I. Preface

This paper pre-dates the current COVID-19 crisis and does not reflect the Fund staffs evolving analysis of potential financial stability implications and advice on financial regulation (IMF, 2020c).² However, its general guidance on the conceptual foundations of stress testing remains highly relevant to articulate the capital impact of economic contraction on Islamic banks, which are likely to face rising capital and liquidity pressures due to shrinking profits, deteriorating asset quality, and adverse funding conditions similar to their conventional peers.

Evaluating the extent to which banks are resilient to the adverse impact of the current crisis puts significant emphasis on stress testing as an integral part of overall risk governance and market surveillance. Stress testing are traditionally prospective—they help banks and supervisors assess capital adequacy and liquidity risk under severe but plausible scenarios when there is time to remedy identified vulnerabilities. However, when shocks have already occurred, such as in the case of the current COVID-19 crisis, the role of stress tests changes. Findings from past stress test exercises on pre-existing vulnerabilities (if available) can help inform timely policy decisions as developments unfold—ideally in the form of scenario analyses of evolving shocks (potentially in combination with selective data updates), especially if the deterioration of economic conditions and their impact on the financial system remains highly uncertain.

The relevance of stress tests during the current crisis also applies to Islamic banks, which share many characteristics with their conventional peers but are also exposed to additional risks due to the specific nature of their business models (Chattha, 2020). Islamic banks are particularly affected by liquidity and commodity price shocks given the scarcity of short-term liquid assets and deep money markets as well as the comprehensive collateralization of all borrowing and lending activities, which is mostly done via precious metals or certain agricultural goods. Most Islamic banks also operate in emerging market and developing economies (EMDEs), for which the multi-faceted nature of the shock raises complex (and in many ways unprecedented) macro-financial challenges. Many EMDEs face acute strains from a sharp reversal of capital inflows due to a deterioration of investor sentiment, with the attendant pressure on exchange rates and credit spreads raising the likelihood of credit defaults, financial distress, and macroeconomic instability.³ For instance, the recent fall in oil prices is bound to result in a tightening of domestic liquidity conditions in oil-exporting countries and a rise in banks’ nonperforming exposures due to the deterioration of the balance sheets of the government, household, and nonfinancial corporate sectors (IMF, 2020b).

II. Introduction

Over the past two decades, Islamic finance has undergone a rapid expansion in many emerging market and developing economies (EMDEs) (Chart), where religious principles often favor the use of financial services and products that are compliant with Islamic finance principles (Imam and Kpodar, 2015). The key characteristics of Islamic finance —such as the concept of profit- and loss-sharing between lenders and borrowers, the focus on investments that are socially responsible, and the requirement of linking finance with real economic activities—have grown in popularity, especially since the global financial crisis, and provide an alternative to more traditional financial products (IMF, 2015). They define an asset-oriented system of ethical financial intermediation and investment built on the principles of risk-sharing in lawful activities (halal or ) rather than rent-seeking gains. In particular, the use of Islamic finance principles for infrastructure projects has provided significant stimulus for Islamic banking (with many institutions entering the Islamic finance field for the first time).⁴

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Market Penetration of Islamic Banking (2017)

(In percent)

Citation: IMF Working Papers 2020, 156; 10.5089/9781513550886.001.A001

Sources: Ernst&Young (2015), IFSB (2013), Lukonga (2015) Pew Research Center (2011), World Bank/Islamic Development Bank (2016), and World Bank (2018), Note: as of mid-2017; the IFSB (2018) currently considers the Islamic financial sector systemically important in 12 countries (Iran, Sudan, Brunei, Saudi-Arabia, Kuwait, Qatar, Malaysia, UAE, Bangladesh, Djibouti, Jordan, and Bahrain), which are identified by filled (green) markers. The criterion for systemic relevance is determined by total Islamic banking assets in a country representing at least 15% (±1%) of its total domestic banking sector assets. Mauritania and Yemen would also qualify but were not included due to data constraints.

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Islamic finance already accounts for more than half of total financial assets in some EMDEs, and the Islamic financial services industry is estimated to amount to $2.6 trillion (or about 0.7 percent of total financial assets [Financial Stability Board {FSB}, 2019]). The potential for growth of this form of finance is nonetheless considerable, given that its penetration rate in large and populous economies, such as Indonesia and Turkey, is still below 20 percent.

Most Islamic finance assets are concentrated in the banking sector,⁵ which has grown in systemic importance. While Islamic banks account for only one percent (or $1.6 trillion) of global banking sector assets ($146.6 trillion) (Chart), they represent at least 15 percent of the total banking sector in 14 countries, of which Iran and Sudan are the only ones where the entire financial system operates in compliance with Islamic law (shari’ah or ).⁶ The market share of Islamic banks in most of these countries has continued to increase over the past few years, further deepening the penetration of Islamic finance principles. Islamic banking is also expanding in countries that have few Islamic banks despite substantial Muslim populations―in Africa (such as Algeria, Egypt, Mauretania, Mauritius, Nigeria, Senegal, Tanzania, and Tunisia), the Middle East and Central Asia (Afghanistan, Iraq, Kazakhstan, Lebanon, Pakistan, and Oman), and Southeast Asia (Indonesia and Singapore) (World Bank/Islamic Development Bank, 2017). During the last monitoring period by the Islamic Financial Services Board (IFSB, 2018), which tracks an expanded list of 36 countries, Islamic banks have increased their domestic market share in 19 countries while remaining constant in seven others (including Iran and Sudan, where they have a 100 percent market share by construction). Iran remains the largest jurisdiction for Islamic banking, accounting for a slightly increased 34.4 percent of the global Islamic banking industry at mid-2017, followed by Saudi Arabia (20.6 percent), UAE (9.6 percent), Malaysia (9.1 percent), and Kuwait (6.0 percent) (Chart).⁷

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Share of Global Islamic Banking Assets (2017)

(In percent)

Citation: IMF Working Papers 2020, 156; 10.5089/9781513550886.001.A001

Sources: IFSB (2015) and authors. Note: as oftelevangelismlismlism; */ The shares are apportioned in U.S. dollar terms; the IFSB (2018) currently considers the Islamic financial sector systemically important in 12 countries (Iran, Sudan, Brunei, Saudi-Arabia, Kuwait, Qatar, Malaysia, UAE, Bangladesh, Djibouti, Jordan, and Bahrain), which are green-colored. The criterion for systemic relevance is determined by total Islamic banking assets in a country representing at least 15% (± 1%) of its total domestic banking sector assets.

