Presentation slide for Risk Management in Islamic Finance

1. RISK MANAGEMENT
IN
ISLAMIC FINANCE
Mahyuddin Khalid

2. Market Risk
Content
Market Risk in Islamic Banks and
Conventional Banks
Urgency Of Market Risk
Scope Of Market Risk In Islamic Banks
• Rate of return risk
• Commodity price
• Foreign exchange rate
• Equity price
Managing Market Risk
Market Risk Mitigations In Islamic Banks
Learning Outcome
• To define the market risk
• To explain urgency of market risk
• To identify the scope of market risk
in Islamic banks
• To acknowledge market risk
mitigation in Islamic banks
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3. Definition
Market risk defined as:
 The potential financial losses suffered by financial institutions due
to movement in market prices; which is beyond control.
The sources of market risk includes movement of interest
rates, foreign exchange rates, or commodity prices.
In Islamic banks, market risk also arises from financing
assets too.
 E.g. market risk due to the movement of interest rates by the
central bank.
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4. Market Risk in Islamic Banks and Conventional
Banks
Islamic Banks Conventional Banks
Direct relationship between the fund user and
fund provider. In a mudarabah contract, due
to the P&L sharing, if the fund user’s business
fails, the depositors will not get any return. So,
depositor’s return depends on the fund user’s
performance not the bank.
The relationship between the bank and fund
users or depositors are independent of each
other. Depositors deal with the bank and are
assured of their deposits. Fund users deal with
the bank and irresponsible of the depositor’s
return.
Hibah is not guaranteed Interest is guaranteed
If the rates have been agreed in the
contractual agreement, they can’t be adjusted
Bank may adjust the deposit and financing
rates either due to market movement or
strategy.
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5. Introduction
Market Risk
 Systematic market risk
 Comes from overall movement of prices and policies in economy such as
Currency Market reference rate
 Non-systematic market risk
 Arises from situation where the price of a specific assets or instruments
charges
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6. Urgency of Market Risk
Islamic bank is considered to bear more risk and be less
profitable than conventional banks which caused by:
The lack of and the interbank money market
Inadequate legal framework
The lack of shariah compliant hedging instruments and
methods
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7. Scope Of Market Risk In Islamic Banks
Market risk can be categorized into four risks:
 Rate of return risk
 Commodity price
 Foreign exchange rate
 Equity price
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8. Rate Of Return Risk
 Rate of return risk or benchmark rate risk related to interest rate
 The risk occurring when there is a mismatch between the yield
actually generated by an asset compared to the expected rates.
 This risk naturally happens when of the bank’s investment
generates unexpected returns due to shifts in the market.
 Rate of return risk also occurs when the expected returns are
not met due to the market price movement.
 In murabahah (which has fixed rate of return) when actual
return in lower than expected rate (agreed in contract), this will
resulted to loss e.g loss of depositors (investors) which may
withdraw their participation in the P&L sharing contract
 IFI cannot adjust their benchmarking rates, thus there are risks
arising from movement of market rates
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9. Commodity Price Risk
 Commodity price risk is one of the dominant drivers of price risk. Commodity price
risk is a risk possessed by the bank by having the physical assets (commodities)
before they are traded or sold
 Any changes in market price before and after asset acquisition is part of market
price
 Commodity risk is risk arising from movements of commodity price.
 Commodity risk occurs when there is potential price changes of a commodity
planned to be purchased or sold.
 In murabahah, the bank is financing at a certain agreed price plus profit margin.
The
difference between the agreed price and current market price upon delivery is the
commodity risk.
 In salam and istisna, the price of commodity should be defined though the
commodity is
subject to future delivery. In case where actual market price differs from the
contractual
agreed price, there is possibility of commodity risk.
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10. Foreign Exchange Rate
FX rate risk refers to risk arises from the change in currency
price against another
The exchange rate risk occurs due to exchange rate
fluctuations between the purchase and sale time, or as the
results of conducting business, specifically due to
maintaining assets and liabilities in different currencies.
Exchange rate risk only has two results: loss or gain.
Depends on the direction of changes to the exchange rate
and the bank’s position when it happens.
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11. Equity Risk
This risk happens in a contract with a profit-sharing
scheme as well as indirect investment in the capital market.
This risk faced by Islamic bank when the income expected
from this investment decreases in value, cause by
fluctuations in the market as well as the business cycle that
can affect asset price movements in the financial market.
Eg : if the share price of a company that an Islamic bank
invested in plummets because business is bad, the Islamic
bank experiences a manifested market risk
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12. Managing Market Risk
In theory, in a full-fledged Islamic financial system, market
risk can be protected by applying shariah-compliant
contracts;
Shariah-compliant contracts require conditions to be
disclosed and agreed by the contracting parties. The
elements of gharar must be eliminated as it is among the
impediments of contracts.
 E.g. In a home financing the profit rate has been declared by the
bank and made known to the customer before the signing of
contracts.
 E.g. in a bay’ salam contract, the price has been agreed prior to
delivery by the supplier. This protects the market risk of the buyer
due to increasing commodity price. 12

13. Market Risk Mitigations In Islamic Banks
In mitigating market risk, Islamic banks could use many
methods such as:
 Netting method
 Loss limit policy
 Asset securitization
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14. Netting method
An alternative method that can be used is cost revenue
matching
The basic strategies for the Islamic bank use to overcome
this potential exchange rate risk.
To ensure that every cost and income from an investment
is denominorate in the same currency
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15. Loss Limit Policy
Loss limit policy generally emphasizes exit strategies from
an investment if the business the bank have been invested
in begins to show sign of bankruptcy or major losses.
E.g The mudharabah and musyarakah financing scheme
can bring the bank into a situation in which contract ends
as a loss.
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16. Asset Securitization
A process of issuing certificates of ownership of a pool of
investment or business. e.g sukuk
The securitization principles in islamic finance :
Avoiding usury
The process must be free from gharar, tadlis and maysir.
The use of funds must always be syariah compliant.
The underlying assets should be in accordance with syariah
principles ( maal al – mutaqawwam).
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17. Mahyuddin Khalid
End of Chapter
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