Risk Management In Islamic Banking

RISK MANAGEMENT IN ISLAMIC BANKING

CHAPTER 1: INTRODUCTION TO ISLAMIC RISK MANAGEMENT

CONCEPT OF RISK

ORIGIN OF THE WORD

• RISQ ( ARABIC )

• Anything that has been endowed to human (by Allah) and from which you attain goodness and have connotations of the fortuitous and favorable outcome.
• A Greek derivative of the world risqué was used in the 12th century would appear to relate to chance of outcomes in general and have either positive or negative implications.
• The French word ‘risq’ has main negative but occasionally positive connotations.
• The English usage of the word since the 18th century has very definite negative associations.

• RISQUM ( LATIN )

• Originally referred to the challenge that a barrier refer present to a sailor and clearly has connotations of an equally fortuitous.

WHAT IS RISK?

• The term risk has no one single definitions.
• Vaughn (2003) defines risk as a condition in which there is a possibility of adverse deviation from desired outcomes that is expected or hoped.
• According to Bickelhaupt (1979), basically ‘risk is uncertainty, or lack of predictability, it concern in possible results which causes risk to occur in so many situations.

RISK AND UNCERTAINTY

• Many consider the terms risk and uncertainty interchangeable but have somewhat different meanings, where risk refers to statistically predictable occurrences and uncertainty to an unknown of generally unpredictable variability.
• Uncertainty is said to exist in situations where decision makers lack complete knowledge, information or understanding concerning the proposed decision and its possible consequences.

RISK RELATED TERMS

• PERILS – The cause of risk
• HAZARDS – Acts or conditions which increase the like hood of risks, physical hazard , moral hazard, morale hazard and legal hazard

CLASSIFICATIONS OF RISK

• Speculative and pure risk involves the chance of loss or gain and pure risks involve the chance of loss or no loss.
• Financial and no financial risks, risk include all situations in which there in an exposure to ad varsity in some cases this adversity involves financial losses.

• Static and dynamic risks, dynamic risks are those resulting from changes in the economy (changes in price levels, consumer’s tastes, and technology). Static risk involve those that would occur even if there no changes in the economy (perils of nature, dishonesty of individuals.
• Pure risk that exists for individuals and business firm can be further classified as follows:

1. Personal risks

• Premature death
• Dependent old age
• Sickness
• Unemployment

1. Property risks

• Directs loss
• Consequential loss

1. Liability risk

• Property damage
• Bodily injury

1. Risks arising from failure of others

Risk Components

According to Allen (1995) risk in made out four essential components namely :

• Probability of occurrence
• Severity of impact
• Susceptibility to change

Risk from an Islamic Perspective

The broad perspectives on risk and its management are embodied in the overall goals of Islamic law defines Maqasid as promotion of “well-being of the people, which lies in safeguarding there:

• Faith
• Self
• Intellect
• Posterity
• Wealth

Hassan (2009) Identifies Three Types Of Risk From The Islamic Perspectives, Namely:

1. Essential risk – that is inherent in all business transactions their risk is necessary and must be undertaken to reap the associated reward or profit, two legal maxim associating returns to essential risks are:

The detriment is as a return for the benefit, this maxim attaches the entitlements of gain to the responsibility of ignorance.

Derived from the prophetic saying “al kharaj bil deman” stating “the benefit of a thing is a return for the liability for loss from thing”. The maxim asserts that the party enjoying the full benefit of an asset or object should bear the risks of ownership.

1. Prohibited risk – in the form excessive gharar. Gharar relates to the ambiguity or ignorance of either the terms of the contract or in the object of the contract. Thus, sale can be void due to gharar, due to risks of existence and taking possessions of the object of sale on one hand, and uncertainty of the quantity, quality, price and time of payment on the other.

1. Permissible risk – Risk that does not fall in the above two categories, examples of these risks can be operational risk, liquidity risk, etc these risks can either be accepted or avoided.

RISK MANAGEMENT

• Norman Baglini (1983) defines risk management as an economic process of allocating a business firm’s financial resources in the optimum combination of loss control and loss financing methods to minimize the costs of pure risks.
• Vaughan (2003) defines risk management is a scientific approach to dealing with risks by anticipating possible accidentals losses and designing and implementing procedures that minimize the occurrence of loss or the financial impact of the losses that the occur.

THE EVALUATION OF RISK MANAGEMENT

• The term risk management relating to business risks first appeared in the 1950s not until 1970 did non- financial businesses begin to practice risk management in a meaning full way.
• Risk management were overwhelmingly concerned with hazard risks and the purchase of insurance, risk associated with the firm’s production processes were managed by human resources, little consideration was given to how disparate risk related to each other, not to overall firm value.
• Managers have since been under pressure to gain a sophisticated understanding of the risks that their organization faced.

THE RISK MANAGEMENT PROCESS

Basically the risk management process involved a six step of activities namely:

1. The setting up of risk management policies.
2. The identification of risk
3. The evaluation of risk.
4. The development of a risk management plan to mitigate the risks i.e. through risk control and risk financing mechanism.
5. The implementation of the risk management plan.
6. The review and monitoring of the risk management plan.

RISK MANAGEMENT FROM ISLAMIC VIEWPOINT

Introduction

• As discussed earlier, economic activities from an Islamic perspectives, are not judged by their inherent risks, but by whether they add value and/or create wealth.
• Hassan (2005), for instance identifies the three types of risks from the Islamic perspectives which are :

• Essential risk
• Prohibited risk
• Permissible risk

• Siddiqi (2009), identifies two ways of managing risks in financing, sharing and transferring while the tendency in conventional finance is to transfer risks (through debt-based financing), he asserts that the approach in Islamic finance should be risk-sharing. Thus, modes such as musharakah and mudharabah reflect the spirit of Islamic teachings and should be adopted by the Islamic financial institutions (IFI).

• In the history of Islam, there are many incidents that are closely related which can be used as a benchmark. In facing and managing risk, several steps can be implemented:

• Risk reduction
• Risk sharing
• Risk avoiding
• Risk controlling

• Among the historical incidents that can be related to a risk management practice:

• The hijrah of the prophet (S.A.W) from Makkah to Madinah
• During the battle of Badr.
• During the Battle of Khandaq.

• The principle of risk sharing was stated in the statute of Madinah.

APPROACHES IN RISK SHARING

• Approaches used in Risk sharing will be in line with the risk management principles which have been set by Islamic Financial Services Board (IFSB). The principle provides a set of guidelines of best practice for establishing and implementing effectives risk management in Financial Institutions that offer services in accordance to Shariah rules and principle of risk management has been set which each principle will provide practical aspect in managing the risks underlying the business objectives that each Islamic Financial Institutions (IFI) may adapt.

GENERAL PRINCIPLES

Principles 1: IFI should have a comprehensive risk management and reporting process in place. The process should consider appropriate steps to comply with shariah rules and principles and to ensure the adequacy of relevant risk reporting to the supervisory authority.

Credit risk

Principles 2: IFI should have a strategy for financing; the instruments used must be in compliance with Shariah, whereby it recognizes the potential credit exposures that may arise at different stages of the various arrangements.

Principles 3: IFI shall carry out a due diligence review in respect of counterparties prior to deciding on the choice of an appropriate Islamic financing instruments.

Principles 4: IFI should have appropriate methodologies for measuring and reporting the credit risk exposures arising under each Islamic financing instrument.

Principles 5: IFI shall have in place shariah- compliant credit risk mitigating techniques appropriate for each Islamic financing instrument.

Investment risk

Principles 6: IFI should have appropriate strategies in place for risk management and reporting processes in respect of the risk characteristics of equity investments, including Mudharabah and Musharakah investments.

Principles 7: IFI must ensure their valuation methodologies are appropriate and consistent, and they should conduct the assessment on the potential impacts of their methods on profit calculation and allocations. The methods shall be mutually agreed between IFI and Mudarib and/or Musharakah partners.

Principles 8: IFI shall, in respects of their equity investment activities, including extension redemption conditions for Mudharabah and Musharakah investments, exit strategies should be defined and established and must subject to the approval of the institution’s Shariah Board.

Market risk

Principles 9: In respect of all assets held, IFI shall have an appropriate framework for market risk management (including reporting) and also those that do not have a ready market and/or are exposed to high price volatility.

Liquidity risk

Principles 10: IFI 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, restricted investment accounts.

Principles 11: IFI shall assume liquidity risk commensurate with their ability to have sufficient resources to Shariah-compliant funds.

