RISK MANAGEMENT IN ISLAMIC BANKING

Presentation by:

MAHMOOD SHAFQATSenior Joint DirectorIslamic Banking Department

September 01, 2008* The views expressed in this presentation are those of the author and do not necessarily represent State Bank of Pakistan.

Outline Definition and Introduction to Risk Management Is Risk Management allowed under Shariah Risks faced by Banks Unique Risks faced by Islamic Banks Risk mitigation tools Regulatory Framework for Risk Management in

Pakistan SBP Guidelines on Risk Management in IBIs IFSB Standard on Capital Adequacy

4

Risks—Basic Concept

Risk: “existence of uncertainty about future outcomes”

“difference between expected and actual result”

Uncertainty classified as general and specific General: ignorance of any potential outcome Specific: when objective/subjective probabilities can

be assigned to potential outcomes—this is usually referred to as risk.

Definition of Financial Risk

Financial risk in a banking organization is possibility that the outcome of an action or event could bring up adverse impacts.

Such outcomes could either result in a direct loss of earnings / capital or may result in imposition of constraints on bank’s ability to meet its business objectives.

RISK MANAGEMENT Risk Management involves identification,

measurement, monitoring, reporting and controlling risks to ensure that The individuals who take or manage risks clearly

understand it. The organization’s Risk exposure is within the limits

established by Board of Directors. Risk taking Decisions are in line with the business strategy

and objectives set by BOD. The expected payoffs compensate for the risks taken Risk taking decisions are explicit and clear. Sufficient capital as a buffer is available to take risk

Risk Management activities Risk management activities take place at:

Strategic level by senior management and BOD Definition of risks, institutions risk appetite, formulating

strategy and policies for managing risks and establish adequate systems and controls to ensure that overall risk remain within acceptable level and the reward compensate for the risk taken.

Macro Level within a business area or across business lines

Risk reviews by middle management Micro Level where risks are actually created

Activities performed by individuals who take risk on organization’s behalf such as front office and loan origination functions. Confined to following operational procedures and guidelines set by management.

Risk management process

Identification Measurement Monitoring Reporting Mitigation and control

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

Shariah Perspective

No Risk No Reward principle (Al Ribh Bi Daman) So No Risk Management? Measures taken by Hazrat Yousuf (AS) for

drought (Ahsan ul Qasas) Do not give your Amwal to Sufahaa Writing of contracts – whether spot or deferred

(Legal risk, Documentation risk, etc) Maqasid-e-Shariah

Protection of Izat, Jaan, ‘Aql, Maal, Nasl

RISKS FACED BY BANKS AND THEIR APPLICATION ON

ISLAMIC BANKING

Risk Dimensions

Credit

Banking Risks

Credit

Credit Liquidity

Market

Operational

Solvency

Legal/Regulatory

Systemic

ISLAMIC BANKING LESS RISKY?

Islamic Banking is safer as it is not based on INTEREST?

Depositors are liable to share losses, therefore solvency risk is mitigated?

Major Types of Risks in IB

Credit Risk Attributed to delayed, deferred, and default in payments by

counterparties. Covers profit sharing contracts (Mudaraba and Musharaka), receivables and lease (Murabaha, DM and Ijara, Salam, Istisna’), and covers different stages of a contract

Market Risk Adverse movements in interest rates, commodity prices and FX

rates. Commodity risk in Murabaha, Ijara, Salam

Equity Risk Adverse changes in market value (and liquidity) of equity held for

investment purposes. Covers all equity instruments including Mudaraba and Musharaka

Major Types of Risks in IB Liquidity Risk

Adverse cash flows in situations arising mainly out of changing market risk exposures, credit risk exposures and operational risk exposures.

Rate of Return Risk Changes in account holders’ expectations of the return on

investment. Also related to fluctuations in returns due to changes in underlying factors of the contract.

