full risk management and new products developme

Copyright IBFIM @ 2008. All Rights Reserved

Risk Management and New Products Development in Islamic Finance� 29 April 2008 � IBFIM �

Introduction

Page 1

By

ZAIRULNIZAD SHAHRIM

24th Feb 2009

New Product Development in Islamic Finance

Introduction

Page 2

New Product Development in Islamic finance

1. Market Updates / Statistics

2. Recent Development

3. Contemporary issues

4. New Products Development in Islamic Finance

5. Commodity Murabahah

6. Islamic Exchange Traded Fund (ETF)



Introduction

Page 3

Market Updates & Statistics

� Sukuk captured 76% of the RM-PDS market in 2007 (55% in 2006)

� Sukuk in 2007 (RM121.3b) increased by 189% from 2006 (RM42.02b)

1 The Sukuk figure includes the approval of 7 combination issuances (conventional and sukuk) with a combined issue size of RM89.5 billion and 2 ABS amounting to RM3.4 billion2The combination issuance of RM60 billion by Cagamas Berhad was not included for the purpose of this calculation due to uncertainty of the amount per multiple Syariah principles to be used.

Source: SC’s ICM Quarterly Bulletin- January 2008

REVIEW OF INDUSTRY – SUKUK MARKET

Introduction

Page 4


Sukuk Approved by SC

37.533.819.3

32.735.338.426.7

121.3

42.043.3

15.212.017.619.0

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

2001 2002 2003 2004 2005 2006 2007

Year

RM

'bil

Conventional Sukuk

of total PDS

INDUSTRY STATISTICS (SUKUK VS CONVENTIONAL BONDS)



Introduction

Page 5


Source: Securities Commission

INDUSTRY STATISTICS (SUKUK VS CONVENTIONAL BONDS)

Introduction


17.6

121.3

15.2

43.3

12.0

19.0

42.0

0.0

20.0

40.0

60.0

80.0

100.0

120.0

140.0

2001 2002 2003 2004 2005 2006 2007

RM

'bil

Source: Securities Commission

DOMESTIC

189%

INDUSTRY STATISTICS (DOMESTIC VS GLOBAL)



Introduction


0.8 1.05.7 7.2

12.0

27.2

47.8

0.0

10.0

20.0

30.0

40.0

50.0

60.0

2001 2002 2003 2004 2005 2006 2007

US

D$'

bil

Source: IFIS

GLOBAL

Continuous growth in both domestic and global marke ts

76%

INDUSTRY STATISTICS (DOMESTIC VS GLOBAL)Introduction

Page 8


Source: Dealogic Database

Full-Year 2007

GLOBAL STATISTICS (SUKUK ISSUED BY COUNTRY)



Introduction

Page 9


United Arab Em irates

30.2%

Qatar0.8%

Malaysia48.6%

Saudi Arabia15.7%

Pakistan1.7%

Kuwait2.1% Bahrain

0.5%

Indonesia0.3%

Malaysia captured the biggest market share in 2007 at

48.6%

GLOBAL STATISTICS (SUKUK ISSUED BY COUNTRY)

Introduction

Page 10


Murabahah19%

Musyarakah58%

BBA2%

Mudharabah1%

Istisna'9%

Ijarah 11%

LOCAL – 58% Musyarakah

Source: Raw data compiled from IFIS and SC

2007- TYPES OF SUKUK CONTRACTS



Introduction

Page 11


Islamic Exchangeable

Bond9%

Others9%

Investment Sukuk

7%

Mudharabah10%

Ijarah17%

Murabahah2%

Musyarakah46%

GLOBAL – 46% Musyarakah

Source: Raw data compiled from IFIS and SC

2007- TYPES OF SUKUK CONTRACTSIntroduction

Page 12


1. There are more than 267 Islamic financial institutions (IFIs) in the world with capitalization in excess of USD 13 billion. This includes banks, mutual funds, mortgage companies and takaful

2. Syariah compliant financial products estimated to exceed USD 250 billion with annual growth rate of 23.5% over the past 5 years

3. The potential is huge. By 2020, there will be 2.5 billion of Muslim population worldwide from the current 1.5 billion level

4. Islamic banks are expected to manage 40% to 50% of total savings of Muslim population in 8 to 10 years. Therefore, potential for Islamic services is estimated at USD 4 trillion by 2020.

Global view of Islamic Finance

Source: IFIS



Introduction

Page 13

Market Updates & Statistics Islamic finance in ASIA

Source: Internal research

Commitment

Research Exploratory Development Expansion

China, India, HK, Japan, Korea, Indo-

ChinaWait & see

Monitor development

Minimum presence

Competitor matching

Market innovation

Business innovation

Syiria, Lebanon, Germany, USA,

Europe

Brunei, Indonesia, Singapore, South Africa, Morocco,

Turkey

Malaysia, S. Arabia, Bahrain, Dubai,

Kuwait, Qatar, UAE

Introduction

Page 14

Recent Development



Introduction

Page 15

Recent Development

1. 14 August 2006 marked the launch of a nationwide initiative to promote Malaysia as an International Islamic Financial Centre - MIFC. The MIFC initiative is aimed at fortifying Malaysia’s position as a vibrant, innovative and competitive Islamic financial hub, with significant roles in: � Facilitating relationships between the international Islamic financial

markets; and

� Bridging and expanding investment and trade relations between the Middle Eastern, West Asian and North African regions with East Asia

2. The MIFC initiative is specifically undertaken by the collective efforts of the country's financial and market regulators, together with the participation of the industry representing the Islamic banking, takaful and capital market in Malaysia

Malaysia International Islamic Financial Centre (MI FC)Introduction

Page 16

Recent Development

3. It comprises a diversified range of financial institutions operating from anywhere in Malaysia that offer Islamic financial products and services in any currency to non-residents and residents. The objective of the MIFC is to promote Malaysia as the centre for :� Origination, distribution as well as trading of Islamic treasury and capital

market instruments� Islamic fund and wealth management services

� International currency Islamic financial services (including deposits and financing)

� Takaful and retakaful

� Islamic finance education, training, consultancy and research

Malaysia International Islamic Financial Centre (MI FC)



Introduction

Page 17

Recent Development

1. An International Currency Business Unit (ICBU) of a licensed institution, namely Islamic bank, commercial bank and investment bank, is permitted to conduct a wide range of Islamic banking business under the Islamic Banking Act 1983 (IBA) or Islamic banking business under Section 124 of the Banking and Financial Institutions Act 1989 (BAFIA) in international currencies other than Malaysian ringgit

2. The income arising from the transactions of the ICBU is eligible for full tax exemption accorded under the Income Tax Act 1967 for ten years from the year of assessment 2007

International Currency Business Unit (ICBU)Introduction

Page 18

Contemporary IssuesInfrastructural support

1. Syariah

• Lack of standardisation in financial contracts and can be a source of ambiguity, dispute and higher cost

• Different Syariah interpretation

2. Legal

• International acceptance of Islamic financial contract requires them to be acceptable to the Syariah as well as enforceable under Common Law and Civil Law



Introduction

Page 19

Contemporary IssuesInfrastructural support

3. Human talent

• Syariah experts that have adequate knowledge of banking and finance

• Finance specialist to have adequate knowledge of the applicable rules and principles

Introduction

Page 20

Contemporary IssuesImage of Islamic products and services

1. The credibility and sustainability of Islamic products as compared to conventional

• Resemblance to the products and services offered by conventionalplayers

• Whether we can integrate standard and codes of good practice developed at national level into global practices

• Acceptance of standard used in Sukuk issuance, rating decision and equity and project screening at international level



Introduction

Page 21

Contemporary IssuesMarket liquidity

1. Market

• Short term liquidity management and asset liability management

• Financial risk management and hedging for issuer as well as investor

2. Products and services

• There is a gaps between Syariah compliant products and conventional

• Lack of hedging and derivatives products to be used as risk management tools

• Money market instruments to manage market liquidity and set benchmark rate of return

Introduction

Page 22

Contemporary IssuesRating and statistical reporting

1. Rating is done using conventional methodology

• Many Sukuk appear to have assets at their core, detailed analyzes of their commercial terms and legal structures shows that performance, for some is not governed by their assets, indeed, the credit risk is really that of the sponsor or originator - Moody’s

• No substantial distinction from traditional rating criteria – Fitch

• No significant difference in the methods to rate conventional and Islamic debt securities. Has own Syariah board and will validate Syariah compliance structure – MARC

• No significant difference in methodology – Standard and Poor’s

• No significant difference in methodology - RAM

2. Different contractual relationships require different type of reporting



Introduction

Page 23


1. Width (increasing issuance of new products) and depth (introducing more derivatives) of product range is one of the essential components of an efficient market

2. Sell what the market want, and not what can be produced

3. Essential product characteristics:

a. Risk tolerance (high, medium and low risk)

b. Meeting the return expectation

c. Meeting the liquidity expectation

d. Meeting the unique needs (Syariah compliance and other needs)

4. Efficient market structure

Preamble Introduction

Page 24


1. Too few products in the market

2. Products are not competitive enough

3. Products are not compatible with the present infrastructure

4. Products are not flexible enough

5. Most currently available products are based on Uqud al-Muawadah (contract of exchange) rather than Uqud al-Isthirak (contract of participation)

Issues



Introduction

Page 25


6. All Islamic capital market products need to have endorsement from Syariahadviser – Attract additional cost and time consuming

