Step 2
Offset the weighted long and short positions within each time band.
Example
If the sum of the weighted long positions in a time band is KZT100 million and the sum of the weighted short positions in the band is KZT90 million, you offset the positions to come up with a matched position of KZT90 million and unmatched position of KZT10 million.
Step 3
For each time band, apply a 10% capital charge (vertical disallowance) on the matched position calculated in step 2.
Example
Continuing on from the example in step 2, apply the 10% on the KZT90 million matched position to come up with a KZT9 million vertical disallowance for the time band.
Step 4
For the unmatched positions calculated in step 2, carry out 2 further rounds of offsetting using the zones (made up of time bands) in table 8.50 B and apply the appropriate capital charge, as follows:
(a) first between the remaining unmatched positions within each of 3 zones and subject to a charge (expressed as a percentage) as follows:
(і) matched weighted positions within zone 1 x 40%;
(ii) matched weighted positions within zone 2 x 30%;
(iii) matched weighted positions within zone 3 x 30%;
(b) subsequently between the remaining unmatched positions across the 3 different zones (in the order set out below) and subject to a capital charge as follows:
(і) matched weighted positions between zones 1 and 2 x 40%;
(ii) matched weighted positions between zones 2 and 3 x 40%;
(iii) matched weighted positions between zones 1 and 3 x 100%.
The absolute value of the net amount remaining is the net position.
Table 8.50 B Zones for profit rate
| Item | Zone | Time Bands |
| 1 | zone 1 | 0 – 1 month 1 – 3 months 3 – 6 months 6 – 12 months |
| 2 | zone 2 | 1 – 2 years 2 – 3 years 3 – 4 years |
| 3 | zone 3 | 4 – 5 years 5 – 7 years 7 – 10 years 10 – 15 years 15 – 20 years more than 20 years |
Step 5
Calculate the horizontal allowance by adding the charges from paragraphs (a) and (b) of step 4.
Step 6
Calculate the general risk capital charge as the sum of:
(a) the net position calculated from steps 1 to 4;
(b) the vertical disallowance from step 3;
(c) the horizontal disallowance from steps 4 and 5; and
(d) the net charge for positions in options, where appropriate, calculated in accordance with Rule 8.19.
8.51. Positions in currencies
(1) An Islamic Bank must use separate maturity ladders for positions in each currency, with capital charges calculated separately for each currency and then summed. Positions in different currencies are not to be offset.
(2) If an Islamic Bank’s position in a currency is less than 5% of the value of an Islamic Bank’s Banking Book assets, that currency is taken to be a residual currency and an Islamic Bank may use a single maturity ladder for all residual currencies (instead of having to use separate maturity ladders for each currency). An Islamic Bank must enter, into each appropriate time band, the net long or short position for residual currencies.
(3) An Islamic Bank must apply, with no further offsets, the risk factor in column 3 of table 8.50 A to the position in each time band for residual currencies.
8.52. Binding unilateral promises
(1) An Islamic Bank must treat a binding unilateral promise on bank or corporate debt as a long position or a short position in the underlying debt security. A binding unilateral promise that is not on bank or corporate debt must be treated as a long position or a short position in a notional government security.
(2) If a range of instruments may be delivered to fulfil a contract, an Islamic Bank may choose the deliverable security to be allocated to the maturity ladder. An Islamic Bank must, however, take account of any conversion factor specified by the exchange where the instrument must be delivered.
8.53. Swaps
(1) An Islamic Bank must treat a swap as 2 notional positions in government securities with maturities. Both legs of the swap must be reported at their market values.
(2) For swaps that pay or receive a fixed or floating profit rate against some other reference price (for example, a stock index), an Islamic Bank must:
(a) enter the profit rate component into the appropriate maturity category; and
(b) include any equity component in the measurement of equity risk.
(3) Each leg of a cross-currency swap must be reported in the maturity ladder for the currency concerned. The capital charge for any foreign exchange risk arising from the swaps must be calculated in accordance with Rules 8.14 to 8.17.
8.54. Shari’ah-compliant hedging instruments
(1) In the measurement of profit rate risk in the Trading Book, an Islamic Bank must include profit rate Shari’ah-compliant hedging instruments and off-balance-sheet instruments in the Trading Book if those instruments react to changes in profit rates.
