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6.46. Credit risk mitigation

(1) An Islamic Bank is able to obtain Capital relief by using Shari’ah-compliant CRM techniques. The techniques must be viewed as complementary to, rather than a replacement for, thorough credit risk assessment.

(2) Eligible CRM techniques include:

  • (a) accepting collateral, standby letters of credit and guarantees;
  • (b) using Shari’ah-compliant hedging instruments; and
  • (c) using netting agreements.

Guidance

i) Credit risk mitigation using collateral and guarantees is usually dealt with at the time credit is granted. In contrast, hedging instruments and netting agreements are often used after the credit is granted, or used to manage an Islamic Bank’s overall portfolio risk.

ii) An Islamic Bank should not rely excessively on collateral or guarantees to mitigate credit risk. While collateral or guarantees may provide secondary protection to an Islamic Bank if the counterparty defaults, the primary consideration for credit approval should be the counterparty’s repayment ability.

iii) An Islamic Bank that provides mortgages at high loan-to-value ratios should consider the need for alternative forms of protection against the risks of such lending, in order to protect itself against the risk of a fall in the value of the property.

(3) In choosing a CRM technique, an Islamic Bank must consider:

  • (a) an Islamic Bank’s knowledge of, and experience in using, the technique;
  • (b) the cost-effectiveness of the technique;
  • (c) the type and financial strength of the counterparties or issuers;
  • (d) the correlation of the technique with the underlying credits;
  • (e) the availability, liquidity and realisability of the technique;
  • (f) the extent to which documents in common use (for example, the ISDA Master Agreement) can be adopted; and
  • (g) the degree of recognition of the technique by financial services regulators.