RISK MANAGEMENT IN ISLAMIC BANKING Presentation By Arslan Asif

arsi2774@gmail.com delldanger@hotmail.com May 31, 2013 THE UNIVERSITY OF LAHORE Lahore School Of Accountancy And Finance

DISCUSSED BELOW:Risk managementDefinitionIntroductionRisk management processRisk management activitiesRisks faced by banksCommon types of risks faced by both Islamic & conventional banks Unique risks faced by Islamic banksMajor unique risks faced by Islamic banks onlyShariah perspectiveRisk mitigation toolsRisk measurementRisk management GovernanceGuiding principles for risk managementChallenge: How to capture unique risk of Islamic banking systemConclusionTen rules to risk managementWord of caution

WHAT IS RISK?Risks are uncertain future events that could influence the achievement of the objectives, including :StrategicOperationalFinancialCompliance

Uncertain future events could be:Failure of a borrower to repay a financingFluctuation of foreign exchange ratesFraud, incomplete security documentations, etc.Non-compliance with Shariah law and principlesOther events that may result in a loss to the Bank

RISK MANAGEMENT PROCESSWhat is risk management?Risk management is the process which involves Identification, measurement, monitoring, reporting and controlling risks to ensure that: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. The organizations Risk exposure is within the limits established by Board of Directors.The individuals who take or manage risks clearly understand it.Sufficient capital as a buffer is available to take risk.

RISK MANAGEMENT ACTIVITIESRisk management activities take place at:

Strategic level by senior management and BODDefinition of risks, 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 business area/across business linesRisk reviews by middle management

Micro Level where risks are actually createdActivities 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.

EXAMPLES OF RISK MANAGEMENT FAILURESBarings / Nick Leeson (1995)Barings Singapore reported SIMEX trade losses of GBP 850 millionBrought down the whole bankNational Australia Bank (2004)FX derivative losses of AUD 360 millionAllied Irish Bank / John Rusnak (2001)US subsidiary Allfirst reported FX Options trading losses of USD 750 millionLTCM, Hedge Fund (1998)Bond Market losses wiping out capital of USD3.9 billionFed and consortium of US Banks bailout

Sumitomo / Yasuo Hamanaka (1996)

Commodity (copper) trading losses of USD1.8 billion

Orange County, CA, USA (1994)

Equity losses of USD2 billion Reverse repos / over-leveraged

Societe Generale, France (2008)

Jerome Kerviel traded Euro stock index futures and concealed losses up to almost EUR 5.0 bio

The 2008 - Financial Crisis

Lack of Management / Board oversight

Weak risk culture

Risk Management function marginalized

Over-reliance on quantitative tools /methodologies

Poor liquidity management

Lack of relevant internal valuation models

RISKS FACED BY BANKSRisk Dimensions

Types of Common risksBoth Islamic and conventional bankingCredit riskThe potential that a counterparty fails to meet its obligations in accordance with agreed terms and conditions of a credit related contractMarket riskThe potential impact of adverse price movements such as benchmark rates, foreign exchange rates, equity prices on the economic value of an assetLiquidity riskThe potential loss arising from the Banks inability either to meet its obligations or to fund increases in assets as they fall due without incurring unacceptable costs or lossesOperational riskThe potential loss resulting from inadequate or failed internal processes, people and system or external events

UNIQUE RISKS FACED BY ISLAMIC BANKS

ISLAMIC BANKING LESS RISKY?

Islamic Banking is safer as it is not based on INTERESTDepositors are liable to share losses, therefore solvency risk is mitigated

MAJOR UNIQUE RISKS FACED BY ISLAMIC BANKS ONLY

Types of Unique risksIslamic banking Only

Shariah noncompliance riskRisk arises from the failure to comply with the Shariah rules and Principles

Rate of return riskThe potential impact on the returns caused by unexpected change in the rate of returns

Types of Unique risksIslamic banking OnlyDisplaced Commercial riskThe risk that the bank may confront commercial pressure to pay returns that exceed the rate that has been earned on its assets financed by investment account holders. The bank foregoes part or its entire share of profit in order to retain its fund providers and dissuade them from withdrawing their funds.Equity Investment riskThe risk arising from entering into a partnership for the purpose of 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 Mudarabah and Musharakah contracts.Inventory riskrisk arising from holding items in inventory either for resale under a Murabahah contract, or with a view to leasing under the Ijarah contract

RISK PROFILE OF ISLAMIC BANKS.uniquecommon

RISK FACTORSFollowing are the risk factors faced by IBs

Financial

Business

Operational

FINANCIAL RISK FACTORSCredit RiskDefault RiskCounter Party RiskSettlement RiskMarket RiskPrice RiskRate of return RiskExchange rate RiskLiquidity RiskFunding Liquidity RiskAsset Liquidity RiskCash Management Risk

BUSINESS RISK FACTORSManagement RiskPlanningOrganizingReportingMonitoringStrategic RiskResearch and DevelopmentProduct DesignMarket DynamicsEconomic

OPERATIONAL RISKPeople RiskRelationshipsEthicsLegal RiskComplianceControlSystem RiskHardwareSoftwareExternal RiskEventClientSecurity

PERCEPTION OF ISLAMIC BANKING INDUSTRY ABOUT RISKSThe 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 some Major Islamic banks are included.

