Credit Risk Management: An Islamic Finance Perspective

Masur A. Alawusa

Risk is a contemporary challenge in today’s financial climate. The global financial crisis of 2008 reinforced the importance of risk management in the financial industry. Risk is generally understood as a situation where there is an uncertainty of desired results and the likelihood that the undesirable consequences. It has simply been defined as a likelihood of loss.

The etymology of the word risk can be traced to the Arabic word ‘rizqon’ meaning “everything given by God for livelihood”. From this definition, risk cannot be totally eliminated by mankind and man can only work to the best of his ability and hope for the good results.

Risks faced by financial institutions (both conventional and Islamic financial institutions) in their operations are of different kinds: exchange rate risk, trade risk (or market risk), political risks, and risks that represent changes in the value of assets and goods, etc. Credit risk is deemed to be the most significant type of risk faced by financial institutions in their relationship with the owners of wealth. Credit risk relates to the debtor’s ability to repay the debt at the appointed time and in accordance with the conditions stipulated in the contract. The debtor’s inability to abide by his obligations will lead to a loss, therefore, becoming a risk for the institution.

The existence of credit risk is not dependant on direct financing by the institution. The institution also faces this type of risk in guarantees and acceptance paper when the originator of the financial instruments owned by the institution is unable to meet his obligations (as in the case of bonds, sukuks). Such is the case in other indirect financing operations. Therefore, prudent management includes strict and detailed regulations specifically for credit risk with the purpose of assessing, managing and mitigating it to its barest minimum.

Conventional financial institutions face credit risk in almost all their operations, because the relationship between the institutions and those who transact with them is often that of a debtor and a creditor in all cases. Islamic financial institutions also face this form of risk in most of the modes of financing that they utilize either directly or as a metamorphosis of another risk.

In Nigeria, the Non-Interest Financial Institutions have an array of contracts for financing transactions but the mainly approved contracts by regulators are the Murabaha (cost plus financing) and Ijara (lease). These contracts often employ installment sales with delayed payment thus generating debts in the accounts of the institutions. The fundamental form of risk in all these contracts is credit risk as these directly involve a reliance on a counterparty to make repayments. Other prominent contracts like,Mudarabah (partnership) and Musharakah (joint venture) are contracts of participation, where the funds given by the institution to entrepreneurs are not classified as liabilities but as investments/equity. Yet, these two also bear a credit risk in two ways. Firstly, in the case of tort or negligence, the entrepreneur is liable to guarantee the capital (from negligent misappropriation) which means a debt liability. Secondly, when the capital of Mudarabah (partnership)or Musharakah (joint venture)are employed in a deferred sale, the owner of capital (rabb al-mal), the institution in this case, bears an indirect credit risk. This risk pertains to the ability of the counter parties to repay.

Risk management is the process by which managers identify key risks by obtaining consistent, understandable and operational risk measures, choosing which risks to reduce and establishing procedures to monitor the resulting risk position. While conventional and non-interest financial institutions may have the same credit risk, their risk management procedures differ. Conventional institutions have developed the control, structure and processes for risk management that enablethem choose a suitable level of risk that they are willing to bear. Their operations are based on the canon that money, risk and time are like goods that are bought and sold. It is possible for each manager to place a suitable limit for himself on each identified risk. He can dispose of those that he does not wish to hold and buy other risks that suit his aims and purposes. However, Islamic Financial Institutions regardthe trade of money, risk and time as impermissible as these financial elements are not commodities to be bought and sold. Money is treated as a means of exchange and not a store of value while the trade of risk involves excessive gharar (speculation)which is against the Shariah (Islamic law).

In addition to have the same credit risk as conventional institutions there are some credit risks that are specific to Islamic financial transactions. In Murabaha (cost plus financing) transactions, institutions deliver assets to clients who in some cases fail to fulfill their contractual obligations on time. In Non-binding Murabaha transactions, clients may refuse delivery of the product purchased in accordance to their right based on thecontract. Credit risk management in Islamic finance institutions has its peculiar challenges as these institutions are prohibited from charging interest and imposing penalties (although some Shari’ah advisers allow penalties on the condition that the penalties do not benefit the institution but are rather given in charity). Due to such delays, investments can become trapped and profits become eroded. The risks associated with Islamic credit transactions; their illiquid nature, lack of lender of last resort and inability to utilize short term money markets are some risks that do not exist for competing conventional financial intermediaries.

Basel II is currently the internationally accepted framework for risk management in the evaluation of credit risk, operational risk and market risk. The Islamic financial system is based on a participatory and risksharing approach. Islamic financial institutions face many challenges in complying with international standards and guidelines for risk management. They face unique and somewhat extra risks, compared to conventional financial institutions. Basel II with certain modifications can be adopted subject to addressing the distinct nature of Islamic financial activities, with accommodating differences in liabilities. Islamic finance is a relatively new phenomenon in this part of the world. Though it has modeled its risk management practices on conventional finance, it retains its basic principles againstriba (interest), gharar (speculation) and maysir(gambling).

It can be argued that Conventional and Islamic financial institutions take equally important risks with an exception of interest rates risk as the latter does not trade or give facilities on an interest basis. Loan recovery mechanisms are different between conventional financial institutions and Islamic financial institutions. Islamic financial institutions are more flexible as a major objective of Islamic finance is to positively impact the businesses of its debtors, therefore preferring to restructure transactions contrary to their conventional counterparts who prefer to recoverthe principal and predetermined rate of return at whatever costs to the debtor. Also, Islamic financial institutions in Nigeria have not started offering unsecured financial products as they see it as risky investments which is a consequence of structural deficiencies in the domestic market; an example is the unavailability and/or inadequate data of creditors history by credit bureaus.

While conventional and Islamic finance institutions differ in their operations, their creditrisk management practices have been found to be alike as listed below: a) Strict regulations for giving credit are based on the credit-worthiness of the client, his ability to abide by his obligations within the appointed time and the conditions agreed upon. Included in this is the financial reputation of the client and his credit history, financial standing, legal ability to raise loans from the institution, to negotiate either by himself or by delegation from his partners or his establishment, and his ability to generate income in future, because the repayment of the debt depends on his cash receipts and payments.

b) Taking of collateral, personal and tangible securities along with an emphasis on the ability of the institution to redeem its claims from these. Credit, however, is not granted on the basis of the strength of collateral and guarantees, but on the ability of the client to pay.

c) The economic circumstances in general and the special circumstances of the sector that generates the income of the client. The inclination and the ability of the client to abide by his obligations may be up to the desired level, but a change in the environment in which the client operates, may force him to default or to procrastinate due to reasons that are beyond his control.

d) Institutions lay down strict regulations and policies for follow up and recovery, directly or through agents, collectors and law firms. The contracts of loans usually contain conditions that grant the institution the right to collect installments by any legal means, like authority over the other accounts of the client in the institution or even in other institutions if possible without an injunction from the court.

Generally the operations and management of credit risk practices are qualitatively similar in both Islamic and conventional financial institutions but with few fundamental differences in the nature of products and methods used in appraising transactions and investments.A safeguard within the current framework revolves around transparency, accountability and corporate governance. These values are more permeable in the Islamic finance environmenttaking into account the restrictions placed by the rules of the Shariah pertaining to financial constraints and other peculiarities. Though some instruments used by conventional financial institutions for credit risk management are not permitted for use by Islamic financial institutions, the latter’s risk management process is as rigorous and efficient as their conventional counterparts.

Alawusa, wrote from Credit and Investment Risk Kord Capital Ltd