(2) An Islamic Bank must convert Shari’ah-compliant hedging instruments into positions in the relevant underlying to enable an Islamic Bank to calculate specific and general risk capital charges. To determine the capital charges, the value of the positions must be the market value of the underlying or notional underlying.
(3) Positions in Shari’ah-compliant hedging instruments are subject to charges for general risk in the same way as cash positions. However, matched positions are exempt from the charges if the positions satisfy the criteria in Rule 8.55 or 8.56.
(4) Positions in Shari’ah-compliant hedging instruments must be allocated to a maturity ladder and treated in accordance with this rule and the maturity method.
8.55. Criteria for matching Shari’ah-compliant hedging instrument positions
(1) An Islamic Bank may offset a matched position in Shari’ah-compliant hedging instruments if the positions relate to the same underlying instruments, have the same nominal value and are denominated in the same currency.
(2) For swaps and binding unilateral promises:
(a) the reference rate (for floating-rate positions) must be identical and the profit rate must differ by no more than 15 basis points; and
(b) the next profit-fixing date (or, for fixed-profit-rate positions or binding unilateral promises, the residual maturity) must comply with the following requirements:
(і) if either instrument has a profit-fixing date or residual maturity up to and including 1 month in the future, the dates or residual maturities must be the same for both instruments;
(ii) if either instrument has a profit-fixing date or residual maturity more than 1 month, but no more than 1 year, in the future, the dates or residual maturities must be within 7 days of each other;
(iii) if either instrument has a profit-fixing date or residual maturity more than 1 year in the future, the dates or residual maturities must be within 30 days of each other.
(3) An Islamic Bank that writes options may offset the delta-equivalent values of options (including the delta-equivalent value of legs arising out of the treatment of caps and floors in accordance with delta-plus method in Rule 8.24).
(4) However, for offsetting between a matched position in a binding unilateral promise and its underlying, Rule 8.56 applies.
8.56. Criteria for offsetting Shari’ah-compliant hedging instrument positions
(1) An Islamic Bank may offset long and short positions (whether actual or notional) in identical instruments with exactly the same issuer, profit rate, currency and maturity.
(2) An Islamic Bank may offset a matched position in a binding unilateral promise and its corresponding underlying. The net position must be reported.
(3) An Islamic Bank may offset positions in a binding unilateral promise with a range of deliverable instruments and the corresponding underlying only if:
(a) there is a readily identifiable underlying Shariah compliant security; and
(b) the price of that security and the price of the binding unilateral promise move in close alignment.
(4) An Islamic Bank must treat each leg of a cross-currency swap or binding unilateral promise in foreign exchange transaction as a notional position in the relevant instrument, and must include the position in the calculation for each currency.
8.57. Market Risk capital charges for Islamic financial contracts
This section describes and sets out the Market Risk capital charges applicable to the main types of Islamic Financial Contracts typically employed by Islamic Banks across the world.
Sale-based contracts
8.58. Treatment of murabahah and related contracts
(1) An Islamic Bank is exposed to Market Risk under a murabahah contract when the asset is available for sale and on firm’s balance sheet.
(2) The capital charge for a murabahah contract is 15% on the position. There is no capital charge for a binding MPO contract or a CMT.
Guidance
In the case of a CMT where an Islamic Bank holds on to the commodity for a longer period than normal (for example, following the customer’s refusal to honour its commitment to buy) the commodity is subject to a capital charge of 15%.
8.59. Treatment of bai bithaman ajil
The capital charge for a bai bithaman ajil contract is 15% on the position. There is no capital charge for a commodity bai bithaman ajil.
8.60. Treatment of salam and related contracts
Under a salam contract, an Islamic Bank is exposed to Market Risk after an Islamic Bank has paid the purchase price to the seller and before the purchased commodity is sold and delivered to a buyer.
Table 8.60 A Market Risk capital charge for salam without parallel salam
| Stage of contract | Capital charge |
| firm has paid purchase price to salam customer (seller) | 15% on the long position of salam exposures |
| firm has received purchased commodity but has not sold and delivered the commodity to a buyer |
Table 8.60 B Market Risk capital charge for salam with parallel salam
| Stage of contract | Capital charge |
| firm has paid purchase price to salam customer (seller) | 15% on the net position (that is, after netting of salam exposures against parallel salam exposures) plus 3% on the gross position (that is, the sum of the salam exposures and parallel salam exposures) |
| firm has received purchased commodity but has not sold and delivered the commodity to a buyer Note: The parallel salam does not extinguish the requirement for capital from the first salam contract. |
8.61. Treatment of istisna without parallel istisna
(1) If an Islamic Bank is the seller under an istisna without parallel istisna contract, an Islamic Bank is exposed to Market Risk when there is unbilled work-in-process inventory. The capital charge for the contract is 1.6% of an Islamic Bank’s unbilled work-in-process inventory.
