Monday, July 11, 2005

Islamic Banking : Dealing with Adverse Selection and Default risk

When Islamic banking operations are largely based on credit financing, Islamic banks’ exposure to credit risk is inevitable. Pricing of credit-based products (CBP) is also similar with interest-bearing ones when a default premium (i.e. spread) is added to the cost of funds and overheads. Adverse selection is also worrying. With smaller market share, Islamic banks run on higher operating costs. With higher overheads, CBP’s profit rates are usually higher than interest-rates. Lower demand for credit-based products increases idle balances. To mop up the excess liquidity, Islamic banks may have acted with less prudence in assessing credit sale applications. In this way, adverse selection seemed have affected Islamic banks more than their conventional competitors.

The credit culture is alien in Islam. Islam encourages man to earn through work and effort as well as risking capital to market volatilities. Man is not expected to live on unearned income. But that's what the credit lifestyle is. People expect their future streams of income will come in steady. Under such illusion, living beyond their means has become a virtue.

The Quran enjoins man to conduct trading and commercial transactions (al-bay') as opposed to riba. It does not encourage man to fall into debt again by conducting trading (al-bay'). In the riba culture, people lend and borrow money to conduct business. They also borrow to live in luxury. Likewise in current Islamic banking business, the players engaged themselves in debt financing called murabahah. bai bitha man ajil bay muajjal, bay 'inah and tawaruq to do just the same.

Financing contracted under the murabahah, BBA and AITAB (i,e.CBP) contracts usually embrace the credit culture. The financial requirement includes collaterals, guarantors and a system of credit assessment in determining the credit-worthiness of a prospective customer. Islamic risk management generally pointed to credit risk management ie. protecting bank’s profit from defaulting customers.

Table 1 showed higher default rate in Islamic banks. The three month non-performing financing is doubled that of conventional banks at 9.6 percent . This may have to do with the problem of adverse selection. Since Islamic banks must compete on sheer size alone, it can lose out to conventional banks in pricing. With smaller market share of assets and deposits, economies of scale is hard to come by. To that effect, Islamic banks usually run under high operating budget, which is later absorbed by bank’s customers who has to pay high profit rates.

When credit products are sold at higher rates than conventional loans, liquidity in Islamic banks may increase as the demand for credit based products is lower than the demand for loans. To reduce the idle balances, Islamic banks may have acted with less prudence when approving credit based products. But only the bad paymasters are willing to pay higher rates. Often rejected by conventional banks, they have no way to go except the Islamic banks. The good ones usually resort to loans. This may explain well the higher non-performing financing in Islamic banks.

Table 1: Malaysian Banking System : Non-Performing loans/financing 2004
Banks 3-month (%) 6-month (%)
Conventional 7.6 5.9
Islamic 13.7 9.6
Source: Bank Negara Malaysia 2004

Credit risk management in Islamic banks therefore should go beyond assessing the credit worthiness criteria of customers. The problem of adverse selection can be overcome by not extending new facilities to customers with less financial viability but this may not remedy the liquidity problem.

Source: Saiful Azhar Rosly, Islamic banking – Doing Things Right and Doing the Right Thing, Symposium on Globalization and the Emerging Economies, Organized by Malaysian Institute of Economic Research (MIER) and University of Lancaster Alumni, Kuala Lumpur Hilton Hotel, 27th June 2005


Blogger siti hajar samsu said...


Adverse selection and default risk practically shows that Islamic bank failed to attract muslim depositers choose Islamic bank upon the name of religion to support development of Islamic banking. In other words, religion factor is insignificant in influencing people interest deposited in Islamic bank. Most of Muslim mind set still believe in profit maximation theory rather than hold up for Islamic application. It may be due to people expected to acquire streams of income steady in the future. Clearly, Islamic product of financing like murabahah, BBA, ijarah can’t run away from credit culture.

