risk management in islamic financial...
TRANSCRIPT
Risk Management in Islamic
Financial Institutions
Rifki Ismal
APRACA International Course on
Islamic Banking and Finance
Jakarta, 30 October 2012
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Associate Professor Rifki Ismal
• Education and Title
– Bachelor degree in economics, University of Indonesia.
– Master in Applied Economics, Department of Economics, University of Michigan, Ann Arbor (USA).
– PhD in Islamic Finance, Durham University (England)
– Associate Professor, Australian Center for Islamic Finance
• Education
– Assistant Director at Department of Islamic Banking, BANK INDONESIA (Central Bank of Indonesia).
– Lecturer at University of Indonesia.
– Lecturer at Trisakti University, Indonesia
– Lecturer at Paramadina University, Indonesia
– Lecturer at Strasbourg University (France) (2009)
CURRICULUM VITAE
Islamic Finance and Risk
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Core Values
All principles of Sharia should be part of man’s obedience and worshiping God.
Every Sharia contract should aim to improve the welfare of people and societies.
Businessmen have to have trust, support each other and, sharing risks
Prohibition of Riba, gharar, maysir, zulm, haram and unfair business transaction.
Final target is falah, reflected in the implementation of Maqasid al sharia
Referring to Islamic law: Qur’an, Hadist, Ijtihad, Ijma, Qiyas, Urf, Istishsan, Istislah,
etc
Honouring property right, individual and social obligation, work and self interest, etc.
Encouraging working hard, blessed wealth, healthy competition.
The ultimate owner of all property is God, human is only His vicegerent.
Obligation to pay zakah, and highly suggested to pay shadaqoh, waqf, hadiah, infaq,
etc
FUNDAMENTAL THEORY OF ISLAMIC FINANCE
Islamic Finance Contracts (Sharia Based) Non Islamic Arabic Contracts
Mudarabah Riba Jahiliah
Musharakah Riba al Fadhl
Murabahah Riba an Nasyiah
Salam Talaqi ruqban
Istishna Ikhtikar
Ijarah Bay kali bi kali
Musaqah Bay Najasi
Muzaraah Gharar
Sukuk Qimar, Maysir
Wadiah, Kafalah, Hiwalah Zulm
CLASSIC ISLAMIC FINANCE CONTRACTS
RISK MANAGEMENT IN FINANCIAL INSTITUTIONS
• Risk management determines the successfulness of financial institutions in managing funds and providing well-expected return to stakeholders.
• It prevents a bank from financial failure, insolvency, liquidity distress, etc and build a good communication/coordination with stakeholders.
• It measures and explains every type of risk which will allow a bank to take necessary actions to anticipate and mitigate any risk.
RISK MANAGEMENT IN FINANCIAL INSTITUTIONS
• In general it is necessity for the robustness of the overall financial system and economic stability at the end.
• Risk management unexceptionally becomes part of Islamic banking institutionwith its unique characteristics and operations.
• Risk in financial terms is usually defined as the probability that the actual return may differ from the expected return (Howells and Bain, 1999:30). There are in fact three broad categories of risk namely (1) Financial risk, (2) Business risk and lastly (3) Operational risk.
TYPES OF RISKS IN BANKING
Credit Risk Management Risk People Risk
Default Risk Planning Risk Relationship Risk
Down Grade Risk Organization Risk Ethics Risk
Counter party Risk Reporting Risk Processes Risk
Settlement Risk Monitoring Risk
Legal Risk
Market Risk Strategic Risk Compliance Risk
Commodity Price Risk R & D Risk Control Risk
Equity Price Risk Product Design Risk
Interest Rate Risk Market Dynamic Risk System Risk
Exchange Rate Risk Economic Risk Hardware Risk
Reputation Risk Software Risk
Liquidity Risk Models ICT Risk
Asset-Liability Imbalance
Maturity Mismatch Risk Followed by External Risk
Insolvency Risk Event Risk
Gov't Taken Over Risk Client Risk
Reputation Risk Security Risk
Legal Risk Supervisory Risk
System Risk
Source : Tariqullah Khan, 2006 (modified) Equity Investment Risk
FINANCIAL AND
BUSINESS RISK
Financial Risk Business Risk Operational Risk
• Risk can be expressed within a casual and interactive system, as the impact of each risk can’t be seen isolated, since they correlate and influence each other.
• Financial risk is the exposures that result in a direct financial loss to the assets or liabilities of a bank. Besides credit, market risk and liquidity risk, Islamic banks face equity investment risk.
• Credit risk relates to the performance of entrepreneurs: failure to fulfill their payment obligations, settlement, clearing, etc.
TYPES OF RISKS IN BANKING
• Market risk happens due to
unfavorable price movement or
economic/financial condition such as
RoR risk, exchange rate, inflation, etc.
Unlike conventional one, Islamic banks
bear risk of tradable, marketable,
leaseable asset and mark up risk.
