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Imad EL Kanj 2012

ISLAMIC RISK MANAGEMENT


6. IF Risk Management
Islamic banking is a relatively new concept and its instruments are generally not well comprehended, neither are their risks. Risk management in Islamic banks deserves special attention. However, it has many complex issues that need to be better understand. In particular, the nature of specific risks facing Islamic banks together with the virtually unlimited number of ways available to them to provide funds through the use of combinations of the permissible Islamic modes of financing PLS and non-PLS raise a host of issues in risk measurement, income recognition, adequacy of collateral and etc. Thus, innovative solutions and an appropriate adoption of available risk management are needed to reflect the special characteristics of Islamic financial products and services.

Several studies have identified weaknesses and vulnerabilities among Islamic banks in the areas of risk management and governance. Operational risk, which arises due to the failure of systems, processes, and procedures, is one area of concern. Weak internal control processes may present operational risks and expose an Islamic bank to potential losses. Governance issues are equally important for Islamic banks, investors, regulators, and other stakeholders. The role of Shariah boards brings unique challenges to the governance of Islamic financial institutions.

6.1. Specific Risk Surrounding Islamic Banks


The features of Islamic banks and the modes of financing that they follow include special risks that needed to be recognized to help make risk management.1 The PLS modes of financing raise several important considerations. Specifically, while PLS modes shift the direct risk of Islamic banks to their investment depositors, they may also increase the overall degree of risk of the asset side of banks. In practice, PLS modes make Islamic banks vulnerable to risks normally

Special risks in Islamic banking can be seen in Chapra and Khan (2000).

borne by equity investors rather than holders of debts. There are a number of reasons for this, including: The administration of PLS modes is more complex than conventional financing. These modes imply several activities that are not normally performed by conventional banks, including the determination of profit / loss sharing ratios on investment projects in various sectors of the economy, as well as the ongoing auditing of financed projects to ensure proper governance is doing. Also, there is a number of activities that Islamic banks can engage in, in addition to a number of ways they can provide funds through the use of the PLS and non-PLS modes.

When Islamic banks provide funds through their PLS facilities especially in Mudarabah contract, there is no recognizable default on the part of the entrepreneur until PLS contracts expire. A default of PLS contracts means that the investment project failed to deliver what was expected. In this case the low profit or loss is shared between parties according to stipulated PLS ratios.

Islamic banks have no legal means to control the entrepreneur who manages the business financed through Mudarabah contracts. This individual has complete freedom to run the enterprise according to his judgment. Banks are entitled only to share profit or loss from the agent according to the contract ratio. In Musharakah and direct investment contracts, banks have better opportunities to monitor the business because, in these contracts, partners may influence on the enterprise and use the voting rights. In Islamic finance PLS modes cannot logically be made with collateral or other guarantees to reduce credit risk.

The mentioned considerations underline operational risk in Islamic banking. Operational risk may arise from various sources: The unique activities that Islamic banks must perform. The non-standardized nature of some Islamic products. The lack of an efficient and reliable Shariah legislation system to enforce financial contracts. Non-PLS modes of financing also carry special risks that need to be recognized. Specifically, Salam (purchase with deferred delivery) contracts expose Islamic banks to both credit and

commodity price risk. This is because banks agree to buy the commodity on a future date against current payment and also hold the commodity until it can be converted to a cash. Similar risk is also involved in Ijarah (leasing), because this contract do not provide Islamic banks with the ability to transfer substantial risks and rewards to the lessee as leased assets must be carried on the balance sheet of banks for the term of the lease.

In the liability side, the specific risk inherent the operations of Islamic banks arise from the special nature of investment deposit, that is the capital value and rate of return are not guaranteed. This feature coupled with asymmetric information resulting from the unrestricted PLS and non-PLS contracts where banks manage deposit of people at their own discretion.2 This increases the potential of moral hazard and creates an incentive for risk taking and for operating Islamic financial institutions without adequate capital.