7. Pricing mechanism – How do we price Islamic capital market products?

8. Products are not well understood

9. Islamic capital market products are not/less liquid – difficult to exit

Issues

Introduction

Page 26


1. It’s a dynamic management processes

2. Market research – Identify the market needs

3. Analysis and product design

4. Pricing and profitability consideration

5. Promotion – selling aspect of the product development

Product Development Process



Introduction

Page 27


ISLAMIC

INSTRUMENTS

Infr

astr

uctu

re &

se

rvic

es

Return from Islamic

instruments vsconventional

products

Product

Developm

ent &

marketing

Identifying fa

ctors

that diffe

rentiate

one instr

ument

over a

nother

Competitiveness

& Performance

Source: Failaka International

Five key elementsIntroduction

Page 28


1. Develop, enhance and coordinate Islamic finance / Islamic capital market infrastructure

2. Interaction between Syariah and Finance

3. Sound and establish regulatory framework

4. A large and diverse number of companies, investors and intermediaries

5. Strong support from the Government

Product Development - The way forward



Introduction

Page 29

Commodity Murabahah & Tawarruq

1. What is Tawarruq?

• Comes from the word al-wariq, meaning silver, because the one who buys the product is only buying for the sake of Dirham’s (originally, silver and coins)

2. Tawarruq – In practice

• Buying a commodity from a supplier on deferred payment basis, then the purchaser sells such commodity to a third party in cash

• This transaction involves three parties:

a. The Trader (owner of the commodity)

b. The purchaser (or the Mustawriq – the person who s engaging in this transaction of tawarruq to obtain cash)

c. The second Purchaser ( who buys the said commodity from the Mustawriq)

Introduction

Page 30


3. Is it permissible? 3 opinions:

Opinion 1

• Majority of scholars say YES! Because Allah says (interpretation -”whereas Allah has permitted trading and prohibited riba”)

• The purchaser is buying the commodity either to benefit from thecommodity itself or to benefit from its price

• Meets the needs of people for cash as compared to Qard Hassan.



Introduction

Page 31


Opinion 2

• Not permissible because:

i. The aim is to take money for money and the commodity comes in between as a means of making the transaction permissible (hilah)

ii. It leads to creation of huge debts in the Muslim society which is undesirable by Syariah and which cause instability in the economy

Introduction

Page 32


Opinion 3

• Permissible subject to certain conditions:

i. That the person be in need of money

ii. That he should not be able to obtain money in any other permissible manner

iii. That he does not sell the purchased commodity to the same seller whom he bought it from for less price

iv. There should not be any pre-arrangement or fictional device (hilah) in this transaction that might lead to riba



Introduction

Page 33

Commodity Murabahah & TawarruqTawarruq via the Banks

1. Is the mode through which some Banks are facilitating the supply of cash to their clients

2. It involves buying a commodity by the Bank (upon the request of the client) from a supplier, then selling the said commodity to the client on deferred payment basis, then the client resells such as commodity to a third party in cash

3. Is different than the original Tawarruq known to earlier scholars

Introduction

Page 34


4. It involves an additional party (the Bank) so we have four parties:

i. The Trader (the original owner of the commodity and the first seller)

ii. The Bank (the first Purchaser of the commodity and the second Seller of the said commodity)

iii. The Mustawriq, who is in need of cash (the second Purchaser of the Commodity and the third Seller)

iv. The Third Purchaser (who buys the said commodity from the Mustawriq)

5. It might involves authorizing the Bank to sell the commodity on behalf of the customer

6. It involves the Banks in a new business without full practice



Introduction

Page 35


7. Banking Tawarruq is permissible subject to certain conditions:

i. The commodity is existed

ii. The Bank has full ownership over the commodity with its rights and liabilities

iii. The Bank acquires the commodity

iv. Upon the conclusion of sale with the customer, the customer has a full ownership over the commodity with it rights and liabilities

v. The customer has the right to keep or sell the commodity

vi. The customer is not allowed to sell the commodity back to the Bank

Introduction

Page 36


1. Murabahah: Definition

• Sale of goods at cost plus mark-up on a deferred basis

2. Commodity Murabahah

• A sale of certain specified commodity, on a cost plus profit basis

• Murabahah transaction is nested in Tawarruq concept

• Tawarruq – Purchase of commodity on deferred payment followed by selling of the commodity to a 3rd party



Introduction

Page 37


3. The users

• Financial institutions providing Islamic services globally

• Islamic Financial Institutions – full fledged Islamic banks and other banks with Islamic banking windows

4. What is it used for?

• To facilitate liquidity management and risk management in the Islamic financial market

Introduction

Page 38

Islamic tools for liquidity management

Broker B

Bank A

Bank B

(excess)

(deficit)

Bank A buys commodity from Broker A spot USD10 mil

Bank A sells commodity to Bank B deferred USD10 mil + profit

Bank B sells the commodity to Broker B spot USD10 mil

Commodity Murabahah

Broker A

Islamic Treasury Operation



Introduction

Page 39

Islamic tools for liquidity management

Commodity Broker A

Commodity Broker B

Bank A

BNM

Bank A purchases

commodities from Broker

Bank A sells commodities to BNM (at cost

plus)

BNM pays to Bank A on deferred basis (at mark up

price)

BNM appoints

Bank A as an Agent to

sell the commodity

(net off)

Bank A credits the

proceeds to BNM

(placement)

1

23

4

Bank A sells the commodities on behalf of BNM

5

6

Commodity Murabahah

Interbank PlacementIntroduction

Page 40

Islamic tools for liquidity managementThe way forward: Commodity Murabahah House (CMH)

Islamic Bank A

CMH

(Trading & Clearing)Islamic Bank B/

Client

CPO Producer A

CPO Producer C

CPO Producer B

Broker B

Broker A1

2

3

4

Commodity

Payment (spot)Payment (deferred)

1. CPO Producer sells commodity straight to Islamic Bank via Broker A

2. CMH guarantees the performance of CPO Producer

3. Islamic Bank A sells commodity to its clients or another Islamic Bank B

4. The Client or Islamic Bank B appoints Islamic Bank A to sell commodity to CMH via Broker B Source: Bursa Malaysia



Introduction

Page 41

Exchange Traded Fund (ETF)

Definition:

1. Simply understood as index fund which is traded like stock

2. An open-ended investment fund that tracks a particular index

3. It combines the characteristics of a closed-end fund and that of a share, i.eit is structured as a unit trust fund with the units listed and traded on the exchange similar to shares

4. However, it differs from share and unit trust fund in many ways

Introduction

Page 42


UpfrontT+3T+3Cash settlement

3-5%00Sales charge

00.6%0.6%Brokerage

1-2% for index fund0<1%Management fees

NOYESYESTraded through broker

NOYESYESPrice Transparency

YESNOYESDiversification

Redemption with the fundPurchases and Sales of the shares take place in the

secondary market

Purchases and Sales of the funds’ shares only take place in the secondary

market

Redemption

YESYESYESTraded on exchange

Units that represent underlying basket of stocks

SharesUnits that represent underlying basket of stocks

Nature

Unit TrustStocksETFs

Source: Bursa Malaysia



Introduction

Page 43


Main Parties in an ETF Structure

1. Fund Manager

• Managers and administers the ETF

2. Trustee

• Acts as custodian of ETF assets

• Safeguards interests of unit holders

3. Participating Dealer (PD) / Liquidity Provider

• Facilitates in-kind creation and redemption

• Provides trading liquidity for listed ETF units

Introduction

Page 44


In-kind Creation and Redemption

1. In-kind Creation

• Delivery of shares of underlying stocks in the ‘basket’ by Participating Dealer (PD) in exchange for new ETF units

• There is minimum creation size in terms of number of ETF units, or creation unit block

• Number of ETF units in circulation will increase



Introduction

Page 45


In-kind Creation and Redemption

2. Redemption

• Delivery of ETF units by Participating Dealer (PD) in exchage for shares of underlying stocks in the ‘basket’

• There is a minimum redemption siza in terms of number of ETF units, usually the same as creation unit block

• Number of ETF units in circulation will decrease

Introduction

Page 46


Benefits of Investing in an ETF

1. Convenience / Accessibility

• Multiple investments in a single transaction

• Immediate effective ownership in basket of securities

2. Risk Management / Diversification

• Simultaneous exposure to basket of securities

3. Transparency

• Constituent stocks, indicative NAV, unit price readily available



Introduction

Page 47


Benefits of Investing in an ETF

3. Tradability / Liquidity

• Units traded anytime during trading hours of the exchage

4. Low transaction cost

• Brokerage for single purchase/sale transaction

6. Low Expense Ratio

• Less frequent transactions

• Lower fee for passive management

Introduction

Page 48


Risks of Investing in an ETF

1. Market Risk

• Performance of ETF or its underlying securities may be adverselyaffected by economic, political or other issues

2. Tracking error

• ETF performance may not closely track performance of underlying benchmark/index



Introduction

Page 49


Risks of Investing in an ETF

3. Discount or Premium

• ETF unit price on the exchange may be at discount or premium to its NAV

4. Manager skills

• Manager may not manage in line with ETF objectives

Introduction

Page 50


ETFs in Malaysia

1. 3 ETFs currently listed on Bursa Malaysia Securities

• 2 Equity ETFs, 1 Bond ETF

• Most recent launch is MyETF Dow Jones Islamic Market Malaysia Titans 25 – 1st Syariah ETF listed in Asia & currently largest SyariahETF in the world

2. Challenges

• Investors’ understanding of products

• Performance expectations

• Competition from unit trust funds



Introduction

Page 51


ETFs in Malaysia

3. Moving forward

• Continuous investor education

• Additional participants (i.e. PDs, market makers)

Introduction

Page 52

Exchange Traded Fund (ETF) Global ETF Industry

41%64%Growth rate

100%796.6100.0%1,171Total

72.9%

16.1%11.0%

580.7

128.487.5

51.3%

36.1%12.6%

601

423147

US

EuropeOthers

ShareAUM (USD bn)ShareNumber

Source: Morgan Stanley Investment Strategies, Bloomberg

1. Global average daily trading volume +143% in 2007 to USD 59.8 billion

• S&P 500, the largest ETF at USD 99.2 billion, accounts for about 40% of average daily volume

2. ETF assets under management (AUM) forecast to exceed USD 2 trillion in 2011, implying CAGR of almost 26% over next 4 years



Introduction

Page 53

Islamic Exchange Traded Fund (ETF)

1. The first Islamic ETF may be that of Saudi NCB and Deutsche Banklaunched in 2001 called Islamic Equity Builder

2. The ETF would be Syariah compatible if:

i. The underlying asset is Syariah permissible. In the case of company sharesthey have to be based on an Islamically acceptable index. The purpose is to screen the sharesso as to select only the ones that satisfy the Islamic equity criteria

ii. These shares must be held in a portfolio which is legally owned by the investors

Introduction

Page 54


iii. ETF securities can be traded if the assets they represent are tradable. The fact that the market value of an ETF may be higher or lower than the NAV of the underlying asset creates no Syariah problem

iv. ETF’s can be bought at cash or on deferred payment basis, except for gold and silver ETF’s where a deferred price sale will not be acceptable

v. For this kind of ETF’s (gold and silver) it is further required that redemption must be affected in kind if so demanded by the investor



Introduction

Page 55


Treatment of dividend

1. One difference between ETF’s and mutual funds is the fact that dividend received from constituent companies is not reinvested as this deviate ETF’s from tracking the index.

