RECOMMENDATION hand, pricing and capital ratio measures need some

RECOMMENDATION

Credit risk is the risk of a counterparty
failing to perform its obligations. Over the years, the nature, scale and
complexity of credit risk undertaken by financial institutions have evolved
amid significant transformations to the Malaysian financial landscape. There are some of recommendations to
reduce credit risk based on several instruments. First, we have suggested credit risk measurement pertaining to PLS instruments. Credit risk pertaining to PLS instruments
in Islamic banking may exist when agent could not fulfill the contract
obligations due to misconduct and negligence within controllable factors.
Today, credit riskiness of banks is measured by credit
ratings. Briefly, credit ratings are professional
opinions about credit risk supported by specific methods, analyses and
evaluations. In general, rating agencies use mathematical model-driven and
analyst-driven ratings. The rating process of the agencies starts with ratings
criteria including principles, methodologies and assumptions then quantitative
and qualitative analyses. Since IFIs became one of the important actors in the
financial market, rating agencies started to prepare credit ratings for them. The
rating agencies are mostly rating Islamic banks and sukuk (Islamic bond)
product.

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When it comes to the credit riskiness of
customers applying for mudarabah and musharakah partnerships, credit scorings need
to be modified since they heavily focus on credit card and home financing
applications. Second, we have suggested credit risk
mitigation pertaining to PLS
instruments. The commonly used modern credit risk mitigation tools are pricing,
tightening, credit guarantee and insurance, collateral, covenant, netting,
diversification, capital adequacy and derivatives. On the other hand, Islamic
banks also use diversification, exposure limits, collateral, covenant,
guarantees, insurance and risk based capital requirements, especially for
debt-based instruments. On the other hand, pricing and
capital ratio measures need some modifications to be used as credit risk mitigation tools for PLS
instruments. However, the use of collateral, guarantee and insurance is
controversial in terms of PLS instruments.

Lastly, we have suggested using of rate of return risk and withdrawal risk mitigation. Rate of return risk arises due to the
variability of return rates of PLS financing modes on the asset side and
benchmark rate expectations of PSIA account holders despite the variability of
return rates on the liability side of an Islamic bank. There are several rate
of return risk mitigation suggestions. Suggested the originality of PSIA
deposits is the uncertainty about return. Hence, the very first thing to do is to increase the apprehension of this property among depositors. Besides, the rate
sensitivity of PSIA deposits can be decreased by choosing investments with more
stable returns and lesser risks. The rate sensitivity of PLS financings can be
decreased by choosing less risky projects or projects from more credible customers. In
addition, the effect of the rate of return risk can change according to bank
specifics such as bank size. Hence, banks should be aware of how their
institutional properties are affecting the rate of return risk. Also, maturity
gapping between PLS financing modes and PSIA investment deposits should be compromised i.e. if the average maturity of the former ones is higher, then either
this should be decreased or the latter ones’ should be increased. In any case, too long maturities for either of them should be avoided. While when it comes to the mitigation of
withdrawal risk, we suggest to decrease volatility in
rate of return, aforementioned
precautions should be taken. Besides, the effect of interest rate on deposit
withdrawals depends on the competition between conventional and Islamic banks.
Islamic banks should emphasize their uniqueness. In addition, Shariah
compatibility and service quality together with customer satisfaction should be
under scrutiny and the buffer against sudden withdrawals should be calculated
without taking into account the effect of PER and IRR.