The Journal of Risk Finance

Emerald Article: Risk management practices of conventional and Islamic banks in Bahrain Hameeda Abu Hussain, Jasim Al-Ajmi

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To cite this document: Hameeda Abu Hussain, Jasim Al-Ajmi, (2012),"Risk management practices of conventional and Islamic banks in Bahrain", The Journal of Risk Finance, Vol. 13 Iss: 3 pp. 215 - 239 Permanent link to this document: http://dx.doi.org/10.1108/15265941211229244 Downloaded on: 22-11-2012 References: This document contains references to 26 other documents To copy this document: permissions@emeraldinsight.com This document has been downloaded 315 times since 2012. *

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Sania Khalid, Shehla Amjad, (2012),"Risk management practices in Islamic banks of Pakistan", The Journal of Risk Finance, Vol. 13 Iss: 2 pp. 148 - 159 http://dx.doi.org/10.1108/15265941211203198 Fauziah Hanim Tafri, Rashidah Abdul Rahman, Normah Omar, (2011),"Empirical evidence on the risk management tools practised in Islamic and conventional banks", Qualitative Research in Financial Markets, Vol. 3 Iss: 2 pp. 86 - 104 http://dx.doi.org/10.1108/17554171111155339 Abul Hassan, (2009),"Risk management practices of Islamic banks of Brunei Darussalam", The Journal of Risk Finance, Vol. 10 Iss: 1 pp. 23 - 37 http://dx.doi.org/10.1108/15265940910924472

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Risk management practices of conventional and Islamic banks in Bahrain

Hameeda Abu Hussain and Jasim Al-Ajmi
Department of Economics and Finance, University of Bahrain, Sekheer, Bahrain
Abstract
Purpose The purpose of this paper is to report empirical evidence regarding the risk management practices of banks operating in Bahrain. Design/methodology/approach A sample of bankers was surveyed through a questionnaire and the results used to examine if the risk management practices are signicantly associated with the type of bank (conventional or Islamic) and if those practices are positively affected by understanding risk, risk management, risk identication, risk assessment analysis, risk monitoring and credit risk analysis. Several statistical and econometric methods were used to the test the hypotheses. Findings Banks in Bahrain are found to have a clear understanding of risk and risk management, and have efcient risk identication, risk assessment analysis, risk monitoring, credit risk analysis and risk management practices. In addition, credit, liquidity and operational risk are found to be the most important risks facing both conventional and Islamic banks. Furthermore, the risk management practices are determined by the extent to which managers understand risk and risk management, efcient risk identication, risk assessment analysis, risk monitoring and credit risk analysis. Islamic banks are found to be signicantly different from their conventional counterparts in understanding risk and risk management. The levels of risks faced by Islamic banks are found to be signicantly higher than those faced by conventional banks. Similarly, country, liquidity, and operational, residual, and settlement risks are found to be higher in Islamic banks than in conventional banks. Research limitations/implications The results may have been inuenced by the current economic global crisis. Although the response rate is very high, there is no evidence of non-response bias, and there is high internal consistency within the responses. The reliance on survey methodology introduces the possibility that respondents expressed their beliefs and did not necessarily describe their actions. Practical implications Bankers, depositors, investors and regulators are likely to benet from the results of the study when taking decisions related to the banking industry. Originality/value This is the rst published attempt to investigate empirically the risk management practices of banks operating in Bahrain and to compare the practices of conventional and Islamic banks. Keywords Bahrain, Banks, Risk management, Conventional banks, Islamic banks, Perceptions, Risk management practices Paper type Research paper

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Received September 2011 Revised November 2011 Accepted February 2012

1. Introduction Effective risk management is accepted as a major cornerstone of bank management by academics, practitioners and regulators. Acknowledging this reality and the need for a comprehensive approach to deal with bank risk management, the Basel Committee
JEL classication G20, G21, G28

The Journal of Risk Finance Vol. 13 No. 3, 2012 pp. 215-239 q Emerald Group Publishing Limited 1526-5943 DOI 10.1108/15265941211229244

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on Banking Supervision adopted the Basel I Accords, followed by the Basel II Accords and recently by the Basel III, to deal with the matter. Moreover, risk management is found to be one of the determinants of returns of banks stocks (Sensarma and Jayadev, 2009). The recent global economic and nancial crisis erupted in the USA when Lehman Brothers Holdings, Inc. led for Chapter 11 bankruptcy on 15 September 2008. The spread of this crisis worldwide raised questions about the effectiveness of risk management practices (RMPs) applied by banks, including those applied by well-established banks. Risk management failure is considered one of the main causes of the crisis (Bank for International Settlements, 2009; KPMG International, 2009; Sabato, 2009; Holland, 2010). The US Sarbanes Oxley Act of 2002 was enacted in response to the boom and bust of the dot.com market and obliges all companies quoted on the US stock exchanges to spend considerable sums of money in order to maintain their control systems (Williams et al., 2006). A global survey of 346 nancial service executives conducted in March 2009 by the Economist Intelligence Unit (2010) on behalf of SAS Inc., aimed to examine how the nancial institutions worldwide are strengthening their risk management capabilities in response to the global crisis. Approximately half of the survey respondents reported that they had conducted, or planned to conduct, a thorough overhaul of their risk management, including improvements to data quality and availability, strengthening risk governance, moving towards a rm-wide approach to risk and deeper integration of risk within lines of business. However, only 40 percent of respondents stated that the importance of risk management is widely understood throughout their company, suggesting that more needs to be done to embed a strong culture of risk management in nancial institutions. Risk management is a continuous process that depends directly on changes in the internal and external environment of banks. These changes in the environment require continuous attention for identication of risk and risk control. In response to the call to enhance the effectiveness of risk management, banks in Bahrain, like those in many other countries, are required to comply with Basel II. Banks in Bahrain are facing an exceptional challenge in managing their risk exposure which came as a result of the continual social and political unrest which erupted on 14 February 2011. The governments struggle to deal with the democratic movement resulted in a decline in non-oil economic activities, deterioration of credit rating and a decline in stability of the banking industry. Among those results are: . the estimated growth rate of gross domestic products (constant prices) in 2011 was 1.5 percent, which is lower than IMF prediction of around 4.5 percent before the uprising; . a credit rating cut of two levels by Standard & Poors to the second-lowest investment grade; similar moves were taken by Fitch and Moodys; . the downgrading credit rating increased the yield paid on the recent seven-year Ijarah sukuk issue to 6.273 percent compared with 5.5 percent yield paid on a bond maturing in 2020 issued before the uprising; and . revision of a Banking Industry Country Risk Assessment by Standard & Poors from groups 5 to 6 (group 1 is the lowest risk while group 10 is the highest risk), and nally, drop in assets value; for example, the market capitalization of Bahrain Bourse decline by 19.34 percent from January 2011 to January 2012.

