RISK MANAGEMENT AND RISK MANAGEMENT AND CORPORATE GOVERNANCE IN CORPORATE GOVERNANCE IN

ISLAMIC FINANCIAL ISLAMIC FINANCIAL INSTITUTIONSINSTITUTIONS

ZULKIFLI HASANZULKIFLI HASANHAWKAMAH, THE INSTITUTE OF CORPORATE GOVERNANCEHAWKAMAH, THE INSTITUTE OF CORPORATE GOVERNANCE

2626THTH MARCH 2009 MARCH 2009

CONTENTSCONTENTS IntroductionIntroduction Case Study: Closure of Ihlas Finance, due to Poor Case Study: Closure of Ihlas Finance, due to Poor

Corporate governance (CG) Corporate governance (CG) What is CG?What is CG? Why it is important to Islamic risk management Why it is important to Islamic risk management

system?system? Elements of Good CG in IFIsElements of Good CG in IFIs Risk Management in IFIsRisk Management in IFIs Roles of Board of Directors (BOD) and Senior Roles of Board of Directors (BOD) and Senior

Management Management Roles of Shari’ah Board Roles of Shari’ah Board Concluding RemarksConcluding Remarks

Financial Distress and Failure of Ihlas FinansFinancial Distress and Failure of Ihlas Finans Financial Crisis in Turkey 2000-2001. Financial Crisis in Turkey 2000-2001.

One Islamic institution Ihlas Finans One Islamic institution Ihlas Finans (the first domestic IFI in Turkey) was (the first domestic IFI in Turkey) was closed during the crisis while the other closed during the crisis while the other five Islamic banks were survived.five Islamic banks were survived.

Ihlas Finans is a special finance house Ihlas Finans is a special finance house established in 1995 and was a established in 1995 and was a subsidiary of Ihlas Holdings.subsidiary of Ihlas Holdings.

The BRSA cancelled the license of The BRSA cancelled the license of Ihlas Finans on 10Ihlas Finans on 10thth February 2001. February 2001.

FactorsFactors Accumulation of bad debtAccumulation of bad debt- Politically motivated - Politically motivated

lending and lending to connected business. Finance lending and lending to connected business. Finance the businesses of its parent company, Ihlas Holdings.the businesses of its parent company, Ihlas Holdings.

Lax Regulation- Lax Regulation- Law on full guarantee of the bank Law on full guarantee of the bank deposits offered by the State made banking a deposits offered by the State made banking a lucrative business for the corrupt entrepreneurs with lucrative business for the corrupt entrepreneurs with political connections who set up banks that siphoned political connections who set up banks that siphoned off money.off money.

Major proportion of the investment was an illiquid Major proportion of the investment was an illiquid assets assets and projects as compared to other domestic and projects as compared to other domestic and foreign commercial banks who could hold very and foreign commercial banks who could hold very liquid government securities.liquid government securities.

Failures in CG and lack of internal checks and Failures in CG and lack of internal checks and balancesbalances:- Control failure, Management failure and :- Control failure, Management failure and regulatory failure.regulatory failure.

What is CG?What is CG? CG is the system by which business corporations are CG is the system by which business corporations are

directed and controlled .directed and controlled . CG specifies the distribution of rights and CG specifies the distribution of rights and

responsibilities among different participants in the responsibilities among different participants in the company such as BOD, Shari’ah board, managers, company such as BOD, Shari’ah board, managers, shareholders, and other stakeholders.shareholders, and other stakeholders.

A concept of CG in IFIs presents distinct A concept of CG in IFIs presents distinct characteristics and features in comparison with the characteristics and features in comparison with the conventional system as it goes beyond the financial conventional system as it goes beyond the financial return whereby it covers the element of ethic, return whereby it covers the element of ethic, Shari’ah and beliefs (aqidah). Shari’ah and beliefs (aqidah).

Shari’ah board plays significant role to supervise , Shari’ah board plays significant role to supervise , oversea and advise the shari’ah aspects of the oversea and advise the shari’ah aspects of the corporation.corporation.

Why CG is important for risk Why CG is important for risk management in IFIs?management in IFIs?

Hypothesis 1: Weak CG may lead to Hypothesis 1: Weak CG may lead to ineffective risk management system.ineffective risk management system.

