank s equity to mitigate financing losses or formulated above as e $ l Recalling conception of e as E/(E þ ) and the assumption of losses, such basic formula has now been extended as (see Appendix 2 for the derivation): E ðe þ Þ $ ð1 2 r b Þ 2 C o ð6þ Formula (6) reveals that total amount of bank s equity should be higher than the ratio of bad asset (l ) which is the Islamic bank s revenue sharing part from operational financing over total return from operational financing Because profit sharing is not applied, any financing loss is borne by Islamic banks through their equity The availability of equity to cover financing losses is one of the keys for Islamic banks to avoid bankruptcy Taking into account formula (6), the ideal revenue sharing ratio (r b ) in the solvency condition is mathematically formulated as (see Appendix 2 for the derivation): r b $ ðe þ Þ 2 C o ð7þ Thus, revenue sharing ratio should be set higher than ratio of total deposits over total equity and deposits subtracted by the ratio of total operational costs over total return

IMEFM 5,1 70 of operational financing As such, if Islamic banks want to attract new depositors and increase their total deposits, they have to be able to offer a high revenue sharing ratio Nevertheless, Islamic banks might have a chance to lower the revenue sharing ratio to depositors (r b ) if the cost of operations is going up as revealed in equation (7) Bankruptcy condition The bankruptcy condition happens if the ratio of bank s equity is not big enough to cover asset losses or e, l Using the same mathematical transformation as in equations (6) and (7), the bankruptcy condition will happen when (see Appendix 2 for the derivation): E ðe þ Þ k ð1 2 r b Þ 2 C o ð8þ Equation (8) shows that the ratio of bank s equity on the left hand side is less than the ratio of bad asset (l ) on the right hand side Confirming the previous argument, the role of determining r b is very crucial to prevent Islamic banks from this unexpected condition When the cost of operational financing is getting higher, Islamic banks should wisely decrease revenue sharing ratio to depositors in order to cover the potential financing (asset) losses Relying on the equity alone would not be enough Next, the revenue sharing ratio that brings into this unexpected condition is the one if (see Appendix 2 for the derivation): r b k ðe þ Þ 2 C o ð9þ Formula (9) explains that when revenue sharing is less than the ratio of total deposits over total liabilities minus the ratio of total costs of operational financing over total operational financing, the banks are bankrupt Thus, in this case, Islamic banks cannot balance the increasing in deposit ratio and the cost of operational financing with the revenue sharing ratio offered to depositors It disappoints depositors and causes the bankruptcy condition 6 A sound and failure of Islamic banks After formulating Islamic banking conditions based on the vulnerability and solvency, a sound Islamic bank is defined as the bank which is in the invulnerable and solvent conditions or simply in a good scenario By combining the two previous formulas representing invulnerability and solvency conditions, we find the ideal revenue sharing ratio that would locate Islamic banks in a good scenario The result of the combination is mathematically written as (see Appendix 3 for the derivation): ðc c þ r sbi ni Þ r b $ ðe þ Þ½ðc c þ r sbi ni Þ 2 Ag c þ C o Š 2 AeðC þ GÞ ð10þ E½ðc c þ r sbi ni Þ 2 Ag c þ C o Š A long with a good scenario is a bad scenario which represents failure conditions of Islamic banks because they are trapped in vulnerable and bankruptcy conditions in the same time The same as computing formula (10), the combination of the previous two formulas of vulnerable and bankruptcy conditions generate the next formula below (see Appendix 3 for the derivation):