These consequences indicate that banks are facing higher credit and market risks now when compared with the situation prior to the uprising. RMPs have been widely investigated over the years. However, little attention has been paid to banks operating in emerging markets and, in particular, Islamic banks (Al-Tamimi, 2002; Al-Tamimi and Al-Mazrooei, 2007; Hassan, 2009). Since risk management failure has been identied as one of the main causes of the nancial crisis, additional study of the subject is warranted. The primary aim of this study is to contribute to the debate about risk management by investigating the RMPs of banks operating in Bahrain. Specically, the studys objectives are threefold: (1) to investigate empirically the degree to which the conventional and Islamic banks in Bahrain use effective RMPs and techniques in dealing with different types of risk; (2) to identify the most important types of risk facing the Islamic banks in Bahrain; and (3) to compare the RMPs of conventional and Islamic banks. The study extends the work of Al-Tamimi and Al-Mazrooei (2007) and Hassan (2009) who suggest similar studies in different environments. Although the study is an extension of these studies, in another context it differs in at least two aspects: (1) the questionnaire used is similar but not identical, having been revised after taking into account the environment and the opinions of practitioners who commented on the earlier version of the questionnaire; and (2) the present study includes a comparison of the practices of conventional and Islamic banks. The remainder of the paper is divided into four sections: Section 2 provides a brief review of the literature, Section 3 describes the conceptual framework and the methodology, Section 4 discusses the results and Section 5 presents the main conclusions, limitations and suggestions for future research. 2. Brief literature review and hypotheses Unlike studies that deal with risk management in general, published empirical studies on the RMPs of nancial institutions are relatively rare (Fatemi and Fooladi, 2006; Al-Tamimi and Al-Mazrooei, 2007). Richard et al. (2008) found that banks credit risk management is affected by the environment in which banks operate. This section offers a brief review of recently published studies that are directly relevant to this endeavor. In a study of the sensitivity to risk of large domestic banks in the USA, Linbo Fan (2004) found that prot efciency is sensitive to credit risk but not to insolvency risk or to the mix of loan products. Hahm (2004) argues that it is necessary to improve banking supervision and banks risk management to ensure successful nancial liberalization. This is based on a study of interest rate and exchange rate exposure of Korean banks before the 1997 Asia Pacic economic crisis, which found that the performance of commercial banks was signicantly associated with their pre-crisis risk exposure (Table I). Fatemi and Fooladi (2006), after investigating the current practices of credit risk management in the largest US-based nancial institutions, report that identifying

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counterparty default risk is the single most important purpose served by the credit risk models utilized. However, it should be noted that these results are based on a very low response rate, i.e. 21 responses to questionnaires sent to 100 banks. Al-Tamimi and Al-Mazrooei (2007) provide a comparative study of banks risk management in locally incorporated banks and foreign banks in the United Arab of Emirates (UAE). The results show that the three most important types of risks facing UAE commercial banks are foreign exchange risk, followed by credit risk and operating risk. However, an earlier study by Al-Tamimi (2002) reports that the main risk facing UAE commercial banks is credit risk. For risk identication (RI), he reports that inspection by branch managers and nancial statement analysis were the main methods used; while Al-Tamimi and Al-Mazrooei (2007) report that inspection by the bank risk manager, audits or physical inspections, nancial statement analysis and risk survey are the main methods used. These results indicate that banks are becoming more sophisticated in managing their risk. The authors also report that the locally incorporated banks are fairly efcient in managing risk; however, the variables such as RI, assessment and analysis have proved to be more inuential in the risk management process. Finally, their results indicate that there was a signicant difference between the UAE national and foreign banks in understanding risk and risk management (URRM), practicing risk assessment and analysis (RAA), and in risk monitoring (RMON) and controlling, but not in RI, credit risk analysis (CRA) and RMPs. On average, they report that foreign banks are better than locally incorporated banks in dealing with risk exposure. A difference in the quality of the staff is the primary reason offered by the authors to account for such signicant differences. Additionally, one could add differences in regulatory requirements that banks are subject to as a possible reason for such results. Branches of foreign banks, such as Citibank, HSBC and Standard Chartered Bank, are required to comply with the regulatory requirements that their parent companies are subject to, which might be more rigorous than those applied by the Central Bank of the UAE. Al-Tamimi (2008) studied the relationship between the readiness to implement the Basel II Accord and the resources needed to implement it in UAE banks. The results revealed that these banks are aware of the benets, impact and challenges associated with the implementation of the Basel II Accord. However, the research did not nd any positive relationship between the UAE banks readiness to implement Basel II and the impact of that implementation. Nor was the relationship between readiness and anticipated cost of implementation conrmed. No signicant difference was found in the level of preparation for the Basel II Accord between the UAE national and foreign banks. It was concluded that there was a signicant difference in the level of the UAE
Risk management aspects URRM RI RAA RMON RMPs CRA All aspects Cronbachs a 0.892 0.713 0.834 0.850 0.872 0.729 0.961

Table I. Internal consistency of the six risk management aspects

banks in relation to Basel II, based on employees educational levels. The results supported the importance of education for the implementation of the Basel II Accord. Hassan (2009) reports that, like the conventional banks, Islamic banks are also subject to a variety of risks due to the unique range of products offered. He also shows that there was a remarkable understanding of risk and risk management among the staff working in the Islamic banks of Brunei Darussalam, which proved their ability to manage risk successfully. The major risks that were faced by these banks were foreign exchange risk, credit risk and operating risk. A regression model was used to develop the results, which showed that RI, and RAA were the most inuential variables, and the Islamic banks in Brunei needed to give more attention to those variables to make their RMPs more effective. Understanding the true application of the Basel II Accord can improve the efciency of Islamic banks risk management systems. Van Greuning and Iqbal (2008) and Iqbal and Mirakhor (2011) argue that a comprehensive framework of risk management is equally applicable to a conventional or Islamic bank. The ndings of Hassan (2009) lend further support to this argument. Khan and Bhatti (2008) observed that Islamic banks face another crucial challenge to improving their risk management strategies and corporate governance because of their adherence to Islamic Shariaa (law). This should have an impact on the risk management of Islamic banks in terms of certain applications, emphasis and inclusion or exclusion. Taking into account the above review and the objectives of the study, the research questions that this study aims to address are: RQ1. Do bankers understand risk and risk management? RQ2. Do banks identify the potential risk to which they are exposed? RQ3. Do banks have in place a system for assessing and analyzing risk? RQ4. Do banks monitor and control risks efciently? RQ5. Do banks have efcient risk management? RQ6. Do banks analyze credit risk efciently? RQ7. What types of RI methods do banks use? RQ8. What are the types of risks to which banks are exposed? Based on the above review and the research questions, the following hypotheses, phrased in a null form, will be tested: H01. RMPs are not determined by URRM, RI, RAA, RMON and CRA. H02. There is no signicant difference between conventional and Islamic banks with respect to URRM, RI, RAA, RMON, CRA, RMPs and level of risk. 3. Methodology 3.1 The instrument A modied version of the questionnaire developed by Al-Tamimi and Al-Mazrooei (2007) and Hassan (2009) is used to collect the data for this study. It is divided into three parts: Part I solicits information about the respondents and the bank for which they work; Part II covers six aspects of risk management:

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(1) (2) (3) (4) (5) (6)

URRM; RI; RAA; RMON; RMPs; and CRA.

