RM-2.2.1

Islamic bank licensees must have in place a framework for credit risk management that includes identification, measurement, monitoring, reporting and control of credit risks. Adequate capital must be held against credit risks assumed. Islamic bank licensees must also comply with CBB rulebook requirements, regulations, resolutions and parts of the CBB Law applicable to their financing activities.

RM-2.2.2

Islamic bank licensees must assess credit risk in a holistic manner and ensure that credit risk management forms a part of an integrated approach to the management of all financial risks.

RM-2.2.3

Given the nature of Islamic financing instruments, the sources of credit risk may be the same as that of market or operational risks. For example, in a Salam contract, changes in market risk factors such as commodity prices, as well as the external environment (for example, bad weather) become key determinants affecting the likelihood of default.

RM-2.2.4

Islamic bank licensees must have in place:

RM-2.2.5

Islamic bank licensees must implement a credit strategy using various instruments in compliance with Shari a, whereby the credit strategy recognizes the potential credit exposures that may arise at different stages of the various financing agreements.

RM-2.2.6

The Board must define and set the bank's overall levels of risk appetite, risk diversification and asset allocation strategies applicable to each Islamic financing instrument, economic activity, geographical spread, season, currency and tenor in the credit strategy document. The Board must be mindful of and take into account the permissible types of financing instruments available in different locations wherever the Islamic bank licensee undertakes cross-border transactions. The Board must take into account seasonal aspects resulting from a shifting or termination of use of certain financing instruments, thus affecting the overall concentration exposures of the Islamic bank licensee's financing portfolio.

RM-2.2.7

For example, the Islamic bank licensee may offer Salam contracts during a certain season where a product can most likely be delivered and sold at maturity.

RM-2.2.8

An Islamic bank licensee's credit strategies must include a list of all types of applicable and approved transactions and financings that the bank is allowed to undertake. The approved list must include formal exclusions from any engagement by the Islamic bank licensee in certain prohibited industries, such as pork meat, alcohol, gambling, pornography etc. The approved list must be kept up to date and communicated to the relevant personnel within the Islamic bank licensee, and an internal compliance function must be organised and empowered to ensure that such rules are applied.

RM-2.2.9

The Board should ensure that it is aware of the commencement of exposure to credit risk inherent in different financing instruments and in various jurisdictions when developing the strategy. The non-binding promise and legal enforcement aspects vary among market counterparties and customers or from one jurisdiction to another, which may give rise to operational risks and other risk management problems relating to Shari a compliance.

RM-2.2.10

When setting the level of risk appetite relating to counterparties, the Board must ensure that:

RM-2.2.11

The risk management function must carry out a due diligence review in respect of counterparties prior to deciding on the choice of an appropriate Islamic financing instrument.

RM-2.2.12

Islamic bank licensees must establish policies and procedures defining eligible counterparties (retail/consumer, corporate or sovereign), the nature of approved financings and types of appropriate financing instruments. The risk management function must obtain sufficient information to permit a comprehensive assessment of the risk profile of the counterparty prior to the financing being granted.

RM-2.2.13

Islamic bank licensees must have a policy for carrying out a due diligence process² in evaluating counterparties, in particular, for transactions involving:

² The process may include Value at Risk, stress testing and sensitivity analysis, amongst others.

³ Please refer to Chapter RM-3 on Equity Investment Risk.

RM-2.2.14

Islamic bank licensees must receive their Shari'a Supervisory Board Fatwa on all new financing proposals that have not been proposed before or amendments to existing contracts. Islamic bank licensees may also engage appropriate technical expert (for example an engineer) to evaluate the feasibility of a proposed new project and to assess and approve progress billings to be made under the contract.

RM-2.2.15

In a financing involving several related agreements, Islamic bank licensees need to be aware of the binding obligations arising in connection with credit risks associated with the underlying assets for each agreement. To be Shari a compliant, subject to the interpretation of its Shari a scholars, an Islamic bank licensee should ensure that all components of the financial structure are contractually independent, although these may be executed in a parallel manner despite their interrelated nature.

RM-2.2.16

Islamic bank licensees must have in place appropriate methodologies for measuring and reporting the credit risk exposures arising under each Islamic financing instrument.

RM-2.2.17

Islamic bank licensees must develop and implement appropriate risk measurement and reporting methodologies relevant to each Islamic financing instrument in respect of managing their counterparty risks, which may arise at different contract stages (including counterparty performance risk in Salam and Istisna' contracts). Depending on the Islamic financing instrument, the Islamic bank licensees must employ an appropriate methodology that takes into account the price volatilities of the underlying assets. The selected methodology must be appropriate given the nature, size and complexity of the Islamic bank licensee's credit related activities. Islamic bank licensees must ensure that adequate systems and resources are available to implement this methodology.

RM-2.2.18

Islamic bank licensees must have in place Shari'a-compliant credit risk mitigating techniques appropriate for each Islamic financing instrument.

RM-2.2.19

Islamic bank licensees must clearly define their credit risk-mitigating techniques including, but not limited to, having in place:

⁴ Islamic bank licensees are expected to include in their processes, an ongoing monitoring of quality and valuation of any collateral.

