Warren edwardes iibi islamic finance risk 041215


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Warren edwardes iibi islamic finance risk 041215

  1. 1. Risk characteristics of Islamic financial products <ul><li>Institute of Islamic Banking & Insurance </li></ul><ul><li>London 15th December 2004 </li></ul><ul><li>Warren Edwardes, </li></ul><ul><li>ceo , Delphi Risk Management Limited </li></ul><ul><li>email : [email_address] </li></ul><ul><li>web : dc3.co.uk </li></ul>
  2. 2. Delphi’s website contains : <ul><li>articles on Islamic banking on : d c3.co.uk/ islamicbanking </li></ul><ul><li>This PowerPoint is on : dc3.co.uk / islamicfinancerisk041215.ppt </li></ul><ul><li>with notes on dc3.co.uk / islamicfinancerisk041215.pdf </li></ul><ul><li>Speech drawn from the book &quot;Key Financial Instruments&quot; </li></ul><ul><li>Appendix 1 (50 Risk types) </li></ul><ul><ul><li>dc3.co.uk / risks .htm </li></ul></ul><ul><li>Appendix 4 (Islamic banking) </li></ul><ul><ul><li>dc3.co.uk /islamicbanking.htm </li></ul></ul>
  3. 3. financial risk <ul><li>some actions can protect </li></ul><ul><li>the same actions can destroy </li></ul><ul><li>risk – a film </li></ul>
  4. 5. <ul><li>Does Islamic banking risk differ from Conventional banking risk? </li></ul><ul><li>Not different - just a very special case </li></ul><ul><ul><li>Trade credit ? </li></ul></ul><ul><ul><li>Asset backed Secured or unsecured ? </li></ul></ul><ul><ul><li>Debt or equity ? </li></ul></ul><ul><ul><li>Leasing ? </li></ul></ul><ul><ul><li>Repos / Murabaha ? </li></ul></ul><ul><ul><li>Fund management ? </li></ul></ul><ul><li>Islamic Banking is ALL about who bears risk </li></ul>
  5. 6. A check-list of 50 banking risk types <ul><li>To put it simply and directly, </li></ul><ul><li>if the bosses do not or cannot understand both the risks and rewards in their products, </li></ul><ul><li>their firm should not be in the business. - </li></ul><ul><li>William J. McDonough, President, Federal Reserve Bank of New York </li></ul>
  6. 7. banking risk types - 1- 4 <ul><li>Acquisition Risk </li></ul><ul><ul><li>Different cultures between banks “consolidating” </li></ul></ul><ul><li>Careless Error Risk </li></ul><ul><ul><li>Human error should be forgiven. But this is not covered by law </li></ul></ul><ul><li>Competitive Risk  </li></ul><ul><ul><li>LIBOR determines competitors returns </li></ul></ul><ul><li>Commodity Risk </li></ul><ul><ul><li>If you take delivery can the commodity price be managed?   </li></ul></ul>
  7. 8. banking risk types - 5 - 8 <ul><li>Communication Risk  </li></ul><ul><ul><li>Define terms clearly </li></ul></ul><ul><ul><li>Deposit or managed funds? </li></ul></ul><ul><li>Country Risk  </li></ul><ul><ul><li>much of Islamic banking is carried out in emerging markets. Riskier? Pakistan is stable in the eyes of Mid East investors </li></ul></ul><ul><li>Credit Risk </li></ul><ul><ul><li>Not loans. Not IOUs. So equity not loan risk </li></ul></ul><ul><li>Cultural Risk  </li></ul><ul><ul><li>Difference between Gulf and Malaysia - narrowing </li></ul></ul>
  8. 9. banking risk types – 9-12 <ul><li>Currency Transaction Risk </li></ul><ul><ul><li>use of derivatives generally not allowed? Cannot hedge exchange rate for purchases </li></ul></ul><ul><li>Currency Translation Risk </li></ul><ul><ul><li>Balance sheet value of dollar assets or liabilities fluctuate </li></ul></ul><ul><li>Currency Economic Risk </li></ul><ul><ul><li>Again no hedging permitted. So can Malaysia compete with USD based countries when the USD depreciates? </li></ul></ul><ul><li>Customer Satisfaction Risk </li></ul><ul><ul><li>If a bank pays no dividends customers will get angry </li></ul></ul>