2. It remains nevertheless, that dividend is the entitlement of the investors. It should not be confiscated by the manager even as a management fees

3. In Islamic ETF’s dividend should periodically be distributed to ETF securities holders. Only actual dividend received should be distributed. If there is any interest earning in the dividend account it must be disposed off

Introduction

Page 56


Issuer

• The Issuer is merely a manager or rather as an agent receiving fees

• It is difficult for issuer to be Mudarib since definition of profit is not clear

• Issuer must not guarantee the performance of ETF’s, but may occasionally provide liquidity facility to smooth the periodically payments, redemption or purchase of new assets

• Fees can be fixed or based on formula based. In all cases must be known or knowable.



Introduction

Page 57


Purification

• The Islamic equity investment criteria require purification of the portfolio from impure income earned by constituent companies in the underlying index

• It always recommended that such purification is done by the manager. However, this makes it difficult for the ETF’s to track the index. Many Syariah boards have permitted that manager only inform investors of theamount they need to dispose off to purify their investment.

Introduction

Page 58

Key Takeaways…

1. Investment climate has evolved from a very simple structure to a more complex and problematic

2. From Islamic perspective any investment can be Syariah compliant if all the requirements of Syariah are fulfilled

3. Malaysia is distinct:

• Clear national strategy

• Clear integrated regulatory and Syariah framework – Syariahharmonisation is reality

• Mandate for legal clarity – common law provides supportive legal environment

• Deepening support infrastructure

• Defined means for global outreach



Introduction

Page 59

Key Takeaways…

4. Scholars and bankers require more interactive dialogue on a deeper level

5. “ Do not permit an error of opinion to be come a tradition for the community”

Thank youThank youThank youThank you

1Copyright IBFIM @ 2008. All Rights Reserved


Introduction

Page 1

By

ZAIRULNIZAD SHAHRIM

29th April 2008

Hedging Mechanism for Islamic Capital Market Products & service

Introduction

Page 2

Derivatives - An overview

What is derivatives?

1. A derivative security is a financial asset whose value is dependent on the value of underlying asset.

2. The underlying asset could be a basic financial asset such as commodity, currency, common stocks, bonds, index or the combination of such assets.

3. Common forms – Forwards, Futures, Options, Swaps and also some exotics such as Swaptions

4. Derivatives enable the avoidance of unnecessary risks



Introduction

Page 3

Definitions

1. Hedging – Reducing a firm’s exposure to price or rate fluctuations. Also known as immunization

2. Derivative – A financial asset that represents a claim to another financial asset

3. Forward contract – A legally binding agreement between two parties calling for the sale of an asset/product in the future at a price agreed upon today

Introduction

Page 4

Definitions

4. Futures contract – A forward contract with the feature that gains and losses are realised each day rather than only on the settlement date

5. Option contract – A contract that gives the buyer/owner the right to buy/sell some asset at a fixed price on or before a given date



Introduction

Page 5

Definitions

6. Strike price – The fixed price specified in an option contract at which the holder/owner can buy/sell the underlying asset. Also known as the exercise price

7. Swaps – Agreement to exchange two securities/currencies/commodities Agreement to exchange two securities/currencies/commodities

Introduction

Page 6

Benefits of derivatives

1. Hedging purposes

• Risk management tool

2. Profit from both bull and bear markets

3. Leverage / Gearing

• The use of leverage will magnify the effect of a given price change

• Small investment (premium) to own the right to purchase stocks.

• The potential loss is capped at premium paid

4. Transaction cost savings e.g SSF



Introduction

Page 7

Risk management for Islamic instruments

1. Risk management is more critical in Islamic finance simply because:

• The nature of contracts

• Real economic transaction

2. It is important to ensure the risk management tools also must be equally Shariah compliant

3. Types of risk• Rate of return risk• Equity investment risk

• Market risk• Operational risk

Introduction

Page 8


Some of Islamic risk management tools are as follows:

1. Option in equities

• Generally acceptable based on ‘urbun’ however the trading part is still questionable by some Shariah scholars

2. Profit rate swap

• Permissible using murabahah transaction for both fixed and floating mark-up

3. Forward sale

• Permissible under the principle of salam.



Introduction

Page 9


4. Short-sale

• Using salam contract is permissible, however the usage of salam to replicate short-sale function in an Islamic hedge fund using both long and short sale is disputable

5. Futures contract

• Uncertainty is removed through standard contract and clearing house to ensure delivery

Introduction

Page 10

Hedging Products

Syariah Compliant Hedging Instruments:

1. Futures contracts

2. Forward contracts

3. Swap Agreements

4. Structured Products



Introduction

Page 11

Hedging Products

Futures:Approved by the Securities Commission of Malaysia provided:

1. Underlying is Syariah compliant2. Performance of contract is certain

Futures contracts deemed Syariah compliant:1. Crude Palm Oil futures contract2. Crude Palm Kernel Oil futures contracts3. Single Stock futures contracts

Introduction

Page 12

Hedging Products

Example of Futures contract transaction:

1 Aug: Investor buys 1 CPO contract @ 1,4001 Aug: End of day settles @ 1,420. Investor makes MYR MYR500 (i.e. 1,420 – 1,400 * MYR25.00)2 Aug: End of day settles at 1,395. Investor loses MYR625 (i.e. 1,420 – 1,395 * MYR25.00)3 Aug: Investor sells @ 1,440. Investor gains MYR1,125.00 (i.e. 1,440 – 1,395 * 25.00)

Irregardless of market price at closing, investor gets to buy CPO @ 1,400



Introduction

Page 13

Hedging Products

Forward contracts

Financial institutions undertake many forms of forward contracts for hedging purposes:

1. Currency forwards e.g. USD/MYR forward2. Commodity forwards e.g. Crude Palm Oil

Introduction

Page 14

Hedging Products

Example of Forward Contract:

On 1 Aug Bank A enters into forward contract with bank B to buy USD10,000,000 against MYR for value 13 Aug @ 3.4750.

On 13 Aug, Bank A will pay Bank B MYR MYR34, 475,000 and receive from Bank B USD10,000,000.

Prevailing market rate at time of exchange is ignored



Introduction

Page 15

Hedging Products

Swap Agreements:

“Agreement to exchange two securities or currencies or commodities”

Types:

1. Currency swap: USD vs. MYR2. Profit rate swap: Floating vs. Fixed3. Commodity: Crude Palm Oil vs. Soy Oil

Introduction

Page 16

Hedging Products

Structured Products1. A new trend among the Islamic financial institutions2. Syariah complaint issues3. Using an existing asset to create a new product

Example of structured products:1. Commodity Murabahah2. Islamic Cross Currency Swaps



Introduction

Page 17

Syariah Issues in Hedging

Freedom to Contract1. Islam provides the basic freedom to enter into

transactions. The holy Qur’an says: “Allah has made trade lawful”

2. A contract is invalid/unlawful if it involves the element of coercion by either of the parties. The holy Qur’an also says: “Let there be among you traffic and trade by mutual goodwill”

3. But this norm does not suggest unrestricted freedom to contract

Introduction

Page 18


Freedom from Riba’

1. All types of contracts and transactions must be free from riba’

2. Implies that there is no reward for time preference and under conditions of zero risk.

3. The question of riba has been addressed in many studies and there is a consensus about the meaning and implications of riba.



Introduction

Page 19

4. Excess or surplus over and above the loan capital. However, riba can be in different forms and is prohibited in all its forms.

5. In the context of derivatives, there are some opinion saying that riba can also occur when one gets a positive return without taking any risk

Introduction

Page 20


Freedom from Gharar/Excessive Uncertainty

1. All contracts and transactions must be free from excessive gharar.

2. Implies that contracting under conditions of excessive uncertainty is not permissible.

3. Intentionally induced uncertainty.



Introduction

Page 21


4. If the person know exactly the state of the contract, he probably will not entered into the contract.

5. However, due to lack of knowledge with respect to contract specification, he had entered into this contract

6. To avoid a case whereby one party suffer from the consequences of his contract of which in normal circumstances, reasonable person would try to avoid


Syariah Issues in Hedging Introduction

Page 22


7. Normally relates to contracts of exchange (mu’awadat) i.esale and lease but not to contract of partnership/equity

8. For instance:

• Pricing: Fixed or depends on certain index

• Delivery: Actual delivery or cash settlement or a third party delivery (futures market)

• Mode of payment: Actual direct payment or through set-off or other payment which is specific on certain products i.e Profit Rate Swap whereby payment between two Murabahah transactions, fixed and floating




Introduction

Page 23


Freedom from Qimar (gambling) and Maysir (Unearned Income)

1. Contracting under excessive uncertainty or gharar is akin to gambling (Qimar).

2. The Qur’an and the sunnah of holy prophet prohibit gains made from games of chance which involve unearned income (Maysir).