• Liquidity risk consists of 2 part: (i)
Liquidity of financial instruments in
financial market and; (ii) Liquidity
related to solvency.
TYPES OF RISKS IN BANKING
• Business risk links with the performance of bank’s business and
internal action such as business
policy, infrastructure, payment
system, etc.
• Thus business risk deals with (i)
management risk which asks how is bank’s planning, organizing,
monitoring, reporting, etc and (ii)
strategic risk is like R&D, product
design, etc.
TYPES OF RISKS IN BANKING
• Operational risk occurs if a bank fails to
manage people, system, legal, external risk
and equity investment. It is internal process
risk which brings together harmonization of :
– People (relationship, ethics, process, etc);
– Legal (compliance and control risk);
– System (hardware, software, etc) and;
– External risk (event, clients, security,
supervisory, etc).
– Equity investment (asset, pricing,
valuation).
TYPES OF RISKS IN BANKING
• Mark up risk is risk because of
fluctuation of benchmark rate or
inaccurate/unfavorable mark up
determination.
• Commodity price risk happens due to
the fluctuation of price of a
commodity.
• Legal risk is because of improper
regulation, lack of regulation, etc.
TYPES OF RISKS IN BANKING
• Withdrawal risk is when depositors
take out their money for regular or
irregular reasons.
• Fiduciary risk, when Islamic bank
operates unislamically (violating
sharia principles).
• Displaced commercial risk occurs
when depositors switch their deposit
into conventional one which offers
more profitable/attractive return.
TYPES OF RISKS IN BANKING
Islamic Banking Principles and
Internal/External Factors
Leading to Risks
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• Islamic contracts require depositors to fully understand consequence of dealing with Islamic bank particularly: no guarantee/fixed return on deposit, no return on demand deposit, periodical withdrawal on long term time deposit and risk/return sharing.
• Islamic bank mitigates its risk through risk sharing with depositors and entrepreneurs particularly profit and loss sharing (PLS) or return sharing scheme.
ISLAMIC BANKING PRINCIPLES & RISK MANAGEMENT
• Economic / financial market risks are pure risk that can not be hindered by all parties but have to be minimized, avoided and handled properly. Islamic bank does not eliminate risk (interest based) but sharing/handling risk.
• Regulator coordinates and designs proper legal and regulatory standard to control and manage performance of Islamic banking as well as preventing any unfavorable economic/business condition.
ISLAMIC BANKING PRINCIPLES & RISK MANAGEMENT
INTERNAL/EXTERNAL FACTORS & RISK MANAGEMENT
PROBLEMS IN HANDLING RISK IN ISLAMIC BANKS
• Every Sharia contract
connects/relates with performance
of real sector. Interest rate
disconnects financial sector with real
sector.
• Market risk applies directly or
indirectly in every Islamic contract.
PROBLEMS IN HANDLING RISK IN ISLAMIC BANKS
• Due to its early stage of development, Islamic banking industry faces lack of infrastructure, technology, regulation, lack of eligible human resources, lack of product innovation, etc. All of them might invite risk into the operation of Islamic bank.
• Islamic banks are free from interest rate risk but indirectly impacted by it.
Risk in Sharia Jurisprudence and
Sharia Mechanism in Risk
Management
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RISK IN SHARIA JURISPRUDENCE
• Risk is close to definition of gharar in sharia.
• Gharar is any uncertainty or ambiguity created by the lack of information or control in contract.
• By size, there are gharar fahish (big gharar) and gharar yasir (small gharar). The former should be controlled and minimized while the latter has characteristics of (i) Negligible (ii) Inevitable (iii) Unintentional; and could be borne or ignored.
RISK IN SHARIA JURISPRUDENCE
• In gharar fahish, by behavior, there are
natural gharar and created gharar.
• Natural gharar happens without any
intervention of any party like business
loss, natural disaster, asset destruction,
etc. Islamic banks may or may not
avoid this risk but can not transfer it to
other parties.
• Created gharar occurs because of human
interventional like gambling, impermissible
contracts, fake contracts, invalid
contracts, etc. Types of intervention are
taghrir al fi’li (fraudulent acts); taghrir al
qawli (fraudulent statement); taghrir
kithman (fraudulent concealment).
• Islamic banks may not do and must avoid
this created gharar because created
gharar means creating problem of
uncertainty or playing with uncertainty
condition.
RISK IN SHARIA JURISPRUDENCE
• Risk management in Islamic banking
deals with minimizing lack of
information and maximizing control
through sharia approaches such as
profit and loss sharing, al ghunmu
billa ghurmi, al kharaj bid daman,
positive or negative sum game,
cooperation and coordination and
sharia compliance business activities,
etc.
