RISK MANAGEMENT IN ISLAMIC BANKING

Presentation by:
MAHMOOD SHAFQAT
Senior Joint Director
Islamic Banking Department
September 01, 2008

* The views expressed in this

presentation are those of the author and

do not necessarily represent State Bank
of Pakistan.

Outline

Definition and Introduction to Risk Management

Is Risk Management allowed under Shariah
Risks faced by Banks
Unique Risks faced by Islamic Banks
Risk mitigation tools
Regulatory Framework for Risk Management in
Pakistan
SBP Guidelines on Risk Management in IBIs
IFSB Standard on Capital Adequacy

RisksBasic Concept

Risk:
existence of uncertainty about future outcomes
difference between expected and actual result

Uncertainty classified as general and specific

General: ignorance of any potential outcome

Specific: when objective/subjective probabilities can
be assigned to potential outcomesthis is usually
referred to as risk.

Definition of Financial Risk

Financial risk in a banking organization is
possibility that the outcome of an action or
event could bring up adverse impacts.
Such outcomes could either result in a
direct loss of earnings / capital or may
result in imposition of constraints on
banks ability to meet its business
objectives.

RISK MANAGEMENT

Risk Management involves identification,

measurement, monitoring, reporting and
controlling risks to ensure that

The individuals who take or manage risks clearly

understand it.
The organizations Risk exposure is within the limits
established by Board of Directors.
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.
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

Macro Level within a business area or across business

lines

Definition of risks, institutions risk appetite, 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.

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.

Risk management process

Identification
Measurement
Monitoring
Reporting
Mitigation and control

To put it simply and directly,

if

the bosses do not or cannot understand

both the risks and rewards in their products,
their firm should not be in the business.

William J. McDonough, President, Federal Reserve Bank

of New York

Shariah Perspective

No Risk No Reward principle (Al Ribh Bi Daman)

So No Risk Management?
Measures taken by Hazrat Yousuf (AS) 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

RISKS FACED BY BANKS AND

THEIR APPLICATION ON
ISLAMIC BANKING

Risk
Dimensions
Banking
Risks

Credit
Liquidity
Credit
Credit
Market
Operational
Solvency
Legal/Regulatory
Systemic

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 Types of Risks in IB

Credit Risk

Market Risk

Attributed to delayed, deferred, and default in payments by

counterparties. Covers profit sharing contracts (Mudaraba and
Musharaka), receivables and lease (Murabaha, DM and Ijara,
Salam, Istisna), and covers different stages of a contract
Adverse movements in interest rates, commodity prices and FX
rates. Commodity risk in Murabaha, Ijara, Salam

Equity Risk

Adverse changes in market value (and liquidity) of equity held for

investment purposes. Covers all equity instruments including
Mudaraba and Musharaka

Major Types of Risks in IB

Liquidity Risk

Rate of Return Risk

Changes in account holders expectations of the return on

investment. Also related to fluctuations in returns due to changes
in underlying factors of the contract.

Operational Risk

Adverse cash flows in situations arising mainly out of changing

market risk exposures, credit risk exposures and operational risk
exposures.

Inadequacy of failed processes, people and systems. Also

includes Shariah non-compliance Risk

Legal Risk

Inadequate legal framework, conflict of conventional and Islamic

laws and conflict between Shariah rulings and legal decisions

Credit Risk Mitigating Tools

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

Regulatory Framework

Risk Management

Stress Testing

Guidelines on Risk Management - BSD Circular No. 7 dt. Aug. 15,

2003
Guidelines on Internal Credit Risk Rating Systems BSD Circular
No. 8 dt. Oct. 29, 2007
Risk Management Guidelines for IBIs IBD Circular No. 1 dt. Jan.
2, 2008.
ICAAP Guidelines - BSD Circular 17 of 2008
Guidelines on Stress Testing - BSD Circular No. 5 dt. Oct. 27, 2005

Internal Controls

Guidelines on Internal Controls - BSD Circular No . 7 dt. May 27,

2004 and BSD Circular No. 1 dt. Jan.14, 2006
Policy Framework in Banks/DFIs - BSD Circular 3 of 2007

SBP RM Guidelines for IBIs

15 Guiding Principles
Divided into

General (1 Principle)
Credit risk (4 Principles)
Equity investment risk( 3 Principles)
Market risk (1 Principle)
Liquidity risk (2 Principles)
Rate of return risk ( 2 Principles)
Operational risk (2 Principles)

IBIs are also exposed to reputational risk arising from

failures in governance, business strategy and process.
Negative publicity about their business practices,
particularly relating to Shar`ah non-compliance in their
products and services, could have an impact upon their
market position, profitability and liquidity.