Rate of return risk

Principles 12: A comprehensive risk management and reporting process should be established by IFI in order to assess the potential impacts of market factors affecting rates of return on assets in comparison with the expected rates of return for investments account holders (IAH).

Principles 13: IFI must ensure that an appropriate framework for managing displaced commercial risk is in place, where applicable.

Operational Risk

Principles 14: IFI should have in place adequate system and controls, including Shariah Board or Advisor, to ensure compliance with Shariah rules ad principles.

Principles 15: IFI shall have in place appropriate mechanism to safeguard the interests of all fund providers.

CHAPTER 2: THE ANALYSIS OF RISK MANAGEMENT

UNDERSTAND THE METHODS OF RISK ANALYSIS

• Risk analysis is a technique to identify and assess for mitigation of risks, at project ignition and during task execution.
• The advantage of this approach is that it is clear to all sides, vendor, contractors and purchase, what the risks are and who has ownership of each one.
• This approach to mitigating the risk factors also helps to define preventive measures to reduce the probability of occurrence and identify methods to avert possible negative effects on the effectiveness of the company to compete in this particular market.

Methods

1. Establish context

• Identification of the risks in a selected interest domain.
• Planning the rest of the processes.
• Mapping out the social scoping, who the stakeholders are and what their objectives. Working out the constraints.
• Defining the activity framework and identification agenda.
• Analyzing risks involved in the process.
• Mitigation of these risks using several available resources.

1. Identify risks

• Source analysis – where are the risks?
• Problem analysis – all risks are related to identify threats.

1. Assessment of risks

• Risk = rate of occurrence x the event impact

1. Treatment of risks

• Avoidance ( or complete elimination)
• Reduction (or mitigation)
• Retention
• Transfer (or buying insurance)

1. Create Mitigatory Plan of risks

• Means carrying out the mitigation plan to the letter!

Mitigation

• Mitigation is the effort to reduce loss of life and property by lessening the impact of disasters.
• This is achieved through risk analysis, which results in information that provides a foundation for mitigation activities that reduce risk, and flood insurance that protects financial investment.
• There are two primary methods of risk analysis and one hybrid method:

1. Primary methods:

• Qualitative: improve awareness of information system security problems and the posture of the system being analyzed.
• Quantitative: identification of where security controls should be implemented and the cost envelope within which they should be implemented.

1. Hybrid method:

• A selected combination of these two methods can be used to implement the components utilizing available information while minimizing the metrics to be collected and calculated.

Frequency and severity

• Also known as Risk Matrix
• Risk = (probability of the hazard) x (expected loss in case of the hazard)
• Risk Matrix is a matrix that is used during Risk Assessment to define the various levels of risk as the product of the harm probability categories and harm severity categories. This is a simple mechanism to increase visibility of risks and assist management decision making.
• This toll (frequency and severity) is used to quantify the likelihood (or frequency) and impact (or consequence) of identified risks in order to prioritize risk response activities.
• Frequency and severity probability should be evaluated first, followed by estimating the potential severity of the consequences.
• It helps identify the risks that are most urgent or must be avoided, those that should be transferred or reduced, and those it is reasonable to retain.

Frequency

• Is the number of occurrences of a repeating event per unit time.
• In risk analysis, frequency refers to probability of the hazard.
• Normally categories of frequency are:

1. Frequent (occurs often, continuously experienced)
2. Likely (occurs several times)
3. Occasional (occurs sporadically)
4. Seldom (unlikely, but could occur at some time)
5. Unlikely (can assume it will not occur)

Severity

• Degree of harshness or sternness.
• “Despite incurring a loss, a company may still generate positive annual profits depending on the severity of the loss”.
• In risk analysis, severity refers to expected loss in case of the hazard.
• Normally categories of severity are:

1. Catastrophic

• Death or permanent total disability, system loss, major property damage.

1. Critical

• Permanent partial disability, temporary total disability in excess of 3 months, major system damage, significant property damage.

1. Marginal

• Minor injury, lost work day accident, compensable injury or illness, minor system damage, minor property damage.

1. Negligible

• First aid or minor supportive medical treatment, minor system impairment.

Descriptive analysis

• The analysis from the consist of methods for organizing, displaying, and describing data by using tables, summary measures or graph.
• Descriptive statistics are distinguished from inferential statistics (or inductive statistics), in that descriptive statistics aim to summarize a sample, rather than use the data to learn about the population that the sample of data is thought to represent.
• Descriptive statistics is also a set of brief descriptive coefficients that summarizes a given data set, which can either be a representation of the entire population or a sample.
• The measures used to describe the data set are measures of central tendency and measures of variability or dispersion.
• Measures of central tendency include the mean, median and mode, while measures of variability include the standard deviation (or variance), the minimum and maximum variables, kurtosis and weakness.
• Descriptive analysis data in a way that is often used to classify customers or prospect into groups.
• Descriptive analysis tools can be utilized to develop further models that can simulate large number of individualized agents and make predictions.

Inferential statistics

• Consists of methods that use sample results to help make decisions or predictions population. Also called inductive statistics.
• Inferential statistics refer to the use of current information regarding a sample of subject in order to:

1. Make assumptions about the population at large.
2. Make predictions about what might happen in the future.

• The goal of inferential statistics is to do just that – to take what is known and make assumption or inferences about what is not known.
• There are five main categories of inferential procedures:

1. T-test

• Is perhaps the most simple of the inferential satistics.
• The purpose of this test is to determine if a difference exists between the means of two groups. (think ‘t’ for two)
• Example: to determine if the result of students with prior work experience differs from the result of students without this experience, we would employ the t-test by comparing the results of each group to each other.

1. ANOVA

• Is short for Analysis of Variance and is typically used when there are one or more independent variables and two or more dependent variables.
• The ANOVA is superior for complex analyses for two reasons, the first being its ability to combine complex data into one statistical procedure.

1. Factor analysis

• Is used when an attempt is being made to break down a large data set into different subgroups or factors.
• By using a somewhat complex procedure that is typically performed using specialized software, a factor analysis will look at each question within a group of questions to determine how these questions accumulate together.

1. Regression analysis

• When a correlation is used we are able to determine the strength and direction of the relationship between two or more variables.

1. Meta analysis

• Refers to the combining of numerous studies into one larger study.
• The Meta analysis basically combines many studies together to determine if the results of all of them, when taken as a whole, are significant.

Measurement of probability

Probability

• Is a numerical measure of the likelihood that a specific event will occur.
• Three conceptual approach to probability:

1. Classical probability

• Applied to compute the probabilities of events for an experiment in which all outcomes are equally likely.
• Example: this experiment has a total six outcomes: 1, 2, 3, 4, 5, and 6. All these outcomes are equally likely. Let A be an event that an even number is observed on the die. Event A includes three outcomes: 2, 4 and 6;

That is, A= (2,4,6)

Answer:

P (A) = 1/ (total number of outcomes for the experiment)

= 3/6

= 0.50

1. The relative frequency concept of probability

• If an experiment is repeated n time and an event A is observed f times, then, according to the relative frequency of probability:

P(A) = f / n

• Example: ten of the 500 randomly selected cars manufactured at a certain auto factory are found to be lemons. Assuming that the lemons are manufactured randomly, what is the probability that the next car manufactured at this auto factory is a lemon?

Answer; let n denote the total number of cars in the sample and f the number of lemons in n. then,

• = 500 and f = 10

Using the relative frequency concept of probability, we obtain:

P (next car is a lemon) = f / n

= 10/500

= 0.02

1. The subjective probability concepts

• Is the probability assigned to an event based on subjective judgment, experience, information and belief.
• Is assigned arbitrarily. It is usually influenced by the biases, preferences and experience of the person assigning the probability.
• In normally banking practice, their will make subjective probability after looking on:

1. CAMELS

Capital + Asset + Management Quality + Equity, Liabilities + Sensitivity to Market Risk

1. 5Cs

Character, capacity, capital, collateral and conditions

1. Financial ratio

Liquidity, leverage, operational, profitability and marketability

1. Types of industries

Manufacturing, tourism, retailing, foods, etc

• Example: the probability that Azman, who is taking PS601, will earn an A+ in this course.

Answer:

Azman will take the test only once and based on that he will either earn A+ or not. The probability assigned to an event in these cases is called subjective probability. The answer refers to who evaluate him depending on attendance, quiz and etc.

• Bank Saham Berhad lends RM100 million to a YAD Industry. The total value of the Ar- Rahn collateral stands at RM75 million. What will be the Lose Given Default (LGD) if the case of default?

