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Risk Management In Islamic Financial Institutions Ebrahim, Mohamed 7396184


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Dissertation in partial fullfillment of the requirements of the Manchester MBA.

Published in: Economy & Finance, Business

Risk Management In Islamic Financial Institutions Ebrahim, Mohamed 7396184

  1. 1. The University of Manchester Manchester Business SchoolRisk Management in Islamic Financial Institutions Mohamed Abdulla Ebrahim Student registration number: 7396184 This dissertation is submitted in partial fulfilment of the requirements for the degree of Master of Business Administration. 0
  2. 2. A. DECLARATIONThis work has not previously been accepted in substance for any degreeand is not being concurrently submitted in candidature for any degree.Signed……………………………………………….Mohamed Abdulla EbrahimStudent number: 7396184Date 4th April 2011STATEMENT 1The dissertation being submitted in partial fulfilment of the requirementsfor the degree of MBASigned……………………………………………….Mohamed Abdulla EbrahimStudent number: 7396184Date 4th April 2011STATEMENT 2This dissertation is the result of my own independent work/investigation,except where otherwise stated. Other sources are acknowledged byfootnotes giving explicit references. A bibliography is appended.Signed……………………………………………….Mohamed Abdulla EbrahimStudent number: 7396184Date 4th April 2011STATEMENT 3I hereby give my consent for my dissertation, if accepted, to be available for photocopying,interlibrary loans and for electronic access, and for the title andsummary to be made available to outside organizations.Signed……………………………………………….Mohamed Abdulla EbrahimStudent number: 7396184Date 4th April 2011 1
  3. 3. B. ACKNOWLEDGEMENTSI would like to dedicate this work to Caliph/Imam Hassan Ibne Ali (A.S) fifth (5th) and last ofthe Rightly Guided (Rashidun) Caliphs, the essence of whose life‟s work was to preserve theunity of the Ummah of his grandfather the Prophet Mohamed (PBUH), the cost of whichincluded his abdicating from the role of Caliph to preserve this unity. One of his sayings whichinspires me and which I would like to share is “Teach others your knowledge and learn theknowledge of other, so you will bring your knowledge to perfection and learn something youdid not know.”I would like acknowledge the support and contributions of my family and friends whoinfluenced, encouraged and supported me to do this excellent MBA. I would like to mention thecontribution of my mother Late Mrs. Shirin Ebrahim, who pushed me to pursue excellence,loved me unconditionally and inspired me to follow the path to actualise my talents and dreams.I am thankful to two of my former employers during whose employ I started and completed theprocess of attaining the Manchester MBA, namely Ernst & Young, Mombasa, Kenya, andCredo Investments FZE, Dubai, UAE under whose employ I completed most of the academiccoursework and allowing leave me to attend the workshops as and when required.I would like to record my appreciation to Dr. Antony Merna for his supervision of the projectand the support he provided during the course of completing this dissertation.I am responsible for anything controversial in the dissertation, which is not meant to undermineany school of thought/individual, as its objective is to increase knowledge.Mohamed Abdulla EbrahimApril 2011 2
  4. 4. C. ABSTRACTIslamic finance (Capital Markets, Banking and Insurance) has emerged from a niche financialmarket to the mainstream of finance. The geographic market, clientele served, products base andvolume of funds have grown significantly. Furthermore, the players have increased and nowinclude not only pure Islamic institutions but also hybrid players (conventional bank withIslamic Finance windows). Therefore, not understanding the unique risks of the Islamic Financemodel (risk sharing and risk pooling) can cause a failure of the model igniting a financial criseswith a ripple effect on the Islamic faith. Hence, managing these unique risks is extremelyimportant.Purpose / Perceived ValueTo increase the academic knowledge base on Risk Management in Islamic Financial Institutionsand hope some useful insights would be obtained which in turn would lead to improvement inrisk management practices in Islamic Financial Institutions. This would explore the subject ofcorporate risk management in the context of Islamic Financial Institutions, which are run on theIslamic legal and economic system, which prohibits Riba (interest), avoids Gharar (uncertainty),avoids Maysir (gambling or excessive speculation).MethodologyReview material on risk management, Islamic finance and risk management in Islamic financialinstitutions and their basis in academic and professional knowledge already written on. Analysedisclosures in annual financial statements of three Islamic Financial Institutions and apply theseagainst a Risk Management framework. Carry out a Linkedin based pilot research survey onRisk Management practices in Islamic Financial Institutions. 3
  5. 5. TABLE OF CONTENTSS/No Title/Chapter From To Page Page Cover page 0 0A Acknowledgements 1 1B Declaration 2 2C Abstract 3 31 Introduction 5 102 Risk Management 11 173 Islamic Finance 18 264 Importance of Risk Management in Islamic Financial Institutions 27 385 Analysis of Risk Management disclosures in Financial Statements 39 516 Analysis of responses from Linkedin pilot survey questioner 52 587 Conclusions and Recommendations for Further Work 59 628 Bibliography 63 63 4
  6. 6. Chapter 1: Introduction1.1 BackgroundRisk Management is gaining momentum as a subject and a professional discipline in its ownright as distinct from Corporate Governance, Internal Audit/control, Financial Reporting andRegulatory compliance to which it is closely aligned with. This has become pertinent as therecent global financial crises (late 2007 to 2009) which has caused the deepest recession sincethe Great depression which started in 1929 and continued to throughout the 1930‟s, has beenseen widely as a failure of financial institutions to manage the risks they undertook whiletransacting business.Islamic Finance has been one of the fastest growing segments of the financial sector. At onetime a common fallacy was Islamic Finance was less riskier than conventional finance, due tothe maxims of “al-kharaj bil dhaman and al-ghunm bil ghurm”, which basically propagate theprinciple of „no risk no gain‟, very much underline the recognition of risk elements in Islamicfinance. (Zaid Ibrahim & Company)1. This dissertation shall endeavour to reflect the view thatIslamic Finance is simply different with its own unique set of risks which are neither more orless riskier than other forms of finance.A study undertaken by the International Monetary Fund (Cihak and Hesse, 2008)2 providesempirical evidences which verify that Islamic finance is not necessarily more or less risky thanconventional finance. The study points out, that by having profit-loss sharing financing, thisshifts the direct credit risk from banks to their investment depositors. However, it also increasesthe overall degree of risk of the asset side of banks‟ balance sheets, because it makes Islamicbanks vulnerable to risks normally borne by equity investors rather than holders of debt.It was also pointed out that, because of their compliance with the Shariah, Islamic banks can usefewer risk hedging techniques and instruments (such as derivatives and swaps) thanconventional banks. However, it is interesting to note that because of this prohibition against theuse of derivative products and short-selling activities in the form used by its conventionalcounterparts, Islamic finance were largely shielded from exposure to „toxic assets‟ such as thosearising from collateralised debt obligations (CDO) and credit default swaps (CDS). But all iswas not well when the dust settled as Islamic Finance institutions like the Kuwait based GlobalInvestment House was technically in solvent.1 Demystifying Islamic Finance – Correcting misconception, advancing value propositions Zaid Ibrahim & Co.2 Islamic Banks and Financial Stability: An Empirical Analysis Martin Čihák and Heiko Hesse (2008) IMF working paper 0816 5
  7. 7. 1.2 Aim and ObjectivesThe aim of this dissertation is to explore the theory and practice of risk management in thecontext of Islamic Financial institutions, which is a fast growing segment of the financial sector.Islamic Finance is no longer a niche confined to Muslim countries in the Middle East, it is partof mainstream finance, with London vying with Dubai and Kuala Lumpur to be the Capital ofIslamic Finance. It is believed that a lot of written material is available on both Islamic Financeand Risk management but much less on Risk Management practices in Islamic Financialinstitutions. Its aim is to show that Islamic Finance is neither more riskier nor less riskier thanconventional finance, it is simply different.The Islamic Finance model is based on social justice as articulated in the Holy Quran and thetraditions, acts and sayings of Prophet Muhammad (PBUH). This system prohibits Interest-Riba, excessive risk taking “Gharar” (Uncertainty, Risk or Speculation) is also prohibited anddealing only in activities considered Halal. In essence it is based on universal ethics flavored bya religious outlook.Objectives To look at Islamic Finance and the unique risks it poses due to its principles and nature. To understand how these risks differ from risks in conventional finance, To review how these risks are currently being addressed How these practices can be improved.1.3 Literature ReviewThe literature review would include among others the following sourcesa) Published research on both Risk Management and Islamic Finance by internationalorganisations and professional firms like IMF, Ernst & Young etc.b) Published books on Corporate Risk Management and Islamic Financec) Publication of articles on Islamic finance, Risk Management on the internet/websites.d) Published articles related to Risk Management in Islamic Finance in Magazines. 6
