RISK MANAGEMENT RISKMANAGEMENT

INANISLAMICFINANCIALINSTITUTION
By By
SyedOthmanAlhabshi
ChiefAcademicOfficer,INCEIF
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CONTENTS CONTENTS
Islamicviewofrisks
Risks in practice Risksinpractice
Costplustransactions
Profitsharingtransactions
Forward transactions Forwardtransactions
Leasingtransactions
Conclusion
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ISLAMIC VIEW OF RISKS ISLAMICVIEWOFRISKS
FromtheQuranic verse275ofChapter2,
whereAllahprohibitsusury(alriba)and p y ( )
permitsexchange(albai),itclearlyimplies
that increase in wealth cannot but must be a thatincreaseinwealthcannotbutmustbea
consequenceofrisktaking(Abbas Mirakhor,
Wither Islamic Finance unpublished) WitherIslamicFinance,unpublished)
Tomitigaterisks,theaboveversedemands
thesharingofrisksandnottransferofrisks
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RISKS IN PRACTICE RISKSINPRACTICE
Si ll t ti t t l th t Sincealltransactionsarecontractual,theymust
meetcertainconditionstomakethemvalid.Two
elements that would nullify any contract are al elementsthatwouldnullifyanycontractareal
riba andgharar (ambiguity)
Every transaction to be Shariahcompliant must EverytransactiontobeShariah compliantmust
avoidthesetwoelements
In practice, Islamic Financial Institutions are not Inpractice,IslamicFinancialInstitutionsarenot
completelyreadytofullysharerisksbecauseof
moralhazards
Weshallnowinvestigatetherisksinvolvedin
practicetoday
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COSTPLUSTRANSACTIONS
(Murabahah)
M b h h i t di t ti hi h Murabahah isatradingtransactionwhichcan
takedifferentforms:
A supplier who sells his product at a mark up Asupplierwhosellshisproductatamarkup
Inbanking,thebankbuysaproductfromasupplier
andsellstoacustomeratitscostplusamarkup.The p p
productcanbebuildings,land,cars,machinery,etc.
Normally,thecustomerpaysbyinstallment
Commodity Murabahah involves buying a commodity CommodityMurabahah involvesbuyingacommodity
orabasketofcommodities,suchasmetalstradedin
LondonMetalExchangewhichareheldbyanother
bankforapredeterminedamountatapredetermined
price
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COSTPLUSTRANSACTIONS
(Murabahah)
N t f Ri k d b h h NatureofRisksundermurabahah
Creditrisks:customermaynothonour hispromise;customer
haspurchasedtheassetandwantsthebanktofinanceit;
d d b f h k damagetoproductbeforethecustomertakespossession
Markuprisks:isbasedonacceptedbenchmarkssuchasLIBOR,
butoncedetermined,cannotbechanged;changesinprice,
othercosts,whichmayhaveadverseeffectsonthebank
Liquidityrisks:customerdefaultspayment;cancellationof
promise
Operationalrisks:assetshavebeenowned,orconsumedbefore
financingtakeplace
Commodity risks: banks may have to hold on to the product if Commodityrisks:banksmayhavetoholdontotheproductif
thecustomerchangeshismindandwillfinddifficultydisposing
it.
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COSTPLUSTRANSACTIONS
(Murabahah)
M i b h h i k Managingmurabahah risks
Inadditiontoreceivingapromisetopurchase,thebankis
allowedtotakeadeposittocoverlossesincasethe p
customerdoesnotkeephispromise
Properduediligenceontheownershipoftheassettobe
financed financed
Physicalinspectionoftheassettoensurequality,damage,
defect,etc
Toreducedefaults,banksimposeasmallpenaltybutthe
moneyisgiventocharity
To reduce liquidity risks bank enters into murabahah with Toreduceliquidityrisks,bankentersintomurabahah with
supplierandonlypayswhencustomerhasagreedto
purchasetheproduct
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PROFITSHARINGTRANSACTIONS
(Mudharabah,Musharakah)
M dh b h t t i l fi i Mudharabah contractsinvolvefinancieras
providerofcapitalandentrepreneurasprovider
of entrepreneurship Profits will be shared at a ofentrepreneurship.Profitswillbesharedata
predeterminedratioandlossesareborne
completelybyfinancier.Itisnormallyusedfor p y y y
longertermprojectfinancing
Musharakah contractsinvolvetwoormore
partnerswhoputupcapitaltofinanceaproject
andshareprofitsaccordingtosharecapitaloras
pre agreed This is also used for long term project preagreed.Thisisalsousedforlongtermproject
financing
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PROFITSHARINGTRANSACTIONS
(Mudharabah,Musharakah)
i i i hi h k h i h h h f DiminishingMusharakah iswhentheshareof
thefinancierdiminishesastheprojectowner
paysupthecost.