It is true that the problem of adverse selection can be defeat by not provides new facilities to customer with low financial viability, yet this approach may only helpful in the short run and may not a concrete remedy of liquidity problem in longer term. The reliability of approach is necessary in order to ensure Islamic banks survival in the global competition.

Therefore, Islamic banks were supposed to adopt new financing policies and to explore new channels of investment which may encourage development and support especially from Muslim customers. On the other hand, Islamic banks must paid attention to potential customer standard in payoff loans and improve efficiency in risk management concurrent with competitor banks to slowly but surely build up public trust worthy for both i.e Muslim and Non muslim. This may indirectly can solve a number of problems

11:07 PM  
Blogger ronald rulindo said...

I want to comment about one of the adverse selection in Islamic Banking business. When Islamic Banking try to attract new customer especially from moslem community, they always mention that the differece of Islamic Banking and conventional banking is Islamic banking not use riba or interest in their activity but they use profit sharing sheme.

However, this explanation is not absolutely true because most transaction in Islamic banking use trading / bay (BBA, Murabahah) and many moslem scholars do not agree with its especially BBA.

Now, BIMB is facing a problem with their NPF and most NPF is come from BBA transaction. may be it is happen because BIMB (not only BIMB actually) is not admit the reality of their business. They should provide more information about their business. They should mention yhat their "islamic bank" is not based on the true characteristic of islamic banking itself.

I think it is the high time for all Islamic Bank to come banck to the true characteristics of Islamic banking by use pure profit and loss sharing. However, one things that Islamic bank should remember is they have to mantain their credit selection in order to hide from the default risk.

9:04 AM  
Blogger Bilal Mohd Parid (G0428469) said...

Channeling the investment towards equity financing and diversify the fees services are among the suggestion that can be taken to solve the adverse selection problem. Joint ventures, strategic alliances and mutual cooperation are among the mode of investment that could be taken to adjust the liquidity problem. Mismanagement of risk has invited the problem in Islamic Bank. They are willing to have a bad paymaster with some collateral rather than investing in a joint venture project without any guarantee of return.

Reducing credit based product is a crucial decision for Islamic Banking due to its significant impact on the stakeholders. Among other alternatives are, the Bank could develop its own business and secure the whole income from the business or buying the shares of public listed company which had a good track record and satisfy the Bursa Malaysia and Securities Commissions requirement. We can use KWSP as a model or Khazanah as a benchmark in investment decision. Both organization had effectively and efficiently manage their investment portfolio.

11:47 PM  
Blogger muhammad said...


I agreed with Br Bilal suggestion on Islamic Bank to give more concentration towards fee income and on profit sharing basis. In fact, this is what our Prophet Muhammad PBUH insisted; promoting trade/al bay which is among others sharing profit/loss & prohibit riba.

Our today conception on Islamic Finance does not truly reflect 'muhibbah' & 'tolerance' spirit within the 'business', which is also regards as an 'ibadah' for Muslim. In fact, our current system is merely a replication of conventional system, which is specially tailored intended to entice more attention of wealthy Muslims.For me, the question of adherence to Islamic pillars is not an issue to any borrowers/depositors. Which is more important to them is the bottomline; profit & return.

In fact, issues of adverse selection and default risk should be anticapted and did happen on both Conventional & Islamic practice. The only difference is its quantum.

Why Islamic Banking industry, particularly BIMB faced higher NPF rates as compare to Conventional Banks ?. For me, it is more to failure of its Risk Management Team to anticipate risks of capability, character, collateral,condition and such which is embedded in one's business via credit risks.In the case of BBA for example, their risk screening and decision may be affected by the value of the 'assets' offered as collaterals instead of the viability of business itself.

Islamic Banking should positioned themselves from a typical banker that lends money and receives money from depositors to more sopshiticated fund providers on risk sharing basis.

However, before this can be implemented, risk management issues has to be rectified and strengthened as they are answerable not only shareholders, but ummah as a whole.


Muhammad (G0217291)

12:17 AM  

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