This document discusses risk management in Islamic banking. It begins with definitions of risk management and describes the risk management process. It then outlines the major risks faced by both Islamic and conventional banks, as well as unique risks faced only by Islamic banks. The document discusses the Shariah perspective on risk, as well as tools for risk mitigation and measurement. It provides guidance principles from Basel, IFSB, and other organizations and discusses challenges in capturing unique risks of Islamic banking. It concludes with ten rules of risk management and a word of caution about managing risks in life.

2. 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

3. 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

4. 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

5. 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.

6. 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.

7. 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

8.  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

9.  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

10. 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

11. 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

12. 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

13. 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

14. RISK FACTORS
 Following are the risk factors faced by IB’s
 Financial
 Business
 Operational

15. 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

16. BUSINESS RISK FACTORS
 Management Risk
 Planning
 Organizing
 Reporting
 Monitoring
 Strategic Risk
 Research and Development
 Product Design
 Market Dynamics
 Economic

17. OPERATIONAL RISK
 People Risk
 Relationships
 Ethics
 Legal Risk
 Compliance
 Control
 System Risk
 Hardware
 Software
 External Risk
 Event
 Client
 Security

18. 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. INDUSTRY AVERAGES

20. CREDIT RISK

21. MARKET RISK

22. LIQUIDITY RISK

23. OPERATIONAL RISK

24. 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

25. 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. SEVERITY OF RISKS

27. 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

28. 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

29. 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)

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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

37. 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.

38. 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

39. 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

40.  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

41. 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 .