Presentation slide for Risk Management in Islamic Finance

1. RISK MANAGEMENT
IN
ISLAMIC FINANCE
Mahyuddin Khalid

2. Introduction to Risk Management
Content
Meaning of Risk Management
Objectives of Risk
Management
Steps in the Risk Management
Process
Benefits of Risk Management
Personal Risk Management
Learning Outcome
• To examine the concept of Risk
Management
• To analyse steps involved in the
Risk Management Process
• To examine the benefits of Risk
Management
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3. Risk Management
• The identification, assessment, and prioritization of risks.
• Followed by a coordinated and economical application of resources to minimize,
monitor, and control the probability and/or impact of unfortunate events.
• Or to maximize the realization of opportunities.
Risk management
is
• to assure uncertainty does not disrupt the purpose of the business goals.
The purpose of
Risk management
is
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4. Risk Management
Norman Baglini (1983) defines Risk Management as an
economic process of allocating a business firm’s financial
resources in the optimum combination of loss control and
loss financing methods to minimize the costs of pure risks.
Vaughan (2003) defines Risk Management is a scientific
approach to dealing with risks by anticipating possible
accidentals losses and designing and implementing
procedures that minimize the occurrence of loss or the
financial impact of the losses that the occur.
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5. The Evaluation Of Risk Management
The term risk management relating to business risks first
appeared in the 1950s not until 1970 did non- financial
businesses begin to practice risk management in a
meaning full way.
Risk management were overwhelmingly concerned with
hazard risks and the purchase of insurance, risk associated
with the firm’s production processes were managed by
human resources, little consideration was given to how
disparate risk related to each other, not to overall firm
value.
Managers have since been under pressure to gain a
sophisticated understanding of the risks that their
organization faced.
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6. The Risk Management Process
Basically the risk management process involved a 6 step of
activities namely:
1. The setting up of risk management policies.
2. The identification of risk
3. The evaluation of risk.
4. The development of a risk management plan to mitigate the
risks i.e. through risk control and risk financing mechanism.
5. The implementation of the risk management plan.
6. The review and monitoring of the risk management plan.
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7. Risk Management From Islamic Viewpoint
As discussed earlier, economic activities from an Islamic
perspectives, are not judged by their inherent risks, but by
whether they add value and/or create wealth.
Hassan (2005), for instance identifies the three types of
risks from the Islamic perspectives which are :
 Essential risk
 Prohibited risk
 Permissible risk
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8. Risk Management From Islamic Viewpoint
Siddiqi (2009), identifies two ways of managing risks in
financing sharing and transferring while the tendency in
conventional finance is to transfer risks (through debt-
based financing)
He asserts that the approach in Islamic finance should be
risk-sharing.
Thus, modes such as musharakah and mudharabah reflect
the spirit of Islamic teachings and should be adopted by
the Islamic financial institutions (IFI).
In the history of Islam, there are many incidents that are
closely related which can be used as a benchmark.
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9. Steps in Managing Risk
In facing and managing
risk, several steps can
be implemented:
Risk
reduction
Risk sharing
Risk
avoiding
Risk
controlling
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10. Risk Management from Islamic Viewpoint
Risk Management in Islam takes its roots from the Quran
and Sunnah.
Among the historical incidents that can be related to a risk
management practice:
 The hijrah of the prophet (S.A.W) from Makkah to Madinah
 During the battle of Badr.
 During the Battle of Khandaq.
 The principle of risk sharing was stated in the statute of Madinah.
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11. Risk Management from Islamic Viewpoint
 During the Hijrah from Makkah to Madina, for instance, the
Muslims went in small groups.
 This shows the understanding of the risks inherent in the
migration and the attempt to mitigate this risk by moving in
small groups.
 On the night the prophet left Makkah for Madinah, he had his
cousin Ali to replace him in his bed in order to give him
sufficient time to leave Makkah and reduce risk the of being
caught by the leaders of Quraish.
 There are many other examples from the Sunnah of
Prophet Muhammad (PBUH) that evidences;
 hedging against a risk or mitigating a risk is not only accepted, but
encouraged in Islam.