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As Islamic finance helps raise financial inclusion in many EMDEs with substantial Muslim populations, its bank-centric structure places a premium on nurturing the rising demand in a safe and sound manner (Lagarde, 2015). The asset-backed, ring-fenced, and project-specific nature of many Islamic financial activities constitutes unique sources of risk that require a suitable supervisory and regulatory environment to preserve the stability of the financial system and its ability to support growth (Lopez and others, 2014). The IFSB issued several prudential standards and guidance notes for institutions that operate (and are supervised) under Islamic finance principles. However, some of these standards are not applied consistently across jurisdictions (Song and Oosthuizen, 2014), and continued efforts are needed to refine supervisory and regulatory frameworks in line with these recommendations while ensuring greater harmonization.⁸

Stress testing is fundamental to analyzing the financial stability implications of Islamic banking in countries where Islamic finance is growing in significance.⁹ Stress tests are designed to identify vulnerabilities to the impact of a rapidly deteriorating operational and market environment affecting the overall risk profile—from the financial system level down to individual banks and their different lending and trading portfolios (Jobst and others, 2013).¹⁰ Over the past decade, bank stress testing has rapidly evolved and has become a central aspect of the IMF’s financial sector surveillance—as a key component of the Financial Sector Assessment Program (FSAP)¹¹ assessments, which are now formally part of IMF Article IV consultations, and its use in crisis program work (Ong, 2014; Ong and Jobst, 2020). Stress testing has also grown in importance for many IMF member countries as a forward-looking technique for supervisors and macroprudential authorities. It enables them to identify any vulnerabilities that individual institutions or an entire financial system might have to adverse events that, while unlikely to happen, would have a significant economic impact if they were to occur.

The development of stress testing approaches has focused largely on conventional banks. While core principles and methods that determine the capital impact of risk factors apply universally, stress tests for Islamic banks would need to acknowledge the distinct characteristics of shari’ah-compliant financial intermediation. Many risk factors affecting both Islamic and conventional banks are similar in form but markedly different in substance.¹² Much like their conventional peers, Islamic banks face credit, market, and operational risks from maturity and liquidity transformation (by managing cash flows over different risk horizons to satisfy payments); however, the capital adequacy of shari’ah-compliant banking activities is also affected by risk-and-profit sharing, which implies some loss-bearing by investors and reduces capital intensity of equity-like financing. In particular, specific risk factors that are germane to Islamic banks involve:

• Displaced commercial risk (DCR) if shareholders forgo some of their profits to provide competitive (and stable) earnings to unsecured depositors (which would otherwise need to absorb losses);

• Project and counterparty risks stemming from partnership-like financing;

• Rate of return risk from pricing frictions if Islamic banks need to adjust profit rates of investment accounts (outside actual underlying asset performance) to compete with conventional banks in response to changes in monetary policy; and

• Operational risk from the failure to comply with Islamic finance principles.

The distinct risk profile of Islamic banks underscores the need for a coherent and consistent approach to the design and implementation of solvency stress testing. This paper establishes a common understanding of the unique properties of Islamic banking in line with relevant Islamic finance principles (IFSB, 2012b and 2013) and provides a conceptual overview of key risk factors affecting the capital adequacy of banks under stress.¹³,¹⁴ The identification and calibration of risk factors follow the functional components of conventional top-down stress testing model(s) and technique(s) of balance sheet-based methods (Jobst and others, 2013). This approach complements the IFSB’s evolving supervisory guidance on microprudential stress testing, building on its Technical Note on Stress Testing (IFSB, 2016) and the associated User Guide (IFSB, 2017),¹⁵ consistent with the high-level principles on stress testing issued by the IFSB (2012a) and the Basel Committee (BCBS, 2018).¹⁶ However, several process-oriented considerations (and the technical implementation of stress tests) remain outside the conceptual scope of the paper, such as the treatment of capital resources, the design of stress scenarios, the calculation of losses consistent with prevailing accounting standards, the definition of output measures, the validation of results, and dealing with the outcome of the stress tests.

The paper is structured as follows. The next two sections review the fundamental principles of Islamic finance and describe the nature of Islamic banking (Sections II and III). Section IV provides an overview of the main risks arising from Islamic banking activities. Section V defines the prevailing solvency requirement for Islamic banks, which forms the basis for assessing the combined impact of these risks under stress (Section VI). Section VII concludes.

III. Fundamentals of Islamic Finance

Islamic finance encompasses all transactions by two or more contractual parties whose actions are subject to prohibitory and permissible norms defined by shari’ah principles in keeping with the qu’ran (or ) and the sunnah (or ) as religious sources.¹⁷ These principles are often reduced to the simple notion of prohibited interest (riba or ); however, they instead should be characterized as a process-driven view of performance-based profits from financing real activities that create heterogeneous goods and/or services (“co-generation”) between two or more parties (see Appendix IV).¹⁸ Investment returns are not guaranteed but derive from transparent rights and obligations regarding the generation and distribution of profits arising from mutual contributions of transacting agents. Investors are entitled to receive commensurate state- or time-contingent payoffs from their direct participation in the performance of the funded asset (that is, payments can vary over time as conditions change). Payments are made in association with the temporary or permanent use of assets and generally not from the time value of money.¹⁹ In contrast, interest payments in conventional finance represent the contractible cost for funds tied to borrowing a certain amount of principal over a prespecified lending period, generating returns without economic conditionality regarding the use of funds. Thus, from the perspective of Islamic finance, interest income is not seen as the effect of business transactions, but as the result of an undesirable process by which such an effect is achieved (Jobst, 2007a; Jobst and others, 2008).²⁰

These overarching requirements distill several specific contractual conditions, which also pertain to shari’ah-compliant financial transactions:

• Price certainty without manipulation of risk. While the fair value of an asset (and the return from investment) is inherently uncertain, Islamic finance principles prohibit transactions with payment obligations that are incalculable ex ante and divorced from (required) asset performance (and/or the rendering of a service). These transactions would be considered gambling (maisir or ) if they (i) generate returns from money as a store of value (rather than a medium of exchange to execute trade or shared investment to help create a lawful usufruct); and (ii) have the manipulation of risk (without commercial interest) as their primary (or sole) purpose. However, contracts that mitigate risks to facilitate trade (and enhance productivity) could be considered permissible.