6.2. General Risk Surrounding Islamic Banks


In addition to the specific risks mentioned above, there are other more general factors that make the operation of Islamic banks riskier and/or less profitable than traditional banks. These are: Lack of risk-hedging instruments. The prohibition against riba and some fiqh issues in the interpretation of gharar mean that many risk hedging instruments based on traditional tools, such as option, futures and forwards are not available to Islamic banks in the current state of Islamic banking. Underdeveloped money market and government securities based on profit loss sharing. This may difficult to manage the liquidity in term of mismatching the assetliquidity and increases the liquidity shocks. Fortunately, significant progress has been made in Iran for government securities and short-term instruments such as National Participation Certificates and Central Bank Musharakah for such issues. Limited availability to access to lender- of- last resort (LOLR) facilities by central banks. The lack of Shariah-compatible LOLR facilities is associated to the prohibition of interest and thus discount rate. Islamic banks have historically been forced to hold a large proportion of their assets in reserve accounts in central banks or in correspondent accounts than conventional
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According to the unrestricted contract, depositors agree that their funds be used by banks at their discretion and they expect to share with banks the overall profits that the bank may earn.

banks. This has significantly affected their profitability because central banks give minimum or no return to these reserves. This in turn, has affected their competitiveness and increases their potentiality to the external shocks with its consequences.

6.3. Reducing Risks of Islamic Banks


Islamic banks bear considerable risks in providing their products and conducting their business. These risks include firstly those faced by conventional banks likewise (for example the credit risk), moreover Islamic banks are often unable to afford high-cost management information systems or the technology to assess and monitor risk in a timely fashion. With weak management and lack of proper risk-monitoring systems, the risk exposure of Islamic banks is high. (Iqbal 2011). However additionally they are affected by additional risks unique to Islamic banks owing their compliance with the Shariah (Ahmed and Khan 2007). Based on the list in Ahmed and Khan (2007) and in comparison with several other literature sources3, the most important risk classes for Islamic banks are outlined below. 6.3.1. Credit Risk The Credit Risk can be defined as the potential that the counterparty fails to meet its obligations in accordance with agreed terms (IFSB 2005). The claim for interest paid on overdraft is forbidden, like every form of interest, and cannot be used to compensate the banks shortfall in payment. Credit risk can arise, for instance, out of a Murabaha contract (please refer to 3.2.1.) when the counterparty fails to fulfill the debt. The IFSB defines in its principle guideline 1 (please refer to 1.3.6.2) a subcategory of credit risk, being the Equity Investment Risk. This relates in particular to the risk exposure in equity participations in Mudarabah and Musharakah contracts (please refer to 3.1.1. and 3.1.2.). (Islamic Financial Services Board[2] 2005) The bank is exposed to the risk that the counterparty does not redeem the shares if due or provides false information about generated profits. In these cases the bank has little opportunity to counteract. (Ahmed and Khan 2007)

Please refer also to the Risk Management Standard of the Islamic Financial Services Board[2] 2005, Zamir Iqbal and abbas Mirakhor (2011) Chapter Risk Management.

6.3.2. Market Risk Market risk refers to the potential impact of adverse price movements on the economic value of an asset resulting in a loss in on- and off-balance sheet positions (Islamic Financial Services Board[2] 2005). The systematic market risk arises out of macro sources. In Islamic Finance and Banking a typical example is the mark-up risk comprised in Murabaha contracts. As explained banks usually use a benchmark to price their product, for example the LIBOR. However an important prerequisite for the products Shariah compliance is that the mark-up is fixed in advance. Assuming a Murabaha contract over a longer duration, the benchmark, in this example the LIBOR, may change significantly whereas the mark-up has to stay the same. (Ahmed and Khan 2007) In this way the bank might be charged higher mark-ups in short-term liquidity transactions with other banks than it receives. The unsystematic market risk is asset or instrument specific. All Mudarabah, Musharakah, Bay Salam and Ijarah (please refer to chapters 3.1.1., 3.1.2. and 3.2.2.) contracts comprise the commodity/ asset price risk. It emerges out of the fact that the bank buys a durable asset on behalf of its customers and might, in case the customer does not fulfill his obligation, be forced to resell the commodity for the lower price.