Operational Risk Inadequacy of failed processes, people and systems. Also

includes Shariah non-compliance Risk

Legal Risk Inadequate legal framework, conflict of conventional and Islamic

laws and conflict between Shariah rulings and legal decisions

Credit Risk Mitigating Tools Pledge of assets as collateral

Inventories, Shares, Sukuk, Units, etc.

Third party Guarantee Personal Guarantee Promise Charge on deposits and assets Takaful Hamish Jiddiya Urbun Khiyar / Option Parallel contract, if permissible

Regulatory Framework Risk Management

Guidelines on Risk Management - BSD Circular No. 7 dt. Aug. 15, 2003 

Guidelines on Internal Credit Risk Rating Systems – BSD Circular No. 8 dt. Oct. 29, 2007

Risk Management Guidelines for IBIs – IBD Circular No. 1 dt. Jan. 2, 2008.

ICAAP Guidelines - BSD Circular 17 of 2008

Stress Testing Guidelines on Stress Testing - BSD Circular No. 5 dt. Oct. 27, 2005 

Internal Controls Guidelines on Internal Controls - BSD  Circular No . 7 dt. May 27,

2004 and BSD Circular No. 1 dt. Jan.14, 2006 Policy Framework in Banks/DFIs - BSD Circular 3 of 2007  

SBP RM Guidelines for IBIs 15 Guiding Principles Divided into

General (1 Principle) Credit risk (4 Principles) Equity investment risk( 3 Principles) Market risk (1 Principle) Liquidity risk (2 Principles) Rate of return risk ( 2 Principles) Operational risk (2 Principles)

IBIs are also exposed to reputational risk arising from failures in governance, business strategy and process. Negative publicity about their business practices, particularly relating to Sharī`ah non-compliance in their products and services, could have an impact upon their market position, profitability and liquidity.

These principles are not radically different from those applicable to conventional banks

However, these are some fundamental differences:- Emphasis on Shariah compliance- 6 out of 15 principles make explicit reference to

Shariah rules

Guiding Principles on RM

1. General Requirement Principle 1.0: IBIs shall have in place a

comprehensive risk management and reporting process, including appropriate board and senior management oversight, to identify, measure, monitor, report and control relevant categories of risks. The process shall take into account appropriate steps to comply with Shariah rules and principles and to ensure the adequacy of relevant risk reporting to the supervisory authority.

1. General Requirement Board of directors (BOD) and senior

management oversightapprove the risk management objectives,

strategies, policies and procedures approvals shall be communicated to all levels ensure the existence of an effective risk

management structure Sharī`ah Advisor to oversee that the IBI’s

products and activities are Sharī`ah compliant

1. General Requirement Board of directors (BOD) and senior

management oversightapprove limits on aggregate financing and

investment exposures review the effectiveness of the risk

management activitiesSenior management shall execute the

strategic direction and set clear lines of authority and responsibility

Independence of risk management function from risk taking activities

1. General Requirement Risk management process

sound process for executing all elements of risk management, including risk identification, measurement, mitigation, monitoring, reporting and control

adequate system of controls with appropriate checks and balances

(a) comply with the Sharī`ah rules and principles, (b) comply with applicable regulatory and internal policies and

procedures; and (c) take into account the integrity of risk management

processes quality and timeliness of risk reporting available

to regulatory authorities appropriate and timely disclosure of information

to depositors

1. General Requirement

Application of Emergency and Contingency Plan Integration of Risk Management Risk Measurement and use of models Utilization of funds Role of Finance Administration Department Management Information System for board or

senior management committee Human Resource: Training and development

2. Credit Risk

Principle 2.1: IBIs shall have in place a strategy for financing, using various instruments in compliance with Shariah, whereby they recognize the potential credit exposures that may arise at different stages of the various financing agreements.

2. Credit Risk

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

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

2. Credit Risk

Principle 2.4: IBIs shall have in place Sharī`ah-compliant credit risk mitigating techniques appropriate for each Islamic financing instrument.