Introduction

Page 24



3. If the process is backed by collection, analysis and interpretation of relevant information it is very much in conformity with Islamic teachings.

4. Islam allows the assumption of risk taking after making proper assessments of risk with the help of information.



Introduction

Page 25



5. From financial perspective would be one where the outcome is purely dependent on chance alone

6. Some might look at it as a zero-sum game whereby it involves a definite loser and winner

7. From derivatives perspective, margin payment is deemed as akin to gambling

Introduction

Page 26

4. Urbun (down payment)

a. Deposit/down payment given by the buyer to the seller in buying and selling contract

b. If the sale proceeds, the deposit will be part of the price of the goods, otherwise it will be considered as hibah (gift) from buyer to seller

c. If the buyer decide to terminate the contract, the money paid (deposit) will be forfeited to compensate the seller

d. This principle can be used in Option in both equity and commodity market



Introduction

Page 27

5. Forward sale

a. If it involves a commodity (normal forward sale), is permissible.

b. Known as salam sale i.e advance payment against future delivery such as wheat, metal

c. Also applicable to assets other than commodity such as Shares and currency

Introduction

Page 28

d. Forward sale on equities:

• Non permissible (AAOIFI Shariah standard)

• Permissible by some Shariah boards/scholars

e. Forward sale on currency – not acceptable as currency exchange requires spot and simultaneous exchange of two different currencies to avoid riba.



Introduction

Page 29

6. Qabadh (possession)

a. Not allowed to sell what you do not own/possess

b. Not allowed to sell before you take delivery of it

c. Require possession by the seller before the buyer can sell to another buyer

d. This prohibition is confined to food items only – The Maliki School of Law

e. Hanafi, Shafi’e and Hanbali – Only concern on the issue of gharar when sale of an object before Qabadh

Introduction

Page 30

7. Arbitrage

• Taking advantage on price discrepancies between markets, products and assets

• Monitor price of the same products in different market –looking at price divergence

• Arbitrage between different product markets

• So far, no Shariah objection as long as the underlying assets and contracts are Shariah compliant



Introduction

Page 31

8. Short Sales

a. A sale of security not owned (by the Seller) in anticipation of making a profit by purchasing the security later (at the market) at a lower price

b. Typically, seller would borrow the security from broker to be repaid later

c. Generally, short sale in this definition is not permissible. Having said that, some Shariah scholars have allowed it under Salam contract

Introduction

Page 32

9. Option

a. Gives the right but not the obligation to purchase or sell an asset during a specified period at an agreed–upon price

b. Islamic contract for Option i.e Urbun (down payment) and Khiyar (contractual stipulation)

c. Generally, no objection with the mechanics of Option. It is the trading of these promises and the charging of premiums that objections are raised.

d. SAC of SC – So far, no formal opinion on stock or index option. However, the SAC has allowed other option-like instruments i.e Call Warrants/TSR as long as shares involved are Shariah approved.



Introduction

Page 33


Freedom from Price Control and Manipulation

1. Islam envisages a free market where prices are determined by demand and supply. There shall be no interference in the price determination process even by the regulators except for cases where the intervention is intended to counter cases of market anomalies caused by impairing the conditions of free competition.

2. It is a requirement that the demand and supply should be genuine and free from any artificial element.

Introduction

Page 34


Entitlement to Transact at Fair Prices

1. Prices that are an outcome of free play of demand and supply without any intervention or manipulation are believed to be fair.

2. However, in some instances, pricing is based on a valuation exercise.

3. In such cases the difference between the price at which a transaction is executed and the fair price (as per the opinion of valuation experts) is termed as ghubn. The presence of ghubn makes a transaction unethical.



Introduction

Page 35


Entitlement to Equal, Adequate and Accurate Information

1. Islam emphasises on the role of information in the market. Provision of inaccurate information is forbidden.

2. Concealment of vital information (ghish) violates Islamic ethics and according to the sunnah of the holy prophet, the party disadvantaged at the time of contracting may to annul the contract.

3. Transactions must also be free from jahalah or misrepresentation

Introduction

Page 36


1. Informational and pricing efficiency are clearly in conformity with the Islamic and ethical notions relating to adequacy and accuracy of information and fair pricing

2. As regards full-insurance efficiency or operational efficiency, these can be justified in the Islamic ethical framework in terms of their maslahah for the people at large.

3. Risk management products allow the market participants at a micro-level to avoid undesirable risks.



Introduction

Page 37


The Case of Futures/Forward Contracts

1. Futures/forward contract is settled at a future date.

2. As the buyer and seller enter into an obligation to deliver the price and object of exchange on a future date, such transaction (bay) is forbidden

3. A futures contract also violates the Shariah prohibition of sale of a non-existent underlying on grounds of gharar.

Introduction

Page 38


1. However, on grounds of public necessity some degree of flexibility in the matter of gharar in settlement of contracts is provided

2. Scholars have permitted salam sale, i.e. sale of what one does not have, but what one is reasonably sure of bringing into existence.

3. Scholars have insisted that one part of the contract must be settled on the spot, i.e., the buyer must give delivery of the underlying instrument or price at the time of contracting to the seller. It is the seller’s obligation that is deferred to a future date.



Introduction

Page 39


The Case of Options1. Shariah scholars is of the opinion that option is a

promise to buy or sell an underlying asset at a specific price within a stipulated time and such a promise cannot be the subject matter of a sale or purchase

2. Scholars have attempted to justify permissibility to options by drawing a parallel with bai al-urbun.

3. Urbun refers to a sale in which the buyer deposits money with the seller as a part payment of the price in advance but agrees that if he fails to ratify the contract he will forfeit the deposit money which the seller can keep

Introduction

Page 40

Types of Shariah-compliant derivatives in Malaysia

1. Currently, there are three (out of nine) products traded were approved instruments by SAC of SC

a. Crude Palm Oil Futures (FCPO)

b. Crude Palm Kernel Oil Futures (FPKO)

c. Single Stock Futures (SSF)

2. In addition, the SAC also approved the mechanics of stock index futures contracts as long as the component is made up of Shariah approved securities



Introduction

Page 41

Shariah-compliant commodity futures

� Exchange-traded agreement to buy and sell a commodity in a actual market (cash market) in a standard quantity, at a future date and at a determined place of delivery.

� It is a financial product innovation for those involved in crude palm oil/palm kernel oil trading to manage risks more efficiently and effectively, especially the risk of price fluctuation

1. Crude Palm Oil Futures (FCPO)

2. Crude Palm Kernel Oil Futures (FPKO)

Introduction

Page 42

Shariah arguments on FCPO/FPKO

Gambling

There were issues regarding the requirement to place a deposit as a margin of payment before begin trading. It is considered akin to prohibited bet.

i. Does not constitute gambling because the fluctuation of the value occurs due to change of demand in CPO futures market.

ii. Common phenomenon in the trading world

iii. Gambling is actually depend solely on luck and is not related to demand and offer



Introduction

Page 43


Gharar

Uncertainty in obtaining goods that have been bought and in receiving potential profits.

i. Profit and loss in business is a common factor, although traders are actually aspire to earn profits

ii. Trader should take steps to minimise loss

iii. Specification such as quantity, type, price and delivery date are made known to the market players.

iv. In addition, surveillance and regulation are provided to ensure there is no cheating

Introduction

Page 44


Bai’ Ma’dum

Which means buying something that does not exist. It exist in futures contract because there is an element of uncertainty to hand over the goods sold

i. However, bai’ma’dum that occurs in something that exists and seller can obtain it or in the form that can be made tangible is considered permissible i.e Salam and Istisna.

ii. In futures market, contract can be settled in cash before the due date or settlement by delivery on the due date

iii. In addition, the clearing house ensures the delivery and settlement of a transaction



Introduction

Page 45


Speculation

Another issue that has trigger doubts on FCPO and FPKO according to Shariah. It refers to making profits out of the price movements of goods.

i. With regards to FCPO/FPKO, the SAC resolved that speculation is permissible under Islamic jurisprudence

ii. It exists in many form of businesses and is not limited to futures market. It represent a blessing and an opportunity for traders

iii. Need to avoid fraud and manipulation. Therefore, these practices have to be monitored and supervised to ensure fairness for market players

Introduction

Page 46


Exchange of goods (‘Iwadh)

In FCPO/FPKO, there is no purchase of goods in the actual sense has occurred. Thus, there is no increase in value in economic activities.

i. In actual fact, futures contract trading gives an increase in value to market players

ii. When CPO producers hedges, the intention is to manage risk and cut costs. Indirectly, it improve company profits and make their products more competitive.



Introduction

Page 47

Composite Index Futures contract

1. The SAC endorsed the concept of stock index futures, however the KLCI futures is based on non-halal stocks, so it is not approved

2. The mechanism for stock index futures contracts does not contradict Shariah principles as long as the index component is made up of Shariah approved securities

3. Shariah approved securities

• There are some variations on stock selection criteria i.eDow Jones vs FTSE vs S&P vs KLSI

Introduction

Page 48


Cash + Interest Bearing Securities to Market Value of Equity (12-months Average) < 33%

Account Receivables to Market Value of Equity (12-months Average) < 49%

Total Debt to Market Value of Equity (12-months Average) < 33%

S&P

NANANAKLSI

FTSE

Dow Jones

Cash + Interest Bearing Securities to Total Asset < 33%

Account Receivables to Total Asset ratio < 45%

Total Debt to Total Asset < 33%

Cash + Interest Bearing Securities to Trailing 120-months Moving Average Market Capitalization <33%

Account Receivables to Total Asset ration < 45%

Total Debt to Trailing 12-month Moving Average Market Capitalization < 33%

CashReceivablesLeverage



Introduction

Page 49


Gambling

1. No similarity with gambling. In gambling player loses all his money if his guess is wrong.

2. Not happen in index trading because the total index point has its own value

Gharar

1. No element of gharar as it is traded in a clear quantity and pricing based on demand and supply.

Introduction

Page 50


Mal

1. The Mal concept – very important to determine whether something can be traded

2. Mal is something that has value that can be bought and sold and can be compensated for its damage.

3. In index futures contracts, it has a value within specific period and is traded in its own market.



Introduction

Page 51


1. It has value until the maturity date, after which the contract cannot be traded.

2. Nevertheless, the holder of the contract still can gain from the differences in the buying and selling price upon maturity.