Guiding Principles on RM

These principles are not radically different from

those applicable to conventional banks
However, these are some fundamental
differences:
-

Emphasis on Shariah compliance

6 out of 15 principles make explicit reference to
Shariah rules

1. General Requirement

Principle 1.0: IBIs shall have in place a

comprehensive risk management and reporting
process, including appropriate board and senior
management oversight, to identify, measure,
monitor, report and control relevant categories of
risks. The process shall take into account
appropriate steps to comply with Shariah rules
and principles and to ensure the adequacy of
relevant risk reporting to the supervisory
authority.

1. General Requirement

Board of directors (BOD) and senior

management oversight
approve

the risk management objectives,

strategies, policies and procedures
approvals shall be communicated to all levels
ensure the existence of an effective risk
management structure
Shar`ah Advisor to oversee that the IBIs
products and activities are Shar`ah compliant

1. General Requirement

Board of directors (BOD) and senior

management oversight
approve

limits on aggregate financing and

investment exposures
review the effectiveness of the risk
management activities
Senior management shall execute the
strategic direction and set clear lines of
authority and responsibility
Independence of risk management function
from risk taking activities

1. General Requirement

Risk management process

sound

process for executing all elements of risk

management, including risk identification,
measurement, mitigation, monitoring, reporting and
control
adequate system of controls with appropriate
checks and balances
(a) comply with the Shar`ah rules and principles,
(b) comply with applicable regulatory and internal policies and
procedures; and
(c) take into account the integrity of risk management
processes
quality

and timeliness of risk reporting available

to regulatory authorities
appropriate and timely disclosure of information
to depositors

1. General Requirement

Application of Emergency and Contingency Plan

Integration of Risk Management
Risk Measurement and use of models
Utilization of funds
Role of Finance Administration Department
Management Information System for board or
senior management committee
Human Resource: Training and development

2. Credit Risk

Principle 2.1: IBIs shall have in place a

strategy for financing, using various
instruments in compliance with Shariah,
whereby they recognize the potential
credit exposures that may arise at different
stages of the various financing
agreements.

2. Credit Risk

Principle 2.2: IBIs shall carry out a due diligence

review in respect of counterparties prior to deciding
on the choice of an appropriate Islamic financing
instrument.

Principle 2.3: IBIs shall have in place appropriate

methodologies for measuring and reporting the
credit risk exposures arising under each Islamic
financing instrument.

2. Credit Risk

Principle 2.4: IBIs shall have in place

Shar`ah-compliant credit risk mitigating
techniques appropriate for each Islamic
financing instrument.

2. Credit risk

These principles apply to:

Murabaha, Salam, ijara and Istisna contracts
Mudaraba and Musharaka
Sukuk
For example, for working capital financing, Salam and
Mudaraba contracts could be used
In case of Salam, the bank enters into a parallel Salam
contract with a third party
What factors may effect the counterpartys ability to
repay

2. Credit risk

The commodity price

- Dont use commodities with high price volatility
- A list of all types of applicable and approved
transaction and financing
- The Islamic banks should ensure that
adequate systems and resources are available
to implement this strategy
In case of using Mudaraba contract as a working
capital tool
- The choices of Mudarib company should be
made with care

2. Credit risk

The bank must have close links with the

company - Shariah implications
Choose an appropriate trading activity for
financing
Guidelines on a realistic review of
expected future cash flow

2. Credit risk

Transformation of risk should be taken into

account while devising a sound risk management
strategy
For example, in Murabaha contracts, the risk gets
transformed from market risk to credit risk
In Mudaraba and Musharaka contracts, equity
investment gets transformed to debt in case of
proven negligence for misconduct on part of the
Mudarib or Musharaka partners
The role of promises must be scrutinized and
recognized in the complex structures

2. Credit risk
Clearly define risk mitigating techniques including but
not limited to
- Methodology for setting Mark-up rates according to the
risk-rating of the counterparties
- Permissible and enforceable collaterals and
guarantees
- Clear documentation as to whether or not purchase
orders are cancelable
- Clear procedure for taking a/c of governing laws
Always try to buy the asset-to-be- financed on sale-orreturn basis

2. Credit risk
IBIs shall assess credit risk in a holistic
manner and ensure that credit risk
management forms a part of an integrated
For example, in a Salam contract, changes in
market risk factors such as commodity prices,
as well as the external environment (for
example,
bad
weather)
become
key
determinants affecting the likelihood of default.

