RISK MANAGEMENT IN ISLAMIC BANKING

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 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

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.

Macro Level within a business area or across business lines

Risk reviews by middle management 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.

Micro Level where risks are actually created

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

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 Adverse changes in market value (and liquidity) of equity held for investment purposes. Covers all equity instruments including Mudaraba and Musharaka

Market Risk

Equity Risk

Major Types of Risks in IB

Liquidity Risk

Adverse cash flows in situations arising mainly out of changing market risk exposures, credit risk exposures and operational risk exposures. 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. Inadequacy of failed processes, people and systems. Also includes Shariah non-compliance Risk Inadequate legal framework, conflict of conventional and Islamic laws and conflict between Shariah rulings and legal decisions

Rate of Return Risk

Operational Risk

Legal Risk

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

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

Stress Testing

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

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
approve

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-or-return 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
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)
Conditional

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 VAR

portfolio theory

Variation from the mean

TEN RULES TO RISK MANAGEMENT

There is no return without risks

Rewards
Risk Risk

go to those who take risks

Be transparent
should be fully understood

Seek experience
is measured and managed by people, not by mathematical models the assumptions made

Know what you dont know

Question Risk

Communicate
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 is better to be approximately right, than to be precisely wrong should be made only after considering the risks and returns of the possibilities cannot be managed in isolation

Use common sense

It

Return is only half of the equation

Decisions

Oversight must be enterprise-wide

Risks

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