(2) If an Islamic Bank is the buyer under an istisna without parallel istisna contract, an Islamic Bank is exposed to Market Risk as it makes progress payments to the supplier. The capital charge for the contract is 15% of the work-in-process inventory.
8.62. Treatment of istisna with parallel istisna
(1) There is no capital charge for an istisna with parallel istisna contract if there is no provision in the parallel istisna contract that allows the seller to increase or vary the selling price. Also, there is no capital charge if there is a written undertaking given to an Islamic Bank that the contractor’s performance (including work-in-process) is the responsibility of the ultimate customer.
(2) However, there is a Capital charge of 1.6% of an Islamic Bank’s unbilled work-in-process inventory if:
(a) there is a provision in the parallel istisna contract that allows the seller to increase or vary the selling price; or
(b) there is no written undertaking that the contractor’s performance is the responsibility of the ultimate customer.
Lease-based contracts
8.63. Treatment of ijarah and related contracts
(1) For an operating ijarah, an Islamic Bank is exposed to Market Risk (from possible fluctuations in the price of the asset) and is subject to capital charges as follows:
(a) 8% of the residual value of the asset during the lease;
(b) 15% of the carrying value of the asset after the expiry of the lease contract until the asset is re-leased or disposed of.
(2) There is no capital charge for an IMB contract or any other ijarah contract.
Equity-based contracts
8.64. Treatment of diminishing musharakah
(1) The capital charge for a diminishing musharakah contract depends on the category of the enterprise or asset to which the contract relates.
(2) If the contract is in relation to a private commercial enterprise to undertake trading activities in foreign exchange, shares or commodities, the capital charge depends on the underlying asset as set out in this chapter.
(3) If the contract is in relation to a joint ownership of real estate or movable assets through musharakah with murabahah subcontract, the capital charge is 15% (that is, the charge for the murabahah subcontract, as set out in Rule 8.58).
(4) If the contract is in relation to a joint ownership of real estate or movable assets through musharakah with ijarah subcontract, the capital charge is 8% or 15% (that is, the charge for the ijarah subcontract, as set out in Rule 8.63).
8.65. Treatment of mudarabah
(1) The capital charge for a mudarabah contract depends on the category of the enterprise or asset to which the contract relates.
(2) If the contract is in relation to a private commercial enterprise to undertake trading activities in foreign exchange, shares or commodities, the capital charge depends on the underlying asset as set out in this chapter.
(3) If the contract is in relation to a placement in the interbank market, there is no capital charge except if the funds are invested in foreign exchange. The capital charge for a mudarabah contract where the funds are invested in foreign exchange is that calculated in accordance with Rule 8.14 (foreign exchange risk).
Loan-based contracts
8.66. Treatment of qardh
There is no capital charge for a qardh contract except if the loan is provided in a foreign currency or in the form of a commodity. For qardh-based financing in a foreign currency or commodity, the capital charge is that calculated in accordance with Rule 8.14 (foreign exchange risk) or Rule 8.29 (commodities risk), as the case requires.
Service-based contracts
8.67. Treatment of wakalah
(1) If a wakalah contract is in relation to a private commercial enterprise to undertake trading activities in foreign exchange, shares or commodities, the capital charge depends on the underlying asset as set out in this chapter.
(2) If the contract is in relation to a placement in the interbank market, there is no capital charge except if the funds are invested in foreign exchange. The capital charge for a wakalah contract where the funds are invested in foreign exchange is that calculated in accordance with Rule 8.14 (foreign exchange risk).
9. OPERATIONAL RISK
9.1. General
(1) Rules 9.1 to 9.9 of this Chapter sets out the requirements for an Islamic Bank’s Operational Risk management policy to identify, measure, evaluate, manage and control or mitigate Operational Risk. Rule 9.11 gives guidance on Operational Risk as it relates to Islamic financial contracts.