  8. 8. 1.4 Research MethodologyTo achieve the stated aims and objectives, the research methodology to be as follows:-a) Questioner on Linkedin to Professionals and advisors working in Islamic finance on risk management practices in Islamic Financial Institutions. The questions would be based on a risk management model i.e. how risk identification takes place, and how these risks are dealt with or should be dealt with in their opinion. This questioner will give an insight in current practices in Risk Management and elicit opinion on the way forward. The following questions will be put forward to be answered by the respondents. Part 1 based on the Risk management cycle3 (Smith, 1995) comprises of the following questions related to each component in accordance with your knowledge and experience related to risk management practices in Islamic Financial institutions (IFI):-1 Identification of Risks/Uncertainties How are potential risks identified in the IFI you are familiar with? Is there a formal process of recording potential risks? Who is responsible for tracking risks undertaken by the IFI (CRO, FD, CEO, CFO)? Are risk specific to a individual major transactions separately identified?2 Analysis of Implications How are the implications quantified? Are risks quantified in accordance with how often they occur? Are risks quantified as to severity i.e. potential of loss or impact on IFI? To whom are these reported i.e. to the Board of directors or executive management?3 Response to minimize risk The following are the typical responses to minimize risk for an entity, please indicate in your opinion the percentage of occurrences the particular response is chosen? Total 100% Risk Avoidance (declining transaction) Risk reduction (maybe by syndication) Risk transfer (hedging or insurance) Risk retention (accept the risk)4 Allocation of appropriate contingenciesHow is the desirable/acceptable level of risk determined?How are resources allocated to ensure the overall risk level is acceptable?Are contingency plans put place should the risk materialize?If yes, how are these communicated to the members of the organization?3 Corporate Risk Management – Tony Merna and Faisal F Al Thani 2nd edition 2010 7
  9. 9. Part 2 Objective is to elicit opinion on way forward on improving the practice of riskmanagement in Islamic Financial Institutions. In your opinion is the state of risk management practice adequate for the needs of the IFI, you are familiar with? In your view what are the three key improvements that should be made to make the risk management process better?The following are the Global Top 10 risks as Identified in The Ernst & Young Business RiskReport 2010 4(2009 rank in brackets), please rank the risks in your opinion as they apply toIslamic Financial Institutions: 1. Regulation and compliance (2) 2. Access to credit/funding (1) 3 Slow recovery or double-dip recession (No change) 4. Managing talent (7) 5. Emerging markets (12) 6. Cost cutting (No change) 7. Non-traditional entrants (5) 8. Radical greening (4) 9. Social acceptance risk and corporate social responsibility (New) 10. Executing alliances and transactions (8)b) Analytical synthesis of publicly available information regarding risk management in Annual Reports of the following three Islamic Financial Institutions Meezan Bank (Pakistan), Al Baraka Banking group (Bahrain but operating through out the Middle East and North African region) and Khaleej Takaful - Insurance (Dubai) .1.5 Limitations of the Research The research is limited to the responses of members of Linkedin groups with interest in Islamic Finance and to the publicly disclosed information in Annual Financial Statements of the three selected Islamic Financial Institutions. Hence it will not be having information on detailed risk management practices in the selected Institutions and in other Islamic Financial Institutions. The opinion on the way forward will be limited to the views of the respondents of the questioner.4 The Ernst & Young Business Risk Report 2010 8
  10. 10. 1.6 Scope of DissertationThe scope of the dissertation will be to explore the risk management practices in IslamicFinancial Institutions, by reviewing the currently published literature and responses on RiskManagement practices and propose a way forward to improve these practices. This will bestructured in chapters as described below:-Chapter 2 - Risk ManagementThis will Introduce Risk Management, exploring what risk management can achieve to enhancevalue to a business. Then I will introduce the concept of risk and uncertainty. Thereafter the riskmanagement process/cycle. Finally the available tools and techniques used to mitigate, share ortransfer risk.Chapter3 – Islamic FinanceThis chapter will introduce the reader to the background and general principles governingIslamic Finance. Then each section will look at the different general products of Islamic Financewhich includes Islamic Banking, Islamic Insurance – Takaful and Islamic Capital markets.Chapter 4: Importance of Risk Management in Islamic FinanceThis chapter will attempt to identify risks unique to the Islamic economic model, the threatsposed by risks peculiar to Islamic Finance, how to deal with these risks identified,Islamic financial instruments which may be considered both to aggravate risk and tomitigate risk depending on the context.Chapter 5: Analysis of Risk Management disclosures in Financial StatementsThis chapter will present the analysis of the risk management disclosures in the financialstatements of Meezan Bank based in Pakistan, Khaleej Takaful an Islamic insurance companybased in Dubai, United Arab Emirates and Al Baraka banking group headquartered in Manama,Bahrain but having a pan Arab base operating through various subsidiaries in Middle East andNorth Africa region. 9
  11. 11. Chapter 6: Analysis of responses from Linkedin questionerThis chapter will analyse the responses from the Questioner for members of Groups on IslamicFinance on Linkedin and CIMA Islamic Finance forum on their perception of Risk Managementin Islamic Finance Institutions and the Questioner for people working in Islamic Financialinstitutions and are members of groups in Linkedin and CIMA Islamic Finance Forum. I shallthen endeavour to synthesis the findings of the analysis and suggest on the way forward toimprove practice of risk management in Islamic Financial Institutions.Chapter 7: Conclusions and Recommendations for Further WorkThis chapter will present a summary of the dissertation, its findings and draw conclusions. Itwill also attempt to suggest the way forward to improve risk management practises in IslamicFinancial Institutions. Lastly it will make recommendation for further work in this areaespecially the interplay between corporate governance and risk management in IslamicFinancial Institutions. 10
  12. 12. Chapter 2: Risk Management2.1 IntroductionThis chapter will give a background to risk management and its development as a discipline.Thereafter it will look at the relationship between risk and uncertainty, from which thedissertation will discuss the risk management process, finally it will discuss the tools andtechniques used. Risk Management has numerous definitions usually based on the context inwhich it is being discussed among these are:“Risk management is formal process that enables the identification, assessment, planning andmanagement of risk.” 5(Merna and Al Thani 2010)COSO ERM defines enterprise risk management as a process designed to identify potentialevents that may effect the entity, and manage risk to be within its risk appetite, to providereasonable assurance regarding the achievement of entity objectives. The process is effected byan entity‟s board of directors, management and other personnel, applied in strategy setting andacross the enterprise. 6ASNZ 4360 states that risk management is an integral part of good business practice and qualitymanagement. The standard further specifies that risk management means inter alia identifyingand taking opportunities to improve performance as well as taking action to avoid or reduce thechances of something going wrong.7The Institute of Risk Management in its risk management standard says Risk can be defined asthe combination of the probability of an event and its consequences (ISO/IEC Guide 73). In alltypes of undertaking, there is potential for events and consequences that constitute opportunitiesfor benefit (upside) or threats to success (downside). Risk Management is increasinglyrecognised as being concerned with both positive and negative aspects of risk. Therefore thisstandard considers risk from both perspectives.8The common theme arising from the various definitions are that risk management is amanagement process to deal with uncertainties faced by any entity, threats to its resources andits consequences, as it chooses the opportunities presented by its operating environment, toincrease the value of the entity.5 Corporate Risk Management 2nd edition Tony Merna and Faisal F Al Thani6 COSO ERM7 ASNZ 43608 A Risk Management Standard - 26 February 2011) 11
  13. 13. 2.2 Risks faced by an Islamic Financial institutionCommon risks faced by an Islamic Financial Institution are shown in Figure 2.1 (author‟s own)below: Risks faced by IFI’s Credit Risk Price Risk Profit Rate Risk Pure Risks Liquidity Risk Commodity or Exchange Damage to assets Legal Liability Asset Price Risk Rate RiskPrice risk is the context of an Islamic Financial Institution is that the value of the underlyingcommodity or asset which forms the basis of the contract between the Islamic financialinstitution and the financed party will vary from the original price. The exchange rate risk ariseswhen the rate of exchange fluctuates for its funding and also financing transaction.Credit risk is the uncertainty of the financed party being unable to meet its obligations to theIslamic Financial Institution as and when they fall due. This is a speculative risk undertakenwith an objective of a gain, with the possibility of a loss.Profit rate risk is the risk that the profit generated from partnership contracts will not be asenvisaged or the profit rate indicated to the institutions investment account holders will not besufficient or balanced. Furthermore, some investment account holders benchmark this profit ratewith interest rates offer by conventional banks, and can move their funds to conventionalfinancial institutions.Liquidity risk arises due to two main reasons, firstly the inherent mismatch been the term of thesource of funds (deposits which are mainly short-term) and the destination of the funds (projectfunding which are mainly long-term) and secondly the risk that the funds raised by the IslamicFinancial Institution from the Capital markets in form of Sukuk‟s and expected to be repaid andat that point in time there is no appetite from buyers to purchase the new issue.Pure risks are risks for which there is potential for only a downside and is best exemplified bydamage to owned assets or property and legal liability due to being sued by third parties likecustomers and employees among others. 12
  14. 14. Key Drivers of Risk- Figure 2.2(Adapted from A Risk Management Standard – Institute of Risk Management) Externally Driven Financial Risks Strategic Risks Foreign Exchange Risk Competition Interest Rate Risk/Profit rate Customer Changes and Demands Credit Risks Industry Structure Changes Liquidity and cash flow Research and product development Internally Driven Accounting controls Products and Services Information systems Legal Contracts National Culture and Regulations Property destruction Operational Risks Hazard Risks Externally Driven 13