• Identifiable characteristics and certainty about delivery results (in terms of quantity and quality). Sales must be immediate and absolute to avoid being deemed gharar (“that with hidden consequences” or “that whose nature and consequences are unknown” or ) or jahl (ignorance or ), which requires that (i) the object of a bona fide transaction must exist (or come into existence based on demonstrated real capital input); and (ii) its characteristics are clearly identifiable before the transfer of title takes place.²¹ Exchanges involving asymmetric information between contracting agents imply the risk of delusion or deception (Al-Suwailem, 1999–2000), especially if payment obligations and delivery results differ from rational expectations. Such contractual uncertainty could lead to exploitation (Vogel and Hayes, 1998) if they generated unilateral (or zero-sum) gains from state- or time-contingent prices, resulting in divergent impacts on different agents.

• Asset ownership and implicit avoidance of leverage (underfunding). Islamic finance principles align financial claims with investments in real assets, which marginalizes the possibility of underfunding through leverage and fosters equity ownership (in lieu of financial leverage from debt creation without underlying asset values). Thus, any reference asset is required to be in the (constructive) ownership and possession of the creditor (or, in the context of risk management, the protection seller) at the inception of a transaction. This ensures the asset-backing of financial obligations (which also “collateralizes” the performance of contractual obligations) and the risk and reward sharing that follows from it.

IV. Islamic Banks’ Balance Sheets and Implications for Stress Testing

The typical balance sheet of an Islamic bank resembles that of a conventional bank but implies a higher sensitivity to monetary dynamics (see Table 1).²² Much like in conventional financial intermediation, Islamic banks engage in maturity/liquidity transformation by accepting short-term deposits and issuing commoditized payment obligations (similar to debt securities) to fund longer term lending and investment. However, Islamic banks can only intermediate funds with shari’ah-compliant contracts and financial instruments, which tends to result in a larger (positive) duration gap than that of conventional banks.²³ While they generate mostly predefined returns (due to religious requirements), their cost of funding is largely variable,²⁴ making them generally more vulnerable to a higher (nominal) cost of capital under monetary tightening.²⁵

^{Table 1.}

Stylized Balance Sheet of an Islamic Bank

Source: authors. Note: ^1/ restricted investment accounts (RIAs) are often recorded as off-balance sheet items; ^2/ cost-plus sale-trade financing; ^3/ for trading, shares, and commodities; ^4/ Islamic collective investment schemes (ICIS) are a structured financial scheme that pools investors’ capital contributions in a fund that is established and managed in accordance with Islamic finance principles.

^{Table 1.}

Stylized Balance Sheet of an Islamic Bank

Assets	Liabilities
Cash and cash equivalents	Demand deposits: checking and savings accounts
Interbank deposits (short-term murabahah)	Investment accounts
Financing/lending portfolio Exchange-based contracts Ordinary sales 2/ of which: murabahah (secured) of which: commodity murabahah (unsecured) Special sales (delayed settlement) of which: salam/istisna (delayed delivery) of which: bay bithaman ajil (delayed payment) Leases of which: ijara (operating lease) of which: ijara muntahia bittamleek (financing lease) Profit- and loss-sharing contracts of which: mudarabah of which: musharakah/diminishing musharakah	of which: profit- and loss-sharing contracts (musharakah/mudarabah) Restricted investment accounts (RIA) 1/ Unrestricted investment accounts (UIA) of which: agency contracts (wakalah) Restricted investment accounts (RIA) Unrestricted investment accounts (UIA)
	Funding liabilities Exchange-based contracts Ordinary sales 2/ of which: reverse murabahah (secured) of which: reverse commodity murabahah (unsecured) Special sales (delayed settlement) of which: parallel salam/istisna (delayed delivery) Profit- and loss-sharing contracts of which: investment certificates (sukuk) of which: Islamic collective investment schemes (ICIS) of which: equity securities
Investment/trading portfolio Inventory (commodities) of which: murabahah inventory—available for sale (AfS) of which: salam commodities of which: ijara assets—available for lease (AfL) of which: mudarabah/musharakah investments (cost basis) 3/ of which: investment properties Profit- and loss-sharing contracts of which: investment certificates (sukuk) of which: Islamic collective investment schemes (ICIS) 4/ of which: equity securities Net foreign exchange position	Reserves Profit equalization reserves (PER) of which: attributable to UIA (PERUIA) of which: attributable to equity (PEREquity) Investment risk reserve (IRR) of which: attributable to UIA (IRRUIA) of which: attributable to RIA (IRRRIA)
	Capital (equity)
Fixed assets	Long-term syndicated musharaka/mudarabah

Source: authors. Note: ^1/ restricted investment accounts (RIAs) are often recorded as off-balance sheet items; ^2/ cost-plus sale-trade financing; ^3/ for trading, shares, and commodities; ^4/ Islamic collective investment schemes (ICIS) are a structured financial scheme that pools investors’ capital contributions in a fund that is established and managed in accordance with Islamic finance principles.

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^{Table 1.}

Stylized Balance Sheet of an Islamic Bank

Assets	Liabilities
Cash and cash equivalents	Demand deposits: checking and savings accounts
Interbank deposits (short-term murabahah)	Investment accounts
Financing/lending portfolio Exchange-based contracts Ordinary sales 2/ of which: murabahah (secured) of which: commodity murabahah (unsecured) Special sales (delayed settlement) of which: salam/istisna (delayed delivery) of which: bay bithaman ajil (delayed payment) Leases of which: ijara (operating lease) of which: ijara muntahia bittamleek (financing lease) Profit- and loss-sharing contracts of which: mudarabah of which: musharakah/diminishing musharakah	of which: profit- and loss-sharing contracts (musharakah/mudarabah) Restricted investment accounts (RIA) 1/ Unrestricted investment accounts (UIA) of which: agency contracts (wakalah) Restricted investment accounts (RIA) Unrestricted investment accounts (UIA)
	Funding liabilities Exchange-based contracts Ordinary sales 2/ of which: reverse murabahah (secured) of which: reverse commodity murabahah (unsecured) Special sales (delayed settlement) of which: parallel salam/istisna (delayed delivery) Profit- and loss-sharing contracts of which: investment certificates (sukuk) of which: Islamic collective investment schemes (ICIS) of which: equity securities
Investment/trading portfolio Inventory (commodities) of which: murabahah inventory—available for sale (AfS) of which: salam commodities of which: ijara assets—available for lease (AfL) of which: mudarabah/musharakah investments (cost basis) 3/ of which: investment properties Profit- and loss-sharing contracts of which: investment certificates (sukuk) of which: Islamic collective investment schemes (ICIS) 4/ of which: equity securities Net foreign exchange position	Reserves Profit equalization reserves (PER) of which: attributable to UIA (PERUIA) of which: attributable to equity (PEREquity) Investment risk reserve (IRR) of which: attributable to UIA (IRRUIA) of which: attributable to RIA (IRRRIA)
	Capital (equity)
Fixed assets	Long-term syndicated musharaka/mudarabah

Source: authors. Note: ^1/ restricted investment accounts (RIAs) are often recorded as off-balance sheet items; ^2/ cost-plus sale-trade financing; ^3/ for trading, shares, and commodities; ^4/ Islamic collective investment schemes (ICIS) are a structured financial scheme that pools investors’ capital contributions in a fund that is established and managed in accordance with Islamic finance principles.

