This document discusses credit risk in Islamic finance. It begins by defining credit risk as the potential financial loss from a counterparty failing to meet contractual obligations. It then outlines the various types of credit risk exposures that can occur in common Islamic financing contracts such as mudarabah, musharakah, murabahah, ijarah, salam and istisna. The document also discusses IFSB guiding principles for credit risk management, including conducting due diligence reviews and having appropriate risk mitigation techniques. It emphasizes the importance of effective credit risk management for ensuring the financial stability and growth of Islamic banks.

1. RISK MANAGEMENT
IN
ISLAMIC FINANCE
Mahyuddin Khalid

2. Credit Risk
Content
What is credit risk?
Exposure of Credit Risk Losses
Understanding Common Credit Risk
Credit Risk in Islamic Banks
IFSB Guiding Principles for Credit
Exposure
Due Diligence Review for Credit
Management
Importance Of Managing Credit Risk
Learning Outcome
• To clearly state what the meaning of
credit risk
• To know how to manage credit risk
• To know credit risk in Islamic banking
product
• To know the function of financial
intermediation and banking supervision
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3. What is Credit Risk?
 The concept of risk is well known in ancient societies. Even in
financial decisions people knew very well that leading to
someone who is bankrupt has a high probability of losing the
money as compared to a debtor with good standing.
Nevertheless, risk become an important tool of decision making
when it become possible to measure it.
 The meaning of credit is an obligation created by the bank for
one who demands from it than he be permitted to use a
particular asset on account of the confidence reposed in him
with respect to it.
 The meaning of risk is the situation that involve probability of
deviation from the path that lead to the expected or usual
result. Or in the other hand is the likelihood of loss.
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4. Credit risk defined as potential financial loss suffered by a
financial institution arising from failure of its counterparty
in honouring its agreement with the respective institution.
Or the risk of a counterparty’s failure to perform its
obligation in an agreed contract. The counterparties refer
to financing customers, financial institutions or security
issuers.
Also referred to default risk –the contracting party default
in performing its obligations. For example, the default risk
of the borrower to pay the promised instalments to the
bank
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5. Exposure of Credit Risk Losses
Loss of
depositors’ fund
Failure to
generate profit
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6. Understanding Common Credit Risk
 Financial institution is an intermediary between surplus and deficit
units;
 Which uses the collected fund from surplus units to finance its
customers
 In a perfect scenario, the fund will used in a productive manner
promising profit benefited by the institution, depositors and bank’s
customer. Bank may then move idle money placed by depositor for
used by its financing customer in return for charging interest, profit
or fee.
 Financing customer are able to use fund for productive economic
activity and able to generate revenue too.
 This perfect scenario, all parties depositors, banks, and financing
customer benefit from excess money which have been lying idle.
 However, credit risk appears when the customers fails to honour its
obligation to the institution (non-performing loans @NPL) 6

