risk characteristics of islamic financial products institute of islamic banking & insurance...

Warren Edwardes

Risk characteristics of Islamic financial products

Institute of Islamic Banking & InsuranceLondon 15th December 2004


• Institute of Islamic Banking & Insurance

• London 15th December 2004

• Warren Edwardes,

• ceo, Delphi Risk Management Limited

• email: [email protected]

• web: dc3.co.uk

Warren Edwardes



Delphi’s website contains:

• articles on Islamic banking on:dc3.co.uk/islamicbanking

• This PowerPoint is on: dc3.co.uk/islamicfinancerisk041215.ppt • with notes on dc3.co.uk/islamicfinancerisk041215.pdf• Speech drawn from the book "Key Financial Instruments" • Appendix 1 (50 Risk types)

– dc3.co.uk/risks.htm

• Appendix 4 (Islamic banking) – dc3.co.uk/islamicbanking.htm

Warren Edwardes



financial risk

• some actions can protect

• the same actions can destroy

• risk – a film

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Warren Edwardes



• Does Islamic banking risk differ from Conventional banking risk?

• Not different - just a very special case– Trade credit ?– Asset backed Secured or unsecured ?– Debt or equity ?– Leasing ?– Repos / Murabaha ?– Fund management ?

• Islamic Banking is ALL about who bears risk

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A check-list of 50 banking risk types

• To put it simply and directly, • if the bosses do not or cannot understand both the

risks and rewards in their products, • their firm should not be in the business. - • William J. McDonough, President, Federal

Reserve Bank of New York

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banking risk types - 1-4

• Acquisition Risk– Different cultures between banks “consolidating”

• Careless Error Risk– Human error should be forgiven. But this is not covered by law

• Competitive Risk – LIBOR determines competitors returns

• Commodity Risk– If you take delivery can the commodity price be managed?

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• Communication Risk – Define terms clearly– Deposit or managed funds?

• Country Risk – much of Islamic banking is carried out in emerging markets.

Riskier? Pakistan is stable in the eyes of Mid East investors • Credit Risk

– Not loans. Not IOUs. So equity not loan risk• Cultural Risk

– Difference between Gulf and Malaysia - narrowing

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banking risk types – 9-12

• Currency Transaction Risk– use of derivatives generally not allowed? Cannot hedge

exchange rate for purchases

• Currency Translation Risk– Balance sheet value of dollar assets or liabilities fluctuate

• Currency Economic Risk– Again no hedging permitted. So can Malaysia compete with

USD based countries when the USD depreciates?

• Customer Satisfaction Risk– If a bank pays no dividends customers will get angry

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• Disaster Recovery Risk– If a terrorist or earthquake strikes can you cope?

• Economic Activity Risk– Applies when overheads are fixed. Outsourcing a solution

• Energy Price Risk – Many Islamic countries’ economies are linked to the oil price

• Environment Risk– Are environment unfriendly policies haram?

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• Equity Market Risk – Islamic banking is ideally profit and loss sharing. This is venture capital or

equity investment

• Fraud (banker) Risk– Transparency is required. Avoid the risk of misinterpretation and mis-

selling

• Fraud (customer) Risk– If an investor loses money will he seek redress? Of course if he wins he will

not

• Fraud (staff) Risk– Haram for lenders to seek material benefit. BCCI was not an Islamic bank

but fraud could occur in Islamic banks

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• Image / PR Risk – Something hallal could be deemed haram. Sep 11 was bad PR for

Islamic banks

• Information Risk – Lack of transparency in accounts in many Islamic countries

• Inflation Risk – Securitised asset rises in value but not the repayment amount which

being a cash amount depreciates. Time value of money?

• Interest rate Risk – This is not a closed economy. If interest rates rise sharply deposits will

flow out. LIBOR linking

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• Interaction Risk – Correlation risk. What happened in New York and

Baghdad impacts on KL. Gold standard?

• Language Risk – Arabic, English, Malay, Indonesian, Urdu? Same word

can have different meanings.

• Legal Risk – UK, Malaysian, .. Is the bank / customer permitted to

carry out such business?. Ultra Vires issue

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• Liquidity Risk – Major problem for Islamic banking is the absence of a

developed Islamic money market. – about managing confidence and the liability side – About managing diversification.

• Morbidity Risk– No different from conventional banking. What happens if there

is an outbreak of dengue fever or Anthrax? • Mortality Risk

– Do you have offices in a tall building? – Would you survive major loss through fire?

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• Operational Risk– Are strong procedural systems in place? Really everything other than

market risks

• Performance Measurement Risk – Most measures of performance are crude and slavish adherence to

rules can lead to poor real performance

• Political Risk – Seizure of assets post Sep 11; boycotts by Western banks

• Competence / Understanding – Are the latest products really understood by the banks’ senior

management? By the customers?

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• Concentration of assets Risk– A problem for Islamic funds. No tobacco, banking and alcohol stocks

can lead to heavy weighting in property and technology

• Concentration of liabilities Risk– Do you have enough investors or do you depend on one or two?

• Concentration of business type Risk– Financial supermarket or nimble niche player are both fine. But can

you reinvent yourself if markets change?– Can you cope with the entry of HSBC / Barclays / Citibank?

• Convertibility Risk– Deliverability risk under exchange controls

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• Property (Real Estate) Risk – Would asset backing be sufficient in times of a property crash?

• Rating Agency Risk – A downgrading or even credit watch can impact on liquidity and the

entire business. Investment grade bonds do not default. They become junk and then default.

• Regulatory Risk – A firm operating globally will face different rules

• Religious Risk – A Hallal product may later be deemed Haram. Zero coupon bonds

were once Hallal. Other than Malaysia no Central Shari’ah authority

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• Resignation Risk – Over dependence on one person’s skills and market contacts?

• Settlement Risk – If there is no escrow account there is settlement risk on Murabaha and

BBA

• Systemic Risk – Financial instability is contagious. Financial systems are

closely inter-linked

• Tax Risk – Do the sale and repurchase transactions face VAT? Income tax or

capital gains tax treatment?

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banking risk types – 47-49

• Technological Risk – Are your fax confirmations going to your customer or a

competitor?

• Transport Risk – traffic jams may have led to cancelled meetings which may never

be rearranged

• Weather Risk – Could you hedge against the weather? KL’s 1998 smog and

Kuwait’s burning oil fields probably had an adverse impact on employees health.

– Weather derivatives are being traded. Haram? Weather Takaful?

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banking risk types – 50

• Zero Risk

• It’s impossible to take an unnecessary risk.

• because you only find out whether a risk was unnecessary

• after you’ve taken it

• Giovanni Agnelli, President FIAT

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Particular Islamic banking risk issues

• Liquidity – under developed money market • Interest rate Risk • Commodity Risk• Communication Risk• Equity risk – fund management or banking?• Operational risk• Religious – Hallal or Haram?• Language Risk - English, Arabic, Malay or Urdu

Warren Edwardes



Risk Issues In Islamic Banking

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