Islamic banks also exhibit a stronger connection between the sources and uses of funding. Shari’ah-compliant financial intermediation is characterized by pervasive risk sharing, which implies that (most) depositors enter into a wide range of profit- and loss-sharing (PLS) agreements that participate in the bank’s asset performance (at varying degrees), but rank senior to capital instruments.²⁶ There are four types of “Islamic deposits:” (i) restricted investment accounts (RIAs); (ii) unrestricted investment accounts (UIAs); (iii) exchange-based contracts using reverse sales, and (iv) current accounts (see Table 1). Many Islamic banks obtain a significant part of their funding from UIAs, which are typically commingled with the bank’s own funds and current accounts;²⁷ however, in some countries, reverse commodity murabahah sale contracts have become the main source of deposit funding (e.g., Malaysia) for Islamic banks. UIAs do not constrain the bank from using these funds (as long as investments are shari’ah compliant).²⁸ In contrast, funds from RIAs are separately managed funds (and often reported as off-balance sheet items) that can be invested only in a limited set of pre-agreed activities whose market and credit risk losses are fully borne by account holders (that is, loss-absorbing from a capital perspective).

Since checking accounts are interest-free loans (qard hasan or ) with guaranteed principal and exchange-based contracts are fully collateralized by design, their economic characteristics are akin to secured (conventional) deposits. However, investment accounts (IAs) are not liabilities of the bank but unsecured sources of funding. UIAs are viewed as puttable instruments (that is, investors have the right of withdrawal) under IAS 32,²⁹ whereas RIAs do not guarantee repayment of either principal or return.³⁰ This results in additional risk factors that impact the solvency and liquidity conditions of Islamic banks.

Consistent with the concept of permissible profits from risky capital investment, there are three basic forms of shari’ah-compliant uses of funds by Islamic banks without explicit interest:

• Lending (debt-based contracts) through cost-plus sale-repurchase agreements (or back-to-back sales) of existing assets provided by the borrower (or a third party) through murabahah or ) (or reverse murabahah/tawarruq), which may contain deferred payment (bay bithaman ajil or ) and/or delivery (salam or /istisna’a or );

• Leasing (asset-based contracts) through sale-leaseback agreements (operating leases) or the leases of third party-acquired assets with purchase obligation components (financing lease) (ijara or ); and

• Profit-and loss-sharing (equity-based contracts) funding the production of future assets (musharakah or / mudarabah or ) through principal-agent relationships with a predetermined allocation of shared profits and full (or limited) risk-sharing.³¹ In contrast, lending and leasing contracts are “exchange based,” that is, they are initiated by a temporary (permanent) transfer of existing (future) assets from the borrower to the lender (for example, via the sale of commodities), or the acquisition of third-party assets by the lender on behalf of the borrower.

Islamic banks incur credit and market risks from exchange-based instruments (that is, sales and leases) on both the assets and liabilities sides of the balance sheet. These instruments are not exclusively financial transactions but involve the sale of an asset between the bank and the customer. The sale establishes a strong funding relation to real economic activity in lieu of indebtedness, irrespective of the use of funds. In a murabahah contract, the bank acquires an asset (typically a durable good) from a third party and then sells it to the borrower in exchange for future installments on the purchasing price and markup until the maturity date (cost-plus sale); in this manner, the bank is able to finance the purchase of the asset.³²,³³ If the asset is acquired from the borrower in return for funding but cannot be delivered at inception (salam/istisna’a), the bank pays an agreed price, and the customer obtains funds (or working capital) instantly in exchange for the promise of delivering a defined commodity (or rendering the specified service) at a future date. In an ijara contract, the bank buys an asset that is subsequently leased to a customer (who has the option but not the obligation to acquire the asset) for a prespecified rate of return.

In all exchange-based transactions, the bank incurs credit risk from nonperformance of the counterparty and/or asset impairment. Moreover, Islamic banks often carry on their balance sheets inventories of commodities and other physical assets, which pre-endow future sales-based transactions.³⁴ Consequently, market price deviations from the purchase price of the asset(s) that motivate the funding relation expose the bank to market risk in the form of potential losses (and also potential gains if the price of the asset(s) increases). This risk is often termed commodity or inventory risk, depending on the nature of the asset. Figures 1 to 3 illustrate the main features of both ordinary and special sales contracts and show the flows of assets and payments.

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Credit and Market Risks in Murabahah (Cost-Plus Sale) Contracts

Citation: IMF Working Papers 2020, 156; 10.5089/9781513550886.001.A001

Source: authors. Note: in a “commodity murabahah” contract, the bank would sell the asset on behalf of the borrower and generate cash (rather than transferring the asset to the borrower), that is, the transaction is not collateralized.

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Credit and Market Risks in Ijara (Leasing) Contracts

Citation: IMF Working Papers 2020, 156; 10.5089/9781513550886.001.A001

Source: authors. Note: /* could be combined with right to (re-)purchase (thumma al-bay); /** implies “put option” to sell the asset if no payment is made due to full collateralization, but entails market risk if current/residual price is lower than spot price of asset.

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Credit and Market Risks in Salam (Forward) Contracts

Citation: IMF Working Papers 2020, 156; 10.5089/9781513550886.001.A001

Source: authors.

