NPF of ISLAMIC BANK
by: Hendy Herijanto
Islamic Economics and Finance (IEF), Trisakti University
Non Performing Financing/ NPF, or like Non Performing Loan / NPL of conventional bank, occurs due to the problems happening during the financing/loan are being processed within the bank, or after the financing/loan is granted. Nevertheless, NPF and NPL are created in different banking systems. Islamic bank has a number of fundamental factors that can prevent the creation of NPF from becoming worse. Conventional banking system, on the other hand, has a bigger room to allow NPL to occur.
The fundamental factors that are ingrained the Islamic banking transactions are as follows. From the asset side of the balance sheet, Islamic bank only extend financing as its main banking activities, and does not grant any commercial loans as conventional bank does. Any money loan granting is viewed as a social transaction, and as such it is not supposed to carry any price like interest. Its commercial banking transactions can only be undertaken through the predefined vehicles like commercial selling-buying mechanism with its agreement or akad called murabaha, leasing agreement or akad ijarah, and partnership agreement called mudharabah and musyarakah.
Any commercial financing must be interest or riba free, as well as not characterized as gharar and maysir. Riba or interest, which is fixed upfront regardless the business being financed turns out to profitable or carrying losses, obviously increases business risk. The increasing or higher risk tends to push the probability of having NPL higher. To substitute interest, Islamic bank focuses itself on getting profit together with its customers. Naturally, business profit or losses can not be determined upfront, and the related nominal amount can only be known following its realization from time to time. With akad muarabaha, for instance, bank buys a certain goods needed and sell it back to its customer with marked up price to include its profit. The customer may buy that goods by installing the price.. With akad ijarah, bank buys goods and lease or rent it back to its customer. With akad mudharabah, bank as the financier or shahibul mal provides capital to finance a business to be undertaken by a customer as the entrepreneur or mudharib. With musharakah, bank and customer (s) finance undertake a business venture jointly as partners for profit and risk to be shared. This profit serves as a common interest for them, where the profit then realized to be divided amont them based upon a predetermined proportionate percentage. This common interest drives a better information transparency, reducing the possibility to create moral hazard among parties in the transaction, thus lowering the business or financing risk for all the parties involved. Each akad contains a feature of justice, where the profit that allowed and shared represents a compensation for the risk assumed by the parties.
Prima causa of the above akads are not money, but tangible goods traded under murabaha , or rentable or leased goods under ijarah , or business venture in riel sector to be undertaken jointly by banks as either fiancier (shahibul mal) or enterpereneur (mudharib) with its customers as either one or joint partner under mudharaba/musharakah. That prima causa serves as the underlying transaction, but not those prohibited like alcoholic goods or gambling business. With the characteristics of the causa, the usage of bank fund is more controllable, especially when it is first drawn down, thus reducing the inherent risk. Money is fungiable in nature, which is just like water. If it is a loan fund, it can be flown to wherever borrower wants to, even creating a breach to a loan agreement that has been signed. For akad of Islamic bank, the underlying transaction in the form of tangible goods or business in the real sector must be certainly determined very early in the beginning of a transaction where, in that sense, the fund follows the flow of the goods and services.
Gharar is the nature of a transaction where the existence or the specification of the prima causa is not very clear, or its existence is in doubt, just like a deer in the forest, or it contains an unnecessary risk, which is beyond a normal business risk. Another characteristic being gharar is that one party to the transaction has no adequate knowledge or information about the prima causa or the transaction; putting him in an imbalanced position via a vis the other party in the transaction. Maysir is the nature of transaction with chances to win or loose based on lucks, or just like gambling. Gambling business is seriously prohibited. Generally speaking, financing a prima causa that exists beyond the real sector of the economy, like derivative products, tend to characterize as maysir and drives it to expose to a bigger risk. In 1929-1930, financing share transaction across the board in America posed itself as one of the main reasons for the Great Depression to occur in that country. Share price always fluctuates, moving up and down randomly, which is labeled as random walk, thus making it to become speculative. The happening of that Great Depression seemed to be as a direct or indirect consequence of the theory introduced by Keynes where demand for money includes for speculative purposes, other than those for transactional and precautionary motives.