  9. 10. banking risk types - 1 3 - 16 <ul><li>Disaster Recovery Risk </li></ul><ul><ul><li>If a terrorist or earthquake strikes can you cope? </li></ul></ul><ul><li>Economic Activity Risk </li></ul><ul><ul><li>Applies when overheads are fixed. Outsourcing a solution </li></ul></ul><ul><li>Energy Price Risk  </li></ul><ul><ul><li>Many Islamic countries’ economies are linked to the oil price </li></ul></ul><ul><li>Environment Risk </li></ul><ul><ul><li>Are environment unfriendly policies haram? </li></ul></ul>
  10. 11. banking risk types - 17 - 20 <ul><li>Equity Market Risk  </li></ul><ul><ul><li>Islamic banking is ideally profit and loss sharing. This is venture capital or equity investment </li></ul></ul><ul><li>Fraud (banker) Risk </li></ul><ul><ul><li>Transparency is required. Avoid the risk of misinterpretation and mis-selling </li></ul></ul><ul><li>Fraud (customer) Risk </li></ul><ul><ul><li>If an investor loses money will he seek redress? Of course if he wins he will not </li></ul></ul><ul><li>Fraud (staff) Risk </li></ul><ul><ul><li>Haram for lenders to seek material benefit. BCCI was not an Islamic bank but fraud could occur in Islamic banks </li></ul></ul>
  11. 12. banking risk types - 21-2 4 <ul><li>Image / PR Risk  </li></ul><ul><ul><li>Something hallal could be deemed haram. Sep 11 was bad PR for Islamic banks </li></ul></ul><ul><li>Information Risk  </li></ul><ul><ul><li>Lack of transparency in accounts in many Islamic countries </li></ul></ul><ul><li>Inflation Risk  </li></ul><ul><ul><li>Securitised asset rises in value but not the repayment amount which being a cash amount depreciates. Time value of money? </li></ul></ul><ul><li>Interest rate Risk  </li></ul><ul><ul><li>This is not a closed economy. If interest rates rise sharply deposits will flow out. LIBOR linking </li></ul></ul>
  12. 13. banking risk types - 2 5 - 27 <ul><li>Interaction Risk  </li></ul><ul><ul><li>Correlation risk. What happened in New York and Baghdad impacts on KL. Gold standard? </li></ul></ul><ul><li>Language Risk  </li></ul><ul><ul><li>Arabic, English, Malay, Indonesian, Urdu? Same word can have different meanings. </li></ul></ul><ul><li>Legal Risk  </li></ul><ul><ul><li>UK, Malaysian, .. Is the bank / customer permitted to carry out such business?. Ultra Vires issue </li></ul></ul>
  13. 14. banking risk types - 2 8 -3 0 <ul><li>Liquidity Risk  </li></ul><ul><ul><li>Major problem for Islamic banking is the absence of a developed Islamic money market. </li></ul></ul><ul><ul><li>about managing confidence and the liability side </li></ul></ul><ul><ul><li>About managing diversification. </li></ul></ul><ul><li>Morbidity Risk </li></ul><ul><ul><li>No different from conventional banking. What happens if there is an outbreak of dengue fever or Anthrax?   </li></ul></ul><ul><li>Mortality Risk  </li></ul><ul><ul><li>Do you have offices in a tall building? </li></ul></ul><ul><ul><li>Would you survive major loss through fire? </li></ul></ul>
  14. 15. banking risk types - 3 1 -3 4 <ul><li>Operational Risk </li></ul><ul><ul><li>Are strong procedural systems in place? Really everything other than market risks </li></ul></ul><ul><li>Performance Measurement Risk  </li></ul><ul><ul><li>Most measures of performance are crude and slavish adherence to rules can lead to poor real performance </li></ul></ul><ul><li>Political Risk  </li></ul><ul><ul><li>Seizure of assets post Sep 11; boycotts by Western banks </li></ul></ul><ul><li>Competence / Understanding  </li></ul><ul><ul><li>Are the latest products really understood by the banks’ senior management? By the customers? </li></ul></ul>