This part includes 51 statements to which respondents are invited to indicate their level of agreement based on an interval scale, where 11 statements correspond to URRM; ve, to RI; seven, to RAA; ve, to RMON, 15, to RMPs and eight, to CRA. Respondents were asked to indicate the extent of their agreement with each of the questions on a seven-point Likert scale. Part III consists of two closed questions based on an ordinal scale dealing with the risks facing the sample banks and based on binary answers about the methods of RI used. 3.2 Sample In the new banking environment, risk management is not restricted to the responsibility of the risk management department, but is the responsibility of everyone working for the bank (KPMG International, 2009). According to KPMG International (2009), bank staff should understand the organizational risk appetite, and the risk management system of checks and balances should incorporate three independent layers of defense against risk: business units, risk management function and internal audit. Therefore, the target population for the survey is not limited to risk management specialists but extends to include all staff. Furthermore, the population is similar to that used in the studies of Al-Tamimi and Al-Mazrooei (2007) and Hassan (2009). Banks operating in Bahrain were assigned to students in the Islamic Finance course in the rst semester of 2009/2010. Before approaching the assigned banks, students were trained to administer the questionnaire. To maintain records of the questionnaires, students were asked to deposit the returned completed questionnaires soon after receiving them. Of 700 questionnaires distributed, 560 were returned. In total, 26 questionnaires were excluded because of missing data. The resulting response rate was 74.9 percent. Although the response is considered very high, testing was conducted for the possibility of non-response bias. Evidence of non-response bias was obtained by examining differences between the responses of 30 early and late 30 respondents. The comparison indicated that there were no signicant differences between the two groups in terms of their responses to the questions in the questionnaire. To assess the reliability of the instrument, Cronbachs a was employed on the six aspects of risk management included in the questionnaire. This measure consists of estimates of how much variation in scores of different variables is attributable to chance or random errors (Selltiz et al., 1976). As a general rule, a coefcient greater than or equal to 0.7 is considered acceptable and a good indication of construct reliability (Nunnally, 1978). The internal consistency measured by Cronbachs a ranges between 0.713 for RI to 0.892 for URRM, indicating that the results are reliable. It is worth noting that all values of Cronbachs a reported by Al-Tamimi and Al-Mazrooei (2007)

and Hassan (2009) are below 0.7. This indicates that construct reliability is better for the results of the current study. The characteristics of the respondents are shown in Table II. The questionnaires were answered primarily by bankers occupying middle management positions or above, and the majority of the respondents (77.5 percent) possess experience of ve years or longer. All respondents held an academic and/or a professional qualication such as Chartered Financial Analyst, Certied Public Accountant or Financial Risk Management. Of the respondents, 52.5 percent work in conventional banks, while the rest work in Islamic banks. The majority of the respondents (75 percent) work for locally incorporated banks. Overall, we can conclude that those who took part in the survey have adequate knowledge about RMPs operating in their banks. In order to obtain a measure of response reliability, interviews (lasting between 45 minutes and 1 hour)
Attributes Gender Female Male Length of experience Less than ve years Five years and less than ten years Ten years or longer Position Executive/managerial Middle management Other Type of job Audit Credit Finance Investment IT Operations Private banking Risk Treasury Other Highest qualication BSc Professional (accounting, nance) Graduate degree Risk management professional qualication Other Type of license Retail conventional Retail Islamic Wholesale conventional Wholesale Islamic Type of bank Locally incorporated Foreign bank Frequency 209 315 205 201 118 124 171 229 60 66 116 63 27 64 32 48 44 4 312 123 60 16 13 175 166 100 83 393 131 % 39.9 60.1 39.1 38.4 22.5 23.7 32.6 43.7 11.5 12.6 22.1 12.0 5.2 12.2 6.1 9.2 8.4 0.8 59.5 23.5 11.5 3.1 2.5 33.4 31.7 19.1 15.8 75.0 25.0

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Table II. Characteristics of the sample

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were conducted with four randomly selected respondents approximately six months after the questionnaires were received. No inconsistencies were found between the questionnaire responses and the interview ndings. 4. Analysis of the results 4.1 Understanding risk and risk management Appreciation of banks risk exposure by board members, executive management and other employees are of extreme importance for effective risk management. In addition, banks in Bahrain are required to comply strictly with the requirements pertaining to managing risk exposure set out in the rule book published by the Central Bank of Bahrain (CBB), the bank regulator. The CBB is known to be very prudent; and as a result, one would expect banks in Bahrain to comply strictly with the rules. The roles of banking regulators are more important as a result of the implementation of the Basel II Accord and the recent global nancial crisis. To capture the URRM aspect of risk management, 11 statements are included in the questionnaire. The summaries of the responses are presented in Table III. The mean responses of all groups to the statements range between 4.95 and 5.78, with an overall average of 5.34. The highest mean is for the statement, Managing risk is important to the performance and success of the bank. The lowest mean is for the statement, It is crucial to apply the most sophisticated techniques in risk management; followed by The bank aims is to extend the application of advanced risk management techniques. This indicates that bankers do not perceive those techniques to improve signicantly the way risks are managed and/or those techniques are not understood well by those staff. Overall, these results indicate that staffs of banks operating in Bahrain have a good understanding of risk and risk management, which gives an indication of the ability of these banks to manage risk efciently in the future. These results are qualitatively similar to those reported by Al-Tamimi and Al-Mazrooei (2007) and Hassan (2009). The sample is divided into two groups: those working for conventional banks and those working for Islamic banks. This makes it possible to compare the perceptions of the two groups. Table III presents the summary of the responses. The mean responses of Islamic bankers to all statements exceed the mean responses of the other group. The test statistics indicate that the mean responses of the two groups to the statements are not signicantly different, with the exception of four statements. 4.2 Risk identication RI is the rst step in managing risk by banks. Failure to identify risk makes it impossible to manage. To capture the RI function performed by banks, the questionnaire includes ve questions. Table IV provides the results of means and standard deviations for the answers to the ve statements for all respondents and for the two subgroups. The average of the means is 4.876, which indicates that banks operating in Bahrain clearly identify the potential risk relating to their declared aims and objectives. The mean responses of all questions exceed the midpoint (i.e. 4) on the seven-point Likert scale. This result is also consistent with the conclusion regarding understanding risk, as the more staff understand risk, the easier they can identify risk. Furthermore, this result for RI is consistent with those reported by Al-Tamimi and Al-Mazrooei (2007) and Hassan (2009). The t-statistics indicate that the mean responses of conventional and Islamic bankers do not signicantly differ from each other,

222

SDa Mean SD Conventional tb 2 1.482 2 0.549 2 0.647 2 1.515 2 2.873 * 2 2.349 * 2 2.600 * 2 0.457 1.539 1.405 5.46 1.135 5.43 1.439 0.988 2 0.162 2 3.092 * 5.37 2 1.839 * * 1.681 2 2.401 * 5.21 5.32 5.25 5.33 5.68 4.77 4.89 5.25 5.51 5.37 4.96 5.24 1.613 1.524 5.39 1.524 5.46 1.439 1.755 5.62 1.479 1.787 5.23 1.505 1.543 5.15 1.434 1.568 5.89 1.507 1.513 5.42 1.465 1.589 5.33 1.575 1.512 5.52 1.561 Mean SD Islamic 1.537 1.582 1.489 1.541 1.503 1.666 1.639 1.529 1.530 1.530 1.573 1.074

No. 379 386 397 437 344 355 402 414 395 385 392 5.31
b

Questions 72.6 73.8 75.9 83.4 66.3 67.7 76.7 79.3 75.7 73.4 75.0 5.34 5.15 5.38 5.53 5.43 5.05 4.95 5.78 5.37 5.29 5.42

Frequency of 5-7 % Mean Whole sample

1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

There is a common understanding of risk management across the bank Responsibility for risk management is clearly set out and understood throughout the bank Accountability for risk management is clearly set out and understood throughout the bank Managing risk is important to the performance and success of the bank It is crucial to apply the most sophisticated techniques in risk management The bank aims to extend the application of advanced risk management techniques It is important for my bank to emphasize continuous review and evaluation of the techniques used in risk management Applications of risk management techniques reduce costs or expected losses Stress testing output is understood by senior management and board My bank has an effective risk management strategy in place My bank has an effective risk management framework (infrastructure, process and policies) in place Average
a

