Risk management in islamic banking


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Slide show for detailed information about risk management in Islamic banking and how it is different from conventional banking
includes risk failures models, risk mitigation tools etc.

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Risk management in islamic banking

  1. 1. RISK MANAGEMENT IN ISLAMIC BANKING Presentation By Arslan Asif arsi2774@gmail.com delldanger@hotmail.com May 31, 2013 THE UNIVERSITY OF LAHORE Lahore School Of Accountancy And Finance
  2. 2. DISCUSSED BELOW:  Risk management  Definition  Introduction  Risk management process  Risk management activities  Risks faced by banks  Common types of risks faced by both Islamic & conventional banks  Unique risks faced by Islamic banks  Major unique risks faced by Islamic banks only  Shariah perspective  Risk mitigation tools  Risk measurement  Risk management Governance  Guiding principles for risk management  Challenge: How to capture unique risk of Islamic banking system  Conclusion  Ten rules to risk management  Word of caution
  3. 3. WHAT IS RISK?  Risks are uncertain future events that could influence the achievement of the objectives, including :  Strategic  Operational  Financial  Compliance Uncertain future events could be: • Failure of a borrower to repay a financing • Fluctuation of foreign exchange rates • Fraud, incomplete security documentations, etc. • Non-compliance with Shariah law and principles • Other events that may result in a loss to the Bank
  4. 4. RISK MANAGEMENT PROCESS  What is risk management?  Risk management is the process which involves Identification, measurement, monitoring, reporting and controlling risks to ensure that:  Risk taking Decisions are in line with the business strategy and objectives set by BOD.  The expected payoffs compensate for the risks taken.  Risk taking decisions are explicit and clear.  The organization’s Risk exposure is within the limits established by Board of Directors.  The individuals who take or manage risks clearly understand it.  Sufficient capital as a buffer is available to take risk.
  5. 5. RISK MANAGEMENT ACTIVITIES  Risk management activities take place at:  Strategic level by senior management and BOD  Definition of risks, formulating strategy and policies for managing risks and establish adequate systems and controls to ensure that overall risk remain within acceptable level and the reward compensate for the risk taken.  Macro Level within business area/across business lines  Risk reviews by middle management  Micro Level where risks are actually created  Activities performed by individuals who take risk on organization’s behalf such as front office and loan origination functions. Confined to following operational procedures and guidelines set by management.
  6. 6. EXAMPLES OF RISK MANAGEMENT FAILURES  Barings / Nick Leeson (1995)  Barings Singapore reported SIMEX trade losses of GBP 850 million  Brought down the whole bank…  National Australia Bank (2004)  FX derivative losses of AUD 360 million  Allied Irish Bank / John Rusnak (2001)  US subsidiary Allfirst reported FX Options trading losses of USD 750 million  LTCM, Hedge Fund (1998)  Bond Market losses wiping out capital of USD3.9 billion  Fed and consortium of US Banks bailout
  7. 7.  Sumitomo / Yasuo Hamanaka (1996)  Commodity (copper) trading losses of USD1.8 billion  Orange County, CA, USA (1994)  Equity losses of USD2 billion  Reverse repos / over-leveraged  Societe Generale, France (2008)  Jerome Kerviel traded Euro stock index futures and concealed losses up to almost EUR 5.0 bio
  8. 8.  The 2008 -… Financial Crisis  Lack of Management / Board oversight  Weak risk culture  Risk Management function marginalized  Over-reliance on quantitative tools /methodologies  Poor liquidity management  Lack of relevant internal valuation models
  9. 9. RISKS FACED BY BANKS  Risk Dimensions Types of Common risks Both Islamic and conventional banking Credit risk The potential that a counterparty fails to meet its obligations in accordance with agreed terms and conditions of a credit related contract Market risk The potential impact of adverse price movements such as benchmark rates, foreign exchange rates, equity prices on the economic value of an asset Liquidity risk The potential loss arising from the Bank’s inability either to meet its obligations or to fund increases in assets as they fall due without incurring unacceptable costs or losses Operational risk The potential loss resulting from inadequate or failed internal processes, people and system or external events