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Equity-based instruments are equivalent to venture capital and project finance, which entail investment risks. In profit-sharing agreements (musharakah and mudarabah), the bank receives a payout in accordance with a pre-agreed disbursement ratio only if the investment project generates enough profit to repay the initial investment amount and the premium payment. Since the lender bears losses up to the total amount of investment (which determines the share capital),³⁵ equity-based contracts preclude any recourse in absence of enforceable collateral. Islamic banks may become exposed to two types of risks, depending on the accounting treatment of equity investment. If shares are held for trading purposes (that is, in the trading book of the bank) and marked-to-market, then their value is subject to the fluctuations in market price, which exposes the bank to market risk. Equity-based instruments held until maturity entail equity position risk, which is defined as the “risk arising from entering into a partnership for the purpose of undertaking or participating in a particular financing or general business activity” (IFSB, 2005a, p. 13).³⁶ According to the IFSB, the rating and the residual maturity of the specific investment position(s) determines the capital charges.

V. Risks and Their Capital Impact Within Islamic Banking

This section reviews the main risks associated with the balance sheet characteristics and financial products commonly found in Islamic banking activities. The strong asset linkage and “process-driven perspective” on profit generation have fundamental implications for the capital assessment of Islamic banks. This entrepreneurial approach underpinning many Islamic finance contracts and the high dependence on collateral also raises the search cost of financial intermediation and monitoring cost of counterparties (especially if repayment is influenced by the access and valuation of commodity prices).³⁷ In addition, the state-contingent nature of payouts from financial transactions complicates the design and implementation of hedging strategies and investor/depositor protection schemes (especially in financial systems where conventional and shari’ah-compliant banking coexist).

Stress tests measure the capital impact of certain risk factors based on the sensitivity of various types of financial activities to negative shocks to economic and financial conditions. As with conventional banks, the most common risks affecting solvency conditions are credit risk (if a counterparty fails to perform its payment obligations), market risk (if market prices, for example, interest rates, foreign exchange, and stock prices, decline), and operational risk (see Figure 4).³⁸ However, the characteristics of these risk factors have different implications for Islamic banks across financial instruments, contractual agreements, and bank business models (IFSB, 2005b):

• Credit risk of asset performance in all exchange-based contracts (murabahah, ijara) in the financing/lending portfolio;

• Market risk of asset price fluctuations affecting the valuation of forward exchange-based contracts (salam, istisna, bay bithaman ajil), including inventory risk³⁹ in the investment/trading portfolio from significant commodities exposures and uncovered/parallel special sales contracts (parallel salam); and

• (General) operational risk if the failure of systems, internal procedures, and controls (as well as external events, such as natural disasters) lead to financial losses.

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Generic and Unique Risks in Islamic Banking

Citation: IMF Working Papers 2020, 156; 10.5089/9781513550886.001.A001

Source: authors.

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Islamic banks also face unique risks, which are particularly relevant for their business model:

• Counterparty and project risks from profit- and loss-sharing arrangements (mudarabah, musharakah) given the asset-based nature of contracts;

• Indirect interest rate risk due to competition for deposits in mixed banking systems;

• Displaced commercial risk, which implies a transfer of some shareholder value to unsecured depositors to fund reserves for smoothing profits from lending and investments (in case of lower-than-expected returns) and compensate for losses in excess of reserves; and⁴⁰

• (Specific) operational risk from either the non-compliance with Islamic finance principles or the non-recognition of shari’ah -compliant business activities and methods under conventional jurisprudence.

Given the limited access of Islamic banks to high-quality shari’ah-compliant funding over short-term horizons, any stress testing approach would need to be flexible enough to also incorporate the interaction of solvency and liquidity risks (through higher funding costs and/or deleveraging needs). Liquidity and solvency risks of individual institutions are increasingly connected during times of stress and tend to be influenced by system-wide liquidity conditions associated with the interconnectedness and network effects within the financial system. Current stress testing models either contain liquidity and solvency interactions and/or network modules to consider contagion and systemic risk from a cross-functional perspective (Jobst and others, 2017). Empirical evidence suggests that (i) the interaction between solvency and funding costs is indeed statistically significant; and (ii) it might be economically relevant, especially during periods of stress. Stress tests that do not account for the interaction between solvency and liquidity shocks substantially underestimate the risk exposure of individual banks and banking sectors (Puhr and Schmitz, 2014; Schmitz and others, 2017).⁴¹

A. Displaced Commercial Risk

Islamic banks endogenize the mutual cost of depositor protection through an informal and non-binding self-insurance scheme covering IA holders as unsecured creditors (investors) without (re)payment guarantees. IAs contractually bear all losses from projects (investments and lending), where the bank acts as agent or mudarib ,⁴² and, thus, can help mitigate losses. However, some Islamic banks with a large share of funding from IAs smooth the returns paid to depositors over time (and absorb some or all losses if necessary) due to competitive pressures.⁴³ Similarly, they might also consider absorbing liquidity risk from assets managed on behalf of IA holders, who can withdraw their funds before the contractual maturity (for instance, when investment projects yield lower-than-expected rates of return).⁴⁴ In both cases, shareholders may forgo part (or all) of their pre-agreed mudarib profit share to offset a profitability shock affecting IA holders’ promised rate of return (as equity is subordinated to deposits) (Lukonga, 2015); this may affect a bank’s capital position if some retained earnings are transferred to IA holders (see Box 1).

This mechanism is referred to as displaced commercial risk (DCR) and varies with the impact of investment and lending performance. DCR is not derived from Islamic finance principles but has evolved as common practice among Islamic banks to maintain stable funding in situations when adherence to the loss-sharing of IAs would suggest otherwise. However, in some countries, profit smoothing is not practiced (such as in the case of Malaysia), and, thus, DCR does not apply to any form of investment account (BNM, 2017).

In absence of depositor protection, DCR normally applies only to unrestricted IAs (UIAs) since restricted IAs (RIAs) are considered fully loss-absorbing (and tend to be treated as off-balance sheet items). DCR covers any unexpected losses that are not absorbed by UIA holders, and thus need to be fully capitalized (that is, the share of IAs assumed to be affected by DCR (consistent with the traditional concept of credit and market risk-weighting). Banks also establish two types of provisions from which to draw funds to smooth the rate of return paid to IA holders and compensate for any expected losses; even though these reserves are outside the concept of DCR, they have an operational impact on the quantification of DCR (see Figure 5):⁴⁵

• The profit equalization reserve (PER) is typically funded by the net income from mudarabah IAs. The bank (as agent or mudarib) is entitled to a pre-agreed fraction of profits from these equity-based contracts, so both IA holders and shareholders are beneficiaries of the PER. Islamic banks normally use PER to smooth the income of investors over time.⁴⁶

• The investment risk reserve (IRR) is solely attributable to IA holders and is funded by income after the deduction of the bank’s share (that is, the mudarib’s share) and contribution to PER. Since the mudarib does not bear losses outside cases of negligence and/or misconduct, IRR is typically used to cover losses from investments financed with IAs.

