Abstract
This paper shows how a risk management mechanism through selling debt can affect the value of Islamic banks. Islamic banks are able to maximize their value from the sale of murabahah on housing debt in order to manage their risk arising from fluctuations in interest rates. A tractable theoretical model is developed to maximize the Islamic banks’ values from the sale of housing debt financing in order to hedge against fluctuations in interest rates. Our findings showed that Islamic banks could improve their earnings and rectify the problem in aligning their assets and liabilities through the benefits of debt selling. A rise in the market interest rates leads to an increase in the base financing rate and the mark-up rate in Islamic banks, since market interest rates serve as benchmarks in determining profits or mark-ups. If the Islamic banks engage in debt selling to decrease their risk exposure, their earnings or value may be amplified since they have the opportunity to undertake other positive NPV projects from the payoffs on the murabahah debt selling.
Highlights
Risk management has become a challenge in Islamic banking because the growth in these banks may not occur without taking risk beyond the norm of conventional banking
This paper considers one of the several mechanisms that are suggested to manage the risk factor in the Islamic banks, i.e., selling murabahah on house financing to a third party in order to hedge against the movement of the market interest rates that, in turn, affects the repayments of the sum lent
We have shown that the Islamic banks are able to maximize their value from the sale of murabahah or debt on housing in the process of managing their risk that arises from fluctuation in interest rates
Summary
Risk management has become a challenge in Islamic banking because the growth in these banks may not occur without taking risk beyond the norm of conventional banking. Taking additional risk is unavoidable for the Islamic banks to progress. Taking excessive risks will hurt investment and may deter future growth. Consideration of effective risk management is important for the bank’s financial stability, the soundness of its business, its charter, and its value and profitability
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