INDUSTRY AVERAGES

CREDIT RISK

MARKET RISK

LIQUIDITY RISK

OPERATIONAL RISK

SHARIAH PERSPECTIVE

No Risk No Reward principle (Al Ribh Bi Daman)

Measures taken by Hazrat Yousuf (A.S) 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-ShariahProtection of Izat, Jaan, Aql, Maal, Nasl

RISK MITIGATION TOOLS

Following are the tools for the mitigation of risk.

Pledge of assets as collateralInventories, Shares, Sukuk, Units etc.Third party GuaranteePersonal GuaranteePromiseCharge on deposits and assetsTakafulHamish JiddiyaUrbunKhiyar / OptionParallel contract, if permissible

SEVERITY OF RISKS

RISK MEASUREMENT

Risk measurement deals with quantification of risk exposures. It includes:Risk measurement methodsTraditionalGAP analysis Duration analysisStatistical analysisScenario analysisModern portfolio theoryVariation from the mean

RISK MANAGEMENT GOVERNANCE

Risk management Governance structure

Board RiskCommitteeBoard AuditCommitteeOther Board subcommitteesSupportCFO, CTO, etcBusinessDivisionsHR

GUIDING PRINCIPLES FOR RISK MANAGEMENT

These includes

BASEL Committee on Banking Supervision

Islamic Financial Services Board (IFSB)

Bank Negara Malaysia (BNM)

Institute of International Finance (IIF)

BASEL1988 Capital Accord (Basel I)Regulatory basedSet out requirements to calculate capital charge i.e. the amount of capital to be set aside to absorb potential loss across banks and across countriesOne size fits all1996 Basel I (Amendments)Market Risk was incorporated into Basel I2004 International Convergence of Capital Measurement and Capital Standards (Basel II)Aims to make capital requirements more risk sensitiveIncludes Operational RiskBank shall be subject to 3 mutually reinforcing pillars2010 Basel III (Response to Financial Crisis)Enhanced capital ratios, liquidity ratios, leverage ratio

IFSB STANDARDS WWW.IFSB.ORGIFSB-1 Guiding Principles of Risk ManagementIFSB-2 Capital Adequacy StandardIFSB-3 Corporate GovernanceIFSB-4 Transparency and Market DisciplineIFSB-5 Supervisory Review ProcessIFSB-6 Islamic Collective Investment SchemesIFSB-7 Sukuk, Securitizations and Real EstateIFSB-8 TakafulIFSB-9 Conduct of BusinessIFSB-10 Shariah Governance Systems

BANK NEGARA MALAYSIA (BNM) WWW.BNM.GOV.MY

Islamic Banking Act 1983

Guidelines on Capital Adequacy (CAFIB)

Guidelines on Financial Reporting

Guidelines on Anti Money Laundering

Guidelines on Prudential Limits and Standards

INSTITUTE OF INTERNATIONAL FINANCE (IIF)WWW.IIF.COMFinal Report of the IIF Committee on Market Best Practices:

Principles of Conduct and Best Practice Recommendations

Financial Services Industry Response to the Market Turmoil of 2007-2008

CHALLENGE: HOW TO CAPTURE UNIQUE RISK OF ISLAMIC BANKING SYSTEM

The answer is to develop Internal Rating Systems (IRSs) in IBs

IRSs can be considered as risk-based inventories of individual assets of banks either based on the loss given default (LGD) of the facility or probability of default (PD) of the obligor or both

Most IRSs are JUDGMENTAL NOT STATISTICAL

USES OF IRSSIRSs differ from bank to bank, from use to use

IRSs are used for a number of purposes:

guiding credit origination process,

portfolio monitoring and management reporting

Analysis of adequacy of loan loss reserves and capital

Profitability and loan pricing analysis

Input to formal mathematical modes of risk management

Facilitate prudential bank supervision

DESIRABILITY OF IRSS FOR ISLAMIC BANKING SYSTEMTo capture the diverse nature of the Islamic modes of finance Internal ratings are based on the profile of individual assets, not on a bucket of assetsInternal ratings help the development of systematic database of critical financial variablesInternal ratings supplement external credit assessmentInternal ratings can enhance external ratings Internal ratings improve quality of MISs

SOURCES AND INPUTS OF IRSSClient oriented system - probability of default (PD)Facility oriented system - value of an asset expected to be lost in the event of a default (loss given a default: LGD)In both cases: balance sheet value of total asset i.e., Exposure-at- Default (EAD)Maturity of facilityConcentration of credit to the specific client as a percentage of total portfolio etc.

CONCLUSION

There are differences in terms of risks faced by Islamic banks compared to conventional banks

As a result, the risk assessment techniques need to consider these risks

The fast-paced development of Islamic banking means that risk assessment approach needs to be continuously refined

TEN RULES TO RISK MANAGEMENTThere is no return without risksRewards go to those who take risksBe transparentRisk should be fully understoodSeek experienceRisk is measured and managed by people, not by mathematical modelsKnow what you dont knowQuestion the assumptions madeCommunicateRisk should be discussed openly

Diversify-avoid concentrationMultiple risks will produce more consistent rewardsShow disciplineA consistent and rigorous approach will beat a constantly changing strategyUse common senseIt is better to be approximately right, than to be precisely wrongReturn is only half of the equationDecisions should be made only after considering the risks and returns of the possibilitiesOversight must be enterprise-wideRisks cannot be managed in isolation

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 .