2. Credit Risk

The IBIs must have

an appropriate credit strategy, including

pricing and tolerance for undertaking various
credit risks;
a risk management structure with effective
oversight of credit risk management;
credit policies and operational procedures
including credit criteria and credit review
processes, acceptable forms of risk
mitigation, and limit setting

2. Credit Risk

an appropriate measurement and careful

analysis of exposures, including market- and
liquidity-sensitive exposures; and
a system to

monitor the condition of ongoing individual

credits to ensure the financings are made in
accordance with the IBIs policies and
procedures,
manage problem credit situations according to
an established remedial process; and to
determine adequate provisions to be made for
such losses.

3. Equity investment risk

Equity investment risk may be defined as the risk

arising from entering into a partnership for the purpose
of undertaking or participating in a particular financing
or general purpose activity as described in the contract,
and in which the bank shares in the business risk
-

Market risk
Liquidity risk
Credit risk
Other risks

Capital impairment risk

3. Equity Investment Risk

Principle 3.1: IBIs shall have in place

appropriate strategies, risk management
and reporting processes in respect of the
risk characteristics of equity
investments, including Mudrabah and
Mushrakah investments.

3. Equity Investment Risk

Principle 3.2: IBIs shall ensure that their

valuation methodologies are appropriate
and consistent, and shall assess the
potential impacts of their methods on profit
calculations and allocations. The methods
shall be mutually agreed between the IBIs
and the Mudrib and/or Mushrakah
partners.

3. Equity Investment Risk

Principle 3.3: IBIs shall define and

establish the exit strategies in respect of
their equity investment activities, including
extension and redemption conditions for
Mudrabah and Mushrakah investments,
subject to the approval of the institutions
Shar`ah Advisor.

3. Equity Investment Risk

Risk mitigation
-

Define and set the objectives of, and criteria for,

investment using profit sharing instruments
Monitoring

Evaluation of Sharia compliance, holding of

periodical meeting with partners and proper
recordkeeping of these meetings
Monitoring of transformation of risks at various
stages of investment lifecycle
Monitoring of factors affecting the expected
volume and timing of cash flows

3. Equity Investment Risk

Valuation
Appropriate

valuation methods profit calculation and

allocation
Assessment and measurement of potential
manipulation of reported results leading to
overstatements or understatements of partnership
earnings
Independent audit and valuations
Appropriate methods for the treatment of retained
profits

Criteria for Exit strategies

4. Market Risk

Principle 4.1: IBIs shall have in place an

appropriate framework for market risk
management (including reporting) in
respect of all assets held, including those
that do not have a ready market and/or
are exposed to high price volatility.

4. Market Risk

The risk that arises from fluctuations in values of

tradable, marketable or leaseable assets
(including Sukuk) and in off- balance sheet
individual portfolios
The risks relate to the current and future volatility
of market values of
-

Salam based assets (due to commodity prices)

Sukuk
Murabaha assets( purchased to be delivered)

Market risk exposures may occur at certain

times or throughout the contract

4. Market Risk
In operating Ijrah, a lessor is exposed to market risk on the
residual value of the leased asset at the term of the lease or if
the lessee terminates the lease earlier (by defaulting), during
the contract.
In Ijrah Muntahia Bittamleek, a lessor is exposed to market
risk on the carrying value of the leased asset (as collateral) in
the event that the lessee defaults on the lease obligations.
In Salam, IBIs are exposed to commodity price fluctuations
on a long position after entering into a contract and while
holding the subject matter until it is disposed of.
In the case of parallel Salam, there is also the risk that a
failure of delivery of the subject matter would leave the IBIs
exposed to commodity price risk as a result of the need to
purchase a similar asset in the spot market in order to honour
the parallel Salam contract.

4. Market Risk

IBIs shall establish a sound and comprehensive

market risk management process and information
system, which (among others) comprise:
a conceptual framework to assist in identifying
underlying market risks;
guidelines governing risk taking activities in different
portfolios of depositors and their market risk limits;
appropriate frameworks for pricing, valuation and
income recognition; and
a strong MIS for controlling, monitoring and
reporting market risk exposure and performance to
appropriate levels of senior management.

4. Market Risk
Market risk is closely related to other
forms of risks, and an overall measure of it
can be calculated with the help of an
appropriate VAR model
Islamic banks then should ensure that
adequate capital is held against the
market risk

5. Liquidity Risk

Principle 5.1: IBIs shall have in place a liquidity

management framework (including reporting) taking into
account separately and on an overall basis their liquidity
exposures in respect of each category of current
accounts, unrestricted and restricted investment
accounts.