6.3.3. Liquidity Risk In general it is problematic for Islamic banks to obtain cash at reasonable cost, also called funding liquidity risk, and to sell assets at a profitable price, also called asset liquidity risk. This is due to three obstacles. Firstly there are strict Fiqh restrictions (please refer to 1.3.) on the securitization of debt instruments leading to the fact that banks have problems to sell its receivables. Secondly the inter-bank money market for Islamic banks develops very slowly. The main reason for this dilemma is that conventional money market instruments cannot or hardly be converted to a Shariahcompliant form (please refer to chapter 4.2.). Therefore Islamic banks cannot raise funds quickly from the market. Finally the lender of last resort facililties provided by central banks are not accessible for Islamic banks as they are all based on interest.4 (Ahmed and Khan 2007)
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There exist some exceptions, for example in Malaysia. There the Bank Negara offers interest-free lending facilities to Islamic financial institutions. (Bank Negara Malaysia 2005)

6.3.4. Operational Risk The Basel Committee on Banking Supervision (2004) defines operational risk as follows: Operational risk is defined as the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events. This definition includes legal risk,5 but excludes strategic and reputational risk.. In Islamic banking the personal risk is especially high due to the infancy of the industry, for example lacking qualified professionally or appropriate IT infrastructure.

6.3.5. Legal Risk The legal systems (except Sudan, Pakistan and Iran) do not provide for or even hinder of the activities of Islamic financial institutions. Regulations aligned with the conventional system might constrain Islamic banks efficiency or make certain transactions impossible. Transactions and contracts are only standardized to a small extent and banks have to invest considerable time and money in the negotiation of complex transactions. Finally Islamic law is not enforceable in front of courts in Non-Muslim countries so that Islamic banks might have problems to sue counterparties who failed to fulfill their obligations. (Ahmed and Khan 2007)

6.3.6. Displaced Commercial Risk The displaced commercial risk can also be referred to as rate of return risk according to IFSB 1 and derives from competitive pressures on IIFS to attract and retain investors (fund providers) (IFSB 2005). Ahmed and Khan (2007) give an example: In case the Islamic bank is not able to offer competitive rates of return compared to its peer group (including conventional banks) due to the restrictions of Shariah, it may be forced to apportion part of [its] own share in profits to investment depositors in order to avoid that depositors withdraw their funds. (Ahmed and Khan 2007)

Legal risk includes, but is not limited to, exposure to fines, penalties, or punitive damages resulting from supervisory actions, as well as private settlements.

6.3.7. Shariah Risk Shariah risk describes the risk that the terms agreed in the contract do not effectively comply with Islamic jurisprudence and thus are not valid under Islamic law (Sol 2007). It can be minimized by constant monitoring of a Shariah Supervisory Board or Shariah adviser. However it might still be rejected by other Shariah scholars or customers, as the interpretation of Islamic law is not uniform. Consequently the product has to be withdrawn from the market and restructured and the Islamic bank might lose in reputation within the Muslim community. Furthermore it is possible that standard setting organizations change the requirements and likewise the competitive basis for the financial institutions. The Frankfurter Allgemeine Zeitung (2008) reported the following example. In March 2008 the AAOIFI (please refer to 4.3.2.) tightened the regulations for the emission of Sukuk (please refer to 3.4.2.). Its scholars declared that most products available on the market are not compliant with Islamic faith because issuers are guaranteed to receive the original face value at maturity on the buyback of the respective commodity, no matter whether it generated profit or loss. Such transactions are now forbidden according to the AAOFIF as the investor and issuer have to participate both in profits and losses equally generated by the commodity. Fortunately already issued Sukuk did not have to be restructured but only new ones. However Sukuk issued before the change might be rejected by some investors and banks have to invest in the product development of the new Sukuk.