Introduction

Page 52


Delivery

1. In index futures contract – no physical delivery on the due date, only cash settlement

2. Generally, Islamic jurisprudence allows physical delivery to be substituted for cash value

3. Cash settlements are carried out when physical delivery cannot be done.



Introduction

Page 53


1. There is a potential to explore on the establishment of Shariah index futures contract i.e FTSE Bursa Malaysia Hijrah Shariah Index

2. Comprises of 30 largest companies in the FBM EMAS Index that meets triple screening process

i. FTSE’s global standards of free float, liquidity and investibility

ii. Yasaar’s international Shariah screening methodology

iii. SAC’s screening methodology

Introduction

Page 54

Single Stock Futures (SSF)

1. SSFs gives a solution to hedge share exposure risk and speculate on share price movements

2. Considered as geared products and are cheaper to trade than direct share investment

i. Standardised contract

ii. Exchange traded

iii. Standard quantity of a specific underlying asset

iv. Expiry on a predetermined future date

Features:



Introduction

Page 55


1. SAC of SC approved SSF as a Shariah-compliant instrument with condition.

2. The underlying stocks of the SSF must be a Shariah-compliant

3. Provides another Shariah-compliant tool to manage risks in relation to Shariah-compliant stocks

4. In line with CMP to introduce more competitive and innovative Islamic financial services and products

Introduction

Page 56


Based on the SAC’s list of Shariah compliant securities as at 25th May 2007, five of the ten SSFs currently trading on Bursa are Shariah-compliant

• Air Asia Bhd

• IOI Corporation Bhd

• Maxis Communication Bhd

• Scomi Group Bhd

• Telekom Malaysia Bhd



Introduction

Page 57


� Muqamarah (Gambling)

� Bai’ Ma’dum (Buying and selling something which does not exist

� Gharar (Uncertainty)

� Jahalah (Ignorance)

SSFs were approved by the SAC on the basis that the instruments are free from prohibited elements:

Introduction

Page 58


Jahalah (Ignorance)

1. From a financial transaction view point, it would be unacceptable if one party to the transaction gains because of other party’s ignorance

2. Not happen in SSFs simply because the instrument is traded in clear quantities ( contract specification) and pricing is based on market demand and supply



Introduction

Page 59

Key takeaways…

1. Risk management is more critical in Islamic finance due to the nature of contracts and it involves a real economic transaction

2. Riba, Gharar, Maysir, Urbun, Forward sale, Qabadh, Arbitrage, Short sale and Option are some of the arguments that always come out when discuss about Islamic derivatives

3. The Hanbalis hold that stipulations that remove a hardship, fulfils a legitimate need, provide a benefit or convenience or facilitate the smooth flow of commercial transactions are generally valid as a matter of principle

Introduction

Page 60

Key takeaways…

4. There are three out of nine products traded were approved instruments by SAC of SC

i. Crude Palm Oil Futures (FCPO)

ii. Crude Palm Kernel Oil Futures (FPKO)

iii. Single Stock Futures (SSF)

5. SAC also approved the mechanics of stock index futures contracts as long as the component is made up of Shariahapproved securities

6. Islamic says we should only be rewarded if we take or share some degree of risk in a venture. It does not prohibit us from managing this risk. As such derivatives products developed to managed risk is allowable.



Thank youThank youThank youThank you



Bank Islam reserves all propriety rights to the contents of thisBank Islam reserves all propriety rights to the contents of this Presentation. No part of this Presentation may be used or reproPresentation. No part of this Presentation may be used or reproduced in any form duced in any form

without Bank Islamwithout Bank Islam’’s prior written permission.s prior written permission.

This Presentation is provided for information purposes only. NeiThis Presentation is provided for information purposes only. Neither Bank Islam nor the Presenter makes any warranty, expressedther Bank Islam nor the Presenter makes any warranty, expressed or implied, nor or implied, nor

assumes any legal liability or responsibility for the accuracy, assumes any legal liability or responsibility for the accuracy, completeness or currency of the contents of this Presentation.completeness or currency of the contents of this Presentation.

STRICTLY PRIVATE & CONFIDENTIAL

NOR SHAHRIZAN SULAIMANNOR SHAHRIZAN SULAIMAN

RISK MANAGEMENT DIVISIONRISK MANAGEMENT DIVISION

BANK ISLAM MALAYSIA BERHADBANK ISLAM MALAYSIA BERHAD

29 APRIL 200829 APRIL 2008

RISK MANAGEMENT IN RISK MANAGEMENT IN

ISLAMIC BANKINGISLAMIC BANKING

IBFIM iIBFIM i--SeriesSeries



Bank Islam reserves all propriety rights to the contents of thisBank Islam reserves all propriety rights to the contents of this Presentation. No part of this Presentation may be used or reproPresentation. No part of this Presentation may be used or reproduced in any form duced in any form

without Bank Islamwithout Bank Islam’’s prior written permission.s prior written permission.

This Presentation is provided for information purposes only. NeiThis Presentation is provided for information purposes only. Neither Bank Islam nor the Presenter makes any warranty, expressedther Bank Islam nor the Presenter makes any warranty, expressed or implied, nor or implied, nor

assumes any legal liability or responsibility for the accuracy, assumes any legal liability or responsibility for the accuracy, completeness or currency of the contents of this Presentation.completeness or currency of the contents of this Presentation.

STRICTLY PRIVATE & CONFIDENTIAL

NOR SHAHRIZAN SULAIMANNOR SHAHRIZAN SULAIMANRISK MANAGEMENT DIVISIONRISK MANAGEMENT DIVISION

BANK ISLAM MALAYSIA BERHADBANK ISLAM MALAYSIA BERHAD

29 APRIL 200829 APRIL 2008

RISK MANAGEMENT IN RISK MANAGEMENT IN

ISLAMIC BANKINGISLAMIC BANKINGIBFIM iIBFIM i--SeriesSeries

IBFIM i-Series Program on Risk ManagementPage 2

“And verily, this is My Straight Path, so follow it. And do not follow

(other) paths, for they will separate you away from His (Allah) path.

This is what He has ordained for you; so that you may become al-

Muttaqin (the pious and righteous person who fear Allah much and

abstain from all kinds of sins and evil deeds which He has

forbidden.)”

(Surah al-An’am: 153)

Allah S.W.T. says …




“O traders! Do not trade in our market for those who not possess

knowledge (of Islamic commercial laws); because he may consume riba

willingly or unwillingly (because of the lack of knowledge).”

Khalifah ‘Umar bin al-Khattab RA said to the traders in the Madinah

al-Munawwarah’s market:


o Introduction to Risk Management

o Risk Management for Islamic Banks

o Guiding Principles of Risk Management

o Risk Management in Bank Islam Malaysia Berhad




INTRODUCTION TO RISK MANAGEMENTINTRODUCTION TO RISK MANAGEMENT

� Concept of risk management

� Definition of risk

� Risk management process

� Impact of poor risk management


CONCEPT OF RISK MANAGEMENT IN ISLAMCONCEPT OF RISK MANAGEMENT IN ISLAM

� Text in Al-Quran

“O my children, do not enter the capital of Egypt by one gate but go into it by

different gates. However, know it well that I cannot ward off you Allah’s will

for none other than He has nay authority whatsoever. In Him I have put my

trust and all who want to rely upon anyone should put their trust in Him alone.”

(Surah Yusuf: Verse 67)

� Hadith from Prophet Muhammad s.a.w

Prophet (peace be upon him) once asked a Bedouin who had left his camel

untied, “Why do you not tie your camel?” The Bedouin answered, “I put my

trust in God.” The Prophet PBUH then said, “tie up your camel first then put

your trust in God.”




WHAT IS RISK?WHAT IS RISK?

Risks are uncertain future events which could influence the achievement of the Bank’s objectives, including strategic,

operational, financial and compliance objectives.

Uncertain future events could be:

• Failure of a borrower to repay a financing

• Fluctuation of foreign exchange rates

• Fraud, incomplete security documentations, etc

• Non-compliance with shariah law and principles

• Other events that may result in a loss to the Bank


WHAT IS RISK MANAGEMENT?WHAT IS RISK MANAGEMENT?

Risk management is the process by which various risk

exposures are

(1) identified,

(2) measured/assessed,

(3) mitigated and controlled,

(4) reported and monitored.