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Profit Equalization Reserve (PER) and Investment Risk Reserve (IRR)

Citation: IMF Working Papers 2020, 156; 10.5089/9781513550886.001.A001

Source: authors. Note: Depending on the country, these deductions are applied either before or after taxes.

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^{Box 1.}

The Quantification of Displaced Commercial Risk

The cascading mechanism underpinning the creation of prudential reserves can also be expressed in terms of income flows and balance sheet identities of an Islamic bank. If the bank’s liabilities consist only of equity, E, and unrestricted IA accounts, UIA, general loan loss provisions and PER (which are expressed as shares l and p, respectively) are retained from estimated annual net income, ${\tilde{r}}_A$ (which is expressed as return from jointly funded total assets, A), so that the available return, $(1-p)(1-l){\tilde{r}}_A$, for disbursement and profit-sharing between investors and shareholders

$(1-p)(1-l){\tilde{r}}_A\{\begin{array}{l}\left(\frac{E}{A}\right)(1-p)(1-l){\tilde{r}}_A\to PER\hfill \\ \left(\frac{UIA}{A}\right)(1-p)(1-l){\tilde{r}}_A\{\begin{array}{c}e\left(\frac{UIA}{A}\right)(1-p)(1-l){\tilde{r}}_A\\ (1-e)\left(\frac{UIA}{A}\right)(1-p)(1-l){\tilde{r}}_A\{\begin{array}{c}i(1-e)\left(\frac{UIA}{A}\right)(1-p)(1-l){\tilde{r}}_A\to IRR\\ \left(\begin{array}{c}1-i\end{array}\right)(1-e)\left(\frac{UIA}{A}\right)(1-p)(1-l){\tilde{r}}_A\end{array}\end{array}\hfill \end{array}$

defines the amount of IRR, $i(1-e)(1-p)(1-l){\tilde{r}}_A\left(\frac{UIA}{A}\right)$, which is retained by the Islamic bank before attributing income to UIAs, where UIA/A represents the share of profits allocated to UIAs, e is the bank’s commission as mudarib for UIAs, and i is the proportion of returns appropriated to IRR. Capital is required to absorb displaced commercial risk (DCR) from unexpected losses (after accounting for reserves) when UIAs’ returns are negative, $\begin{array}{c}{\tilde{r}}_{UIA}=\left(\begin{array}{c}1-i\end{array}\right)(1-e)\left(\frac{UIA}{A}\right)(1-p)(1-l){\tilde{r}}_A<0\end{array}$ and exhaust available (accumulated) reserves so that $\begin{array}{c}{\tilde{r}}_{UIA}A>PER+IRR\end{array}$.

We can determine the amount of capital required to cover unexpected losses by estimating the worst negative returns based on the historical cumulative distribution function of UIAs’ returns, ${\tilde{r}}_{UIA}$, at a given level of statistical confidence, a ∈ (0,1), over time horizon t (consistent with bank’s prevailing solvency standards).¹ Let ${\tilde{r}}_{UIA}$ be a sample of observations drawn from identically distributed, independent random variables {X_t; t = 1,2,..., n} following the stochastic process

$\begin{array}{cc}F\left(x\right)={\mu }_{{\tilde{r}}_{{UIA}_t}}+z_t{\sigma }_{{\tilde{r}}_{{UIA}_t}}{z}_t\sim iid(0,1),& \left(B1.1\right)\end{array}$

with conditional mean and standard deviation $\begin{array}{c}{\mu }_{{\tilde{r}}_{{UIA}_t}}=𝔼\left({\tilde{r}}_{UIA}\right)and{\sigma }_{{\tilde{r}}_{{UIA}_t}}\end{array}$ respectively, where ${\sigma }_{{\tilde{r}}_{{UIA}_t}}^2=𝔼\left(z_t^2\right|{\Omega }_{t-1})$, and z has the conditional c.d.f G(z) = Pr(z_t < z|Ω_t-1), based on the available information Ω_t-1 at time t – 1.

Thus, we can rewrite equation (B1.1) above as

$\begin{array}{cc}Va{R}_{a,t}\equiv \inf \left(x_t\right|F(x\ge a))={\mu }_{{\tilde{r}}_{{UIA}_t}}+N(1-a){\sigma }_{{\tilde{r}}_{{UIA}_t}},& \left(B1.2\right)\end{array}$

which represents the point estimate of the (1 – a)-quantile of the probability distribution F(VaR_a,t) = Pr[x_t > VaR_a,t] = 1 – a, where $F\left(x\right)\sim N[{\mu }_{{\tilde{r}}_{{UIA}_t}},{\sigma }_{{\tilde{r}}_{{UIA}_t}}^2]$ converges to a normal distribution. The corresponding conditional tail expectation (CTE) (which represents a coherent risk measure of unexpected negative returns) with $\frac{1}{a}{\int }_0^{\infty }{F}_t^{\leftarrow }\left(x\right)dx=\frac{1}{1-a}{\int }_0^1{F}_t^{-1}\left(a\right)$ (a)da is defined as

$\begin{array}{cc}CT{E}_{a,t}=𝔼\left[x_t\right|x_t\ge F_t^{-1}\left(a\right)=Va{R}_{a,t}],& \left(B1.3\right)\end{array}$

based equation (B1.2), after accounting for available (accumulated) reserves, where

$\begin{array}{c}Va{R}_{a,t}=-\sup \left\{F_r^{-1}\right(a\left)\right|\mathrm{Pr}\left[\right({\tilde{r}}_{UIA}-\frac{PER+IRR}{A})>0]\ge a\}\\ ={\mu }_{{\tilde{r}}_{{UIA}_t}}+N(1-a){\sigma }_{{\tilde{r}}_{UIA}}+\frac{PER+IRR}{A}\mathrm{.}\left(B1.4\right)\end{array}$

While the empirical diffusion process of returns might not necessarily converge to normality, this assumption makes it straightforward to derive point estimates of CTE_a,t based on the equivalency between the z-scores ø(Φ^-1) (1 – a))/(1 – a) (for CTE) and Φ^-1(a) (for Value-at-Risk [VaR]), where ø(.) and Φ^-1(.) are the standard normal probability distribution and quantile functions.² Appendix II shows how to determine CTE_a,t if the normality assumption is relaxed and the asymptotic tail properties are modeled using extreme value theory (EVT).

