Risk Management in the

Institutions offering Islamic

Financial Services (IIFS)

Abdullah Haron
Presentation at the Universitas Indonesia
15 April 2006
 Agenda

Introduction
Overview of risks in IIFS
Regulatory requirement on risk
management

2
 Introduction

The environment and evolution of

risk
Brief history of modern Islamic
finance
Definition of risk, and risk
management

3
 Environment and Evolution

1970s and 1980s

Inflating role of the financial markets
Floating exchange rates accelerated the growth of
uncertainty
Deregulation
Disappearance of old existing regulation
Distinction between commercial, investment and
universal banks
New range of products and services
Increase competition
Product innovation, diverse scope of operation
these waves of changes generated risks
4
History of Islamic Finance

5
 Definition

Risk
Measure of the volatility of unexpected
outcomes (if something is known with
certainty, then there is no risk)
Two major categories
Pure risk involves the risk of loss only such as
Takaful
Speculative risk involves both profits and losses

6
 Definition (contd)

Risk management
A systematic approach to setting the best
course of action under uncertainty by
identifying, assessing, understanding, acting
on and communicating risk issues
Goal: optimise the risk-reward trade-off and
to plan, and fund, the business development
It consists of:
A set of tools and techniques
A process that is required to implement the
strategy of an institution

7
 Is risk acceptable in Islam?
Quran
O my children, do not enter the capital of Egypt by one gate but
go into it by different gates. However, know it well that I cannot
ward off you Allahs will for none other than He has any authority
whatsoever. In Him I have put my trust and all who want to rely
upon anyone should put their trust in Him alone. And it so
happened that when they entered the city by different gates, as
their father had advised them, the precautionary measure proved
ineffective against Allahs will. Of course, Jacob had done his
best to avert the fear he had in his heart. Indeed he possessed
knowledge because of what We had taught him: but most people
do not understand the reality of the matter.
Hadith
Prophet peace be upon him once asked a Bedouin who had left
his camel untied, Why do you not tie your camel? the Bedouin
answered. I put my trust in God the Prophet then said, tie up
your camel first then put your trust in God

8
 Overview of risks in IIFS

Conventional vs. IIFS

Risk inherent in IIFS
Perception of risks in IIFS

9
 Conventional vs. IIFS

To understand the difference between

conventional risk and Islamic risk in
financial products, we need to understand
the basic concept of Fiqh Muamalat and
the unique characteristics of Islamic
business contracts

10
 Conventional vs. IIFS (contd)

Permissibility of trading and prohibition of

riba
All types of contracts are acceptable as long
as they are guided by Shari`ah rules/
principles.
Riba has been conclusively forbidden.

11
 Conventional vs. IIFS (contd)

Type of Definition How it will arise

Riba
Riba-an- Arises from loan There is excess/surplus over and above
nasiah transaction as a result the loan capital.
of delay in repayment Determination of this excess in relation
of the loan. to time.
Stipulation of this excess in the loan
agreement
Riba-al-fadl As a result of In the exchange of ribawi commodities;
exchange transaction i.e. gold, silver, wheat, barley, dates
and salt.
In the exchange of exactly similar ribawi
commodities whenever the exchanged
counter values are not equal in
amount/quantity.

12
 Conventional vs. IIFS (contd)

Free from the element of batil and

necessity of mutual consent in every
transactions
It is crucial to ensure that the contracts are
entered with mutual consent and satisfaction
of all parties involved and not tainted with any
oppressive or negative elements such as
fraud, dishonesty, misrepresentation and so
on.
Full consent can only be attained through
certainty, full knowledge, full disclosure and
transparency and zero deceit.

13
 Conventional vs. IIFS (contd)

Initial legal ruling in Muamalat is

permissibility
The flexibility and elasticity of Shari`ah
rules/principles in the area of Muamalat is
largely attributed to the fact that initial legal
ruling in this field is permissibility.

Freedom to stipulate conditions

The parties to the contract is freely to specify
whatever conditions they wish, provided that
no violation of Shari`ah rules/principles.
14
 Stylised balance sheet

ASSETS LIABILITIES

Cash & cash equivalents Current Accounts

Sales receivables Other Liabilities
Investment in securities
Investment in leased assets Equity of Profit Sharing Investment
Accounts (PSIA)
Investment in real estate
Profit Sharing Investment Accounts (PSIA)
Equity investment in joint ventures
Profit equalization reserve
Equity investment in capital ventures Investment risk reserve
Inventories
Other assets Owners Equity
Fixed assets