On the liability side of the balance sheet, the third parties’ funds do not represent as loans to the bank, but rather being considered as fund in custody using akad wadiah, or resembling investment fund under akad mudharabah. The same funds at conventional bank, however, constitute loans or liabilities to the bank. From here, it can be seen that Islamic bank does not apply the concept of leverage, that is using loans in order to increase profitability; but, on the other hand, increasing the business or credit risk. Because investment loan has a periodical time frame and as such, it can not be demanded back prior to its maturity, this fact reduces the possibility of facing a run on the bank. Beside that, bank can synchronize the risk and profitability level of akad mudharabah between the owner of fund or the financier or shahibul mal (hence, bank acts as an entrepreneur or mudharib), on the liability side, with akad mudharabah between the customer to whom financing is extended by bank as a mudharib (bank acts as a shahibul mal), on the asset side. This synchronization can reduce the risk to or vulnerability of bank.
On the macro level, the concept of fractional banking in the conventional banking system allows the creation of “accounting liquidity” or larger credit in the society. This liquidity or credit, if not being controlled quite well, can cause bank failure, or even banking or financial crisis. Many banking or financial crisis happening in the world were initially caused by a financial liberalization for the sake of increasing the liquidity in the economy, hoping to boost economic growth; but, then, more often than not, it pushes lending boom and bigger NPL at the end. On overall, almost every crisis create a number of negative consequence to include slower economic growth, creating a big unemployment, and huge debts, as well as a heavy financial burden to the tax payers. On the net result, it can be said that economic growth induced by tapping a bigger credit to the economy is temporary, and not real in the sense that the benefits of the growth were wiped negatively by the indirect and direct cost to the remedy the banking industry and the economy.
Money in Islamic economy is mainly considered as a medium of exchange, but not as a commodity with interest as its price as in the capitalistic economy. Money is mainly used to fulfill the transactional motives in the real sector as is suggested by the Irving Fisher equation, or called as endogeneous money, and not being added by (money) credit. Islamic economy put a significant importance to trade, as allowed by God the Almighty as being revealed it in one of the Divine verses in the Al Qur’an. Trade increases the productivity of goods and services, creating an larger employment to society, and enhancing the prosperity of the (Islamic) society or the Umat. Islamic Bank only provides financing all the prima causas mentioned above, thus supporting the true and real economic growth.
Islamic bank is governed by the Divine book, Al Qur’an, and the Hadiths or the Sayings of the Prophet Muhammad Peace upon Him or SAW. It can be said that the system where NPF occur is indirectly created by God the Almighty or SWT, and therefore it must be the best of all. Nevertheless, how the system is being used is so much dependent on the men who uses it. The factors causing NPF/NPL during the internal process of bank are basically the same, that is related to the following internal factors: financing/credit knowledge and skills, professionalism and integrity, and spirituality level of the people, corporate culture, credit/financing culture that develop in the institutions, moral leadership, as well as reward & penalty system that implemented firmly. The process itself needs to do reputation check, due diligence & care, and internal credit supervision or credit audit. The causes of NPF/ NPL after the financing/credit is granted are related to borrowers, i.e, to their honesty and trust, their business acumen, their business commitment, and their moral commitment to keep their written promise to pay. All these factors must be analysed or scrutinized by conventional or Islamic banks, by using the internal above said earlier.
If the internal factors are applied with the same intensity in both types of bank, ceteris paribus, in the Islamic banking system above, NPF tend to be lower than NPL conventional bank. Furthermore, if the internal factors are implemented in tandem with the Tauhidi principles (principally in Islamic bank), NPF can be even lowered (hho, 20/11/2011).