LGD = (1 – 0.75)

= 0.25

= (0.25) (RM100 M)

= RM25 M

• If the Bank Saham Berhad provides a master borrowing line of RM300 million to a YAD industry, and drawdown is 10%; what will be the bank’s total Exposure At Default (EAD) in Ringgit Malaysia?

EAD = (RM300 M) (0.10)

= RM30 M

• Al- Rajhi Bank assigns a financing facility to a client with Loss Given Default (LGD) of 45%, what will be the Recovery Rate (RR)?

RR = 1 – 0.45

= 0.55

= 55%

• If the client bank has a Probability of Default (PD) of 5%, than what is the Repayment Probability?

RP = (1 – 0.05)

= 0.95

= 95%

• If PD is 25% and LGD is 11%, what will be Expected Loss (EL)?

= 2.75%

• If Bank Saham Berhad has ab expected loss of 10%, what will be its Unexpected Loss (UL)?

UL = (1 – 0.10)

= 0.90

= 90%

UNDERSTAND THE VARIOUS METHODS OF REPRESENTING DATA

Various Methods of Measuring Data:

1. Measures of location

• Is the single value that best represents characteristics such as age or height of a group of persons.
• Measure of location:

1. Mean

The sample mean is an estimator available for estimating the population mean. It is a measure of location, commonly called the average, often symbolized.

1. Median

The median is the value halfway through the ordered data set, below and above which there lays an equal number of data values.

1. Mode

The mode is the value of the random sample that occurs with the greatest frequency. It is not necessarily unique. The mode is typically used in a qualitative fashion.

1. Measures of dispersion

• A measure of dispersion quantifies how much persons in the group vary from each other and from our measure of central location.
• The data values in a sample are not all the same. This variation between values is called dispersion.
• When the dispersion is large, the value are widely scattered; when it is small they are tightly clustered.
• In manufacturing or measurement, high precision is associated with low dispersion.

1. Skew

• Skewness is defined as asymmetry in the distribution of the sample data values. Values on one side of the distribution tend to be further from the ‘middle’ than values on the other side.
• For skewed data, the usual measures of location will give different values, for example, mode<median<mean would indicate positive (or right) skewness.
• Positive (or right) skewness is more common than negative (or left) skewness.

UNDERSTAND VARIOUS TYPES OF RISK ANALYSIS

Types of Risk Analysis

1. The Investment Portfolio Analysis

• An investment portfolio is a mixture of investment types all held simultaneously and is a method decreasing or limiting the risk associated with investing.
• By balancing the portfolio, the organization may limit the risk of being left without investment options or earnings should there be a down turn in any particular area of the financial industry.
• A portfolio can include any combination of investments, including bank accounts, bonds, stocks, warrants, deeds, options, futures, certificates and businesses. Any item that is likely to retain its value and/ or produce a return can be include in an investment portfolio.

1. The Performance of Various Islamic Funds

• A mutual funds that invests primarily or exclusively in high-risk, high-return securities.
• Customers may invest in IPOs and quickly re-sell.
• Very little of the income from an aggressive growth mutual fund comes from dividend, rather, most of its earnings come from capital appreciation.
• The funds have a high degree of volatility and tend to correlate highly with stock market performance.
• Some analysts believe that while aggressive growth mutual funds are correlate highly meaning that their values increase and decrease more sharply than stock markets as a whole.

1. The Growth Analysis

• Growth ratios or growth rates – tell the analyst just how fast a company is growing.
• The most important of these ratios analysis include:

1. Sales (%)

Normally stated in terms of a percentage growth from the prior year. Sales is the term used for operating revenue, so it’s important to see the sales growth rate as high as possible.

1. Net income (%)

Growth in net income is even more important than sales because net income tells the investor how much money is left over after all of the operating costs are subtracted from sales.

1. Dividend (%)

A good indicator of the financial health of a company. Some companies do not pay stock dividend; rather they use these excess profit to reinvest money back into the company to accelerate growth. The change in dividend (%) should never be negative. That is, once a dividend rate is established, a company needs to have a very good reason to decrease the payout.

1. The Relative Financial Ratio

• Is a relative magnitude of two selected numerical values taken from an enterprise.
• Financial ratios may be used by managers within a firm by current and potential shareholder (owners) of a firm and by a firm’s creditors.
• It is used to compare the strengths and weaknesses in various companies financial statements.

1. The Financial Ratios and Systematic Risk

• Types of financial ratios:

1. Liquidity ratios

Measure the availability of cash to pay debt.

1. Activity ratios

Measures how quickly a firm converts non-cash assets to cash assets.

1. Debt ratios

Measure the firm’s ability to repay long-term debt.

1. Profitability ratios

Measure the firm’s use of its assets and control of its expenses to generate an acceptable rate of return.

1. Market ratios

Measure investor response to owning a company’s stock and also the cost of issuing stock.

• Systematic risk

• Systematic risk refers to the risk intrinsic to the complete market or the complete market segment.
• Systematic risk is also sometimes referred as “market risk” or “un-diversifiable risk”.
• Systematic risk results from political factors, economic crashes and recessions, changes in taxation, nature disasters and foreign-investment policy. These risks are widespread as they can affect any investment or any organization.
• They affect the complete market and are unavoidable through diversification.
• While this risk type affect a wide range of securities, unsystematic risk affects quite a particular group of securities or even an individual security.
• Moreover, systematic risk can be reduced by just being hedged.

1. The Financial Ratios and Sukuk

• A financial ratio that expresses the leverage of a bond issuer. The bond ratio formally expresses the ratio of the bond issued to the company’s capitalization as a percentage. The ratio is equivalent to the total amount of bonds due after one year divided by that same amount plus all outstanding equity.
• In Islamic banking, bond is a Sukuk which is an Islamic financial certificate that complies with Sharia, Islamic religious law.
• The issuer of a sukuk sells an investor group the certificate, who then rents it back to the issuer for a predetermined rental fee. The issuer also makes a contractual promise to buy back the bonds at a future date at par value.
• Sukuks must be able to link the returns and cash flows of the financing to the assets purchased, or the returns generated from an asset purchased. This is because trading in debt is prohibited under Sharia. As such, financing must only be raised for identifiable assets.

CHAPTER 3: SOURCES OF RISK IN ISLAMIC BANKING

State the Various Types Of Risk In Islamic Banking (Generic Risk)

1. Credit Risk
2. Market Risk and Business Risk
3. Liquidity Risk
4. Operational Risk

CREDIT RISK

• Credit risk management lies at the heart of survival for the vast majority of banks.
• The largest source of risk for banking institutions in Malaysia.
• The consequence of such loses not only disrupts the intermediation function of the institution affected, but also imposes large financial burdens on the government in recapitalizing such banking institutions.
• Effective credit risk management is therefore vital to ensure that a banking institution’s credit activities are conducted in a prudent manner and the risk of potential bank failures reduced.
• Who is counterparty?

• Single-customer(and individual, legal person or a connected group to which a bank is exposed)
• Related-party(bank’s parent, major shareholders, subsidiaries, affiliate companies, directors and executive officers)
• Overexposure to geographic areas.
• Economic sectors.

IFSB principles of credit risk;

• Principle 2.1. Islamic financial institutions

• Shall have in place a strategy for financing, using the various Islamic instruments in compliance with Shariah, whereby there recognize the potential credit exposure that may arise at different stages of the various financing agreements.

• Principle 2.2. Islamic financial institutions

• Shall carry out a due diligence review in respect of counterparties prior to deciding on the choice of and appropriate Islamic financing instrument.

• Principle 2.3. Islamic financial institutions

• Shall have in place appropriate methodologies for measuring and reporting the credit risk exposures rising under each Islamic financial instrument.

• Principle 2.4. Islamic financial institutions

• Shall have in place Shariah compliance credit risk-mitigating techniques appropriate for each Islamic financial instrument.

CREDIT RISK SPECIFIC TO ISLAMIC BANKS

• Murabahah transaction

• Islamic banks are exposed to credit risks when the bank delivers the asset to the client but does not received payment from the client in time.
• In case of a nonbinding murabahah, where the client has the right to refuse delivery of the product purchased by the bank, the bank is further exposed to price and market risks.

• Bai’al-salam or Istisna’ contracts

• The bank is exposed to the risk of failure to supply on time, to supply at all, or to supply the quality of goods contractually specified.
• Such failure could result in a delay or default in payment, or in delivery of the product and can exposed Islamic banks to financial loses of income as well as capital.