15
 Asset Side

Asset receivables in place of loans but short-term in

nature, except in certain countries
Ijarah and Ijarah Muntahia Bittamleek assets in place of
longer-term conventional loans, but issues on tax
framework
Salam and Istisnaa give rise to non-financial assets
Salam position in commodities (where permissible,
hedged with Parallel Salam)
Parallel Istisnaa work-in-progress inventories
Musharaka and Mudaraba are still in limited use

16
 Implications

Adequacy of risk mitigations, risk transfers and other risk

management tools for credit and market risks
Where non-binding order is recognised, Murabaha, Murabaha
for Purchase Orderer, IMB may expose the Islamic banks with
unwanted assets
Lower price at the point of disposing the assets
Operational issues such as storage
Salam assets may expose the Islamic banks with price
risk at contract maturity
Issue of hedging permissibility

17
 Implications (contd)

Adequacy of risk mitigations, risk transfers and other risk

management tools for credit and market risks
Istisnaa and Parallel Istisnaa entail operational risks
Issue of asset quality
Mudaraba and Musharaka investment
Exposure to market or credit risks depend on purpose or nature of
underlying assets
Capital impairment, Price risk at the point of disposal, Exit strategy
Issue of fair value information
Non-performing financing
Issue of penalties, guarantees

18
 Liability Side

Unrestricted profit-sharing investment accounts (PSIA)

take the place of interest-bearing deposits
do not represent liabilities, but accepted on Mudaraba
basis
PSIA constitute the bulk of the funding side
A few Islamic banks have a large proportion of current
accounts which are liabilities
Restricted PSIA are normally considered as off-balance
sheet assets
In principle, PSIA bear the credit and market risk on the
assets they finance, but not the operational or funding
risks
19
 Implications

Adequacy of risk mitigations, risk transfers and

other risk management tools for funding risk
Number of possible instruments are limited a need
for financial innovation to handle risks on long-term
fixed rate Murabaha exposures
Lack of depth of Sharia compliant interbank market
Risk of mismatch between long-term fixed rates of
return and those expected by PSIA
Estimation of liquidity risk
Rate of return risk may lead to displaced commercial
risk

20
 Implications (contd)

Status of investment account holders (IAH)?

Investment accounts funds are not ring-fenced from
Islamic banks funds
No participation in the governance and monitoring
process
Issue of transparency
Adequate disclosure
Reputational risk
Expectation of IAH on rates of return
Shariah non-compliance

21
 An IIFS relationship

Profit & Loss

Dividend/
Revenue
Hibah

Financing Investment

Balance Sheet

22
 An IIFS as fund provider
Product offering
Type of financing to market?
Size or amount?
Market segment?
Customer segment?
Budget?

Pricing decision
Revenue Price to offer?
Competitors pricing?
Fixed rate or variable rate?
Expected return to investors?

Maturity decision
Tenor/Duration?
Liquidity profile/cash flow?

Financing Funding decision

Sources of funds?
Match or mis-match funding?

Risk exposures
Credit risk/probability of default?
Liquidity risk?
Rate of Return risk?

Others
Leading economic indicators?

23
 An IIFS as Mudarib
Product offering
Deposit to market/ mobilize?
Size or amount?
Stable or volatile?
Market segment?
Customer segment? Dividend/
Budget?
Hibah
Profit Sharing Decision
Sharing Ratio to offer?
Competitors pricing?

Maturity decision
Tenor/duration?
Liquidity profile/cashflow?

Investment decision Investment

What it will be use for?

Risk exposures
Liquidity risk?
Rate of Return risk?
Credit risk/probability of default?

Others
Leading economic indicators?

24
 Fund revenue flow
Financing Investment Money Market

Funds
Revenue
Revenue Revenue

Dividend Dividend/Hibah
Funds Funds

Shareholders Investors
Dividend
Hibah

Al-Wadiah Al-Mudharabah
(Trust) (Profit-Sharing)
25
 Risk inherent in IIFS

Reputation Transparency
Risk Risk
Unique to IIFS

Shari`ah Equity
Non-compliance Investment
Risk Risk

Displaced
Rate of Return
Commercial
Risk
Risk
IIFS
Risk Profile
Operational
Credit Risk Risk
Generic

Market Risk Liquidity Risk

26
 Risk inherent in IIFS (contd)
Type of Risks Definition

Shari`ah Non- Risk arises from the IIFSs failure to comply with the
compliance Risk Shari`ah rules and principles.
Rate of Return The potential impact on the IIFSs returns caused by
Risk unexpected change in the rate of returns.
Displaced The risk that the IIFS may confront commercial
Commercial Risk pressure to pay returns that exceed the rate that has
been earned on its assets financed by investment
account holders. The IIFS forgoes part or its entire
share of profit in order to retain its fund providers and
dissuade them from withdrawing their funds.
Equity Investment The risk arising from entering into a partnership for the
Risk purpose of undertaking or 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
Mudharabah and Musharakah contracts.
27
 Risk inherent in IIFS (contd)