Notes: Signicant at: *5 and * *10 percent; SD standard deviation; t-statistics

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Table III. Responses to statements about URRM

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No. 381 264 363 357 360 4.88 1.051 69.0 4.97 1.569 4.97 4.899 68.1 5.09 1.689 5.01 1.702 1.642 1.090 69.3 5.05 1.479 5.10 1.566 50.4 4.13 1.832 4.31 1.809 3.94 5.00 5.18 4.97 4.87 73.1 5.14 1.451 5.07 1.476 5.22 1.421 1.843 1.377 1.673 1.488 1.007

Table IV. Responses to statements about RI SDa Mean SD Conventional Mean SD Islamic Frequency of 5-7 % Mean Whole sample tb 2 1.242 2.201 * 0.764 2 1.147 2 0.07 0.222

Questions

1.

2.

3.

4.

5.

The bank carries out a comprehensive and systematic identication of its risk relating to each of its declared aims and objectives The bank nds it difcult to identify, and classify its main risks Changes in risk are recognized and identied by the banks rules and responsibilities The bank is aware of the strengths and weaknesses of the risk management systems of other banks My bank has developed and applied procedures for the systematic identication of investment opportunities Average

Notes: Signicant at: *5 percent; aSD standard deviation; bt-statistics

with one exception as shown in Table IV. Like the results reported by Al-Tamimi and Al-Mazrooei (2007) and Hassan (2009), these results indicate that banks do not nd it difcult to identify and classify the main risk they face. However, the conventional banks in Bahrain appear to face more difculties in prioritizing their main risks compared with Islamic banks. Respondents were asked to state whether or not their banks use the RI methods included in the questionnaire. Table V depicts the frequency and the percentage of the responses that indicate that they used the RI method. The entire sample ranked the methods inspection by the bank risk staff, audit and physical inspection and nancial statement analysis as the three methods most widely used to identify types of risks. Although both Al-Tamimi and Al-Mazrooei (2007) and Hassan (2009) report a similar ranking, their results indicate that more than 90 percent of the respondents indicate the use of these methods, while the results of the current study indicate that none of the methods is used by 90 percent of the banks. The least used method is SWOT analysis, with only 61.7 percent of all respondents indicating their banks use this method. Similar results are found for the subgroups from conventional and Islamic banks. Overall, the results show that conventional and Islamic banks in Bahrain use more traditional methods of RI than sophisticated methods. 4.3 Risk assessment and analysis Risks are generally identied at both the individual entity and the fully consolidated levels of an institution on the basis of management policies. While most risks are identiable, not all are quantiable. An example of an identiable but unquantiable risk is legal risk. The next step in risk management, after RI, is to assess and analyze the identied risks. The mean responses of the entire sample to the seven components included in the questionnaire to capture this aspect of risk management (Table VI)
Frequency % Rank Frequency % Rank Frequency % yes yes yes Whole sample Conventional Islamic 426 419 402 321 386 318 N/A 342 353 362 81.3 80.0 77.2 62.0 74.4 61.7 1 2 3 8 4 9 232 220 211 157 199 169 N/A 177 185 191 84.2 80.0 58.4 57.1 72.4 61.5 1 2 8 9 3 7 194 199 191 164 187 149 178 165 168 171 77.9 79.9 76.7 65.9 75.4 59.8 71.5 66.3 67.5 68.7

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Rank 2 1 3 9 4 10 5 8 7 6

No. Questions 1. Inspection by the bank risk staff 2. Audit and physical inspection 3. Financial statement analysis 4. Risk survey 5. Process analysis 6. SWOT analysis 7. Inspection by Shariaa auditors (Islamic banks only) 8. Benchmarking 9. Scenario analysis 10. Internal communication

66.3 68.1 69.7

7 6 5

64.4 67.3 69.5

6 5 4

Note: N/A not applicable

Table V. Responses regarding RI methods

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No. 397 378 400 400 406 398 76.1 5.36 1.504 5.23 1.574 77.5 5.37 1.569 5.36 1.558 5.38 5.51 76.3 5.19 1.496 5.12 1.483 5.27 76.5 5.35 1.529 5.27 1.552 5.44 1.502 1.509 1.584 1.412 76.1 72.3 5.21 5.16 1.362 1.507 5.19 5.10 1.376 1.556 5.23 5.22 1.350 1.451

Table VI. Responses to statements about RAA SDa Mean SD Conventional tb 2 0.291 2 0.869 2 1.273 2 1.167 2 0.127 2 2.123 * Mean SD Islamic Frequency of 5-7 % Mean Whole sample 300 5.16 57.3 4.51 1.671 1.065 4.50 5.10 1.601 1.113 4.51 5.22 1.749 1.001 2 0.084 2 0.208

Questions

1. 2.

3.

4.

5.

6.

7.

My bank assesses the likelihood of risk occurring The banks risk is assessed by using quantitative analysis methods The banks risk is assessed by using qualitative analysis methods (e.g. high, moderate and low) My banks response to analyzing risk includes assessment of the costs and benets of addressing risk My banks response to analyzing risk includes identifying, prioritizing of risk and selecting those that need active management My banks response to analyzing risk includes identifying, prioritizing risk treatments where there are resource constraints on risk treatment implementation My bank relies on the output of quantitative data without human judgment Average

Notes: Signicant at: *5 percent; aSD standard deviation; bt-statistics

range between 4.51 and 5.37 with an average of 5.16. The lowest mean response is to the statement My bank relies on the output of quantitative data without human judgment. This indicates that banks give important consideration to human judgment as well as quantitative analysis. Overall, the results indicate that banks in Bahrain are efcient in assessing and analyzing risk. These results are qualitatively similar to those reported by Al-Tamimi and Al-Mazrooei (2007) and Hassan (2009). Table V summarizes the responses of conventional and Islamic bankers which indicate that the mean responses to the seven statements by Islamic bankers are higher than those of their conventional counterparts. To test the hypothesis that the mean responses of the samples are not signicantly different, t-statistics were used. The results show that the mean responses of the groups to the statements are not signicantly different, with the exception of My banks response to analyzing risk includes identifying, prioritizing risk treatments where there are resource constraints on risk treatment implementation. 4.4 Risk monitoring The primary components of risk management are internal controls and management information systems for controlling, monitoring and reporting risks. RMON aims to determine whether the risk exposures are in line with the desired level and are dealt with properly. To capture this aspect of risk management, ve statements are included in the questionnaire. Table VII reports the responses of the whole sample, conventional bankers and Islamic bankers. The mean responses to the ve statements range between 5.16 and 5.41, with an overall average of 5.29. These results indicate that bankers believe that banks operating in Bahrain have efcient RMON and control system. The mean of the responses of conventional bankers is lower than that of Islamic bankers. The mean responses of Islamic bankers on the ve components of the RI aspect of risk management are higher than those of conventional bankers. To test the hypothesis that the mean responses of conventional and Islamic bankers are not signicantly different from each other, we used the t-test. The results of the test are shown in Table VII. They indicate that there are no signicant differences between the mean responses of the groups, with the exception of the mean responses to the statement Reporting and communication processes within my bank support the effective management of risk. 4.5 Risk management practices Banks boards and staff understanding of the risks faced and having effective risk management strategies and frameworks (infrastructure, process and policies) in place do not guarantee that banks manage their risk exposure effectively. The gap between what is expected from bank staff and RMP is one of the reasons for banking failure. In total, 15 statements are included in the questionnaire to capture the RMPs. Table VIII summarizes the responses to those statements. The overall mean response is 5.23, and means responses range between 4.38 and 5.51. The lowest mean response (very close to the midpoint of the Likert scale) was that of the statement Risk management techniques are used for regulatory purposes only. These results lend further support to the responses to the statements that capture URRM, in which the respondents agreed that effective risk management improves banks performances. These results also indicate that the banks staffs are aware of the application of the Basel Capital Accord, which was introduced to improve the efciency of banks risk management.