  15. 15. 2.3 The Concept of Risk and UncertaintyRisk is simply defined as a probability of a loss or gain. One situation is riskier than another if ithas a greater expected loss or a greater uncertainty (defined as the variability around theexpected loss).9 Therefore risk is linked to the quantum of loss or profit (risk reward ratio) i.e.the probability of an event occurring causing either a gain or loss and how much the gain/lossvaries from the expected outcome which is an average.Business inevitable has to undertake risk in its daily activities as perfect information is a myth.Risk is usually thought of in respect of a negative event happening, the probability of ithappening and the quantum of the loss when it occurs. Uncertainty is said to exist in a businesstransaction whereby the decision-makers lack complete knowledge, information orunderstanding of the proposed transaction and its possible consequences.In his seminal work Risk, Uncertainty, and Profit, Frank Knight (1921) established thedistinction between risk and uncertainty.10“Uncertainty must be taken in a sense radicallydistinct from the familiar notion of Risk, from which it has never been properly separated. Theterm "risk," as loosely used in everyday speech and in economic discussion, really covers twothings which, functionally at least, in their causal relations to the phenomena of economicorganization, are categorically different. The essential fact is that "risk" means in some cases aquantity susceptible of measurement, while at other times it is something distinctly not of thischaracter; and there are far-reaching and crucial differences in the bearings of the phenomenondepending on which of the two is really present and operating. ... It will appear that ameasurable uncertainty, or "risk" proper, as we shall use the term, is so far different from anunmeasurable one that it is not in effect an uncertainty at all. We accordingly restrict the term"uncertainty" to cases of the non-quantitive type.9 Risk Management & Insurance 2nd edition Harrington and Niehaus10 accessed on 26 February 2011 14
  16. 16. 2.4 The Risk Management ProcessRisk Management deals both with insurable as well as uninsurable risks and is an approachwhich involves a formal orderly process for systematically identifying, analysing andresponding to risk events.1 (Merna & Al Thani 2010).A diagrammatic representation of the Risk Management Process Figure 2.3 adapted from ARisk Management Standard by the Institute of Risk Management4 Organisation’s Strategic Objectives Risk Assessment  Risk Analysis - Risk Identification - Risk Description - Risk EstimationModifications  Risk Evaluation Formal Audit Risk Reporting: Threats and Opportunities Risk Treatment Th Residual Risk Reporting MonitoringDefinitionsRisk Assessment: Is the overall process of risk analysis and risk evaluation.Risk Reporting: Threats & Opportunities to Board of Director & affected Business ManagersRisk Treatment: Is the process of selecting and implementing measures to modify the risk.Residual Risk Reporting: to its stakeholders on a regular basis setting out its risk managementpolicies and the effectiveness in achieving its objectivesMonitoring: This process provides assurance that there are appropriate controls in place for theorganisation‟s activities and that the procedures are understood and followed. 15
  17. 17. There are two major dimensions of a loss exposure are the loss frequency and loss severity.Loss frequency is measured by probability of the occurrence of an event based on pastexperience. Loss severity is measured by maximum possible loss and expected loss. Henceclassification of risk in accordance with these two dimensions is the starting point in managingrisk. In the view of business it is sensible to focus on exposures to risks rather than the potentialupside. The key exposures to risk in any organisation are physical asset exposures, legal liabilityexposures, human resource exposure and financial asset exposures.2.5 Risk Management Tools and TechniquesThere are two major categories of risk management tools and techniques used by riskprofessionals to analyse risk namely Quantitative techniques and Qualitative techniques, whichare applied to the dimensions of loss exposures. Qualitative techniques seek to compare therelative significance of risk faced by an enterprise in terms of the consequences to it.Quantitative techniques and tools attempt to determine absolute value ranges, using statisticaltools like probability distributions to quantify probable outcome.Qualitative Techniques for risk management include Brainstorming, Assumption Analysis,Delphi, Interviews, Hazard and Operability Studies (HAZOP), Failure Modes and EffectCriticality Analysis (FMECA), Checklist, Prompt list, Risk Registers, Risk Mapping,Probability Impact Tables, Risk Matrix Chart, Project Risk Management Road Mapping.Quantitative techniques for risk management include Decision Trees, Controlled Interval andMemory Technique, Monte Carlo Simulation, Sensitivity Analysis and Probability-Impact GridAnalysis.Other techniques include Soft Systems Methodology, Utility Theory, Risk attitude and UtilityTheory, Nominal Group Technique, Stress Testing and Deterministic Analysis, TornadoDiagram, Country Risk Analysis and Political Risk Analysis.Risk Control techniques include Risk Avoidance by not undertaking the activity which can leadto a loss, Loss Control which include Loss prevention (reducing the frequency of losses) andLoss reduction (reducing the severity of losses), Risk Separation this reduces the probabilitythat several losses will at the same time , Risk Combination/pooling increases the predictabilityof losses through the law of large numbers and Risk Transfer which can include transferring thecause of the risk, transferring the risk itself, transferring the cause of the risk and transferring theconsequence of the risk through insurance. 16
  18. 18. Contracts can be used to mitigate or transfer risk like insurance contracts for hazard (pure riskslike theft, fire etc), derivative contracts (options, forwards, futures and swaps) to mitigateagainst financial risks like commodity prices, foreign exchange risks, interest rate risks andcontracts where risk is transferred to the counterparty through legal clauses.The choice of the technique whether to assess the risk or alter the risk depends on the context ofthe situation, availability and the resources including time and money to the organisation.Hence, there is no one set of techniques to ensure universal applicability.2.6 SummaryRisk management should be embedded within the organisation through the strategy and budgetprocesses. It should be highlighted in induction and all other training and development as wellas within operational processes e.g. product/service development projects. The Board has theoverall responsibility for determining the strategic direction of the organisation and for creatingthe environment and the structures for risk management to operate effectively. There should bea risk champion on the board to ensure the board is aware of the risks under taken by the entityand decide whether these are acceptable. Business unit managers s have primary responsibilityfor managing risk on a day to-day basis, hence risk management should be a regularmanagement-meeting item to allow consideration of exposures and to reprioritise work in thelight of effective risk analysis. The same awareness of risk issues is also required for thoseinvolved in the audit and review of internal controls and facilitating the risk managementprocess and includes both the internal audit function and external auditors. 17
  19. 19. Chapter 3: Islamic Finance3.1 IntroductionIslamic finance constitutes the fastest growing segment of the financial system in the world.Modern Islamic banking started about three decades ago, the number and reach of Islamicfinancial institutions worldwide has risen from one institution in one country in 1975 to over300 institutions operating in more than 75 countries (El Qorchi, 2005)11. In Sudan and Iran, theentire banking system is currently based on Islamic finance principles. However the roots of theIslamic Banking system goes back back through time to the profit and loss sharing principles inthe Code of Hammurabi in the 18th century BCE. Over the centuries, philosophers andtheologians alike have debated the issues surrounding justness of exchange and the charging ofinterest. Charging of interest is long seen as damaging to individuals as well as the economy bythe majority of theologians and philosophers. Even the Christian Holy Bible and Jewish HolyTorah forbid Usury. This chapter will explore the general principle of Islamic Finance, brieflygoing into the sources of Islamic Law without going into the details of the various schools ofthought which are contentious issues even among Islamic scholars depending on whether theyare Sunni or Shia, region from which they come from (scholars from some regions are moreliberal than others). There are Islamic Scholars who have approved derivative s contracts(forward, swaps and options), while other scholars consider these as unlawful. An examplewould be HH Prince Karim Aga Khan IV Imam to Nizari Ismaili Shia Muslims, direct linealmale descendant of the Prophet Mohamed (PBUH) and widely respected in the Muslimcommunity worldwide has a different opinion on the interest which is not usury therefore not“Riba” which is prohibited in the Quran, hence he has significant interests in conventionalbanking institutions both in the developed and developing world, which is significantly alteringthe economic lives of people living in those countries. In the other end of the Shia spectrum liesthe Mustali Ismaili Shia Muslims, in whose view even instalment sale contracts where thecurrent cash price and instalment sale price differ is considered unlawful and profit loss sharingwithout the investor being actively involved in the business is prohibited, This based on theprinciple, all earnings have to be from the individuals sweat, law of one price and avoidance ofexcessive profit. Then it will give a bird‟s eye view of Islamic Banking, which is a bankingsystem that is based on the principles of Islamic law and guided by Islamic economics. Twobasic principles behind Islamic banking are the sharing of profit and loss and, significantly, theprohibition of the collection and payment of interest. Collecting interest is not permitted underIslamic law.11 IMF Working Paper WP/08/16 Islamic Banks and Financial Stability: An Empirical AnalysisPrepared by Martin Čihák and Heiko Hesse 18