Shari`ah compliance relates to principles of Fiqh

Muamalat. Such requirements must permeate
through the entire organisation, including
products and activities.
Shari`ah non-compliance risk is considered as
within a higher priority category in relation to
other risks as if IIFS not acting in accordance
with Shari`ah principles, the respective
transactions shall be nullified and any income
earned from them shall not be recognised as
part of the IIFS profit. It also can give rise to
reputation risk and legal risk.
28
 Risk inherent in IIFS (contd)

Rate of return risk generally associated with

the management of the IIFS assets and sources
of funds.
It differs from interest rate risk where IIFS are
concerned with the result of their investment
activities at the end of the investment-holding
period where such results cannot be pre-
determined exactly.
IIFS responsibility is to manage their fund
providers expectations.

29
 Risk inherent in IIFS (contd)

Due to the unique features of IIFS balance

sheet, i.e. assets are mostly fixed rate while
liabilities are repriceable, a movement in
benchmark rates give rise to a different kind of
risk.
An increase in benchmark rates may result in
fund providers having expectations of a higher
rate of return.
A consequence of the change in fund providers
expectation result in displaced commercial
risk where, due to market pressure, the IIFS
need to pay a return that exceeds the rate that
has been earned on its assets.
30
 Risk inherent in IIFS (contd)

If IIFS do not yield to market pressure, they may

lose their fund providers which consequently
lead to liquidity risk.
In conventional banks, market risk is mostly in
the trading book.
In Islamic banks, market risk exist in the banking
book due to Murabahah, Ijarah, Salam,
Musharakah and Mudarabah in the banking
book asset portfolio.

31
 Risk inherent in IIFS (contd)

Market risk arise from owning the underlying

non-financial asset until maturity of a contract or
until the ownership is transferred to customer.
This create transformation of credit risk to
market risk and market risk to credit risk at
various stages of a contract
Hence it is unique for Islamic banks that market
risk and credit risk are strongly bundled
together.

32
 Perception of Risk in IIFS

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 15 major Islamic banks are
included.
Average value of assets of the participating
banks is US$492 million.

Based on, Tariqullah Khan and Habib Ahmed (2001), Risk

Management: An Analysis of Issues in Islamic Financial
Industry, Jeddah: IRTI

33
 Perception of risk in IIFS (contd)
3.1
3.0
2.9
2.8
Average 2.7
Ranking
2.6
2.5
2.4
2.3
2.2
Credit Risk Rate of Liquidity Operational Market Risk
Return Risk Risk Risk

Rate of return risk ranked the highest may be due to fixed-rate characteristics of Islamic financing and
its inability to use swap to transfer the risk.
Operational risk may have been ranked high due to the new nature of Islamic banking, i.e. a lot of the
issues related to the operations need to be instituted. These include training of employees, legal
documents, etc.
Liquidity risk is also ranked higher than credit risk due to lack of money market instruments to manage
liquidity.
Credit risk ranked relatively low may be due to the existence of collateral to mitigate this risk.
Market risk is ranked lowest may be due to the fact that these banks are not actively involved in trading
activities.
34
 Perception of risk in IIFS (contd)

3.7

3.5

3.3
Average
3.1
Ranking
2.9

2.7

2.5

h
h
ah

ah

m
na
ra

ka
ka

la
ija
ah

ab

tis

ra
ra

sa
ar
ab

is

ha
ha
ud
ur

us
us
m

m
m

D
It appears that profit-sharing modes of financing (Mudarabah and Musharakah) are perceived to have
higher credit risk.
Ijarah contract has relatively low credit risk may be due to the ownership of the leased asset remains
with the Bank.
Istisna and Salam are perceived to be riskier than Murabahah as there may be chances that the
counterparty may not be able to deliver the goods on time due to production failure, etc.

35
 Perception of risk in IIFS (contd)

3.7
3.5
3.3
Average
3.1
Ranking
2.9
2.7
2.5

h
m
h
h

ah

na
h

ka
ha

ka

ra

la
ab

tis
ija

ra
sa
ra
a

ar
ab

is

ha
ha
ud
ur

us

us
m

.m
m

D
Istisna is ranked highest in term of severity may be due to long-term nature of the contract. The
contracts are tied up to a certain mark-up rate and changes in the market rate of return would expose
these contracts to benchmark risks.
Murabahah shows the least risk as this mode of financing is usually short-term.
Ijarah is conceived to have relatively less risk may be due to the return of these contracts that can be
adjusted to reflect market conditions.