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No. 384 403 395 403 406 5.29 1.210 77.8 5.26 1.478 5.21 5.21 76.9 5.41 1.574 5.38 1.633 1.526 1.274 75.4 5.24 1.602 5.16 1.688 5.34 5.44 5.32 5.37 76.9 5.39 1.550 5.20 1.623 5.60 73.3 5.16 1.450 5.14 1.463 5.19 1.438 1.439 1.500 1.510 1.423 1.133

Table VII. Responses to statements about RMON SDa Mean SD Conventional Mean SD Islamic Frequency of 5-7 % Mean Whole sample tb 2 0.432 2 2.977 * 2 1.273 2 0.432 2 0.872 2 1.813 * *

Questions

1.

2.

3.

4.

5.

Monitoring the effectiveness of risk management is an integral part of routine management reporting Level of control by the bank is appropriate for the risk that it faces Reporting and communication processes within my bank support the effective management of risk The banks response to risk includes an evaluation of the effectiveness of the existing controls and risk management responses The banks response to risk includes action plans in implementation decisions about identied risk Average

Notes: Signicant at: *5 and * *10 percent; aSD standard deviation; bt-statistics

SDa Mean SD Conventional tb 2 0.070 2 0.036 2 0.752 2 1.730 2 1.871 2 1.584 2 2.208 * 2 1.562 1.331 1.283 1.389 1.511 1.442 1.419 1.750 5.46 1.200 4.24 5.64 1.759 0.934 2 0.391 2 2.026 * 2 2.741 * 2 1.448 2 2.655 * 2 1.001 1.575 1.780 1.770 1.505 1.527 5.28 5.69 5.48 5.10 5.39 1.726 2 1.978 * 5.39 5.32 5.31 4.91 4.92 5.37 5.37 5.40 5.10 5.05 5.31 5.27 4.76 5.26 4.50 1.386 5.15 1.499 5.60 1.350 1.705 5.66 1.451 1.500 5.57 1.432 1.704 5.20 1.733 1.748 5.16 1.557 1.721 5.42 1.471 1.595 5.32 1.498 1.613 5.41 1.481 Mean SD Islamic 1.551 1.548 1.606 1.663 1.722 1.470 1.594 1.433 1.359 1.448 1.616 1.654 1.483 1.477 1.757 1.085

No. 402 400 402 365 374 418 415 405 356 380 411 401 312 399 283 5.54
b

Questions 76.7 76.3 76.7 69.7 71.4 79.8 79.3 78.2 69.7 73.8 78.6 77.5 60.0 76.4 54.0 4.38 5.16 5.50 5.37 4.93 5.32 5.12 5.49 5.51 5.47 5.06 5.02 5.36 5.32 5.40

Frequency of 5-7 % Mean Whole sample

1.

2.

3.

4.

5.

6.

7.

8.

9.

10. 11. 12. 13. 14.

15.

The banks executive management regularly reviews the organizations performance in managing its business risk My bank is highly effective in continuous review/ feedback on risk management strategies and performance My banks risk management procedures and processes are documented and provide guidance to staff about managing risks My banks policy encourages training programs in the area risk management as well as ethics My bank emphasizes the recruitment of highly qualied people who have knowledge of risk management pertaining to the type of the bank Effective risk management is one of the objectives of my bank It is too risky to invest my banks funds in one specic sector of the economy The application of Basel Accord II improved of efciency and RMPs in my bank in particular My banks capital is adequate if the ratio of capital to total risk-weighted assets is equal to the CAR prescribed by the CBB I consider the level of RMPs in my bank to be excellent Risk management is given great importance by my bank Senior management lead risk management from the top Risk factors are consolidated across all banks operations Risk management techniques are used as management tools Risk management techniques are used for regulatory purposes only Average
a

Notes: Signicant at: *5 and * *10 percent; SD standard deviation; t-statistics

229

Table VIII. Responses to statements about RMPs

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The responses of those working in conventional and Islamic banks are shown in Table VIII. With the exception of the mean response to the statement Risk management techniques are used for regulatory purposes only, the means responses to the statements by Islamic bankers are higher than those of the conventional bankers. The t-statistics indicate that the differences between the mean scores of the two groups are not signicantly different from zero, with three exceptions. 4.6 Credit risk assessment Banks face different types of risk. However, credit risk is the most signicant of those risks. This is evident in the calculation of the capital adequacy ratio according to Basel II requirements. For this reason, eight statements are included in the questionnaire to capture the perception of the respondents of this risk. Table IX reports the samples responses on these questions. The mean of the responses to the eight questions is 5.34, which provides evidence about the efciency of credit risk management by the Bahraini banking industry. For the whole sample, the most important aspect is the risk rating of applicants, followed by the specic analysis of the applicants character, capacity, collateral and conditions. The need for applicants to provide sufcient collateral is considered, based on the mean of the responses, the fth most important aspects of CRA. Requiring applicants to adhere to certain covenants as pre-conditions for granting credit or executing transactions came in seventh place with a mean response rate of 5.35. Responses to the eight statements range between 5.04 and 5.56. The mean responses to all questions of respondents working in Islamic banks are higher than those of their conventional counterparts, but only two are signicantly different. 4.7 Types of risks Banks are exposed to different types of risks. The importance of those types depends on the asset portfolio, the way they conduct their business lines (i.e. conventional or Islamic), and regulatory requirements to which banks are subjected. To identify the importance of the types of risks to which banks are exposed, respondents were asked to state their perceptions of the level of importance of 15 different types of risks on a seven-point Likert scale ranging from very important (7) to not important at all (1). Table X presents a summary of the responses and the t-statistics to test the hypothesis that the mean responses of the conventional and Islamic bankers do not differ signicantly. The types of risk are shown in terms of relative importance based on the mean responses of the whole sample. As shown in Table X, the mean responses for all types of risk, with the exception of residual risk, are higher than 5. The results show that the most important risk banks face is credit risk. This type of risk has long been identied as the dominant risk for banking rms and is an inherent part of their core lending business. Credit extended to customers and customers deposits generally represents the most signicant asset and liability classes on a banks balance sheet. Liquidity risk is ranked the second most important risk, while it is ranked fourth in the study of Al-Tamimi and Al-Mazrooei (2007) and Hassan (2009). The difference in ranking is probably due to the period during which the data for the study was collected, which was a year after the beginning of the global nancial crisis; the liquidity crunch was central to that crisis. Operational risk is ranked third by the respondents. This risk is dened as the risk of direct or indirect loss resulting from inadequate or failed internal processes, people and systems or from external events. The level of importance of this