Principle 5.2: IBIs shall undertake liquidity risk

commensurate with their ability to have sufficient
recourse to Shar`ah-compliant funds to mitigate such
risk.

5. Liquidity Risk

Two major types of fund providers:

current

account holders; and

PLS Deposit holders

PLS Deposit holders do not share in the

risks on assets financed by current
accounts, which are borne by shareholders
alone
As fiduciary agents, the IBIs are concerned
with matching their investment policies with
PLS Deposit holders and shareholders risk
appetites

5. Liquidity Risk

Linked with displaced commercial and Shariah

compliance risks
Islamic banks must maintain adequate liquidity
to meet their obligations at all times
Strategy for managing liquidity involving effective
BOD and senior management oversight
A framework for developing and implementing
sound processes for measuring and monitoring
liquidity
Adequate systems in place for monitoring and
reporting liquidity exposures on a periodic basis

5. Liquidity Risk
-

Adequate funding capacity, with particular

reference to the willingness and ability of
shareholders to provide additional capital
when necessary
Liquidity crisis management, fixed asset
realization and sale and leaseback
arrangements etc.

5. Liquidity Risk

Risk mitigation
- Diversity sources of funds
- Reduce concentration of funding base
- Rely on marketable assets
Identity any future shortfalls in liquidity by
constructing maturity ladders
Known cash flows
Murabaha, Ijara, IMB and diminishing
Musharaka receivables

5. Liquidity Risk
Conditional

but predictable cash flows

Salam and Istisna receivables
Conditional and unpredictable cash flows
Musharaka investments
Periodic cash flow analysis under different scenarios
A normal operating environment (e.g., a steady
state condition)
Adverse circumstances (e.g., non-linear events
and chaotic conditions)

5. Liquidity Risk
establish the maximum amounts of
cumulative liquidity mismatches they
consider acceptable
Liquidation procedures must be
incorporated in the investment contracts
Liquidity contingency plans addressing
various stages of liquidity crisis

6. Rate of Return Risk

Principle 6.1: IBIs shall establish a comprehensive

risk management and reporting process to assess
the potential impacts of market factors affecting
rates of return on assets in comparison with the
expected rates of return for PLS Deposit holders.

Principle 6.2: IBIs shall have in place an

appropriate framework for managing displaced
commercial risk, where applicable.

6. Rate of Return Risk

An increase in benchmark rates may result in

PLS depositors having expectations of a higher
rate of return
The actual return on assets may be under
performing as compared to the competitors rate
of returns
Displace commercial risk
Profit Equalization Reserve
Investment Risk Reserve

7. Operational Risk

Principle 7.1: IBIs shall have in place

adequate systems and controls,
including Shar`ah Advisor, to ensure
compliance with Shar`ah rules and
principles.

7. Operational Risk

Principle 7.2: IBIs shall have in place

appropriate mechanisms to safeguard the
interests of all fund providers. Where PLS
deposit holders funds are commingled with
the IBIs own funds, the IBIs shall ensure that
the bases for asset, revenue, expense and
profit allocations are established, applied and
reported in a manner consistent with the IBIs
fiduciary responsibilities.

7. Operational Risk

Shariah compliance risk

- The risk that arises form Islamic banks failure to
comply with the Shariah rules & principles determined
by the Shariah Advisor or the relevant body in the
jurisdiction in which Islamic banks operate
Fiduciary risks
- The risk that arises from the Islamic banks failure
to perform in accordance with explicit and implicit
standards applicable to their fiduciary responsibilities

7. Operational Risk
IBIs

shall establish and implement a clear and

formal policy for undertaking their different
and potentially conflicting roles in respect
of managing different types of investment
accounts.
IBIs shall adequately disclose information
on a timely basis to their PLS deposit holders
and the markets in order to provide a reliable
basis for assessing their risk profiles and
investment performance.