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12. Risk Management from Islamic Viewpoint
Muslims are asked to work hard in order to be able to
change their conditions as obvious in the verse of Holy
Quran,
 “… Verily never will Allah change the condition of people until
they change it themselves (with their own souls) …” (Qur’an 3:11).
However, it is true that only Allah knows one’s future and
fate,
Muslims should strive to achieve the goodness in this
world and the hereafter.
Submission to Allah, of course, has a positive effect on
human behavior.
 For it will lead to peace and contentment. 12

13. Risk Management from Islamic Viewpoint
 It was narrated by Anas bin Malik that an Arab Bedouin asked the Prophet
(p.b.u.h.) in Medina:
 “O the Messenger of Allah…Should I leave my camel untied and trust in
Allah, or
should I tie it?” The Holy Prophet (p.b.u.h.) replied: “Tie your camel and
then trust
in Allah”
 (Al-Tirmidhi, 1998)
 The hadith proves that a Muslim should not be passive and fatalistic. The
hadith
does not only illustrate how a Muslim should deal with his fate, but it also
instructs to manage the risk of calamities and losses.
 It is worth mentioning that risk management is not against the concept of
tawakkul (trust in Allah). Tawakkul is to choose appropriate means toward
achieving the goals first, then entrusting Allah for the better result
(Usmani M.T., 1999)
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14. Risk Management from Islamic Viewpoint
Narrated by Anas bin Malik that the Prophet (p.b.u.h.) said:
“Trade the money of the orphans, so it will not be eaten
(decreased) by zakah”
(Malik, 2004)
Prophet (p.b.u.h.) encourages the trustee on behalf of
orphans to invest the wealth in a business that will yield a
positive return.
This is to avoid the risk of decrease in the wealth due to
payment of zakat portion.
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15. Risk Management from Islamic Viewpoint
 One of the clear examples of risk management could be the business
of Abbas ibn Abdul Muttallib (may Allah be pleased with him) as
narrated by his son:
 “Whenever Abbas ibn Abdul Muttalib (may Allah be pleased with
him) handed
over his assets [camels] for mudarabah to his partner, he stipulated
that he
should not take the assets across the sea, nor take them down to the
bottom of
a dry river bed, nor trade them for live animals. If he were to do any
of these, he
would have to bear the compensation. Word of al-Abbas stipulation
reached
Rasulullah (p.b.u.h.) and he allowed it”
(Al Daraqutni, 2004).
 This hadith permits stipulating conditions in mudarabah business in
order to
prevent exposure to undue risks.
 Foundation for the ruling of restricted mudarabah where capital
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16. Risk Management from Islamic Viewpoint
Undoubtedly, one has to submit every single thing to Allah,
but only after an individuals hands stretch out to do the
best effort they can.
In order to be able to manage and cope with unforeseen
calamities or misfortune.
If risk is defined as possibility of loss, then it becomes clear
from an Islamic perspective that risk as such is not
desirable.
Islamic principles clearly call for the preservation
and development of wealth.
Exposing wealth to loss cannot be a goal in itself.
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17. Risk Management from Islamic Viewpoint
 One of the core principles practiced by every living creature is
to identify and assess risks.
 It is because almost everything on this earth is subject to some type of
risk.
 Without managing risks properly, it is hard to imagine stability.
 Since humans are distinguished from other living things by their
ability to think and learn; failure to manage risks is
characterized by inability to decide what to do, when to do it,
and whether enough has been done or otherwise.
 This is the practice of today’s businesses and enterprises to
incorporate risk management as a facet of quality for business
success.
 Such enterprises are using basic techniques to ensure that risks
are properly identified, classified, and managed.
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18. Risk management consists of processes, methods,
and tools for managing risks in a project.