• Mudharabah investments

• Where the Islamic bank enters into the Mudharabah contract as Rabbul Mal (principle) with and external Mudharib (agent), in addition to the typical principle-agent problems, the Islamic bank is exposed to and enhanced credit risk on the amounts advanced to the mudharib.
• The nature of the Mudharabah contract is such that it does not give the bank appropriate rights to monitor the mudharib or to participate in management of the project, which makes it difficult to assess and manage credit risk.
• The bank is not in a position to know or decide how the activities of the mudharib can be monitored accurately, especially is losses are claimed.
• This risk is especially present in markets where information asymmetry is high and transparency in financial disclosure by the mudharib is low.

PORTFOLIO ANALYSIS

1. Analysis of the aggregate portfolio credit risk should therefore include the following :

• A summary of the major types of investment and financing assets, including details of the number of customers or customer types, average maturity, and average earnings.
• A list of government or other guarantees.
• A review of accounts by risk classification.
• And analysis of nonperforming accounts.
• A review of the distribution of the portfolio, including various perspectives on the number of investment and financing assets and total amounts, for example, according to currency, short term (less then 1 year) and log term (more then 1 year) maturities, industrial or other pertinent economic sectors, state own and private clients and corporate and retail landing.

1. A detailed credit portfolio review should include the following :

• All customers with an aggregate exposure large that 5% of the bank’s capital.
• All exposures to shareholder and connected parties.
• All investment and financing asset for which the financing schedule has been risk schedule or otherwise altered since the guarantee of the facility.
• All investment and financing assets classified as substandard, doubtful or loss.

1. A summary file(business purposes) should be made showing the following :

• Entrepreneurs name and line of business.
• Use of proceeds.
• That credit granted.
• Maturity date, amount, currency, and term of investment.
• Principle source of repayment.
• The nature and value of collateral and security (or valuation basis, if a fixed asset).
• Total outstanding liabilities in cases where the bank is absorbing the credit risk.
• Delinquency or non performance, if any.
• Description of monitoring activities undertaken.
• Financial information, including current financial statements and other pertinent information.
• Specific provision that is required and available.

INTERBANK DEPOSITS

1. Interbank deposits are an important category of bank asset. There may account for a significant percentage of banks balance sheet, particularly in countries that lack convertibility but allow citizen and economic agent to maintain foreign exchange deposit.
2. A review of interbank (landing) transactions typically focuses on the following aspects :

• The establishment and observation of counterparty credit limits, including a description of the existing credit limit policy.
• Any interbank credit for which specific provision should be made.
• The method and accuracy of reconciliation of nostro and vostro account.
• Any interbank credits with terms of pricing that are not the market norm.
• The concentration of interbank exposure with a detailed listing of bank and amounts outstanding as well as limits.
• Known as ‘ours’ and ‘yours’ accounts. Accounting term used to distinguish an account held for another entity from an account another entity holds.

OFF-BALANCE-SHEET COMMITMENTS

1. All off-balance sheet commitments that incur credit exposure should be reviewed.
2. An assessment should be made of the adequacy of procedures for analyzing credit risk and the supervision and administration of off-balance-sheet credit instruments, such as guarantees.
3. The key objective is to assess the ability of the client to meet particular financial commitments in a timely manner.

NONPERFORMING ASSETS

1. Nonperforming assets are assets that are not generating income.
2. Loans are often considered to be nonperforming when principles or interest on them is due and left unpaid for 90 days or more (this period may vary by jurisdiction).
3. The investment cash flow and overall ability to repair amounts owed are significantly more important then whether the payment is overdue or not.
4. The analysis of a nonperforming portfolio should cover a number of aspects, as follows:

• Classifications, broken down by type of customers and branch of economic activity, to determine overall trends and whether or not all customers are affected equally.
• Reasons for the deterioration of the portfolio quality, which can help to identify possible measures to reverse a given trend.
• Provision levels, to determine the bank’s capacity to withstand default.
• The impact on profit and loss sharing accounts, to determine exactly how the bank will be affected by the deterioration in asset quality.
• A list of nonperforming accounts, including all relevant details, assessed on a case by case basis, what can be done to improve repayment capacity, and whether or not workout or collection plans has been used.

CREDIT RISK FACED BY LENDERS TO CONSUMERS

• A consumer will default on any type of debt by failing to make payments which it is obligated to do.
• The risk is primarily what of the lender and includes lost principle and interest, disruption to cash flows and increased collection costs.
• To reduce the lender’s credit risk, the lender may perform a credit check on the prospective borrowed, may required the borrower to take out appropriate takaful, such as mortgage takaful or seek security or guarantees of third parties (kafalah/hiwalah), besides other possible strategies.
• The loss may be or partial and arise in a number of circumstances:

• Consumers may fail to make a payment due on a mortgage financing, credit card, line of credit, or other financing.
• A company is unable to repay amounts secured by a fixed or floating charge over the assets of the company.
• A business or consumers does not pay a treat invoice when due.
• A business does not pay an employee’s earned wages when due.
• A business of government sukuk issuer does not make a payment on principle payment when due.
• An insolvent takaful company does not pay a policy obligation.
• An insolvent bank won’t return funds to depositors.
• A government grants bankruptcy protection to an insolvent to consumer or business.

• Lender’s mitigate credit risk using methods:

• Risk based pricing:

Lenders generally charge a higher profit rate to borrowers who are more likely to default, a practice called risk based pricing. A lender consider factors relating to loan such as financing purpose, credit rating, and loan-to-value ratio and estimates the effect on yield (credit or financing spread).

• Covenants:

Lenders may right stipulations on the borrower, called covenants, into loan agreements:

• Periodically report its financial condition.
• Refrain from paying dividends, repurchasing shares, borrowing further, or other specific, voluntary action that negatively affect the company’s financial position.
• Repay the loan in full, at the lender’s request, in certain events such as changes in the borrower’s debt to equity ratio or interest coverage ratio.

• Credit insurance and credit derivatives:

Lenders and bond holders may hedge their credit risk by purchasing credit insurance derivatives. These contracts transfer the risk from the lender to the seller (insurer) in at changes for payment. The most common credit derivative is the credit default swap.

• Tightening:

Lenders can reduce credit risk by reducing the amount of credit extended, either in total or to certain borrowers.

• Diversification:

Lenders to a small number of borrowers (of kinds of borrowers) faced a high degree of unsystematic credit risk, called concentration risk. Lenders reduce this risk by diversifying the borrower pool.

• Deposit insurance:

Many governments established deposit insurance to guarantee bank deposits of insolvent banks. Such protection discourages consumers from withdrawing money when a bank is becoming insolvent, to avoid bank run and encourages consumers to hold their savings in the banking system instead of in cash.

CREDIT RISK FACED BY LENDERS TO BUSINESS

• Same as credit risk faced by lender to borrower. The different only at types of business.
• Normally the lender will look on the types of business, nature of business and the reputations of the business.
• Lenders will look on view of ratio and view of quality management of the business its self.

CREDIT RISK FACED BY BUSINESS

• Categories business normally are:

• Constructions Business, Manufacturing Business, Retailing Business and Agriculture Business.

• Categories SMes:

• Medium Enterprises, Small Enterprises and Micro Enterprises.

• Credit risk faced are different accordingly to types and categories business its self.
• High enterprises and medium enterprises normally faced high or credit risk because of amount the need.
• Small Enterprises and Micro Enterprises normally faced high of to pay back the financing or debt.
• Nature business retailing and manufacturing also faced more credit risk because of them buys stock, asset and inventories by credit.

CREDIT RISK FACED BY INDIVIUALS

• Credit is a facility to borrow with agreement to repair the creditor, as per the terms and conditions outlined in the contract.
• Money on loan needs to be paid back-with profit charges or penalty charges (ujr) when it is repaid late.
• The individuals will face bankruptcy if they fail to pay back loan.
• Rules to individuals to borrowing:

• Borrow for productive purpose.
• Borrow within individual means.
• The individual has a moral commitment.

MARKET RISK

• Market risk is the risk that a bank may experience loss due to unfavorable movements in market prices.
• Exposure to market risk may arise as a result of the bank taking deliberately speculative positions (proprietary trading) or may ensue from the bank’s market-making (dealer) activities.
• Market risk result from changes in the prices of equity instruments, commodities fixed-income securities, and currencies.
• Market risk is a major components:

• Equity position risk
• Commodities risk
• Rate of return risk
• Currency risk

IFSB PRINCIPLE OF MARKET RISK

1. Principle 4.1. Islamic financial institutions

• 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 or exposed to high price volatility.