  20. 20. Thereafter, we shall take a peek into the world of Islamic insurance – Takaful, which is basedon risk pooling and sharing rather than risk transfer. Takaful is where members contributemoney into a pooling system in order to guarantee each other against loss or damage. Takaful isbased on Islamic religious law, and is based on the responsibility of individuals to cooperate andprotect each other. Lastly, it will explore Islamic Capital Markets products the most well knowis the Islamic bond called a Sukuk. Since interest is prohibited Sukuks must be able to linkthe returns and cash flows of the financing to the assets purchased, or the returns generated froman asset purchased. This is because trading in debt is prohibited under Sharia. Assuch, financing must only be raised for identifiable assets. It can be compared to a sale,lease/rent and buy back transaction in conventional finance.3.2 Islamic Finance general principlesThe guiding principles of Islamic Finance are based on Islamic Law (Sharia) as documented inthe Holy Quran and promulgated in the Sunnah (Hadith - sayings and living habits/acts ofProphet Mohamed (PBUH), which are universally accepted by all Muslims. Different schoolsof jurisprudence both Sunni and Shia place different level of emphasis on secondary sourceslike Ijma (consensus of Scholars), Ijtihad (independent legal reasoning), Qiyas (analogicaldeduction), Aql (use intellect to find general principles applicable in the situation from the HolyQuran and Sunnah ), saying and acts of Shia Imams who are descendents of Prophet Mohamed–PBUH according to Shia beliefs they are responsible for guiding the Muslims ummah andinterpreting the Holy Quran according to the changing time and space, Urf (common practicesof a given society not addressed in the Holy Quran and Sunnah) and Al-Maslaha Al-Mursalah(Maliki Sunni) "underlying meaning of the revealed text in the light of public interest". 12Islamic Finance is based on the prohibition of interest ("Riba"), excessive uncertainty("Gharar") and gambling ("Maysir" or "Qimar"). Being Sharia compliant also means that thefunding should not be for the purposes of haram (prohibited activities) like pornography,building a brewery or casino or a pork farm etc. Judaism and Christianity also prohibit usury(interest) in their religious texts the Torah and Bible respectively. Holy Quran commands honestfulfilment of all contracts (al-Maidah: 1); prohibits the betrayal of any trust (al-anfal: 27);forbids the earning of income from cheating, price manipulation, dishonesty or fraud (an-nisa‟a:29); shuns the use of bribery to derive undue advantage (al-baqarah: 188); and promotes clarityin contracts to minimise manipulation from dubious ambiguity (al-baqarah: 282)12 (accessed 14th March 2011) 19
  21. 21. 3.3 Islamic BankingThe roots of Islamic banking goes to the time of the establishment of the Islamic Arab empire -the Caliphate which conquered vast areas in Middle Central Asia, North Africa and parts ofEurope in the 7th Century, where systems of payments and finance were required whichincluded Qardan Hasannah (interest free loan), Hawallah (promissory notes/ bills of exchange),a currency (Dinar), Waqf (trusts), to facilitate trade and mercantilism and pay the employees ofthe Islamic state. However, this dissertation shall focus on modern Islamic banking, which isbased on the following concepts - Definitions adapted from FAS 1 issued by AAOIFI13:-Mudarabha - A partnership in profit between capital and labour. It may be conductedbetween investment account holders as providers of funds and the Islamic bank as amudarib. The Islamic bank announces its willingness to accept the funds of investmentamount holders, the sharing of profits being as agreed between the two parties, and thelosses being borne by the provider of funds except if they were due to misconduct,negligence or violation of the conditions agreed upon by the Islamic bank. In the lattercases, such losses would be borne by the Islamic bank. A Mudarabha contract may alsobe concluded between the Islamic bank, as a provider of funds, on behalf of itself or onbehalf of investment account holders, and business owners and craftsmen.Salam : - Purchase of a commodity for deferred delivery in exchange for immediate paymentaccording to specified conditions or sale of a commodity for deferred delivery in exchange forimmediate payment.Murabaha : - Sale of goods with an agreed upon profit mark up on the cost. Murabaha sale isof two types. In the first type, the Islamic bank purchases the goods and makes it available forsale without any prior promise from a customer to purchase it. In the second type, the Islamicbank purchases the goods ordered by a customer from a third party and then sells these goods tothe same customer. In the latter case, the Islamic bank purchases the goods only after a customerhas made a promise to purchase them from the bank.Musharaka : - A form of partnership between the Islamic bank and its clients whereby eachparty contributes to the capital of partnership in equal or varying degrees to establish a newproject or share in an existing one, and whereby each of the parties becomes an owner of thecapital on a permanent or declining basis and shall have his due share of profits. However,13 Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) (accessed 14 March 2011) 20
  22. 22. losses are shared in proportion to the contributed capital. It is not permissible to stipulateotherwise.Istisna’a : - A contract whereby the purchaser asks the seller to manufacture a specificallydefined product using the seller‟s raw materials at a given price. The contractual agreement ofIstisna‟ has characteristic similar to that of Salam in that it provides for the sale of a product notavailable at the time of sale. It also has a characteristic similar to the ordinary sale in that theprice may be paid on credit; however, unlike Salam, the price in the Istisna‟ contract is not paidwhen the deal is concluded.Ijarah and Ijarah Wa Iktana:- A lease agreement (similar to a hire purchase agreement)whereby instead of lending money and earning interest, the Islamic bank purchases the asset andrents it to the party requiring the asset and earns rental income. In ijarah wa iktana the renteragrees to buy the asset at a nominal price at the end of the contract, in ijarah there is no suchagreement to purchase the asset.3.4 Islamic Insurance – TakafulTakaful is an Arabic word meaning guaranteeing each other. An Islamic insurance(Takaful) industry observing the rules and regulations of Islamic Sharia law hasdeveloped in recent years, which in common with Islamic banking avoids interest,excessive uncertainty and gambling. However this concept has been practiced in variousforms for over 1400 years based on shared responsibility in the system of aquila aspracticed between Muslims of Mecca and Medina, which laid the foundation of mutualassistance insurance – Takaful based on risk pooling and sharing today. Although someMuslim scholars consider any form of insurance to be against the concept that Muslimsbelieve in God, who is the provider and sustainer of all and is based on the followingverse from the Holy Quran “Who, when a misfortune overtakes them, say: Surely webelong to Allah and to Him shall we return.". (Sura Al-Baqara, Verse 156)Takaful is based on the concept of social solidarity, cooperation and mutualindemnification of losses of members. It is a pact among a group of persons who agreeto jointly indemnify the loss or damage that may inflict upon any of them, out of thefund they donate collectively. The Takaful contract so agreed usually involves theconcepts of Mudarabah (partnership in profit), Tabarru´ (to donate for benefit of others)and Ta-Awun (mutual assistance or sharing of losses) with the overall objective of 21
  23. 23. eliminating the element of uncertainty. Even though all Muslims believe in the will ofAllah who is the owner of everything and we are merely his stewards, the steward had aduty to protect the assets given to him in trust by the owner, hence justification for aSharia compliant Islamic alternative Takaful to conventional insurance. This view pointfor Takaful is justified based on the following Islamic jurisprudence sources14.Basis of Co-operation Help one another in al-Birr and in al-Taqwa (virtue, righteousness andpiety): but do not help one another in sin and transgression. (Holy Quran Surah Al-Maidah,Verse 2) and Allah will always help His servant for as long as he helps others. (Hadith Narratedby Imam Ahmad bin Hanbal and Imam Abu Daud)Basis of Responsibility The place of relationships and feelings of people with faith, betweeneach other, is just like the body; when one of its parts is afflicted with pain, then the rest of thebody will be affected. (Narrated by Imam al-Bukhari and Imam Muslim)One true Muslim (Mu‟min) and another true Muslim (Mu‟min) is just like a building wherebyevery part in it strengthens the other part. (Narrated by Imam al-Bukhari and Imam Muslim)Basis of Mutual Protection: - By my life, which is in Allah‟s Power, nobody will enter Paradiseif he does not protect his neighbor who is in distress. (Narrated by Imam Ahmad bin Hanbal)Key Elements of TakafulMutual Guarantee: Loss covered by donations of members in fund which pays out losses.Ownership of Fund: Contributors are owners of fund, hence entitled to the profit.Elimination of uncertainty: Donations are voluntary and no pre-determined benefits.Management of Takaful Fund: Operator uses either Mudaraba (Partnership) or Wakala(Principal Agent relationship ) contract to manage funds, which are Sharia compliant.Investments Conditions: Avoids interest and haram (prohibited) activities for investment.14 (accessed on 14 March 2011) 22
  24. 24. 3.5 Islamic capital marketsThere are two major components of Islamic capital markets namely Sukuk‟s (Sharia compliantbonds) and Islamic investment funds. Using the double entry sheet terminology the Sukuk sitson the credit side of the balance sheet hence is a liability, while Islamic investment funds sit onthe debit side of the balance sheet hence an asset. Both the capital market instruments aremarket traded on organised stock exchanges, with some restrictions on the tradability of debtinstruments.Sukuk is the Arabic word for financial certificate, commonly analogous to a bond (promise topay) in conventional finance. It is asset based rather than asset backed to comply with shariarequirements. The beauty of the Sukuk lies in asset securitisation, whereby future cash flowsemanating from an asset are converted into present cash flow. A sukuk can be created on anexisting asset and also on a future asset which is being created. The sukuk can be structured asSukuk Murabaha which constitutes partial ownership in a debt, Sukuk Al Ijara which is assetbacked, Sukuk Al Istisna which is project backed, Sukuk Al Musharaka which is businessbacked or Sukuk Al Istithmar which is an investment. From a strict sharia perspective debtcertificates are not tradable at a price other than at par or face value, as any money generatedfrom holding money is considered interest which is prohibited, hence most sukuk instrumentsare held to maturity. Therefore the secondary market although in exists but has limited trades.An Islamic investment fund is a Sharia compliant fund which invests in halal activites, avoidsexcessive uncertainty, avoid interest and is not overly speculative (gamble). These can bestructured as a mutual fund, a hedge fund or electronic traded fund (ETF).The common types of investments funds are commodity funds, equity funds, murabahafunds and Ijara funds.Commodities funds generate profits by buying and reselling commodities. Due to therestrictions on the use of derivatives, commodities fund make use of two types of contracts: 1. Istina‟a- It‟s a contract where the buyer of an item funds upfront the production of the item. A detailed specification of the item as to be agreed before production starts and the cost of production has to be paid in full when the contract is agreed. 2. Bay al-salam which is similar to a forward contract where the buyer pays in advance for the delivery of raw materials or tangible goods at a later date.Equity funds invest in equity shares of companies engaged in halal business activities. These aresimilar to ethical investing funds. 23
