RISK MANAGEMENT IN ISLAMIC BANKING

Presentation By
Arslan Asif
arsi2774@gmail.com
delldanger@hotmail.com

THE UNIVERSITY OF LAHORE

Lahore School Of Accountancy And Finance

May 31, 2013

DISCUSSED BELOW:

Risk management

Risk management process

Risk management activities
Risks faced by banks

Common types of risks faced by both Islamic & conventional banks

Unique risks faced by Islamic banks

Definition
Introduction

Major unique risks faced by Islamic banks only

Shariah perspective
Risk mitigation tools

Risk measurement
Risk management Governance

Guiding principles for risk management

Challenge: How to capture unique risk of Islamic banking system
Conclusion

Ten rules to risk management

Word of caution

WHAT IS RISK?

Risks are uncertain future events that could influence the

achievement of the objectives, including :
Strategic
Operational
Financial
Compliance

Uncertain future events could be:

Failure of a borrower to repay a financing
Fluctuation of foreign exchange rates
Fraud, incomplete security documentations, etc.
Non-compliance with Shariah law and principles
Other events that may result in a loss to the Bank

RISK MANAGEMENT PROCESS

What is risk management?

Risk management is the process which involves

Identification, measurement, monitoring, reporting and
controlling risks to ensure that:
Risk taking Decisions are in line with the business strategy and
objectives set by BOD.

The expected payoffs compensate for the risks taken.

Risk taking decisions are explicit and clear.

The organizations Risk exposure is within the limits established

by Board of Directors.

The individuals who take or manage risks clearly understand it.

Sufficient capital as a buffer is available to take risk.

RISK MANAGEMENT ACTIVITIES

Risk management activities take place at:

Strategic level by senior management and BOD

Definition of risks, formulating strategy and policies for
managing risks and establish adequate systems and controls
to ensure that overall risk remain within acceptable level
and the reward compensate for the risk taken.

Macro Level within business area/across business lines

Risk reviews by middle management

Micro Level where risks are actually created

Activities performed by individuals who take risk on
organizations behalf such as front office and loan origination
functions. Confined to following operational procedures and
guidelines set by management.

EXAMPLES OF RISK MANAGEMENT

FAILURES

Barings / Nick Leeson (1995)

Barings Singapore reported SIMEX trade losses of GBP 850

million
Brought down the whole bank

National Australia Bank (2004)

Allied Irish Bank / John Rusnak (2001)

FX derivative losses of AUD 360 million

US subsidiary Allfirst reported FX Options trading losses of

USD 750 million

LTCM, Hedge Fund (1998)

Bond Market losses wiping out capital of USD3.9 billion

Fed and consortium of US Banks bailout

Sumitomo / Yasuo Hamanaka (1996)

Commodity

(copper) trading losses of USD1.8 billion

Orange County, CA, USA (1994)

Equity

losses of USD2 billion

Reverse repos / over-leveraged

Societe Generale, France (2008)

Jerome

Kerviel traded Euro stock index futures and

concealed losses up to almost EUR 5.0 bio

The 2008 - Financial Crisis

Lack

of Management / Board oversight

Weak
Risk

risk culture

Management function marginalized

Over-reliance

on quantitative tools /methodologies

Poor liquidity management

Lack of relevant internal valuation models

RISKS FACED BY BANKS

Risk Dimensions

Types of Common risks

Credit risk

Market risk

Liquidity risk

Operational risk

Both Islamic and conventional banking

The potential that a counterparty fails to
meet its obligations in accordance with
agreed terms and conditions of a credit
related contract
The potential impact of adverse price
movements such as benchmark rates, foreign
exchange rates, equity prices on the
economic value of an asset
The potential loss arising from the Banks
inability either to meet its obligations or to
fund increases in assets as they fall due
without incurring unacceptable costs or
losses
The potential loss resulting from inadequate
or failed internal processes, people and
system or external events

BANKS

ISLAMIC BANKING LESS RISKY?