MARKET RISK SPECIFIC TO ISLAMIC BANKING

• MARKUP RISK

• Islamic banks are exposed to markup risk, as the markup rate used in Murabahah and other trade-financing instruments is fixed for the duration of the contract, while the benchmark rate may change.
• This means that the prevailing markup rate may rise beyond the rate the bank has locked into a contract, making the bank unable the benefit from higher rates.

• PRICE RISK

• In other to hedge is position, the bank may enter into a parallel (off-setting) Bai’ Salam contract.
• In such cases, the bank is exposed to price risk if there is default on the first contract and is obligated to deliver on the second contract.

• LEASED ASSET VALUE RISK

• In case of an operating Ijarah, the bank is exposed to market risk due to a fall in the residual value of the leased asset at the expiry of the lease term or in case of a early termination due to default over the life of the contract.

• CURRENCY RISK

• Currency risk is of a “speculative” nature and can therefore results in a gain or a loss, depending on the direction of exchange rate shifts and whether a bank is net long or net short in the foreign currency.
• In the absence of any tradable derivatives with which to hedge currency risk, Islamic financial institutions are further exposed to this risk.

• HEDGING RISK

• Hedging risk is the risks to failure to mitigated and manage different types of risks. This increases the bank’s overall risk exposure.
• In addition to the absence of derivative products with which to hedge risks, illiquid, non existent and shallow secondary markets are other sources of the increasing hedging risk of Islamic banks.

• BENCHMARK RISK

• Benchmark Risk is the possible loss due to a change in the margin between domestic rates of return and the benchmark rates of return, which may not be linked closely to domestic returns.
• Price the markup in murabahah contracts, in part reflecting the lacked reliable domestic benchmark rates of return.

BUSINESS RISK

1. Business risk is associated with a bank’s business environment including macroeconomic and policies concern as, legal and regulatory factors, and the overall financial sector infrastructure such as payment systems and auditors.

MARKET RISK MEASUREMENTS

1. The increasing involvement of bank’s in investment and trading activities and the high volatility of the market environment, the timely and accurate measurement of market risk is a necessity.
2. This includes measurement of the exposures on a bank’s investment and trading portfolios and on and off-balance-sheet positions.

MARKET RISK MANAGEMENT

• Market risk management policies should pacifically stated a bank’s objectives and the related policy guidelines that have been established to protect capital from the negative impact of unfavorable market price movements.
• Policies guidelines should normally be formulated within restrictions provided by the applicable legal and prudential framework.
• Marking to market:

• Refers to the (re) pricing of a bank’s portfolios to reflect changes in assets prices due to market price movements.
• Considerate prudent for a bank to evaluate and (re) price positions related to its investment portfolio on at least monthly basis.
• The reports repaired in this process should be submitted to and reviewed by the senior bank mangers responsible for the bank’s investment, assets liability, and riskj management.
• Financing assets like murabahah and salam are not negotiable or trade able once the initial sale has taken placed, which make making to market difficult.
• Other financing assets based on ijarah and istisna’ are also not negotiable and not liquid, which makes the task of making to market more difficult.

• Position limits:

• A market risk management policy should provide for limits on positions (long, short or net), bearing in mind the liquidity risk that could arise on execution of unrealized transactions such as open contracts or commitments to purchase and sell securities.
• These types of policies should specify the manner and frequency of position valuations and position limit controls.

• Stop-loss provisions:

• Market risk management policies should also include stop-loss sale or consultation requirements that related to a predetermined loss exposure limit.
• The stop-loss exposure limit should be determined with regard to a bank’s capital structure and earning trends as well as to its overall risk profile.

• Limit to new market presence:

• Financial innovations involve profits that are much higher than those of standard instruments, because profit is a key factor motivating innovation.
• In a highly competitive market environment, innovation also pressures competitors to engage in new business in an effort to make profits or not to lose market presence.

LIQUIDITY RISK

• Liquidity is necessary for bank’s to compensate for expected and unexpected balance sheet fluctuations and to provide funds for growth.
• The liquidity management policies of a bank normally comprise a decision making structure, an approach to funding and liquidity operations, a set of limits to liquidity risk exposure and a set of procedures for planning liquidity under alternative scenarios, including crisis situations.
• The bank’s strategy for funding and liquidity operations should be approved by the board and should include specific policies for particular aspects of risk management, such as the target liabilities structure, the use of certain financial instruments or the pricing of deposits.
• Liquidity risk results when the bank’s ability to match the maturity of assets and liabilities is impaired.
• Such risk results from the mismatch between maturities on the two sides of the balance sheet, creating either a surplus of cash that must be invested or a shortage of cash that must be funded.
• Lack of liquidity adversely affects the bank’s ability to manage portfolios in a diversified fashion and to enter or exit the market when needed.

IFSB PRINCIPLES OF LIQUIDITY RISK

• Principle 5.1. Islamic financial institutions

• 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 investment accounts, and restricted investment accounts.

• Principle 5.2. Islamic financial institutions

• Shall undertake liquidity risk commensurate with their ability to have sufficient recourse to Shariah compliant funds to mitigate such risk.

Liquidity risk is one most critical risk facing Islamic banks for the following reasons:

• Shallow secondary markets are another source of liquidity risk. The financial instruments that can be traded in the secondary market are limited, and the Shariah imposes certain limitations on the trading of financial claims, unless such claims are linked to a real asset. Therefore, there is a need to develop asset backed tradable securities, known as sukuk. Even where instruments are available, the number of market participants is limited.

• Limited availability of a Shariah compatible money market and interbank market is the leading cause of liquidity risk. Prohibition by Shariah law from borrowing on the basis of interest in case of need and the absence of an active interbank money market have restricted Islamic banks’ options to manage their liquidity positions efficiently.

• Certain characteristics of some Islamic instruments give rise to liquidity risks for Islamic banks. For example, liquidity becomes a problem given the cancellation risks in Murabahah or the inability to trade Murabahah or Bai’ Salam contracts, which can be traded only at par.

• Typical avenues of liquidity management available to conventional banks – the interbank market, secondary market for debt instruments, and discount windows from the lender of last resort (central bank) – are all considered as based on riba (interest) and therefore, are not acceptable. Conventional banks have access to borrowing with overnight to extended short term maturity through well-developed and efficient interbank markets. This access is vital for meeting the institution’s need for short term cash flow.

• Islamic banks hold a considerable proportion of funds as demand deposits in current accounts and these can be withdrawn at any time. Banks guarantee repayment of the principle deposited, and account holders do not have rights to a share in the profits. Some Islamic banks invest only a small fraction of the current account holders’ funds and, in the absence of liquid short term instruments, maintain a high level of idle cash.

The assessment and measurement of liquidity risk:

• Liquidity gap

• The liquidity gap as the net liquid assets of a firm. The excess value of the firm’s liquid assets over its volatile liabilities. A Islamic bank or conventional bank with a negative liquidity gap should focus on their cash balances (client deposit) and possible unexpected changes in their values.
• As a static measure of liquidity risk it gives no indication of how the gap would change with an increase in the firm’s marginal funding cost.

• Liquidity risk elasticity (LRE)

• The change of net of assets over funded liabilities that occurs when the liquidity premium on the bank’s marginal funding cost rises by a small amount as the liquidity risk elasticity. For bank this would be measured as a spread over commercial paper rater.
• Problems with the use of liquidity risk elasticity are that it assumes parallel changes in funding spread across all maturities and that it is only accurate for small changes in funding spreads
• Bid-offer spread
• The bid-offer spread is used by market participants (international trade normally) as an assets liquidity measure. To compare different products the ratio of the spread to the product’s mid price can be used.
• This spread is composed of operational, administrative and processing costs as well as the compensation required for the possibility of trading with a more informed trader.

• Resilience

• Resilience can only be determined over a period of time.

• Ratio

• Normally between 3 years above comparatives.
• Sometimes the comparative between banks have been made to find the comparative ratio especially in liquidity and also in quality management.