(2) Operational Risk is the risk resulting from inadequate or failed internal processes, people and systems, or from external events. It can be classified into general risk, Shari’ah non-compliance risk and legal risk.
(3) Operational Risk does not include strategic risk and reputational risk.
(4) Part of an Islamic Bank’s general Operational Risk arises from banking operations that are common to all financial institutions. For example, an Islamic Bank must ensure that its critical payments are made promptly in order to avoid systemic disruptions to other payment systems and money markets.
(5) The other part arises from the features specific to Islamic finance products and/or services including the structure, execution, manner of delivery, particular set of process, etc, and the asset-backed or based nature of its financial products. For example, murabahah, salam, istisna and ijarah may give rise to additional forms of Operational Risk in contract drafting and execution.
Guidance
Although the Operational Risk that could arise for Islamic Banks can be considered similar to that of conventional banks, the characteristics of such risk may be different, thus:
(a) Shari’ah-compliant products may involve processing steps different from those of their conventional counterparts
(b) the assets held on the balance sheets of Islamic Banks (physical assets and real estate) are different from those of conventional banks
(c) the requirements of Shari’ah-compliance result in different risks relating to information technology products and systems.
9.2. Operational Risk—Shari’ah non-compliance
(1) Shari’ah non-compliance risk, of an Islamic Bank, is the risk of non-compliance resulting from the failure of an Islamic Bank’s Shari’ah compliance policy to ensure that Shari’ah rules and principles (as determined by its Shari’ah supervisory board) are complied with.
(2) The risk can lead to non-recognition of an Islamic Bank’s income, and resultant losses. For sukuk, the risk may adversely affect the marketability (and, therefore, the value) of the sukuk.
(3) The risk may cause adverse effect to the reputation of an Islamic Bank. It may also shake the public confidence and/or customers' trust in an Islamic Bank and/or its products and service.
(4) Shari’ah non-compliance risk can take 3 forms:
(a) the risk arising from mistaken and/or shortcomings in the application of Shari’ah principles in an Islamic Bank's processes, procedures and/or products and services, including the risk that a transaction or contract is void ab initio;
(b) the risk relating to potential non-compliance with Shari’ah rules and principles in an Islamic Bank’s operations, including the risk that non-permissible income is recognised; and
(c) the risk relating to an Islamic Bank’s fiduciary responsibilities as mudarib towards fund providers under a mudarabah contract, according to which, in the case of negligence, misconduct, fraud or breach of contract by the mudarib, the funds provided by the fund providers become a liability of the mudarib.
9.3. Operational Risk—legal
(1) Legal risk, of an Islamic Bank, includes exposures to fines, penalties or punitive damages resulting from supervisory actions as well as private settlements.
(2) The risk can arise from:
(a) an Islamic Bank’s operations (that is, from legal risks common to all financial institutions); or
(b) problems of legal uncertainty in interpreting and enforcing contracts based on Shari’ah; or
(c) mismatch between the applicable law in a given jurisdiction (including mandatory procedures, etc) and the requirements of Shari’ah that may render certain products and/or services cannot be offered by an Islamic Bank due to such legal constraints.
(3) Legal risk also includes the risk that sukuk in which an Islamic Bank is the originator, sponsor or manager fail to perform as intended because of a legal deficiency.
9.4. Role of Governing Body—Operational Risk
(1) An Islamic Bank’s Governing Body must ensure that an Islamic Bank’s Operational Risk management policy addresses, on a firm-wide basis, all the major aspects of Operational Risk in an Islamic Bank’s business.
(2) In particular, the Governing Body must ensure that a Shari’ah governance mechanism is incorporated into an Islamic Bank’s Operational Risk management policy and that there is appropriate cooperation and communication between an Islamic Bank’s risk management function, Governing Body and the Shari’ah supervisory board.
9.5. Powers of the AFSA
If the AFSA identifies points of exposure or vulnerability to Operational Risk that are common to 2 or more Islamic Banks, it may impose specific Capital Requirements or limits on each affected firm.
Examples
(і) outsourcing of important operations by many Islamic Banks to a single provider
(ii) severe disruption to providers of payment and settlement services.
