SUNANDO ROY – On Banking, Finance and Society

 

Banks often extend mortgage or Ijara-based financing secured by residential or commercial real estate, assuming that the collateral can be sold or transferred in case of borrower default. A credit risk materializes when the government subsequently declares the relevant land or property restricted or prohibited for sale, transfer, or alienation. Such prohibitions may arise from national security measures, urban redevelopment plans, environmental or heritage protection policies, or the acquisition of land for strategic infrastructure projects.

Although the borrower may retain use or possession rights, the asset’s marketability becomes legally impaired. This undermines its effectiveness as a credit risk mitigant and challenges the prudential recognition of collateral coverage for both conventional and Islamic financial institutions.

 Nature of the Risk: Legal Impairment Rather Than Market Illiquidity

This type of impairment reflects a legal prohibition, not a cyclical market fluctuation or temporary illiquidity. Even if appraised values remain high, the inability to enforce, transfer, or liquidate the collateral renders its value non-recoverable for credit risk mitigation purposes. As per the Basel Committee’s eligibility criteria, collateral must be legally enforceable and realizable within a reasonable timeframe to qualify for capital relief.

Accordingly, once legal restrictions arise, the collateral should be excluded from the definition of “eligible security,” requiring reassessment of exposure treatment and loss estimation.

Implications for Mortgage and Ijara Structures

Under conventional mortgage lending, the security interest becomes ineffective once sale or transfer is legally prohibited, limiting recovery to the borrower’s continuing cash flows or other assets.

In Islamic Ijara arrangements, the risk is even more acute. The bank (lessor) is the legal owner of the leased property and bears ownership-related risks. A restriction on alienation affects the residual value assumptions and the bank’s ability to sell or re-lease the property at lease maturity or default. This complicates both financial and Shariah compliance dimensions, as the bank retains ownership liabilities without a viable exit or realization mechanism.

Impact on Credit Risk Measurement and Capital Adequacy

Once collateral becomes unsaleable, the associated exposure must be reassessed as effectively unsecured. Banks should accordingly:

• Increase the loss-given-default (LGD) assumption to reflect near-zero recovery.
• Revise risk grades and update risk-weighted asset (RWA) calculations under Basel III or equivalent prudential standards.
• Under IFRS 9 or AAOIFI FAS 30, adjust expected credit loss (ECL) estimates based on the revised recoverability assessment.

Failure to revalue the collateral realistically could overstate capital adequacy and misrepresent credit risk.

 Provisioning, Classification, and Portfolio Effects

The legal impairment of collateral often triggers methodological reassessments across credit policy and loan classification processes:

• Exposures may migrate to higher-risk categories or Stage 2/3 under IFRS 9 staging criteria, even if payments remain current.
• For Ijara or diminishing Musharaka structures, heightened monitoring and watch-list classification may be warranted.
• If multiple assets within the same region become unsaleable due to government actions, sectoral concentration risk emerges. This should be reflected in management overlays, portfolio stress testing, and ICAAP scenarios.

Risk Management and Remedial Actions

Possible remedial actions include:

• Legal appeals or administrative requests for exemption or compensation (e.g., under land acquisition or redevelopment laws).
• Facility restructuring to align exposures with demonstrated cash-flow repayment capacity rather than collateral reliance.
• Substitute collateral or additional guarantees, where permissible.
• Updating internal systems to reflect partially or fully unsecured status and re-rating exposures accordingly.

However, banks should not assume prospective government compensation or exemption when determining accounting or capital treatment.

 Governance, Due Diligence, and Supervisory Expectations

Supervisors increasingly expect institutions to exhibit forward-looking collateral due diligence—including verification of zoning compliance, land title restrictions, and possible state acquisition risks—prior to loan origination.

Supervisory reviews may assess:

• Whether legal opinions and valuation reports reflect governmental override risks.
• Whether collateral eligibility criteria are prudently conservative.
• For Islamic banks, Shariah boards may review the permissibility of continuing ownership or lease contracts where disposal rights are restricted, to ensure that risk transfer and ownership elements conform to Shariah standards.

 Stress Testing and Forward-Looking Assessment

Institutions should integrate “unsaleable collateral” scenarios into their ICAAP, stress testing, and recovery planning frameworks. Simulated events may include:

• Permanent alienation restrictions on a certain geographic zone.
• Forced acquisition or transfer at below-market compensation levels.
• Simultaneous default of multiple borrowers within affected zones.

These stress outcomes should test capital adequacy, profitability, and liquidity impacts under zero-recovery assumptions, supporting enhanced supervisory dialogue and resilience planning.

Sum up

Legal restrictions that render real estate collateral unsaleable fundamentally alter the exposure’s risk characteristics. What begins as a secured loan may effectively become unsecured due to loss of enforceability.

Prudent banks recognize this early, revising recovery assumptions, capital metrics, and provisioning in line with reality. Transparent recognition supports financial stability, sound governance, and regulatory credibility, while failure to adjust can result in hidden vulnerabilities, mispriced risk, and supervisory intervention.

References

1. Basel Committee on Banking Supervision (BCBS). Basel Framework: Credit Risk – Standardised Approach (CRE20). Bank for International Settlements, 2023.
2. International Financial Reporting Standard 9 (IFRS 9). Financial Instruments. International Accounting Standards Board (IASB), 2014.
3. Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI). Financial Accounting Standard (FAS) 30: Impairment, Credit Losses and Onerous Commitments., 2020.
4. Islamic Financial Services Board (IFSB). IFSB-15: Revised Capital Adequacy Standard (BASEL III aligned framework), 2013.
5. IMF. Supervisory Review and Evaluation Process (SREP) for Islamic Banks – Guidance Note., 2021.
6. World Bank Group. Real Property and Collateral Risk Management in Emerging Markets., 2022.
7. Bank for International Settlements. Principles for the Management of Credit Risk., 2020.
8. Central Bank of Bahrain (CBB). Rulebook Volume 2—Credit Risk Management (Conventional) and Volume 4 (Islamic Banks)., updated 2024.