  10. 10. BANKS  ISLAMIC BANKING LESS RISKY?  Islamic Banking is safer as it is not based on INTEREST  Depositors are liable to share losses, therefore solvency risk is mitigated  MAJOR UNIQUE RISKS FACED BY ISLAMIC BANKS ONLY Types of Unique risks Islamic banking Only Shariah noncompliance risk Risk arises from the failure to comply with the Shariah rules and Principles Rate of return risk The potential impact on the returns caused by unexpected change in the rate of returns
  11. 11. Types of Unique risks Islamic banking Only Displaced Commercial risk The risk that the bank may confront commercial pressure to pay returns that exceed the rate that has been earned on its assets financed by investment account holders. The bank foregoes part or its entire share of profit in order to retain its fund providers and dissuade them from withdrawing their funds. Equity Investment risk The risk arising from entering into a partnership for the purpose of participating in a particular financing or general business activity as described in the contract, and in which the provider of finance shares in the business risk. This risk is relevant under Mudarabah and Musharakah contracts. Inventory risk risk arising from holding items in inventory either for resale under a Murabahah’ contract, or with a view to leasing under the Ijarah contract
  12. 12. RISK PROFILE OF ISLAMIC BANKS . Islamic Bank Rate of return risk Displaced Commercial risk Equity Investment risk Inventory risk Shariah noncompliance risk Credit risk Market risk Liquidity risk Operational risk uniquecommon
  13. 13. RISK FACTORS  Following are the risk factors faced by IB’s  Financial  Business  Operational
  14. 14. FINANCIAL RISK FACTORS  Credit Risk  Default Risk  Counter Party Risk  Settlement Risk  Market Risk  Price Risk  Rate of return Risk  Exchange rate Risk  Liquidity Risk  Funding Liquidity Risk  Asset Liquidity Risk  Cash Management Risk
  15. 15. BUSINESS RISK FACTORS  Management Risk  Planning  Organizing  Reporting  Monitoring  Strategic Risk  Research and Development  Product Design  Market Dynamics  Economic
  16. 16. OPERATIONAL RISK  People Risk  Relationships  Ethics  Legal Risk  Compliance  Control  System Risk  Hardware  Software  External Risk  Event  Client  Security
  17. 17. PERCEPTION OF ISLAMIC BANKING INDUSTRY ABOUT RISKS  The research asked Islamic banks to rank the Islamic modes of finance used by them from 1 (least severe) to 5 (most severe) in terms of risks.  Responses of some Major Islamic banks are included.
  19. 19. CREDIT RISK
  20. 20. MARKET RISK
  23. 23. SHARIAH PERSPECTIVE  No Risk No Reward principle (Al Ribh Bi Daman)  Measures taken by Hazrat Yousuf (A.S) for drought (Ahsan ul Qasas)  Do not give your Amwal to Sufahaa  Writing of contracts – whether spot or deferred (Legal risk, Documentation risk etc.)  Maqasid-e-Shariah  Protection of Izat, Jaan, ‘Aql, Maal, Nasl
  24. 24. RISK MITIGATION TOOLS Following are the tools for the mitigation of risk. Pledge of assets as collateral  Inventories, Shares, Sukuk, Units etc. Third party Guarantee Personal Guarantee Promise Charge on deposits and assets Takaful Hamish Jiddiya Urbun Khiyar / Option Parallel contract, if permissible
  26. 26. RISK MEASUREMENT  Risk measurement deals with quantification of risk exposures. It includes:  Risk measurement methods  Traditional  GAP analysis  Duration analysis  Statistical analysis  Scenario analysis  Modern portfolio theory  Variation from the mean
  27. 27. RISK MANAGEMENT GOVERNANCE  Risk management Governance structure Managing Director Chief Risk Officer Board Board Risk Committee Board Risk Committee Board Audit Committee Board Audit Committee Other Board sub committees Other Board sub committees Chief Internal Auditor Compliance / Shariah SupportSupport CFO, CTO, etc CFO, CTO, etc Business Divisions Business Divisions HRHR
  28. 28. GUIDING PRINCIPLES FOR RISK MANAGEMENT These includes •BASEL Committee on Banking Supervision •Islamic Financial Services Board (IFSB) •Bank Negara Malaysia (BNM) •Institute of International Finance (IIF)