1. Barings / Nick Leeson (1995)� Barings Singapore reported SIMEX trade losses of GBP

850 million� Brought down the whole bank…

2. National Australia Bank (2004)� FX derivative losses of AUD 360 million…

3. Allied Irish Bank / John Rusnak (2001)� US subsidiary Allfirst reported FX Options trading losses of

USD 750 million

EXAMPLES OF RISK MANAGEMENT FAILURESEXAMPLES OF RISK MANAGEMENT FAILURES


4. LTCM, Hedge Fund (1998)� Bond Market losses wiping out capital of USD3.9 billion � Fed and consortium of US Banks bailout

5. Sumitomo / Yasuo Hamanaka (1996)� Commodity (copper) trading losses of USD1.8 billion…

6. Orange County, CA, USA (1994)� Equity losses of USD2 billion� Reverse repos / over-leveraged

7. Societe Generale, France (2008)� Jerome Kerviel traded Euro stock index futures and

concealed losses up to almost EUR 5.0 bio

EXAMPLES OF RISK MANAGEMENT FAILURESEXAMPLES OF RISK MANAGEMENT FAILURES









RISK MANAGEMENT FOR ISLAMIC BANKSRISK MANAGEMENT FOR ISLAMIC BANKS

� Islamic banking business activities

� Risks inherent in Islamic banking business

� Uniqueness of Islamic banking

� Risk issues for Islamic banks

� Shariah non-compliance risk

� Rate of return risk/ benchmark rate risk

� Displaced commercial risk

� Equity Investment risk

� Inventory risk/ completion risk

� Risk transformation at different stages of a contract




ISLAMIC BANKING BUSINESS ACTIVITIESISLAMIC BANKING BUSINESS ACTIVITIES


BALANCE SHEET OF ISLAMIC BANKBALANCE SHEET OF ISLAMIC BANK

Islamic bankCustomer Depositors

Revenue Dividend/Hibah

Financing Deposit

Profit & Loss

Balance Sheet

Equity

Special investment accounts

Mudharabah/Musharakah

Fee based services

Investment accounts

Mudharabah

Profit sharing transactions

Mudharabah/Musharakah

Demand deposits

Wadiah/Mudharabah

Asset-backed transactions

Murabahah/Ijarah/Istisna/Salam

LiabilitiesAssets

Off Balance Sheet

Direct investorsRestricted investments




RISK PROFILE OF ISLAMIC BANKRISK PROFILE OF ISLAMIC BANK

Islamic bank

Rate of return risk

Displaced Commercial

risk

Equity Investment

risk

Operationalrisk

Liquidity riskMarketrisk

CreditRisk

Shariah non-compliance

risk

Unique

Generic

TransparencyStrategic Regulatory complianceReputationFiduciaryLegal


GENERIC RISKS FOR BANKSGENERIC RISKS FOR BANKS

The potential loss resulting from inadequate or failed

internal processes, people and system or external events

Operational risk

The potential loss arising from the Bank’s inability either to

meet its obligations or to fund increases in assets as they

fall due without incurring unacceptable costs or losses

Liquidity risk

The potential impact of adverse price movements such as

benchmark rates, foreign exchange rates, equity prices on

the economic value of an asset

Market risk

The potential that a counterparty fails to meet its

obligations in accordance with agreed terms and conditions

of credit-related contract

Credit risk

DefinitionTypes of risks




RISKS TRANSFORMATION FOR FINANCING OF ASSETSRISKS TRANSFORMATION FOR FINANCING OF ASSETS

� Even generic risks are not that straight forward in Islamic banking

� For financing that involves financing assets e.g. Murabahah, Salam, Istisna and Ijarah, the risks of financing may transform from credit to market and vice versa at different stages of contract

� Hence capital management needs to take into account both the credit and market risk


RISK TRANSFORMATION UNDER MURABAHAH & MPORISK TRANSFORMATION UNDER MURABAHAH & MPO

--Maturity of contract or upon full

settlement

-XAsset is sold to and payment is due

from customer

-XAsset available for sale (asset on

balance sheet)

Binding MurabahahPurchase Order

--Maturity of contract or upon full

settlement

-XAsset is sold to and payment is due

from customer

X-Asset available for sale (asset on

balance sheet)

Murabahah and non-binding Murabahahpurchase order

Market riskCredit riskStage of contractType of contract

Murabahah – Bank sells assets it already owned to customer at cost +

Murabahah Purchase Orderer (MPO) – Bank sells assets it acquires to customer at

cost + based on promise to purchase (PP) by customer




RISK TRANSFORMATION UNDER IJARAH & IMBRISK TRANSFORMATION UNDER IJARAH & IMB

--

Maturity of contract term and the

leased asset is sold and the

ownership of asset is transferred to

the customer

-XUpon signing a leasing contract and

the asset is available for lease

X-Asset available for lease (prior to

signing of a lease contract)

Ijarah Muntahia

Bittamleek

X-Maturity of contract term and the

leased asset is returned to the bank

XXUpon signing a leasing contract and

the asset is available for lease

X-Asset available for lease (prior to

signing of a lease contract)

Operating Ijarah

Market riskCredit riskStage of contractType of contract

Ijarah – Bank owns the assets whilst transferring the right to use the asset to lessee. Liabilities & risks pertaining to

the asset is born by Bank

IMB – Bank promise to transfer the asset by sale or hibah & MUST be separately expressed and independent of

underlying Ijarah


UNIQUE RISKS FOR ISLAMIC BANKSUNIQUE RISKS FOR ISLAMIC BANKS

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. This risk is relevant under Mudharabah and

Musharakah contracts.

Equity Investment risk

The 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.

Displaced Commercial risk

The potential impact on the returns caused by unexpected

change in the rate of returns

Rate of return risk

Risk arises from the failure to comply with the Shariah rules

and principles

Shariah non-compliance risk

DefinitionTypes of risks




SHARIAH COMPLIANT IS PARAMOUNTSHARIAH COMPLIANT IS PARAMOUNT

� Original basis for having a banking system that meets the

religious requirements of Muslims in line with their ‘Aqidah.

� Factor that distinguishes Islamic banking from conventional

banking.

� Ensures acceptance, validity and enforceability of contracts

from Shariah point of view.

� Fulfills the objectives of Islamic finance i.e. to achieve

justice (‘adalah) and fairness (musawah) in the distribution of

resources.


SHARIAH REQUIREMENTSSHARIAH REQUIREMENTS

Trade and commerce in Islam

must conform to the

requirements of the Shariah,

which broadly refers to :

� Abstinence from prohibited

elements (haram matters); and

� Observing that every contract

possesses all the essential

elements and that every essential

element meets the necessary

conditions




SALIENT FEATURES OF ISLAMIC BANKINGSALIENT FEATURES OF ISLAMIC BANKING

Prima-facie free from prohibitive list as prescribed clearly by Shariah.

� To ensure every contract behaves in its proper

context.

� This does not negate freedom of contract

(hurriyah al-ta’aqud)

4. Not in direct conflict with

“established” Shariah principles

in mu’amalah.

� Not ‘productive’ i.e. does not create new wealth

or economic activities (zero-sum game) –

different from speculation

3. Gambling (maysir)-free

� Avoid any dispute due to unfairness in dealings

caused by the lack of knowledge.

2. Uncertainty or lack of

knowledge (gharar)-free

� Money is just a medium of exchange.

� It cannot earn more money by itself. Must be

‘churned’ via productive economic activities.

1. Interest (riba)-free

WHY?FEATURE


EXAMPLES OF SHARIAH ISSUESEXAMPLES OF SHARIAH ISSUES

� Completeness of aqad (contract) risk

� Must be absolute and in definite and decisive language.

� Must be unconditional.

� Must be in present or past tense.

� Acceptance must agree with the offer.

� Executed in one and same meeting (majlis ‘aqd)

5. Contract: Ijab & Qabul

� Must be in known currency and absolute amount.4. Price

� Must exist at the time of sale

� Must be pure (halal) according to Shariah

� Must have use or usufruct according to Shariah.

� Must be in the ownership of the seller at the time of sale.

� Must be capable of being delivered i.e. free from any encumbrances

� Must be known and specific by address, specification or description

3. Subject matter of sale

2. Buyer

� Capable of accepting responsibilities – ‘aqil (of sound mind), baligh (of

age of puberty), rasyid (of age of majority), not prohibited from

entering into contract (bankrupt or prodigal) and no coercion is

exerted on either of them

1. Seller

SHARATRUKUN




1. Wadi’ah Based Deposit:

� Disclosure of the hibah on the rate

board, website etc.

� Declaration of gift to depositors

� Shariah non-compliance fund

2. Mudharabah Based Deposit

� Guarantee on the capital and return

� Maintenance cost


3. Remittance



4. Sale (Bai’ Inah & BBA)

� MPO – Ownership of the asset

prior to sale aqad

� Inter-conditional clause between

ASA & APA

� The word “agree” in the aqad

� Financing of non-Shariah

compliant asset

� Financing of asset intended for

non-Shariah compliant activities

5. AITAB

� Appointment of customer as the

Bank’s purchasing agent prior to

Ijarah contract


6. Trade Financing

� Commitment fee on the unutilized line

� BG – guarantee of non Shariah compliant asset, activities etc.

7. Refinancing

� Refinancing of encumbered property

8. Recovery

� Repossession - BBA





IMPLICATIONS OF SHARIAH NONIMPLICATIONS OF SHARIAH NON--COMPLIANCECOMPLIANCE

� Against the commands of Allah.

� Impediment from Allah’s blessing

or barakah

� Contravention of the provision of

Islamic Banking Act 1983 (Section

3(5)(a) & Section 4)

� Jeopardize the Bank’s reputation

as an Islamic bank

� Invalidation of contract (‘aqad)

� Non-halal income

� Capital adequacy ratio (CAR)

Impact

Non Financial Impacts Financial Impacts


“ Refers to the potential impact on an Islamic

Financial Institution’s (IFI) net income / net

income margin or market value of equity arising

from changes in the market rate of returns ”

�Gap/Mismatch Risk or

�Re-pricing Risk or

�Benchmark Rate Risk

RATE OF RETURN RISKRATE OF RETURN RISK





� Associated with the management of assets and liabilities

� Fixed rate long term assets funded by variable rate short-

term liabilities

� Movement in benchmark rates may result in fund providers

having expectations of a higher rate of return

� Subsequently, it may result in displaced commercial risk

where due to market pressure, an Islamic bank needs to pay a

return that exceeds the rate that has been earned on its

assets.