ROLE OF SUPERVISORY
AUTHORITY
adequate understanding on the wide array
of risks and satisfy itself that the IBIs have
in place an adequate risk management
and reporting process
Develop and utilise prudential regulations
and requirements to control these risks

ROLE OF SUPERVISORY
AUTHORITY

Credit Risk
maintain

a detailed description of each financing

instrument used by the IBIs in their jurisdiction and
the risk exposures to which each instrument gives rise
may decide to develop Shar`ah guidelines or
minimum documentations in respect of agreements
adequacy of the policies and procedures to be
implemented by the IBIs to mitigate risks are subject
to review by the supervisory authority in compliance
with Shar`ah

ROLE OF SUPERVISORY
AUTHORITY

Equity Investment Risk

satisfy

itself that adequate policies and procedures

are in place for equity investment risk management
ensure that the IBIs have sufficient capital when
engaging in equity investment activities
may develop regulatory guidelines for measuring,
managing and reporting the risk exposures when
dealing with non-performance financing and providing
provisions

ROLE OF SUPERVISORY AUTHORITY

Market Risk
satisfy

itself on the adequacy of IBIs internal

systems and controls and internal limits set by
the IBIs on their market risk management in
relation to the activities undertaken.
Supervisory authorities should require IBIs in
their jurisdictions to develop guidelines for
acceptable valuation techniques where direct
market prices are not available, and should
approve such guidelines. Alternatively, the
supervisory authorities may themselves
develop such guidelines.

ROLE OF SUPERVISORY
AUTHORITY

Liquidity Risk
satisfy

itself that the IBIs have adequate

liquidity policies, systems and controls in place
to manage their liquidity
may establish appropriate minimum levels of
liquidity for each category
central bank in its capacity as lender of last
resort may provide Shar`ah compatible
mechanisms for liquidity arrangements to IBIs
as per stipulated regulations before the IBIs
can resort to seeking funds

ROLE OF SUPERVISORY
AUTHORITY

Rate of Return Risk

assess

the capacity of the IBIs to manage the

rate of return risk may establish appropriate
minimum levels of liquidity for each category
Where the supervisory authority may have a
policy of stating an expected rate of return for
unrestricted IAH, the supervisory authority
shall establish a framework within which this
is to be undertaken by the IBIs operating in its
jurisdiction

ROLE OF SUPERVISORY AUTHORITY

Rate of Return Risk

The ROR framework may include amongst

others, methods, applicable periods and
recognisable income and expenses, and
other calculation bases relating to the use
of funds. This framework shall assist the
supervisory authority to assess the
efficiency of IBIs in terms of their
profitability and prudent management.

ROLE OF SUPERVISORY AUTHORITY

Operational Risk
satisfy

itself that IBIs have in place a

comprehensive and sound framework for
developing and implementing a prudent control
environment for the management of operational
risks
IBIs have adequate Shar`ah compliance
mechanisms in place
well-defined and adequately qualified and staffed
organisational structure
clear lines of authority and accountability
policies and procedures for approval of products and
activities

ROLE OF SUPERVISORY
AUTHORITY

Operational Risk
prescribe

formal guidance for the IBIs to ensure they

fulfil their fiduciary duties towards their IAH
applicable auditing standards relevant to IBIs are
being implemented correctly in respect of the
assessment of the appropriateness of allocations,
distributions and reporting of profits to IAH
The supervisory authority may require IBIs to have an
independent and regular review of Shar`ah
compliance in this regard.

Risk Measurement

Risk measurement methods

- Traditional
GAP analysis
Duration analysis
Statistical analysis
Scenario analysis
Modern

portfolio theory

Variation from the mean

VAR

TEN RULES TO RISK MANAGEMENT

There is no return without risks

Rewards

Be transparent
Risk

go to those who take risks

should be fully understood

Seek experience
Risk

is measured and managed by people, not by

mathematical models

Know what you dont know

Question

the assumptions made

Communicate
Risk

should be discussed openly

TEN RULES TO RISK MANAGEMENT

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

IFSB Capital Adequacy Standard

Overview

Largely based on the Basel approach, with necessary

modification and adaptation to cater for specific nature and
characteristics of Shariah compliant products and services
Uses Risk weights derived from those proposed in Basel II
because of lack of historical data to modify risk weights
For Credit Risk - Standardized approach
Market Risk
- 1996 Market Ris Amendment
Operational Risk - Basic Indicator approach
CAS is structured in a Matrix format to cater for transformation
of risk at different stages of contract
Treatment of PSIA and assets financed by PSIA in CAR

Adoption after Impact Study by SBP

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 .

For Comments and Suggestions please

contact:
Mahmood Shafqat
Senior Joint Director
Islamic Banking Department
State Bank of Pakistan
I.I. Chundrigar Road, Karachi
Ph: +92-21-9212509, 2453741
Fax: +92-21-9212472
E-mail: mahmood.shafqat@sbp.org.pk

THANK YOU
MAY ALLAH THE ALMIGHTY SHOW US THE
RIGHT PATH,
THE PATH OF HIS LOVED ONES (AAMEEN)