7. Credit Risk in Islamic Banks
 Credit risk would take the form of settlement /payment risk arising
when one party to a deal pays money (e.g. in a Salam or Istishna’
contract) or delivers assets (e.g. in a Murabahah contract) before
receiving its own assets or cash, thereby, exposing it to potential
loss.
 In case of profit-sharing modes of financing the credit risk will be
non-payment of the share of the bank by the entrepreneur when it is
due
 This problem may arise for banks in the case due to the asymmetric
information problem in which they do not have sufficient
information on the actual profit in the firm.
 As Murabahah contracts are trading contracts, credit risk arises in the
form of counterparty risk due to nonperformance of a trading
partner.
 The non-performance can be due to external systematic sources
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8. Credit Risk In Islamic Banks
Mudarabah (profit sharing)
Musharakah (profit and loss sharing)
Murabahah (sale of goods with markup)
Ijarah (leasing)
Salam (forward sale)
Istisna (Order to manufacture)
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9. Mudarabah (profit sharing)
Relationship between bank and mudarib (borrower)
involves a principal–agent relationship
2 potential credit risks
• Risk of non-delivery goods by the supplier or
delivery not accordance with customer’s
requirement.
Thus, the bank is unable to complete sale to the
customer – no income will be received
• Risk of default payment- Once the goods are
delivered, the credit risk is transferred to the
customer
to fulfil instalments accordingly.
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10. Musharakah (profit and loss sharing)
 Banks and other partners provide capital and share the profit
and loss on a pre-agreed upon ratio
 Most shariah scholars agree that musharakah is the closest
islamic finance alternative to interest-based financing
 Because of asymmetric information, bank is again exposed to a
high level of credit risk with the partner investor
 Because as the bank finances the partner, in the case of
liquidation, the bank's share of invested capital will rank lower
to debt and it may lose all its invested capital
 Islamic bank will also have to cover its share of any loss
incurred due to the negligence of the partner.
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11. Murabahah (sale of goods with markup)
 Sales-based contract where the buyer (borrower) provides
necessary information to the bank regarding its purchasing
requirements
 Bank then purchases the product and sells it to the buyer with a
margin for profit.
 Credit risk occur when customer fails to honor the payment
obligation at the time of product delivery
 May arise in nonbinding mudrabahah if the customer refuses
the delivery of the product purchased by bank at a later time
 Because of, say, subsequent price variation or variation in
product quality
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12. Ijarah (leasing)
Exposed to credit risk in the event of the default of the
lessee when rent is due
Arise because of variable lease rents that may distress the
customer's ability to pay (loss of rental receivables).
Credit risk in binding ijarah corresponding to when the
lessee may cancel the lease before the stipulated time
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13. Salam (forward sale)
Islamic banks face credit risk here in the event of a failure
to deliver the products at a specified time
Because of adverse price fluctuations, the seller may
default and hence not deliver the products
The islamic banks will need to purchase the products from
an alternative source at a potentially higher price to meet
delivery to the buyer
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14. Istisna (Order to manufacture)
Istisna is mostly used for manufacturing goods
Islamic banks are exposed to credit risk in this financial
contract in two ways
 First, if the banks fail to deliver the products on the stipulated
date to the buyer due to late delivery from the manufacturer,
bank will need to purchase from an alternative source at a
potentially higher price.
 Second, if the bank sells this product in instalments to the buyer,
the buyer may default in a subsequent period and this be
reflected in a loss of receivables for the bank
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15. IFSB Guiding Principles for Credit Exposure
 IFIs should have a strategy for financing using various shariah-
compliant instruments to recognise the potential credit exposures.
(strategy of pricing etc)
 IFIs should carry out Due Diligence Review among the potential
counterparties prior to deciding an appropriate Islamic financing
instrument.
 IFIs should have appropriate methodologies to measure and report
credit risk exposures arising from Islamic financing instruments
 IFIs should have appropriate shariah compliant credit risk mitigating
techniques for each financing instrument.
 IFIs should have a system
 Monitor condition of individual credit
 Manage problematic credit situations
 Ensure adequate monitoring and provisions are provided
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16. Due Diligence Review for Credit Management
5Cs Identified Risk Mitigation
Character • Management lack of
experience
• Performance risk
• Appointment of an
independent industry
expert
• Key man insurance
Capacity • Financial risk
• Performance risk
• Covenants
• Monitoring of cashflow
Capital • Performance risk
• Commitment from
shareholder
Covenants
Conditions • Industry risk
• Concentration risk
• Funding risk
• Downside risk
Risk policy which limits
exposure to industry and type
of funding
Collateral • Financing structure
• Operational risk
Risk policy
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17. Credit Check Tools
Worldcheck
CCRIS
Credit Bureau
CTOS
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18. Importance Of Managing Credit Risk
To ensure the financial institution’s survival and growth
To protect the image and reputation of the financial
institution.
Increasing customers’ confidence and preference to Islamic
banks
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19. Mahyuddin Khalid
End of Chapter
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