Financial Stability

The research that is been conducted by M. Kabir Hassana, , Ashraf Khanb , Andrea
Paltrinier (2019) using the comprehensive data set from 52 Islamic banking and
Conventional banking from selected OIC for the period of 2007-2015 and showing
the result of both phases of post financial and crisis and during financial crisis ith it
liquidity risk. The evidence show that Islamic Banking perform significantly better as
compared to its counterpart during both phases, the result of their analysis which says
that Islamic Banking are better in managing their liquidity risk. Practitioners and
academic scholars unanimously agree on the point that IBs have relatively less
investment opportunities in order to maintain extra checks for the safe parking of their
deposits. Thus, IBs normally have excess liquidity in terms of cash holdings, which
can lead to commercial risk due to the difference of return rate between IBs and CBs.

Comparing Credit Risk to Financial Stability

Frrom the result of M. Kabir Hassana, , Ashraf Khanb , Andrea Paltrinier(2019), it

shows that credit risk management in IBs. The reason of the stability are IBs do not
deal only in documents but also in goods and use money as a tool of exchange rather
dealing in money, which is common in CBs (Ayub, 2009). IBs strictly make sure the
underlying asset that makes the transaction related to the real economic activity.
Secondly, the structure of the products is entirely different in IBs compared to their
counterparts. IBs do not generally extend loan in the form of hard cash to their
customers. Lastly, all financial institutions dealing in loans charge penalty in case of
late payment, and in similar way IBs act.

But, there is fundamental difference between such penalties. In Islamic finance, the
impact of this charge is positive for society. Instead of making it part of their profit, as
in CBs, IBs create charity account and spend that charity for the welfare of society,
keeping it separate from their CSR (corporate social responsibility) activities.
Regarding bank stability, find that CBs to be more stable at statistically significant
and IBs to be more stable during financial crisis.But higher DD mean value of 3.216
suggests that CBs are more stable. There might be several reasons, but some points
are worth mentioning here. Firstly, IBs have very limited market share in all
countries . Secondly, IBs, with limited investment opportunities, have generally
excess liquidity which ultimately reduces their profitability, thus negatively affecting
their stability. Our contrasting results of banks’ stability, using accounting and market
based measures, are partially in line with the findings of Kabir et al. (2015) and
suggest to emphasize more on the identification of specific methodology in assessing
banks’ stability.

Solution and Recommendation

Credit risk

1. Sufficient loan loss reserves offer protection against expected credit losses. The
effectiveness of these reserves depends on the credibility of the systems in place for
calculating the expected losses. Recent developments in credit risk management
techniques have enabled large traditional banks to identify their expected losses
accurately. The Islamic banks are also required to maintain the mandatory loan loss
reserves subject to the regulatory requirements in different jurisdictions. However, as
discussed above, the Islamic modes of finance are diverse and heterogeneous as
compared to the interest-based credit. These require more rigorous and credible
systems for expected loss calculation. Furthermore, for comparability of the risks of
different institutions, there is also a need for uniform standards for loss recognition
across modes of finance, financial institutions and regulatory jurisdictions.

2. Collateral is also one of the most important securities against credit loss. Islamic
banks use collateral to secure finance, because al-rahn (an asset as a security in a
deferred obligation) is allowed in the shari’a. According to the principles of Islamic
finance, a debt due from a third party, perishable commodities and something which
is not protected by the Risk management in Islamic banking 155 Islamic law as an
asset, such as an interest-based financial instrument, is not eligible for use as
collateral. On the other hand, cash, tangible assets, gold, silver and other precious
commodities, shares in equities and debt due from the finance provider to the finance
user are assets eligible for collateral. The industry-wide general quality of collateral
depends on a number of institutional characteristics of the environment as well as the
products offered by the industry. An improvement in the institutional infrastructures
and a refinement of the Islamic banking products can be instrumental in enhancing the
collateral quality and reducing credit risks

Liquidity Risk

1. focuses on the shorter end of the time horizon and is aimed at helping to ensure
that each bank owns liquid resources to such an amount that short-term cash
obligations are fulfilled even under a severe stress. The ratio requires banks to hold
enough liquid assets to offset the sum of all cash outflows expected over the next 30
days.

2. looks at a medium-term horizon and focuses on the structural balance between

maturities of a bank’s assets and liabilities. It is aimed at preventing banks from
exposing themselves to extreme maturity transformation risks by funding medium and
long-term assets with very short-term liabilities.