2. Credit risk

These principles apply to:- Murabaha, Salam, ijara and Istisna’ contracts- Mudaraba and Musharaka- Sukuk

For example, for working capital financing, Salam and Mudaraba contracts could be used

- In case of Salam, the bank enters into a parallel Salam contract with a third party

- What factors may effect the counterparty’s ability to repay

2. Credit risk The commodity price

- Don’t use commodities with high price volatility

- A list of all types of applicable and approved transaction and financing

- The Islamic banks should ensure that adequate systems and resources are available to implement this strategy

In case of using Mudaraba contract as a working capital tool - The choices of “Mudarib company” should be

made with care

2. Credit risk

The bank must have close links with the company - Shariah implications

- Choose an appropriate trading activity for financing

- Guidelines on a realistic review of expected future cash flow

2. Credit risk Transformation of risk should be taken into

account while devising a sound risk management strategy

- For example, in Murabaha contracts, the risk gets transformed from market risk to credit risk

- In Mudaraba and Musharaka contracts, equity investment gets transformed to debt in case of proven negligence for misconduct on part of the Mudarib or Musharaka partners

The role of promises must be scrutinized and recognized in the complex structures

2. Credit risk

Clearly define risk mitigating techniques including but not limited to

- Methodology for setting Mark-up rates according to the risk-rating of the counterparties

- Permissible and enforceable collaterals and guarantees

- Clear documentation as to whether or not purchase orders are cancelable

- Clear procedure for taking a/c of governing lawsAlways try to buy the asset-to-be- financed on “sale-or-

return” basis

2. Credit risk IBIs shall assess credit risk in a holistic

manner and ensure that credit risk management forms a part of an integrated

For example, in a Salam contract, changes in market risk factors such as commodity prices, as well as the external environment (for example, bad weather) become key determinants affecting the likelihood of default.

2. Credit Risk

The IBIs must have an appropriate credit strategy, including

pricing and tolerance for undertaking various credit risks;

a risk management structure with effective oversight of credit risk management;

credit policies and operational procedures including credit criteria and credit review processes, acceptable forms of risk mitigation, and limit setting

2. Credit Risk an appropriate measurement and careful

analysis of exposures, including market- and liquidity-sensitive exposures; and

a system to monitor the condition of ongoing individual

credits to ensure the financings are made in accordance with the IBIs policies and procedures,

manage problem credit situations according to an established remedial process; and to determine adequate provisions to be made for such losses.

3. Equity investment risk Equity investment risk may be defined as the risk

arising from entering into a partnership for the purpose of undertaking or participating in a particular financing or general purpose activity as described in the contract, and in which the bank shares in the business risk- Market risk- Liquidity risk - Credit risk - Other risks

Capital impairment risk

3. Equity Investment Risk

Principle 3.1: IBIs shall have in place appropriate strategies, risk management and reporting processes in respect of the risk characteristics of equity investments, including Mudārabah and Mushārakah investments.

3. Equity Investment Risk

Principle 3.2: IBIs shall ensure that their valuation methodologies are appropriate and consistent, and shall assess the potential impacts of their methods on profit calculations and allocations. The methods shall be mutually agreed between the IBIs and the Mudārib and/or Mushārakah partners.

3. Equity Investment Risk

Principle 3.3: IBIs shall define and establish the exit strategies in respect of their equity investment activities, including extension and redemption conditions for Mudārabah and Mushārakah investments, subject to the approval of the institution’s Sharī`ah Advisor.

