Rate of Return Risk
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This document discusses rate of return risk in Islamic finance. It defines rate of return risk as the potential impact of changes in market rates of return on an Islamic bank's net income or equity value. Rate of return risk exists for Islamic banks because they use conventional interest rates as benchmarks, exposing them mismatch risk between asset and liability rates. The document outlines various techniques Islamic banks can use to manage this risk, such as diversifying assets, securitization, and off-balance sheet hedging methods. Managing rate of return risk is important for Islamic bank profitability and competitiveness.
Rate of Return Risk
- 2. Rate of Return Risk Content Definition rate of return risk Identification of rate of return risk in Islamic Bank Type of risk in rate of return risk Differentiation between rate of return risk and the interest Rules to help Islamic Bank to manage the rate of return risk Implication rate of return risk in Islamic Bank Risk mitigation techniques of rate of return risk Learning Outcome • To explain definition and feature of Rate of Return Risk • To state Rate of Return Risk and their contract • To explain ways to manage Rate of Return Risk in contract 2
- 3. Introduction Islamic Banks use the conventional benchmark rate to mark-up their financial instruments, in absence of an Islamic benchmark. As a result of using market interest as a benchmark to determine the rate of return on deposit and also the financing rate, Islamic Banks are exposed to the problem of Rate of Return Risk. 3
- 4. Return is the profit or income generated by savings and investing. Total Return on investment expressed as a percentage of the amount of money invested.(Total return divided by amount of money invested will get rate of return risk) Fundamental Relationship between Risk and Return The greater the risk, the greater the expected return 4
- 5. Definition Refers to the potential impact on an Islamic Financial Institution’s (IFI) net income/net income margin or market value of equity arising from changes in the market rate of returns. According to IFSB, rate of return risk is uncertainty in returns earned by Islamic Banks on their assets. 5
- 6. Rate of Return Risk in Islamic Banks This risk is associated with overall balance sheet exposures where mismatches arise between the assets and liabilities of Islamic financial institutions. Revenue and expenses are generally accounted for an accrual basis when deriving the exposure and the Islamic financial institutions are exposed to the expectation of IAH when allocating their profits. 6
- 7. Identification The operations of Islamic banks are riskier and less profitable than conventional banks. This is due to the special nature of investment deposits in Islamic banks whereby their capital value and rate of return are not guaranteed. Rate of return risk is present to a certain extent It is because in practice, they actually use the market interest rates as a benchmark in pricing their products. It is from uncertainty in return earned by Islamic Bank on their assets. This uncertainty can cause a divergence from expectations that investment account holders have on liabilities side. 7
- 8. Alludes to the potential effect on an Islamic Financial Institution's (IFI) net wage/net pay edge or market estimation of value emerging from changes in the market rate of profits : Gap/ Mismatch risk Re-pricing risk 8
- 9. 1.Gap/ Mismatch Risk Mismatch risk designates the gap between maturities and interest rate reset dates of assets and liabilities. Banks tend to lend medium or long-term while securing financing in the short end of the market. Mismatch risk is not specific to banks. Many financial entities and vehicles, such as securitization vehicles, tap liquidity in the short-term market while asset maturity is much longer. 9
- 10. 2. Re-pricing Risk Arises from timing differences in maturity (for fixed rate) and repricing (for floating rate) of bank assets, liabilities and off balance sheet positions. 10
- 11. Differentiate Between The Rate-Of-Return Risk and The Interest Since conventional banks operate on interest-based, fixed income securities on the assets side, there is less uncertainty in the rate of return earned on investments held until maturity. Since Islamic banks have a mix of markup-based and equity- based investments, this uncertainty is higher. The return on deposits in conventional banks is predetermined; in contrast, the return on deposits in Islamic banks is anticipated, but not agreed beforehand. In addition, the return on some investments that based on equity partnerships are not known accurately until the end of the investment period. Islamic banks have to wait for the results of their investment to determine the level of return that investors-depositors will earn. If, during this period, the prevailing yields or expected rates of return change, the investors may expect to receive similar yields from the bank. 11
- 12. Islamic Banks Managing The Rate Of Return Risk Placing an appropriate systems for identifying and measuring the factors which give rise to rate of return risk. Gapping method as Islamic banks should employ the gapping method when calculating a rate of return for allocating positions into time bands with remaining maturities or re pricing dates, whichever is earlier. 12
- 13. Cash flow forecasting for instruments and contracts where Islamic banks are required to simulate and assess their behavioural maturity, underlying assumptions and parameters, which must be reviewed periodically for reliability. Islamic banks are encouraged to employ balance sheet techniques to minimize their exposures using the following strategies, among others: Determining and varying future profit ratios according to expectations of market conditions. Developing new Shariah-compliant instruments; and Issuing securitization tranches of Shariah permissible assets 13
- 14. Implication Islamic banks may not be able to pay competitive rate of return as compared to their peers and other competitors the depositor will have the incentive to seek withdrawal and to prevent the withdrawal, the bank will need apportion part of their share of profits to the depositors. The practice of forgoing part of all of shareholders profits may be adversely effect the bank capital this may significantly affect their profitability and competiveness as well as increase their vulnerability to external stocks. Some of profit-sharing investment account holders’ asset (PSIA) risk are absorb by shareholder the DCR is potentially an efficient and value‐creating means of sharing risks between two classes of investor with different risk diversification capabilities and preferences. 14
- 15. Risk Mitigation Techniques Islamic Banks should diversify into equity financing The flexibility on the asset side, where the Return on assets(ROA) can be altered according to prevailing market interest rate, can make Islamic banks more responsive to the changes in the market interest rate. Through securitization Which allows banks to manage their risk exposures, while at the same time allowing banks to be more aggressive in risk taking which involves devoting a higher portion of their assets to more risky activities such as bank lending and derivatives. The off‐balance‐sheet and on‐balance‐sheet techniques Using the off‐balance‐sheet techniques, banks can hedge the RORR by using derivatives like interest rate future contracts and forward rate agreements. Using on‐balance‐sheet techniques, banks can use floating rate loans and adjust the asset or liability durations. 15
- 16. Conclusion The fact that Islamic banks transactions are free from interest, movements in the interest rate have significant effects on Islamic banks' performance. Furthermore, the development of Islamic banking side‐by‐side with the conventional banking system poses rate of return risk. One of the reason the risk occur is when the depositor withdraw their money from Islamic Bank because they know that Conventional Bank could give more return rather than Islamic Bank. As conclusion, Islamic Bank have to mitigate the risk well so that they could manage their profitability and stability. 16
- 17. Mahyuddin Khalid End of Chapter 17