Typesofrisks: yp
Equityinvestmentrisks:whentheprojectisnot
makingprofits g p
Creditrisks:whenprofitpaymentsaredelayedor
notpaidatall.Creditrisksareveryhighbecause p y g
theprojectislongtermandsecondlythereisno
collateral
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PROFITSHARINGTRANSACTIONS
(Mudharabah,Musharakah)
Operationalrisks:duetocomplexityofcontracts
anddifficultiesinimplementation
Markuprisks:duetofluctuationsinthemarket
rateofreturn
liquidityrisks:dependingonthesizeandnatureof
thefunding.Iffundingcomesfrominvestment e u d g u d g co es o es e
depositsandthedepositorscannottakeout
moneyuntilmaturity,thenliquidityriskis y y, q y
reduced.
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PROFITSHARINGTRANSACTIONS
(Mudharabah,Musharakah)
i h i k Managingtheserisks
Firstistosetupastronganalysisframeworksand
strictlycontrolandmonitorprocesses.Proper
evaluationofprojectmustbedone.Ongoing
it i t b d t d monitoringmustbedonetoreduce
misrepresentationofprofits,etc.
M j l d t ti l i k b Majorlossesduetooperationalriskscanbe
coveredbytakaful (Islamicinsurance)
At l l l di ifi ti i ti l Atamoregenerallevel,diversificationisessential,
acrosscountries,regions,industries,etc.
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FORWARDCONTRACTS
(Salam)
S l i f d t t diti ith Salamisaforwardcontractoncommoditieswith
immediatepaymentofthefullprice.Quality,date
and place of delivery must be predetermined and andplaceofdeliverymustbepredeterminedand
agreedbybothparties
Types of risks Typesofrisks
Markuprisk:thepriceatpointofdeliverymaydiffer
withthatattimeofpurchase.
Commodityrisk:maynotbeabletosellthepurchased
commoditytoanotherpartyinthemarket.Thereare
possibilities of quality risks failure to deliver due to possibilitiesofqualityrisks,failuretodeliverdueto
weatherrisks,cropfailure,
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FORWARDCONTRACTS
(Salam)
Typesofrisks(contd)
Creditrisks:lateornodeliveryduetocropfailureor
weatherrisks,disputesoverquality,etc.IftheIslamic
bankactsasapurchaser,itmayhavetoincurstorage
costs,defectiveordamageorpilferagecosts,etc
Liquidityrisks:Salamcontractsarenotliquidbecause
theShariah disallowssellingsomethingthatonedoes
notyetpossess;aftertakingpossession,thebankmay
b bl ll i di l i i i notbeabletosellimmediatelygivingrisetostorage
andinsurancecosts,etc.whichwillaffectliquidity
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FORWARDCONTRACTS
(Salam)
Typesofrisks(contd)
Operationalrisks:Lookingatthenatureofsalam p g
contracts,thepurchaserfaceswithcreditrisks
fromthebeginning.Ifdeliveryisontime,there g g y ,
mightbequalitydisputes,markuprisksand
commoditypricerisks.Ifdeliveryisdelayed,there y p y y ,
isliquidityrisk,commoditypricerisks,storageand
insurancecosts,etc ,
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FORWARDCONTRACTS
(Salam)
i S l i k ManagingSalamrisks:
Commoditypricerisksandliquidityrisksmaybe
h d d b ll l l t t H thi hedgedbyaparallelsalam contract.However,this
mayleadtofiduciaryriskwhenthefirstslamcontract
is not fulfilled isnotfulfilled
Commoditypriceriskmaybemitigatedbychoosing
commoditiesthathavesteadyandcleardemandin y
themarket
Tolimitcreditrisks,onemayrequirecollateral,specify
indetailthequalityandquantityofgoodsandforce
suppliertopayapenaltywhichwillbegiventocharity
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FORWARDCONTRACT
(Istisnaa)
Istisnaa likesalam isaforwardcontractbut
onmanufacturedproducts.Quality,price, p y p
timeandplaceofdeliverymustbe
predetermined However buyer may not have predetermined.However,buyermaynothave
topayforthefullprice
f k Typesofrisks:
markuprisks:duetolongtermnatureofthe p g
contractandsecondlythemarkupisnormally
fixedwhilstthemarketratefluctuates
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FORWARDCONTRACT
(Istisnaa)
T f i k ( td) Typesofrisks(contd)
Operationalrisks:duetocomplexityofcontracts,
damage to manufactured products and other risks damagetomanufacturedproductsandotherrisks
relatedtoassetsortomaterialemployed
Creditrisks:thebankmaynotreceivethesellingprice
fortheunderlyingasseteitherintheconstruction
stageoruponcompletionoftheproject.Similarly,
there may be late delivery of completed products. In theremaybelatedeliveryofcompletedproducts.In
thecaseofcontractfailure,thebankhasnoclaimon
thematerialsthatbelongtothemanufacturer.Unlike
Salam Istisnaa contracts are not binding as long as Salam,Istisna a contractsarenotbindingaslongas
theworkhasnotstarted
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FORWARDCONTRACT
(Istisnaa)
Typesofrisks(contd)
Liquidityrisks:existbecausethecontractcannot q y
betraded.Nevertheless,bothliquidityrisksand
creditrisksinIstisnaa contractsarelowerthanin
Salamcontractsbecausepaymentisnotinfulland
canbemadebyinstallments y
Commodityrisks:commoditypricerisksarise
because of possible fluctuations in price becauseofpossiblefluctuationsinprice
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FORWARDCONTRACT
(Istisnaa)
i i i k ManagingIstisnaa risks
IslamicBanksmayrequirecollateraltomitigate
risksofnonperformance
IslamicbanksmayenterintoparallelIstisnaa
contractstohedge
Islamicbanksmayrequirequalityguaranteefrom
thesupplier
WhilesellingproductsunderIstisnaa contractis
notallowed,thebanksmayobtainpromisetobuy
andrequestfordeposits
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FORWARDCONTRACT
(Istisnaa)
M i I ti i k ( td) ManagingIstisnaa risks(contd)
ItisinterestingtonotethatIstisnaa financingallows
penalty to be collected for nonperformance without penaltytobecollectedfornonperformancewithout
havingtogiveittocharity.