Hypothesis 2: Strong commitment to Hypothesis 2: Strong commitment to good CG will improve and good CG will improve and strengthen risk management system strengthen risk management system in IFIsin IFIs

Case Study: Ihlas Finans was closed Case Study: Ihlas Finans was closed in 2001 due to poor CG while the in 2001 due to poor CG while the other five Islamic banks in Turkey other five Islamic banks in Turkey were survived because of better CG.were survived because of better CG.

Existing StudiesExisting Studies Well governed UK companies posted 18% higher Well governed UK companies posted 18% higher

returns than those with poor governance after returns than those with poor governance after adjusting for risk (ABI Research Paper 7: 2008);adjusting for risk (ABI Research Paper 7: 2008);

Well governed firms in Korea have been found to Well governed firms in Korea have been found to trade at a premium of 160% to poorly governed trade at a premium of 160% to poorly governed firms (Black, B Et al: 2004);firms (Black, B Et al: 2004);

A study of S&P 500 firms showed that companies A study of S&P 500 firms showed that companies with strong or improving CG practices with strong or improving CG practices outperformed those with poor or deteriorating outperformed those with poor or deteriorating governance practices by about 19% over a 2-year governance practices by about 19% over a 2-year period (Grandmont, R Et al: 2004).period (Grandmont, R Et al: 2004).

A worst-to-best improvement in CG predicted an A worst-to-best improvement in CG predicted an astronomical 700-fold increase in firm value astronomical 700-fold increase in firm value among Russian firms (Black, B: 2001).among Russian firms (Black, B: 2001).

The Six Elements of Good CG in The Six Elements of Good CG in IFIsIFIs

Risk Management in IFIsRisk Management in IFIs Certain types of risks are of equal Certain types of risks are of equal

concern to all financial institutions, concern to all financial institutions, including IFIs.including IFIs.

IFIs face additional risks that emanate IFIs face additional risks that emanate from the unique characteristics of Islamic from the unique characteristics of Islamic finance transactions, along with risks finance transactions, along with risks associated with the real or perceived associated with the real or perceived non-compliance of Shariah principles.non-compliance of Shariah principles.

The survival and success of IFIs depends The survival and success of IFIs depends on the efficiency in which they can on the efficiency in which they can manage its risks and how they will manage its risks and how they will manage different risks arising from their manage different risks arising from their operations. operations.

How good CG may improve Risk How good CG may improve Risk Management System?Management System?

IFIs shall have in place a IFIs shall have in place a comprehensive risk management and comprehensive risk management and reporting process, including reporting process, including appropriate board and senior appropriate board and senior management oversightmanagement oversight, to identify, , to identify, measure, monitor, report and control measure, monitor, report and control relevant categories of risks and, where relevant categories of risks and, where appropriate, to hold adequate capital appropriate, to hold adequate capital against these risks. against these risks.

The process shall take into account The process shall take into account appropriate steps appropriate steps to comply with to comply with Sharī`ah Sharī`ah rules rules and principles and to and principles and to ensure the adequacy of relevant risk ensure the adequacy of relevant risk reporting to the supervisory authority. reporting to the supervisory authority.

Risk Management in IFIsRisk Management in IFIs

Roles of Board and Senior Roles of Board and Senior ManagementManagement

Approve the risk Approve the risk management objectives, management objectives, strategies, policies and procedures strategies, policies and procedures ;;

Ensure the existence of Ensure the existence of an effective risk an effective risk management structure management structure for conducting IFIs’ for conducting IFIs’ activities, including adequate systems for activities, including adequate systems for measuring, monitoring, reporting and measuring, monitoring, reporting and controlling risk exposures; controlling risk exposures;

IFIs shall have in place IFIs shall have in place an appropriate an appropriate body, in accordance with sound principles body, in accordance with sound principles of CGof CG, to oversee that all products and , to oversee that all products and activities comply with activities comply with Sharī`ah Sharī`ah rules and rules and principles as approved in each jurisdictionprinciples as approved in each jurisdiction. .

Cont…Cont… Approve Approve limits on aggregate financing and limits on aggregate financing and

investment exposuresinvestment exposures to avoid concentration to avoid concentration of risk and, ensure that IFIs hold adequate of risk and, ensure that IFIs hold adequate capital against these exposures. capital against these exposures.

Review the effectiveness of the risk Review the effectiveness of the risk management management activities periodically and make activities periodically and make appropriate changes as and when necessary.appropriate changes as and when necessary.