  25. 25. Murabaha funds are similar to development funds, and use the „cost-plus‟ financing model,where a fund will buy goods and sell them to a third party at a given price. The price is made ofthe cost of goods plus a profit margin.Ijara Funds acquire and keep ownership of an asset (real estate, machinery, vehicles orequipment) and then makes profits by leasing it out in return of a rental payment. The fund isresponsible for the management of the assets and will earns a management fee. This is similar toReal Estate Investments Trusts (REITs) and Energy Royalty Trusts (common in Canada).3.6 Differences between Islamic Finance and Conventional Finance instrumentsSukuk and BondsAccounting and Auditing Organisation for Islamic Financial Institutions (AAOIFI) defines asukuk as being: “Certificates of equal value representing after closing subscription, receipt ofthe value of the certificates and putting it to use as planned, common title to shares and rights intangible assets, usufructs and services, or equity of a given project or equity of a specialinvestment activity”. Hence, it is a mezzanine financial instrument that is neither debt norequity, created by a process of securitization of cash flow and ownership of an asset or project.The sukuk holder shares in the cash flow generated by the asset and the disposition proceed ofthe assets. A bond on the other hand is a contractually obligation to pay to bondholders, oncertain specified dates, interest and principal.Takaful and InsuranceTakaful is based on the principles on mutual assistance and voluntary contribution in a pool offunds to be shared among those in the group afflicted by perils or calamities, without guaranteesthat the fund will be adequate of expectation that the operator will earn a profit. In conventionalinsurance the insurer collects premium from the insured to cover expected payout and profit,this is akin to speculation (Maysir) which is forbidden in Islamic Finance. The insurer payspremiums to be covered for risks that may or may not materialize, this is uncertainty (Gharar),which is also forbidden in Islamic Finance. Lastly, the premiums collected are invested to earninterest (usury) which is forbidden in Islamic Finance.3.7 SummaryThe basic principles underlying the Islamic Finance concept are very similar to ethicalinvesting, co-operative arrangements, and mutual principles, very closely aligned toconventional financial products but avoiding interest, excessive uncertainty and speculation. 24
  26. 26. Chapter 4: Importance of Risk Management in Islamic Finance4.1 IntroductionProduct complexity in Islamic Finance has increased as there is a trend to develop an Islamicvariant for most products in non-Islamic finance, but the pace in risk management practices hasnot developed at the same rate. This has been attributed (Ahsan Ali, December 2009)15 to thefollowing:- Lack of Standardised product descriptions and attributes within Islamic Finance. Lack of understanding of Islamic structures and therefore, weak regulatory frameworks within countries to manage Islamic Financial Institutions (IFIs). Limited data on Islamic transaction and low technological adaptability for technology-based risk management models. Concentration of Islamic Finance institutions in emerging markets, where the risk management techniques for both conventional and Islamic modes of financing lag the developed markets.Due to the above reasons it is (Ahsan Ali, 2009)15 postulated that Islamic Financial Institutionsare inherently riskier propositions than their conventional counterparts.The above arguments can be countered by the following:- Standardisation of product descriptions, Islamic Finance Structures and accounting attributes are taking places through the efforts of Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI) and Islamic Financial Services Board (IFSB). However, having two bodies with similar objectives and membership of which is voluntary by Islamic Financial Institutions creates confusion in the perception of the general public. Furthermore, there is weak enforcement capability as these organizations do not have credible sanctions mechanisms, to enforce application of standards set. Islamic Finance is no longer confined to the developing world as London and New York are becoming major centers for Islamic Capital Market products, hence risk management techniques are improving and technological developments will catch up. The data availability is increasing especially in Malaysia and Gulf markets, with publications like Business Islamica, Gulf news quarterly and Global Islamic Finance.15 Risk Management Integral to the Future of Islamic Finance – Article in Business Islamica December2009 25
  27. 27. Risk management in Islamic Finance is driven by the principles of Islamic economics which arederived from the Holy Quran and Sunnah of Prophet Mohamed (PBUH). Hence it is prone tothe usual risks faced by all financial institutions plus risks which affect primarily IslamicFinancial Institutions. The importance of the concept of risk management in Islamic Finance isemphasised by the following verse in the Holy Quran and Saying of Prophet Mohamed (PBUH)Further he said: "O my sons! Do not enter the capital of Egypt by one gate: but go into it bydifferent gates. However know it well that I cannot ward off you Allah‟s will for none otherthan He has nay authority whatsoever. On Him do I put my trust and all who want to rely uponanyone should put their trust on Him alone." (Surah Yusuf: Verse 67)Prophet Muhammad noticed a Bedouin leaving his camel without tying it and he asked theBedouin “Why didn‟t you tie down your camel?” The Bedouin answered, “I put my trust inGod.” Muhammad replied, “Tie your camel and put your trust in God.”In this chapter the author shall identify risks faced by Islamic Financial Institutions, look at riskaffected due to its economic model or how normal business risks uniquely affect them. Then theauthor shall look at threats posed by these risks and consequently how those risks can be dealtwith. Finally it shall discuss Islamic Financial Instruments which are used in Islamic Financewhich mitigate certain risks but create a different type of risk for an IFI.4.2 Identification of risks in the Islamic Finance economic modelCredit RiskThis is the risk whereby the borrower defaults on the loan. In the Islamic Financial Institution‟s(IFI‟s) context this means the counter party defaults on its contractual obligation and the IFI hasto foreclose on the underlying asset, this becomes particularly challenging in the instance ofresidential real estate instalment sale transaction, which would conflict with its responsibility tosociety. It is important to note that IFI‟s generally have greater exposure to real estate thanconventional banks, where the bank becomes owner of the asset which according to IFRS thisneeds to be incorporated on its balance sheet, which creates additional volatility in its reportedearnings. Furthermore greater focus on asset financing through Ijara (leasing) and Murabaha(sale with profit mark-up), may cause a tendency to overlook credit worthiness and ability torepay of the counterparty.Market RiskHedging using conventional derivatives is restricted, as some scholars consider it to be Maysir(gambling) which is prohibited, hence the possibility of a higher than normal margin risk 26
  28. 28. especially in fixed margin Murabaha (sale with profit mark up) i.e. mismatch between what isearned on the assets and what is paid out on its investment accounts. These restriction leads toartificial inflation of values of investment opportunities as too much capital is chasing too fewassets. Furthermore, IFI‟s run a higher foreign exchange risk on their balance sheets particularlytranslation risk for banks with operation in multiple countries, which have to be consolidated asper IFRS requirements, due to limited opportunities to hedge.Operational RiskIFI‟s have to ensure correct processing and sequential documentation for most of itstransactions, as any error invalidates the entire transactions and profit has to be donated.Liquidity RiskThis is higher in IFI‟s as the secondary market for Islamic Capital market instruments isunderdeveloped, due to prohibition in sale of debt at a price other than at par. Thus most IslamicCapital market instruments are held to maturity, which restricts the ability to realise cash whenrequired repay investment account holders, hence a minor run on an IFI can have a major effecton its solvency, as it cannot access its central bank as lender of last resort.Reputational RiskThis is higher in IFI‟s due to the risk of Sharia compliance requirements, while Sharia decreesand decisions are not standardised or follow the principles of judicial precedence as in Englishcommon law. Sharia boards are made up of scholars, who sometimes disagree on products lineslike Tawaruk (Shariah-compliant of finance through which loan finance is raised by buyinginstallments in local commodities that are owned by the bank) which is acceptable to certainscholars and prohibited by others. The Sharia board of an IFI can be changed to get scholarswho are compliant to the wishes of the IFI‟s owners, hence they could be accused of “scholarshopping or fatwa shopping” which has the potential to damage its reputation in the eyes ofInvestment Account holders. This happened in Dubai during the recent global financial criseswhen some real estate developers wished to change the underlying assets of instruments in aprocess of consolidation of projects, which were considered unacceptable to certain scholars.Furthermore, fatwa‟s issued by prominent scholars not on the IFI‟s Sharia board also tend toinfluence behaviour of market participants. 27