230

SDa Mean SD Conventional tb 2 1.449 2 2.298 * 2 2.405 * 2 1.197 2 0.586 2 0.918 1.451 1.368 5.43 0.855 2 0.090 2 0.966 2 2.218 * 1.118 5.25 5.22 5.29 5.26 5.34 4.99 5.33 5.27 5.27 1.528 5.39 1.634 5.35 1.628 5.11 1.454 1.559 5.41 1.335 1.593 5.42 1.376 1.681 5.60 1.433 1.797 5.67 1.204 1.411 5.43 1.348 Mean SD Islamic 1.383 1.575 1.532 1.495 1.465 1.548 1.549 1.455 1.142

No. 421 395 411 393 412 366 404 411 5.45
b

Questions 80.3 75.7 78.7 75.6 78.9 70.1 77.8 78.7 5.32 5.34 5.04 5.37 5.34 5.56 5.44 5.33

Frequency of 5-7 % Mean Whole sample

My bank undertakes a credit worthiness analysis before granting credit or executing transactions Before granting capital or credit my bank undertakes specic analysis including the applicants character, capacity, collateral and conditions My banks borrowers are classied according to risk factors (risk rating) It is essential to require sufcient collateral from small borrowers My banks policy requires collateral for granting capital, extending credit, or making transactions It is preferable to require collateral against some capital and not all of it The level of capital (credit) granted to defaulting clients must be reduced The bank requires applicants to adhere to certain covenants as pre-conditions for granting credit or executing transactions Average
a

Notes: Signicant at *5 and * *10 percent; SD standard deviation; t-statistics

Table IX. Responses to statements addressing CRA

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Questions 446 441 428 418 412 402 397 399 213c 188d 381 407 387 391 379 288 5.48 5.55 5.39 5.41 5.31 5.38 5.04 5.57 85.1 84.2 81.7 79.8 78.6 76.7 75.9 76.6 77.5 75.5 72.8 77.8 74.1 74.6 72.6 58.3 6.01 5.91 5.78 5.72 5.58 5.52 5.47 5.39 5.31 5.48 5.39 5.31 5.30 5.28 5.23 4.76 5.42 1.566 1.604 1.594 1.625 1.504 1.592 1.67 1.613 1.524 1.476 1.592 1.366 1.534 1.583 1.556 1.666 1.135 5.94 1.600 5.80 1.641 5.64 1.706 5.61 1.704 5.49 1.541 5.43 1.593 5.42 1.689 5.26 1.705 5.31 1.524 Not applicable 5.24 1.63 5.23 1.387 5.21 1.554 5.26 1.644 5.08 1.615 4.51 1.836 5.34 1.202 6.09 6.04 5.92 5.84 5.68 5.61 5.52 5.53

1. Credit risk 2. Liquidity risk 3. Operating risk 4. Legal risk 5. Regulatory risk 6. Reputation risk 7. Strategic risk 8. Solvency risk 9. Interest rate risk (conventional banks only) 10. Rate of return risk (Islamic banks only) 11. Settlement risk 12. Concentration risk 13. Price (equity) risk 14. Foreign-exchange risk 15. Country (political) risk 16. Residual risk Average

Notes: Signicant at: *5 and * *10 percent; aSD standard deviation; bt-statistics; cout of 275 respondents; dout of 349 respondents

Table X. Risk faced by conventional and Islamic banks Frequency of 5-7 % Mean Whole sample tb SDa Mean SD Conventional Mean SD Islamic 1.528 2 1.099 1.555 2 1.715 * * 1.45 2 2.030 * 1.526 2 1.645 1.460 2 1.429 1.588 2 1.303 1.651 2 0.725 1.495 2 1.015 Not applicable 1.476 1.537 2 2.291 * 1.339 2 1.326 1.509 2 1.553 1.515 2 0.397 1.474 2 2.215 * 1.406 2 3.643 * 1.062 2 2.256 *

risk stems from the fact that it is part of the capital adequacy ratio calculated in accordance with the requirements of Basel II. Operational risk includes legal and regulatory risks which the respondents ranked third and fourth, respectively. Foreign-exchange risk, unlike the results of Hassan (2009) which ranked this as the most important risk, was ranked 13th by the respondents. The low ranking of the foreign exchange risk by the sample is probably due to the fact that the Bahraini dinar is xed against the US dollar. Furthermore, the banks assets in foreign countries do not use the US dollar or their currencies do not have a xed rate against the US dollar as of the August 2011; this represents 20.7 percent of the retail banking assets according to the CBB (2011). Those working in conventional and Islamic banks reported and ranked similarly the same top six types of risk: credit, liquidity, operational, legal, regulatory and reputational. These results are somewhat similar to those reported by Arifn et al. (2009); they found that Islamic bankers perceived credit risk as the most important. However, those ndings contradict Khan and Ahmed (2001), Al-Tamimi and Al-Mazrooei (2007) and Hassan (2009). The mean responses of all types of risk exceed 5, with the exception of the mean responses of residual risk by bankers in conventional banks. The mean responses of the types of risks included in the questionnaire by the Islamic bankers exceed those of conventional bankers. The t-test is used to test the hypothesis that the samples perceived the level of importance of the types of risk similarly. According to the results, the overall risk level facing Islamic banks is perceived to be signicantly higher than that faced by conventional banks. Furthermore, the t-statistics indicate that there are no signicant differences between the mean responses of the two groups, with the exception of liquidity, operational, settlement, country (political) and residual risks. With those types of risks, it is found that Islamic banks face signicantly higher risks than their conventional counterparts. The higher liquidity risk faced by Islamic banks may be the result of: . a lack of active money markets for Islamic Shariaa compliant money market instruments; . restricted access to short-term nancing options that are available for conventional banks, including such funding from the CBB; and . maintaining high cash balances out of the balance of current accounts held to cover clients demands for withdrawals from their accounts (Iqbal and Mirakhor, 2011). As for higher operational risk facing Islamic banks, this is due partly to a unique type of risk facing Islamic banks; namely, Shariaa risk, which is a part of operational risk. This unique risk is due to the need to make their products Shariaa-compliant. Unlike conventional bank products, products of Islamic banks lack standardization. In order to ensure that their products are Shariaa-compliant, Islamic banks should obtain the approval of their respective Shariaa supervisory boards. However, this approval may not ensure acceptability of those products by other Shariaa supervisory boards of other Islamic banks or clients. Another dimension of Shariaa risk is legal risk. Islamic banking products can involve a number of separate contracts, giving rise to additional legal risks. For example, in the case of murabahah[1] transactions, which represent the dominant investment of Islamic banks, the bank has to buy an item and then sell