Inthecaseofdelaysindelivery,apenaltycanbe
imposedonthesupplierthroughareductioninthe
pricetobepaidbythepurchaser.Thisexceptionalrule
is allowed by the Shariah scholars on the basis of isallowedbytheShariah scholarsonthebasisof
SharteJazaiallowingaclausetobeinsertedinthe
contracttothateffect.Thisistoactasafinetothe
manufacturer when he may not have devoted enough manufacturerwhenhemaynothavedevotedenough
timetocompletetheproductcausingproblemstothe
purchaser
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LEASINGCONTRACT
(Ijarah)
Ijarah contractisdirectlycomparabletoaleasing
contractwithsomeimportantdifferences:
First,itdoesnotautomaticallyleadtoafinaltransfer
oftheunderlyingasset.Thismustbeaccomplishedby
usingaseparatesalecontractorthelessor givingthe
objectasagifttothelesseeattheendlatheleasing
period
Second,thelessor bearsallrisksduringtheleasing
periodaslongasthereisnonegligencebythelessee.
Maintenanceandinsurancecostsarebornbylessor.
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LEASINGCONTRACT
(Ijarah)
TypesofRisks:
Liquidityrisks:Ijarah contractsoftenrequiresthe q y j q
banktopurchasetheobjectandpayupfront
beforeitcanleaseittothelessee.Theextentof
liquidityrisksdependsonthetradabilityofthe
asset.Liquidityrisksarealsoinfluencedbyother q y y
risks(suchascreditrisks)butmaybereducedin
theijarahwaliqtina contractwhenthesaleprice j q p
isbuiltintotheinstallmentpayments.
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LEASINGCONTRACT
(Ijarah)
Typesofrisks(contd)
Markuprisks:itdependsonhowtherental p p
paymentsarecalculated.Thesemaybelinkedto
Liborwhichmayreducetheimpactofmarket y p
returnchangesonthevalueoftheinstrument
Operational risks: related to the asset that may be Operationalrisks:relatedtotheassetthatmaybe
damagedordestroyed.Thelosswillbetreated
depending on whether there is negligence on the dependingonwhetherthereisnegligenceonthe
partofthecustomerorsomenaturaldisaster.
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LEASINGCONTRACT
(Ijarah)
Typesofrisks(contd)
Creditrisks:existontheassumptionthatthe p
customermaydelayornotpaytherental
Commodity risks: since in Ijarah contract the Commodityrisks:sinceinIjarah contract,the
lesseeisnotobligedtopurchaseortake
possession of the asset at the end of the leasing possessionoftheassetattheendoftheleasing
period,andhencethebankmayhavedifficulty
disposing the asset disposingtheasset.
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LEASINGCONTRACT
(Ijarah)
i j h i k ManagingIjarah risks:
Requireguaranteesorcollateralfromthe
customertomitigatecreditandliquidityrisks
Ifacustomerpromisestoleasetheassetbut
breaksthepromise,thelessor canusethedeposit
torecoversomelosses
Forlatepayments,penaltycanbechargedbut
mustbegiventocharity
Operationalriskscanbeoutsourcedtotakaful
coverage
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LEASINGCONTRACT
(Ijarah)
ManagingIjarah risks(contd)
Aseparatepromisetopurchasetheassetbythe p p p y
lesseeattheendofleasingperiodcanbemadeto
mitigatethecommodityrisk. g y
Throughavariablerentalratethatislinkedto
benchmark rates of return (such as Libor) both benchmarkratesofreturn(suchasLibor)both
markupriskandinflationrisksmaybereduced.
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CONCLUSION CONCLUSION
Thisisnotall,becausetherearefinancial
servicessuchasIslamicFundManagement, g
IslamicStructuredProducts,Sukuk,etc.that
have their own peculiarities and hence the risk havetheirownpeculiaritiesandhencetherisk
managementmaybeslightlydifferent.
h b f h Theobjectofthisexerciseistoprovidean
overviewofsomepeculiaritiesinrisk
managementoftheIslamictransactions.
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THANK YOU THANKYOU
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