Islamic Banking is safer as it is not based on INTEREST
Depositors are liable to share losses, therefore solvency risk is
mitigated

MAJOR UNIQUE RISKS FACED BY ISLAMIC BANKS ONLY

Types of Unique risks

Islamic banking Only

Shariah noncompliance risk

Risk arises from the failure to comply

with the Shariah rules and Principles

Rate of return risk

The potential impact on the returns

caused by unexpected change in the
rate of returns

Types of Unique risks

Islamic banking Only

Displaced Commercial risk

The risk that the bank may confront

commercial pressure to pay returns
that exceed the rate that has been
earned on its assets financed by
investment account holders. The bank
foregoes part or its entire share of
profit in order to retain its fund
providers and dissuade them from
The risk arising from entering into a
withdrawing their funds.
partnership for the purpose of
participating in a particular financing
or general business activity as
described in the contract, and in which
the provider of finance shares in the
business risk. This risk is relevant
under Mudarabah and Musharakah
risk arising from holding items in
contracts.
inventory either for resale under a
Murabahah contract, or with a view to

Equity Investment risk

Inventory risk

RISK PROFILE OF ISLAMIC

BANKS

common

unique

Displaced
Commercial
risk
Rate of return
risk

Equity
Investment
risk

Inventory
risk

Islamic Bank

Credit risk
Market risk

Liquidity
risk

Shariah
noncompliance
risk

Operational
risk

RISK FACTORS

Following are the risk factors faced by IBs

Financial
Business
Operational

FINANCIAL RISK FACTORS

Credit Risk
Default

Risk
Counter Party Risk
Settlement Risk

Market Risk
Price

Risk
Rate of return Risk
Exchange rate Risk

Liquidity Risk
Funding

Liquidity Risk
Asset Liquidity Risk
Cash Management Risk

BUSINESS RISK FACTORS

Management Risk
Planning

Organizing
Reporting

Monitoring

Strategic Risk
Research

and Development
Product Design
Market Dynamics
Economic

OPERATIONAL RISK

People Risk

Relationships
Ethics

Legal Risk

Compliance
Control

System Risk
Hardware
Software

External Risk
Event

Client

Security

PERCEPTION OF ISLAMIC BANKING

INDUSTRY ABOUT RISKS

The research asked Islamic banks to rank the Islamic

modes of finance used by them from 1 (least severe)
to 5 (most severe) in terms of risks.

Responses of some Major Islamic banks are included.

INDUSTRY AVERAGES

CREDIT RISK

MARKET RISK

LIQUIDITY RISK

OPERATIONAL RISK

SHARIAH PERSPECTIVE

No Risk No Reward principle (Al Ribh Bi Daman)

Measures taken by Hazrat Yousuf (A.S) for drought (Ahsan ul
Qasas)
Do not give your Amwal to Sufahaa
Writing of contracts whether spot or deferred (Legal risk,
Documentation risk etc.)
Maqasid-e-Shariah
Protection of Izat, Jaan, Aql, Maal, Nasl

RISK MITIGATION TOOLS

Following are the tools for the mitigation of risk.
Pledge

of assets as collateral

Inventories, Shares, Sukuk, Units etc.

Third

party Guarantee
Personal Guarantee
Promise
Charge on deposits and assets
Takaful
Hamish Jiddiya
Urbun
Khiyar / Option
Parallel contract, if permissible

SEVERITY OF RISKS

RISK MEASUREMENT

Risk measurement deals with quantification of

risk exposures.
It includes:
Risk measurement methods
Traditional
GAP analysis
Duration analysis
Statistical analysis
Scenario analysis
Modern portfolio theory
Variation from the mean

RISK MANAGEMENT
GOVERNANCE

Risk management Governance structure

Board

Board Risk
Committee

Board Audit
Committee

Other Board sub

committees

Chief Risk
Officer

Chief Internal
Auditor

Compliance /
Shariah

Managing
Director

Business
Divisions

Support

CFO,
CTO, etc

HR

GUIDING PRINCIPLES FOR RISK

MANAGEMENT
These includes
BASEL

Committee on Banking Supervision

Islamic

Financial Services Board (IFSB)

Bank

Negara Malaysia (BNM)

Institute

of International Finance (IIF)

BASEL

1988 Capital Accord (Basel I)

Regulatory based
Set out requirements to calculate capital charge i.e. the amount of
capital to be set aside to absorb potential loss across banks and across
countries
One size fits all