Execute the strategic direction Execute the strategic direction set by the set by the BOD on an ongoing basis and set clear lines BOD on an ongoing basis and set clear lines of authority and responsibility;of authority and responsibility;

Senior management shall ensure that the Senior management shall ensure that the risk management function is risk management function is independent independent from the risk-taking activitiesfrom the risk-taking activities and is and is reporting directly to the BOD or senior reporting directly to the BOD or senior management outside the risk-taking unit. management outside the risk-taking unit.

Types of Risk Roles of BOD and Senior Management

Credit Risk •Strategy for financing and recognize the potential credit exposures.•Carry out due diligence review•Appropriate methodologies for measuring and reporting credit risk exposure•Shariah-compliant credit risk mitigating techniques

Equity Investment Risk

•Strategy for risk characteristics of equity investments•Appropriate valuation methodologies•Establish exit strategies in respect of equity investment activities

Market Risk •Appropriate framework for market risk management in respect of all assets held

Liquidity Risk

•Appropriate liquidity management framework•Able to assume that liquidity risk commensurate with their ability to have sufficient recourse to Shariah-compliant funds to mitigate such risks

Rate of Return Risk

•Comprehensive risk management and reporting process to assess the potential impacts of market factors affecting rates of returns on assets in comparison with the expected returns for IAH

Operational Risk

•Adequate system and controls to ensure Shariah compliance•Appropriate mechanism to safeguard the interest of all fund providers.

Roles of Shari’ah BoardRoles of Shari’ah Board IFIs shall have adequate system of controls IFIs shall have adequate system of controls

including Shari’ah governance (SG) system.including Shari’ah governance (SG) system. SG is a set of institutional and organizational SG is a set of institutional and organizational

arrangements through which IFIs ensure that arrangements through which IFIs ensure that there is independent oversight of Shari’ah there is independent oversight of Shari’ah compliance.compliance.

IFIs shall have in place a Shari’ah board (SB) IFIs shall have in place a Shari’ah board (SB) to review and ensure that all financing to review and ensure that all financing proposals are Shari’ah compliant at all times.proposals are Shari’ah compliant at all times.

Internal/External Shari’ah review unit to Internal/External Shari’ah review unit to assist the SB for Shari’ah-compliance assist the SB for Shari’ah-compliance purpose. purpose.

How Shari’ah governance How Shari’ah governance complements the existing complements the existing

corporate governance?corporate governance?

Shari’ah Non-Compliance RiskShari’ah Non-Compliance Risk IFIs are exposed to risk relating to IFIs are exposed to risk relating to Shari’ah non-Shari’ah non-

compliance riskscompliance risks and also and also to reputational riskto reputational risk. . These risk exposes IFIs to fund providers’ These risk exposes IFIs to fund providers’

withdrawals, loss of income or voiding contracts withdrawals, loss of income or voiding contracts leading to a diminished reputation or the leading to a diminished reputation or the limitation of business opportunities.limitation of business opportunities.

IFIs shall at all times IFIs shall at all times comply with the Shari’ah comply with the Shari’ah rules and principles as determined by the SB rules and principles as determined by the SB with respect to products, activities and contract with respect to products, activities and contract documentation.documentation.

IFIs shall IFIs shall undertake a Shari’ah compliance undertake a Shari’ah compliance reviewreview. .

IFIs shall IFIs shall keep track of income not recognized keep track of income not recognized arising out of Shari’ah non-compliance.arising out of Shari’ah non-compliance.

Some Impact of Shari’ah Non-Some Impact of Shari’ah Non-Compliance RiskCompliance Risk

Slowdown of global Sukuk issuance.Slowdown of global Sukuk issuance. By the end of 2008, global Sukuk issuance had By the end of 2008, global Sukuk issuance had

declined by more than 50% compared to 2007.declined by more than 50% compared to 2007. Chairman of the AAOIFI Shari’ah board- Chairman of the AAOIFI Shari’ah board-

criticized a common form of sukuk that criticized a common form of sukuk that apparently violates the Sharia-compliant apparently violates the Sharia-compliant principles surrounding risk and profit-sharing. principles surrounding risk and profit-sharing. He estimated that up to 85% of Gulf Sukuk He estimated that up to 85% of Gulf Sukuk structures were not Shari’ah-compliant. structures were not Shari’ah-compliant.