9.6. Policies—compliance with Shari’ah
An Islamic Bank must establish and implement policies to ensure that its business is conducted in accordance with Shari’ah. The policies must include effective and comprehensive procedures so that an Islamic Bank complies with:
(a) Shari’ah (in general and in relation to the requirements for Islamic financial contracts); and
(b) the fatwas, rulings and guidelines issued by its Shari’ah supervisory board.
9.7. Policies—business continuity
(1) An Islamic bank’s Operational Risk management policy must include effective and comprehensive procedures for disaster recovery and business continuity.
(2) An Islamic Bank must have a business continuity plan for possible scenarios of severe business disruption. The plan must provide for an Islamic Bank to continue to operate as a going concern, and to minimise losses (especially those from disturbances to payment and settlement systems), in those scenarios.
9.8. Policies—information infrastructure
(1) An Islamic Bank must establish and implement appropriate information technology policies for the accurate and timely identification, measurement, evaluation, management and control or mitigation of Operational Risk. In particular, the policies must enable an Islamic Bank to maintain an adequate and sound information infrastructure:
(a) that meets an Islamic Bank’s current and projected requirements (under normal circumstances and in times of stress);
(b) that ensures that the data, and the system itself, remain secure and available; and
(c) that supports integrated and comprehensive risk management.
(2) An Islamic Bank’s information infrastructure must enable an Islamic Bank to compile and analyse Operational Risk data, and must facilitate reporting to an Islamic Bank’s Governing Body and senior management and the AFSA.
(3) An Islamic Bank must have appropriate reporting procedures to keep the AFSA informed of developments affecting Operational Risk at an Islamic Bank.
9.9. Policies—outsourcing
(1) An Islamic Bank must establish appropriate policies to assess, manage and monitor outsourced activities. The management of those activities must include:
(a) carrying out due diligence for selecting service providers;
(b) structuring outsourcing arrangements;
(c) managing and reporting the risks associated with an outsourcing;
(d) ensuring effective control over an outsourcing; and
(e) contingency planning.
(2) The outsourcing policies must require an Islamic Bank to have comprehensive contracts and service level agreements. The contract and agreements must clearly state the allocation of responsibilities between service providers and an Islamic Bank.
9.10. Operational Risk Capital `Requirement - Basic indicator approach
(1) An Islamic Bank must use the basic indicator approach to Operational Risk. Operational Risk Capital Requirement is the amount of capital that an Islamic Bank must have to cover its Operational Risk.
(2) An Islamic Bank’s Operational Risk Capital Requirement is calculated in accordance with the following formula:
where:
GI is an Islamic Bank’s average annual gross income (as defined in sub-rule (3) below) for those years (out of the previous 3 years) for which an Islamic Bank’s annual gross income is more than zero.
α is 15% or a higher percentage set by the AFSA.
n is the number of years out of the previous 3 years for which an Islamic Bank’s gross income is more than zero.
(3) Gross income, for a year, means the total of the following income for the year:
(a) net income from financing activities, which is gross of provisions, operating expenses and depreciation of ijarah assets;
(b) net income from investment activities, which includes an Islamic Bank’s share of profit from mudarabah and musharakah;
(c) fee income, which includes commissions and agency fees;
less an Islamic Bank’s share in income attributable to IAHs and other account holders.
(4) Gross income excludes:
(a) realised profits from the sale of securities in the Banking Book;
(b) realised profits from securities in the ‘Held to Maturity’ category in the Banking Book;
(c) extraordinary or irregular items of income;
(d) income derived from insurance;
(e) any collection from previously written-off financings; and
(f) income obtained from the disposal of real estate and other assets during the year.
Guidance
Because of the definitions of GI and n, figures for any year in which the annual gross income of a firm is negative or zero must be excluded from both the numerator and denominator when calculating the average.
9.11. Operational Risks relating to Islamic financial contracts
An Islamic bank’s failure to comply with the requirements, or any lack of precision in contract documentation, may give rise to Shari’ah non-compliance risk.
9.12. Requirements for murabahah and ijarah contracts
(1) The asset is in existence at the time of sale or lease or, in the case of ijarah, the lease contract is preceded by acquisition of the usufruct of that asset (except if the asset was agreed upon based on a general specification).
(2) The asset is in the legal and constructive possession of the Islamic Bank when it is offered for sale or lease.
(3) The asset is intended to be used by the buyer or lessee for activities or businesses permissible by Shari’ah. If the asset is leased back to its owner in the first lease period, it does not lead to a contract of ’inah.
