Credit-Risk Sharing in Islamic Banking

Risk-sharing is a well-known principle in Islamic finance, which predominantly deals with equity-based transactions, namely mudaraba and musharaka.  While it is practically absent in the banks’ financing instruments, risk-sharing has been around in the Islamic deposit market for quite some time.

My aim today is to connect risk-sharing in the deposit market to the financing side of the balance sheet.  If one looks at the four Shariah Compliance indicators in Table 1 below, indicator number 2 says that the “allocation of profits and charging of losses relating to the investment accounts (i.e. a risk-sharing or profit-sharing account) conforms to the requirement of Shariah”.

Table 1: Shariah Compliant Indicators

Items
1.	The contracts, transaction and dealings entered in to the IFI during the year ended xxx are in compliance with the Shariah Principles
2.	The allocation of profits and charging of losses relating to investment accounts conform to the basis that has been approved by SC in accordance with Shariah Principles
3.	All earnings that have been realized from sources or by means prohibited by the Shariah principles have been considered for the disposal to charitable sources
4.	The calculation of zakat is in compliance with Shariah principles

Source: BNM 2006, Shariah Governance Framework updated

How this is true is interesting when we look at the hypothetical profit & loss statement of an Islamic bank below:

Table 2:  Islamic Bank Profit & Loss

Items	Amount
1.       Income derived from the Investment of Deposit Funds	$300 million
2.       Income derived from the Investment of Shareholders’ Fund	$50  million
3.       Impairment allowances for financing and advances	$40 million
4.       Total distributable income	$290 million

In the above, we see that the impairment expenses (item 3) are charged to both shareholders and depositors. In contrast to conventional banks, the impairment expenses in Islamic banks which measures the provisions for credit default is also carried by depositors.  To some extent the impairment provision evidences the charging of losses to the Mudarabah investment account holders as stipulated in Table 1 above at Item 2.

This form of credit-risk sharing between the investment account depositors and the bank should suggest that the rewards to the former for taking such risk could be higher than the fixed deposit rates. This however depends on the size of risk absorbed by the depositors which is not readily explained in the financial report.

Going forward we expect to see more transparency in the disclosure of the impairment expenses  of Islamic banks to include the proportion of credit risk carried by the bank and investment account depositors.  This can help explain gaps between return on equities (ROE) and return on deposits (ROD), if any.

By Prof. Saiful Azhar Rosly