The following should be built into and risk management
exercise
 Assess continuously what could go wrong (risks)
 Determine which risks are important to deal with (impact and
prioritization)
 Implement strategies to deal with those risks (mitigation)
 Monitor and control (tracking)
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19. Meaning of Risk Management
Risk Management is a process that identifies loss
exposures faced by an organization and selects the most
appropriate techniques for treating such exposures
A loss exposure is any situation or circumstance in which a
loss is possible, regardless of whether a loss occurs
 E.g., a plant that may be damaged by an earthquake, or an
automobile that may be damaged in a collision
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20. Objectives of Risk Management
 Risk management has objectives before and after a loss occurs
 Pre-loss objectives:
 Prepare for potential losses in the most economical way
 Reduce anxiety
 Meet any legal obligations
 Post-loss objectives:
 Survival of the firm
 Continue operating
 Stability of earnings
 Continued growth of the firm
 Minimize the effects that a loss will have on other persons and on
society
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21. Risk Management Process
Identify potential losses
Measure and analyze the loss exposures
Select the appropriate combination of techniques for
treating the loss exposures
Implement and monitor the risk management program
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22. Steps in the Risk Management Process
 Identify potential losses
 Evaluate potential losses
 Select the appropriate techniques for treating loss exposure:
 1- Risk Control:
 Avoidance,
 Loss Prevention,
 Loss Reduction
 Risk Financing :
 Retention
 Noninsurance transfer
 Commercial Transfer
 Implement & Administer the program
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23. Identify Loss Exposures
Property loss exposures
Liability loss exposures
Business income loss exposures
Human resources loss exposures
Crime loss exposures
Employee benefit loss exposures
Foreign loss exposures
Intangible property loss exposures
Failure to comply with government rules and regulations
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24. Identify Loss Exposures
Risk Managers have several sources of information to
identify loss exposures:
 Risk analysis questionnaires and checklists
 Physical inspection
 Flowcharts
 Financial statements
 Historical loss data
Industry trends and market changes can create new loss
exposures.
 e.g., exposure to acts of terrorism
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25. Measure and Analyze Loss Exposures
Estimate for each type of loss exposure:
 Loss frequency: the probable number of losses that may occur
during some time period
 Loss severity: the probable size of the losses that may occur
Rank exposures by importance
Loss severity is more important than loss frequency:
 The maximum possible loss is the worst loss that could happen to
the firm during its lifetime
 The probable maximum loss is the worst loss that is likely to
happen
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26. Selecting The Appropriate Technique: Risk
Control
Risk control refers to techniques that reduce the frequency
and severity of losses
Methods of risk control include:
 Avoidance: a certain loss exposure is never acquired or
undertaken, or an existing loss exposure is abandoned
 Loss prevention: measures that reduce the frequency of a
particular loss e.g., installing safety features on hazardous
products
 Loss reduction: measures that reduce the severity of a loss after it
occurs e.g., installing an automatic sprinkler system
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27. Selecting The Appropriate Technique: Risk
Financing
Risk financing refers to techniques that provide for the
payment of losses after they occur
Methods of risk financing include:
 Retention: the firm retains part or all of the losses that can result
from a given loss
 Non-insurance Transfers: a method other than insurance by
which a pure risk and its potential financial consequences are
transferred to another party
 Commercial Insurance: appropriate for low-probability, high-
severity loss exposures. i.e. the risk manager selects the coverages
needed, and policy provisions
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28. Exhibit 3.2 Risk Management Matrix
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29. Implement and Monitor the Risk Management
Program
Implementation of a risk management program begins
with a risk management policy statement that:
 Outlines the firm’s objectives and policies
 Educates top-level executives
 Gives the risk manager greater authority
 Provides standards for judging the risk manager’s performance
A risk management manual may be used to:
 Describe the risk management program
 Train new employees
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30. Implement and Monitor the Risk Management
Program
A successful risk management program requires active
cooperation from other departments in the firm
The risk management program should be periodically
reviewed and evaluated to determine whether the
objectives are being attained
 The risk manager should compare the costs and benefits of all
risk management activities
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31. Benefits of Risk Management
Enables firm to attain its pre-loss and post-loss objectives
more easily
A risk management program can reduce a firm’s cost of
risk
Reduction in pure loss exposures allows a firm to enact an
enterprise risk management program to treat both pure
and speculative loss exposures
Society benefits because both direct and indirect losses are
reduced
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32. Personal Risk Management
Personal risk management refers to the identification of
pure risks faced by an individual or family, and to the
selection of the most appropriate technique for treating
such risks
The same principles applied to corporate risk management
apply to personal risk management
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33. Example 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…
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34. 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
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35. Mahyuddin Khalid
End of Chapter
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