6.3.8. Risk management techniques and regulations Regarding the product descriptions in chapter 1.2 and the various types of risk mentioned in this chapter, it becomes obvious that Islamic banking goes beyond the pure financing activities of conventional banking (Lewis and Algaoud 2001). Therefore risk management and diversification of risk is of utmost importance. In the following several approaches to deal with the high risk exposure are presented. Firstly most Islamic banks have a strong preference for particular contracts. For example, they prefer a debt financing mode (like Murabaha) over an equity participation (like Musharaka) in order to limit the potential loss. In this way the original twin pillars (Lewis and Algaoud 2001) of Islamic banking, being Musharakah and

Mudarabah contracts (please refer to 3.1.1.), lose importance compared to more innovative and more secure modes of financing, for example Ijarah (please refer to 3.3.) and Sukuk issuance (please refer to 3.4.2.). Secondly banks establish extensive reserve funds out of past profits (Lewis and Algaoud 2001) to compensate major losses resulting, for example, from counterparty default in a partnership contract (Musharaka or Mudaraba). Consequently they hold a higher, more conservative, level of equity in relation to debt compared to conventional banks that usually operate with higher leverage ratios (Lewis and Algaoud 2001). Due to large conceptional difference compared with the conventional system, regulatory frameworks like Basel II6 can only be adopted in Islamic banking to a small extent. However the standard setting organization IFSB mentioned in chapter 4.3.3. issued own guiding principles for risk management and capital adequacy that serve to complement BCBSs guidelines in order to cater for the specifities of IIFS [Institutions offering only Islamic Financial Services] (Islamic Financial Services Board[2] 2005). These are in particular the standards IFSB 1: Guiding Principles of Risk Management for Institutions (other than Insurance Institutions) offering only Islamic Financial Services (IIFS) and IFSB 2: Capital Adequacy Standard for Institutions (other than Insurance Institutions) offering only Islamic Financial Services (IIFS) (IFSB 2005). It is quite problematic to structure derivatives in compliance with Shariah. (Gassner and Wackerbeck 2007). Eventhough the demand is increasing such instruments are very rare in the Islamic banking system, so far. This leads to major difficulties in efficient risk management.

6.3.9. Suitable Clear Information Strategy A Clear information system in Islamic banks is more important than the conventional banking system. This is because the impact of PLS methods on depositors and the need for such investments is at the core of Islamic banking. The more depositors are needed, the more public disclosure of information about banks strategy become necessary to enable depositors to monitor banks performance. Moreover, in the Islamic banking
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The Basel Committee of Banking Supervision (BSCB) is a standard-setting body on all aspects of banking supervision in the conventional (interestbased) banking system. The framework Basel II provides a measure and a minimum standard for capital adequacy that is implemented by various national authorities. (Bank for International Settlement 2008)

system, depositors have more incentives to monitor banks operations than traditional banks, because in Islamic banks return to depositors depends on the performance of the bank. Monitoring ensure depositors that the rates of return paid to them reflect the application of PLS principle, which are the cornerstone of Islamic finance, by banks and also reduces the possibility of asymmetric information and thus, adverse selection and moral hazard. The advantageous of such a system are: This System helps depositors to choose a specific bank in which they can allocate their funds according to its performance. A clear information system in Islamic banks assists depositors with regard to diversification of their portfolio. Disclosure provides information on the main risk factors associated with the investment portfolio. Good governance and internal controls which reduce mismanagement and also brings market confidence for banks. Providing data for depositors for the expected rate of return which is an important consideration of the public. Providing information on the education and professional background of the banks staff and management.

The basis for the above considerations for more developing of Islamic banking in the future is an Islamic financial regime which could compete with the international financial organizations. One of the major pillars required to be put in the place in order to strengthen both international and domestic financial system is; to develop a uniform supervisory and regulatory frameworks which are consistent with internationally accepted practices for banks and non-banks financial entities. Organizations such as Islamic Development Bank7 (IDB) in Saudi Arabia can play a major role in the development of Islamic banks and the essential dissemination of information on the above issues to its global membership. The issues include such vital topic as: The need for regulation and uniform supervisory of Islamic Banks. Issues of risk management and guidelines on risk weight of assets. Capital adequacy, liquidity management and issues of controlling of the asset side of Islamic banks.
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http://www.isdb.org

Issues in profitability and good governance.

In the next chapter will be discussed the development of IF and its Issues/Challenges.

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