OPERATIONAL RISK

• Operational risk is defined as the risk of loss resulting from the inadequacy or failure of internal processes, as related to people and systems or from external risks.
• Operational risk also includes the risk of failure of technology, system and analytical models.
• Specific aspects of Islamic banking could raise the operational risks of Islamic banks:

• Cancellation risks in the nonbinding Murabahah (partnership) and Istisna’ (manufacturing) contract.
• Failure of the internal control system to detect and manage potential problems in the operational processes and back-office functions as well as technical risks of various sorts.
• Potential difficulties in enforcing Islamic contracts in a broader legal environment.
• Need to maintain and manage commodity inventories often in illiquid markets.
• Failure to comply with Shariah requirements.

Operational risks specific to Islamic banking:

• Withdrawal risk

• Another type of business risk is “withdrawal risk”, which results mainly from the competitive pressures an Islamic bank faces both from other Islamic banks and from conventional banks with Islamic windows.
• An Islamic bank could be exposed to the risk that depositors will withdraw their fund if they are receiving a lower rate of return than they would receive from another bank.

• Governance risk

• Governance risk refers to the risk arising from a failure to govern the institution, negligence in conducting business and meeting contractual obligations, and a weak internal and external institutional environment, including legal risk, whereby banks are unable to enforce their contracts.

• Fiduciary risk

• Fiduciary risk is the risk that arises from an institution’s failure to perform in accordance with explicit and implicit standard applicable to its fiduciary responsibilities.
• Fiduciary risk leads to the risk facing legal resource if the bank breaches its fiduciary responsibility toward depositors and shareholders.
• As fiduciary agents, Islamic banks are expected to act in the best interests of investors and shareholders.

• Transparency risk

• Transparency is defined as “the public disclosure of reliable and timely information that enables users of that information to make an accurate assessment of a bank’s financial condition and performance, business activities, risk profile and risk management practices”.
• Lack of transparency arises from two sources: the use of nonstandard conventions for reporting Islamic financial contracts and the lack of uniform standard of reporting among banks.

• Reputational risk

• Reputational risk or “headline risk” is the risk that the irresponsible actions or behavior of management will damage the trust of the bank’s clients.
• Negative publicity can have a significant impact on an institution’s market share, profitability and liquidity.
• Close collaboration among financial institutions, standardization of contracts and practices, self examination and establishment of industry associations are some of the steps needed to mitigate reputational risk.

The management control of operational risk in Islamic banking:

1. The first step in the operational risk management process is to acknowledge the reality of risk.
2. The function assesses monitors and reports operational risk as a whole and ensures that the management of operational risk in the bank is carried out as per strategy and policy. To accomplish the task, the function would help establish policies, standards and coordinates various risk management activities. Besides, it would also provide guidance relating to various risk management tools, monitors and handle incidents and prepare reports for the senior management.
3. Banks should initiate Risk Control Self Assessment (RCSA) and Key Risk Indicators (KRI) exercises for monitoring and managing operational risk.
4. RCSA should form an integral element of a banks overall operational risk management and control framework. The goal of RCSA is to continuously assess changing market and business conditions and evaluate all operational risks impacting the business.
5. Operational risk management function should then monitor the quantitative/ qualitative aspects periodically and advise the senior management on the potential risks which may arise.
6. Staff managers should instinctively look for risks and consider their impacts when making effective operational decisions. An effective monitoring process is essential for adequate management of operational risk. Regular monitoring would allow quick detection and correctness of deficiencies in the policies, processes and procedure for managing operational risk.

CHAPTER 4 : UNIQUE RISK IN ISLAMIC BANKING

TYPE OF RISKS

DEFINITION

Shariah non-compliance risk

Risk arises from the failure to comply with the shariah roles and principle.

Rate of return risk

The potential impact on the returns caused by unexpected change in the rate of returns.

Displace commercial risk

The risk that the bank confronts 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 of its entire share of profit in order to retain its fund providers and dissuade them from withdrawing their funds.

Equity investment risk

The risk arising from entering into a partnership for the 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. The risk is relevant under mudharabah and musyarakah contracts.

SHARIAH COMPLIANCE IS PARAMOUNT

• Original basis for having a banking system that meet the religious requirements of muslims.
• Factor that distinguishes Islamic banking from conventional banking ensure acceptance, validity and enforceability of contracts from shariah point of view.
• Fulfil the objective of the Islamic finance i.e. to achieve justice fairness in the distribution of resources.

IMPLICATION OF SHARIAH NON COMPLIANCE

Non Financial mpacts:

• Against the commands of Allah.
• Impediment from Allah blessing or barakah.
• Contravention of the provision of Islamic Banking Act 1983.
• Jeopardize the bank’s reputation as an Islamic bank.

Financial Impacts

• In validation of contact‘s (akad).
• Non halal income capital adequacy ratio(car) impact.

RATE OF RETURN RISK

“refer to the potential impact on a Islamic financial institution’s(IFI) net income/net income margin or market value of equity arising from change in the market the rate of return”.

• Gap/mismatch risk or
• Re-pricing risk or
• Benchmark rate risk

ASSOCIATED WITH THE MANAGEMENT OF ASSET AND LIABILITIES

• Fixed rate long term asset founded by variable short term liability.
• Movement in benchmark rate my result in fund providers having expectation of a higher rate of return.
• Subsequently, it may result in displace commercial risk where do to market pressure, and Islamic bank needs to pay a return that exceeds the rate that has been earned on its asset.
• If Islamic bank does not yield to market pressure, they may lose their fund providers which cool consequently lead to liquidity risk.

DISPLACED COMMERCIAL RISK

Investment deposits based on mudharabah should be a powerful risk mitigate for Islamic bank, but:

• “refers to the risk rising from assets managed by the IFI on behalf of investment account holder which is effectively transferred to the IFI owns capital because the IFI follows the practice of foregoing part of all of its mudharib share of profit on such fund”....IFSB
• Smoothening to ensure competitive returns comparable with conventional bank.

Displaced commercial risk – mitigate

• PER and IRR

- Reserves for the purpose of income smoothening.

• Adjust PSR
• Alternative deposit instrument

- Islamic negotiable instrument of deposit

- Commodity/murabahah

• However, probably not in the spirit of a Islamic finance which encourage entrepreneurship.
• Best to focus on optimising income/revenue news from sources of fund i.e. mudharabah deposit/investor.
• Efficient management of fund ... Islamic banking is essentially about fund and asset management.

EQUITY INVESTMENT RISK

“Refers to the risk of a decline in the fair value of equity positions how by the IFI in its trading and banking books”

BNM classify the following as equity positions :

• Ordinary share: voting and nonvoting(common or preferred).
• Convertible securities.
• Commitments to buy or sell equity security.
• Equity derivative.
• Off – balance sheet item i.e. swaps and options.
• Underwriting of equities.

Equity type shariah contact :

• Mudharabah
• Musyarakah
• Musyarakah mutanakisah

POLICIES & GUIDELINES

• Policies for principle risk areas are in place covering areas of credit market operational and Shariah compliance.
• Policies are supported by Guidelines and further supported by operational manuals to ensure policies are implemented properly and affectively.

• Approving authority

- RMF – Board

- Policy – Board

- Guideline – MRCC

- Manual – Stakeholders

• The RMF and all policies are reviewed at a minimum once in 2 years.
• All guidelines and manuals are reviewed annually at a minimum.

CREDIT RISK

POLICY

GUIDELINES

The policy addresses the broad credit management framework that covers the objective strategy, structure and credit processes in order to establish the best practices in the management of credit risk that are in line with the regulatory requirements.

1. Pricing Matrix Guidelines
2. Acceptance Letter Offer Guideline
3. Negative List Guideline
4. Collaterals Guideline
5. Valuation Guideline
6. Discretionary Power Guideline
7. Sovereign Risk Guideline
8. Consumer Grading Guideline
9. Sectoral Guideline
10. Business Relationship Etiquette Guideline
11. Watch list Guideline
12. Financing Process Guideline
13. Credit Recovery Guideline
14. Guidelines on Risk Adjusted Pricing for Corporate & Commercial

MARKET RISK

POLICY

GUIDELINE

• Market risk policy – Describe the risk policy and analytics. Asset and liability management and middle office function of the market risk department.
• Trading book policy – Addresses market risk factors which include but not limited to profit rate or rate of return, foreign exchange, equity and commodity risk inherence in the bank’s trading and banking books.

1. Market risk limits guideline
2. Hedging guideline
3. Mark-to-market guideline
4. Rate reasonability check guideline
5. Value-at-risk guideline
6. Asset and liability management guideline

OPERATIONAL RISK

POLICY

GUIDELINE

The policy providers the effective and efficient operational risk management throughout the bank through its strategies in terms of organization structure process risk tolerant, risk measurement and analysis model management information system.