Guidance
An ’inah (also called bay ’inah or bay-al inah) is a double sale by which the borrower and the lender sell and then resell an asset between them, once for cash and once for a higher price whose payment is deferred. This transaction is prohibited by the majority of Shari’ah scholars.
9.13. Requirements for salam and istisna contracts
(1) Sale and purchase contracts cannot be interdependent and interconditional on each other (such as salam and parallel salam, or istisna and parallel istisna).
(2) The is no penalty clause for delay in the delivery of a commodity that is purchased under a salam contract. However, such a penalty clause is allowed under istisna and parallel istisna.
Guidance
An essential characteristic of a salam or istisna contract is that the subject matter does not, and is not required to, exist physically when the parties enter into the contract.
9.14. Requirements for mudarabah and musharakah contracts
(1) The capital of the Islamic Bank should be invested in Shari’ah-compliant investments or business activities.
(2) A partner in musharakah cannot guarantee the capital of another partner, nor may the mudarib guarantee the capital of the mudarabah.
(3) The purchase price of another partner’s share in a musharakah with a binding promise to purchase can only be set at market value or according to an agreement entered into at the time the contract became binding. However, the agreement should not stipulate that the share be purchased at its nominal value based on the capital originally contributed.
9.15. Operational Risks—murabahah
(1) At the time the murabahah contract becomes binding, it is required that an Islamic Bank has purchased the asset and had it in its legal or constructive possession before selling it to the customer. Therefore, an Islamic Bank should ensure that the legal characteristics of the contract properly match the commercial intent of the transactions.
9.16. Operational Risks—salam
(1) This rule sets out the Operational Risks that may arise when an Islamic Bank purchases from a customer, under a salam contract, goods against advanced payment.
(2) If the underlying goods are agricultural commodities and the goods delivered are of an inferior quality to that specified in the contract, the Islamic Bank (as buyer) should:
(a) reject the goods; or
(b) accept them at the originally agreed price.
In the latter case, an Islamic Bank may suffer loss if it sells the goods at a lower price than would have been obtained for those specified in the contract.
(3) The underlying goods may be delivered by the customer before the agreed date. If the goods delivered meet the contract specifications, the Islamic Bank (as buyer):
(a) normally has to accept the goods before the agreed delivery date; and
(b) may incur additional costs for storage, takaful cover and deterioration (if the goods are perishable) before the goods are resold.
(4) An Islamic Bank may face legal risk if the goods in a parallel salam cannot be delivered to the parallel salam buyer because of:
(a) late delivery by the salam seller (the customer); or
(b) delay by an Islamic Bank itself.
For legal risk not to arise in such a case, the parallel salam buyer will have to agree to change the delivery date of the goods.
Guidance
In case of a parallel salam, however, the buyer of the commodity from the Islamic Bank may (but is not obliged to) agree to accept the goods at the contract price. In such a case, an Islamic Bank does not suffer any loss of profit
9.17. Operational Risks—istisna
(1) In the case of istisna with parallel istisna, an Islamic Bank contracts to deliver a constructed or manufactured asset and enters into a contract with a subcontractor to construct or manufacture the asset.
(2) The reliance of an Islamic Bank on the subcontractor can expose it to various Operational Risks such as those set out in (3) to (6) below. These risks need to be managed by a combination of:
(a) legal precautions;
(b) due diligence in choosing subcontractors; and
(c) selection of suitably qualified consultants and staff to carry out the contract with the subcontractor and, ultimately, deliver the constructed or manufactured asset to the customer.
(3) In case of late delivery by the subcontractor, an Islamic Bank may be unable to deliver the asset to the ultimate customer on the agreed date, and can, therefore, be subject to penalties for late delivery.
(4) In case of cost overruns during the construction or manufacturing process (because of increases in the prices of raw materials, increases in manufacturing or production costs or delays by the subcontractor), additional costs may have to be absorbed wholly or partly by an Islamic Bank, in the absence of an agreement in advance with the ultimate customer.
(5) If the subcontractor fails to meet quality standards or other specifications agreed with the ultimate customer, an Islamic Bank may face legal risk if no agreement is reached with the subcontractor and the ultimate customer:
(a) for remedying the defects; or
(b) for reducing the contract price.