  29. 29. Classical Islamic Law 16 classified risk in into three categories as follows:-1. Essential risk and al-kharāj bi-dhaman, which can be roughly translated as „the profit belongs to him who bears responsibility‟. This maxim encapsulates the concept of risk for return (al ghunm bil ghurm). Parties who enter into an agreement are entitled to its benefit as long as there is some form of associated risk. Without the risk, the transaction would not be shari‟a compliant. Any condition to the contrary would make the transaction void, such as anything contrary to the rule on a total or partial loss or decrease in value of an asset is on account of its owner). If one requires a return of some form, then one should be able to take on the associated level of risk. In an Islamic sales contract, the seller bears all the risks of loss of the asset until title is transferred to the buyer who then in turn takes on the full risks, including risks of defect, damage or depreciation arising thereafter. In an Islamic leasing arrangement, the lessor assumes all risks of loss (not caused by the lessee) and the risks of maintenance and payments of taxes. Whereas the lessee assumes the risks of rental payment, of any loss of profit and of under-utilisation associated with the rental of the asset. In a mudaraba arrangement, the risk of loss, damage or decrease in value of the mudaraba assets and capital is borne by the investor (rab al mal) as long as there is no default, misconduct or breach by the investment manager (mudarib).2. Gharar Katheer, which can be roughly translated as „excessive/gross uncertainty or speculation‟. Muslims are strictly prohibited from entering into this second category of risks as such risks make a transaction or a contract void from a shari‟a perspective. Whereas in conventional finance, this is a form of tradable risk which can be separated and sold on, or, which can be mitigated against. This form of risk is also known as gharar jaseem and it can be further classified into the following sub-types of prohibited risks: a. Risk in Existence (i.e., the sale of an non-existent item, such as crops, on a future basis); b. Risk in taking Possession (i.e., the sale of a run-away camel or commodity / property that has to be repossessed); c. Risk in Quantity (i.e., sale price or rent being unknown in a sale or lease contract); d. Risk in Quality (i.e., type, quantity or specifications of the subject matter of contract being unknown); and e. Risk in Time of Payment (i.e., a deferred sale without fixing the exact period). 16 Islamic Finance project Harvard Law School, Islamic Legal Studies Program, Harvard-LSE Workshop London School of Economics 26 February 2009 Workshop on Risk Management: Islamic Economic and Islamic EthicoLegal Perspectives on the Current Financial Crisis – A short Report Prepared by Husam El-Khatib Introduction by Zohaib Patel. 28
  30. 30. Involvement of any of the above types of risks make contracts of consideration or exchange(aqood al muawadat) void with the unanimous opinion of the jurists. In contracts of gifts ordonations (aqood al tabarro‟at), the majority of jurists are of the opinion that these risks makesuch forms of contracts void, with the exception of Maliki jurists who view risks in contracts ofgifts are permissible. From this Maliki opinion, contemporary jurists have derived that takaful ispermitted despite containing Risks in Existence, Possession, Quantity and Period.These risks are deemed excessive and gross in nature as they fall into the categories of gamblingand speculation, being some of the causes for the current global financial crisis. Short sales forinstance are prohibited on the basis they fall foul of the rule on Risk of Possession; they involvethe sale of something (i.e., shares) which are not owned by the seller at the time of the initialsale. Also, the sale and trading of debt falls foul of the above prohibited categories of risks assuch activities carry with them additional („gross‟) levels of risks, such as the possibility of non-payment of the debt by the actual debtor.An important corollary to the prohibition on excessive risk is that shari‟a does not permit a partyto intentionally take on such forms of excessive risks and then to hedge against those same riskswith the help of some form of hedging or risk management tool, irrespective of whether theactual hedging/risk management tool is shari‟a compliant in itself or not.3. The third category can be described as a level in between the former two. This can include a variety of forms of risk, including market risk and operational risk. This is not a risk that is part of a financing tool‟s inherent structure per se. Therefore, this type of risk can be mitigated against or avoided.4.3 Threats posed by risks peculiar to Islamic financeInsolvencyThe threat of insolvency is higher than average due by lack of liquidity in Islamic assetinstruments and securities due to an under developed secondary markets and lack of access tocentral bank as lender of last resort in case of a run by investment account holders on theIslamic Financial Institution. This happens because of the mismatch of maturity term betweenInvestment account deposits and the longer term financing arrangements. Also mostinstruments are held to maturity due to prohibition on sale of debt other than at par, so whenthere is a short-term liquidity crunch its effects are more severe unless its owners have fundselsewhere to provide liquidity, which the usual response is to withdraw from other marketscausing a domino effect. 29
  31. 31. Reputational Damage to the Islamic Finance Brand/SegmentDue to the fragmented nature of Sharia decisions and decrees, which are developedindependently by scholars in different markets, without having judicial precedencerequirements, with some scholars from different schools of thought being more liberal thanother, widespread acceptance is difficult, especially for controversial issues. This prevents anorderly development of standards of product development and financial reporting. A point tonote is that IFI‟s are required to confirm to the financial reporting framework of its country ofoperation. A general fatwa by prominent scholar not on a particular IFI‟s Sharia board cancause loss of credibility and confidence by the consumers if he makes a compelling argument inpublic about a particular transaction or product developed and IFI and approved by its Shariaboard. This is a controversial issue for Islamic Credit card issuers (fixed fee based) and processon changing underlying security for a sukuk or project funding transaction in the event of realestate project consolidation on the crash in real estate market. This is compounded by lack of auniversally accepted body for determining mandatory product standards and financial reporting,plus membership of AAOIF and IFSB is voluntary. In short the risk borne by an IFI is productis approved by its Sharia board, but vocally disapproved by a leading scholar, causing areputational disaster in the perception of the public, aggravated if the scholar was a dissentingformer member of the Sharia advisory board.Greater potential for volatility of reported earningsIFI‟s financial statements if prepared and compliant with International Financial ReportingStandards (IFRS) have to report financial instruments and assets using “mark to market”principles, due to the requirement of ownership of assets which have to be reported on thebalance sheet and movement in value passing through the income statement, caused profits tofluctuate more than conventional financial institutions. This aggravates during economicdownturn, as not only are the financial instruments subject to downward valuation, also losseson assets which will eventually be sold to counterparties.Operational Risk - ContractsIslamic Finance transactions are subject to multiple contracts to make them compliant withSharia rules, the threat of misclassification of a transaction can lead to a requirement fordifferent type of contract which if missed would negate the entire transaction i.e. making it non-Sharia compliant. This is further compounded by lack suitable trained finance personnel inSharia Law and Sharia scholars suitably trained in finance to structure Islamic Financialtransactions appropriately. 30
  32. 32. 4.4 How to deal with the risks identifiedInsolvencyInsolvency caused by lack of liquidity in Islamic Financial Instruments and Sharia non-compliance of short-term funding from lender of last resort (Central Bank) could be solved byforming a supra-national body to bailout Islamic Financial Institution‟s funded by a voluntarydonation each year say 0.2% of the member institution‟s operating profits. This fund could alsobe used to buy illiquid instruments from IFI‟s to finance short-term liquidity constraints, giveQardan Hasanah (interest free good loan) to IFI‟s for their short –term liquidity needs, andoperated on a mutual assistance basis. It could also act as manager of last resort to protectinvestment account holder‟s funds in case of eminent collapse of a member IFI. This measurewould have a positive impact on the credibility of the Islamic Finance market and improve itsreputation. Qardan Hassanah mentioned in The Holy Quran If you lend unto Allah QardanHasanah , He will multiply it for you and He will forgive you, for Allah is the MostAppreciative , Most Forbearing (Verse 64-17)Reputational Damage to the Islamic Finance Brand/SegmentA supra-national co-ordinating body (possibly formed by the merger of AAOIFI and IFSB withunification of standards) which operates a global database of Islamic Financial productsapproved by validly constituted Sharia advisory boards, irrespective of national, sectarian ordoctrinal bias, preferable based in a neutral International Financial Centre like London. Thisbody could also have a depository of experts on Islamic Law and Finance which could reviewproducts developed which have been challenged by other scholars and considered acceptable byothers by giving an independent opinion (a form of judicial review). Financial reporting forIFI‟s could benefit if the industry would petition the International Accounting Standards Board(IASB) to consider issuing an International Financial Reporting Standard (IFRS) for IFI‟s.Operational Risk – ContractsThis risk can be dealt with by having well reputed scholars on Sharia boards with persons withknowledge of both Islamic Law and Financial knowledge and belonging to multiple schools ofthought or Islamic jurisprudence, to enable a diversified meaningful debate, when consideringIslamic Products. Furthermore more personnel working within IFI should be encouraged to becertified by globally reputed Institutions like the Chartered Institute of ManagementAccountant‟s17 Certificate in Islamic Finance qualification.17 31