1. Operational risk management guideline
2. Management awareness and self – assessment (MASA) reporting guideline
3. Fraud handling and reporting guideline
4. Takaful insurance guideline
5. Key risk indicators (KRIs) Guideline
6. Outsourcing Guideline
7. Operational Risk Management Process for Information Security Management System
8. Customer Complaint Guideline

CHAPTER 5: LEGULATORY REQUIRMENTS ON RISK MANGAEMEN IN ISLAMIC BANKING

THE IFSB FRAME OF WORK AIMS

• Identify specific structure and content of Shariah compliant products and services offered.
• Standardize all products and services that comply with Shariah.

IFSB GUIDELINES OF RISK MANAGEMENT

RISK

GUIDELINES

General Requirement

• IFSB should have a comprehensive risk management.

Credit Risk

• IFSB shall have a financing strategy.
• IFSB should always do research.
• IFSB shall make an appropriate place to measure and study the risk exposure.

Equity Investment

• IFSB to make good risk management strategy during the reporting process occurs with the characteristics of equity instruments are used.
• Have reported that their methods exist and are consistent.

Market Risk

• IFSB shall make an orderly framework for the management of market.

Liquidity Risk

• IFSB will bear the liquidity commensurate with their ability to make a sufficient claim.

Rate of Return Risk

• IFSB should make the process of risk management and monitoring of the impact of the overall market facts that affect the return on assets.

Operational Risk

• IFSB shall provide adequate and operating system and controlled.
• IFSB should provide the ideal place to protect the interests of all preparation.

BASEL

• A document written in 1988 by the Basel Committee on Banking Supervision, Switzerland, which recommends certain standard and regulations for banks.
• The main recommendation of this document is that in order to lower credit risk, bank should hold enough capital to equal at least 8% of its risk-weighted assets.
• Basel Capital Accord (Basel I): strengthen soundness and stability of international banking system by requiring higher capital ratios.

BASEL I

• Aim – to ensure financial soundness of such institutions, maintain customer confident in the solvency of the institutions, ensure stability of financial system at large, and protect depositors against loses.
• Basel committee on banking supervision established in 1974 to provide a forum for banking supervisory matters.
• Members are from Belgium, Canada, France, Germany, Italy, Japan, Luxembourg, Netherland, Spain, Sweden, Switzerland, UK and USA.

FAILURE OF BASEL I

• Since it does not differentiate risk very well, it perversely encourage seeking. All a loans given to corporate borrowers were subject to the same capital requirement, without taking into account ability of the counterparties to repay.
• It ignores credit rating, credit history, risk management and corporate governance structure of all corporate borrowers. All were treated as Private Corporation.
• It also promoted loan securitization that led to the unwinding in the subprime market.

BASEL II

• In June 1999, proposal issued for a new Capital Adequacy framework to replace Basel I.
• After extensive communication with banks and industry groups, the revised framework, Basel II issued in 2004.
• Basel II much more risk sensitive, as it is aligning capital requirement to risk of lose.
• Apart from looking at financial.

FAILURE OF BASEL II

• Reducing profitability of small banks and threat of take over.
• Lack of comprehensive approach to address risk.
• Self - regulation in area of asset securitization.
• Lack of safety.
• In ability to strengthen the stability of financial system.
• Failure to achieve large capital reduction.
• Failure in enhancing the competitive equality amongst banks.

BASEL III

• Objective :

The Basel III proposals have two main objectives:

• To strengthen the regulations regarding capital base and liquidity of bank with the gold of promoting a more resilient banking sector.
• To improve the banking sector’s ability to absorb shocks a rising from financial and economic stress.

• AIM

• To minimize the profitability of recurrence of crisis to greater extent.
• To improve the banking sector’s ability to absorb shocks a rising from financial and economic stress.
• To improve risk management and governance to strengthen banks transparency and disclosure.

THE ISLAMIC FINANCIAL SERVICE BOARD

• International standard – stating organisation that promotes and enhance the soundness and stability of the Islamic financial services industry by issuing global prudential standard and within principles for the industry, broadly defined to include banking, capital market and insurance sectors.
• The IFSB also conducts research and coordinate initiatives on industry related issues, as well as organises roundtable, seminars and conferences for regulators and industry state holders.

HISTORY IFSB

• Based in Kuala Lumpur, was officially inaugurated on 3rd November 2002 and stated operation on 10th March 2003.
• Promote the development of a prudent and transparent Islamic financial services industry trough introducing new, or adapting existing international standards consistence with Shariah principles and recommend them for adoption.
• Malaysia, the host country of the IFSB, has enacted a law noun as the Islamic Financial Services Act 2002, which give the IFSB the immunities and privileges that are usually granted to international organisation and diplomatic mission.
• 184 members of the IFSB comprise 55 regulatory and supervisory authorities, eight international inter-governmental organizations and 121 market players, professional firms and industry association operating in 41 jurisdictions.

CONTENT OF IFSB

• Principle 1.0: IIFS 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 and where appropriate, to hold adequate capital against these risks. The process shall take into account appropriate step to comply with Shariah rules and principle and to ensure the adequacy of relevant risk reporting to the supervisory authority.

• Principle 2.1: IISF shall have in place strategies for financing, using various instrument in compliance with Shariah, whereby it recognises the potential credit exposures that may arise at different stages of the various financing agreement.

• Principle 2.2: IIFS shall carry out a due diligent review in respect of counterparties prior to deciding on the choice of an appropriate Islamic financing instrument.

• Principle 2.3: IIFS shall have in place appropriate methodologies for measuring and reporting the credit risk exposure arising under each Islamic financing instrument.

• Principle 2.4: IIFS shall have in place Shariah-compliant credit risk mitigating techniques appropriate for each Islamic financing instrument.

• Principle 3.1: IIFS shall have in place appropriate strategies, risk management and reporting process in respect of the risk characteristics of equity investments, including Mudharabah and Musharakah financing.
• Principle 3.2: IIFS 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 IIFS and the mudarib and or Musharakah partners.

• Principle 3.3: IIFS shall define and establish the exit strategies in respect of their equity investment activities, including extension and redemption conditions for Mudharabah and Musharakah investments, subject to the approval of the institution’s Shariah Board.

• Principle 4.1: IIFS 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.

• Principle 5.1: IIFS 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: IIFS shall assume liquidity risk commensurate with their ability to have sufficient recourse to Shariah-compliant funds to mitigate such risk.

• Principle 6.1: IIFS 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 investment account holders (IAH).

• Principle 6.2: IIFS shall have in place an appropriate framework for managing displaced commercial risk, where applicable.
• Principle 7.1: IIFS shall have in place adequate systems and controls, including Shariah Board/ Advisor, to ensure compliance with Shariah rules and principles.

• Principle 7.2: IIFS shall have in place appropriate mechanism to safeguard the interest of all fund providers. Where IAH funds are commingled with the IIFS’s own funds, the IIFS shall ensure that the bases for asset, revenue, expense and profit allocations are established, applied and reported in a manner consistent with the IIFS’s fiduciary responsibilities.

ADOPTION OF STANDARD

1. Risk Management (IFSB-1)
2. Capital Adequacy (IFSB-2)
3. Corporate Governance (IFSB-3)
4. Transparency and Market Discipline (IFSB-4)
5. Supervisory Review Process (IFSB-5)
6. Governance for Collective Investment Schemes (IFSB-6)
7. Special Issues in Capital Adequacy (IFSB-7)
8. Guiding Principles on Governance for Islamic Insurance (Takaful) Operations (IFSB-8)
9. Conduct of Business for Institutions offering Islamic Financial Services (IIFS) (IFSB-9)
10. Guiding Principles on Shariah Governance System (IFSB-10)
11. Standard on Solvency Requirements for Takaful (Islamic Insurance) Undertakings (IFSB-11)
12. Guiding Principles on Liquidity Risk Management for Institutions offering Islamic Financial Services (IFSB-12)
13. Guiding Principles on Stress Testing for Institutions offering Islamic Financial Services (IFSB-13)
14. Recognition of Ratings on Shariah-Compliant Financial Instruments (GN-1)
15. Guidance Note in Connection with the Risk Management and Capital Adequacy Standards:

Commodity Murabahah Transactions (GN-2)

1. Guidance Note on the Practice of Smoothing the Profits Payout to Investment Account Holders (GN-1)
2. Guidance Note in Connection with the IFSB Capital Adequacy Standard: The Determine of Alpha in the Capital Adequacy Ratio for Institutions (other than Insurance Institutions) offering only Islamic Financial Services (GN-4)
3. Guidance Note on the Recognition of Ratings by External Credit Assessment Institutions (ECAIS) on Takaful and ReTakaful Undertakings (GN-5)
4. Development of Islamic Money Markets (TN-1)

DIFFERENCE OF BASEL III COMMITTEE & IFSB

BASEL III

IFSB

DEFINITION

A set of banking regulations put forward by the Basel Committee on banking supervision, which regulates finance and international banking.