Multiplying the estimated value of CTE_a,t with the amount of total assets, A, determines the unexpected losses absorbed by shareholders in the absence of any risk-sharing between the Islamic bank and UIA holders, which would imply perfect DCR (and a so-called a-parameter equal to one, which is explained in Section V). DCR declines by any amount of unexpected losses that are absorbed by UIA holders (net of provisions), so that α < 1.

Note:

^1/ We ignore cases where returns are either smoothed by PER or absorbed by IRR if they fall below a benchmark return rate but are still positive. See Toumi and others (2011) for a detailed analytical treatment of these cases. ^2/ For instance, we can approximate CTE at the statistical confidence level a = 99.7 percent via VaR at a = 99.9 percent.

VI. Capital Requirement for Islamic Banks

The capital adequacy of Islamic banks is similar to that of conventional banks, but also accounts for the potential loss absorption by depositors. Unlike in conventional banking, the capital base of Islamic banks does not cover all unexpected losses, assuming that unsecured investors, such as IA holders, are not fully repaid if the bank becomes a gone concern. In keeping with the Basel Accord for conventional banks, the IFSB (2005a) introduced (and later refined; see IFSB [2012b]) the Capital Standard for Islamic Financial Institutions, which adjusts both the numerator (capital) and the denominator (risk-weighted assets) of the conventional capital adequacy ratio (CAR) to accommodate the business model of Islamic banks. This capital standard comprises a Standard Formula and a more elaborate Supervisory Discretion Formula (SDF), which differ from the capital standard defined in the Basel II/III framework for conventional banks (BCBS, 2010).

The Standard Formula does not explicitly recognize the potential the DCR banks face in practice (which can reduce capital), but all existing reserves are assumed to be available to absorb losses.

Thus, capital adequacy ratio (CAR_std) is defined as

where the numerator defines the amount of eligible capital, OpRisk is the capital charge for operational risk, RWA_Total stands for total RWAs (related to market and credit risks). The RWAs are reduced by the amount of RWAs funded by IAs (IFSB, 2013).⁵² However, operational risk losses are attributable to the bank, and thus need to be capitalized.⁵³ Eligible capital is defined as total equity, which might—in some circumstances—also include the shareholders’ share of PER and (RIA’s share of) IRR.⁵⁴ This definition of capital is similar to that of Tier 1 under the revised Basel Accord (BCBS, 2010), which includes disclosed reserves from after-tax retained earnings. The consideration of PER for Islamic banks is consistent with this approach (Grais and Kulathunga, 2007).

The SDF adjusts the Standard Formula to account for the bank’s voluntary loss absorption through DCR (beyond existing reserves), but also recognizes that shari’ah-compliant banking does not cover all investor-specific losses from investments/lending funded by UIA holders.⁵⁵ The UIA holders’ share of reserves mitigating some of the DCR and any unexpected losses on investments financed by IAs (in the case of UIAs only beyond DCR) are subtracted from RWAs (IFSB, 2013; see Figure 6).⁵⁶ The eligible capital in the specification of CAR_SDF can also—in some circumstances^omprise the shareholders’ share in the PER, PER_equity, and IRR attributable to IAs (after accounting for the degree of DCR affecting UIAs), IRR_RIA.

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Loss Absorption of Unexpected Losses by Unrestricted Investment Accounts

Citation: IMF Working Papers 2020, 156; 10.5089/9781513550886.001.A001

Source: authors.

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Thus, the appropriate CAR is given by

where α ∈ [0,1] signifies the estimated degree of DCR, that is, the amount of unexpected losses from UIAs, which need to be capitalized. In practice, the supervisory authorities have relative discretion in setting the value of a (see Table 2).⁵⁷ RWA_RIA and RWA_UIA are the RWAs funded by the two types of loss-bearing investment accounts (RIA and UIA).

^{Table 2.}

Displaced Commercial Risk―Current Regulatory Implementation and Industry Practice

(ordered by global share of Islamic banking assets)*

Sources: Adewale and Archer (2019), Farooq and Vivek (2012), IFSB (2011), and authors. Note: */ no data available for Iran and Bangladesh;

^1/Dubai.

^{Table 2.}

Displaced Commercial Risk―Current Regulatory Implementation and Industry Practice

(ordered by global share of Islamic banking assets)*

Country	Alpha-Value
Saudi-Arabia	1.00
UAE 1/	0.35
Malaysia	0.00
Kuwait	0.50
Qatar	0.35
Turkey	0.70
Indonesia	0.00
Bahrain	0.30
Sudan	0.50
Kazakhstan	0.35
IFSB Example	0.30

Sources: Adewale and Archer (2019), Farooq and Vivek (2012), IFSB (2011), and authors. Note: */ no data available for Iran and Bangladesh;

^1/Dubai.

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^{Table 2.}

Displaced Commercial Risk―Current Regulatory Implementation and Industry Practice

(ordered by global share of Islamic banking assets)*

Country	Alpha-Value
Saudi-Arabia	1.00
UAE 1/	0.35
Malaysia	0.00
Kuwait	0.50
Qatar	0.35
Turkey	0.70
Indonesia	0.00
Bahrain	0.30
Sudan	0.50
Kazakhstan	0.35
IFSB Example	0.30

Sources: Adewale and Archer (2019), Farooq and Vivek (2012), IFSB (2011), and authors. Note: */ no data available for Iran and Bangladesh;

^1/Dubai.

Alternatively, when supervisory authorities have discretion in accounting for DCR and also for RIAs, the corresponding reserves would need to be made explicit in the capital adequacy formula by including PER_RIA and RWAs funded by PER_RIA. The deduction of RWAs would decline by aRWA_RIA and the diminished loss-absorbing impact of reserves on capital decreases by IRR_RIA and aPER_RIA, so that

However, for the remainder of the paper, we disregard this augmented definition of capital in equations (1) and (2), so that

For illustrative purposes (see Figure 6), we retain the IRR available to smooth returns of UIAs for a given degree of DCR (see Box 1) so that

The share (1 – α) of RWAs associated with UIAs, (1 – α)RWA_UIA, is deemed unaffected by DCR (that is, it constitutes loss absorption by depositors), and, thus, is deducted from the denominator—just like RWA_RIA, which is often treated as an off-balance sheet item and need not be capitalized.⁵⁸,⁵⁹ Only the proportion of RWAs funded by reserves that cover expected losses incurred by UIAs, (1 – α)RWA_PERiIRR, is relevant for the denominator in the calculation of capital adequacy.