(6) If the subcontractor fails to complete the asset on time, an Islamic Bank may have to find a replacement from the market and can, therefore, be subject to additional costs.
9.18. Operational Risks—ijarah and IMB contracts
(1) In an ijarah or ijarah muntahiyah bittamlik (IMB) contract, an Islamic Bank (as lessor) may face, during the period of lease, the Operational Risks set out in this rule.
(2) The ultimate use of the ijarah asset should be Shari’ah-compliant. Otherwise, an Islamic Bank will be exposed to non-recognition of the ijarah income as non-permissible, and an Islamic Bank will be required to repossess the asset and find a new lessee.
(3) If the lessee damages the asset in its possession and refuses to pay for the damage, an Islamic Bank will have to repossess the asset and take legal action to cover damages. This might involve operational and litigation costs.
(4) In the event of severe damage or destruction of the asset without the fault of the lessee, an Islamic Bank (as lessor) is required to provide a replacement to the lessee. If the asset is not insured, an Islamic Bank will have to bear the cost of buying the new asset.
(5) Further, if an Islamic Bank fails to provide the lessee with a replacement, the lessee may terminate the ijarah contract without paying the rentals for the remaining period.
(6) In the event of default or misconduct by the lessee, an Islamic Bank may face legal risk in relation to the enforcement of its contractual right to repossess the asset.
9.19. Operational Risks—musharakah
(1) In a musharakah contract, an Islamic Bank provides financing on the basis of a profit-sharing and loss-sharing contract.
(2) An Islamic Bank may fail to carry out adequate due diligence on the customer or the financed venture.
(3) During the period of the investment, an Islamic Bank may fail to monitor the venture’s financial performance adequately or may not receive the required information from the customer.
9.20. Operational Risks—mudarabah
(1) In a mudarabah contract, an Islamic Bank provides financing on the basis of a profit-sharing and loss-bearing contract.
(2) An Islamic Bank’s customer (as mudarib) is not required to bear any losses, in the absence of negligence, misconduct, fraud or breach of contract on its part. The customer is required to act in a fiduciary capacity as the manager of an Islamic Bank’s funds.
(3) The absence of an Islamic Bank’s right to control the management of the enterprise as capital provider (rabb al-mal) may give rise to Operational Risk.
(4) The customer may fail to provide an Islamic Bank with regular, adequate and reliable information about the financial performance of the venture.
(5) An Islamic Bank may fail to carry out adequate due diligence on the customer or the financed venture.
10. LIQUIDITY RISK
10.1. General
(1) This Chapter sets out the requirements for an Islamic bank:
(a) to establish and implement policies to manage Liquidity Risk; and
(b) to maintain an adequate level of liquidity;
in compliance with Shari’ah rules and principles and in the context of available Shari’ah-compliant instruments and markets.
(2) This chapter also requires an Islamic Bank to have sufficient Shari’ah-compliant resources and funding to withstand severe liquidity stress.
(3) Liquidity Risk is the risk that a firm may not be able to meet its financial obligations as they fall due. Overall Liquidity Risk for an Islamic Bank largely depends on the mix of Shari’ah-compliant modes of financing and investment in its asset portfolio and the concentration of individual customers exposed to each type of contract.
(4) An Islamic Bank’s overall liquidity may be affected by other risks. Liquidity Risk is related to group risk more than any other risk because an Islamic Bank that is a member of a group could be called on to make good on commitments and guarantees in favour of the other members of its group.
(5) Liquidity Risk can be classified into funding Liquidity Risk and market Liquidity Risk. An Islamic Bank must take into account the interaction between funding and market liquidity in its analysis of Liquidity Risk.
10.2. Funding Liquidity Risk
(1) Funding Liquidity Risk, of an Islamic Bank, is the risk that an Islamic Bank will not be able to efficiently meet:
(a) its expected and unexpected current and future cash flow; and
(b) its collateral needs;
without affecting its daily operations or financial condition.
(2) Funding Liquidity Risk may arise because of unexpected withdrawals or transfers of funds by an Islamic Bank’s IAHs and other account holders.
(3) On the assets side, an Islamic Bank may face funding strain due to problems in its financing and investment portfolio. An Islamic Bank may also face Liquidity Risk because of counterparties’ operational and information system failures, or because problems in a payment and settlement system result in late payment or non-payment of funds.