ðc c þ r sbi ni Þ r b k ðe þ Þ½ðc c þ r sbi ni Þ 2 Ag c þ C o Š 2 AeðC þ GÞ ð11þ E½ðc c þ r sbi ni Þ 2 Ag c þ C o Š Formulas (10) and (11) generate two important ratios in the right hand side of the formulas which determine the sound or failure of Islamic banks The first one is the ratio of potential of withdrawal risk over potential of capital outflow after reserving some liquidity or: ðc c þ r sbi ni Þ ðe þ Þ½ðc c þ r sbi ni Þ 2 Ag c þ C o Š : The second one is the ratio of liquidity reserves (the liquidity policy of Islamic banks) to mitigate both withdrawal risk and bankruptcy risk over potential of capital outflow or: AeðC þ GÞ E½ðc c þ r sbi ni Þ 2 Ag c þ C o Š : The important finding from formulas (10) and (11) is that the revenue sharing ratio should be set in accordance with the difference between the first and the second ratio If the revenue sharing ratio is less than such difference, Islamic banks are in a bad scenario But, if it is higher than that, Islamic banks are in a good scenario Formulating risk in Islamic banking 71 7 Revenue sharing equilibrium ratio Considering the good and failure scenarios, the equilibrium of revenue sharing ratio is constructed to reveal the ideal condition which positions Islamic banks in both invulnerable and solvent conditions It is mathematically formulated as a minimum revenue sharing ratio decided by Islamic banks for their depositors or: ðc c þ r sbi ni Þ r b ¼ ðe þ Þ½ðc c þ r sbi ni Þ 2 Ag c þ C o Š 2 AeðC þ GÞ ð12þ E½ðc c þ r sbi ni Þ 2 Ag c þ C o Š Further, this ideal condition occurs under the assumptions of: sustainable and stable economic conditions that support the performance of banks financing; robust performance of Islamic banks in managing the funds and producing positive return on financing; smaller probability of liquidity withdrawals as depositors respond positively against the prospective achievements of Islamic banks; decreasing portion of the bad assets; and the liquid instruments in the market such as repurchasing Bank Indonesia Sharia Certificate (SBIS), borrowing from the Islamic money market, asking for the central bank intra day emergency funds (FLI) are not occupied by Islamic banks because of their robust liquidity management In order to make an easy illustration, a three dimensions graph is created to illustrate the equilibrium area of equation (12) The first horizontal axis represents the ratio of potential withdrawal risk over potential of capital outflow after reserving some liquidity Meanwhile, the second axis is the ratio of liquidity reserves (the liquidity policy

IMEFM 5,1 72 of Islamic banks) to mitigate both withdrawal risk and bankruptcy risk over potential of capital outflow The ordinate is the minimum revenue sharing ratio set up by Islamic banks for their depositors The three dimensions graph explains that in the first stage (under the assumptions being made), the potential of liquidity withdrawals and bankruptcy risk is minimal Particularly, the conducive economic/business conditions enable Islamic banks to perform well such as paying competitive return sharing, inviting new depositors and reserving appropriate liquidity reserves However, in the second stage and the rest of the stages, such supportive economic conditions automatically reduce the potential of liquidity withdrawals and open an opportunity for the banks to reduce the revenue sharing ratio for depositors Moreover, they do not have to prepare a lot of liquid instruments to mitigate the unanticipated liquidity withdrawals Figure 1 shows that three dimensions graph Technically, the graph consists of a combination of points such as a 1 b 1 c 1 ;a 2 b 2 c 2 ; a 3 b 3 c 3,a 6 b 6 c 6 The first combination points or (a 1 b 1 c 1 ) are the conditions where all prior assumptions occur Thus, a combination points of (a 1 b 1 c 1 ) assumes that: the high value of ratio of potential withdrawal risk over potential of capital outflow after reserving some liquidity; the low ratio of the liquidity reserves (the liquidity policy of Islamic banks) to mitigate both withdrawal risk and bankruptcy risk over the potential of capital outflow; and the high revenue sharing ratio set up by Islamic banks to their depositors However, if the point a goes smaller, point b goes higher, then point c goes down The movement of point a 1 into point a 6 is followed by an increasing trend of point b 1 into point b 6 with a consequence of the ideal revenue sharing offered to depositors, from point c 1 into point c 6 This is shown by the movement of a combination points from (a 1 b 1 c 1 ) into (a 6 b 6 c 6 ) Revenue Sharing Ratio (r) c1 c2 c3 c4 c5 c6 Figure 1 Revenue sharing equilibrium ratio b6 2nd Ratio b5 b4 b3 b2 b1 a6 a5 a4 a3 a2 a1 1st Ratio