  33. 33. 4.5 Islamic Financial Instruments/Transactions – Risk Mitigation and Risk CreationSukuk (Sharia compliant bond equivalents) and Ijara (lease or buy and rent contracts)Islamic Financial Institutions that either issue or purchase Sukuk or enter into Ijara contracts areinvesting in real assets. The return on these assets takes the form of rent, and is uniformlyspread over the rental period. The underlying asset provides additional security for the investorand the productivity of the asset is the basis of the return on investment. The claim embodied inSukuk is not simply a claim to cash flow but an ownership claim. Hence, interest risk isavoided and so is the risk of the fluctuation of the value of the borrowing (as selling of debt at aprice other than at par is forbidden), which mitigates the financial risk of the entity. Howeverthe ownership claim has to be reflected in the balance sheet of the IFI which results in volatilityof earnings and balance sheet values due to mark to market rules required for most financialreporting frameworks. Furthermore, the prohibition of the sale of debt other than at par,prevents the development of the secondary market in these securities, creating liquidityconstraints as these are not easily convertible to cash.Musharaka and MudarabaUnder these transactions the Islamic Financial Institution participates in the profit or loss of thetransaction, instead of receiving interest. These transactions even though compliant with Shariacreate above average credit risk, as a known amount of cash flow in form of interest is replacedby an uncertain amount of profit or loss.Derivatives Instruments in Islamic FinanceThis is one area which has the most controversy in Islamic Finance, as some of the hadith‟sused to justify derivative contracts like futures, options and forwards are challenged by manyscholars, plus the lack of understanding of the workings of these instruments among Shariascholars and the larger public. However, this dissertation would like to take the view that it isonly a matter of time and financial education of Sharia scholars in the working of derivatives tohedge against market risks faced by IFI‟s like currency risk and commodity risk, that Shariacompliant products will gain widespread use. The main argument against derivatives are that ithas excessive uncertainity (Gharar) and is gambling (Maysir). A comment in support ofdevelopment of Islamic derivative products by a scholar is stated - "we should realize that evenin the modern degenerated form of futures trading, some of the underlying basics concepts aswell as some of the conditions for such trading are exactly the same as were laid down by theProphet Mohamed (PBUH) for forward trading. For example, there are clear sayings of theProphet Mohamed (PBUH) that he who makes a Salaf (forward trade) should do that for a 32
  34. 34. specific quantity, specific weight and for a specified period of time. This is something thatcontemporary futures trading pays particular attention to." (Fahim Khan, 1996) 18A recent development in Iran is to allow trading Islamic Derivative products.The Securities and Exchange Organization of Iran has put on agenda to add new Islamicinstruments such as Derivative Securities, Istisna & Murabaha in Capital Market as of the nextIranian calendar year (March 21, 2011).19(Ali Salehabadi, Iran Daily 8th March 2011)4.6 SummaryIt is well understood that Risk Management is Integral for Islamic Financial institutions, whichis supported by both statements in the Holy Quran and traditions of the Prophet Mohamed(PBUH). It has been seen that Islamic financial transactions are interest (Riba) free, abhorsuncertainty (Gharar), and eschews gambling (Maysir), however these are not risk free. IslamicFinancial Instruments mitigate against certain risks, while creating others for Islamic FinancialInstitutions.The effect of the recent global financial crises on Islamic Financial Institutions has beenminimal, some commentators have tried to portray this as the superiority of the Islamiceconomic system which eschews uncertainty, interest and gambling. This is because one of thekey causes was complex derivative products like credit default swap (CDS) and collateraliseddebt obligations (CDO) which very few people understood how they operate and the risksinbuilt in these instruments. While it is agreed that Islamic Financial Institutions would haveavoided these instruments, however some Islamic Financial Institutions For example, a numberof renowned players in the management of Islamic funds, such as The Investment Dar (TID)and Global Investment House (GIH), both based in Kuwait, have suffered major losses duringthe crisis and have become technically insolvent. Plus the debt crises of Dubai and itsconsequent real estate market crash revealed excessive speculation. Hence, a majority of IslamicFinancial Institutions while relatively immune because they were not in the centres where thefinancial markets were sophisticated. Furthermore, the experience of Kuwait Finance Houseduring the Souk Al Manakh20, is a signal for Islamic Financial Institutions to be vigilant aboutrisk management, as being Islamic will not protect them from excessive speculation.18 Fahim Khan (Islamic Futures and their Markets, Research Paper No.32, Islamic Research and Training Institute,Islamic Development Bank, Jeddah, Saudi Arabia, 1996, p.12)19 (21 March 201120 (accessed 25 March 2011) 33
  35. 35. Chapter 5: Analysis of Risk Management disclosures in Financial Statements5.1 IntroductionThis chapter will look at disclosed information on Risk Management in the published financialstatements of three Islamic Financial institutions namely:- Meezan Bank (Pakistan) Khaleej Takaful (UAE) Al Baraka Banking group (Kingdom of Bahrain)Disclosures on risk management made in the financial statements will be analysed in referenceto figure 2.2 Key Drivers of Risk in Chapter 2.5.2 Meezan Bank (Pakistan) - based on the Annual Report 2009Meezan bank is a Pakistan based bank offering retail, corporate and investment bankingservices i.e. savings products, Investment products, credit cards, trade finance, capital raising(Sukuk) for corporate clients and the Government of Pakistan. The products are similar to thoseoffered by conventional banks.Risk Management Framework (Annual Report 2009 - Operations review & Note 40)“Risk management is an integral part of the business activities of the Bank. The Bank managesthe risks through a framework of risk management policies and procedures, organizationalstructure and risk measurement and monitoring mechanism that are closely aligned with theoverall operations of the Bank. Risk management activities broadly take place at differenthierarchy levels. The Board of Directors provides overall risk management supervision whilethe management of the Bank actively ensures that the risks are adequately identified, measuredand managed. An independent and dedicated Risk Management department guided by a prudentand a robust framework of risk management policies and guidelines is in place.The Board has constituted the following committees for effective management of riskscomprising of the Board members: 1. Risk Management Committee 2. Audit CommitteeThe Risk Management Committee is responsible for reviewing and guiding risk policies andprocedures and control over risk management. The Audit Committee - comprised of three non-executive directors - monitors compliance with the best practices of the Code of CorporateGovernance and determines appropriate measures to safeguard the Banks assets.The Board has delegated the authority to monitor and manage different risks to the specializedcommittees at management level. These committees are comprised of senior management teammembers with relevant experience and expertise, who meet regularly to deliberate on the 34
  36. 36. matters pertaining to various risk exposures under their respective supervision. Such committeesinclude: 1. Credit Committee 2. Asset Liability Management Committee (ALCO)The Credit Committee is responsible for approving, monitoring and ensuring that financialtransactions are within the acceptable risk rating criteria. Well defined policies, procedures andmanuals are in place and authorities have been appropriately delegated to ensure credit quality,proper risk-reward trade off, industry diversification, adequate credit documentation andperiodic credit reviews.ALCO is responsible for reviewing and recommending all market risk and liquidity risk policiesand ensuring that sound risk measurement systems are established and comply with internal andregulatory requirements. The Bank applies Stress Testing and Value at Risk (VaR) techniquesas market risk management tools. Contingency Funding Plan for managing liquidity crisis is inplace. Liquidity management is done through cash flow matching, investment in commoditymurabaha, Sukuks and placements in foreign exchange. Treasury Middle Office monitors andensures that banks exposures are in line with the prescribed limits. The Bank ensures that thekey operational risks are measured and managed in a timely and effective manner throughenhanced operational risk awareness, segregation of duties, dual checks and improving earlywarning signals. The Bank has developed effective manuals and procedures necessary for themitigation of operational risk. The Bank has an Internal Audit department that reports directly tothe Audit Committee of the Board. Internal Audit independently reviews various functionalareas of the Bank to identify control weaknesses and implementation of internal and regulatorystandards. The Compliance department ensures that all directives and guidelines issued by theState Bank of Pakistan are being complied with in order to manage compliance and operationalrisks. The Internal Controls and Operational Risk Management Committee ensures adequateinternal controls and systems are in place thereby ensuring operating efficiency.The Board has constituted a full functional audit committee. The audit committee works toensure that the best practices of the Code of Corporate Governance are being complied by theBank and that the policies and procedures are being complied with. The Bank‟s riskmanagement, compliance, internal audit and legal departments support the risk managementfunction. The role of the risk management department is to quantify the risk and ensure thequality and integrity of the Bank‟s risk-related data. The compliance department ensures that allthe directives and guidelines issued by SBP are being complied with in order to mitigate thecompliance and operational risks. Internal audit department reviews the compliance of internalcontrol procedures with internal and regulatory standards. 35