Risk mitigation- Define and set the objectives of, and criteria for,

investment using profit sharing instruments- Monitoring

Evaluation of Sharia compliance, holding of periodical meeting with partners and proper recordkeeping of these meetings

Monitoring of transformation of risks at various stages of investment lifecycle

Monitoring of factors affecting the expected volume and timing of cash flows

3. Equity Investment Risk

3. Equity Investment Risk

Valuation Appropriate valuation methods profit calculation and

allocation Assessment and measurement of potential

manipulation of reported results leading to overstatements or understatements of partnership earnings

Independent audit and valuations Appropriate methods for the treatment of retained

profits Criteria for Exit strategies

4. Market Risk

Principle 4.1: IBIs shall have in place an appropriate framework for market risk management (including reporting) in respect of all assets held, including those that do not have a ready market and/or are exposed to high price volatility.

4. Market Risk The risk that arises from fluctuations in values of

tradable, marketable or leaseable assets (including Sukuk) and in off- balance sheet individual portfolios

The risks relate to the current and future volatility of market values of - Salam based assets (due to commodity prices)- Sukuk- Murabaha assets( purchased to be delivered)

Market risk exposures may occur at certain times or throughout the contract

4. Market RiskIn operating Ijārah, a lessor is exposed to market risk on the residual value of the leased asset at the term of the lease or if the lessee terminates the lease earlier (by defaulting), during the contract.

In Ijārah Muntahia Bittamleek, a lessor is exposed to market risk on the carrying value of the leased asset (as collateral) in the event that the lessee defaults on the lease obligations.

In Salam, IBIs are exposed to commodity price fluctuations on a long position after entering into a contract and while holding the subject matter until it is disposed of.

In the case of parallel Salam, there is also the risk that a failure of delivery of the subject matter would leave the IBIs exposed to commodity price risk as a result of the need to purchase a similar asset in the spot market in order to honour the parallel Salam contract.

4. Market Risk IBIs shall establish a sound and comprehensive

market risk management process and information system, which (among others) comprise: a conceptual framework to assist in identifying

underlying market risks; guidelines governing risk taking activities in different

portfolios of depositors and their market risk limits; appropriate frameworks for pricing, valuation and

income recognition; and a strong MIS for controlling, monitoring and

reporting market risk exposure and performance to appropriate levels of senior management.

4. Market Risk

Market risk is closely related to other forms of risks, and an overall measure of it can be calculated with the help of an appropriate VAR model

Islamic banks then should ensure that adequate capital is held against the market risk

5. Liquidity Risk

Principle 5.1: IBIs shall have in place a liquidity management framework (including reporting) taking into account separately and on an overall basis their liquidity exposures in respect of each category of current accounts, unrestricted and restricted investment accounts.

Principle 5.2: IBIs shall undertake liquidity risk commensurate with their ability to have sufficient recourse to Sharī`ah-compliant funds to mitigate such risk.

5. Liquidity Risk Two major types of fund providers:

current account holders; and PLS Deposit holders

PLS Deposit holders do not share in the risks on assets financed by current accounts, which are borne by shareholders alone

As fiduciary agents, the IBIs are concerned with matching their investment policies with PLS Deposit holders and shareholders’ risk appetites

5. Liquidity Risk Linked with displaced commercial and Shariah

compliance risks Islamic banks must maintain adequate liquidity

to meet their obligations at all times- Strategy for managing liquidity involving

effective BOD and senior management oversight- A framework for developing and implementing

sound processes for measuring and monitoring liquidity

- Adequate systems in place for monitoring and reporting liquidity exposures on a periodic basis

5. Liquidity Risk

- Adequate funding capacity, with particular reference to the willingness and ability of shareholders to provide additional capital when necessary

- Liquidity crisis management, fixed asset realization and sale and leaseback arrangements etc.