  15. 16. banking risk types - 3 5 - 38 <ul><li>Concentration of assets Risk </li></ul><ul><ul><li>A problem for Islamic funds. No tobacco, banking and alcohol stocks can lead to heavy weighting in property and technology </li></ul></ul><ul><li>Concentration of liabilities Risk </li></ul><ul><ul><li>Do you have enough investors or do you depend on one or two? </li></ul></ul><ul><li>Concentration of business type Risk </li></ul><ul><ul><li>Financial supermarket or nimble niche player are both fine. But can you reinvent yourself if markets change? </li></ul></ul><ul><ul><li>Can you cope with the entry of HSBC / Barclays / Citibank? </li></ul></ul><ul><li>Convertibility Risk </li></ul><ul><ul><li>Deliverability risk under exchange controls </li></ul></ul>
  16. 17. banking risk types - 39 -4 2 <ul><li>Property (Real Estate) Risk  </li></ul><ul><ul><li>Would asset backing be sufficient in times of a property crash? </li></ul></ul><ul><li>Rating Agency Risk  </li></ul><ul><ul><li>A downgrading or even credit watch can impact on liquidity and the entire business. Investment grade bonds do not default. They become junk and then default. </li></ul></ul><ul><li>Regulatory Risk  </li></ul><ul><ul><li>A firm operating globally will face different rules </li></ul></ul><ul><li>Religious Risk  </li></ul><ul><ul><li>A Hallal product may later be deemed Haram. Zero coupon bonds were once Hallal. Other than Malaysia no Central Shari’ah authority </li></ul></ul>
  17. 18. banking risk types - 4 3 -4 6 <ul><li>Resignation Risk  </li></ul><ul><ul><li>Over dependence on one person’s skills and market contacts? </li></ul></ul><ul><li>Settlement Risk  </li></ul><ul><ul><li>If there is no escrow account there is settlement risk on Murabaha and BBA </li></ul></ul><ul><li>Systemic Risk  </li></ul><ul><ul><li>Financial instability is contagious. Financial systems are closely inter-linked </li></ul></ul><ul><li>Tax Risk  </li></ul><ul><ul><li>Do the sale and repurchase transactions face VAT? Income tax or capital gains tax treatment? </li></ul></ul>
  18. 19. banking risk types – 47-49 <ul><li>Technological Risk  </li></ul><ul><ul><li>Are your fax confirmations going to your customer or a competitor? </li></ul></ul><ul><li>Transport Risk  </li></ul><ul><ul><li>traffic jams may have led to cancelled meetings which may never be rearranged </li></ul></ul><ul><li>Weather Risk  </li></ul><ul><ul><li>Could you hedge against the weather? KL’s 1998 smog and Kuwait’s burning oil fields probably had an adverse impact on employees health. </li></ul></ul><ul><ul><li>Weather derivatives are being traded. Haram? Weather Takaful? </li></ul></ul>
  19. 20. banking risk types – 50 <ul><li>Zero Risk </li></ul><ul><li>It’s impossible to take an unnecessary risk. </li></ul><ul><li>because you only find out whether a risk was unnecessary </li></ul><ul><li>after you’ve taken it </li></ul><ul><li>Giovanni Agnelli, President FIAT </li></ul>
  20. 21. Particular Islamic banking risk issues <ul><li>Liquidity – under developed money market </li></ul><ul><li>Interest rate Risk  </li></ul><ul><li>Commodity Risk </li></ul><ul><li>Communication Risk </li></ul><ul><li>Equity risk – fund management or banking? </li></ul><ul><li>Operational risk </li></ul><ul><li>Religious – Hallal or Haram? </li></ul><ul><li>Language Risk  - English, Arabic, Malay or Urdu </li></ul>
  21. 22. Risk Issues In Islamic Banking