This document discusses risk management in Islamic banking. It begins with definitions of risk management and describes the risk management process. It then outlines the major risks faced by both Islamic and conventional banks, as well as unique risks faced only by Islamic banks. The document discusses the Shariah perspective on risk, as well as tools for risk mitigation and measurement. It provides guidance principles from Basel, IFSB, and other organizations and discusses challenges in capturing unique risks of Islamic banking. It concludes with ten rules of risk management and a word of caution about managing risks in life.
2. RISK MANAGEMENT IN ISLAMIC BANKING
Presentation By
Arslan Asif
arsi2774@gmail.com
delldanger@hotmail.com
May 31, 2013
THE UNIVERSITY OF LAHORE
Lahore School Of Accountancy And Finance
3. DISCUSSED BELOW:
Risk management
Definition
Introduction
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
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
4. 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
5. 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 organization’s 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.
6. 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
organization’s behalf such as front office and loan origination
functions. Confined to following operational procedures and
guidelines set by management.
7. 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)
FX derivative losses of AUD 360 million
Allied Irish Bank / John Rusnak (2001)
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
8. 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
9. The 2008 -… Financial Crisis
Lack of Management / Board oversight
Weak risk culture
Risk Management function marginalized
Over-reliance on quantitative tools /methodologies
Poor liquidity management
Lack of relevant internal valuation models
10. RISKS FACED BY BANKS
Risk Dimensions
Types of Common risks Both Islamic and conventional banking
Credit risk The potential that a counterparty fails to
meet its obligations in accordance with
agreed terms and conditions of a credit
related contract
Market risk The potential impact of adverse price
movements such as benchmark rates, foreign
exchange rates, equity prices on the
economic value of an asset
Liquidity risk The potential loss arising from the Bank’s
inability either to meet its obligations or to
fund increases in assets as they fall due
without incurring unacceptable costs or
losses
Operational risk The potential loss resulting from inadequate
or failed internal processes, people and
system or external events
11. 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
12. 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
withdrawing their funds.
Equity Investment risk The risk arising from entering into a
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
contracts.
Inventory risk risk arising from holding items in
inventory either for resale under a
Murabahah’ contract, or with a view to
leasing under the Ijarah contract
18. 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.
24. 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
25. 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
27. 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
28. RISK MANAGEMENT
GOVERNANCE
Risk management Governance structure
Managing
Director
Chief Risk
Officer
Board
Board Risk
Committee
Board Risk
Committee
Board Audit
Committee
Board Audit
Committee
Other Board sub
committees
Other Board sub
committees
Chief Internal
Auditor
Compliance /
Shariah
SupportSupport CFO,
CTO, etc
CFO,
CTO, etc
Business
Divisions
Business
Divisions HRHR
29. 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)
30. 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
31. 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
32. 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
33. 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
34. 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
35. 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
36. 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
37. 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.
38. 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
39. TEN RULES TO RISK
MANAGEMENT
There is no return without risks
Rewards go to those who take risks
Be transparent
Risk should be fully understood
Seek experience
Risk is measured and managed by people, not by
mathematical models
Know what you don’t know
Question the assumptions made
Communicate
Risk should be discussed openly
40. Diversify-avoid concentration
Multiple risks will produce more consistent rewards
Show discipline
A consistent and rigorous approach will beat a
constantly changing strategy
Use common sense
It is better to be approximately right, than to be
precisely wrong
Return is only half of the equation
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
41. 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 .