5. Liquidity Risk

Risk mitigation- Diversity sources of funds- Reduce concentration of funding base- Rely on marketable assets

Identity any future shortfalls in liquidity by constructing maturity laddersKnown cash flows

Murabaha, Ijara, IMB and diminishing Musharaka receivables

5. Liquidity Risk

Conditional but predictable cash flows Salam and Istisna’ receivables

Conditional and unpredictable cash flows Musharaka investments

Periodic cash flow analysis under different scenariosA normal operating environment (e.g., a steady

state condition)Adverse circumstances (e.g., non-linear events

and chaotic conditions)

5. Liquidity Risk

establish the maximum amounts of cumulative liquidity mismatches they consider acceptable

Liquidation procedures must be incorporated in the investment contracts

Liquidity contingency plans addressing various stages of liquidity crisis

6. Rate of Return Risk

Principle 6.1: IBIs shall establish a comprehensive risk management and reporting process to assess the potential impacts of market factors affecting rates of return on assets in comparison with the expected rates of return for PLS Deposit holders.

Principle 6.2: IBIs shall have in place an appropriate framework for managing displaced commercial risk, where applicable.

6. Rate of Return Risk

An increase in benchmark rates may result in PLS depositors having expectations of a higher rate of return

The actual return on assets may be under performing as compared to the competitors’ rate of returns

- Displace commercial risk- Profit Equalization Reserve- Investment Risk Reserve

7. Operational Risk

Principle 7.1: IBIs shall have in place adequate systems and controls, including Sharī`ah Advisor, to ensure compliance with Sharī`ah rules and principles.

7. Operational Risk

Principle 7.2: IBIs shall have in place appropriate mechanisms to safeguard the interests of all fund providers. Where PLS deposit holders funds are commingled with the IBIs own funds, the IBIs shall ensure that the bases for asset, revenue, expense and profit allocations are established, applied and reported in a manner consistent with the IBIs fiduciary responsibilities.

7. Operational Risk

Shariah compliance risk- The risk that arises form Islamic banks’ failure to comply with the Shariah rules & principles determined by the Shariah Advisor or the relevant body in the jurisdiction in which Islamic banks operate

Fiduciary risks- The risk that arises from the Islamic banks’ failure to perform in accordance with explicit and implicit standards applicable to their fiduciary responsibilities

7. Operational Risk IBIs shall establish and implement a clear and

formal policy for undertaking their different and potentially conflicting roles in respect of managing different types of investment accounts.

IBIs shall adequately disclose information on a timely basis to their PLS deposit holders and the markets in order to provide a reliable basis for assessing their risk profiles and investment performance.

ROLE OF SUPERVISORY AUTHORITY adequate understanding on the wide array

of risks and satisfy itself that the IBIs have in place an adequate risk management and reporting process

Develop and utilise prudential regulations and requirements to control these risks

ROLE OF SUPERVISORY AUTHORITY Credit Risk

maintain a detailed description of each financing instrument used by the IBIs in their jurisdiction and the risk exposures to which each instrument gives rise

may decide to develop Sharī`ah guidelines or minimum documentations in respect of agreements

adequacy of the policies and procedures to be implemented by the IBIs to mitigate risks are subject to review by the supervisory authority in compliance with Sharī`ah

ROLE OF SUPERVISORY AUTHORITY Equity Investment Risk

satisfy itself that adequate policies and procedures are in place for equity investment risk management

ensure that the IBIs have sufficient capital when engaging in equity investment activities

may develop regulatory guidelines for measuring, managing and reporting the risk exposures when dealing with non-performance financing and providing provisions

ROLE OF SUPERVISORY AUTHORITY Market Risk

satisfy itself on the adequacy of IBIs internal systems and controls and internal limits set by the IBIs on their market risk management in relation to the activities undertaken.

Supervisory authorities should require IBIs in their jurisdictions to develop guidelines for acceptable valuation techniques where direct market prices are not available, and should approve such guidelines. Alternatively, the supervisory authorities may themselves develop such guidelines.