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it under different payment terms. Each step takes time and involves a new contractual agreement, magnifying the scope for disagreements and complications. Shariaa risk may lead to a loss of prot generated from non-Shariaa-compliant sources. The settlement risk to Islamic banks, as a form of credit risk, arises when an Islamic bank pays money such as salam[2] or istisna[3] contracts or delivers assets such as murabahah contracts before receiving its own assets or cash, thereby exposing it to potential loss (Khan and Ahmed, 2001). Such practices make the level of settlement risk faced by Islamic banks higher than that which faces conventional banks. The residual risk is the risk that third party claims must be met rst before the shareholders receive any return on capital. Unlike conventional banks, which provide loans fully backed by the borrowers assets and thus shift the entire risk to borrowers, some of nancial products of Islamic banks, such as mudharaba[4] and musharakah[5], are structured in a way that Islamic banks share the risk of the asset with the clients (Ebrahim, 2000). In addition, Islamic banks, unlike conventional banks, have limited opportunity to charge clients for the additional risks they face in case of delinquency and loan restructuring. Consequently, Islamic banks face higher residual risk compared with conventional banks. The lack of signicant differences between the types of banks regarding credit risk warrants an explanation. Based on Islamic banking principles of risk sharing and prot-and-loss sharing, it is expected that the credit risk facing Islamic banks should be signicantly higher than that of conventional banks. One of the most important explanations is that the murabahah is the dominant investment instrument of the asset portfolio of Islamic banks (Rosly, 2011), and prot-sharing nancing, such as mudharabah and musharakah has remained negligible in operations of Islamic banks. As of August 2011, the latter represent not more than 6.12 percent of the assets managed by Islamic banks in Bahrain (CBB, 2011). Although, theoretically, banks are exposed to business and credit risks when they enter into contracts of banking murabahah, in reality such contracts are considered to be akin to loans granted by conventional banks and as such are gross violations of Shariaa principles (Khan and Bhatti, 2008). This is because Islamic banks: . insure themselves against the risk of damage to goods, theft and destruction and levy charges against the clients (Bashir, 1999), or make the necessary arrangements with asset dealers or charge the client hamish jiddiyah (security deposit)[6] to eliminate business risks that they may be exposed to during the ownership period before signing the murabahah contract with clients; . use the market interest rate to determine the mark-up (interest rate) charged to clients; . charge higher mark-up on murabahah contracts with longer terms, and higher credit risk; and . use the market interest rate as a benchmark for setting the mark-up they charge to clients (borrowers). Overall, the unique risks facing Islamic banks lead them to face higher total risk compared with conventional banks.

4.8 Testing the hypotheses regarding RMPs This paper examines the relationship between RMPs and the ve aspects of the risk management process (H01): (1) URRM; (2) RI; (3) risk analysis and assessment; (4) RMON; and (5) CRA. Following Al-Tamimi and Al-Mazrooei (2007), the function of RMPs is as follows: RMPs f URRM; RAA; RI; RMON; CRA; bank type Unlike Al-Tamimi and Al-Mazrooei (2007), a dummy variable is included in the model to capture the possible effect of the type of bank (conventional or Islamic) on the RMPs. Table XI presents the regression results. The variance information factors of the independent variables are less than 5 and tolerance of more than 0.215 indicates that multicolinearity does not pose a problem in interpreting these results (Kutner et al., 2003). Furthermore, the Durbin-Watson statistic of 2.005 indicates no serious autocorrelation exists. The results show that the constant and coefcients of all independent variables, including the dummy variable, have a positive sign. Also, the coefcients of URRM, RAA, RI, RMON and CRA are signicant at the 5 percent level or less. The adjusted R 2 is 81.6 percent and highly signicant. These results indicate that the null hypothesis that states no effect of URRM, RAA, RI, RMON and CRA on RMPs is rejected. Our results are partially similar to those reported by Al-Tamimi and Al-Mazrooei (2007) and Hassan (2009) who found that only the coefcient of RI and RAA are signicant. These differences may be attributed to the prudent and vibrant CBB which follows a risk-based supervision approach (IMF, 2006). To test H02 the analysis of variance (ANOVA) was applied on each of the six aspects of risk management and risks facing banks. The results are presented in Table XII. Using the 5 percent level of signicance, the results indicate that there are no signicant differences in any aspect of risk management between conventional and Islamic banks, with the exception of URRM and level of risk. This is an unexpected result, as both types
Variable Constant URRM RAA CRA RI RMON Banks type Adjusted R 2 (%) F-statistics Durbin-Watson Estimates 0.175 0.362 * 0.205 * 0.275 * 0.057 * 0.118 * 0.024 81.6% 353.569 * 2.005 SE 0.135 0.043 0.035 0.036 0.029 0.033 0.043 Standardized b 0.359 0.200 0.258 0.056 0.131 0.011 Tolerance 0.215 0.338 0.343 0.481 0.289 0.973 VIF 4.648 2.958 2.918 2.079 3.459 1.028

Risk management practices 235

Note: Signicant at: *5 percent or less

Table XI. Regression results: dependent variable RMPs

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of bank are subject to the same regulatory requirements and a regulatory system that maintains closely aligned prudential regulations for both types of banks to guarantee as far as possible a level playing eld (IMF, 2006). However, Islamic banks are exposed to additional types of risks that are unique to those banks, such as Shariaa risk, and some risks arising from prot-sharing investment deposits (Khan and Ahmed, 2001; Arifn et al., 2009). Additionally, the structure of some products of Islamic banks make them share asset risks with their clients (borrowers). This explains the ndings that show Islamic banks face higher risk than those of conventional banks because the conventional banks protect themselves by granting loans fully backed by the borrowers assets and thus shift the entire risk to the other party. 5. Conclusions, implications, limitations and further research The purpose of this paper is to report the results of an empirical study of the RMPs of conventional and Islamic banks operating in Bahrain. A questionnaire was used to obtain the information needed to achieve the studys objectives. The main conclusions of the study are: . bankers in Bahrain are aware of the importance and the role of effective risk management in reducing costs and improving bank performance; . banks in Bahrain have in place effective risk strategies and effective risk management frameworks (infrastructure, process and policies); . the three most important types of risk facing banks operating in Bahrain are credit risk, followed by liquidity and operating risk; . banks are somewhat effective in assessing and analyzing risks, RMPs, RMON and RI; . the quality of RMPs is determined by URRM, RI, RAA and CRA; and . the RMPs, RI, RAA and CRA of Islamic banks do not differ signicantly from those of conventional banks, although the types of banks differ signicantly from each other with respect to their URRM. Overall the results show that Islamic banks face higher levels of risk than conventional banks. It is found that Islamic banks face higher liquidity, operational, settlement, country and residual risks than their conventional counterparts. These results are attributable to differences in the products of both types of banks that lead to unique risks to Islamic banks.
Aspect URRM RI RAA CRA RMON RMPs Risk Note: Signicant at: *5 percent or less F-statistics 5.338 3.083 0.065 1.227 2.469 3.763 5.025 Signicant level 0.021 * 0.080 0.800 0.268 0.117 0.053 0.025 *

Table XII. The results of ANOVA for conventional banks and Islamic banks

The results of the study have implications for clients, banks management, investors and regulators. Depositors should know that they are facing higher risks when they deal with Islamic banks, and they would therefore expect to receive a higher rate of returns. Also, borrowers are expected to pay a higher prot (interest) rate to Islamic banks because those banks share the asset risk with them. However, competition with conventional banks may put them at a disadvantage, which reduces their ability to charge a higher prot rate. As for management and regulators, knowledge of the unique types of risk facing each type of bank should lead to the development of special risk management techniques and monitoring procedures that are suitable for those risks, in addition to enhancing transparency. Finally, investors holding shares in Islamic banks are expected to hold stocks with relatively high unsystematic risk compared with stocks of conventional banks. This is an important result for portfolio construction and management. The results of this study should be interpreted in the light of a number of limitations: . the conditions facing banks in Bahrain during the period in which the questionnaires were distributed might have affected some of the results, especially the type of risk facing the banking industry; and . although the response rate is very high, there was no evidence of non-response bias, and the responses were highly consistent internally, the study relies on survey methodology which measures the beliefs, but not necessarily the actions, of bankers. Therefore, caution should be taken in generalizing the ndings. In summary, additional research is recommended in order to further understanding of RMPs of conventional and Islamic banks. This could be achieved by studying: . risk management techniques used to mitigate risk exposure; . the specic risks to which banks are exposed, such as liquidity, market (price) and operational risk; . the role of boards of directors and regulators in enhancing RMPs; and . banks transparency with regard to risk management. An important effect of Shariaa is that all investments are, in effect, backed by a physical asset, and there cannot be pure speculation in money terms alone. This should have substantial implications on the way Islamic banks handle their risks. For example, they should be much less highly geared than traditional banks and should not be trading in options, which did so much to produce the recent economic and nancial crisis. In the light of those considerations, it was very surprising that employees of Islamic banks and traditional banks should have such similar views about some aspects of risk management. This could be another focus for future research.
Notes 1. A form of nancing, often used to nance asset purchases or for consumer loans or conventional trade nance. The bank buys the asset on a cash basis before selling it to the client (borrower) on credit.