� If Islamic bank does not yield to market pressure, they may

lose their fund providers which could consequently lead to

liquidity risk


� Function of IFI’s income generated from the investment of depositors/ investors’ funds

� Optimal asset allocation – optimal returns

� BNM Rate of Return Framework – computes IFIs’ gross “R”

� Based on the return-on-assets (ROA) approach





� Objectives of Rate of Return Framework� Set minimum standards

� Provide level playing field

� Provide BNM with better means for assessing IFIs

� Shariah contract applicable – Mudharabah� Profit sharing but loss solely borne by depositors unless there is evidence

of negligence on the part of the Mudarib (IFI)

� Profit Sharing Ratio (PSR) – refers to the portion of profit distributable to depositors and the bank

� Profit Equalization Reserve (PER) – refers to the amounts appropriated out of total income to maintain an acceptable level of return to the depositors. Consists of an IAH portion and a shareholder’s portion



CAPITALMUDHARIB (Manager – Bank)

RABB AL-MAL (Capital provider

- depositor)

Profit Losses

� Shared between mudharib + rabb

al-mal.

� Profit sharing according to a

contractually agreed ratio.

� Profit sharing cannot be a fixed

amount/ a fixed percentage of

capital contribution.

� Borned solely by rabb al-mal.

� Mudharib will only be

personally liable if the loss is

caused by negligence.





PROFIT DISTRIBUTIONPROFIT DISTRIBUTION

Income from investment

Income from financing

Income from IMM investing

Gross Income

Net Distributable Income

Depositor Islamic bank

Less:Net trading income and other income

Financing and investment loss provision

Profit equalization reserveDirect expenses

Profit Sharing Ratio

Investment Risk Reserve


“ Refers to the risk arising from assets managed by the IFI on behalf of investment account holders (IAHs) which is effectively transferred to the IFI’s own capital because the IFI follows the practice of foregoing part or all of its Mudarib share of profit on such fund ”…IFSB

IAH = Capital Provider (“Rabb al Mal”)

IFI = Entrepreneur (“Mudharib”)

RoR Risk DCR Liquidity Risk

DISPLACED COMMERCIAL RISKDISPLACED COMMERCIAL RISK




� PER & IRR� Reserves for the purpose of income smoothening

� Alternative deposit instruments� Islamic Negotiable Instrument of Deposits (INIDs)

� Commodity Murabahah

� However, probably not in the spirit of Islamic Finance which encourages entrepreneurship…

� Best to focus on optimizing income / revenues from sources of funds i.e. Mudharabah Depositors / investors

� Efficient Management of funds…ISLAMIC BANKING IS ESSENTIALLY ABOUT FUND AND ASSET MANAGEMENT

DISPLACED COMMERCIAL RISK DISPLACED COMMERCIAL RISK -- MitigantsMitigants


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

BNM classifies the following as equity positions:� Ordinary shares; voting or nonvoting (common or preferred)

� Convertible Securities

� Commitments to buy or sell equity securities

� Equity Derivatives

� Off-balance sheet items i.e. swaps and options

� Underwriting of equities

� Equity-type Shariah Contracts:� Mudharabah

� Musharakah

� Musharakah Mutanaqissah (Diminishing Musharakah)

EQUITY INVESTMENT RISKEQUITY INVESTMENT RISK




Mudarib

Ultimate Customer Progress payment (PP) $

(2a)

Bank contribute $ (1)

Bank Receive $ (2)

Project Finance -Construction Contract

Project Finance

NA

�If PP is paid to `project a/c’ with the Bank – based on rating of Mudharib. � amount held in `project a/c’ – 0%.� remaining amount is based on PCE bus. venture.

Prior to certification (fund advanced to Mudharib)

NAUp to a max of 150% under BNM CAF

PCE – business venture

Depend on asset under market risk requirement

NAPCE – trading in FX, share or commodity

NABased on rating of ultimate customer.

After certification (receivables are PP due to Mudaribfrom ultimate customer)

Market RiskCredit RiskRisk Weight1. Bank contributes capital to an enterprise where profit is shared but loss is borne by the Bank.

2. Mudharib can’t guarantee against losses

3. Can be applied to placement of excess funds in the interbank market

EQUITY INVESTMENT RISK EQUITY INVESTMENT RISK -- MudharabahMudharabah


Partner

Third party

Bank contribute $ (1)

Bank Receive $ (2)

Sub-contract-Ijarah or-Murabahah

Musharaka’• contribute capital in partnership which shares profit & loss• capital is redeemable by liquidation of musyarakah asset at the end of contract which has a fixed tenure or upon divestment of partnership.Musharaka’ Mutanaqissah (Diminishing Musharaka’)• Bank’s share in partnership is reduced gradually until fully sold to the partner. • It is an alternative to avoid conventional Term Loan repayable by installment.

MusharakahMusharakah

NAUp to a max of 150% under BNM

CAF

PCE –business venture

Depend on asset under market risk requirement

NAPCE –

trading in FX, share or commodity

Refer to MR charge for sub-

contract, Ijarah or

Murabahah

Based on partner’s rating

Joint ownership of real estate &

movable property

Market RiskCredit RiskRisk Weight

$

Bank sell its share (2a)

Bank receives SP(3)Diminishing Diminishing MusharakahMusharakah

PCE – Private Commercial Enterprise

EQUITY INVESTMENT RISK EQUITY INVESTMENT RISK –– MusharakaMusharaka’’ and and MusharakaMusharaka’’

MutanaqissahMutanaqissah




“ risk arising from holding items in inventory either for resale under a Murabaha’ contract, or with a view to leasing under the ijarah contract “

� Items held under Non-binding Murabaha’ for Purchase Order (MPO)

� Items purchased under Istisna’ contract (‘unbilled work-in-progress’)

INVENTORY RISKINVENTORY RISK


1.6 % (on unbilled inventory)

YesUnbilled WIPIstisna’

NoneAll stagesBinding MPO

15 %YesAsset Held for Sale

Murabaha’ and Non-binding

MPO

Proposed Capital Charge

Market RiskApplicable Stage of the Contract

Islamic

Contract

INVENTORY RISK BY SHARIAH CONTRACTINVENTORY RISK BY SHARIAH CONTRACT




15%

(of the carrying value)

YesMaturity of contract term

8%

(Based on residual value)

YesUpon consigning a lease contract

15%YesAsset available for lease

Operating

Ijarah

Proposed Capital Charge

Market RiskApplicable Stage of the Contract

Islamic

Contract

NoneUpon consigning

a lease contract

15%YesAsset available for lease

Ijarah MuntahiaBittamleek

(IMB)

INVENTORY RISK BY SHARIAH CONTRACTINVENTORY RISK BY SHARIAH CONTRACT









GUIDING PRINCIPLES OF RISK MANAGEMENTGUIDING PRINCIPLES OF RISK MANAGEMENT

� BASEL Committee on Banking Supervision

� Islamic Financial Services Board (IFSB)

� Bank Negara Malaysia


BASELBASEL

� 1988 Capital Accord (Basel I)

� Regulatory based

� Set out requirements to calculate capital charge ie the amount of capital to be set aside to absorb potential loss across banks and across countries

� One size fits all

� 1996 Basel I (Amendments)

� Market Risk was incorporated into Basel I

� 2004 International Convergence of Capital Measurement and Capital Standards (Basel II)

� Aims to make capital requirements more risk sensitive

� Includes Operational Risk

� Bank shall be subject to 3 mutually reinforcing pillars

� Pillar 1: Minimum Capital requirements

� Pillar 2: Supervisory Review Process

� Pillar 3: Market Discipline




IFSB STANDARDSIFSB STANDARDS

� 2005 Guiding Principles of Risk Management

� 2005 Capital Adequacy Standard

� 2006 Corporate Governance

� 2007 Supervisory Review Process

� 2007 Transparency and Market Discipline


IFSB GUIDING PRINCIPLES OF RISK MANAGEMENTIFSB GUIDING PRINCIPLES OF RISK MANAGEMENT

15 guiding principles which cover

� General requirement for an effective risk management process (1)

� Credit risk (4)

� Equity Investment Risk (3)

� Market Risk (1)

� Liquidity Risk (2)

� Rate of Return Risk (2)

� Operational risk (2)





General requirements

� Principle 1.0 – IIFS shall have in place a comprehensive risk management

and reporting process, including:

� Appropriate Board and Senior Management oversight

� Identify, measure, monitor, report and control relevant categories of risks

� Held adequate capital against risk

� Comply with Shariah rules and principles

� Adequate risk reporting to the supervisory authority


Rate of return risk

� Principle 6.1 – IIFS shall establish a comprehensive risk management

framework 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

� Principle 6.2 – IIFS shall have in place an appropriate framework for

managing displaced commercial risk, where applicable





Shariah non-compliance

� Principle 7.1 – IIFS shall have in place adequate systems and controls,

including Shariah Board/Advisor, to ensure compliance with Shariah rules

and principles

� Requirements:

� IIFS shall ensure that they comply at all times with the Shariah rules and

principles

� IIFS shall ensure that their contract documentation complies with Shariah rules

and principles

� IIFS shall undertake a Shariah compliance review at least annually

� IIFS shall keep track of income not recognised arising out of Shariah non-

compliance and assess the probability of similar cases arising in the future



IFSB CAPITAL ADEQUACY STANDARDIFSB CAPITAL ADEQUACY STANDARD

The need for RWCR framework

� To ensure that Islamic banks can absorb a reasonable level of losses before

becoming insolvent.

� To provide protection to depositors and/ or PSIA – the higher the CAR, the

higher the level of protection.

� To promote stability and efficiency of the financial system by reducing the

likelihood of Islamic banks becoming insolvent.

� To ensure that the Islamic banks’ capital position commensurate with its

overall risk profile and strategy.