  37. 37. RISK MANAGEMENT (Note 40)The wide variety of the Bank‟s business activities require the Bank to identify, measure,aggregate and manage risks effectively which are constantly evolving as the business activitieschange in response to credit, market, product and other developments. The Bank manages therisk through a framework of risk management, policies and principles, organisational structuresand risk measurement and monitoring processes that are closely aligned with the businessactivities of the Bank.40.1 Credit riskThe Bank manages credit risk by effective credit appraisal mechanism, approving and reviewingauthorities, limit structures, internal credit risk rating system, collateral management and postdisbursement monitoring so as to ensure prudent financingactivities and sound financing portfolio under the umbrella of a comprehensive Credit Policyapproved by the Board of Directors. The Bank also ensures to diversify its portfolio intodifferent business segments, products and sectors. Bank take into account the risk mitigatingeffect of the eligible collaterals for the calculation of capital requirement for credit risk. Useof credit risk mitigation (CRM) resulted in the total credit risk weighted amount of Rs.58,863.71 million whereas in the absence of benefit of CRM this amount would have been Rs.61,883.49 million. Thus, use of CRM resulted in improved capital adequacy ratio of the Bankfrom 12.25% (without CRM) to 12.77% (with CRM).40.1.2 Credit Risk - General Disclosures Basel II SpecificThe Bank is operating under standardised approach of Basel II for credit risk. As such riskweights for the credit risk related assets (on-balance sheet and off-balance sheet-market and nonmarket related exposures) are assigned on the basis of standardised approach.The Bank is committed to further strengthen its risk management framework that shall enablethe Bank to move ahead for adopting Foundation IRB approach of Basel II; meanwhile none ofour assets class is subject to the foundation IRB or advanced IRB approaches.40.2 Equity position risk in the banking book-Basel II SpecificThe Bank makes investment in variety of products/instruments mainly for the followingobjectives;- Investment for supporting business activities of the bank and generating revenue in short termor relatively short term tenure.- Strategic Investments which are made with the intention to hold it for a longer term and aremarked as such at the time of investment. 36
  38. 38. Classification of equity investmentsBank classifies its equity investment portfolio in accordance with the directives of SBP asfollows: - Investments - Held for trading - Investments - Available for sale - Investments in associates - Investments in subsidiariesSome of the above mentioned investments are listed and traded in public through stockexchanges, while other investments are unlisted.Policies, valuation and accounting of equity investmentsThe accounting policies for equity investments are designed and their valuation is carried outunder the provisions and directives of State Bank of Pakistan, Securities and ExchangeCommission of Pakistan and the requirements of approved International Accounting Standardsas applicable in Pakistan. The investments in listed equity securities are stated at the revaluedamount using market rates prevailing on the balance sheet date, while the investment inunquoted securities are stated at lower of cost or break-up value. The unrealized surplus /(deficit) arising on revaluation of the held for trading investment portfolio is taken to the profitand loss account. The surplus / (deficit) arising on revaluation of quoted securities classified asavailable for sale is kept in a separate account shown in the balance sheet below equity. Thesurplus / (deficit) arising on these securities is taken to the profit and loss account when actuallyrealised upon disposal. The carrying value of equity investments are assessed at each balancesheet date for impairment. If the circumstances exist which indicate that the carrying value ofthese investments may not be recoverable, the carrying value is written down to its estimatedrecoverable amount. The resulting impairment loss is charged to profit and loss account.Market riskThe Bank is exposed to market risk which is the risk that the value of on and off balance sheetexposures of the Bank will be adversely affected by movements in market rates or prices such asbenchmark rates, profit rates, foreign exchange rates, equity prices and market conditionsresulting in a loss to earnings and capital. The profit rates and equity price risk consists of twocomponents each. The general risk describes value changes due to general market movements,while the specific risk has issuer related causes. The capital charge for market risk has beencalculated by using Standardized Approach. The Bank applies Stress Testing and Value at Risk(VaR) techniques as risk management tool; Stress testing enables the Bank to estimate changesin the value of the portfolio, if exposed to various risk factor. VaR quantifies the maximum lossthat might arise due to change in risk factors, if exposure remains unchanged for a given periodof time. 37
  39. 39. 40.3.1 Foreign exchange riskThe foreign exchange risk is the risk that the value of a financial instrument will fluctuate due tothe changes in foreign exchange rates. The Bank does not take any currency exposure except tothe extent of statutory net open position prescribed by SBP. Foreign exchange open andmismatch position are controlled through internal limits and are marked to market on a dailybasis to contain forward exposures.40.3.2 Equity position riskEquity position risk is the risk arising from taking long positions, in the trading book, in theequities and all instruments that exhibit market behaviour similar to equities. Counter partieslimits, as also fixed by SBP, are considered to limit risk concentration. The Bank invests inthose equities which are Shariah compliant as advised by the Shariah adviser.40.3.3 Yield / Interest Rate Risk in the Banking Book (IRRBB) - Basel II SpecificIRRBB includes all material yield risk positions of the Bank taking into account all relevantrepricing and maturity data. It includes current balances and contractual yield rates. Bankunderstands that its financings shall be repriced as per their respective contracts. Regardingbehaviour of non-maturity deposits, the Bank assumes that 75% of those deposits shall fall inupto one year time frame and remaining 25% of those deposits shall fall in the range of one tothree years time buckets. The Bank estimates changes in the economic value of equity due tochanges in the yield rates on on-balance sheet positions by conducting duration gap analysis. Italso assesses yield rate risk on earnings of the Bank by applying upward and downward shocks.These IRRBB measurements are done on monthly basis.40.4 Liquidity riskLiquidity risk is the risk that the Bank either does not have sufficient financial resourcesavailable to meet its obligations and commitments as they fall due or can fulfil them only atexcessive cost that may affect the Bank‟s income and equity. The Bank seeks to ensure that ithas access to funds at reasonable cost even under adverse conditions, by managing its liquidityrisk across all class of assets and liabilities in accordance with regulatory guidelines and to takeadvantage of any lending and investment opportunities as they arise. 38
  40. 40. 40.5 Operational riskThe Bank uses Basic Indicator Approach (BIA) for assessing the capital charge for operationalrisk. Under BIA the capital charge is calculated by multiplying average positive annual grossincome of the Bank over past three years with 15% as per guidelines issued by SBP under BaselII. To reduce losses arising from operational risk, the Bank has strengthened its riskmanagement framework by developing polices, guidelines and manuals. It also includes set upof fraud and forgery management unit, defining responsibilities of individuals, enhancingsecurity measures, improving efficiency and effectiveness of operations, outsourcing andimproving quality of human resources through trainings.Critical Analysis There is a risk committee at board level and there is a Head of Risk Management as part of the senior management team. However in Meezan, he does not sit in the board of directors. It is suggested that “the key to making the enterprise or integrated approach actually happen is through the appointment of one key individual who takes charge of the whole process and is given the power at board level to follow through all ideas. Often the person is the Chief Risk Officer(CRO)” (Merna & Thani 2010)21 The Meezan bank‟s statement on risk management in the operations review and notes to the financial statements does not disclose its classification risks undertaken by kind of transaction and type of risk posed, mitigating factors and its response. Although it claims to have a robust risk management framework, the disclosures are skewed towards financial risks (probably due to focus by external auditors on quantifiable information) and scant reference to strategic risks and hazard risks. It would have been interesting to classify risks in accordance with type of transactions like Sukuk, Islamic Credit card business, Mudaraba, Ijara, Musharaka etc transactions, how these are mitigated and risks which are retained as part of the business undertaken.21 Corporate Risk Management 2nd Edition Merna and Thani 39
  41. 41. 5.3 Al Khaleej Takaful Insurance and Reinsurance Q.S.C.(Qatar)Al Khaleej is a fully fledged Takaful company offering the full range of insurance productssimilar to conventional insurance companies which are Sharia compliant in the State of Qatar.Risk Management Framework (extracts from Annual Report 2009 Note 25)The risks faced by the Group and the way these risks are mitigated by management aresummarised below.Insurance riskThe principal risk the Group faces under insurance contracts is that the actual claims and benefitpayments or the timing thereof, differ from expectations. This is influenced by the frequency ofclaims, severity of claims, actual benefits paid and subsequent development of long-termclaims. Therefore, the objective of the Group is to ensure that sufficient reserves are available tocover these liabilities. The above risk exposure is mitigated by diversification across a largeportfolio of insurance contracts. The variability of risks is also improved by careful selectionand implementation of underwriting strategy guidelines, as well as the use of reinsurancearrangements.Reinsurance riskIn common with other insurance companies, in order to minimize financial exposure arisingfrom large claims, the Group, in the normal course of business, enters into agreements withother parties for reinsurance purposes. Such reinsurance arrangements provide for greaterdiversification of business, allow management to control exposure to potential losses arisingfrom large risks, and provide additional capacity for growth. A significant portion of thereinsurance is effected under treaty, facultative and excess-of-loss reinsurance contracts.To minimize its exposure to significant losses from reinsurer insolvencies, the Group evaluatesthe financial condition of its reinsurers and monitors concentrations of credit risk arising fromsimilar geographic regions, activities or economic characteristics of the reinsurers. Reinsuranceceded contracts do not relieve the Group from its obligations to policyholders and as a result theGroup remains liable for the portion of outstanding claims reinsured to the extent that thereinsurer fails to meet the obligations under the reinsurance agreements. The two largestreinsurer account for 32% of the maximum credit exposure at 31 December 2009 (2008: 45%). 40