RISK IN SHARIA JURISPRUDENCE
ISLAMIC WAY OF MITIGATING RISK IN BANKS
ECONOMIC &
FINANCIAL MARKET
Exchange rate risk, RoR
risk, Inflation risk, Price
risk
Legal risk, Supervisory
risk, Systemic risk,
Monitoring risk
Withdrawal risk,
Displaced
commercial risk,
Liquidity Risk
DEPOSIT/ SOURCE
OF FUNDINGISLAMIC BANK
REAL SECTOR
FINANCING
BANKING AUTHORITY
Credit risk, Default risk,
Counterparty risk,
Settlement risk, etc
People risk, Legal risk,
Reputation risk, External risk,
Equity investment risk
Risk Sharing Risk Sharing
Coordination and
Regulation
Pure Risk
ISLAMIC BANKING OPERATIONS & RISK MANAGEMENT
Managing Risks and
in Sharia Contracts
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RISK MANAGEMENT IN MUSHARAKAH
• Musharakah is a partnership (joint venture) contract where two parties (Islamic bank and business partner) combine their capital in an investment to share profit and loss whereby they have similar right and liabilities.
• There are permanent and diminishing Musharakah.
Depositors
Profit - 3
Loss - 4
Islamic Bank Entrepreneur2
Islamic
Projects
1
• Credit, Operational, Market and Liquidity risk
exposes both permanent and diminishing
Musharakah.
• Permanent Musharakah faces operational risk
in determination of profit and loss sharing. Profit
is shared related/unrelated to capital
contribution while loss sharing is precisely
based on capital contribution.
• When business fails to produce income, it
bears credit risk. This might interrupt payment
of PLS to depositors and invite liquidity risk.
RISK MANAGEMENT IN MUSHARAKAH
• Finally if the business can not be
continued, value of final capital
faces market risk.
• Diminishing Musharakah exposes
operational risk when business
partner fails to buy share of
diminishing capital.
• Since expected income can’t be
fulfilled, credit risk appears.
RISK MANAGEMENT IN MUSHARAKAH
• When it disturbs payment of PLS to
depositors, liquidity risk comes into the
bank.
• At the end of diminishing Musharakah,
when value of total equity investment
is different with market value, banks
bears market risk.
• To handle both operational risk and
credit risk, bank must take part in
company’s management, do
monitoring and insure the business.
RISK MANAGEMENT IN MUSHARAKAH
• Bank may have right to sale its share
to third party in diminishing
Musharakah contract to avoid credit
risk.
• Stop the loss of a business is one of the
solutions to mitigate market risk.
• Gradually selling bank’s share to
business partner is also another
solution for credit and market risk.
Finally, reserving capital might hinder
bank from liquidity risk.
RISK MANAGEMENT IN MUSHARAKAH
• Mudarabah is a partnership where one party provide capital and another party provide skill. Any profit will shared but loss will be borne by owner of capital only.
1 2
4 3
5
Islamic Bank
Islamic Project
Profit
Loss
Depositors EntrepreneurPLS PLS
RISK MANAGEMENT IN MUDARABAH
• External events like catastrophic and internal
business failure might invite operational risk
ending with business losses which should be
covered by the bank.
• Following it, liquidity of the bank is disturbed
(failure to provide cash to depositors) which is
liquidity risk.
• Specifically, if mudarib is not capable (skillful)
enough to run the business, it can cause credit risk
to the bank and because value of the project
dropped in the market equity price risk appears.
• Because management of the project can’t be
controlled by bank, transparency risk exists.
RISK MANAGEMENT IN MUDARABAH
• To mitigate, bank should be sure the
eligibility and capability of the mudarib
(business partner).
• Monitoring business performance and
balance sheet of company might lessen
credit risk.
• Accurately measuring, predicting and
anticipating market risk are some ideas to
tackle market risk issue in this case.
• Providing capital adequacy and internal
reserve are also tools to prevent liquidity
risk in Mudarabah contract.
RISK MANAGEMENT IN MUDARABAH
• Mudarabah stands for a sale of good on a mutually agreed profit and deferred payment. The seller was obliged to declare his cost and the profit to the buyer (transparency) .
1b
3
4
1a 2
Bank's Client Islamic Bank
Vendor
(Owner of
the Asset)
RISK MANAGEMENT IN MURABAHAH
• Client promises to buy asset under wa’ad contract (unbinding) so it might lead to operational risk or asset risk if he/she declines to buy.
• Before asset being sold to client, bank is responsible for any risk of the asset such as market risk, risk of loss, damage, etc.
• If mark up price is not accurately determined, it may cause mark up risk.
RISK MANAGEMENT IN MURABAHAH
• At the end or during payment period of Murabahah, the bank faces commodity price risk and market risk.
• When client (buyer) fails to pay the installment, credit risk comes and if he/she is default, price and market risk bear the bank when the asset is sold to market.
• Further, such difficult situation will end up with credit liquidity risk, withdrawal risk and bank rush.
RISK MANAGEMENT IN MURABAHAH
End of the Day
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