AAOIFI made a recommendation to Islamic AAOIFI made a recommendation to Islamic finance market participants to refrain from finance market participants to refrain from issuing Sukuk structures that have a purchase issuing Sukuk structures that have a purchase undertaking or guarantee from the Sukuk issuer undertaking or guarantee from the Sukuk issuer to repurchase at a future date at a specific price. to repurchase at a future date at a specific price.

Elements of Good Shari’ah BoardElements of Good Shari’ah Board

Concluding RemarksConcluding Remarks Good CG is crucial in providing effective risk Good CG is crucial in providing effective risk

management system.management system. Certain types of risks are of equal concern to Certain types of risks are of equal concern to

all institutions offering financial services, but all institutions offering financial services, but there are certain specific risks which are there are certain specific risks which are exclusive to IFIs.exclusive to IFIs.

Board of Directors and Senior management Board of Directors and Senior management have specific roles in relation to have specific roles in relation to risk risk management objectives, strategies, policies management objectives, strategies, policies and procedures in order to mitigate all types and procedures in order to mitigate all types of risks.of risks.

Shari’ah board is more concerned on the Shari’ah board is more concerned on the aspect of Shari’ah non-compliance and aspect of Shari’ah non-compliance and reputational risks.reputational risks.

IFIs need for a set of best practices of IFIs need for a set of best practices of corporate governance and effective risk corporate governance and effective risk Management that give practical effect to Management that give practical effect to managing the underlying risks.managing the underlying risks.

ReferencesReferences Ali, Salman Syed (2007). Ali, Salman Syed (2007). Financial Distress and Bank Failure: Lessons Financial Distress and Bank Failure: Lessons

from Closure of Ihlas Finans in Turkeyfrom Closure of Ihlas Finans in Turkey, , Islamic Economic Studies, Vol. Islamic Economic Studies, Vol. 14, No. 1 & 2, Aug. 2006 & Jan. 2007, pp: 1-52.14, No. 1 & 2, Aug. 2006 & Jan. 2007, pp: 1-52.

ABI Research Paper 7. (February 2008). ABI Research Paper 7. (February 2008). Governance and Performance Governance and Performance in Corporate Britainin Corporate Britain. London: The Association of British Insurers.. London: The Association of British Insurers.

Black, B. S. Jang, H and Kim, W (2004). Black, B. S. Jang, H and Kim, W (2004). Predicting Firms CG Choices: Predicting Firms CG Choices: Evidence From Korea.Evidence From Korea. University of Texas Law School Working Paper University of Texas Law School Working Paper No. 39, August.No. 39, August.

Black, B. (2001). Black, B. (2001). The CG Behavior and Market Value of Russian FirmsThe CG Behavior and Market Value of Russian Firms . . Emerging Market Review, Vol. 2, March.Emerging Market Review, Vol. 2, March.

Grandmont, R, Grant, G. and Silva, F. (2004). Grandmont, R, Grant, G. and Silva, F. (2004). Beyond the Numbers- CG: Beyond the Numbers- CG: Implications for InvestorsImplications for Investors, (Deutsche Bank, April 1)., (Deutsche Bank, April 1).

Hijazi, Faisal. (2009). Global Sukuk Issuance: 2008 Slowdown Mainly Hijazi, Faisal. (2009). Global Sukuk Issuance: 2008 Slowdown Mainly Due to Credit Crisis and Some Impact on Shari’ah compliance issues. Due to Credit Crisis and Some Impact on Shari’ah compliance issues. International Structured Finance Special Report. International Structured Finance Special Report.

IFC and Hawkamah. (2008). IFC and Hawkamah. (2008). A Corporate Governance Survey of Listed A Corporate Governance Survey of Listed Companies and Banks Across the Middle East & North AfricaCompanies and Banks Across the Middle East & North Africa . . Washington: IFC.Washington: IFC.

IFSB Exposure Draft Guiding Principles on Shari’ah Governance IFSB Exposure Draft Guiding Principles on Shari’ah Governance System.System.

IFSB Guiding Principles of Risk Management For Institutions (Other IFSB Guiding Principles of Risk Management For Institutions (Other then Insurance Institutions) Offering Only Islamic Financial Services.then Insurance Institutions) Offering Only Islamic Financial Services.

Thank YouThank You

Zulkifli HasanZulkifli HasanE-mail: E-mail: zul361977@yahoo.com

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