An international organization that publishes principles and standards in the banking sector, capital market, insurance and to promote stability in the Islamic financial services industry.

GOAL

Integrating standards Basel model with state regulations by setting minimum capital requirements of financial institutions with the aim to ensure liquidity of the institution.

Promote awareness of the issues affecting the Islamic finance industry.

ROLE

• Ensure the provision of risk capital is more sensitive.

• Allows market participants to assess the capital adequacy of the institution.

• Ensure that the credit risk, operational risk and market risk is assessed based on the data and formal techniques.

• Attempts to reconcile economic and regulatory capital more frequently to reduce the scope for regulatory equilibrium.

• Issuance of Shariah-compliant standards, holds conferences and seminars, and provides guidance and oversight.

• Develop and recommend standards implementation.
• Provide guidance on the supervision and regulation, and to develop effective management and exposure risk criteria.

• Establish cooperation with other international standards setting body other countries.

CHAPTER 6: THE RISK IN CONVENTIONAL BANKING VS THE RISK IN ISLAMIC BANKING

DIFFERENTIATE BETWEEN THE RISK MANAGEMENT IN CONVENTIAL BANKING AND ISLAMIC BANKING

Fundamentals

• Shariah laws other tenets of Islamic banking.
• Conventional banking was build upon the fundamentals of debtor-creditor relationship with interest being the price of credit and reflecting the opportunity cost of money.
• Risk and reward relationship is guided by the socio-economic principles.
• There are two major difference between conventional and Islamic banking:

• Conventional banking practices are concerned with “elimination of risk” where as Islamic bank “bear the risk”. When involve in any transaction.
• When conventional banks involve in transaction with consumer they do not take the liability only get the benefit from consumer in form of interest whereas Islamic banks bear older liability when involve in transaction with consumer. Getting out any benefit without bearing its liability is declared haram in Islam.

CONVENTIONAL BANKING SYSTEM VS ISLAMIC BANKING SYSTEM

CONVENTIONAL BANKING SYSTEM

ISLAMIC BANKING SYSTEM

Depositors are paid interest.

Depositors are entitle to profit sharing.

The customer has no say where bankers invest money.

Under special investment account, the customer can decide where bankers invest the money.

Borrowers are charged interest.

Financing is done through purchase and resale to the customer, thus earning profit. If a loss is incurred under murabahah, the capital provider will bear the loss, whereas under musharakah, the loss will be shared according to the financing ratio.

Except for financing under leasing, margin of financing will be less than 100%.

Under mudharabah or BBA contract, 100% financing can be availed.

Legal relationship:

• Debtor and creditor.

Legal relationship:

• Seller and buyer
• Lessor and lessee
• Partner and partner

Commodity, e.g. house become the security.

Commodity e.g. house is a subject matter and major element.

Repayment is not fixed.

Repayment price is fixed.

FINANCIAL PRODUCT

PERSONAL LOAN VS PERSONAL FINANCING

CONVENTIONAL PERSONAL LOAN

ISLAMIC PERSONAL FINANCING

Usury

Return: profit/loss

Law: man maid law

Law: usul fiqh and qawaid fiqh

Customer suffer the risk

Risk sharing concept.

Involve riba, gharar, and maisir.

Prohibited riba, gharar and maisir.

Reimbursement from the nominated reimbursement bank.

Subject to 2 tier interest rate.

Reimbursement upon receipt of complied document at the counter of the issuing bank.

Not subject to 2 tier interest rate.

Based on lending/borrowing contract.

Normally based on sale and transaction.

Lender and borrower.

Seller and buyer.

HOUSING LOAN VS HOUSING FINANCING

CONVENSIONAL HOUSING LOAN

ISLAMIC HOUSING LOAN

BLR is subject to change.

BLR + Fixed rate = BFR(based financing rate)

If the BLR goes up, the borrower has to pay more in interest.

The user gains to benefit if the interest rate go up, as they are not affected by the increase.

The user tends to gain, if the BLR goes down.

They would tend to loss of if the rates go down and they would not benefit from the lower rates.

Concept:

Customer borrows the money from bank to purchase a property.

Concepts:

The bank purchases the property from the seller on client behalf, and resale to client with an agreed profit rate, so the profit rate is to be paid by client to the bank. When client fully paid the installment then the property will be transferred to client.

No stamp duty reduction.

20% stamp duty reduction from principal document based on shariah principles or waiver of stamp duty for the conversion of conventional loan to shariah financing.

Based on human rule.

Based on shariah.

Not restricted.

Prohibited riba, gharar, maisir and zulm.

The purchaser will pay interest.

The purchase will pay a profit.

Lender and borrower.

Seller and buyer.

Lessee or lessor.

HIRE PURCHASE VS AITAB (AL IJARAH THUMMA AL BAI’)

ITEM

CONVENTIONAL HIRE PURCHASE

ISLAMIC HIRE PURCHASE

Terms

Loan

Interest rate

Hiring charges

Late payment interest

Financing

Profit rate

Markup

Late payment charges

Eligible customer

Good credit rating.

Not involved in immoral activities against shariah.

Goods

Limited to customer goods, motor vehicles and non-act goods (corporate)

Applicable to all types of goods.

Contract

One standard contract.

Two akad (sighah).

Purchase price or instalments

Cost price x interest rate

month

Cost price + profit

Number of payments

Profit margin or interest rate

Floating based on the annual rate, decided up front.

Determine based on market value.

Responsibility

Hirer or customer bears all costs of maintenance.

Owner bears basic and structural maintenance.

MORTGAGE VS AR RAHNU

MORTGAGE

AR RAHNU

Interest per month based on the loan amount.

Cost of loan

Monthly safekeeping fees based on the value of the pawned gold (Marhun value)

Six month loan period may be extended for another six month.

A loan may be extended indefinitely.

Loan duration

The first period of six month may be extended for three months and finally another two months.

Gold of various grades of fineness, white gold, gold watches, gold bars, gold coins/dinars, diamonds, hollow gold jewelry and gold jewelry with stones. Gold items which are damaged, broken, torn, or cru she dare also accepted. Anything valuable are accepted.

Collateral

18k – 24k (750-999) gold.

High quality silver

Valuable jewelry

Most transactions will take only of a few minutes. No forms to fill out.

process

Customers must fill out form and provide information such as employer’s name, work address, occupation, growth income and her personal details to the bank. Customers must also open a savings account with the bank.

Sole proprietor based individual.

Operator

Institutions based e.g. : banks, cooperatives, YAPEIM, state government agencies, etc.

Interest is charged more expensive rate.

Charges

Monthly safekeeping charger

No interest charger

cheaper

No covered

If the pledged items are lost, only 25% compensation is offered.

Insurance

Takaful coverage.

ADDITIONAL DIFFERENTIATION

CONVENTIONAL BANKING

ISLAMIC BANKING

Its function and operation are based fully on man-made principles.

Functions and operation

Its function operation follow the Quran and the Sunnah as much as possible

Aiming for the profit without religious or moral boundaries.

Aim

Aiming for profit that adheres to Islamic discipline that is limited to what which benefit society.

Ignores zakat

Zakat

Pays zakat has it is a social responsibility fulfilled by Islamic banks.

The retail loan product applies the system of giving out loan with multiplied interest.

Retail loan

Its retail product utilizes the trading or renting of an asset and not the loan contract.

The main priority is to protect the bank’s interest; no priority is given to ensure equity development.

Priority

Emphasize projects that benefit society. The main aim is to ensure equity development.

The bank- customer relationship: loan, lender and borrower.

Relationship

The bank-customer relationship: seller, buyer or partner.

CHALLENGES

• Shariah interpretation versus the financing commercial viability.
• Legal jurisdictions and governing laws.
• Transparency, accountability and governance for public and private sectors.
• Tax incentives, pervasive government intervention and controls.
• Supervisory and prudential regulatory framework.
• Lack in depth capital markets and liquidity funding.
• Accounting and auditing standards.