36
 Perception of risk in IIFS (contd)

3.4
3.2
3.0
Average 2.8
Ranking 2.6
2.4
2.2
2.0
ah h h ra na am ah
ah ba ka ij a is l k
ab ar
a ra
i st sa ra
ur ud sha h a
m m u us
m .m
D

Liquidity risk of instruments will be smaller if the assets can be sold in the market and/or have short-
term maturity.
Mudarabah and Murabahah are perceived to have the least risk as these instruments are usually used
for short-term financing.

37
 Perception of risk in IIFS (contd)

3.4
3.3
3.2
3.1
Average 3.0
Ranking 2.9
2.8
2.7
2.6
2.5

m
na
h
ah

ah

ah

h
ra

ka
la
tis
ah

ab

ija

sa
ra

ra
is
ar
ab

ha

ha
ud
ur

us

us
m

m
D.
Operational risk can arise from different sources. Some aspects relevant to operational risk in Islamic
banks are legal risk involved in contracts, the understanding of the modes of financing by employees,
legal documents for different instruments, etc.
Musharakah, Istisna and Salam are ranked high may indicate that banks find these contracts complex
and difficult to implement.

38
 Perception of risk in IIFS (contd)

3.9
3.7
Average Ranking

3.5
3.3
3.1
2.9
2.7
2.5

h
h
ah

m
'
ah

ra

na

ka
ka

la
ija
ah

tis

ra
ra

sa
ra
ab

is

ha
ha
ha
ur

us
us
ud
m

.m
m
m

D
credit risk market risk liquidity risk operational risk

39
 Regulatory requirement

IFSB risk management guidelines

IFSB capital adequacy standard

40
 IFSB risk management guidelines
General Requirement

Comprehensive risk management and reporting process, including appropriate Board and senior management oversight; ensuring
adequate holding of capital against risks; and complying with Shariah rules and principles.

Credit Risk Equity Investment Market Risk Liquidity Risk Rate of Return Operational Risk
Risk Risk

Strategy for Strategy, risk Appropriate Liquidity Comprehensive Adequate systems

financing which management and framework for management risk management and controls to
includes overall reporting process market risk framework for and reporting ensure compliance
level of risk for equity management in overall and each process to assess with Shariah rules
appetite. investments, respect of all liquidity exposures potential impacts and principles.
Due diligence including assets held, in respect of each of market factors Appropriate
review in respect Musharakah and including those category fund on rates of return mechanisms to
of counterparties Mudharabah that do not have a providers. on assets in safeguard the
and engage investments. ready market and/ Undertake liquidity comparison with interest of all fund
appropriate expert Appropriate and or are exposed to risk the expected rate providers.
for Shariah consistent high price commensurate of return for
compliance. valuation volatility. with ability to have investment
Methodology for methodologies. sufficient recourse account holders.
measuring and Define and to Shariah- Appropriate
reporting credit establish exit compliant funds. framework for
risk for each strategies. managing
financing displaced
instrument. commercial risk
Appropriate credit and maintaining
risk mitigating appropriate level
techniques for of balances of
each financing Profit Equilization
instrument. Reserve (PER).

41
 Measurement of Credit Risk

Individual Claims based Investment Made Under Profit-Sharing and Loss-

on External Assessment bearing Modes

Simple Risk Weight

Standardised Approach Slotting Method
Method

Four Categories

Risk Weight based on External Credit Assessments (R)

CRWA = R x Net Exposure*

*Amount of exposure less eligible collateral (Net exposure)

42
 Measurement of Market Risk

Equity Position/ Sukuk Foreign Exchange Commodity/Inventory @

Standardised Approach

Maturity
Simplified
Ladder

+ Specific + Single Currency + Directional +

+ General Market + Portfolio + Forward Gap
+ Basis +
@In case of inventory risk, only simplified approach is applicable

Market Risk Capital Requirement (MRCR)

MRWA = 12.5 * MRCR

43
 Measurement of Operational Risk

Basic Indicator
Approach
Annual Average Gross Income X 15%
(previous three years)
Capital Requirement
Gross income is defined as:

Net income from financing activities (e.g. selling price

less purchase price) which is gross of any
provisions and operating expenses; plus
Net income from investment activities; plus
Fee income (e.g. commission and agency fee)

Less:

Investment account holders share of income

Operational Risk Capital Requirement (ORCR)

ORW = 12.5 * ORCR

44
 SELF-TEST RISK MANAGEMENT IN IIFS

Do you agree that IIFS has more risks

compared to that of conventional bank?
Do you think reputational risk is higher
in IIFS operation?
Do you agree that the investment
account holders (akin to fixed
depositors) bear their own investment
risks?

45
Thank you for your attention
Special thanks to Badrul Hisham Mohd Salleh, Chief Risk Officer, Bank Muamalat
Malaysia Berhad for permitting me to use some of his materials.

46