However, the predefined impact of DCR on loss absorption by UIAs in CAR_SDF entails conceptual challenges by commingling expected and unexpected losses. The loss-absorbing share of UIAs, (1 – α)RWA_UIA, is contingent on the adequate provisioning for expected losses to UIAs through IRR_UIA and the capitalization of unexpected losses up to αRWA_UIA. If earmarked capital and reserves are insufficient to cover a higher-than-expected DCR, the lower loss absorption by UIAs would decrease CAR_SDP. Also, CAR is likely to decline (all else being equal) if the bank does not generate enough profits to allocate retained earnings to keep the assumed loss-absorbing share of UIAs unchanged (which is likely in an adverse situation).⁶⁰

Figure 7 compares the conventional and Islamic specification of CAR based on equations (3) and (4) using the stylized balance sheet data of an Islamic bank (see Appendix I, Table A2). The first chart shows that the capital adequacy of the Islamic bank is strictly higher under the adjusted specification of CAR due to the loss absorption by IA holders. Considering that reserves covering expected losses of UIAs are deducted from capital, CAR_SDP can drop below the conventional CAR if low loss absorption by IAs implies high DCR, and RWAs of Islamic banks converge to those under the conventional assessment of capital adequacy as the α-parameter increases.

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Comparison of Conventional and Islamic Banking Capital Adequacy Formulae with Same Input Parameters

(in percent)

Citation: IMF Working Papers 2020, 156; 10.5089/9781513550886.001.A001

Source: authors. Note: The surface shows the difference between the conventional capital adequacy ratio (CAR) and the CAR using the Supervisory Discretion Formula (SDF) for Islamic banks, CAR_SDF (see equation (2) above), for the rising degree of DCR and share of investment accounts, so that CAR_SDF|DCR,RWA_UIARIA – CAR, where CAR = 9.5% represents the ratio of eligible capital and total risk-weighted assets (RWA), based on the assumptions and data in Appendix I, Table A2. The increase of reserves was implemented consistent with changes in the alpha-parameter, so that the numerator becomes capital – αlRR_UIA (without including other reserves, similar to the general specification of CAR_SDF). For a common assumption of DCR of 30 percent (see Table 2), CAR_SDF = CAR + 6.8% (all else being equal). For this illustration, equation (2) was amended to account for the accumulation of reserves in the form of IRR_UIA over time.

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Based on the analytical determination of DCR in the previous section (Section IV. A), we can evaluate whether a certain choice of the α-parameter is consistent with the actual investment risk faced by UIAs, assuming that the bank capitalizes most (but not all) unexpected losses that are not absorbed by the loss-sharing arrangement with UIAs. Given that the loss-absorbing share of RWAs funded by UIAs, (1 – α)RWA_UIA, is subtracted from total RWAs in the denominator of CAR_SDF, an appropriate a-parameter for αRWA_UIA ≤ UL would need to satisfy

which simplifies to

where the conditional tail expectation CTE_a,t specifies the estimated share of UIA being lost with given level of statistical confidence, a ∈ (0,1), over time horizon t (consistent with bank’s prevailing solvency standards) (see Box 1), assuming that the average credit and market risk weights for assets funded by UIAs, ${\overline{RW}}_{UIA}={\overline{RW}}_{total}={RWA}_{total}/A$, is the same as the one for all other balance sheet assets, where RWA_total = RWA_credit + RWA_market.

The assumed DCR is not credible if the bank cannot absorb actual unexpected losses in addition to expected losses covered by available IRR. In case of UL* > UL, unexpected losses are insufficiently capitalized (that is, the assumed capital relief from UIAs in equation (2) is too high since α* > α,) and would require a transfer of shareholder wealth, (α* – α) RWA_UIA, to compensate for higher-than-expected loss absorption by UIA holders; this also implies that the bank would need to remain profitable to fund such a transfer during times of stress.

We construct a simple practical example of this approach by using the historical return performance of the MSCI World Islamic Equity Index⁶¹ as a proxy for the investment returns of UIAs and the stylized balance sheet of an Islamic bank (see Appendix I, Table A2). The amount of unexpected loss is determined as a point estimate (see equation (B1.4) in Box 1) for different levels of statistical confidence after accounting for the “cascading mechanism” of provisioning (PER and IRR) and the loss-mitigating effect of existing reserves. Figure 8 shows the sensitivity to VaR_ait to the historical return volatility. Under these conditions, we find that that choice of α = 0.3 would be insufficient since ${CTE}_{a,t}>\alpha {\overline{RW}}_{total}=0.15$ if the historical volatility doubles to a level of statistical confidence close (but below) the prudential requirement (99.9 percent).⁶²

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Comparison of Conventional CAR and CARSDF

(in percent)

Citation: IMF Working Papers 2020, 156; 10.5089/9781513550886.001.A001

Source: authors. Note: The surface shows the tail estimates of the mean-variance of the MSCI World Islamic Equity Index as a proxy for the unexpected investment returns of UIAs at different percentile levels, subject to the scaling of the volatility parameter. The index is transformed by taking the logarithmic differences of the closing daily price (in percentage) over a 10-year time period, t = 10, until end-2018 (with ${\mu }_{{\tilde{r}}_{A_t}}=4.57\%and{\sigma }_{{\tilde{r}}_{A_t}}=3.34\%$), and the bank-specific assumptions l = 0.03 (for general loan loss reserves), p = 0.022 (for PER), l = 0.03 (for IRR), e = 0.01 (for bank’s commission)), UIA/A = 0.4, which are derived from Appendix I, Table A2.

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VII. Stress Testing Islamic Banks

This section provides an overview of the calibration of shocks to specific risk factors and their impact on the determination of capital adequacy of Islamic banks. In general, the capital assessment under stress should capture all material risks affecting all operations and provide a total view of capital adequacy—on an aggregated or individual basis—of legal entities and/or across groups. Compared to conventional banks, Islamic banks require a more nuanced treatment of risk factors given the specificities of risk exposures, the influence of shari’ah compliance on the transmission of shocks, and the impact of potential risk mitigation. Thus, this section identifies the characteristics of these risk factors and illustrates how properties of Islamic banking shape the way in which shocks can be integrated into a standard specification of risk factors underlying the capital assessment.