Eligible Capital

Total RWA (Credit + Market Risks) + Operational Risk

LessLess

RWA funded by PSIA (Credit + Market Risks)

PSIA is is

Profit Profit

Sharing Sharing

Investment Investment

AccountAccount

IFSB RWCR - Standard Formula

> 8.00%



Eligible Capital

Total RWA (Credit + Market Risks) + Operational Risk

LessLess

RWA funded by Restricted PSIA (Credit + Market Risks)

LessLess

(1 – α)[RWA funded by Unrestricted PSIA (Credit + Market Risks)]

LessLess

α [RWA funded by Profit Equalisation Reserve (PER) and Investment Risk Reverse (IRR)

of Unrestricted PSIA (Credit + Market Risks)]

IFSB RWCR - Supervisory Discretion Formula





RISK MANAGEMENT IN BANK ISLAMRISK MANAGEMENT IN BANK ISLAM

� Risk Management Framework

� Organizational Structure

� Policy and Guidelines

� Enablers


RISK MANAGEMENT FRAMEWORK (RMF)RISK MANAGEMENT FRAMEWORK (RMF)

� Providing an architecture that governs the overall risk

management philosophy and strategy

� Acting as a foundation to allow management of risks to be

conducted most effectively in line with the industry’s best

practices

� Setting a tone for the philosophical and practical approaches

in managing risk




SOLAH – THE PILLAR OF

ISLAM

NIYYAHPronouncement/ Statement of Pronouncement/ Statement of Pronouncement/ Statement of Pronouncement/ Statement of SolahSolahSolahSolah

SYARATNecessary Elements of Necessary Elements of Necessary Elements of Necessary Elements of SolahSolahSolahSolah

RUKUNEssential Activities of Essential Activities of Essential Activities of Essential Activities of SolahSolahSolahSolah

JAMA’AHImplementation Structure of Implementation Structure of Implementation Structure of Implementation Structure of SolahSolahSolahSolah

QAEDAHFacilities Required for Facilities Required for Facilities Required for Facilities Required for SolahSolahSolahSolah

PHILOSOPHY OF

SOLAH IN LIFE

MISSION STATEMENTMISSION STATEMENTMISSION STATEMENTMISSION STATEMENT

RULE OF LAWRULE OF LAWRULE OF LAWRULE OF LAW

PROCEDUREPROCEDUREPROCEDUREPROCEDURE

STRUCTURESTRUCTURESTRUCTURESTRUCTURE

TOOLSTOOLSTOOLSTOOLS

BANK ISLAM’S RMF

MISSION & OBJECTIVESMISSION & OBJECTIVESMISSION & OBJECTIVESMISSION & OBJECTIVES

POLICIES & GUIDELINESPOLICIES & GUIDELINESPOLICIES & GUIDELINESPOLICIES & GUIDELINES

PROCESSESPROCESSESPROCESSESPROCESSES

FUNCTIONAL STRUCTUREFUNCTIONAL STRUCTUREFUNCTIONAL STRUCTUREFUNCTIONAL STRUCTURE

ENABLERSENABLERSENABLERSENABLERS

CONCEPT & METHODOLOGYCONCEPT & METHODOLOGY


BOARD OF DIRECTORS

Other Board Committees

Board Risk Committee (BRC)

Managing Director

Financing Committees

(FCA, FCB, RFC)

Management Risk Control Committee

(MRCC)

Risk Management Division (RMD)

Business Support Units

Market Risk

Credit Analysis

Constitution As per BNM guidelines Function Risk Mgmt Oversight and Over-riding authority for Risk Mgmt Approval of RMD Submissions

Shariah Supervisory Council (SSC)

Functional

Administrative

SHAREHOLDER

MANAGEMENT

Internal Audit Department

Credit Risk

Credit Administration

Board Financing Review Committee

(BFRC)

Business Risk Control & Compliance

Other Corporate Support Units

Asset Liability Committee (ALCO)

Other Management Committees

Business Units

Operational Risk

Shariah Compliance Risk

FUNCTIONAL STRUCTUREFUNCTIONAL STRUCTURE




POLICIES & GUIDELINESPOLICIES & 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 effectively

� 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 RISKCREDIT RISK

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.Watchlist Guideline

12.Financing Process Guideline

13.Credit Recovery Guideline

14.Guidelines on Risk Adjusted Pricing for Corporate & Commercial

Credit Risk Policy - 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.

GuidelinesPolicy




MARKET RISKMARKET RISK

1. Market Risk Limits Guideline

2. Hedging Guideline

3. Mark-to-Market Guideline

4. Rate Reasonability Check Guideline

5. Value-at-Risk (VaR) Guideline

6. Asset and Liability Management Guideline

7. Market Risk Manual & Procedures

� Market Risk Policy – Describes the Risk Policy and Analytics, Asset and Liability

Management (ALM) and Middle Office

functions 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 risks

inherent in the Bank’s trading and

banking books

GuidelinesPolicy


OPERATIONAL RISKOPERATIONAL RISK

1. Operational Risk Management Guideline

2. Management Awareness and Self-

3. Assessment (MASA) Reporting Guideline

4. Fraud Handling and Reporting Guideline

5. Takaful/Insurance Guideline

6. Key Risk Indicators (KRIs) Guideline

7. Outsourcing Guideline

8. Operational Risk Management Process for Information Security Management System

9. Customer Complaint Guideline

Operational Risk Policy – The policy provides the effective and efficient operational risk

management through out the Bank through its

strategies in terms of organization structure,

process, risk tolerance, risk measurement and

analytic model management information system

GuidelinesPolicy




SHARIAH COMPLIANCE RISKSHARIAH COMPLIANCE RISK

1. Wadiah Contract Guideline.

2. Ijarah and Ijarah Muntahiah Bit TamlikGuideline

3. Murabahah and MPO Contract Guideline

4. Mudharabah (financing) Contract Guideline

5. Musharakah (financing) Contract Guideline

6. Handling and Reporting of Shariah Non Compliances Guideline

7. Mudharabah (Deposit) Contract Guideline

8. Musharakah Mutanaqisah Contract Guideline

9. Musharakah (Investment) Contract Guideline

10.Kafalah Contract Guideline

11.Wakalah Contract Guideline

12.Tawarruq Contract Guideline

Shariah Compliance Risk Management Policy – The policy provides the Shariah requirements applicable throughout the Bank

in its activities, products and services in

compliance with the Shariah principles,

provisions of the Islamic Banking Act 1983

and Bank Negara Malaysia’s rules and

regulations.

GuidelinesPolicy


RISK MANAGEMENT PROCESSRISK MANAGEMENT PROCESS

� Awareness & Identification

� Knowing what the risks/risk areas are

� Assessment & Measurement

� Analytical ability to assess & measure risks

� Mitigation & Control

� Identifying & applying appropriate mitigations & controls of identified

risks/risk areas

� Monitoring & Reporting

� Continuous monitoring & appropriately reporting identified risks/risk areas




ENABLERSENABLERS

� Tools to assess and monitor risk issues include:

� Key Risk Indicator (KRI)

� Management Awareness and Self Assessment (MASA)

� Risk Profiling

� Portfolio / Exposure tracking

� Customer Ratings

� Value at Risk (VaR)

� Systems to manage risk issues

� Core Banking and Middle-wares

� Financing Origination & Collection Systems

� Treasury Middle Office systems - QRisk, Quantum

� Operational Risk Management System

� Administrative systems


MANAGING SHARIAH NONMANAGING SHARIAH NON--COMPLIANCE RISKCOMPLIANCE RISK

Shariah Supervisory

Council

Audit E

xamination

Committe

e

Board Risk Committee

External Audit/ BNM

Audit

Shariah Compliance

Risk Mgmt

Sharia

h Audit U

nit o

f

IAD

Shariah Department

Shariah Compliance

Risk Working Group

Functional structure





Support the SSC’s function on day-to-day basis

� Providing Shariah advice based on the decisions of Shariah councils

� Conducting training on Shariah related matters.

Shariah Department

� Sub-committee of Management Risk Control Committee – established to be

responsible for developing the SCRM capability of the Bank.

� Chairman: GM CABD, Deputy Chairman: CRO, Secretary: Head of SCRMD and

members: Senior officers from Business and Support Units.

Shariah Compliance Risk Working Group

Third layer of control mechanism after SSC and SD.

� Facilitating the process of managing SCR in the Bank.

� Formulating SCRM policy and guidelines

� Performing independent evaluation on products, manual & guidelines

� Monitoring SNC and keeping track of income arising from SNC

� Identifying internal control weakness and recommending mechanism to address

the SNC.

SCRM Department

� Structurally reports to Board, but functionally is independent of the Board and

management of the Bank.

� Governed by BNM GPS1

Shariah Supervisory Council

Key Roles and Responsibilities/ RemarksFunction

Functional structure



� Awareness & Identification� Conduct Shariah awareness program to all staff

� Incorporate Shariah requirement in operational manuals

� Newsletter on quarterly basis

� Risk portal

� Assessment & Measurement� Develop Shariah compliance risk scorecard

� Shariah assessment on new products, initiatives, manuals

� Mitigation & Control� Issue policy and guidelines

� Establish Shariah Compliance Risk Working Group

� Shariah representative in all committees

� Require sign off

� Monitoring & Reporting� Shariah non-compliances tracking report

� Key Risk Indicators

� Monthly reporting to MRCC and BRC




KEY RISK INDICATORS REPORTKEY RISK INDICATORS REPORT

Detection of > 10 cases of PSNC.Unsatisfactory4

Confirmation of at least 1 SNC by SSC.Very

Unsatisfactory

5

Detection of 6 - ≤ 10 cases of PSNC.Fair3

Detection of ≤ 5 cases of PSNC.Satisfactory2

No potential SNC case being reported to

SCRMU.

Very Satisfactory1

DESCRIPTIONDEFINITIONRATING

Shariah non-compliance is “ZERO TOLERANCE”

� SNC is one of the Bank’s Key Risk Indicator (KRI) parameters.

� Objectives of the parameter:

� To promote better understanding of Shariah compliance.

� To provide a benchmark in determining the level of SNC.


Q & AQ & A……




Wassalam

وا��موا��م

Thank You

ا� ا� ��

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