1996 Basel I (Amendments)

Market Risk was incorporated into Basel I

2004 International Convergence of Capital

Measurement and Capital Standards (Basel II)
Aims to make capital requirements more risk sensitive
Includes Operational Risk
Bank shall be subject to 3 mutually reinforcing pillars

2010 Basel III (Response to Financial Crisis)

Enhanced capital ratios, liquidity ratios, leverage ratio

IFSB STANDARDS

WWW.IFSB.ORG

IFSB-1 Guiding Principles of Risk Management

IFSB-2 Capital Adequacy Standard
IFSB-3 Corporate Governance
IFSB-4 Transparency and Market Discipline
IFSB-5 Supervisory Review Process
IFSB-6 Islamic Collective Investment Schemes
IFSB-7 Sukuk, Securitizations and Real Estate
IFSB-8 Takaful
IFSB-9 Conduct of Business
IFSB-10 Shariah Governance Systems

BANK NEGARA MALAYSIA (BNM)

WWW.BNM.GOV.MY

Islamic Banking Act 1983

Guidelines on Capital Adequacy (CAFIB)

Guidelines on Financial Reporting

Guidelines on Anti Money Laundering

Guidelines on Prudential Limits and Standards

INSTITUTE OF INTERNATIONAL
FINANCE (IIF)
WWW.IIF.COM

Final Report of the IIF Committee on Market

Best Practices:
Principles of Conduct and Best Practice
Recommendations
Financial Services Industry Response to the
Market Turmoil of 2007-2008

CHALLENGE: HOW TO CAPTURE UNIQUE

RISK OF ISLAMIC BANKING SYSTEM

The answer is to develop Internal Rating

Systems (IRSs) in IBs

IRSs can be considered as risk-based

inventories of individual assets of banks
either based on the loss given default (LGD)
of the facility or probability of default (PD) of
the obligor or both

Most IRSs are JUDGMENTAL NOT STATISTICAL

USES OF IRSS

IRSs differ from bank to bank, from use to use

IRSs are used for a number of purposes:

guiding credit origination process,

portfolio monitoring and management reporting

Analysis of adequacy of loan loss reserves and capital

Profitability and loan pricing analysis

Input to formal mathematical modes of risk management

Facilitate prudential bank supervision

DESIRABILITY OF IRSS FOR

ISLAMIC BANKING SYSTEM
To capture the diverse nature of the Islamic
modes of finance
Internal ratings are based on the profile of
individual assets, not on a bucket of assets
Internal ratings help the development of
systematic database of critical financial
variables
Internal ratings supplement external credit
assessment
Internal ratings can enhance external ratings
Internal ratings improve quality of MISs

SOURCES AND INPUTS OF IRSS

Client oriented system - probability of default

(PD)

Facility oriented system - value of an asset

expected to be lost in the event of a default
(loss given a default: LGD)

In both cases: balance sheet value of total

asset i.e., Exposure-at- Default (EAD)

Maturity of facility

Concentration of credit to the specific client

as a percentage of total portfolio etc.

CONCLUSION

There are differences in terms of risks faced by

Islamic banks compared to conventional banks
As a result, the risk assessment techniques need to
consider these risks
The fast-paced development of Islamic banking
means that risk assessment approach needs to be
continuously refined

TEN RULES TO RISK

MANAGEMENT

There is no return without risks

Be transparent

Risk is measured and managed by people, not by

mathematical models

Know what you dont know

Risk should be fully understood

Seek experience

Rewards go to those who take risks

Question the assumptions made

Communicate

Risk should be discussed openly

Diversify-avoid concentration

Show discipline

It is better to be approximately right, than to be

precisely wrong

Return is only half of the equation

A consistent and rigorous approach will beat a

constantly changing strategy

Use common sense

Multiple risks will produce more consistent rewards

Decisions should be made only after considering the

risks and returns of the possibilities

Oversight must be enterprise-wide

Risks cannot be managed in isolation

A WORD OF CAUTION

Risk Management of your life is important than

everything.
Would you ever think about it.
Various risks are related with our body and Soul.
Some of them could harm a lot and some less.
Kindly Think about it .