⁵ In some jurisdictions, a purchase order backed by a promise to purchase would constitute a binding contract according to contract law and would be legally enforceable if adequately evidenced.

RM-2.2.20

Islamic bank licensees must establish limits on the degree of reliance and the enforceability of collateral and guarantees. They must protect themselves against legal impediments that may restrict the accessibility of collateral when they need to enforce their rights in respect of a debt. Islamic bank licensees must formally agree with the counterparty at the time of signing the contract on the usage, redemption and utilisation of collateral if the counterparty defaults in payment, and avoid over concentration on certain classes of collateral, such as real estate.

RM-2.2.21

Islamic bank licensees must have policies to define adequately the action to be taken by the Islamic bank licensee when a customer cancels a non-binding purchase order. The policies must describe how the Islamic bank licensee:

⁶ Islamic bank licensees shall be mindful that the counterparty risk will not commence prior to execution of other contracts or before certain events take place. In the case of certain Murabahah transactions, the long period preceding the delivery of imported goods from abroad gives rise to other risks which may not all be covered by takaful or insurance.

RM-2.2.22

With respect to Subparagraph RM-2.2.21, the Islamic bank licensee may enter into a purchase contract with a supplier on a "sale or return" basis, with an option to return the purchased item within a specified period.

RM-2.2.23

The risk management function must implement appropriate credit management systems and administrative procedures to undertake early remedial action in the case of financial distress of a counterparty or, in particular, for managing problem credits, potential and defaulting counterparties⁷. This system must be reviewed on a regular basis. Remedial actions must include both administrative and financial measures.

⁷ In certain jurisdictions, the Shari'a may differentiate between two kinds of defaulter; (a) the affluent or able (wilful defaulter or procrastinator); and (b) the insolvent defaulter who is unable to pay his debts due to reasons permitted by Shari'a, to determine whether a penalty can be imposed which should be disposed of.

RM-2.2.24

Administrative measures may inter alia include:

RM-2.2.25

Financial measures may include, among others:

RM-2.2.26

Islamic bank licensees must set appropriate measures for early settlements, which are permissible under Shari'a rules and principles for each Islamic financing instrument. These arrangements must be in line with CBB Rulebook requirements in Section CM-7.6.

RM-2.2.27

With respect to early settlements referred to in Paragraph RM-2.2.26, Islamic bank licensees may grant discretionary rebate, to their customers by reducing the amount of receivables in subsequent transactions, if they so wish.

RM-2.2.28

Islamic bank licensees must assess and establish appropriate policies and procedures pertaining to the risks associated with their own exposures in parallel transactions.

RM-2.2.29

For instance, in the case of an Istisna transaction, the Islamic bank licensee enters into an Istisna contract as seller to provide manufactured goods or a building to a customer. The Islamic bank licensee will then enter into another (parallel) Istisna contract as buyer with a supplier (manufacturer or builder), using the specifications drawn up for the original contract. If the supplier fails to deliver the manufactured goods or the building according to the agreed specifications, the Islamic bank licensee would equally be in default of its obligation. If necessary, a separate engineering department might be established or an outside expert should be engaged to evaluate, approve and monitor the technical aspects. Islamic bank licensees may also stipulate that the party to the first contract must inspect the manufactured goods or building from time to time during the production or construction process to satisfy themselves that the specifications are being met.

RM-2.2.30

Islamic bank licensees must establish appropriate policies and procedures that require them to honour their commitment to the parallel contract counterparty. In certain countries, where parallel contract is necessary to be transacted with the first Salam contract in order to mitigate market risk exposures, there must be no legal linkages between the two contracts.

RM-2.2.31

Islamic bank licensees must implement a system to ascertain and fulfil their obligations in respect of leased assets, which are permanently impaired through no default of the lessee. In case of such impairment, Islamic bank licensees must provide the lessee with a replacement asset with similar specifications, if such specifications were agreed upon, or if the contract was renewed, or to refund the additional amounts (capital payments) included in the Ijarah Muntahia Bittamleek (IMB) lease rentals as compared with those in an operating Ijarah. Islamic bank licensees must establish appropriate risk management policies to mitigate losses arising from such damage during the term of the lease.

RM-2.2.32

Islamic bank licensees must ensure, whenever possible, that there is sufficient Shari'a-compliant insurance coverage of the value of the assets, subject to availability. If necessary, Islamic bank licensees must engage an insurance advisor at an early stage to review the insurance coverage of the leased assets.

RM-2.2.33

If a loss arises from negligence by the lessee, Islamic bank licensees are permitted to claim compensation from the lessee. The Islamic bank licensee (as lessor) bears the risks associated with the leased assets and cannot use a lessee's guarantees to recover the amount of the losses on the leased assets (unless these are due to misconduct, negligence or breach of contract on the part of the lessee).

RM-2.2.34

Islamic bank licensees must implement an appropriate policy for determining and allocating provisions for non-performing credit facilities including counterparty exposures (See CM-3 for more details).