The main finding of this illustration is that every combination points (a, b and c) depicts an ideal revenue sharing ratio offered by Islamic banks to depositors For example, the combination of a 1 b 1 explains that with the economic conditions of a 1 and b 1, the ideal revenue sharing ratio offered by Islamic bank to depositors is c 1 When Islamic banks set r b lower than c 1, they will face by both withdrawal and bankruptcy risk and when they set r b higher than c 1, they release their potential revenue to depositors The reverse condition might also occur uring the difficult economic/business conditions, the performance of Islamic banks might not as good as before The revenues from business sector are limited and invite the potential of liquidity withdrawals Islamic banks are forced to raise their revenue sharing ratio to retain their depositors with a consequence of sacrificing their sharing part In the figure, it is depicted by the movement from a combination points (a 6 b 6 c 6) into (a 1 b 1 c 1 ) Finally, this paper opens areas for further research because it does not capture the formulas for both withdrawal and bankruptcy risks under PLS scheme instead of revenue sharing scheme Moreover, it also does not include other risks related to withdrawal risk such as, liquidity risk, liquidity run and maturity mismatch risk Accommodating those concerns in the future could make this research more applicable and useful to manage risk in Islamic banking institution Formulating risk in Islamic banking 73 8 Conclusion The prospective development of the Indonesian Islamic banking industry should be accompanied by a proper way of managing both withdrawal risk and bankruptcy risk There are conditions where the Islamic banks are in vulnerable, invulnerable, bankrupt and solvent conditions Particularly, it is because of the characteristics of Islamic banking industry and the depositors themselves In order to manage and quantitatively determine the four conditions above, four mathematical formulas under four liquidity withdrawal scenarios are developed in the paper Ultimately, the combination of all formulas constructs the equilibrium area of revenue sharing ratio that locates Islamic banks in good (solvent and invulnerable) condition The outputs of the paper is hopefully beneficial for Islamic banks, banking regulators and all market players to asses the problems of withdrawal risk and bankruptcy risk Especially, the equilibrium area constructed in the paper is suggested to be the ideal revenue sharing ratio to be considered and followed by Islamic banks to protect them from both withdrawal risk and bankruptcy risk Notes 1 Islamic banking financing which composes of Murabahah, Mudarabah and, Musharakah financing 2 Islamic banking financing which composes mostly of Ijarah financing References Ahmed, H (2003), Withdrawal risk in Islamic banks, market discipline and bank stability, Proceeding Conference on Islamic Banking: Risk Management, Regulation and Supervision, Organized by Bank Indonesia, Ministry of Finance Indonesia and IB, Jakarta, 30 September-2 October

IMEFM 5,1 74 Bank Indonesia (2006), Blue Print of Indonesian Islamic Banking evelopment, Islamic Banking irectorate of Bank Indonesia Publication, Jakarta Bank Indonesia (2009), Annual Report: Indonesian Islamic Banking, available at: wwwbigoid (accessed 3 January 2010) El-Hawary, A, Grais, W and Iqbal, Z (2003), Regulating Islamic financial institutions: the nature of the regulated, Proceeding Conference on Islamic Banking: Risk Management, Regulation and Supervision, Organized by Bank Indonesia, Ministry of Finance Indonesia and IB, Jakarta, 30 September-2 October Ismal, R (2009), Factors determining asset liability balancing, Journal of Islamic Banking and Finance, International Association of Islamic Banks, Vol 26 No 1 Ismal, R (2010), How do Islamic banks manage liquidity risk, Kyoto Bulletin of Islamic Area Studies, March Mars, RS (2008), Study of the Market and Islamic Banking epositors Behaviors 2008, PT Mars Indonesia, Jakarta, Jl Paus 89G Rawamangun Further reading Bank Indonesia (2000-2010), Monthly Statistics Report of Indonesian Islamic Banking Statistics, available at: wwwbigoid (accessed 12 March 2010) Appendix 1 c c þ r sbi ni 2 r b A # C þ G such that: ðc c þ r sbi ni 2 r b Þ # AðC þ G Þ: As we know that: ¼ c þ i, so: ð c þ i Þðc c þ r sbi ni 2 r b Þ # AðC þ G Þ; and we get: r b ð c þ i Þlc c ð c þ i Þþr sbi ni ð c þ i Þ 2 AðC þ G Þ: Because g c ¼ (C þ G), finally: r b l ðc c þ r sbi ni Þ 2 Ag c ðprovenþ: In order to compute g c, we modify it into: such that: r b lðc c þ r sbi ni Þ 2 Ag c g c l c c þðr sbi ni 2 r b Þ A ðprovenþ:

Conversely, when: c c þ r sbi ni 2 r b l C þ G A with the same way of mathematical transformation but different in sign, we come up with: Formulating risk in Islamic banking and: r b k ðc c þ r sbi ni Þ 2 Ag c g c k c c þðr sbi ni 2 r b Þ A ðprovenþ: 75 Appendix 2 From basic formula e $ l, we also know that e ¼ E/(E þ ) and: thus the original formula becomes: l ¼ ð1 2 r b Þ 2 C o E ðe þ Þ $ ð1 2 r b Þ 2 C o : Next, this equation is extended to be: E $ [ (1 2 r b ) 2 C o ](E þ ) By multiplying every element and pooling elements which contain revenue sharing ratio in the left hand side of the equation, we find: r b ( E þ ) $ 2 (E þ )C o with the last formula becomes: r b $ ðe þ Þ 2 C o ðprovenþ: Conversely, with e, l, the same way of calculation is applied but with different sign so that this original formula is derived as: E ðe þ Þ k ð1 2 r b Þ 2 C o and revenue sharing ratio of bankruptcy scenario is found to be: r b k ðe þ Þ 2 C o ðprovenþ: Appendix 3 Combining formula of solvency condition: and invulnerability: r b $ ðe þ Þ 2 C o r b l ðc c þ r sbi ni Þ 2 Ag c

IMEFM 5,1 76 all together we find the equilibrium equation on both conditions First, invulnerability equation is modified into: l ðc c þ r sbi ni Þ 2 Ag c r b and inserted into solvency formula above so that: r b $ ðe þ Þ 2 C o r b : ðc c þ r sbi ni Þ 2 Ag c Solving the equation through pooling all elements containing r b in the left hand side and leaving the rest in the right hand side, we find: r b ½ðc c þ r sbi ni ÞðE þ Þ 2 Ag c ðe þ ÞþC o ðe þ ÞŠ $ ðc c þ r sbi ni Þ 2 Ag c ; such that: ðc c þ r sbi ni Þ r b $ ðe þ Þ½ðc c þ r sbi ni Þ 2 Ag c þ C o Š 2 Ag c ðe þ Þ½ðc c þ r sbi ni Þ 2 Ag c þ C o Š : Recalling formula of equity and liquidity reserve, we simplify such equation to be: ðc c þ r sbi ni Þ r b $ ðe þ Þ½ðc c þ r sbi ni Þ 2 Ag c þ C o Š 2 AeðC þ GÞ E½ðc c þ r sbi ni Þ 2 Ag c þ C o Š ðprovenþ: For the opposite condition where Islamic banks is in both invulnerable and bankrupt condition, the calculation is the same except with different direction so that: ðc c þ r sbi ni Þ r b k ðe þ Þ½ðc c þ r sbi ni Þ 2 Ag c þ C o Š 2 AeðC þ GÞ E½ðc c þ r sbi ni Þ 2 Ag c þ C o Š ðprovenþ: Appendix 4 Glossary of Arabic words Mudarabah A form of partnership where one party provides funds while the other provides expertise and management Any profits accrued are shared between the two parties on a pre-agreed basis, while loss is borne by the provider(s) of the capital Murabahah It is a contract of sale in which the seller declares his cost and the profit It can involve a request by the client to the bank to purchase a certain item for him The bank does that for a definite profit over the cost which is stipulated in advance Musharakah It is a mutual consent business contract to share profits and losses in the joint business Islamic bank and enterprise provides funds together Any profit will be distributed among partners in pre-agreed ratios and loss will be borne by every partner in proportion to respective capital contributions Bay Salam The buyer makes advance payment for goods to be delivered by the seller later on It is necessary that the quality of the commodity intended to be purchased is fully specified leaving no ambiguity leading to dispute Bay Istishna It is a contractual agreement for manufacturing goods and commodities, allowing cash payment in advance and future delivery or a future payment and future delivery A manufacturer or builder agrees to produce or build a well described good or building at a given price on a given date in the future Price can be paid in installments, step by step as agreed between the parties

Ijarah Sale of a definite usufruct of any asset in exchange of definite reward It refers to a contract of land leased at a fixed rent payable in cash and also to a mode of financing adopted by Islamic banks Kafalah (Suretyship) In Kafalah, a third party become surety for the payment of debt It is a pledge given to a creditor that the debtor will pay the debt, fine, etc Suretyship in Islamic law is the creation of an additional liability with regard to the claim, not to the debt or the assumption only of a liability and not of the debt Hiwalah Legally, it is an agreement by which a debtor is freed from a debt by another becoming responsible for it, or the transfer of a claim of a debt by shifting the responsibility from one person to another contract of assignment of debt Wakalah A contract of agency in which one person appoints someone else to perform a certain task on his behalf, usually against a certain fee Formulating risk in Islamic banking 77 Corresponding author Rifki Ismal can be contacted at: rifki_ismal@yahoocom To purchase reprints of this article please e-mail: reprints@emeraldinsightcom Or visit our web site for further details: wwwemeraldinsightcom/reprints