ROLE OF SUPERVISORY AUTHORITY Liquidity Risk

satisfy itself that the IBIs have adequate liquidity policies, systems and controls in place to manage their liquidity

may establish appropriate minimum levels of liquidity for each category

central bank in its capacity as lender of last resort may provide Sharī`ah compatible mechanisms for liquidity arrangements to IBIs as per stipulated regulations before the IBIs can resort to seeking funds

ROLE OF SUPERVISORY AUTHORITY Rate of Return Risk

assess the capacity of the IBIs to manage the rate of return risk may establish appropriate minimum levels of liquidity for each category

Where the supervisory authority may have a policy of stating an expected rate of return for unrestricted IAH, the supervisory authority shall establish a framework within which this is to be undertaken by the IBIs operating in its jurisdiction

ROLE OF SUPERVISORY AUTHORITY Rate of Return Risk The ROR framework may include amongst

others, methods, applicable periods and recognisable income and expenses, and other calculation bases relating to the use of funds. This framework shall assist the supervisory authority to assess the efficiency of IBIs in terms of their profitability and prudent management.

ROLE OF SUPERVISORY AUTHORITY Operational Risk

satisfy itself that IBIs have in place a comprehensive and sound framework for developing and implementing a prudent control environment for the management of operational risks

IBIs have adequate Sharī`ah compliance mechanisms in place

well-defined and adequately qualified and staffed organisational structure

clear lines of authority and accountability policies and procedures for approval of products and

activities

ROLE OF SUPERVISORY AUTHORITY Operational Risk

prescribe formal guidance for the IBIs to ensure they fulfil their fiduciary duties towards their IAH

applicable auditing standards relevant to IBIs are being implemented correctly in respect of the assessment of the appropriateness of allocations, distributions and reporting of profits to IAH

The supervisory authority may require IBIs to have an independent and regular review of Sharī`ah compliance in this regard.

Risk Measurement

Risk measurement methods- Traditional

GAP analysis Duration analysis Statistical analysis Scenario analysis

Modern portfolio theory Variation from the mean

VAR

TEN RULES TO RISK MANAGEMENT

There is no return without risks Rewards go to those who take risks

Be transparent Risk should be fully understood

Seek experience Risk is measured and managed by people, not by

mathematical models Know what you don’t know

Question the assumptions made Communicate

Risk should be discussed openly

TEN RULES TO RISK MANAGEMENT Diversify-avoid concentration

Multiple risks will produce more consistent rewards Show discipline

A consistent and rigorous approach will beat a constantly changing strategy

Use common sense It is better to be approximately right, than to be

precisely wrong Return is only half of the equation

Decisions should be made only after considering the risks and returns of the possibilities

Oversight must be enterprise-wide Risks cannot be managed in isolation

IFSB Capital Adequacy Standard

Overview Largely based on the Basel approach, with necessary

modification and adaptation to cater for specific nature and characteristics of Shariah compliant products and services

Uses Risk weights derived from those proposed in Basel II because of lack of historical data to modify risk weights

For Credit Risk - Standardized approach Market Risk - 1996 Market Ris Amendment Operational Risk - Basic Indicator approach CAS is structured in a Matrix format to cater for transformation

of risk at different stages of contract Treatment of PSIA and assets financed by PSIA in CAR

Adoption after Impact Study by SBP

A Word of Caution

Risk Management of your life is important Risk Management of your life is important than everything.than everything.

Would you ever think about it.Would you ever think about it. Various risks are related with our body Various risks are related with our body

and Soul. Some of them could harm a lot and Soul. Some of them could harm a lot and some less.and some less.

Kindly Think about it .Kindly Think about it .

For Comments and Suggestions please contact:

Mahmood ShafqatSenior Joint DirectorIslamic Banking DepartmentState Bank of PakistanI.I. Chundrigar Road,

KarachiPh: +92-21-9212509, 2453741Fax: +92-21-9212472E-mail: mahmood.shafqat@sbp.org.pk

THANK YOU

MAY ALLAH THE ALMIGHTY SHOW US THE RIGHT PATH,

THE PATH OF HIS LOVED ONES (AAMEEN)