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2. A sales contract in which the price is paid in advance at the time of contracting against delivery of the purchased goods/services at a specied future date. 3. A form of sale in which a commodity is sold before it comes into existence. 4. Mudharabah is venture capital funding of an entrepreneur who provides labor while nancing is provided by the bank so that both prot and risk are shared.

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5. In musharakah nancing, the Islamic bank contributes the depositors funds to a joint enterprise with the client (an entrepreneur). Generally, clients manage all the affairs of a musharakah business, and they share the prot and loss made on the musharakah investment with the Islamic bank. 6. A certain amount of money taken from a customer who places an order to purchase as a security for his/her promise. References Al-Tamimi, H.A.H. (2002), Risk management practices: an empirical analysis of the UAE commercial banks, Finance India, Vol. 16 No. 3, pp. 1045-57. Al-Tamimi, H.A.H. (2008), Implementing Basel II: an investigation of the UAE banks Basel II preparations, Journal of Financial Regulation and Compliance, Vol. 16 No. 2, pp. 173-87. Al-Tamimi, H.A.H. and Al-Mazrooei, F.M. (2007), Banks risk management: a comparison study of UAE national and foreign banks, The Journal of Risk Finance, Vol. 8 No. 4, pp. 394-409. Arifn, N.M., Archer, S. and Abdul Karim, R.A. (2009), Risks in Islamic banks: evidence from empirical research, Journal of Banking Regulation, Vol. 10 No. 2, pp. 153-63. Bank for International Settlements, Financial Stability Board (2009), Risk Management Lessons from the Global Banking Crisis of 2008, Bank for International Settlements, Basel. Bashir, M. (1999), Risk and protability measures in Islamic banks: the case study of two Sudanese banks, Islamic Economic Studies, Vol. 6 No. 2, pp. 1-26. CBB (2011), Statistical Bulletin, Central Bank of Bahrain, Manama. Ebrahim, M.S. (2000), Pricing asset backed Islamic nancial instruments, International Journal of Theoretical and Applied Finance, Vol. 3 No. 1, pp. 59-83. Economist Intelligence Unit (2010), After the storm: a new era for risk management in nancial services, EIU, available at: www.sas.com/resources/whitepaper/wp_9196.pdf Fatemi, A. and Fooladi, I. (2006), Credit risk management: a survey of practices, Managerial Finance, Vol. 32 No. 3, pp. 227-33. Hahm, J.H. (2004), Interest rate and exchange rate exposures of banking institutions in pre-crisis Korea, Applied Economics, Vol. 36 No. 13, pp. 1409-19. Hassan, A. (2009), Risk management practices of Islamic banks of Brunei Darussalam, The Journal of Risk Finance, Vol. 10 No. 1, pp. 23-37. Holland, J. (2010), Banks, knowledge and crisis: a case of knowledge and learning failure, Journal of Financial Regulation and Compliance, Vol. 18 No. 2, pp. 87-105. IMF (2006), Kingdom of Bahrain: Financial System Stability Assessment, Including Reports on the Observance of Standards and Codes on the Following Topics, Banking Supervision, Insurance Supervision, Securities Regulation, and Anti-money Laundering and Combating the Financing of Terrorism, International Monetary Fund, Washington, DC. Iqbal, Z. and Mirakhor, A. (2011), An Introduction to Islamic Finance: Theory and Practice, 2nd ed., Wiley, Singapore. Khan, M.M. and Bhatti, M.I. (2008), Development in Islamic banking: a nancial risk-allocation approach, The Journal of Risk Finance, Vol. 9 No. 1, pp. 40-51.

Khan, T. and Ahmed, H. (2001), Risk management: an analysis of issues in Islamic nancial industry, IRTI/IDB Occasional Paper, No. 5. KPMG International (2009), Never Again? Risk Management in Banking Beyond the Credit Crisis, KPMG International, Berne. Kutner, M., Nachtsheim, C.J. and Neter, J. (2003), Applied Linear Regression Models, McGraw-Hill, New York, NY. Linbo Fan, L. (2004), Efciency versus risk in large domestic US, Managerial Finance, Vol. 30 No. 9, pp. 1-19. Richard, E., Chijoriga, M., Kaijage, E., Peterson, C. and Bohman, H. (2008), Credit risk management system of a commercial bank in Tanzania, International Journal of Emerging Markets, Vol. 3 No. 3, pp. 323-32. Rosly, S.A. (2011), Risk-based pricing in al-bai-bithaman ajil (BBA)/murabaha sales: scal liability with business and credit risks exposures, paper presented at 14th International Business Research Conference, Crown Plaza Hotel, Sheikh Zayed Road, Dubai, UAE, 28-30 April. Sabato, G. (2009), Financial crisis: where did risk management fail?, available at SSRN: http:// ssrn.com/abstract1460762 Sensarma, R. and Jayadev, M. (2009), Are bank stocks sensitive to risk management?, The Journal of Risk Finance, Vol. 10 No. 1, pp. 7-22. Van Greuning, H. and Iqbal, Z. (2008), Risk Analysis for Islamic Banks, The World Bank, Washington, DC. Williams, R., Bertsch, B., Dale, B., van der Wiele, T., van Iwaarden, J., Smith, M. and Visser, R. (2006), Quality and risk management: what are the key issues?, The TQM Magazine, Vol. 18 No. 1, pp. 67-86. About the authors Hameeda Abu Hussain is an Assistant Professor of Finance at the University of Bahrain. Her research interests are international nance, currencies, stock exchange markets, conventional and Islamic banking. She teaches Corporate Finance, International Finance and Investment Management. She was chairperson of the Department of Economics & Finance, Department of Ofce Management Department, and Dean of the College of Business Administration. Jasim Al-Ajmi is a Professor of Finance and Corporate Governance at the University of Bahrain. He has worked in the banking industry and has published extensively in the areas of corporate governance, nancial institutions, investors behavior, capital markets, risk management, nancial analysis, Islamic nance and behavioral nance. He served as a Board Member of the Eskan (Housing) Bank, Chairman of the Remuneration Committee of the Eskan Bank, and member of the Audit Committee of the Eskan Bank. He is a board member of Bahrain Competitive Council and MENA-OECD Investment Center. He was a member of the National Committee of Corporate Governance that drafted the unied corporate governance code. Jasim Al-Ajmi is the corresponding author and can be contacted at: jasimalajmi@gmail.com

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