  29. 29. BASEL  1988 Capital Accord (Basel I)  Regulatory based  Set out requirements to calculate capital charge i.e. the amount of capital to be set aside to absorb potential loss across banks and across countries  One size fits all  1996 Basel I (Amendments)  Market Risk was incorporated into Basel I  2004 International Convergence of Capital Measurement and Capital Standards (Basel II)  Aims to make capital requirements more risk sensitive  Includes Operational Risk  Bank shall be subject to 3 mutually reinforcing pillars  2010 Basel III (Response to Financial Crisis)  Enhanced capital ratios, liquidity ratios, leverage ratio
  30. 30. IFSB STANDARDS WWW.IFSB.ORG  IFSB-1 Guiding Principles of Risk Management  IFSB-2 Capital Adequacy Standard  IFSB-3 Corporate Governance  IFSB-4 Transparency and Market Discipline  IFSB-5 Supervisory Review Process  IFSB-6 Islamic Collective Investment Schemes  IFSB-7 Sukuk, Securitizations and Real Estate  IFSB-8 Takaful  IFSB-9 Conduct of Business  IFSB-10 Shariah Governance Systems
  31. 31. BANK NEGARA MALAYSIA (BNM) WWW.BNM.GOV.MY  Islamic Banking Act 1983  Guidelines on Capital Adequacy (CAFIB)  Guidelines on Financial Reporting  Guidelines on Anti Money Laundering  Guidelines on Prudential Limits and Standards
  32. 32. INSTITUTE OF INTERNATIONAL FINANCE (IIF) WWW.IIF.COM  Final Report of the IIF Committee on Market Best Practices:  Principles of Conduct and Best Practice Recommendations  Financial Services Industry Response to the Market Turmoil of 2007-2008
  33. 33. CHALLENGE: HOW TO CAPTURE UNIQUE RISK OF ISLAMIC BANKING SYSTEM  The answer is to develop Internal Rating Systems (IRSs) in IBs  IRSs can be considered as risk-based inventories of individual assets of banks either based on the loss given default (LGD) of the facility or probability of default (PD) of the obligor or both  Most IRSs are JUDGMENTAL NOT STATISTICAL
  34. 34. USES OF IRSS  IRSs differ from bank to bank, from use to use  IRSs are used for a number of purposes:  guiding credit origination process,  portfolio monitoring and management reporting  Analysis of adequacy of loan loss reserves and capital  Profitability and loan pricing analysis  Input to formal mathematical modes of risk management  Facilitate prudential bank supervision
  35. 35. DESIRABILITY OF IRSS FOR ISLAMIC BANKING SYSTEM  To capture the diverse nature of the Islamic modes of finance  Internal ratings are based on the profile of individual assets, not on a bucket of assets  Internal ratings help the development of systematic database of critical financial variables  Internal ratings supplement external credit assessment  Internal ratings can enhance external ratings  Internal ratings improve quality of MISs
  36. 36. SOURCES AND INPUTS OF IRSS  Client oriented system - probability of default (PD)  Facility oriented system - value of an asset expected to be lost in the event of a default (loss given a default: LGD)  In both cases: balance sheet value of total asset i.e., Exposure-at- Default (EAD)  Maturity of facility  Concentration of credit to the specific client as a percentage of total portfolio etc.
  37. 37. CONCLUSION  There are differences in terms of risks faced by Islamic banks compared to conventional banks  As a result, the risk assessment techniques need to consider these risks  The fast-paced development of Islamic banking means that risk assessment approach needs to be continuously refined
  38. 38. TEN RULES TO RISK MANAGEMENT  There is no return without risks  Rewards go to those who take risks  Be transparent  Risk should be fully understood  Seek experience  Risk is measured and managed by people, not by mathematical models  Know what you don’t know  Question the assumptions made  Communicate  Risk should be discussed openly
  39. 39.  Diversify-avoid concentration  Multiple risks will produce more consistent rewards  Show discipline  A consistent and rigorous approach will beat a constantly changing strategy  Use common sense  It is better to be approximately right, than to be precisely wrong  Return is only half of the equation  Decisions should be made only after considering the risks and returns of the possibilities  Oversight must be enterprise-wide  Risks cannot be managed in isolation
  40. 40. A WORD OF CAUTION  Risk Management of your life is important than everything.  Would you ever think about it.  Various risks are related with our body and Soul. Some of them could harm a lot and some less.  Kindly Think about it .